Wild and Shaw Fundamental Accounting Principles Chapter 15: Investments

Chapter 15 Learning Objectives

• CONCEPTUAL C1: Distinguish between debt and equity securities and between short-term and long-term investments.
• CONCEPTUAL C2: Describe how to report equity securities with controlling influence.
• ANALYTICAL A1: Compute and analyze the components of return on total assets.
• PROCEDURAL P1: Account for debt securities as trading.
• PROCEDURAL P2: Account for debt securities as held-to-maturity.
• PROCEDURAL P3: Account for debt securities as available-for-sale.
• PROCEDURAL P4: Account for equity securities with insignificant influence.
• PROCEDURAL P5: Account for equity securities with significant influence.

Basics of Investments

• Motivation for Investments

  • Companies invest extra cash into investments to earn more income.
  • Some entities are specifically set up to earn income from investments.
  • Companies make investments for strategic reasons.

• Investment Proportions (Exhibited by Selective Companies)

  • Apple: Short-term: $0\% \text{ to } 9\%$; Long-term: $9\% \text{ to } 38\%$ of total assets.
  • Coca-Cola: Short-term: $0\% \text{ to } 1\%$; Long-term: $1\% \text{ to } 21\%$ of total assets.
  • Microsoft: Short-term: $0\% \text{ to } 19\%$; Long-term: $19\% \text{ to } 21\%$ of total assets.

• Short-Term Investments

  • Management intends to convert to cash within one year or the operating cycle, whichever is longer.
  • Must be readily convertible to cash.
  • Usually mature between $3$ and $12$ months.

• Long-Term Investments

  • Not readily convertible to cash or not intended to be converted to cash in the short term.
  • Reported in the noncurrent section of the balance sheet, often in its own category.

• Debt Securities versus Equity Securities

  • Debt Securities:
    • Reflect a creditor relation.
    • Examples: Investments in notes, bonds, and CDs.
    • Issued by governments, companies, or individuals.
  • Equity Securities:
    • Reflect an owner relation.
    • Examples: Investments in shares of stock.
    • Issued by companies.

Classification and Reporting Factors

• Accounting for investments depends on three primary factors:
  1. Security type: Debt or equity.
  2. Intent to hold: Short term or long term.
  3. Percentage ownership: Specifically regarding another company’s equity securities.

Accounting for Debt Investments

• Acquisition of Debt Investments

  • Debt investments are recorded at cost.
  • Example: On July 1, 2026, Ling Co. paid $30,000$ to buy Dell’s $7\%$, $2-year$ bonds payable with a $30,000$ par value. The bonds pay interest semiannually on December 31 and June 30.
  • Journal Entry (July 1, 2026):
    • Debit: Debt Investments $30,000$
    • Credit: Cash $30,000$

• Recording Interest and Reporting

  • Interest revenue is recorded when earned.
  • Calculation: $\text{Par value } (30,000) \times \text{Interest rate } (0.07) \times \text{Time } (6/12) = 1,050$
  • Journal Entry (Dec. 31, 2027):
    • Debit: Cash $1,050$
    • Credit: Interest Revenue $1,050$
  • Income Statement (Year 2027): Interest revenue of $1,050$
  • Balance Sheet (Dec. 31, 2027): Debt investments of $30,000$

• Maturity of Debt Investments

  • When bonds mature, the company receives the par value in cash.
  • Journal Entry (July 1, 2029):
    • Debit: Cash $30,000$
    • Credit: Debt Investments $30,000$

Specialized Debt Classifications

• Trading Securities (P1)

  • Actively managed for profit.
  • Always classified as current assets.
  • Portfolio reported at fair value.
  • Requires a "fair value adjustment" from the cost of the portfolio (group of securities).
  • Unrealized gain (or loss) from change in fair value is reported in the Income Statement.
  • Example: TechCom’s portfolio cost $11,500$; Fair value is $13,000$ on Dec. 31, 2027.
    • Journal Entry (Dec. 31, 2027):
      • Debit: Fair Value Adjustment—Trading $1,500$
      • Credit: Unrealized Gain—Income $1,500$
  • Sale of Trading Securities:
    • Assume TechCom sells trading securities costing $100$ for $120$ cash on January 9, 2028.
    • Journal Entry (Jan. 9, 2028):
      • Debit: Cash $120$
      • Credit: Debt Investments—Trading $100$
      • Credit: Gain on Sale of Debt Investments $20$
    • Realized gains are reported in Other Revenues and Gains; losses in Other Expenses and Losses.

• Held-to-Maturity (HTM) Securities (P2)

  • Debt securities the company intends to hold until maturity.
  • Classification:
    • Current assets if maturity is within one year or the operating cycle.
    • Noncurrent investments if maturity is longer.
  • Recorded at cost when purchased; interest recorded when earned.
  • Portfolio is reported at amortized cost.
  • Note: No fair value adjustment is made to the portfolio.

• Available-for-Sale (AFS) Securities (P3)

  • Debt investments not classified as trading or HTM.
  • Classification:
    • Short-term if intent is to sell within one year/operating cycle.
    • Long-term if they do not meet short-term criteria.
  • Valued at fair value.
  • Unrealized gain (or loss) is reported as part of Other Comprehensive Income (OCI) in the Statement of Comprehensive Income.
  • OCI is closed to Accumulated Other Comprehensive Income (AOCI) in the equity section of the balance sheet.
  • Mitsu Co. Example (Dec. 31, 2027):
    • Apple bonds: Cost $30,000$, Fair Value $29,050$, Unrealized Loss $(950)$.
    • Index notes: Cost $43,000$, Fair Value $45,500$, Unrealized Gain $2,500$.
    • Total: Cost $73,000$, Fair Value $74,550$, Unrealized Gain $1,550$.
  • Journal Entry (Dec. 31, 2027):
    • Debit: Fair Value Adjustment—Available-for-Sale $1,550$
    • Credit: Unrealized Gain—Equity $1,550$
  • Adjustment for Next Year (Dec. 31, 2028):
    • Assume cost is $81,000$ and fair value is $82,000$.
    • Since the required adjustment must move the account balance, if the prior unrealized gain was higher, a reversal may be needed.
    • Transcript entry: Debit Unrealized Gain-Equity $550$, Credit Fair Value Adjustment—Available-for-Sale $550$.

Accounting for Equity Investments

• Insignificant Influence (P4)

  • Typically involves ownership of under 20\% of investee stock.
  • Investment is recorded at cost (including commissions/brokerage fees).
  • Acquisition Example: ITI purchased $100$ shares of Lynx for $7,000$.
    • Debit: Stock Investments $7,000$
    • Credit: Cash $7,000$
  • Dividends: Accounted for as revenue.
    • Debit: Cash $10$
    • Credit: Dividend Revenue $10$
  • Fair Value (Year-End):
    • Cost $7,000$, Fair Value $9,000$. Unrealized Gain = $2,000$.
    • Debit: Fair Value Adjustment—Stock $2,000$
    • Credit: Unrealized Gain—Income $2,000$
  • Sale of Stock:
    • Difference between net proceeds and cost is recorded as gain/loss.
    • ITI sold stock (cost $500$) for $800$. Gain = $300$.
    • Debit: Cash $800$
    • Credit: Stock Investments $500$
    • Credit: Gain on Sale of Stock Investments $300$

• Significant Influence (P5)

  • Typically involves ownership between 20\% and 50\% of investee stock.
  • Uses the Equity Method.
  • Acquisition: Recorded at cost. Micron Co. bought $3,000$ shares ($30\%\text{) of Star Co. for } 70,000$.
    • Debit: Equity Method Investments $70,000$
    • Credit: Cash $70,000$
  • Share of Earnings:
    • Investee reports Net Income of $20,000$. Micron share = $20,000 \times 30\% = 6,000$.
    • Debit: Equity Method Investments $6,000$
    • Credit: Earnings from Equity Method Investments $6,000$
  • Share of Dividends:
    • Accounted for as a conversion of one asset to another; reduces investment account book value.
    • Investee pays $10,000$. Micron share = $10,000 \times 30\% = 3,000$.
    • Debit: Cash $3,000$
    • Credit: Equity Method Investments $3,000$
  • Book Value Calculation:
    • $\text{Cost } (70,000) + \text{Share of Earnings } (6,000) - \text{Share of Dividends } (3,000) = 73,000$
  • Sale: proceeds minus book value equals gain/loss. Sold for $80,000$.
    • Debit: Cash $80,000$
    • Credit: Equity Method Investments $73,000$
    • Credit: Gain on Sale of Stock Investments $7,000$

• Controlling Influence (C2)

  • Ownership exceeds 50\% of the investee.
  • Uses the Consolidation Method for long-term investments.
  • Results in Consolidated Financial Statements showing parent and subsidiaries as a single entity.

Summary Table of Investment Accounting

Comprehensive Income and Reporting

• Comprehensive Income: Includes all changes in equity during a period except those from owners' investments and dividends.
• Formula: $\text{Comprehensive Income} = \text{Net Income} + \text{Other Comprehensive Income (OCI)}$
• OCI Components:
  • Unrealized gains/losses on available-for-sale securities.
  • Foreign currency translation adjustments.
  • Changes in cash flow hedges, net of tax.
• Accumulated Other Comprehensive Income (AOCI):
  • Cumulative impact of OCI for all prior periods.
  • $\text{AOCI (Ending)} = \text{Beginning Balance} + \text{OCI (Income/Loss)}$

Return on Total Assets (A1)

• Overall Formula:
  • $\text{Return on Total Assets} = \frac{\text{Net Income}}{\text{Average Total Assets}}$
• Components of Return on Total Assets:
  • $\text{Return on Total Assets} = \text{Profit Margin} \times \text{Total Asset Turnover}$
  • $\text{Profit Margin} = \frac{\text{Net Income}}{\text{Net Sales}}$
  • $\text{Total Asset Turnover} = \frac{\text{Net Sales}}{\text{Average Total Assets}}$
• Comparison (Current Year):
  • Costco: $9.4\% = 2.6\% \times 3.6$
  • Walmart: $6.3\%$
• Strategic Note: To improve return, a company must offset a decline in one component with an increase in the other.