Investments Notes

Investments

Companies invest for various reasons, such as earning returns on excess cash or gaining strategic advantages like vertical integration.

Debt Investments

  • Companies invest in bonds or other debt securities for stability and income.
  • Accounting for debt investments differs from equity investments.
  • Objectives:
    • Earn returns from dividends or interest.
    • Achieve capital gains.
    • Develop affiliations for benefits.
  • Bonds payable:
    • Maturity date and face amount (principal/par value).
    • Interest payments to investors at a stated rate.
    • Bonds can be sold at a discount or premium depending on the market rate.
    • Discount: Bonds are sold at a discount when the market rate is higher than the stated rate.
    • Premium: Bonds are sold at a premium when the market rate is lower than the stated rate.
  • For the investing company, the discount on the bond investment is a debit, which is opposite of bonds payable.
  • The bond is amortized down, and interest income is recorded.
  • Amortized Cost Method
Classification of Debt Investments

Debt investments are classified into three categories:

  • Held to Maturity:
    • The company intends to hold the securities until maturity.
  • Trading Securities:
    • The company actively buys and sells securities.
  • Available for Sale Securities:
    • Securities that are not held to maturity or actively traded, somewhere in between the two.

The classification affects how fair value changes are recognized.

Accounting Treatment
  • Held to Maturity:
    • Reported at amortized cost.
    • Unrealized gains and losses are not recognized.
  • Trading Securities:
    • Changes in fair value are recognized in net income.
  • Available for Sale:
    • Reported at fair value on the balance sheet.
    • Changes in fair value are recognized in accumulated other comprehensive income (AOCI) within equity.

AOCI is used to park items that affect the balance sheet but not the income statement until realized.

Held-to-Maturity Securities

  • The investor intends and has the ability to hold the securities until maturity.
  • Unrealized gains and losses are ignored.

Trading Securities

  • Involve active buying and selling with short holding periods.
  • Carried at fair value.
  • Unrealized gains and losses are included in net income.
  • Classified as current assets.

Available-for-Sale Securities

  • Not held to maturity but not actively traded.
  • Reported at fair value on the balance sheet.
  • Changes in fair value are recorded in other comprehensive income (OCI).
  • Gains and losses show up on the statement of other comprehensive income.
  • Cash Flow Statement:**
    • Trading securities: Operating activities.
    • Available for sale securities: Investing activities.

Equity Investments

Accounting depends on the level of influence or control the investor has over the investee.

  • Cost Method Investments
Levels of Ownership and Accounting Methods
  • Control (More Than 50% Ownership):
    • Consolidated financial statements are prepared.
  • Significant Influence (20-50% Ownership):
    • Equity method is used.
  • Lack of Significant Influence (Less Than 20% Ownership):
    • Fair value through net income method is used.
Defining Significant Influence
  • Owning more than 20% of voting stock is generally considered significant influence.
Accounting Treatment Based on Influence
  • Lack of Significant Influence (Cost Method):
    • Changes in fair value are reported through net income, similar to trading securities.
    • Dividends are recorded as investment income.
  • Significant Influence (Equity Method):
    • Dividends are not recorded as investment income but as a return of investment.
    • Investment income is recorded as a percentage of the investee's net income.
    • Example: Owning 25% of a company with $100 million net income results in $25 million investment income.
    • (25,000,000=0.25×100,000,000)(25,000,000 = 0.25 \times 100,000,000)
Cost Method (Lack of Significant Influence)
  • Example: Purchase of $1,050,000 of common stock, receipt of $75,000 cash dividend, and adjustment down to $1,000,050.
  • Journal Entries:
    • Debit: Loss on Investment, Credit: Investment.
    • Debit: Cash, Credit: Dividend Income.
  • Unrealized losses are expensed.
Equity Method (Significant Influence, No Control)
  • Ownership between 20% and 50%.
  • Decisions can be influenced by the investor.
  • Ignore fair value for equity method.
  • Equity Method Accounting:
    • United Intergroup purchases 30% of Argent's common stock for $1,500,000.
    • Argent earns $500,000 net income and pays $250,000 in dividends.
Journal Entries
  • Purchase: Debit Investment in Argent Stock, Credit Cash for $1,500,000.
  • Income: Debit Investment in Argent Stock, Credit Investment Revenue for 30% of Argent's net income.
    • Investment Revenue=0.30×500,000=150,000Investment \space Revenue = 0.30 \times 500,000 = 150,000
  • Dividends: Debit Cash, Credit Investment in Argent Stock for 30% of Argent's dividends.
    • Cash Received=0.30×250,000=75,000Cash \space Received = 0.30 \times 250,000 = 75,000
  • Investment value is adjusted by the share of net income minus dividends received. The value of that investment in our debt is gonna continue then on our percent of their net income minus our dividends that we receive.