Principles of financial accounting 12e by needles crosson appendix a

 Investments in debt and equity securities are classified as either short-term or long-term..  Short-term and long-term investments must be further classified as trading securities,

Concepts and Management Issues

Related to Investments

 A company invests in the stock or debt securities of other firms for one or more

of the following reasons:

– A company may temporarily have excess

funds on which it can earn a return.

– Investments may be an integral part of the company’s business, as in the case of a

bank.

– A company may invest in other firms for the purpose of partnering with or controlling

them.

 Purchases and sales of investments are

recorded on the date on which they are made.

 Income from investments is reported as other income on the income statement Any gains or losses are also reported on the income

statement.

 Gains and losses appear as adjustments in the operating activities section of the statement of cash flows The cash amounts of purchases

and sales of investments appear in the

investing activities section of the statement of cash flows.

 Investments are valued according to the cost

principle—that is, their cost at the time they

are purchased, including any commissions or

fees.

 However, after purchase, the value of the

investments on the balance sheet is adjusted

to reflect subsequent conditions, including:

– Changes in the market value or fair value of the

investments – Changes caused by the passage of time (as in

amortization) – Changes in the operations of the investee

companies

 Long-term investments must be evaluated

annually for any impairment or decline in

value that is more than temporary If such an impairment exists, a loss on the investment

must be recorded.

 Under certain circumstances, companies are required to measure investments at fair value.

– Fair value is not difficult to determine when there is

a ready market in which there are buyers and sellers for an asset.

– However, if a ready market does not exist, another valuation technique must be used.

 Investments in debt and equity securities

are classified as either short-term or

long-term.

– Short-term investments (or marketable

securities) have a maturity of more than 90

days but are intended to be held only until cash

is needed for current operations.

– Long-term investments , which are intended

to be held for more than one year, are reported

in the investments section of the balance sheet

 Although long-term investments may be just as marketable as short-term assets, management intends to hold them for an indefinite time.

 Short-term and long-term investments must be

further classified as trading securities, for-sale securities, or held-to-maturity securities – Trading securities are debt or equity securities

available-bought and held principally for the purpose of being sold in the near term.

– Available-for-sale securities are debt or equity

securities that do not meet the criteria for either trading

or held-to-maturity securities They may be short- or long-term depending on management’s intentions.

– Held-to-maturity securities are debt securities that management intends to hold until their maturity date.

Accounting for Equity Investments

– In general, the percentage of ownership in another company’s stock has the following effects:

 Noninfluential and noncontrolling investment : A firm that owns less than 20 percent of the stock of another

company has no influence on the other company’s operations.

 Influential but noncontrolling investment : A firm that owns between 20 to 50 percent of another company’s stock

can exercise significant influence over that company’s

operating and financial policies Indications of significant influence include representation on the board of directors, participation in policymaking, exchange of managerial personnel, and technological dependency between the two companies.

 Controlling investment : A firm that owns more than 50 percent of another company’s stock can exercise control over that company.

Ethics of Investing

 When a company engages in investment

transactions, there is always the possibility that its employees may use their knowledge about the transactions for personal gain.

– Insider trading , or making use of inside

information for personal gain, is unethical and illegal.

 Before a publicly held company releases significant information about an investment to its stockholders and the general public, its officers and employees are not allowed to buy or sell stock in the company or in the firm whose shares the company is buying.

 Only after the information is released to the public can insiders engage in such trading.

Short-Term Investments in Trading Securities

 Trading securities are always short-term investments and are frequently bought

and sold to generate profits on short-term changes in their prices.

– They are classified as current assets on the

balance sheet and are valued at fair value, which is usually the same as market value.

– An increase or decrease in the fair value of a company’s total trading portfolio is included

in net income in the period in which the increase or decrease occurs.

Available-for-Sale Securities

 Short-term available-for-sale securities are accounted for in the same way as trading securities, with two exceptions:

– An unrealized gain or loss is reported as

other comprehensive income (loss).

– If a decline in the value of a security is

considered permanent, it is charged as a loss on the income statement.

Long-Term Investments in Equity Securities

 The accounting treatment of long-term investments in equity securities, such

as common stock, depends on the

extent to which the investing company can exercise control over the other

company.

Noninfluential and Noncontrolling Investment

(slide 1 of 3)

 Available-for-sale securities are debt or equity

securities than cannot be classified as trading or held-to-maturity securities.

– When long-term equity securities are involved, a further criterion for classifying them as available for sale is that they be noninfluential and noncontrolling investments of less than 20 percent of the voting stock.

– Accounting for long-term available-for-sale securities

requires using the cost-adjusted-to-market method

 With this method, the securities are initially recorded at cost and are thereafter adjusted periodically for

changes in market value by using an allowance account.

Noninfluential and Noncontrolling Investment

 The debit part of the entry is treated as a temporary decrease and does not appear as a loss on the income statement It is shown in an account called Unrealized Loss on Long-Term Investments, which is reported on a statement of other comprehensive income.

Noninfluential and Noncontrolling Investment

(slide 3 of 3)

 If the market value exceeds the cost, the allowance account is added to Long-Term Investments, and the unrealized gain appears on the statement of other comprehensive income.

– When a company sells its long-term

investments in stock, the difference between the sale price and the cost of the stock is recorded and reported as a realized gain or loss on the income statement.

– Dividend income from such investments is recorded by a debit to Cash and a credit to Dividend Income.

An Influential but Noncontrolling Investment

 When a firm owns between 20 to 50 percent of

another company’s stock, the equity method

should be used to account for the stock investment.

– The three main features of this method are as follows:

 The investor records the original purchase of the stock at cost.

 The investor records its share of the company’s periodic net income as an increase in the Investment account, with a corresponding credit to an income account It records its share

of any periodic loss as a decrease to the Investment account, with a corresponding debit to a loss account.

 When the investor receives a cash dividend, the Cash account

is increased, and the Investment account is decreased.

statements into a single set of statements called

consolidated financial statements

Investments in Debt Securities

 When a company purchases debt securities, it records them at cost plus any commissions or fees.

 Like investments in equity securities,

short-term investments in debt securities are valued

at fair value at the end of the period and are accounted for as trading securities or

available-for-sale securities.

 However, the accounting treatment is

different if they qualify as held-to-maturity

securities.

Held-to-Maturity Securities

 Held-to-maturity securities are debt

securities that management intends to hold to their maturity date.

 Such securities are recorded at cost

and are valued on the balance sheet at cost adjusted for the effects of interest.

Long-Term Investments in Bonds

 Like all investments, investments in bonds are recorded at cost, which, in this case, is the price of the bonds plus the broker’s

commission.

– When bonds are purchased between interest payment

dates, the purchaser must also pay an amount equal to the interest that has accrued on the bonds since the last

interest payment date.

– Then, on the next interest payment date, the purchaser

receives an interest payment for the whole period.

 The payment for accrued interest should be recorded as

a debit to Interest Income, which will be offset by a credit to Interest Income when the interest is received.

Long-Term Investments in Bonds

investments depends on the classification of the bonds.

– Most long-term bond investments are classified as

available-for-sale securities Such bonds are accounted for at fair value, which is usually the market value.

– When bonds are intended to be held to maturity, they are accounted for not at fair value but at cost, adjusted for the amortization of their discount or premium.

 The procedure is similar to accounting for long-term bond liabilities, except that separate accounts for discounts and premiums are not used.