UNIT 6 LONG TERM INVESTMENTS 1 CHAPTER THREE LONG TERM INVESTMENTS 3 1 INTRODUCTION In Financial Accounting –I, we discussed short term investments in marketable debt and equity securities, bonds etc[.]
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CHAPTER THREE LONG-TERM INVESTMENTS
3.1 INTRODUCTION
In Financial Accounting –I, we discussed short-term investments in marketable debt and equity securities, bonds etc The basis of distinction between short-term investments and long-term investments lies in the nature and purpose of the investment Investments that are readily marketable and that may be sold without disrupting business relationships or impairing the operations of the business enterprise are classified as current assets Investments made to foster business relationships with other enterprises are classified as long-term investments
3.2 Objectives of long-term investments
A business enterprise may make long-term investments in securities of other companies for many reasons Among these are:
To create close ties to major suppliers or to retail outlets
Serve as a means of gaining control of a competitor
To enhance its own income
To acquire ownership of a company with a strong cash position
3.3 Acquisition cost
The cost of an investment in securities includes the acquisition price plus brokerage fees and any other expenditure incurred in the transaction If assets other than cash are given in payment for the securities, the cost of the securities acquired and the value of the non-cash assets given in exchange may be established by
(1) The fair value of the non-cash assets or
(2) The current market price of the securities, whichever is more objectively determinable
Example: ABC Company acquires from XYZ Company 120 units of 4 shares of common stock and 2 shares of preferred stock each at a price of Br 500 a unit, when the common stock is trading at Br 40 and the preferred stock at Br 120 a share Compute the cost allocated to each kind of security
Solution
Totalcostof a q isiio = 1 0 x Br.5 0 = Br.6 ,0 0
Marketpric of e ch u i = (Br.4 x 4) + (Br.1 0 x 2) = Br.4 0
- Porto of costal oc ted o commo stock =
400
160
Br
Br
x Br.6 ,0 0
= Br.2 ,0 0
Trang 2- Porto of costal oc ted o prefered stock =
400
240
x Br.6 ,0 0
= Br.3 ,0 0
3.4 Accounting for long-term investments in common stock
Shares of stock may be acquired on the open market from a firm’s stockholders, from the issuing corporation, or from stockbrokers
There are hre dif erent meth ds of a co ntn for o g-term n estmentin commo stock,depen in
o which return an n estor wishes o me sure.These meth ds are:
1 Cost meth d – n estmentincome co sists o ly of dividen s re eived
2 Eq i y meth d – In estment income co sists of the n estor’s pro orto ate share of he
in este ’s netincome
3 Mark t value meth d – n estment income nclu es dividen s re eived an chan es n he marketvalue of he n estment
3.4.1 The Cost Method of Accounting for Long-Term Investment in Common
Stocks
Under this method a long-term investment is originally recorded and reported at cost It continues to be carried and reported at cost in the investments account until it is either partially or entirely disposed of,
or until some fundamental change in conditions makes it clear that the value originally assigned can no longer be justified Ordinary cash dividends received from the investee are recorded as investment revenue
Ex mple: X Company acquired 10% of Y Company’s outstanding common stock at the beginning of
2002 for Br 300, 000 Y Company reported net income of Br 200, 000 on December 31, 2002 and paid cash dividends of Br 250, 000 on January 10, 2003
The Jo rnalentries o re ord he ab ve ransa to s usin costmeth d
(1) To re ord a q isiio of he commo stock
(2) To re ord c sh dividen s re eived o Jan ary 1 , 2 0
Total c sh dividen re eived b X Compan = 0.1 x 2 0, 0 0 = Br 2 , 0 0
P st-a q isi o e rnin s, share of X Compan = 0.1 x 2 0, 0 0 = 2 , 0 0
Cash………2 , 0 0
Dividen reven e………2 , 0 0
In estment n Y Compan commo stock………5, 0 0
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Permanent De l ne n Value of Inv stment
Operatn os es of he n este hatred c he n este ’s net as ets su stantaly an serio sly mpair
is future prospe ts al re orded as os es b he n estor A p rto of he o g-term n estment has
be n ost an his fa tis re orded b red cin he c r yin amo ntof he n estment
For example, the Jo rnal entry o re ord a permanent de lne of Br 1 0, 0 0 n value of o g-term
in estments n BESA Compan commo stock s as folows:
Re lz d Los n value of o g-term n estments………… 1 0,0 0
To re ord a perma ent de l ne n value of Lo g-term nv stments n commo stoc
3.4.2 Valuation at Lowe of Cost or Market
Whenever he n estmentis n “Marketable eq iy se uriies” an he eq iy meth d s n tap ro riate (commo stocks hatare es han 2 % nterest or “la k sig ific nt influenc ”), he n estor s req ired
to use he ower of cost or market meth d n a co ntn for he n estment Se uriies q alfy as
“marketable eq iy se uriies” f
(1) They represent ownership shares or he rig t to a q ire or disp se of ownership shares n an enterprise atfixed or determinable pric s,an
(2) Sales pric s or bid an ask pric s are cur enty avaiable for such se uriies n he se uriies market
Un er he ower of cost or marketmeth d al n n cur entmarketable eq iy se uriies are gro ped n a separate n n cur ent p rtfolo for p rp ses of comparin he ag regate cost an he ag regate market value o determine he c r yin amo ntat he balanc she tdate
Ac o nt n for n n-cur ent marketable eq iy se uriies is b th simiar to an dif erent f om
a co ntn for marketable eq iy se uriies clas ified as cur entas ets
Simi arity: he amo nt b ag regate costof he n n-cur entp rtfolo exc eds marketvalue (u re lz d los ) s a co nted for as he valuato alowanc
Dif e enc : Where s chan es n he valuato alowanc for eq i y se uriies clas ified as cur ent
as ets are nclu ed n he determinato of ncome,a cumulated chan es n he valuato alowanc for
a marketable eq iy se uriies p rtfolo nclu ed n n n-cur ent as ets are n t p t o he ncome statement b t are nclu ed n he “eq iy” se to of he balanc she t an sh wn separately (as a ded ct o f om otalstock h lders’ eq iy)
Il ustration: Assume the following transactions and information for GEDA Company
(1) Jan ary 6,2 0 ,made o g-term n estments of Br.1,0 0,0 0 n he commo stock of several
p blcly owned corp rato s
Trang 4(2) The ag regate marketvalue of he n estments was Br.8 0,0 0 at he en of 2 0 an Br.9 0,
0 0 atthe en of 2 0
(3) July 1 ,2 0 ,sold o g-term n estments hatcostBr.5 0,0 0 for Br.3 5,0 0
(4) The ag regate marketvalue of he remainin n estments (cost Br.5 0,0 0) was Br.5 0,0 0
at he en of 2 0
Requir d: Present the Journal entries to record the above transactions and information
Solution
A Jo rnalentries o re ord he ransa to s an nformato
J nuary 6, 2 0
Lo g-term In estments n marketable Eq iy se uriies………….1,0 0,0 0
De ember 3 , 2 0 (u re l z d los = Br 1, 0 0, 0 0 – Br 8 0, 0 0 = Br 2 0, 0 0)
Unre l z d os n value of o g-term n e tments n marketable eq i y s curi e ………2 0, 0 0
Al owanc o red c o g-term n e tments n marketable eq i y s curi e o market value ………2 0, 0 0
De ember 3 , 2 0 (incre se in market value ( e o ery) = Br 9 0, 0 0 – Br 8 0, 0 0
= Br 1 0, 0 0)
Al owa c o e c o g- erm n estme t n Mark ta le e i y se r ies o mark t v lu ……….1 0, 0 0
Unre l z os n v lu of o g- erm n estme ts n mark ta le e ui y se ur es……… 1 0, 0 0
July 1 , 2 0 ( e l z d los = Br 5 0, 0 0 – Br 3 5, 0 0 = Br 1 5, 0 0) = 3 5, 0 0
Re lz d os o o g-term n estments
Lo g-term n estments n Marketable equiy se uriies……….5 0,0 0
De ember 3 , 2 0
The ncre se n marketvalue ab ve cost(u re lz d gain) of Br.5 ,0 0 (5 0,0 0 – 5 0,0 0) s
n tre o niz d.Inste d,the balanc eftin he u re lz d os (2 0,0 0 – 1 0,0 0 = Br.8 ,0 0)
is fuly re o ered an re orded
Al owanc o red c o g-term n e tments n Marketable eq i y s curi e o market value……… 8 , 0 0
Unre l z d os n value of o g-term In e tments n marketable eq i y s curi e ………8 , 0 0
Stock
When an n estor Compan a q ires suf icient ownership n he v tn stock of an n este Compan
to have sig ific nt influenc o er he af airs of he n este Compan b t les han a co trolin interest he n estmentis a co nted for usin he eq iy meth d.The n estment is originaly re orded
atthe cost of he shares a q ired butis su seq enty adjusted e ch perio for chan es n he netas ets
of he n este That is,the n estment’s c r yin amo nt is perio ic ly ncre sed (de re sed) b he
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in estor’s pro orto ate share of he e rnin s (los es) of he n este an de re sed b al dividen s
re eived b he in estor fom the in este The eq iy meth d re o niz s that in este e rnin s incre se n este netas ets hatu derle he n estment an hat n este os es an dividen s de re se these netas ets
Co c ptualy, the eq iy meth d re ts he n este compan as f t were co densed nto o e balanc she tiem an o e ncome statementiem an hen merged nto he n estor compan at he pro orto owned b he n estor
In he absenc of evidenc o he co trary,in estments n which he n estor compan owns 2 perc nt
or more of he o tstan in v tn stock of he n este Compan ,the n estor compan s presumed o have sig ific ntinfluenc o er he n este compan Th s,when an n estor has an n estmentin he commo stock of an n este compan hat resuls n sig ific nt influenc b t n t co trol o er he
in este ,the n estmentis a co nted for b he eq iy meth d
Il ustration: The following transactions were occurred in the years 2002 and 2003:
Jan 5,2 0 ,CABU Compan a q ired 2 ,0 0 shares (2 % of BATU Compan commo stock) ata
costof Br.1 a share
De 3 ,2 0 ,BATU Compan rep rted netincome of Br.1 0,0 0
Jan.2 ,2 0 ,BATU Compan an o nc d an paid a c sh dividen of Br.6 ,0 0
De 3 ,2 0 ,BATU Compan rep rted a net os of Br.3 ,0 0
Requir d:
Present the Jo rnal entries req ired o a co nt for he n estment in he b o s of CABU Compan , usin
a Costmeth d of a co ntn
b Eq iy meth d of a co ntn
Solution
(1) J n 5, 2 0
In estment n BATU Compan In estment n BATU Compan
Commo stock (2 , 0 0 x 1 ) 2 0, 0 0 Commo stock 2 0, 0 0
(2) De 3 , 2 0
Commo stock (2 % x Br 1 0, 0 0) 2 , 0 0
In estment ncome 2 , 0 0 (3) J n 2 , 2 0
Cash (2 % x Br 6 , 0 0) 1 , 0 0 Cash 1 , 0 0
Trang 6In estment ncome 1 , 0 0 In estment n BATU
Compan commo stock 1 , 0 0 (4) De 3 , 2 0
No entry Los o n estment (2 % x 3 , 0 0) 6, 0 0
In estment n BATU Compan
3.5 Accounting for long-term investment in bonds
A bond arises from a contract known as an indenture and represents a promise to pay:
(1) A sum of money at a designated maturity date, plus
(2) Periodic interest at a specified rate on the maturity amount (face value)
3.5.1 Computation of Acquisition pric of ong- e m nvestments n bonds
In estments n b n s sh uld be re orded o he date of a q isiio at cost which nclu es bro erage
fe s an an other costs ncidentalto he p rchase.The cost or p rchase pric of a b n n estmentis
is market value,which s determined b he market’s ap raisal of he risk n olved an co siderato
of he stated nterest rate n compariso wih he prevaiin market(yield) rate of nterestfor hatty e
of se uriy.The c sh amo ntof nterestto be re eived perio ic ly s fixed b he stated rate of nterest
o he fa e value
As y u se here are wo y es of nteresto he b n n minalinterestrate (the rate atwhich he fixed interest is payable) an yield rate (the market rate of nterest) The cost of an n estment in b n s (market value at a q isiio ) s he present value of he future c sh re eipts p rsuant to he b n
co tra t me sured n erms of he market(yield) rate of nterestat he me of n estment
Costof n estmentin presentvalue of he fa e amo nt b n s = disco nted atmarketinterestrate for
n perio s + presentvalue of ordinary an uiy of n nterestre eipts disco nted atmarket nterestrate
I he rate of return desired b he n estors (yield rate) s exa ty eq al to he stated rate, he b n wil sel at is fac amount.I n estors deman a hig er yield han he n rmalrate,the b n wilsel ata disco nt I he yield rate s below he stated rate, in estors wil pay a premium, more han maturiy value,,for he b n
3.5.2 Acquisition of Bonds betwe n Inte est Rates
I b n s are p rchased betwe n nterest payment dates, the n estor must pay he owner he market pric plus he nterest a crued sinc he astinterestpaymentdate.The n estor wilcole t his nterest plus he ad iio alintereste rned b h ldin he b n o he nextinterestdate
Ex mple: In estor p rchased o July 1 of b n s havin a Br 1 0, 0 0 fa e value an payin 1 % interest o May 1 an No ember 1, for 9 The Jo rnal entry o re ord p rchase of he b n s an
a crued nterestis as folows:
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Interestre eivable (Br.1 0,0 0 x 0.1 x 2/1 ) ………….2,0 0
On No ember 1, he n estor wil re eive nterestof Br.6,0 0 (Br.1 0,0 0 x 0.1 x 6/1 ) Co sistn
of Br 2, 0 0 paid at date of a q isiio an Br 4, 0 0 e rned for h ldin he b n for fo r mo ths (July 1 o No ember 1)
3.5.3 Discount and Pr mium on Long-Te m Investment n Bonds
On he date of a q isiio of b n s,the n estmentled er a co nt is debied for he costof a q irin the b n s,inclu in bro erage an other fe s, b t exclu in an a crued nterest A separate disco nt
or premium ed er a co ntas a valuato a co ntis n t usualy used.The su seq enttre tment of he
in estmentmig tbe han led n o e of he hre ways:
(1) The n estment mig t be c ried at cost g orin he a cumulato of disco nt or amortz to of premium
(2) The n estment led er a co nt balanc mig t be revalued perio ic ly o refle t market value chan es
(3) The disco nt or premium mig t be a cumulated or amortz d o refle t the chan e n he c r yin amo ntof he b n s based o he ef e tve rate of nterestprevaiin at he ime of a q isiio The first alernatve s used primariy n a co ntn for sh rt-term b n n estments, for co vertble
b n s,an for other b n s for which he disco ntor premium s nsig ific nt
The se o d alernatve s n tin a cord wih he present interpretato of he re lz to principle or he
co c ptof co servatsm,espe ialy d rin perio s of risin b n pric s.When he n estment n b n s
is n eo ard be ause of serio s c sh sh rtages of he s uer, i generaly s a c ptable o wrie he
in estmentd wn o ts ex e ted netre lz ble value an o re o niz a os
The hird alernatve s he prefer ed re tment for o g-term n estments n b n s This ap roa h
re o niz s hat the nterest reven e represented b he disco nt or he red cto n nterest reven e represented b he premium, a crues o er he erm of he b n s This meth d s co sistent wih he principle hatreq ires as ets other han c sh an re eivables o be re orded atcost
Metho s of discount ac umulat on or premium amort zat on
Two meth ds:interestmeth d an straig t-lne meth d
Inte est method
Trang 8This meth d pro uc s a co stant rate of return o he n estment in b n s The nterest reven e s comp ted for e ch nterestperio b muliplyin he balanc of he n estment atthe begin in of he perio b he ef e tve nterestrate at he ime he n estmentwas made
→ Disco nta cumulated =
Straight-Line Metho
The disco ntor premium s spre d u iformly o er he erm of he b n s
periods of
number
discount premium
Total
Perio ic nterestreven e = Perio ic c sh re eipt– disco nta cumulated
Or perio ic c sh re eipt+ premium amortz d
Il ustration: DAWA Compan a q ired Br 1, 0 0, 0 0, 1 % b n s of JARA Compan hat wil mature after 2 ye rs.The b n s yield:
Case 1 – 1 % comp u ded semian ualy
Case 2 – 8% comp u ded semian ualy
The b n s pay nterestsemian ual y startn six mo ths f om date of a q isiio
Requir d
(1) Comp te he perio ic nterestto be cole ted o he n estment
(2) Comp te he a q isiio pric of he b n s u der c se 1
(3) Comp te he amo nt of he perio ic a cumulato of disco nt u der c se 1 usin he straig t-lne meth d
(4) Present he Jo rnalentry ne es ary o re ord he a q isiio of he b n s u der c se 1
(5) Comp te he a q isiio pric of he b n s u der c se 2
(6) Comp te he amo nt of he perio ic amortz to of premium u der c se 2 usin he straig t-lne meth d
(7) Present he Jo rnalentry ne es ary o re ord he a q isiio of he b n s u der c se 2
(8) Present the Jo rnal entry ne es ary o re ord re eipt of nterest at the en of he first six-mo th perio u der c se 1 usin (a) The nterestmeth d
(b) The straig t-lne meth d (9) Presentthe Jo rnal entry ne es ary o re ord re eipt of nterest atthe en of he se o d six-mo th perio u der c se 1 usin (a) The nterestmeth d
Interestreven e Comp ted
By ef e tve rate of nterest -
Perio ic c sh
re eipt
b ef e tve nterestrate
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(b) The straig t-lne meth d (1 ) Present the Jo rnal entry ne es ary o re ord he re eipt of nterest at the en of he first
six-mo th perio u der c se 2 usin (a) he nterestmeth d (b) he straig t-lne meth d
(1 ) Presentthe Jo rnalentry o re ord he re eiptof nterestatthe en of he se o d six-mo th perio
u der c se 2 usin (a) he nterestmeth d (b) he straig t-lne meth d
Solution
(1) Perio ic nterestto be cole ted = Br.1,0 0,0 0 x 1 /1 0 x ½
= Br.5 ,0 0 (2) Acq isiio pric u der c se 1 (1 %):
( = 1 /2% = 6% n = 2 x 2 = 5 )
Presentvalue of Br.1,0 0,0 0 disco nted at6%
For 5 -mo th perio s (Br.1,0 0,0 0 x 0.0 4 8 ) Br.5 ,2 8
Ad :Presentvalue of ordinary an ui y of 5 rents
Of Br.5 ,0 0 disco nted at6% (Br.5 ,0 0 x 1 7 1 6) 7 8.0 3
(3) Disco nt= Br.1,0 0,0 0 – Br.8 2,3 1 = Br.1 7,6 9
Amo ntof perio ic a cumulato of disco nt
Un er c se 1 = Br.1 7,6 9 9 5 = Br.3,1 2
(4) Jo rnalentry o re ord a q isiio u der c se 1
(5) Acq isiio pric u der c se 2 (8%) ( = 8%/2 = 4%)
Presentvalue of Br.1,0 0,0 0 disco nted at4%
For 5 -mo th perio s (Br.1,0 0,0 0 x 0.1 0 1 ) Br.1 0,7 3
Ad :PV of ordinary an uiy of 5 rents of Br.5 ,0 0
(6) Premium = Br.1,2 4,8 2 – Br.1,0 0,0 0 = Br.2 4,8 2
Amo ntof he perio ic amortz to of premium u der c se 2
Usin straig t-lne meth d = Br.2 4,8 2 2 5 = Br.4,2 6
(7) Jo rnalentry o re ord a q isiio u der c se 2
Trang 10(8) Jo rnalentry o re ord re eiptof nterestatthe en of he firstsix-mo th perio un er c se 1 (a) Interestmeth d
Computation
InterestReven e (Br.8 2,3 1 x 1 /1 0 x ½) – Br.5 ,5 3
(b) Straig t-lne meth d
(9) At he en of he se o d six-mo th perio
(a) Interestmeth d
Computation
Interestreven e (Br.8 2,3 1 + Br.5 3) x 1 /1 0 x ½ = Br.5 ,5 5
(b) Straig t-lne meth d
(1 ) Atthe en of he firstsix-mo ths (c se 2)
(a) Interestmeth d
Computation
Interestreven e (Br.1,2 4,8 2 x 8/1 0 x ½) = Br.4 ,5 3