APPENDIX A Accounting for Investments Principles of Accounting 12e Needles Powers Crosson © human/iStockphoto 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Recognition  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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Valuation  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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Valuation  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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Classification  Investments in debt and equity securities are classified as either short-term or long-term – S ho rt-te rm inve s tme nts (or m arke table s e curitie s ) have a maturity of more than 90 days but are intended to be held only until cash is needed for current operations – Lo ng -te rm inve s tme nts , 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Classification  Short-term and long-term investments must be further classified as trading securities, available-forsale securities, or held-to-maturity securities – Trading s e c uritie s are debt or equity securities bought and held principally for the purpose of being sold in the near term – Available -fo r-s ale s e c uritie s are debt or equity securities that not meet the criteria for either trading or held-tomaturity securities They may be short- or long-term depending on management’s intentions – He ld-to -maturity s e c uritie s are debt securities that management intends to hold until their maturity date ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Accounting for Equity Investments – In general, the percentage of ownership in another company’s stock has the following effects:  No ninflue ntial and no nc o ntro lling inve s tme nt: A firm that owns less than 20 percent of the stock of another company has no influence on the other company’s operations  Influe ntial but no nc o ntro lling inve s tme nt: A firm that owns between 20 to 50 percent of another company’s stock can exercise s ignificant influe nce 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  Co ntro lling inve s tme nt: A firm that owns more than 50 percent of May another company’s exercise ©2014 Cengage Learning All Rights Reserved not be scanned, copied or duplicated, orstock posted to a can publicly accessible website, incontrol whole or in part 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 – Ins ide r 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Noninfluential and Noncontrolling Investment (slide 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 c o s t-adjus te d-to -marke t me tho d  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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Noninfluential and Noncontrolling Investment (slide of 3) – The unrealized gain/loss resulting from the adjustment is reported as other comprehensive income (loss) – At the end of the accounting period, the total cost and the total market value of these long-term investments must be determined  If the total market value is less than the total cost, the difference must be credited to a contra-asset account called Allowance to Adjust Long-Term Investments to Market  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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Noninfluential and Noncontrolling Investment (slide 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part An Influential but Noncontrolling Investment  When a firm owns between 20 to 50 percent of another company’s stock, the e quity me tho d 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part A Controlling Investment  Ownership of more than 50 percent of the voting stock is required for accounting recognition of control – When a firm has a controlling interest in another company, a parent-subsidiary relationship is said to exist The investing company is the pare nt c o mpany; the other company is a s ubs idiary – The FASB requires that the parent company and its subsidiaries combine their financial statements into a single set of statements called c o ns o lidate d financ ial s tate me nts ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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, shortterm 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Long-Term Investments in Bonds  Subsequent accounting for long-term bond 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 ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part  ... 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 ©2014 Cengage Learning... 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... and financial policies Indications of significant influence include representation on the board of directors, participation in policymaking, exchange of managerial personnel, and technological