CHAPTER 16

INVESTMENTS

Learning Objectives

1. EXPLAIN HOW TO ACCOUNT FOR DEBT

INVESTMENTS.

2. EXPLAIN HOW TO ACCOUNT FOR STOCK

INVESTMENTS.

3. DISCUSS HOW DEBT AND STOCK INVESTMENTS ARE

REPORTED IN FINANCIAL STATEMENTS.

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 CHAPTER REVIEW

Why Corporations Invest

1. Corporations purchase investments because (1) they may have excess cash, (2) they generate
earnings from investment income, and (3) for strategic reasons.

Accounting for Debt Investments

2. (L.O. 1) Debt investments are investments in government and corporation bonds. At acquisition,
debt investments are recorded at cost and all expenditures necessary to acquire these
investments are included in the cost (e.g., brokerage fees). At acquisition, Debt Investments is
debited and Cash is credited for the cost of the investment.

3. Interest revenue must also be recorded on debt investments. Assume Bodhi Company (fiscal year
ends December 31) receives $2,000 interest every six months on a debt investment purchased
April 1, 2014. The following entries are required:

Oct. 1 Cash........................................................................... 2,000

Interest Revenue................................................. 2,000

Dec. 31 Interest Receivable..................................................... 1,000

Interest Revenue................................................. 1,000

Apr. 1 Cash........................................................................... 2,000

Interest Receivable............................................. 1,000
Interest Revenue................................................. 1,000

4. When bonds are sold, it is necessary to credit the Investment account for the cost of the bonds,
debit Cash, and any difference between the sale price and cost of bonds is recorded as a gain or
loss. The gain or loss on the sale of debt investments is reported under Other revenues and gains
or Other expenses and losses, respectively, in the income statement.

Accounting for Stock Investments

5. (L.O. 2) Stock investments are investments in the capital stock of corporations. The accounting
for stock investments differs depending on the degree of influence the investor has over the issuing
corporation. The presumed influences based on the investor’s ownership interest and the
accounting guidelines that are to be used are as follows:
Investor’s Ownership Interest Presumed Influence
in Investee’s Common Stock on Investee Accounting Guidelines
Less than 20% Insignificant Cost Method
Between 20% and 50% Significant Equity Method
More than 50% Controlling Consolidated financial
statements

Holdings Less than 20%

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 6. In accounting for stock investments of less than 20%, the cost method is used. Under the cost
method, the investment is recorded at cost and revenue is recognized only when cash dividends
are received.

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 a. At acquisition, stock investments are recorded at cost. Stock Investments is debited and Cash
is credited.
b. When dividends are received, Cash is debited and Dividend Revenue is credited.
c. When stock is sold, Cash is debited, Stock Investments is credited, and any difference between
the two is debited or credited to Loss or Gain on Sale of Stock Investments, respectively. The
loss or gain is reported under Other Expenses and Losses or Other Revenues and Gains in
the income statement.

Holdings Between 20% and 50%

7. When an investor owns between 20% and 50% of the common stock of a corporation, it is
generally presumed that the investor has a significant influence over the financial and operating
activities of the investee; and therefore the equity method is used. Under the equity method, the
investor does not record its share of the investee income until the investee has earned income.
a. At acquisition, the investor records the investment at cost. Stock Investments is debited and
Cash is credited.
b. Each year, the investor records its share of the investee’s income (investee’s income X % of
ownership in investee) with a debit to Stock Investments and a credit to Revenue from Stock
Investments (if the investee incurred a loss, then the opposite entry is made).
c. Upon receiving dividends from the investee, the investor makes a debit to Cash and a credit
to Stock Investments.

Holdings of More Than 50%

8. (L.O. 4) A company that owns more than 50% of the common stock of another entity is known
as the parent company. The entity whose stock is owned by the parent company is called the
Subsidiary (affiliated) company. Because of its stock ownership, the parent company has a
controlling interest in the subsidiary company.

9. When a company owns more than 50% of the common stock of another company, consolidated
financial statements are usually prepared. Consolidated financial statements present the assets
and liabilities controlled by the parent company and the aggregate profitability of the subsidiary
companies.

Valuation and Reporting of Investments

10. (L.O. 3) For purposes of valuation and reporting at a financial statement date, debt and stock
investments are classified into the following three categories.
a. Trading securities are securities bought and held primarily for sale in the near term to
generate income on short-term price differences.
b. Available-for-sale securities are securities the company may sell sometime in the future.
c. Held-to-maturity securities are debt securities that the investor has the intent and ability to
hold to maturity.

11. The valuation guidelines for the above securities are as follows:

Trading Available-for-sale Held-to-maturity

At fair value with At fair value with changes At amortized cost
changes reported in reported in the stock-
net income holders’ equity section

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Trading Securities

12. When the trading securities are not sold, the difference between the total cost of the securities
and their total fair value is reported as unrealized gains or losses in the income statement. The
adjusting entry to record an unrealized gain would include a debit to Fair Value Adjustment—
Trading and a credit to Unrealized Gain—Income. The adjusting entry to record an unrealized loss
would include a debit to Unrealized Loss—Income and a credit to Fair Value Adjustment—
Trading. The unrealized gains or losses are reported in the income statement under Other
revenues and gains or Other expenses and losses, respectively.

Available-for-Sale

13. If available-for-sale securities are held with the intent to sell them within the next year or operating
cycle, the securities are classified as current assets in the balance sheet. Otherwise, they are
classified as long-term assets in the investments section of the balance sheet.

14. The available-for-sale securities adjusting entry is made in the same way as the trading securities
adjusting entry except that the unrealized gain or loss is reported in the stockholders’ equity
section of the balance sheet. This balance is then adjusted with the Fair Value Adjustment
account to show the difference between the cost and fair value at that time.

15. Short-term investments are securities held by a company that are (a) readily marketable and (b)
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.

16. An investment is readily marketable when it can be sold easily whenever the need for cash
arises. Intent to convert means that management intends to sell the investment within the next
year or the operating cycle, whichever is longer.

Balance Sheet Presentation

17. Short-term investments are listed immediately below cash in the current assets section of the
balance sheet. Short-term investments are reported at fair value. Long-term investments are
generally reported in a separate section of the balance sheet immediately below current assets;
and available-for-sale securities are reported at fair value, and investments in common stock
accounted for under the equity method are reported at equity.

18. In the income statement, the following items are reported in the nonoperating activities section:

Other Revenue and Gains Other Expenses and Losses

Interest Revenue Loss on Sale of Investments
Dividend Revenue Unrealized Loss—Income
Gain on Sale of Investments
Unrealized Gain—Income

The unrealized gain or loss on available-for-sale securities is reported as a separate component

of stockholders’ equity.

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 LECTURE OUTLINE

A. Why Corporations Invest.

1. Corporations purchase investments in debt or stock securities for

several different reasons.

2. To house excess cash until needed.

3. To generate earnings from investments.

4. To meet strategic goals (i.e., gaining control of a competitor).

B. Accounting for Debt Investments.

1. Companies record investments in debt securities when they purchase bonds,

receive or accrue interest, and sell the bonds.

2. At acquisition, debt investments are recorded at cost. Cost includes all

expenditures necessary to acquire the investment, such as the price paid
plus brokerage fees (commissions).

3. When a company sells debt investments, it 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 investment.

C. Accounting for Stock Investments.

1. 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). The general guidelines for stock
investments are:

TEACHING TIP

Emphasize that evidence of the extent of investor influence is the determining

factor in choosing the proper accounting method.

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 Investor’s Ownership Presumed Influence Accounting
Interest in Investee Guidelines
on Investee
Less than 20% Cost method
Insignificant
Between 20 and 50% Equity method
Significant
More than 50% Consolidated
Controlling financial statements

2. Companies record common stock investments of less than 20% when

they purchase the stock, receive dividends, and sell the stock.

a. Companies record the receipt of dividends with a debit to Cash and

a credit to Dividend Revenue.

b. 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 investment.

3. 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, and the investment
should be accounted for by the equity method.

a. Under the equity method, the investor company initially records the
investment in common stock at cost, and it annually adjusts the invest-
ment account to show the investor’s equity in the investee.

b. Each year, the investor debits the investment account and credits
revenue for its share of the investee’s net income.

c. The investor records dividends received with a debit to Cash and a

credit to the investment account.

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 4. A company that owns more than 50% of the common stock of another
entity is known as the parent company and has a controlling interest in the
subsidiary (affiliated) company. When a company owns more than 50%
of the common stock of another company, it usually prepares consolidated
financial statements.

5. Consolidated financial statements present the total assets and liabilities

controlled by the parent company. They also present the total revenues
and expenses of the subsidiary companies. Consolidated statements are
useful to the stockholders, board of directors, and management of the
parent company because they indicate the magnitude and scope of
operations of the companies under common control.

ACCOUNTING ACROSS THE ORGANIZATION

Recently, Procter & Gamble acquired Gillette Company for $53.4 billion. The
common stockholders of Procter & Gamble are in a position to elect the board of
directors of Gillette and, in effect, control its operations.

Where on Procter & Gamble’s balance sheet will you find its investment in
Gillette Company?

Answer: Because Procter & Gamble owns 90% of Gillette, P&G does not report
Gillette in the investment section of its balance sheet. Instead, Gillette’s
assets and liabilities are included and commingled with the assets and
liabilities of Procter & Gamble.

D. Valuing and Reporting Investments.

1. Companies classify all debt securities and stock investments in which

the holdings are less than 20% into three categories for valuation and
reporting purposes: (1) trading securities, (2) available-for-sale securities,
and (3) held-to-maturity securities.

a. Trading securities are bought and held primarily for sale in the near
term to generate income on short-term price differences.

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 b. Available-for-sale securities are held for purposes other than
trading. Companies may sell these securities sometime in the
future.

c. Held-to-maturity securities are debt securities that the investor has

the intent and ability to hold to maturity.

2. Fair value is the amount for which a security could be sold in a normal
market.

3. Companies report trading securities at fair value with the unrealized gains or
losses reported as part of net income. Companies report the unrealized
gain (or loss) in the Other revenues and gains (or Other expenses and
losses) section in the income statement.

ACCOUNTING ACROSS THE ORGANIZATION

Many companies have equity investments of some type. For example, the total
amount of equity-method investments appearing on company balance sheets is
approximately $403 billion.

Why might the use of the equity method not lead to full disclosure in the financial
statements?

Answer: Under the equity method, the investment in common stock of another
company is initially recorded at cost. After that, the investment account
is adjusted at each reporting date to show the investor’s equity in the
investee. However, on the investor’s balance sheet, only the investment
account is shown. The pro-rata share of the investee’s assets and
liabilities are not reported. Because the pro-rata share of the investee’s
assets and liabilities are not shown, some argue that the full disclosure
principle is violated.

4. Companies report available-for-sale securities at fair value and the unrealized

gains or losses as a separate component of stockholders’ equity.

5. Companies use a Fair Value Adjustment account to adjust the securities

to their fair value. Companies add (deduct) the Fair Value Adjustment
debit (credit) balance to (from) the cost of the investments to arrive at
the securities’ fair value.

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E. Short-Term and Long-Term Investments.

1. Short-term investments (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.

2. Investments that do not meet both criteria are classified as long-term

investments.

a. An investment is readily marketable when it can be sold easily when-

ever the need for cash arises. Short-term paper (CDs, money market
certificates, Treasury bills) meets this criterion as do stocks and
bonds traded on organized securities exchanges (i.e., New York
Stock Exchange).

b. Intent to convert means that management intends to sell the investment

within the next year or operating cycle, whichever is longer.

c. Short-term investments appear immediately below Cash in the

“Current assets” section of the balance sheet and are reported at
fair value.

d. Companies generally report long-term investments in a separate

section of the balance sheet immediately below “Current assets”.

F. Presentation of Realized and Unrealized Gain or Loss.

1. Companies must report in the income statement in the nonoperating activi-

ties section gains and losses on trading securities, whether realized or
unrealized.

2. Companies report an unrealized gain or loss on available-for-sale securities

as a separate component of stockholders’ equity.

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 IFRS
A Look at IFRS

Until recently, when the IASB issued IFRS 9, the accounting and reporting for
investments under IFRS and GAAP were for the most part very similar. However,
IFRS 9 introduces new investment classifications and increases the situations
when investments are accounted for at fair value, with gains and losses recorded
in income.

KEY POINTS

• The basic accounting entries to record the acquisition of debt securities, the
receipt of interest, and the sale of debt securities are the same under IFRS and
GAAP.

• The basic accounting entries to record the acquisition of stock investments, the
receipt of dividends, and the sale of stock securities are the same under IFRS
and GAAP.

• Both IFRS and GAAP use the same criteria to determine whether the equity
method of accounting should be used—that is, significant influence with a
general guide of over 20% ownership, IFRS uses the term associate
investment rather than equity investment to describe its investment under the
equity method.

• Under IFRS, both the investor and an associate company should follow the
same accounting policies. As a result, in order to prepare financial information,
adjustments are made to the associate’s policies to conform to the investor’s
books. GAAP does not have that requirement.

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• The basis for consolidation under IFRS is control. Under GAAP, a bipolar
approach is used, which is a risk-and-reward model (often referred to as a
variable-entity approach) and a voting-interest approach. However, under both
systems, for consolidation to occur, the investor company must generally own
50% of another company.

• In general, IFRS requires that companies determine how to measure their

financial assets based on two criteria:
♦ The company’s business model for managing their financial assets; and
♦ The contractual cash flow characteristics of the financial asset.
If a company has (1) a business model whose objective is to hold assets in
order to collect contractual cash flows and (2) the contractual terms of the
financial asset gives specified dates to cash flows that are solely payments of
principal and interest on the principal amount outstanding, then the company
should use cost (often referred to as amortized cost). For example, assume that
Mitsubishi purchases a bond investment that it intends to hold to maturity (held-
for-collection). Its business model for this type of investment is to collect interest
and then principal at maturity. The payment dates for the interest rate and
principal are stated on the bond. In this case, Mitsubishi accounts for the
investment at cost. If, on the other hand, Mitsubishi purchased the bonds as
part of a trading strategy to speculate on interest rate changes (a trading
investment), then the debt investment is reported at fair value. As a result, only
debt investments such as receivables, loans, and bond investments that meet
the two criteria above are recorded at amortized cost. All other debt
investments are recorded and reported at fair value.

• Equity investments are generally recorded and reported at fair value under
IFRS. Equity investments do not have a fixed interest or principal payment
schedule and therefore cannot be accounted for at amortized cost. In general,
equity investments are valued at fair value, with all gains and losses reported in
income.

• GAAP classifies investments as trading, available-for-sale (both debt and equity

investments), and held-to-maturity (only for debt investments). IFRS uses held-
for-collection (debt investments), trading (both debt and equity investments),
and non-trading equity investment classifications. GAAP classifications are
based on management’s intent with respect to the investment. IFRS

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 classifications are based on the business model used to manage the
investments and the type of security.

• The accounting for trading investments is the same between GAAP and IFRS.
Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are
accounted for at amortized cost. Gains and losses related to available-for-sale
securities (GAAP) and non-trading equity investments (IFRS) are reported in
other comprehensive income.

• Unrealized gains and losses related to available-for-sale securities are reported

in other comprehensive income under GAAP and IFRS. These gains and
losses that accumulate are then reported in the balance sheet.

• IFRS does not use “Other revenues and gains” or “Other expenses and losses”
in its income statement presentation. It will generally classify these items as
unusual items or financial items.

LOOKING TO THE FUTURE

As indicated earlier, both the FASB and IASB have indicated that they believe
that all financial instruments should be reported at fair value and that changes in
fair value should be reported as part of net income. It seems likely, as more
companies choose the fair value option for financial instrument, that we will
eventually arrive at fair value measurement for all financial instruments.

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 20 MINUTE QUIZ

True/False
1. To be considered a short-term investment, the investment must be readily marketable
and management should intend to convert the investment into cash within the next year
or operating cycle, whichever is longer.
True False

2. Accounting for short-term investments involves entries for the acquisition, interest and
dividend revenue, and the sale.
True False

3. The accounting guidelines for long-term investments in stock are based on the extent of
the investor’s influence over the operating affairs of the issuing corporation.
True False

4. Under the equity method of accounting, the investment account is credited for the investor’s
share of investee earnings and is debited for dividends received from the investee.
True False

5. A parent/subsidiary relationship exists only when the parent company has a controlling
interest in the subsidiary company.
True False

6. Consolidated financial statements are useful to parent company stockholders and managers
because they indicate the magnitude and scope of operations of the companies under
common control.
True False

7. The Fair Value Adjustment balance could be added to the cost of the investments to
arrive at their fair value.
True False

8. Under the fair value method, companies report the unrealized gain in the income state-
ment for available-for-sale securities.
True False

9. Companies report both realized and unrealized gains and losses on trading securities in
the income statement.
True False

10. Pension funds and banks regularly invest in equity securities for strategic reasons.

True False

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Multiple Choice

1. Ross Corporation purchased 6,000 shares of Hunter common stock at $60 per share
plus $7,200 brokerage fees as a short-term investment. The shares were subsequently
sold at $65 per share less $8,400 brokerage fees. The cost of the securities purchased
and gain or loss on the sale were
Cost Gain or Loss
a. $360,000 $30,000 gain
b. $360,000 $14,400 gain
c. $367,200 $14,400 gain
d. $367,200 $14,400 loss

2. A company pays $600,000 for 30% of the common stock of X, Inc. In the first year, X,
Inc. reports net income of $120,000 and pays a cash dividend of $45,000. The balance in
Stock Investments-X, at year end under the equity method is:
a. $577,500.
b. $622,500.
c. $636,000.
d. $675,000.

3. The equity method is used when the investor

a. makes long-term investments in stocks.
b. plans to sell the investments within one year.
c. owns less than 20% of the investee’s common stock.
d. owns between 20% and 50% of the investee’s common stock.

4. At the end of its first year, the trading securities portfolio consisted of the following securities:
Cost Fair Value
Magnum Corp. $38,000 $40,000
Spencer Inc. 49,000 43,000
$87,000 $83,000

The unrealized loss to be recognized is

a. $2,000.
b. $6,000.
c. $4,000.
d. none of the above.

5. Which of the following would not appear in an income statement?

a. Unrealized gain on trading securities.
b. Realized gain on available-for-sale securities.
c. Unrealized loss on available-for-sale securities.
d. Realized loss on trading securities.

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 ANSWERS TO QUIZ

True/False

1. True 6. True
2. True 7. True
3. True 8. False
4. False 9. True
5. True 10. False

Multiple Choice

1. c.
2. b.
3. d.
4. c.
5. c.

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