Investments inDebt and EquitySecurities

Investments inDebt and EquitySecurities

C H A P T E R 12

Learning Objective 1

Understand why companies invest in other companies.

A Cash Flow Pattern

Companies often need cash flow from sources other than their own operations because the company’s own cash flow

might vary greatly over the course of a year.

AverageCash

Needs

1/1 6/30 12/31

Actual Cash on Hand

Excess cash(used for short-term investments)

Insufficient cash(relieved byshort-termborrowing)

What Are Some Other Reasons Companies Invest Their Excess

Cash? To earn a return.

Banks give a fixed return. Investing in stocks or bonds of other

companies may earn a higher rate of return (and demand a higher degree of risk).

The ability to ensure a supply of raw materials.

To influence a board of directors. To diversify their product offerings. Less expensive than R&D.

Learning Objective 2

Understand the different classifications for securities.

Define the Two Classifications for Securities.

Debt SecuritiesFinancial instruments issued by a company that carry with them a promise of interest payments and the repayment of principal.

Equity Securities (Stock)Shares of ownership in a corporation that can change significantly in value and that provide for a return to investors in the form of dividends.

Classifying Securities

Investments

Debt Equity

Classifying Securities—Matching

Method used to account for an investment in the stock of another company when significant influence can be imposed (presumed when 20 to 50 percent of the outstanding voting stock is owned).

Equity Method SecuritiesHeld-to-Maturity Securities

Debt securities purchased by an investor with the intent of holding the securities until they mature.

Equity Method Securities

Held-to-Maturity Securities

Classifying Securities—Matching

Debt and equity securities not classified as trading, held-to-maturity, or equity method securities.

Debt and equity securities purchased with the intent of selling them should the need for cash arise or to realize short-term gains.

Available-for-Sale Securities

Trading Securities

Trading SecuritiesAvailable-for-Sale Securities

Classifying Securities

Held-to-Maturity

Available-for-Sale

EquityMethod

Debt Equity

Trading

Investments

Classifying Securities

Debt Equity

Held-to-Maturity Trading

Available-for-Sale

EquityMethod

Investments

Fair value

Fair value

Amortized cost

Cost adjusted for changes in net assets of investee

Income statement

Stockholders’ equity

Not recognized

Not recognized

Classifying Securities—Fill in the Chart

Held-to- Maturity

Trading

Available-for-Sale

EquityMethod

Classification Disclosed atReporting ofChanges in FMV

Learning Objective 3Learning Objective 3

Account for the purchase, recognition of revenue, and sale of trading and available-for-sale securities.

Purchase of Securities

Caribou Corp. purchased the following securities on January 1, 2003. Record the appropriate entry.

1 Debt Trading $ 3,0002 Equity Trading 15,5003 Debt Available-for-sale 10,0004 Equity Available-for-sale 7,300

Type Classification

Cost(including

broker’s fees)

Purchase of Securities

Investment in Trading Securities . . . . . . . . . . 18,500Investment in Available-for-Sale Securities. . 17,300

Cash . . . . . . . . . . . . . . . . . . . . . . 35,800Purchased debt and equity securities.

1 Debt Trading $ 3,0002 Equity Trading 15,5003 Debt Available-for-sale 10,0004 Equity Available-for-sale 7,300

Type Classification

Cost(including

broker’s fees)

Accounting for Return Earned on an Investment

Buffalo Corp. earned the following return on their owned securities. Record the journal entry.

1 Debt $2702 Equity $8953 Debt 9204 Equity 560

Security Interest Dividends

Cash. . . . . . . . . . . . . . . . . . . . . . . . . 2,645Interest Revenue. . . . . . . . . . . . . 1,190Dividend Revenue. . . . . . . . . . . . 1,455

Received interest and dividend revenues.

Accounting for the Sale of SecuritiesBuffalo Corp. sold Security 2 for $17,000. The historical cost was $15,500. Record the entry.

1 Debt Trading $ 3,0002 Equity Trading 15,5003 Debt Available-for-sale 10,0004 Equity Available-for-sale 7,300

Type Classification

Cost(including

broker’s fees)

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . .17,000Investment in Trading Securities. . . 15,500Realized Gain on Sale of Securities 1,500

Sold Security 2 for $17,000.

What Are Realized Gains and Losses?

Gains and losses resulting from the sale of securities in an arm’s-length transaction.

At the end of the accounting period, any gain or loss on the sale of securities must be included on the income statement.

Learning Objective 4

Account for changes in the value of securities.

What Are Unrealized Gainsand Losses?

Gains and losses resulting from changes in the value of securities that are still being held.

Accounting for Changes in Value — Trading Securities

The following market values were recorded for Buffalo Corp.’s portfolio on December 31, 2003. Record the changes in the values of the securities.

1 Trading $ 3,000 $ 2,8003 Available-for-sale 10,000 10,5004 Available-for-sale 7,300 9,250

TypeHistorical

CostMarket Value

12/31/03

Unrealized Loss on Trading Securities . . . 200Market Adjustment, Trading Securities 200

Recorded market adjustment for trading securities.

Accounting for Changes in Value — Available-for-Sale

Market Adjustment, Available-for-Sale Securities. 2,450Unrealized Increase in Value of Available-for-Sale Securities . . . . 2,450

Recorded market adjustment for available-for-sale securities.

1 Trading $ 3,000 $ 2,8003 Available-for-sale 10,000 10,5004 Available-for-sale 7,300 9,250

TypeHistorical

CostMarket Value

12/31/03

Market Adjustment, Trading Securities. . . . 300Unrealized Gain on Trading Securities . 300

Recorded market adjustment for trading security.

The following market values were recorded for Buffalo Corp.'s portfolio on December 31, 2004. Record the subsequent change in the trading security.

Subsequent Changesin Value

1 Trading $ 3,000 $ 3,1003 Available-for-sale 10,000 10,3004 Available-for-sale 7,300 9,500

TypeHistorical

CostMarket Value

12/31/04

Expanded MaterialLearning Objective 5

Account for held-to-maturity securities.

The Moose Company purchased a 5-year, $500,000 bond and received interest payments of 10 percent, payable semiannually. Assume the effective rate is 12 percent. Record the investment.

Example: Initial Purchase of Held-to-Maturity Securities

1. Semiannual interest payments$ 25,000Present value of interest annuity $184,002

2. Principal of bonds $500,000Present value of bonds 279,197

3. Present value of investment $463,199

Example: Initial Purchase of Held-to-Maturity Securities

1. Semiannual interest payments$ 25,000Present value of interest annuity $184,002

2. Principal of bonds $500,000Present value of bonds 279,197

3. Present value of investment $463,199

Investment in Held-to-Maturity Securities. . . . . . . . . . . . . . . . . . . . . 463,199

Cash. . . . . . . . . . . . . . . . . . . . . 463,199Purchased a $500,000 bond as an investment.

Bonds PurchasedBetween Interest Dates

Assume the bond purchased by the Moose Company paid interest on July 1 and January 1 of each year. If the Moose Company purchased the bond on April 31, 2003, how will the purchase be recorded?

Investment in Held-to-Maturity Security. . . . . . . . . . . . . . . . . . . . .463,199Bond Interest Receivable . . . . . . . .16,667

Cash. . . . . . . . . . . . . . . . . . . . . . 479,866Purchased a $500,000 bond as an investment and paid four months’ accrued interest.

Accounting for Amortization of Premiums and Discounts. Define.

Straight-Line AmortizationA method of systematically writing off a bond discount or premium in equal amounts each period until maturity.

Effective-Interest AmortizationA method of systematically writing off a bond premium or discount that takes into consideration the time value of money and results in an equal rate of amortization for each period.

Cash. . . . . . . . . . . . . . . . . . . . . . . . 600.00Investment in Held-to-MaturitySecurities. . . . . . . . . . . . . . . . . . . . 134.20

Bond Interest Revenue . . . . . . 734.20Received bond interest and amortized discount.

Straight-Line Amortization

The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually. Using the straight-line method, record the first interest payment received.

Effective-Interest Amortization

The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually and the market rate is 16 percent. Using the effective-interest method, record the first interest payment received.

Hint:

Won’t you need an

amortization table?

Cash Interest Amortized InvestmentPayment Received Earned Amount Balance

(0.16 x 0.5 x Balance) $ 8,658 1 $600 $693 $ 93 8,751 2 600 700 100 8,851 3 600 708 108 8,959 4 600 717 117 9,076 5 600 726 126 9,202 6 600 736 136 9,338 7 600 747 147 9,485 8 600 759 159 9,644 9 600 772 172 9,816 10 600 784 184 10,000

Effective-Interest Amortization

Cash. . . . . . . . . . . . . . . . . . . . . . . . 600 Investment in Held-to-Maturity

Securities. . . . . . . . . . . . . . . . . . . . 93Bond Interest Revenue . . . . . . . 693

Received bond interest and amortized discount.

Effective-Interest Amortization

The Rhinoceros Company purchased a 12 percent, 5-year, $10,000 bond for $8,658 on the issuance date. The interest payments are made semiannually and the market rate is 16 percent. Using the effective-interest method, record the first interest payment received.

Sale or Maturity of Bonds

The Rhinoceros Company holds the bond until maturity. Record the entry for the receipt of the bond principal.

Cash. . . . . . . . . . . . . . . . . . . . . . . . 10,000Investment in Held-to-MaturitySecurities. . . . . . . . . . . . . . . . . 10,000

Received the principal of bond at maturity.

Sale or Maturity of Bonds

What journal entry is required if the Rhinoceros Company sells the bond for $9,900 before maturity when the balance in the bond account is $9,800?

Cash. . . . . . . . . . . . . . . . . . . . . . . . 9,900Gain on Sale of Bond. . . . . . . . 100Investment in Held-to-MaturitySecurities. . . . . . . . . . . . . . . . . . 9,800

Sold bond for $9,900.

Expanded MaterialLearning Objective 6

Account for securities using the equity method.

Illustrating the Equity MethodBrown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Record Brown Tree’s transactions using both the available-for-sale method and the equity method.

Equity MethodInvestment in Equity Method Securities 200

Cash. . . . . . . . . . . . . . . . . . . . . . . . 200

Available-for-Sale MethodInvestment in Available-for-Sale Securities . . . . . . . . . . . . . . . . . . . . . . . 200

Cash. . . . . . . . . . . . . . . . . . . . . . . . 200

Illustrating the Equity Method

Equity MethodCash. . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Investment in Equity Method Securities. . . . . . . . . . . . . . . . . . . 80

Available-for-Sale MethodCash . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Dividend Revenue . . . . . . . . . . . . . 80

Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Record the $0.80 per share dividend.

Illustrating the Equity Method

Equity MethodInvestment in Equity Method Securities. 2,000

Revenue from Investments. . . . . . . . 2,000

Available-for-Sale MethodNo entry.

Brown Tree Co. purchased 100 shares of Koala Corp. common shares at $2 per share, representing a 20 percent ownership in the company. Koala Corp. announces a $10,000 earnings for the year. Record the appropriate entries.