Investments and Fair Value Accounting

Full text

(1)

Warren Reeve Duchac Financial Accounting 14e

Investments and Fair

Value Accounting

15

C H A P T E R hum an/ iS toc k /36 0/ G et ty I m ages

(2)

Investing Cash in Current Operations

Cash may be used to replace worn-out equipment or

to purchase new, more efficient and productive

equipment.

In addition, cash may be reinvested in the company to

expand its current operations.

Cash may be used to pay:

o Expenses.

o Suppliers of merchandise and other assets. o Interest to creditors.

(3)

Investing Cash in Temporary Investments

Instead of letting excess cash remain idle in a checking account, most companies invest their excess cash in securities such as:

o Debt securities, which are notes and bonds that pay interest and have

a fixed maturity date.

o Equity securities, which are preferred and common stock that

represent ownership in a company and do not have a fixed maturity date.

Investments in debt securities and equity securities, termed

investments or temporary investments, are reported in the Current Assets section of the balance sheet.

The primary objective of investing in temporary investments is to earn interest revenue, receive dividends, or realize gains from increases in the market price of the securities.

(4)

Investing Cash in Long-Term Investments

Long-term investments often involve the purchase of a

significant portion of the stock of another company.

o Such investments usually have a strategic purpose:

Reduction of costs.

 Replacement of management.

 Expansion.

(5)

Accounting for Debt Investments

Debt securities include notes and bonds issued by

corporations and governmental organizations.

Most companies invest excess cash in bonds as

investments to earn interest revenue.

The accounting for bond investments includes

recording the following:

o Purchase of bonds o Interest revenue o Sale of bonds

(6)

Purchase of Bonds

The purchase of bonds is recorded by debiting an

investments account for the purchase price of the

bonds, including any brokerage commissions.

o A brokerage commission is the fee charged by the agent

who arranges the transaction between the buyer and seller.

If the bonds are purchased between interest dates,

the purchase price includes accrued interest since the

last interest payment.

o This is because the seller has earned the accrued interest,

but the buyer will receive the accrued interest when it is paid.

(7)

Sale of Bonds

The sale of a bond investment normally results in a

gain or loss.

o If the proceeds from the sale exceed the book value (cost)

of the bonds, then a gain is recorded.

o If the proceeds are less than the book value (cost) of the

bonds, a loss is recorded.

The gain or loss on the sale of bond investments is

reported as part of Other Income (Loss) on the income

statement.

(8)

Accounting for Equity Investments

A company may invest in the preferred or common stock of another company.

o The company investing in another company’s stock is the investor. o The company whose stock is purchased is the investee.

The percent of the investee’s outstanding stock purchased by the investor determines the degree of control that the investor has over the investee. This, in turn, determines the accounting method used to record the stock investment.

The percent of the investee’s outstanding stock purchased by the investor determines the degree of control that the investor has over the investee. This, in turn, determines the accounting method used to record the stock investment.

(9)

Cost Method: Less Than 20% Ownership

Investments of less than 20% of the investee’s

outstanding stock are accounted for by using the

cost

method

.

Under the cost method, entries are recorded for the

following transactions:

o Purchase of stock o Receipt of dividends o Sale of stock

(10)

Equity Method: Between 20%–50% Ownership

Investment of between 20% and 50% are accounted for using the equity method.

o Under the equity method, the stock is recorded initially at its cost,

including any brokerage commissions.

Under the equity method, the investment account is adjusted for the investor’s share of the net income and dividends of the

investee. These adjustments are as follows:

o Net income: The investor records its share of the net income of the

investee as an increase in the investment account. Its share of any net loss is recorded as a decrease in the investment account.

o Dividends: The investor’s share of cash dividends received from the

(11)

Consolidation: More Than 50% Ownership

(slide 1 of 2)

If the investor purchases more than 50% of the

outstanding stock of the investee, the investor is

considered to have control over the investee. The

purchase is termed a

business combination

.

o In this case, it is assumed that the investor purchased the

stock of the investee primarily for strategic reasons, such as to produce more efficiently, diversify product lines, expand geographically, or acquire know-how.

(12)

Consolidation: More Than 50% Ownership

(slide 2 of 2)

A corporation owning all or a majority of the voting

stock of another corporation is called a

parent

company

.

The corporation that is controlled is called the

subsidiary company

.

At the end of the year, the financial statements of the

parent and subsidiary are combined and reported as

a single company. These combined financial

statements are called

consolidated financial

statements

.

(13)

Valuing and Reporting Investments

Debt and equity securities are financial assets that are often traded on public exchanges such as the New York Stock

Exchange. As a result, their market value can be observed and, thus, objectively determined.

o For this reason, generally accepted accounting principles (GAAP) allows

some debt securities, and requires equity securities where there is less than a 20% ownership interest to be valued in the accounting records and financial statements at their fair market values.

 These securities are classified as follows:

– Trading securities

– Available-for-sale securities – Held-to-maturity securities

(14)

Trading Securities

(slide 1 of 3)

Trading securities

are debt and equity securities that

are purchased and sold to earn short-term profits

from changes in their market prices.

Trading securities are often held by banks, mutual

funds, insurance companies, and other financial

institutions.

Because trading securities are held as a short-term

investment, they are reported as a current asset on

the balance sheet.

(15)

Trading Securities

(slide 2 of 3)

Trading securities are valued as a portfolio (group) of securities using the securities’ fair values.

o Fair value is the market price that the company would receive for a

security if it were sold.

 A change in the fair value of the portfolio (group) of trading securities is recognized as an unrealized gain or loss for the period.

If the fair value of the portfolio of trading securities was less than the cost:

o The adjustment would debit Unrealized Loss on Trading Investments and

credit Valuation Allowance for Trading Investments for the difference.

o Unrealized Loss on Trading Investments would be reported on the

income statement as Other Expenses.

o Valuation Allowance for Trading Investments would be shown on the

balance sheet as a deduction from Trading Investments (at cost).

(16)

Trading Securities

(slide 3 of 3)

Over time, the valuation allowance account is

adjusted to reflect the difference between the cost

and fair value of the portfolio.

o Thus, increases in the valuation allowance account from the

beginning of the period will result in an adjustment to record an unrealized gain.

o Likewise, decreases in the valuation allowance account from

the beginning of the period will result in an adjustment to record an unrealized loss.

(17)

Available-for-Sale Securities

(slide 1 of 4)

Available-for-sale securities

are debt and equity

securities that are neither held for trading, held to

maturity, nor held for strategic reasons.

Changes in the fair values of available-for-sale

securities are reported as part of stockholders’ equity

and, thus, excluded from the income statement.

(18)

Available-for-Sale Securities

(slide 2 of 4)

The valuation allowance and unrealized gain are

reported on the balance sheet as follows:

(19)

Available-for-Sale Securities

(slide 3 of 4)

If the fair value of the portfolio of available-for-sale

securities was less than the cost:

o The adjustment would debit Unrealized Gain (Loss) on

Available-for-Sale Investments and credit Valuation Allowance for Available-for-Sale Investments for the difference.

o Unrealized Gain (Loss) on Available-for-Sale Investments

would be reported in the Stockholders’ Equity section as a negative item.

o Valuation Allowance for Available-for-Sale Investments

would be shown on the balance sheet as a deduction from Available-for-Sale Investments (at cost).

(20)

Available-for-Sale Securities

(slide 4 of 4)

Over time, the valuation allowance account is

adjusted to reflect the difference between the cost

and fair value of the portfolio.

o Thus, increases in the valuation allowance from the

beginning of the period will result in an adjustment to record an increase in the valuation and unrealized gain (loss) accounts.

o Likewise, decreases in the valuation allowance from the

beginning of the period will result in an adjustment to

record decreases in the valuation and unrealized gain (loss) accounts.

(21)

Held-To-Maturity Securities

(slide 1 of 2)

Held-to-maturity securities

are debt investments, such

as notes or bonds, that a company intends to hold until

their maturity date.

Held-to-maturity securities are primarily purchased to

earn interest revenue.

If a held-to-maturity security will mature within a

year, it is reported as a current asset on the balance

sheet. Held-to-maturity securities maturing beyond a

year are reported as noncurrent assets.

(22)

Held-To-Maturity Securities

(slide 2 of 2)

Only securities with maturity dates, such as corporate notes and bonds, are classified as held-to-maturity securities.

o Equity securities are not held-to-maturity securities because they have no

maturity date.

Held-to-maturity bond investments are recorded at their cost, including any brokerage commissions.

If the interest rate on the bonds differs from the market rate of interest, the bonds may be purchased at a premium or discount.

o In such cases, the premium or discount is amortized over the life of the

bonds.

Held-to-maturity bond investments are reported on the balance sheet at their amortized cost.

(23)

Fair Value Accounting

Fair value is the price that would be received for

selling an asset.

Fair value assumes that the asset is sold under normal

business conditions.

Generally accepted accounting principles require

trading and available-for-sale investments to be

recorded at their fair value.

(24)

Effect of Fair Value Accounting on the

Financial Statements: Balance Sheet

When an asset is reported at its fair value, any

difference between the asset’s original cost or prior

period’s fair value must be reported in a valuation

allowance.

Changes in the fair value of available-for-sale

securities are included as part of stockholders’ equity

through the comprehensive income and accumulated

other comprehensive income accounts.

(25)

Effect of Fair Value Accounting on the

Financial Statements: Income Statement

Although trading securities are reported at fair value

in the balance sheet, changes in their fair values are

not reported as part of stockholders’ equity; rather,

the unrealized gains or losses are reported on the

income statement.

(26)

Financial Analysis and Interpretation:

Dividend Yield

The

dividend yield

measures the rate of return to

stockholders, based on cash dividends.

Dividend yield is most often computed for common

stock because preferred stock has a stated dividend

rate.

o In contrast, the cash dividends paid on common stock

normally vary with the profitability of the corporation.

The dividend yield is computed as follows:

Dividend Yield = Dividends per Share of Common Stock

(27)

Appendix: Comprehensive Income

Comprehensive income is defined as all changes in

stockholders’ equity during a period, except those resulting from dividends and stockholders’ investments.

Comprehensive income is computed by adding or subtracting other comprehensive income to (from) net income, as follows:

o Other comprehensive income items include unrealized gains and losses

on available-for-sale securities as well as other items such as foreign currency and pension liability adjustments.

 The cumulative effect of other comprehensive income is reported on the balance sheet, as accumulated other comprehensive income.

Figure

Updating...

References

Updating...

Related subjects : Fair Value Accounting