Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 1
APPENDIX E
REPORTING AND INTERPRETING
INVESTMENTS IN OTHER CORPORATIONS
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
1. Analyze and report investments in
debt securities held to maturity.
1, 2
1, 11
1
1
1, 2
2. Analyze and report passive
investments in securities using the fair
value method.
1, 3, 4, 5,
6, 10
2, 3, 4, 5,
6, 10
2, 3, 4, 5,
6, 7, 11
2, 3, 4, 5
1, 2, 3
3. Analyze and report investments
involving significant influence using
the equity method.
1, 7, 8
2, 7, 8
5, 6, 7, 8,
9
4, 5
3
4. Analyze and report investments in
controlling interests.
1, 9, 11
9
10
6
1, 4, 5
Chapter Supplement A – Held-to–
Maturity Bonds Purchased at Other
than Par Value: Amortized Cost
Method
Synopsis of Chapter Revisions
Focus Company: The Washington Post Company
▪ Reporting and interpreting investments in other corporations coverage moved to Appendix E.
▪ Material organized so that instructors can easily choose which (if any) investments topics they wish to
cover.
▪ Focus and contrast company data updated.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on passive
investments accounting.
▪ New Chapter Supplement A on held-to-maturity bonds purchased at other than par value using the
amortized cost method.
▪ New CONTINUING CASE added to the end-of-chapter problems. Students are asked to prepare
journal entries for Pool Corporation, a public company, assuming that it has purchased shares for the
trading securities portfolio and the securities portfolio.
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 2
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
1. Analyze and report investments in debt securities held to maturity.
12-1 through 12-10
2. Analyze and report passive investments in securities using the fair value
method.
12-11 through 12-23
3. Analyze and report investments involving significant influence using the
equity method.
12-24 through 12-31
4. Analyze and report investments in controlling interests.
12-32 through 12-40
Chapter Supplement A – Held-to–Maturity Bonds Purchased at Other than Par
Value: Amortized Cost Method
Chapter Take-Aways
1. Analyze and report investments in debt securities held to maturity.
When management intends to an investment in a debt security (such as a bond or note) until it
matures, the held-to–maturity security is recorded at cost when acquired and reported at amortized
cost on the balance sheet. Any interest earned during the period is reported on the income statement.
2. Analyze and report passive investments in securities using the fair value method.
Acquiring debt securities not held to maturity or less than 20 percent of the outstanding voting shares
of another company’s common stock is presumed to be a passive stock investment. Passive
investments may be classified as
▪ Trading securities (actively traded to maximize return) or
▪ Available-for-sale securities (earn a return but are not as actively traded), depending on
management’s intent.
The investments are recorded at cost and adjusted to fair value at year-end. The resulting unrealized
gain or loss is recorded.
▪ For trading securities, the net unrealized gains and losses are reported in net income.
▪ For available-for-sale securities, the net unrealized gains and losses are reported as a component
of stockholders’ equity in other comprehensive income.
Any dividends earned are reported as revenue, and any gains or losses on sales of passive investments
are reported on the income statement.
3. Analyze and report investments involving significant influence using the equity method.
If between 20 and 50 percent of the outstanding voting shares are owned, significant influence over
the affiliate firm’s operating and financing policies is presumed, and the equity method is applied.
Under the equity method, the investor records the investment at cost on the acquisition date. Each
period thereafter, the investment amount is increased (or decreased) by the proportionate interest in
the income (or loss) reported by the affiliate corporation and decreased by the proportionate share of
the dividends declared by the affiliate corporation.
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 3
Chapter Take-Aways, continued
4. Analyze and report investments in controlling interests.
Mergers occur when one company purchases all of the net assets of another and the target company
ceases to exist as a separate legal entity. Mergers and ownership of a controlling interest of another
corporation (more than 50 percent of the outstanding voting shares) must be accounted for using the
purchase method. The acquired company’s assets and liabilities are measured at their fair values on
the date of the transaction. Any amount paid above the fair value of the assets less liabilities is
reported as goodwill by the buyer.
Key Ratio
Economic Return from Investing measures the performance of a company’s securities portfolios.
Investment returns include both dividends received and any change in the fair value. A high or rising
ratio suggests that a firm’s securities portfolio is improving. It is computed as follows
Economic Return from Investing = (Dividends and Interest Received + Change in Fair Value) ÷ Fair
Value of Investments (beginning of period)
Change in Fair Value = Beginning Balance of Investments – Ending Balance of Investments
Finding Financial Information
Balance Sheet
Current Assets
Investment in trading securities
Investment in available-for-sale securities
Noncurrent Assets
Investment in available-for-sale securities
Investment in affiliates (or associated
companies)
Investments held to maturity
Stockholders’ Equity
Other comprehensive income:
Net unrealized gains and losses (on
available-for-sale securities)
Income Statement
Under “Other Items”
Dividend (and interest) revenue
Loss or gain on sale of investments
Net unrealized gains/losses (on trading
securities)
Equity in affiliate earnings/losses
Statement of Cash Flows
Operating Activities
Net income adjusted for:
Gains/losses on sale of investments
Equity in earnings/losses of affiliates
Dividends received from affiliates
Net unrealized gains/losses on trading
securities
Investing Activities
Purchase/sale of investments
Notes
In Various Notes
Accounting policies for investments
Details on securities held as trading and
available-for-sale securities and
investments in affiliates
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 4
Chapter Outline
Teaching Notes
LO 1 – Analyze and report bond investments held to maturity.
I. Types of Investments and Accounting Methods
Illustrated in Exhibit E.1
A. Passive Investments in Debt and Equity Securities
1. Passive investments – Made to earn a return on funds that
may be needed for future
2. Category includes:
a. Investments in debt (bonds and notes); always
considered passive investments
i. If the company intends to hold the securities until
they reach maturity, the investments are measured
and reported at amortized cost
ii. If they are to be sold before maturity, they are
reported using the fair value method
b. Investments in equity securities (stock)
i. Presumed passive if the investing company owns
less than 20% of the outstanding voting shares of
the other company
ii. The fair value method is used to measure and
report the investments
B. Investments in Stock for Significant Influence
1. Significant influence – The ability to have an important
impact on the operating, investing, and financing policies
of another company
a. Presumed if the investing company owns from 20% to
50% of the outstanding voting shares of the other
company
b. Other factors may also indicate that significant
influence exists
i. Membership on the board of directors of the other
company
ii. Participation in the policy-making processes
iii. Evidence of material transactions between the two
companies
iv. An interchange of management personnel
v. Technological dependency
2. Equity method is used to measure and report investments
in stock for significant influence
C. Investments in Stock for Control
1. Control – The ability to determine the operating and
financing policies of another company through ownership
of voting stock
2. Presumed when the investing company owns more than
50% of the outstanding voting stock of the other company
3. Purchase accounting and consolidation are applied to
combine the companies
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 5
II. Debt Held to Maturity: Amortized Cost Method
A. Terminology
1. Held-to-maturity investments – Investments in debt
securities that management has the intent and ability to
hold until maturity
2. Amortized cost method – Reports investments in debt
securities held to maturity at cost minus any premium or
plus any discount
B. Bond Purchases
1. On the date of purchase, a bond may be acquired at the
maturity amount (at par), for less than the maturity
amount (at a discount), or for more than the maturity
amount (at a premium)
2. The total cost of the bond, including all incidental
acquisition costs such as transfer fees and broker
commissions, is debited to the Held-to-Maturity
Investments account
3. On July 1, 2013, Washington Post paid the par value of
$100,000 for 8% bonds that mature on June 30, 2015;
interest at 8% is paid each June 30 and December 31, and
management plans to hold the bonds for five years, until
maturity
dr Held-to-Maturity Investments
(+A)
100,000
cr Cash (–A)
100,000
Assets = Liabilities + Stockholders’ Equity
Held-to-Maturity Investments (A) + 100,000 + Cash (A)
– 100,000 = 0
B. Interest Earned
1. Since no premium or discount needs to be amortized, the
book value remains constant over the life of the
investment; revenue earned from the investment each
period is measured as the amount of interest collected in
cash or accrued at year-end
Only purchases at par are
covered here; purchases of
bonds at amounts at other
than par are covered in the
chapter supplement
2. Interest is received on December 31
dr Cash (+A)
($100,000 x .08 x 6/12)
4,000
cr Interest Revenue (+R, +SE)
4,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 4,000 = Interest Revenue (R) + 4,000
C. Principal at Maturity
1. Principal payment is received when the bonds mature on
June 30, 2015
dr Cash (+A)
100,000
cr Held-to-Maturity Investments
(–A)
100,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 100,000+ Held-to–Maturity Investments (A)
– 100,000 = 0
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 6
2. If sold before maturity, any difference between market
value (the proceeds from the sale) and net book value
would be reported as a gain or loss on sale
3. If management intends to sell the bonds before the
maturity date, they are treated in the same manner as
investments in stock classified as available-for-sale
securities (discussed in next section)
LO 2 – Analyze and report passive investments in securities using the fair value method.
III. Passive Stock Investments: The Fair Value Method
A. Reporting Method for Passive Stock Investments
1. Among all assets and liabilities, only passive investments
in marketable securities (other than debt held to maturity)
are required to be reported using the fair value method
2. Fair value method – used to report securities at their
current market value (the amount that would be received
in an orderly sale)
3. Reasons that passive investments are reported at fair
value:
a. Relevance – best estimate of cash that could be
generated by the sale of these securities is their current
fair value
b. Measurability – only items that can be measured in
dollar terms with a high degree of reliability (an
unbiased and verifiable measurement) are recorded
4. Whenever the fair value of investments changes:
a. The investment account is adjusted
b. The other account affected is for unrealized holding
gains or losses
i. Unrealized holding gains or losses – amounts
associated with price changes of securities that are
currently held
ii. Unrealized because no actual sale has taken place;
value has changed simply by holding the security
iii. Financial statement treatment depends on the
classification of the passive investments
B. Classifying Passive Stock Investments
Depends on management’s intent; passive investments are
classified as:
1. Trading securities
a. All investments in stocks or bonds held primarily for
the purpose of active trading (buying and selling) in
the near future
b. Classified as short term
2. Available-for-Sale Securities
a. All passive investments other than trading securities
and debt held to maturity
b. Classified as short or long term
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 7
C. Available-for-Sale Securities
1. Purchase of Securities
a. Recorded initially at cost
b. At the beginning of 2012, Washington Post purchases
for cash 15,000 shares of INews common stock for
$10 per share; Washington Post owns 15% of INews,
which is treated as a passive investment
dr Investments in AFS (+A)
150,000
cr Cash (–A)
150,000
Assets = Liabilities + Stockholders’ Equity
Investments in AFS (A) + 150,000 + Cash (A) –
150,000 = 0
2. Dividends Earned
a. Dividends earned are reported as investment income
on the income statement and are included in the
computation of net income for the period
b. Washington Post received a $1 per share cash
dividend from INews totaling $15,000
dr Cash (+A)
15,000
cr Dividend Revenue (+R, +SE)
15,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 15,000 = Dividend Revenue (R) + 15,000
3. Year-End Valuation
a. At end of accounting period, passive investments are
reported on the balance sheet at fair value
b. Reporting the AFS investment at fair value requires
adjusting the Investment in AFS to fair value
c. The gain is credited or the loss is debited to the Net
Unrealized Losses/Gains account
i. For available-for-sale securities, the Net
Unrealized Losses/Gains account is reported in the
stockholders’ equity section of the balance sheet
under Other Comprehensive Income (denoted as
OCI).
ii. Thus, the balance sheet remains in balance.
d. Only when the security is sold are any realized gains
or losses included in net income
e. INews had an $8 per share fair value at the end of
2012; the investment had lost value ($10 − $8 = $2 per
share) for the year
dr Net Unrealized Losses/Gains
(–OCI, –SE) (15,000 x $2)
30,000
cr Investments in AFS (–A)
30,000
Assets = Liabilities + Stockholders’ Equity
Investments in AFS (A) – 30,000 = Net Unrealized
Losses/Gains (OCI) – 30,000
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 8
f. INews had an $11 per share fair value at the end of
2013; the investment had gained value ($11 − $8 = $2
per share) for the year
dr Investments in AFS (+A)
45,000
cr Net Unrealized Losses/
Gains (+OCI, +SE)
(15,000 x $3)
45,000
Assets = Liabilities + Stockholders’ Equity
Investments in AFS (A) + 45,000 = Net Unrealized
Losses/Gains (OCI) + 45,000
g. On its balance sheet at the end of 2013, Washington
Post would report:
i. Under Assets – an investment in available-for-sale
securities of $165,000
ii. Under Other Comprehensive Income – its net
unrealized gain on available-for-sale securities of
$15,000 ($30,000 debit at end of 2013 offset by
$45,000 credit at end of 2013 = account balance of
$15,000)
4. Sale of Securities
a. When available-for-sale securities are sold, Cash is
increased and two accounts on the balance sheet are
eliminated: Investments in AFS (A) and Net
Unrealized Losses/Gains (OCI, SE)
b. Proceeds from sale − Investment Cost = Gain if
positive (Loss if negative)
c. At the end of 2014, Washington Post sold all of its
AFS investment in INews for $13 per share for
$195,000 in cash ($13 × 15,000 shares) for stock it
paid $150,000 for in 2012 ($10 × 15,000 shares)
dr Cash (+A)
195,000
dr Net Unrealized Losses/Gains
(− OCI, − SE)
15,000
cr Investments in AFS (−A)
165,000
cr Gain on Sale of
Investments (+Gain, +SE)
45,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) +195,000 + Investments in AFS (A)
− 165,000 + Net Unrealized Losses/Gains (OCI)
− 15,000 = Gain on Sale of Investments (Gain)
+ 45,000
Use Supplemental
Enrichment Activity #1
See Financial Analysis
feature “Reporting the Fair
Value of Investments”
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 9
D. Comparing Trade and Available-for- Sale Securities
Accounting for Trading
Securities and Available-for-
Sale Portfolios – compared in
Exhibit E.2
1. Available-for-Sale Portfolio
a. Balance in net unrealized holding gains and losses is
reported as a separate component of stockholders’
equity (under Other Comprehensive Income)
i. Not reported on the income statement
ii. Does not affect net income
b. At the time of sale:
i. Difference between the proceeds from the sale and
the original cost of the investment is recorded as a
gain or loss on sale of available-for-sale securities
ii. At the same time, the Investment in AFS and Net
Unrealized Losses/Gains accounts are eliminated
2. Trading Securities Portfolio
a. Amount of the adjustment to record net unrealized
holding gains and losses is included on each period’s
income statement
i. Net holding gains increase and net holding losses
decrease net income
ii. This also means that the amount recorded as net
unrealized gains and losses on trading securities is
closed to Retained Earnings at the end of the period
b. At time of sale , only the Cash and Investments in TS
account are affected
c. Only the difference between the cash from the sale
and the book value (not cost) of the Investment in TS
is recorded as a gain or loss on sale
Refer students to Pause for
Feedback – Self-Study Quiz
3. Over time, the total income reported is the same for both
trading securities and available-for-sale securities; only
the allocation across the three periods differs
Use Supplemental
Enrichment Activity #2
E. Financial Analysis: Reporting the Fair Value of Investments
1. GAAP requires that companies disclose the
measurements used to determine the fair values of assets
2. The fair value of an asset is the amount that would be
received in an orderly sale
3. The standard recognizes three approaches in order of
decreasing reliability:
a. Level 1: Quoted prices in active markets for identical
assets
b. Level 2: Estimates based on other observable inputs
(e.g., prices for similar assets)
c. Level 3: Estimates based on unobservable estimates
(the company’s own estimates of factors that market
participants would consider)
4. Fair value should be determined using the most reliable
method available (Level 1 if possible)
5. Reporting company must disclose the amounts
determined under each approach in a note to the financial
statements
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 10
F. Key Ratio Analysis: Economic Return from Investing
1. Economic Return from Investing = Dividends and Interest
Received + Change in Fair Value ÷ Fair Value of
Investments (beginning of period)
2. Change in Fair Value = Beginning balance of Investments
− Ending balance of Investments
3. Ratio provides a percentage of what was earned plus any
realized and/or unrealized gains or losses on the portfolio
LO 3 – Analyze and report investments involving significant influence using the equity method.
IV. Investments for Significant Influence: Equity Method
A. Recording Investments Under the Equity Method
1. An investor may want to exert influence (presumed by
owning 20% to 50% of the outstanding voting stock)
without becoming the controlling shareholder (presumed
when owning more than 50% of the voting stock) for the
following reasons:
a. A retailer may want to influence a manufacturer to be
sure that it can obtain certain products designed to its
specifications
b. A manufacturer may want to influence a computer
consulting firm to ensure that it can incorporate the
consulting firm’s cutting-edge technology in its
manufacturing processes
c. A manufacturer may recognize that a parts supplier
lacks experienced management and could prosper with
additional managerial support
2. Equity method – Used when an investor can exert
significant influence over an affiliate; the method permits
recording the investor’s share of the affiliate’s income
3. Investments in affiliates or associated companies –
Investments in stock held for the purpose of influencing
the operating and financing strategies of the entity for the
long term
4. Under the equity method, the investor’s 20% to 50%
ownership of a company presumes significant influence
over the affiliate’s process of earning income
a. As a consequence, the investor reports its portion of
the affiliate’s net income as its income and increases
the investment account by the same amount
b. The receipt of dividends by the investor is treated as a
reduction of the investment account (not revenue)
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 11
5. Summary:
Investments in Affiliates (A)
Beginning balance
Purchases
Sales
Company’s % share of
affiliates’ net income
(credit Equity in Affiliate
Earnings [increase
income])
Company’s % share of
affiliates’ net losses
(debit Equity in Affiliate
Losses [decrease
income]
Company’s % share of
affiliates’ dividends
declared for the period
(debit Cash)
Ending balance
6. Purchase of Stock
In 2013, Washington Post purchased 40,000 shares of the
outstanding voting common stock of INews for $400,000;
Washington Post acquired 40% and was presumed to
have significant influence
dr Investments in Affiliates (+A)
400,000
cr Cash (–A)
400,000
Assets = Liabilities + Stockholders’ Equity
Investments in Affiliates (A) + 400,000 + Cash (A)
– 400,000 = 0
7. Earnings of Affiliates
During 2013, INews reported a net income of $500,000
for the year
dr Investments in Affiliates (+A)
200,000
cr Equity in Affiliate Earnings
(+R, +SE)
200,000
Assets = Liabilities + Stockholders’ Equity
Investments in Affiliates (A) + 200,000 = Equity in
Affiliate Earnings (R) + 200,000
8. Dividends Received
During 2013, INews declared and paid a cash dividend of
$1 per share to stockholders; Washington Post received
$40,000 ($1 × 40,000 shares)
dr Cash (+A)
40,000
cr Investments in Affiliates
(–A)
40,000
Assets = Liabilities + Stockholders’ Equity
Investments in Affiliates (A) + 200,000 + Cash (A)
– 200,000 = 0
Use Supplemental
Enrichment Activity #3
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 12
B. Reporting Investments Under the Equity Method
1. The Investments in Affiliates account is reported on the
balance sheet as a long-term asset
a. The investment account does not reflect either cost or
fair value; instead:
i. The investment account is increased by the cost of
shares that were purchased and the proportional
share of the affiliates’ net income
ii. The account is reduced by the amount of dividends
received from the affiliate companies and the
proportional share of any affiliates’ net losses
b. At the end of the accounting period, accountants do
not adjust the investment account to reflect changes in
the fair value of the securities that are held.
Refer students to Pause for
Feedback – Self-Study Quiz
c. When sold, the difference between the cash received
and the book value of the investment is:
See A Question of Ethics
feature “Transaction
Structuring: Selecting
Accounting Methods for
Minority Investments”
i. Recorded as a gain or loss on the sale of the
investment
ii. Reported on the income statement in the Other
Items section
C. Focus on Cash Flows: Investments
1. The cash resulting from the sale or purchase is reflected in
the Investing Activities section
2. In the Operating Activities section, there are a number of
adjustments to net income:
a. Any gain (loss) on the sale is subtracted from (added
to) net income
b. Any unrealized holding gain (loss) on trading securities
is subtracted from (added to) net income
c. Equity in affiliate earnings (losses) is subtracted from
(added to) net income because no cash was involved
in the recording of the revenue under the equity
method
d. Any dividends received from an affiliate are added to
net income because, when cash was received, no
revenue was recorded under the equity method.
Appendix E – Reporting and Interpreting Investments in Other Corporations
App E – 13
LO 4 – Analyze and report investments in controlling interests.
V. Controlling Interests: Mergers and Acquisitions
A. Reasons for Acquiring Control of Another Corporation
1. Vertical integration – in this type of acquisition, a
company acquires another at a different level in the
channels of distribution
2. Horizontal growth – These acquisitions involve companies
at the same level in the channels of distribution
3. Synergy – The operations of two companies together may
be more profitable than the combined profitability of the
companies as separate entities
B. Recording a Merger
1. Merger – occurs when one company purchases all of the
assets and liabilities of another and the acquired company
goes out of existence
2. Purchase method – records assets and liabilities acquired
in a merger or acquisition at their fair value on the
transaction date
a. Only method allowed by U.S. GAAP and IFRS for
recording a merger or acquisition.
b. Requires that the assets and liabilities of the company
acquired be recorded by the acquiring company on its
books at their fair value on the date of the merger
c. Acquiring company must go through a two-step
process, often called the purchase price allocation, to
determine how to record the acquisition:
i. Step 1: Estimate the fair value of the acquired
company’s tangible assets, identifiable intangible
assets, and liabilities
ii. Step 2: Compute goodwill (cost in excess of net
assets acquired) – the excess of the purchase price
of a business over the fair value of the acquired
company’s assets and liabilities
C. Reporting for the Combined Companies
1. After the merger, the acquiring company will treat the
acquired assets and liabilities in the same manner as if
they were acquired individually
a. For example, the company will depreciate amounts
added to equipment over its remaining useful life
b. Goodwill is considered to have an indefinite life
As discussed in Chapter 8
i. As a consequence, it is not amortized, but, like all
long-lived assets, goodwill is reviewed for possible
impairment of value
ii. Recording an impairment loss would increase
expenses for the period and reduce the amount of
goodwill on the balance sheet