Chapter 3.Pdf

1 Unit Three Accounting for Long term Investments Objectives of long term investments Usually, a business enterprise may make long term investments in the securities of other companies for many reason[.]

Unit Three Accounting for Long term Investments Objectives of long term investments

Usually, a business enterprise may make long term investments in the securities of other companies for many reasons For example, investments may be used to create close ties

to major suppliers or retail outlets The rights of ownership inherent in common stock investments give an investor investing in such securities a degree of influence or control over the management of the investee Thus, many enterprises use investments in common stocks as a means of gaining control over competitors, acquiring ownership of a company with a strong cash position, or diversifying their investment portfolio by acquiring an ownership interest in investees in order to obtain dividend revenue and capital appreciations

Consolidated financial statements

A company that acquires a controlling interest in the common stock of another company

is termed as the parent company while the controlled company which sales investment securities is said to be the subsidiary company The investment in the common stock of the subsidiary is a long term investment for the parent company In reporting these issues,

in addition to the separate financial statements prepared for the parent and the subsidiary company, consolidated financial statements are often prepared to reflect such investment conditions When such financial statements represent more than one corporation, we refer

to them as consolidated financial statements

Accounting for acquisition costs of long term investments

The cost of an investment in long term investment securities includes the acquisition price plus brokerage fees and any other expenditure that may be incurred in the transaction If assets other than cash are given in payment for the securities and the current fair value of such noncash assets is unknown, the current market price of the securities may be used to establish the cost of the securities acquired and the value of the noncash assets given in exchange When neither a market price for the securities nor the

current fair value of the assets given in exchange is known, accountants must rely on independent appraisals to establish values for recording the transaction Furthermore, if two or more securities are acquired for a lump sum or single price, the total cost should

be allocated among the various securities If the various securities acquired are publicly traded, the existing market prices serve as the basis for apportionment or allocation of the total cost Such type of cost apportionment is termed as relative market value allocation

Example: Assume that Hawassa’s Company acquires from Adama’s Company 100 units

of five shares of common stock and one share of preferred stock each, at a price of Br

240 a unit, when the common stock and preferred stock are trading at Br 30 and Br 100

a share, respectively

Required: Compute the cost allocated to each kind of security

Solution:

Total cost of acquisition = 100 x 240 = Br 24,000

Market price of each unit = (Br 30 x 5) + (Br 100 x 1) = Br 250

The portion of the cost allocated to the common stock =

250

150

Br

Br

x Br 24,000 = Br 14,400

The portion of the cost allocated to the preferred stock =

Methods of accounting for long term investment in common stock

It is vital to remark here that stock investments are investments in the capital stock of a corporation When a company holds stock of several different corporations, the group of securities is identified as investment portfolio The return on investment in common stock consists of the stream of dividend received from the investment and a portion of net

income retained in the company which will increase the investees stockholder’s equity 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) The accounting method applied will differ based on the degree of influence

The following table shows ownership interest, presumed influence on investee and the appropriate accounting guidelines for long term investments in common stocks

Investor’s ownership

interest in investee’s

common stock

Degree of influence on investee

Accounting guidelines

Less than 20% Insignificant (no control) Cost method

Between 20% and 50% Significant influence Equity method

statement

The cost method of accounting for long term investment in common stocks

As presented in the above table, the cost method of accounting for the investment in common stock is appropriate when an investor owns only a small portion (for example, less than 20%) of the total outstanding common stock of an investee so that the investor has little or no influence over the investee In this case, the investor cannot influence the investee’s dividend policy, and the only portion of the investee’s income that reaches the investor is the dividends paid by the investee Thus, when the investor has little or no influence over the investee, the dividends received represent the only return realized by

the investor

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 Revenue is recognized

by the investor only to the extent of dividends received In this case, it is assumed that the investor purchased the stock primarily to earn dividends or realize gains on price

increases of the stock The entries for stock investment under cost method are illustrated for various investment scenarios as indicated in discussions that follow

(To record receipt of a cash dividend)

Jegol Corporation reports dividend revenue under “other revenues and gains” in the income statement However, if a material portion of the dividends received represents a distribution of investee’s earnings realized prior to the time the stock was acquired, that portion of the dividends is a return of capital (a liquidating dividend), not revenue Because liquidating dividends represent a return of capital, receipt of such dividends by the investor is recorded by a credit to the investment ledger account

To illustrate the accounting for a liquidating dividend, assume that Alexander Company acquired 15% of outstanding common stock of Duran Company early in Year 1 During Year 1, Duran reported net income of Br 100,000 and paid a cash dividend of Br 150,000 Because the dividend exceeded by a material amount the net income of Duran for the period Alexander owned Duran common stock, Alexander records the dividend as follows:

Cash (Br 150,000 x 0.15)……… 22,500

Dividend revenue (Br 100,000 x 0.15)……….15, 000

Investment in Duran Company Common Stock……….… 7,500

(To record receipt of dividend, including distribution of Br 7,500 in excess of net income since the investment was acquired)

The equity method of accounting for long-term investments in common stock

When an investor Company acquires sufficient ownership in the voting stock of an investee Company to have significant influence over the affairs of the investee Company but less than a controlling interest, the investment is accounted for using the equity method The investment is originally recorded at the cost of the shares acquired but is subsequently adjusted each period for changes in the net assets of the investee That is, the investment’s carrying amount is periodically increased (decreased) by the investor’s proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee The equity method recognizes that investee earnings increase investee net assets that underlie the investment, and that investee losses and dividends decrease these net assets

Conceptually, the equity method treats the investee company as if it were condensed into one balance sheet item and one income statement item and then merged into the investor company at the proportion owned by the investor In the absence of evidence to the contrary, investments in which the investor company owns 20 percent or more of the outstanding voting stock of the investee Company, the investor company is presumed to have significant influence over the investee company Thus, when an investor has an investment in the common stock of an investee company that results in significant

influence but not control over the investee, the investment is accounted for by the equity method

To illustrate the equity method of accounting, assume that on January 2, year 1, Investor Company acquired 40% of the common stock of Lee Company for Br 300,000, which corresponded with the carrying amount of Lee’s net asset On December 31, year1, Lee reported net income of Br 70,000 (including a Br 10,000 extraordinary gain) and declared and paid dividend of Br 30,000 Investor Company accounts for its investment

in Lee Company as follows (disregarding income tax effects):

Dec 31 Investment in Lee company common stock……….28, 000

Investment Income (ordinary)………24,000 Investment income (extraordinary)…… 4,000

[To record 40% of net income of Lee company for year 1 (60,000 x 40% = Br 24,000; 10,000 x 40% = Br 4,000]

Dec 31 Cash (30,000 x 40%) ……….12,000

Investment in Lee company common stock…………12,000

(To record dividend received from Lee Company)

After the foregoing journal entries have been posted, the investment and investment income ledger accounts appear as follows (before closing entries for the investment income accounts):

Investment in lee company common stock

12,000

300,000

dr 328,000

dr 316,000

dr Investment income (ordinary)

Investment income (extraordinary)

Note that the net effect of Investor’s accounting for Lee’s net income and dividends was

to increase the balance of the investment ledger account by Br 16,000 This correspondents with 40% of the increase in Lee’s net assets as a result of undistributed earnings during Year 1 [(Br 70,000 – Br 30,000) x 0.40 = Br 16,000)

Example 2

 The following transactions were occurred in the years 2010 and 2011:

 Jan 5, 2010: Selam Company acquired 24, 000 shares (20% of Alex Company

common stock) at a cost of Br 10 per share

 Dec 31, 2010: Alex Company reported net income of Br 100, 000

 Jan 20, 2011: Alex Company announced and paid a cash dividend of Br 60, 000

 Dec 31, 2011: Alex Company reported a net loss of Br 30, 000

Required: Present the journal entries required to account for the investment in the books

of Selam Company, using

a) Cost method of accounting

b) Equity method of accounting

Investment in Alex Company Common Stock (20% x Br 100,000)…….20,000

Investment income……… 20,000

(3) Jan 20, 2011

Cash……….12,000 Investment in Alex Company Common Stock……… 12, 000

(4) Dec 31, 2011

Loss on investment (20% x 30,000)………… 6, 000 Investment in Alex Company Common Stock……… 6, 000

Problems in the application of the equity method

Four problems may arise in the application of the equity method of accounting Let us see them separately:

Intercompany profits (gains) or losses: These are resulted from transaction between the

investor and the investee For example, an investor or an investee may sell merchandise

or, less frequently, plant or intangible assets to its affiliate If so, any unrealized profit (gain) or loss must be excluded from the net income of the investor To illustrate, assume that on November 30, year 2, Investor Company sold merchandise costing Br 50, 000 to

Lee Company for Br 80, 000, or for a gross profit rate of 371/2% 

,80

000,30

On December 31, year 2, the inventories of Lee included Br 60, 000 (at billed price) of this merchandise In addition, on December 31, year 2, Lee sold merchandise that cost Br 30,000 to Investor for Br 50,000; none of this merchandise was sold by Investor to its customers on that date If Lee reported net income of Br 95,000 (none of which was an extraordinary item) for year 2, but did not declare or pay dividends for that year Investor Company has a 40% ownership in Lee Company

Under the equity method, the following journal entries are required on December 31, year

Income summary (Br 60, 000 x 0.375)……… 22,500

Deferred gross profit on sales………22,500

(To defer unrealized gross profit attribute to merchandise in Lee Company’s inventories

A review of the foregoing illustration of intercompany profits emphasizes the necessity of excluding unrealized intercompany profits (gains) and losses from an investor’s net income The investor’s ability to influence the operating and financial policies of an investee enables the investor to determine to a large degree the quantity and unit price of merchandise sold by investor to investee, and vice versa Obviously, if unrealized intercompany profits were not eliminated from the investor’s net income, the investor might reach the desired earnings per share amount merely by selling merchandise to, or purchasing merchandise from, an investee

Cost in excess of equity acquired: - Often an investor will pay more than the underlying equity of an investment because current fair values of the investee’s identifiable assets

may be larger than their carrying amounts, or because the investee has unrecorded goodwill or other intangible assets

In either case, the excess amount would be amortized over the economic lives of the undervalued assets or the unrecorded assets as follows:

Investment income (ordinary) ………xxx

Investment in investee company common stock……… xxx

(To adjust investment income for amortization of excess of cost over underlying equity of investee’s net assets)

Cost less than equity acquired: - When an investor acquires an investment in common

stock at a cost less than the underlying equity, it is assumed that specific identifiable assets of the investee are overvalued If these assets have limited economic lives, the investor allocates the excess of the underlying equity over cost to investment income over

the economic lives of the assets as follows:

Investment in investee company common stock………xxx

Investment income (ordinary)……….xxx

(To adjust investment income for amortization of excess of underlying equity of investee’s net assets over cost)

Example: Assume that Ambo Corporation acquired Br 200,000 a 20% interest in

outstanding common stock of Babile Company Ambo’s long-term investment enabled it

to exercise significant influence over Babile’s operating and financial policies

Case 1: Babile’s stock holders’ equity attributable to the common stock acquired by

Ambo was Br 160,000 and the excess Br 40,000 paid by Ambo was attributable to unrecorded goodwill which had a remaining life of 10 years

The yearly amortization of Br 40,000 excess is recorded as follows:

Investment income (Br 40,00010)……… 4,000

Investment in Babile Company common stock ……… 4,000

(To adjust investment income for amortization of excess of cost over underlying equity of investee’s net assets)

Case 2: Babile’s stockholders’ equity attributable to the common stock acquired by

Ambo was Br 220,000 The Br 20,000 power amount is attributable to overvalued building that had remaining economic life of 20 years

The yearly amortization of Br 20, 000 is recorded as follows:

Investment in Babile Company common stock (Br 20,00020)………… 1,000

Investment income………1,000

(To adjust investment income for amortization of excess of underlying equity of investee’s net assets over cost)

Accounting for long term investments in bonds

A bond contract represents a promise to pay an amount of money at maturity and a series

of interest payments during the term of the contract Investors acquire corporate bonds to earn a return on investment The effective rate of return on bonds to investors is determined by the price investors pay for the bonds

Computation of acquisition price of long-term investments in bonds

The cost of an investment in bonds (market value at acquisition) is the present value of the future cash receipt pursuant to the bond contract, measured in terms of the market rate

of interest (yield rate) at the time of investment The stated or nominal rate of interest (the

rate at which the fixed interest is payable) in the bond contract measures the cash to be received periodically by the investor If the rate of return demanded by the investors is exactly equal to the nominal rate, the bonds may be acquired at the face amount If the market rate of interest exceeds the nominal rate, the bonds may be acquired at a discount, because the investor is demanding a higher return than the bond contract offers; therefore,

to equate the yield on the bond with the market rate of interest, the bond is acquired at a price below face amount If the market rate of interest is below the nominal rate, the investor will be willing to pay a premium for the bond, that is, a price above face amount and the bond is said to be acquired at premium Dear learners! As described earlier the acquisition cost of a bond is the present value of the face amount of the bond and the present value of the periodic interest received computed using the effective interest rate Present value of Bond = PV of face amount + PV of periodic Interests received

r

r r

n

n

I P

PV

)

11

(

) 1 ( )

1 (

n = number of discounting period

I = Interest per period computed using nominal rate

r = effective rate

To illustrate the computation of the acquisition price of bonds, assume that Br 200,000

of 7% bonds of Villa Company maturing in 15 years are acquired by Kane Company to yield 8% compounded semi-annually The bonds pay interest semi-annually starting six months from the date of acquisition Because the market rate of interest exceeds the nominal rate, the bonds are acquired at a discount as shown below

Present value of Br 200,000 discounted at 4% for 30 six-month periods

(Br 200,000 x 0.308319)……… Br 61,664

Add: Present value of ordinary annuity of 30 rents of Br 7,000*

(Semi-annual interest payments) discounted at 4% (7,000 x 17.292033)…

Acquisition price of bonds (discount of Br 17,292) ……… Br 182,708

*(200,000 x 0.07 x ½ = Br 7,000)

Or

r

r r

n

n

I P

PV

)

11

(

) 1 ( )

1 (

11

(000,7.)

0.04+1(

000,200

PV

PV = Br 182,708

If the market rate of interest was only 6% compounded semi-annually, the bonds paying semi-annual interest at 7% a year would be acquired at a premium, as shown below (again using the Appendix at the end of this Module):

Present value of Br 200,000 discounted at 3% for 30 six-month periods

(Br 200,000 x 0.411987)……… Br 82,397 Add: Present value of ordinary annuity of 30 rents of Br 7,000*

(semi-annual interest payments) discounted at 3% (7,000 x 19.600441)… 137,203 Acquisition price of bonds (premium of Br 19,600) ……… Br 219,600

*(200,000 x 0.07 x ½ = Br 7,000)

Or

r

r r

n

n

I P

PV

)

11

(

) 1 ( )

1 (

11

(000,7.)

0.03+1(

000,200

PV

PV = Br 219,600

Example 2

Assume an Investor invested in Br 100,000 of five year, 7% term bond on January 2,

year 1 The bond promised to pay Br 100,000 at the end of the five years and Br.7, 000

(7% x Br.100, 000) annual interest The bond pays interest annually

Required

Under the following three alternative effective rate of interest, determine the acquisition

cost of the bond and give the appropriate journal entries for the investor

i If the effective market interest rate is 7%

ii If the effective market interest rate is 6%

iii If the effective market interest rate is 8%

Solution

i Effective rate (r) = 7%

0.07

))0.07+1(

11

(000,7.)

0.07+1(

000,100

PV

000,100

Br

PV 

Since the bond nominal rate is equal to the effective rate, the acquisition price of the bond

is the same as the face value The following is the appropriate journal entry in the book of

the investor

Year 1

Jan 2 Investment in issuer company bonds………100,000 Cash……… 100,000

(To record the acquisition of bonds at a face value)

ii Effective rate (r) = 6%

06.0

))06.01(

11

(000,7.)

06.01(

000,100

PV

213,104

Br

PV 