APPENDIX E

REPORTING AND ANALYZING INVESTMENTS

Why Corporations Invest

Corporations purchase investments in debt or equity securities generally for one of three reasons. First, a corporation may have excess cash that it does not need for the immediate purchase of operating assets. For example, many companies experience seasonal fluctuations in sales. A Cape Cod marina has more sales in the spring and summer than in the fall and winter. The reverse is true for an Aspen ski shop. Thus, at the end of an operating cycle, many companies may have cash on hand that is temporarily idle until the start of another operating cycle. These companies may invest the excess funds to earn—through interest and dividends—a greater return than they would get by just holding the funds in the bank. Illustration E-1 shows the role that such temporary investments play in the operating cycle.

A second reason some companies such as banks purchase investments is to generate earnings from investment income. Although banks make most of their earnings by lending money, they also generate earnings by investing in debt and equity securities. Banks purchase investment securities because loan demand varies both seasonally and with changes in the economic climate. Thus, when loan demand is low, a bank must find other uses for its cash.

Some companies attempt to generate investment income through speculative investments. That is, they are speculating that the investment will increase in value and thus result in positive returns. Therefore, they invest primarily in the common stock of other corporations.

Third, companies also invest for strategic reasons. A company may purchase a noncontrolling interest in another company in a related industry in which it wishes to establish a presence. Alternatively, a company can exercise some influence over one of its customers or suppliers by purchasing a significant, but not controlling, interest in that company. Or, a corporation may choose to purchase a controlling interest in another company in order to enter a new industry without incurring the costs and risks associated with starting from scratch.

In summary, businesses invest in other companies for the reasons shown in Illustration E-2.

Accounting for Debt Investments

Debt investments are investments in government and corporation bonds. In accounting for debt investments, companies must make entries to record (1) the acquisition, (2) the interest revenue, and (3) the sale.

RECORDING ACQUISITION OF BONDS

At acquisition, debt investments are recorded at cost. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.

For example, assume that Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2014, at a cost of $50,000. Kuhl records the investment as:

RECORDING BOND INTEREST

The Doan Inc. bonds pay interest of $2,000 semiannually on July 1 and January 1 ($50,000 × 8% × ). The entry for the receipt of interest on July 1 is:

If Kuhl Corporation's fiscal year ends on December 31, it accrues the interest of $2,000 earned since July 1. The adjusting entry is:

Kuhl reports Interest Receivable as a current asset in the balance sheet. It reports Interest Revenue under “Other revenues and gains” in the income statement.

Kuhl records receipt of the interest on January 1 as follows.

A credit to Interest Revenue at this time would be incorrect. Why? Because the company earned and accrued the interest revenue in the preceding accounting period.

RECORDING SALE OF BONDS

When Kuhl sells the bond investments, it credits the investment account for the cost of the bonds. The company records as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds.

Assume, for example, that Kuhl Corporation receives net proceeds of $54,000 on the sale of the Doan Inc. bonds on January 1, 2015, after receiving the interest due. Since the securities cost $50,000, Kuhl has realized a gain of $4,000. It records the sale as follows.

Kuhl reports the gain on the sale of debt investments under “Other revenues and gains” in the income statement and reports losses under “Other expenses and losses.”

Accounting for Stock Investments

Stock investments are investments in the capital stock of corporations. When a company holds stock (and/or debt) of several different corporations, the group of securities is an investment portfolio.

The accounting for investments in common stock depends on the extent of the investor's influence over the operating and financial affairs of the issuing corporation (the investee). Illustration E-3 shows the general guidelines.

Companies are required to use judgment instead of blindly following the guidelines.¹ We explain and illustrate the application of each guideline next.

HOLDINGS OF LESS THAN 20%

In the accounting for stock investments of less than 20%, companies use the cost method. Under the cost method, companies record the investment at cost and recognize revenue only when cash dividends are received.

Recording Acquisition of Stock

At acquisition, stock investments are recorded at cost. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any.

Assume, for example, that on July 1, 2014, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock at $40 per share. The entry for the purchase is:

Recording Dividends

During the time the company holds the stock, it makes entries for any cash dividends received. Thus, if Sanchez Corporation receives a $2 per share dividend on December 31, the entry is:

Sanchez reports Dividend Revenue under “Other revenues and gains” in the income statement.

Recording Sale of Stock

When a company sells a stock investment, it recognizes the difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the stock as a gain or a loss.

Assume, for instance, that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation stock on February 10, 2015. Because the stock cost $40,000, Sanchez has incurred a loss of $500. It records the sale as:

Sanchez reports the loss account under “Other expenses and losses” in the income statement and shows a gain on sale under “Other revenues and gains.”

HOLDINGS BETWEEN 20% AND 50%

When an investor company owns only a small portion of the shares of stock of another company, the investor cannot exercise control over the investee. But when an investor owns between 20% and 50% of the common stock of a corporation, it is presumed that the investor has significant influence over the financial and operating activities of the investee. The investor probably has a representative on the investee's board of directors. Through that representative, the investor begins to exercise some control over the investee—and the investee company in some sense becomes part of the investor company.

For example, even prior to purchasing all of Turner Broadcasting, Time Warner owned 20% of Turner. Because it exercised significant control over major decisions made by Turner, Time Warner used an approach called the equity method. Under the equity method, the investor records its share of the net income of the investee in the year when it is earned. An alternative might be to delay recognizing the investor's share of net income until a cash dividend is declared. But that approach would ignore the fact that the investor and investee are, in some sense, one company, making the investor better off by the investee's earned income.

Under the equity method, the company initially records the investment in common stock at cost. After that, it adjusts the investment account annually to show the investor's equity in the investee. Each year, the investor does the following. (1) It increases (debits) the investment account and increases (credits) revenue for its share of the investee's net income.² (2) The investor also decreases (credits) the investment account for the amount of dividends received. The investment account is reduced for dividends received because payment of a dividend decreases the net assets of the investee.

Recording Acquisition of Stock

Assume that Milar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2014. The entry to record this transaction is:

Recording Revenue and Dividends

For 2014, Beck reports net income of $100,000. It declares and pays a $40,000 cash dividend. Milar must record (1) its share of Beck's income, $30,000 (30% × $100,000), and (2) the reduction in the investment account for the dividends received, $12,000 (30% × $40,000). The entries are:

After Milar posts the transactions for the year, the investment and revenue accounts are as shown in Illustration E-4.

During the year, the investment account increased by $18,000. This $18,000 is Milar's 30% equity in the $60,000 increase in Beck's retained earnings ($100,000 − $40,000). In addition, Milar reports $30,000 of revenue from its investment, which is 30% of Beck's net income of $100,000.

Note that the difference between reported revenue under the cost method and reported revenue under the equity method can be significant. For example, Milar would report only $12,000 of dividend revenue (30% × $40,000) if it used the cost method.

HOLDINGS OF MORE THAN 50%

A company that owns more than 50% of the common stock of another entity is known as the parent company. The entity whose stock is owned by the parent company is called the subsidiary (affiliated) company. Because of its stock ownership, the parent company has a controlling interest in the subsidiary company.

When a company owns more than 50% of the common stock of another company, it usually prepares consolidated financial statements. Consolidated financial statements present the assets and liabilities controlled by the parent company. They also present the total revenues and expenses of the subsidiary companies. Companies prepare consolidated statements in addition to the financial statements for the individual parent and subsidiary companies.

As noted earlier, prior to acquiring all of Turner Broadcasting, Time Warner accounted for its investment in Turner using the equity method. Time Warner's net investment in Turner was reported in a single line item—Other investments. After the merger, Time Warner instead consolidated Turner's results with its own. Under this approach, Time Warner included the individual assets and liabilities of Turner with its own assets. That is, Turner's plant and equipment were added to Time Warner's plant and equipment, its receivables were added to Time Warner's receivables, and so on. A similar sort of consolidation went on when AOL merged with Time Warner.

Consolidated statements are useful to the stockholders, board of directors, and management of the parent company. Consolidated statements indicate to creditors, prospective investors, and regulatory agencies the magnitude and scope of operations of the companies under common control. For example, regulators and the courts undoubtedly used the consolidated statements of AT&T to determine whether a breakup of the company was in the public interest. Illustration E-5 lists three companies that prepare consolidated statements and some of the companies they have owned.

Valuing and Reporting Investments

The value of debt and stock investments may fluctuate greatly during the time they are held. For example, in a 12-month period, the stock of Time Warner hit a high of 58 and a low of 9. In light of such price fluctuations, how should companies value investments at the balance sheet date? Valuation could be at cost, at fair value, or at the lower-of-cost-or-market value.

Many people argue that fair value offers the best approach because it represents the expected cash realizable value of securities. Fair value is the amount for which a security could be sold in a normal market. Others counter that unless a security is going to be sold soon, the fair value is not relevant because the price of the security will likely change again.

CATEGORIES OF SECURITIES

For purposes of valuation and reporting at a financial statement date, debt and stock investments are classified into three categories of securities:

1. Trading securities are bought and held primarily for sale in the near term to generate income on short-term price differences.
2. Available-for-sale securities are held with the intent of selling them sometime in the future.
3. Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.³

Illustration E-6 shows the valuation guidelines for these securities. These guidelines apply to all debt securities and to those stock investments in which the holdings are less than 20%.

Trading Securities

Trading securities are held with the intention of selling them in a short period of time (generally less than a month). Trading means frequent buying and selling. As indicated in Illustration E-6, companies adjust trading securities to fair value at the end of each period (an approach referred to as mark-to-market accounting). They report changes from cost as part of net income. The changes are reported as unrealized gains or losses because the securities have not been sold. The unrealized gain or loss is the difference between the total cost of trading securities and their total fair value. Companies classify trading securities as a current asset.

As an example, Illustration E-7 shows the costs and fair values for investments classified as trading securities for Pace Corporation on December 31, 2014. Pace Corporation has an unrealized gain of $7,000 because total fair value ($147,000) is $7,000 greater than total cost ($140,000).

The fact that trading securities are a short-term investment increases the likelihood that Pace will sell them at fair value for a gain. Pace records fair value and the unrealized gain through an adjusting entry at the time it prepares financial statements. In this entry, the company uses a valuation allowance account, Fair Value Adjustment—Trading, to record the difference between the total cost and the total fair value of the securities. The adjusting entry for Pace Corporation is:

The use of the Fair Value Adjustment—Trading account enables the company to maintain a record of the investment cost. Actual cost is needed to determine the gain or loss realized when the securities are sold. The company adds the debit balance (or subtracts a credit balance) of the Fair Value Adjustment—Trading account to the cost of the investments to arrive at a fair value for the trading securities.

The fair value of the securities is the amount companies report on the balance sheet. They report the unrealized gain on the income statement under “Other revenues and gains.” The term income in the account title indicates that the gain affects net income. If the total cost of the trading securities is greater than total fair value, an unrealized loss has occurred. In such a case, the adjusting entry is a debit to Unrealized Loss—Income and a credit to Fair Value Adjustment—Trading. Companies report the unrealized loss under “Other expenses and losses” in the income statement.

The fair value adjustment account is carried forward into future accounting periods. No entries are made to this account during the period. At the end of each reporting period, a company adjusts the balance in the account to the difference between cost and fair value at that time. It closes the Unrealized Gain—Income account or Unrealized Loss—Income account at the end of the reporting period.

Available-for-Sale Securities

As indicated earlier, available-for-sale securities are held with the intent of selling them sometime in the future. If the intent is to sell the securities within the next year or operating cycle, a company classifies the securities as current assets in the balance sheet. Otherwise, it classifies them as long-term assets in the investments section of the balance sheet.

Companies also report available-for-sale securities at fair value. The procedure for determining fair value and unrealized gain or loss for these securities is the same as that for trading securities. To illustrate, assume that Elbert Corporation has two securities that are classified as available-for-sale. Illustration E-8 provides information on the cost, fair value, and amount of the unrealized gain or loss on December 31, 2014. There is an unrealized loss of $9,537 because total cost ($293,537) is $9,537 more than total fair value ($284,000).

BALANCE SHEET PRESENTATION

For balance sheet presentation, companies must classify investments as either short-term or long-term.

Short-Term Investments

Short-term investments (also called marketable securities) are securities held by a company that are (1) readily marketable and (2) intended to be converted into cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classified as long-term investments.

Both the adjusting entry and the reporting of the unrealized loss from Elbert's available-for-sale securities differ from those illustrated for trading securities. The differences result because these securities are not going to be sold in the near term. Thus, prior to actual sale it is much more likely that changes in fair value may reverse the unrealized loss. Therefore, Elbert does not report an unrealized loss in the income statement. Instead, the company reports it as a separate component of stockholders' equity. In the adjusting entry, Elbert identifies the fair value adjustment account with available-for-sale securities, and identifies the unrealized gain or loss account with stockholders' equity. The adjusting entry for Elbert Corporation to record the unrealized loss of $9,537 is:

If total fair value exceeds total cost, Elbert would record the adjusting entry as an increase (debit) to Fair Value Adjustment—Available-for-Sale and a credit to Unrealized Gain or Loss—Equity.

For available-for-sale securities, the company carries forward the Unrealized Gain or Loss—Equity account to future periods. At each future balance sheet date, the account is adjusted with the fair value adjustment account to show the difference between cost and fair value at that time.

READILY MARKETABLE. An investment is readily marketable when it can be sold easily whenever the need for cash arises. Short-term paper⁴ meets this criterion because a company can readily sell it to other investors. Stocks and bonds traded on organized securities markets, such as the New York Stock Exchange, are readily marketable because they can be bought and sold daily. In contrast, there may be only a limited market for the securities issued by small corporations and no market for the securities of a privately held company.

INTENT TO CONVERT. Intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer. Generally, this criterion is satisfied when the investment is considered a resource that the company will use whenever the need for cash arises. For example, a ski resort may invest idle cash during the summer months with the intent to sell the securities to buy supplies and equipment shortly before the next winter season. This investment is considered short-term even if lack of snow cancels the next ski season and eliminates the need to convert the securities into cash as intended.

Because of their high liquidity, companies list short-term investments immediately below Cash in the current assets section of the balance sheet. Short-term investments are reported at fair value. For example, Weber Corporation would report its trading securities as shown in Illustration E-9.

Long-Term Investments

Companies generally report long-term investments in a separate section of the balance sheet immediately below “Current assets,” as shown in Illustration E-10. Long-term investments in available-for-sale securities are reported at fair value. Investments in common stock accounted for under the equity method are reported at equity.

PRESENTATION OF REALIZED AND UNREALIZED GAIN OR LOSS

Companies must present in the financial statements gains and losses on investments, whether realized or unrealized. In the income statement, companies report gains and losses, as well as interest and dividend revenue, in the nonoperating activities section under the categories listed in Illustration E-11.

As indicated earlier, companies report an unrealized gain or loss on available-for-sale securities as a separate component of stockholders' equity. To illustrate, assume that Muzzillo Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $100,000. Illustration E-12 shows the financial statement presentation of the unrealized loss.

Note that the presentation of the loss is similar to the presentation of the cost of treasury stock in the stockholders' equity section. (It decreases stockholders' equity.) An unrealized gain would be added in this section. Reporting the unrealized gain or loss in the stockholders' equity section serves two important purposes. (1) It reduces the volatility of net income due to fluctuations in fair value. (2) It informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value.

Companies must report, as part of a more inclusive measure called comprehensive income, items such as unrealized gains and losses on available-for-sale securities, which affect stockholders' equity but are not included in the calculation of net income. For example, Tootsie Roll reported other comprehensive loss in 2011 of $8,740,000. Note 12 to Tootsie Roll's financial statements shows that one component of this amount was unrealized gains and losses on investment securities. Comprehensive income is discussed more fully in Chapter 13.

STATEMENT OF CASH FLOWS PRESENTATION

As shown previously in Illustrations E-9, E-10, and E-12, the balance sheet presents a company's investment accounts at a point in time. The “Investing activities” section of the statement of cash flows reports information on the cash inflows and outflows during the period that resulted from investment transactions.

Illustration E-13 presents the cash flows from investing activities from a recent statement of cash flows of The Walt Disney Company. From this information, we learn that Disney received $1,530 million from the sale or redemption of investments during the year.

Summary of Learning Objectives

1. Identify the reasons corporations invest in stocks and debt securities. Corporations invest for three common reasons. (a) They have excess cash. (b) They view investment income as a significant revenue source. (c) They have strategic goals such as gaining control of a competitor or supplier or moving into a new line of business.
2. Explain the accounting for debt investments. Entries for investments in debt securities are required when companies purchase bonds, receive or accrue interest, and sell bonds.
3. Explain the accounting for stock investments. Entries for investments in common stock are required when companies purchase stock, receive dividends, and sell stock. When ownership is less than 20%, the cost method is used—the investment is recorded at cost. When ownership is between 20% and 50%, the equity method should be used—the investor records its share of the net income of the investee in the year it is earned. When ownership is more than 50%, consolidated financial statements should be prepared.
4. Describe the purpose and usefulness of consolidated financial statements. When a company owns more than 50% of the common stock of another company, consolidated financial statements are usually prepared. These statements are especially useful to the stockholders, board of directors, and management of the parent company.
5. Indicate how debt and stock investments are valued and reported in the financial statements. Investments in debt and stock securities are classified as trading, available-for-sale, or held-to-maturity for valuation and reporting purposes. Trading securities are reported as current assets at fair value, with changes from cost reported in net income. Available-for-sale securities are also reported at fair value, with the changes from cost reported in stockholders' equity. Available-for-sale securities are classified as short-term or long-term depending on their expected realization.
6. Distinguish between short-term and long-term investments. Short-term investments are securities held by a company that are readily marketable and intended to be converted to cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classified as long-term investments.