In a rapidly changing world, you must change rapidly or suffer the consequences. In business, change requires investment.
A case in point is found in the entertainment industry. Technology is bringing about innovations so quickly that it is nearly impossible to guess which technologies will last and which will soon fade away. For example, will both satellite TV and cable TV survive? Or, will both be replaced by something else?
Consider the publishing industry as well. Will paper newspapers and magazines be replaced completely by online news? If you are a publisher, you have to make your best guess about what the future holds and invest accordingly.
Time Warner, Inc. lives at the center of this arena. It is not an environment for the timid, and Time Warner's philosophy is anything but that. Instead, it might be characterized as, “If we can't beat you, we will buy you.” Its mantra is “invest, invest, invest.” A list of Time Warner's holdings gives an idea of its reach:
Magazines: People, Time, Life, Sports Illustrated, Fortune.
Book publishers: Time-Life Books, Book-of-the-Month Club, Little, Brown & Co, Sunset Books.
Television and movies: Warner Bros. (“ER,” “Without a Trace,” the WB Network), HBO, and movies like Harry Potter and the Deathly Hollows: Part 2 and the Dark Knight Rises.
Broadcasting: TNT, CNN news, and Turner's library of thousands of classic movies.
Internet: America Online and AOL Anywhere.
Time Warner owns more information and entertainment copyrights and brands than any other company in the world.
The merger of America Online (AOL) with Time Warner, one of the biggest mergers ever, was originally perceived by many as the gateway to the future. In actuality, it was a financial disaster. It is largely responsible for much of the decline in Time Warner's stock price, from a high of $95.80 to a recent level of $32. Ted Turner, who was at one time Time Warner's largest shareholder, lost billions of dollars on the deal and eventually sold most of his shares. In 2009, Time Warner completed a spin-off of AOL after years of trying to integrate the two companies. One analyst called the failed deal “a nine-year adventure akin to a marathon through mud.”
Preview of Chapter 16
Time Warner's management believes in aggressive growth through investing in the stock of existing companies. Besides purchasing stock, companies also purchase other securities such as bonds issued by corporations or by governments. Companies can make investments for a short or long period of time, as a passive investment, or with the intent to control another company. As you will see in this chapter, the way in which a company accounts for its investments is determined by a number of factors.
The content and organization of Chapter 16 are as follows.
Corporations purchase investments in debt or stock securities generally for one of three reasons. First, a corporation may have excess cash that it does not need for the immediate purchase of operating assets. For example, many companies experience seasonal fluctuations in sales. A Cape Cod marina has more sales in the spring and summer than in the fall and winter. The reverse is true for an Aspen ski shop. Thus, at the end of an operating cycle, many companies may have cash on hand that is temporarily idle until the start of another operating cycle. These companies may invest the excess funds to earn—through interest and dividends—a greater return than they would get by just holding the funds in the bank. The role that such temporary investments play in the operating cycle is shown in Illustration 16-1.
Excess cash may also result from economic cycles. For example, when the economy is booming, General Electric generates considerable excess cash. It uses some of this cash to purchase new plant and equipment, and pays out some of the cash in dividends. But, it may also invest excess cash in liquid assets in anticipation of a future downturn in the economy. It can then liquidate these investments during a recession, when sales slow and cash is scarce.
When investing excess cash for short periods of time, corporations invest in low-risk, highly liquid securities—most often short-term government securities. It is generally not wise to invest short-term excess cash in shares of common stock because stock investments can experience rapid price changes. If you did invest your short-term excess cash in stock and the price of the stock declined significantly just before you needed cash again, you would be forced to sell your stock investment at a loss.
A second reason some companies purchase investments is to generate earnings from investment income. For example, banks make most of their earnings by lending money, but they also generate earnings by investing in debt. Conversely, mutual stock funds invest primarily in equity securities in order to benefit from stock-price appreciation and dividend revenue.
Third, companies also invest for strategic reasons. A company can exercise some influence over a customer or supplier by purchasing a significant, but not controlling, interest in that company. Or, a company may purchase a noncontrolling interest in another company in a related industry in which it wishes to establish a presence. For example, Time Warner initially purchased an interest of less than 20% in Turner Broadcasting to have a stake in Turner's expanding business opportunities. At a later date, Time Warner acquired the remaining 80%. Subsequently, Time Warner merged with AOL and became AOL Time Warner, Inc. Now, it is again just Time Warner, Inc., as indicated in the Feature Story.
A corporation may also choose to purchase a controlling interest in another company. For example, as the Accounting Across the Organization box on page 746 shows, Procter & Gamble purchased Gillette. Such purchases might be done to enter a new industry without incurring the tremendous costs and risks associated with starting from scratch. Or, a company might purchase another company in its same industry.
In summary, businesses invest in other companies for the reasons shown in Illustration 16-2.
Debt investments are investments in government and corporation bonds. In accounting for debt investments, companies make entries to record (1) the acquisition, (2) the interest revenue, and (3) the sale.
At acquisition, debt investments are recorded at cost. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.
For example, assume that Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2014, for $50,000. Kuhl records the investment as:
The Doan Inc. bonds pay interest of $2,000 semiannually on July 1 and January 1 ($50,000 × 8% × ½). The entry for the receipt of interest on July 1 is:
If Kuhl Corporation's fiscal year ends on December 31, it accrues the interest of $2,000 earned since July 1. The adjusting entry is:
Kuhl reports Interest Receivable as a current asset in the balance sheet. It reports Interest Revenue under “Other revenues and gains” in the income statement.
Kuhl reports receipt of the interest on January 1 as follows.
A credit to Interest Revenue at this time is incorrect because the company earned and accrued interest revenue in the preceding accounting period.
When Kuhl sells the bonds, it credits the investment account for the cost of the bonds. Kuhl records as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds.
Assume, for example, that Kuhl Corporation receives net proceeds of $54,000 on the sale of the Doan Inc. bonds on January 1, 2015, after receiving the interest due. Since the securities cost $50,000, the company realizes a gain of $4,000. It records the sale as:
Kuhl reports the gain on sale of debt investments under “Other revenues and gains” in the income statement and reports losses under “Other expenses and losses.”
Debt Investments
Waldo Corporation had the following transactions pertaining to debt investments.
Jan. 1 Purchased 30, $1,000 Hillary Co. 10% bonds for $30,000. Interest is payable semiannually on July 1 and January 1.
July 1 Received semiannual interest on Hillary Co. bonds.
July 1 Sold 15 Hillary Co. bonds for $14,600.
(a) Journalize the transactions, and (b) prepare the adjusting entry for the accrual of interest on December 31.
Record bond investments at cost.
Record interest when received and/or accrued.
When bonds are sold, credit the investment account for the cost of the bonds.
Record any difference between the cost and the net proceeds as a gain or loss.
Solution
Related exercise material: BE16-1, E16-2, E16-3, and DO IT! 16-1.
Stock investments are investments in the capital stock of other corporations. When a company holds stock (and/or debt) of several different corporations, the group of securities is identified as an investment portfolio.
The accounting for investments in common stock depends on the extent of the investor's influence over the operating and financial affairs of the issuing corporation (the investee). Illustration 16-3 shows the general guidelines.
Companies are required to use judgment instead of blindly following the guidelines.1 We explain the application of each guideline next.
In accounting for stock investments of less than 20%, companies use the cost method. Under the cost method, companies record the investment at cost, and recognize revenue only when cash dividends are received.
Helpful Hint The entries for investments in common stock also apply to investments in preferred stock.
At acquisition, stock investments are recorded at cost. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions), if any.
For example, assume that on July 1, 2014, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock. Sanchez pays $40 per share. The entry for the purchase is:
During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is:
Sanchez reports Dividend Revenue under “Other revenues and gains” in the income statement. Unlike interest on notes and bonds, dividends do not accrue. Therefore, companies do not make adjusting entries to accrue dividends.
When a company sells a stock investment, it recognizes as a gain or a loss the difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the stock.
Assume that Sanchez Corporation receives net proceeds of $39,000 on the sale of its Beal stock on February 10, 2015. Because the stock cost $40,000, Sanchez incurred a loss of $1,000. The entry to record the sale is:
Sanchez reports the loss under “Other expenses and losses” in the income statement. It would show a gain on sale under “Other revenues and gains.”
When an investor company owns only a small portion of the shares of stock of another company, the investor cannot exercise control over the investee. But, when an investor owns between 20% and 50% of the common stock of a corporation, it is presumed that the investor has significant influence over the financial and operating activities of the investee. The investor probably has a representative on the investee's board of directors. Through that representative, the investor may exercise some control over the investee. The investee company in some sense becomes part of the investor company.
For example, even prior to purchasing all of Turner Broadcasting, Time Warner owned 20% of Turner. Because it exercised significant control over major decisions made by Turner, Time Warner used an approach called the equity method. Under the equity method, the investor records its share of the net income of the investee in the year when it is earned. An alternative might be to delay recognizing the investor's share of net income until the investee declares a cash dividend. But, that approach would ignore the fact that the investor and investee are, in some sense, one company, making the investor better off by the investee's earned income.
Under the equity method, the investor company initially records the investment in common stock at cost. After that, it adjusts the investment account annually to show the investor's equity in the investee. Each year, the investor does the following. (1) It increases (debits) the investment account and increases (credits) revenue for its share of the investee's net income.2 (2) The investor also decreases (credits) the investment account for the amount of dividends received. The investment account is reduced for dividends received because payment of a dividend decreases the net assets of the investee.
Helpful Hint Under the equity method, the investor recognizes revenue on the accrual basis—i.e., when it is earned by the investee.
Assume that Milar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2014. The entry to record this transaction is:
For 2014, Beck reports net income of $100,000. It declares and pays a $40,000 cash dividend. Milar records (1) its share of Beck's income, $30,000 (30% × $100,000) and (2) the reduction in the investment account for the dividends received, $12,000 ($40,000 × 30%). The entries are:
After Milar posts the transactions for the year, its investment and revenue accounts will show the following.
During the year, the net increase in the investment account was $18,000. As indicated above, the investment account increased by $30,000 due to Milar's share of Beck's income, and it decreased by $12,000 due to dividends received from Beck. In addition, Milar reports $30,000 of revenue from its investment, which is 30% of Beck's net income of $100,000.
Note that the difference between reported revenue under the cost method and reported revenue under the equity method can be significant. For example, Milar would report only $12,000 of dividend revenue (30% × $40,000) if it used the cost method.
A company that owns more than 50% of the common stock of another entity is known as the parent company. The entity whose stock the parent company owns is called the subsidiary (affiliated) company. Because of its stock ownership, the parent company has a controlling interest in the subsidiary.
When a company owns more than 50% of the common stock of another company, it usually prepares consolidated financial statements. These statements present the total assets and liabilities controlled by the parent company. They also present the total revenues and expenses of the subsidiary companies. Companies prepare consolidated statements in addition to the financial statements for the parent and individual subsidiary companies.
Helpful Hint If parent (A) has three wholly owned subsidiaries (B, C, & D), there are four separate legal entities. From the viewpoint of the shareholders of the parent company, there is only one economic entity.
As noted earlier, when Time Warner had a 20% investment in Turner, it reported this investment in a single line item—Other Investments. After the merger, Time Warner instead consolidated Turner's results with its own. Under this approach, Time Warner included Turner's individual assets and liabilities with its own. Its plant and equipment were added to Time Warner's plant and equipment, its receivables were added to Time Warner's receivables, and so on.
ACCOUNTING ACROSS THE ORGANIZATION
How Procter & Gamble Accounts for Gillette
Several years ago, Procter & Gamble Company acquired Gillette Company for $53.4 billion. The common stockholders of Procter & Gamble elect the board of directors of the company, who, in turn, select the officers and managers of the company. Procter & Gamble's board of directors controls the property owned by the corporation, which includes the common stock of Gillette. Thus, they are in a position to elect the board of directors of Gillette and, in effect, control its operations. These relationships are graphically illustrated here.
Where on Procter & Gamble's balance sheet will you find its investment in Gillette Company? (See page 773.)
Consolidated statements are useful to the stockholders, board of directors, and management of the parent company. These statements indicate the magnitude and scope of operations of the companies under common control. For example, regulators and the courts undoubtedly used the consolidated statements of AT&T to determine whether a breakup of the company was in the public interest. Illustration 16-5 lists three companies that prepare consolidated statements and some of the companies they have owned.
Stock Investments
Presented below are two independent situations.
1. Rho Jean Inc. acquired 5% of the 400,000 shares of common stock of Stillwater Corp. at a total cost of $6 per share on May 18, 2014. On August 30, Stillwater declared and paid a $75,000 dividend. On December 31, Stillwater reported net income of $244,000 for the year.
2. Debbie, Inc. obtained significant influence over North Sails by buying 40% of North Sails’ 60,000 outstanding shares of common stock at a cost of $12 per share on January 1, 2014. On April 15, North Sails declared and paid a cash dividend of $45,000. On December 31, North Sails reported net income of $120,000 for the year.
Prepare all necessary journal entries for 2014 for (1) Rho Jean Inc. and (2) Debbie, Inc.
Action Plan
Presume that the investor has relatively little influence over the investee when an investor owns less than 20% of the common stock of another corporation. In this case, net income earned by the investee is not considered a proper basis for recognizing income from the investment by the investor.
Presume significant influence for investments of 20%–50%. Therefore, record the investor's share of the net income of the investee.
Solution
Related exercise material: BE16-2, BE16-3, E16-4, E16-5, E16-6, E16-7, E16-8, and DO IT! 16-2.
The value of debt and stock investments may fluctuate greatly during the time they are held. For example, in one 12-month period, the stock price of Time Warner hit a high of $58.50 and a low of $9. In light of such price fluctuations, how should companies value investments at the balance sheet date? Valuation could be at cost, at fair value, or at the lower-of-cost-or-market value.
Many people argue that fair value offers the best approach because it represents the expected cash realizable value of securities. Fair value is the amount for which a security could be sold in a normal market. Others counter that unless a security is going to be sold soon, the fair value is not relevant because the price of the security will likely change again.
For purposes of valuation and reporting at a financial statement date, companies classify debt investments into three categories:
1. Trading securities are bought and held primarily for sale in the near term to generate income on short-term price differences.
2. Available-for-sale securities are held with the intent of selling them sometime in the future.
3. Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.3
Stock investments are classified into two categories:
1. Trading securities (as defined above).
2. Available-for-sale securities (as defined above).
Stock investments have no maturity date. Therefore, they are never classified as held-to-maturity securities.
Illustration 16-6 shows the valuation guidelines for these securities. These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%.
Companies hold trading securities with the intention of selling them in a short period (generally less than a month). Trading means frequent buying and selling. As indicated in Illustration 16-7, companies adjust trading securities to fair value at the end of each period. They report changes from cost as part of net income. The changes are reported as unrealized gains or losses because the securities have not been sold. The unrealized gain or loss is the difference between the total cost of trading securities and their total fair value. Companies classify trading securities as current assets.
Illustration 16-7 shows the cost and fair values for investments Pace Corporation classified as trading securities on December 31, 2014. Pace has an unrealized gain of $7,000 because total fair value of $147,000 is $7,000 greater than total cost of $140,000.
Pace records fair value and unrealized gain or loss through an adjusting entry at the time it prepares financial statements. In this entry, the company uses a valuation allowance account, Fair Value Adjustment—Trading, to record the difference between the total cost and the total fair value of the securities. The adjusting entry for Pace Corporation is:
The use of a Fair Value Adjustment—Trading account enables Pace to maintain a record of the investment cost. It needs actual cost to determine the gain or loss realized when it sells the securities. Pace adds the debit balance (or subtracts a credit balance) of the Fair Value Adjustment—Trading balance to the cost of the investments to arrive at a fair value for the trading securities.
The fair value of the securities is the amount Pace reports on its balance sheet. It reports the unrealized gain in the income statement in the “Other revenues and gains” section. The term “Income” in the account title indicates that the gain affects net income.
If the total cost of the trading securities is greater than total fair value, an unrealized loss has occurred. In such a case, the adjusting entry is a debit to Unrealized Loss—Income and a credit to Fair Value Adjustment—Trading. Companies report the unrealized loss under “Other expenses and losses” in the income statement.
The Fair Value Adjustment—Trading account is carried forward into future accounting periods. The company does not make any entry to the account until the end of each reporting period. At that time, the company adjusts the balance in the account to the difference between cost and fair value. For trading securities, it closes the Unrealized Gain (Loss)—Income account at the end of the reporting period.
ACCOUNTING ACROSS THE ORGANIZATION
And the Correct Way to Report Investments Is...?
The accompanying graph presents an estimate of the percentage of companies on the major exchanges that have investments in the equity of other entities.
As the graph indicates, many companies have equity investments of some type. These investments can be substantial. For example, the total amount of equity-method investments appearing on company balance sheets is approximately $403 billion, and the amount shown in the income statements in any one year for all companies is approximately $38 billion.
Source: “Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers,” United States Securities and Exchange Commission—Office of Chief Accountant, Office of Economic Analyses, Division of Corporation Finance (June 2005), p. 36–39.
Why might the use of the equity method not lead to full disclosure in the financial statements? (See page 773.)
As indicated earlier, companies hold available-for-sale securities with the intent of selling these investments sometime in the future. If the intent is to sell the securities within the next year or operating cycle, the investor classifies the securities as current assets in the balance sheet. Otherwise, it classifies them as long-term assets in the investments section of the balance sheet.
Companies report available-for-sale securities at fair value. The procedure for determining fair value and the unrealized gain or loss for these securities is the same as for trading securities. To illustrate, assume that Ingrao Corporation has two securities that it classifies as available-for-sale. Illustration 16-8 provides information on the cost, fair value, and amount of the unrealized gain or loss on December 31, 2014. There is an unrealized loss of $9,537 because total cost of $293,537 is $9,537 more than total fair value of $284,000.
Ethics Note
Some managers seem to hold their available-for-sale securities that have experienced losses, while selling those that have gains, thus increasing income. Do you think this is ethical?
Both the adjusting entry and the reporting of the unrealized gain or loss for Ingrao's available-for-sale securities differ from those illustrated for trading securities. The differences result because Ingrao does not expect to sell these securities in the near term. Thus, prior to actual sale it is more likely that changes in fair value may change either unrealized gains or losses. Therefore, Ingrao does not report an unrealized gain or loss in the income statement. Instead, it reports it as a separate component of stockholders’ equity.
In the adjusting entry, Ingrao identifies the fair value adjustment account with available-for-sale securities, and it identifies the unrealized gain or loss account with stockholders’ equity. Ingrao records the unrealized loss of $9,537 as follows.
If total fair value exceeds total cost, Ingrao debits Fair Value Adjustment— Available-for-Sale and credits Unrealized Gain or Loss—Equity.
For available-for-sale securities, the company carries forward the Unrealized Gain or Loss—Equity account to future periods. At each future balance sheet date, Ingrao adjusts the Fair Value Adjustment— Available-for-Sale account and the Unrealized Gain or Loss—Equity account to show the difference between cost and fair value at that time.
Ethics Note
At one time, the SEC accused investment bank Morgan Stanley of overstating the value of certain bond investments by $75 million. The SEC stated that, in applying market value accounting, Morgan Stanley used its own more-optimistic assumptions rather than relying on external pricing sources.
> DO IT!
Trading and Available-for-Sale Securities
Some of Powderhorn Corporation's investment securities are classified as trading securities and some are classified as available-for-sale. The cost and fair value of each category at December 31, 2014, are shown below.
At December 31, 2013, the Fair Value Adjustment—Trading account had a debit balance of $9,200, and the Fair Value Adjustment—Available-for-Sale account had a credit balance of $5,750. Prepare the required journal entries for each group of securities for December 31, 2014.
Action Plan
Mark trading securities to fair value and report the adjustment in current-period income.
Mark available-for-sale securities to fair value and report the adjustment as a separate component of stockholders’ equity.
Solution
Related exercise material: BE16-4, BE16-5, BE16-6, BE16-7, E16-10, E16-11, E16-12, and DO IT! 16-3.
In the balance sheet, companies classify investments as either short-term or long-term.
Short-term investments (also called marketable securities) are securities held by a company that are (1) readily marketable and (2) intended to be converted into cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classified as long-term investments.
Helpful Hint Trading securities are always classified as short-term. Available-for-sale securities can be either short-term or long-term.
READILY MARKETABLE An investment is readily marketable when it can be sold easily whenever the need for cash arises. Short-term paper4 meets this criterion. It can be readily sold to other investors. Stocks and bonds traded on organized securities exchanges, such as the New York Stock Exchange, are readily marketable. They can be bought and sold daily. In contrast, there may be only a limited market for the securities issued by small corporations, and no market for the securities of a privately held company.
INTENT TO CONVERT Intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer. Generally, this criterion is satisfied when the investment is considered a resource that the investor will use whenever the need for cash arises. For example, a ski resort may invest idle cash during the summer months with the intent to sell the securities to buy supplies and equipment shortly before the winter season. This investment is considered short-term even if lack of snow cancels the next ski season and eliminates the need to convert the securities into cash as intended.
Because of their high liquidity, short-term investments appear immediately below Cash in the “Current assets” section of the balance sheet. They are reported at fair value. For example, Pace Corporation would report its trading securities as shown in Illustration 16-9.
Companies generally report long-term investments in a separate section of the balance sheet immediately below “Current assets,” as shown later in Illustration 16-12 (page 755). Long-term investments in available-for-sale securities are reported at fair value. Investments in common stock accounted for under the equity method are reported at equity.
Companies must present in the financial statements gains and losses on investments, whether realized or unrealized. In the income statement, companies report gains and losses in the nonoperating activities section under the categories listed in Illustration 16-10. Interest and dividend revenue are also reported in that section.
As indicated earlier, companies report an unrealized gain or loss on available-for-sale securities as a separate component of stockholders’ equity. To illustrate, assume that Dawson Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $100,000. Illustration 16-11 shows the balance sheet presentation of the unrealized loss.
Note that the loss decreases stockholders’ equity. An unrealized gain is added to stockholders’ equity. Reporting the unrealized gain or loss in the stockholders’ equity section serves two purposes. (1) It reduces the volatility of net income due to fluctuations in fair value. (2) It informs the financial statement user of the gain or loss that would occur if the securities were sold at fair value.
Companies must report items such as this, which affect stockholders’ equity but are not included in the calculation of net income, as part of a more inclusive measure called comprehensive income. We discuss comprehensive income more fully in Chapter 18.
We have presented many sections of classified balance sheets in this and preceding chapters. The classified balance sheet in Illustration 16-12 includes, in one place, key topics from previous chapters: the issuance of par value common stock, restrictions of retained earnings, and issuance of long-term bonds. From this chapter, the statement includes (highlighted in red) short-term and long-term investments. The investments in short-term securities are considered trading securities. The long-term investments in stock of less than 20% owned companies are considered available-for-sale securities. Illustration 16-12 also includes a long-term investment reported at equity and descriptive notations within the statement, such as the basis for valuing inventory and one note to the statement.
Financial Statement Presentation of Investments
Identify where each of the following items would be reported in the financial statements.
1. Interest earned on investments in bonds.
2. Fair value adjustment—available-for-sale.
3. Unrealized loss on available-for-sale securities.
4. Gain on sale of investments in stock.
5. Unrealized gain on trading securities.
Use the following possible categories:
Balance sheet: |
|
Current assets |
Current liabilities |
Investments |
Long-term liabilities |
Property, plant, and equipment |
Stockholders’ equity |
Intangible assets |
|
Income statement: |
|
Other revenues and gains |
Other expenses and losses |
Action Plan
Classify investments as current assets if they will be held for less than one year.
Report unrealized gains or losses on trading securities in income.
Report unrealized gains or losses on available-for-sale securities in equity.
Report realized earnings on investments in the income statement as “Other revenues and gains” or as “Other expenses and losses.”
Solution
Related exercise material: BE16-5, BE16-7, BE16-8, E16-10, E16-11, E16-12, and DO IT! 16-4.
In its first year of operations, DeMarco Company had the following selected transactions in stock investments that are considered trading securities.
June 1 Purchased for cash 600 shares of Sanburg common stock at $24 per share.
July 1 Purchased for cash 800 shares of Cey Corporation common stock at $33 per share.
Sept. 1 Received a $1 per share cash dividend from Cey Corporation.
Nov. 1 Sold 200 shares of Sanburg common stock for cash at $27 per share.
Dec. 15 Received a $0.50 per share cash dividend on Sanburg common stock.
At December 31, the fair values per share were Sanburg $25 and Cey $30.
Instructions
(a) Journalize the transactions.
(b) Prepare the adjusting entry at December 31 to report the securities at fair value.
Action Plan
Record the price paid as the cost of the investment.
Compute the gain or loss on sales as the difference between selling price and the cost of the securities.
Base the adjustment to fair value on the total difference between the cost and the fair value of the securities.
Solution to Comprehensive DO IT!
1 Discuss why corporations invest in debt and stock securities. Corporations invest for three primary reasons. (a) They have excess cash. (b) They view investments as a significant revenue source. (c) They have strategic goals such as gaining control of a competitor or moving into a new line of business.
2 Explain the accounting for debt investments. Companies record investments in debt securities when they purchase bonds, receive or accrue interest, and sell the bonds. They report gains or losses on the sale of bonds in the “Other revenues and gains” or “Other expenses and losses” sections of the income statement.
3 Explain the accounting for stock investments. Companies record investments in common stock when they purchase the stock, receive dividends, and sell the stock. When ownership is less than 20%, the cost method is used. When ownership is between 20% and 50%, the equity method should be used. When ownership is more than 50%, companies prepare consolidated financial statements.
4 Describe the use of consolidated financial statements. When a company owns more than 50% of the common stock of another company, it usually prepares consolidated financial statements. These statements indicate the magnitude and scope of operations of the companies under common control.
5 Indicate how debt and stock investments are reported in financial statements. Investments in debt securities are classified as trading, available-for-sale, or held-to-maturity securities for valuation and reporting purposes. Stock investments are classified either as trading or available-for-sale securities. Stock investments have no maturity date and therefore are never classified as held-to-maturity securities. Trading securities are reported as current assets at fair value, with changes from cost reported in net income. Available-for-sale securities are also reported at fair value, with the changes from cost reported in stockholders’ equity. Available-for-sale securities are classified as short-term or long-term, depending on their expected future sale date.
6 Distinguish between short-term and long-term investments. Short-term investments are securities that are (a) readily marketable and (b) intended to be converted to cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classified as long-term investments.
__________
1Among the questions that are considered in determining an investor's influence are these: (1) Does the investor have representation on the investee's board? (2) Does the investor participate in the investee's policy-making process? (3) Are there material transactions between the investor and investee? (4) Is the common stock held by other stockholders concentrated or dispersed?
2Or, the investor increases (debits) a loss account and decreases (credits) the investment account for its share of the investee's net loss.
3This category is provided for completeness. The accounting and valuation issues related to held-to-maturity securities are discussed in more advanced accounting courses.
4Short-term paper includes (1) certificates of deposit (CDs) issued by banks, (2) money market certificates issued by banks and savings and loan associations, (3) Treasury bills issued by the U.S. government, and (4) commercial paper (notes) issued by corporations with good credit ratings.