CHAPTER 17 INVESTMENTS In accounting for investments entries

CHAPTER 17

INVESTMENTS • In accounting for investments, entries are required to record the: – Acquisition – Interest/dividends – Disposal

TYPES OF INVESTMENTS 1. DEBT – Bonds, GICs, T-Bills, Commercial Paper – Typically: • • Come with no ownership or decision-making rights Priority claim on the assets of a debtor when insolvent Are interest bearing securities that pay a stated annual interest rate on a “face value” or “principal” Interest fully taxable 2. EQUITY – Stocks, real assets – Typically: • • • Come with ownership and voting rights in a business Last to be paid off in a bankruptcy Value is linked to expectation of future cash flows of the business Some may pay dividends (return of profits to owner) but don’t have to Tax favoured status for lower tax brackets NOTE: Capital gains can be earned on Debt or Equity investments and are only 50% taxable in Canada. Do you know the difference between Profit, Interest, Dividends, and Capital gains?

ACCOUNTING FOR INVESTMENTS • Accounting for DEBT investments differs depending on whether investments are 1. Temporary, or 2. Long-term • Accounting for EQUITY differs depending on how much of the company’s stock you own.

TEMPORARY VS. LONG-TERM INVESTMENTS • Temporary investments are securities, held by a company, that are 1. 2. • Readily marketable (can be sold easily), and Intended to be converted into cash in the near future (<12 mths). Investments that do not meet both criteria are classified as long-term investments.

TEMPORARY INVESTMENTS AND THE OPERATING CYCLE • At the end of their operating cycles, many companies may have idle cash on hand (temporarily) • Until the cash is needed, these companies may invest the excess funds to earn interest and dividends. Cash Accounts Receivable Invest Sell Inventory Temporary Investments

TEMPORARY INVESTMENTS AND THE OPERATING CYCLE • Why would you bother with temporary investments? Does it make that much of a difference in revenues? • Reasons: – Opportunity cost – Will invest only if no superior opportunities for money – Time value of money – avoids inflationary erosion of purchasing power – Profitability – MUST understand the cost structure of a business; observe…

Assume Company A and B are identical, and both have an extra $1 million available for three months this year. Company A lets it sit in the business’s regular bank account, earning no interest. Company B invests in a 90 -day Bond which pays 8% per annum.

TEMPORARY DEBT INVESTMENTS NOTE: I recommend you start a fresh page and make a chart in your notes like this one (leave enough space for a journal entry in each section): Temporary 1. Acquiring Bonds 2. Recording Interest Earned 3. Disposing of (selling) Bonds Long-Term

TEMPORARY DEBT INVESTMENTS 1. Acquisition • Kuhl Corporation acquires 50 Doan Inc. 6%, 10 -year, $1, 000 bonds on January 1 for $54, 000. The bonds pay interest on December 31. • The entry to record the temporary investment is: Date Jan. 1 Particulars Bonds Cash Debit 54, 000 Credit 54, 000

TEMPORARY DEBT INVESTMENTS 2. Interest • Interest receipts are calculated using the bond’s face or principal value, which is $50, 000 (50 x $1, 000). • The interest for December 31 will be $3, 000 ($50, 000 x 6%). The entry on December 31 is: Date Dec 31 Particulars Cash Interest Revenue Debit 3, 000 Credit 3, 000

TEMPORARY DEBT INVESTMENTS 3. Disposal Assume the Bond is sold for $49, 000 on April 30 of year 2. Step 1: Record interest up to the date of disposal. Date April 30 Year 2 Particulars Interest Receivable Interest Revenue (4/12 of $3, 000) Debit 1, 000 Credit 1, 000 Step 2: Dispose of the Bond. Date April 30 Year 2 Particulars Cash Loss on Sale of Bond Interest Receivable Bonds Debit 49, 000 6, 000 Credit 1, 000 54, 000

LONG-TERM DEBT INVESTMENTS 1. Acquisition • Market forces determine the price of a bond; this is almost NEVER the same as the face value • When you hold bonds for the long-term, you must recognize the difference in price paid and the face value. Date Jan. 1 Year 1 Particulars Bonds Premium on bonds Cash Debit 50, 000 4, 000 Credit 54, 000

LONG-TERM DEBT INVESTMENTS 2. Interest • As interest accrues, a bond premium (or discount) must be amortized over the life of the bond, since nothing will be received for the premium when the bond matures (only the face value will be paid by the issuer of the bond). This corresponds with the Matching Principle. • The straight-line method is used G to!amortize bond N U T premiums and discounts. H Why? Date Dec 31 Year 1 C A Particulars Cash Premium on bonds ($4, 000 / 10 years) Interest Revenue (6% x $50, 000) - $400 Debit 3, 000 Credit 400 2, 600

LONG-TERM DEBT INVESTMENTS 3. Disposal • Disposal resembles the process for long-term assets • When we sell the bond, we must ensure that any discount or premium is amortized up to the date of disposal • Then remove any remaining premium/discount and record any gain or loss on the sale. • Just like disposing of assets, there are two steps to the process. Say on April 30 of year 2, the bond is sold for $49, 000

LONG-TERM DEBT INVESTMENTS 3. Disposal Step 1: Amortize premium up to the date of disposal. Date April 30 Particulars Interest Receivable Premium on bonds (4/12 of $400) Interest Revenue Debit 1, 000. 00 Credit 133. 33 866. 67 Step 2: Dispose of the Bond. Date April 30 Year 2 Particulars Cash Loss on Sale of Bond Interest Receivable Premium on bonds ($4, 000 – 400 – 133. 33) Bonds Debit Credit 49, 000 5, 466. 67 1, 000 3, 466. 67 50, 000

Do Problems: BE 17 -2 P 17 -1 A

ACCOUNTING GUIDELINES FOR EQUITY INVESTMENTS NOTE: I recommend you start a fresh page and make a chart in Investor’s Ownership Presumed notes like this one (leave enough space for a Interest in your Investee’s Influence journal entry in each section): Accounting Common Shares on Subsidiary Guidelines <20% 20 -50% >50% Cost Equity Consol. Less than 20% Insignificant 1. Acquiring Between 20% Equity and 50% Significant More than Dividends 50% 2. Recording earned Controlling 3. Divesting of Equity (selling) Cost method Equity method for accounting; Consolidated financial statements for financial reporting

RECORDING EQUITY INVESTMENTS HOLDINGS LESS THAN 20% The Cost Method • Investment is recorded at cost and revenue is recognized only when cash dividends are received. (Same as cost method for Bonds really…) • Unrealized gains and losses are reported in net income

LESS THAN 20% 1. Acquisition On July 1, 2003, we acquire 1, 000 shares (10 percent ownership) of Beal Corporation at $40 per share plus brokerage fees of $500. The entry for the purchase is: Date July 1 Particulars Equity Investment – Beal Common Shares Cash Debit 40, 500 Credit 40, 500

LESS THAN 20% 2. Dividends • Entries are required for any cash dividends received during the time the shares are held. • If we receive a $2 per share dividend on December 1, 2003, the entry is: Date Dec. 1 Particulars Cash Dividend Revenue Debit 2, 000 Credit 2, 000

LESS THAN 20% 3. Disposal • When shares are sold, the difference between the net proceeds from the sale and the cost of the shares is recognized as a gain or loss. • Assume we receive $39, 500 on the sale of our investment of Beal common shares on February 10, 2004. • Because the shares cost $40, 500, a loss of $1, 000 has been incurred. The entry to record the sale is: Date Feb. 10 Particulars Cash Loss on Sale of Investment Equity Investment Debit 39, 500 1, 000 Credit 40, 500

BETWEEN 20% AND 50% The Equity Method • The equity method: • The investment in common shares is initially recorded at cost, and the investment account is adjusted annually to show the investor’s equity in the investee. • Each year, the investor 1. Debits the investment account and credits revenue for its share of the investee’s net income and 2. Credits dividends received to the investment account. • Why?

BETWEEN 20% AND 50% The Equity Method • What is significant influence? – Representation on the board of directors – Participation in the policy-making process – Material inter-company transactions – Interchange of managerial personnel – Provision of technical information

BETWEEN 20% AND 50% 1. Acquisition • We acquire 30% of the common shares of Beck Company for $120, 000 on January 1, 2003. The entry to record this transaction is: Date Jan. 1 Particulars Equity Investment Cash Debit 120, 000 Credit 120, 000

BETWEEN 20% AND 50% 2. Dividends and Net Income Beck reports 2003 net income of $100, 000 and declares and pays a $40, 000 cash dividend. We are required to record: 1) Our share of Beck’s net income, $30, 000 (30% x $100, 000) Date Dec. 31 Particulars Equity Investment Revenue from Investment Debit 30, 000 Credit 30, 000 ! G N U T H C 2) The reduction in the. Ainvestment account for the dividends received, $12, 000 ($40, 000 x 30%). The entries are: Date Dec. 31 Particulars Cash Equity Investment Debit 12, 000 Credit 12, 000

BETWEEN 20% AND 50% 3. Disposal Same as the Cost Method (i. e. same as when holdings are less than 20%)

MORE THAN 50% • A company that controls (e. g. , owns more than 50 %) of the common shares of another entity is known as a parent company. • The company it owns is the subsidiary. • For this, the equity method of accounting is used to account for the investment, and consolidated financial statements are prepared.

MORE THAN 50% • Consolidated financial statements present the assets and liabilities controlled by the parent company and the combined profitability of any subsidiaries. • They are prepared in addition to the financial statements for each individual company.

VALUATION AND REPORTING OF INVESTMENTS • The value of debt and equity investments may fluctuate greatly during the time they are held. • Conservatism principle requires accountants to use the lower of cost and market rule. (When else is this used? ) • Application of the LCM rule varies depending upon whether the investment is temporary or longterm.

VALUATION AND REPORTING OF TEMPORARY INVESTMENTS • The decline in value from cost to market is reported as a loss. nic! a P t ’ n Do • l u f t b u Do ich r o f e c h w an. Market f w o o An Allowance to Reducelik. Cost to Value l l h e A tion, bot t s ia ju c s e e r t p a e r ! e record account is iused to the difference D p W d o O e e t N a u q K ul n m Y h u c D c e c t A A and E LR This unthe between market value. andcost A s t U O o Y c Ac • The Allowance account is a contra asset and is deducted from the cost of the investments

VALUATION AND REPORTING OF LONG-TERM INVESTMENTS • Long-term investments should not be adjusted to reflect temporary fluctuations in market value. • Only when a drop is NOT due to temporary fluctuations should lower of cost and market be used for long term investments. • Any write-down to market value is accounted for on the income statement as a permanent loss. No allowance account is used.

COMPREHENSIVE BALANCE SHEET

Do Problems: P 17 -7 A Homework: P 17 -9 A Submit word processed (use excel)