Appendix C – Investments and International Operations
APP C-1
Appendix C
Investments and International Operations
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
(A &B set)**
Beyond the
Numbers
Conceptual objectives:
C1. Distinguish between debt and
equity securities and between
short-term and long-term
investments.
1, 5, 8, 9, 10
C-5, C-6
C-4, C-12
TTN, TIA
C2. Describe how to report equity
securities with controlling
influence.
4, 17
C-6, C-11
C-5
C-4
TIA
C3. Explain foreign exchange rates
between currencies.
(Appendix C-A)
12, 13, 14
C-15, C-14
C-15, C-16
C-6
RIA, HTR,
ED
Analytical objectives:
Al. Compute and analyze the
components of return on total
assets.
18
C-12, C-13
C-14
RIA, CA,
GD
Procedural objectives:
P1. Account for trading securities.
2, 16
C-1, C-16
C-1, C-6,
C-8
C-1
TIA
P2. Account for held-to-maturity
securities.
C-7, C-9
C-2, C-8,
C-12
EC, TIA
P3. Account for available-for-sale
securities.
3, 6, 7, 15
C-2, C-3,
C-4, C-8,
C-10
C-3, C-7,
C-8, C-9,
C-10, C-11,
C-12, C-17
C-2, C-3,
C-4, C-5
EC, TIA
P4. Account for equity securities
with significant influence.
4, 11
C-9
C-12, C-13
C-4, C-5
CIP, TIA
Notes appear on next page.
Appendix C – Investments and International Operations
*Assignment materials that can be completed by students using:
Appendix C – Investments and International Operations
APP C-3
Appendix Outline
Notes
I. Basics of Investments
A. Motivation for Investments
1. Companies transfer excess cash into investments to produce
higher income.
2. Some entities, such as mutual funds and pension funds, are set
up to produce income from investments.
3. Companies make investments for strategic reasons. Examples:
investments in competitors, suppliers, and even customers.
B. Short-Term versus Long-Term Investments
1. Short-term investments—current assets that must meet these
two requirements:
a. Expected to be converted into cash within one year or the
current operating cycle of the business, whichever is
longer.
b. Readily convertible to cash.
2. Long-term investments—investments not meeting the two
requirements for short-term investments.
3. Debt Securities versus Equity Securities debt securities
reflect a creditor relationship such as investments in notes,
bonds, and certificates of deposit. Equity securities reflect an
owner relationship such as shares of stock issued by
companies.
C. Classification and Reporting
1. Accounting for investments depends on three factors:
a. Security type, either debt or equity.
b. The company’s intent to hold the security either short–
term or long-term, and
c. The company’s (investor’s) percent ownership in the other
company’s (investee’s) equity securities.
d. Exhibit C.2 identifies five classes of securities using these
three factors.
D. Debt Securities: Accounting Basics
1. Acquisition: debt securities are recorded at cost when
purchased. They are classified as held-to-maturity (HTM)
securities. If they are short-term, they are classified as Short-
Term Investments (HTM).
2. Interest earned: interest revenue for investments in debt
securities is recorded when earned.
3. Disposition: when the bonds mature, the proceeds are recorded
as a debit to cash and a credit to Long-Term Investments
(HTM).
Appendix C – Investments and International Operations
APP C-4
Appendix Outline
Notes
E. Equity Securities: Accounting Basics
1. Acquisition: equity securities that are available-for-sale are
recorded at cost when acquired, including commissions or
brokerage fees paid.
2. Dividends earned: any cash dividends received are credited to
Dividend Revenue and reported in the income statement.
3. Disposition: when the securities are sold, the proceeds are
compared with cost, and any gain or loss is recorded.
II. Reporting of Noninfluential Investments – companies must value and
report most noninfluential investments at fair value. Reporting
requirements depend on whether the investments are classified as trading,
held-to-maturity or available-for-sale.
A. Trading securities are debt and equity securities that the company
intends to actively manage and trade for profit. Frequent purchases
and sales are expected and are made to earn profits on short-term
price changes. Always reported as current assets.
1. Valuing and reporting trading securities
a. The entire portfolio of trading securities is reported at its
fair value; this requires a “fair value adjustment” from the
cost of the portfolio.
2. The unrealized gain (or loss) from a change in the fair value of
the portfolio of trading securities is reported on the income
statement in the Other Revenues and Gains (or Expenses and
Losses).
3. Selling trading securities – when individual trading securities are
sold, the difference between the net proceeds (sales price less
fees) and the cost of the individual trading securities that are
sold is recognized as a gain or a loss.
Any prior period fair value adjustment is not used to compute
the gain or loss from sale.
B. Held-to–maturity – includes debt securities intended to be held to
maturity. Reported in current assets if their maturity dates are
within one year or operating cycle. Amortized cost method used for
reporting purposes. No fair value adjustment to the portfolio of
HTM securities.
C. Available-for-Sale Securities (AFS)
1. Available-for-sale includes debt and equity securities not
classified as trading or held-to-maturity. AFS securities are
purchased to yield interest, dividends or increases in fair value.
They are not actively managed.
2. Valuing and reporting AFS securities – companies adjust the
cost of the portfolio of AFS securities to reflect changes in fair
value through a fair value adjustment to its total portfolio cost.
Any unrealized gain or loss is reported in the equity section of
the balance sheet as part of comprehensive income.
Appendix C – Investments and International Operations
APP C-5
Appendix Outline
3. Selling AFS securities – identical to that described for the sale
of trading securities. The difference between the cost of the
individual securities sold and the net proceeds is recognized as
a gain or loss.
III. Reporting of Influential Investments
A. Investment in Securities with Significant Influence
A long-term investment classified as equity securities with
significant influence implies that the investor can exert significant
influence over the investee.
1. An investor that owns 20% or more (but not more than 50%) of a
company’s voting stock is usually presumed to have significant
influence over the investee. (In some cases, the 20% test is
overruled by other, more persuasive, evidence.)
2. The equity method of accounting and reporting is used for long-
term investments in equity securities with significant influence.
a. Long-term investments in equity securities with significant
influence are recorded at cost in a Long-Term Investments
account when acquired.
b. When the investee reports its earnings, the investor records
its share of those earnings in its investment account and
credits the Earnings from Long-Term Investments account.
c. The receipt of cash dividends is not revenue because the
investor has already recorded its share of the investee’s
earnings; instead, the cash dividends received reduce the
balance of the Long-Term Investments account.
d. The book value of an investment under the equity method
equals the cost of the investment plus (minus) the investor’s
equity in the undistributed (distributed) earnings of the
investee.
e. When the investment is sold, the gain or loss is computed by
comparing the proceeds from the sale with the book value on
the date of the sale.
B. Investment in Securities with Controlling Influence. A long-term
investment classified as equity securities with controlling
influence implies that the investor can exert a controlling influence
over the investee.
1. An investor who owns more than 50% of a company’s voting
stock has control over the investee. (In some cases, controlling
influence can extend to situations of less than 50%
ownership.)
2. The equity method with consolidation is used to account for
long-term investments in equity securities with controlling
influence.
a. The investor reports consolidated financial statements
when owning such securities. The controlling investor is
Notes
Appendix C – Investments and International Operations
APP C-6
Appendix Outline
Notes
called the parent and the investee is called the subsidiary.
b. Consolidated financial statements show the financial
position, results of operations, and cash flows of all
entities under the parent’s control, including all
subsidiaries; these statements are prepared as if the
business were organized as one entity.
c. The parent uses the equity method in its accounts, but the
investment account is not reported on the consolidated
financial statements.
C. Accounting Summary for Investments in Securities—See Exhibit
C.8 for a summary of the accounting for investments in securities.
D. Comprehensive Income
1. The term comprehensive income refers to all changes in
equity for a period except those due to investments and
distributions to owners. This means that it includes:
a. The revenues, gains, expenses, and losses reported in net
income, and
b. The gains and losses that bypass net income but affect
equity.
2. Other comprehensive income: most often this simply requires
one additional column for Other Comprehensive Income in the
statement of stockholders’ equity.
IV. Global View
A. Accounting for Noninfluential Securities – broadly similar between
U.S. GAAP and IFRS.
1. Trading securities are accounted for using fair values with
unrealized gains and losses report in net income as fair value
change.
2. Available-for-sale securities are accounted for using fair values
with unrealized gains and losses reported in other
comprehensive income as fair value change.
3. Held-to–maturity securities are accounted for using amortized
cost.
4. Both systems review held-to-maturity securities for impairment.
5. Under IFRS trading securities are referred to as financial assets at
fair value through profit and loss.
6. Under IFRS available-for-sale securities are referred to as
available-for-sale financial assets.
B. Accounting for Influential Securities – broadly similar across U.S.
GAAP and IFRS.
1. Under the equity method, the share of investee’s net income is
reported in the investor’s income in the same period the investee
earns that income.
2. The investment account equals the acquisition cost plus the share
Appendix C – Investments and International Operations
APP C-7
Appendix Outline
Notes
of investee income less the share of investee dividends.
3. Under the consolidation method, investee and investor revenues
and expenses are combined, absent intercompany transactions
and subtracting noncontrolling interests.
4. Nonintercompany assets and liabilities are similarly combined
and noncontrolling interests are subtracted from equity.
5. U.S. GAAP companies refer to earnings from long-term
investments as equity in earnings of affliates whereas IFRS
companies use equity in earnings of associated companies.
6. U.S. GAAP companies refer to noncontrolling interests in
consolidated subsidiaries are minority interess whereas IFRS
companies commonly use noncontrolling interests.
V. Decision Analysis—Components of Return on Total Assets
A. A company’s return on total assets is used to assess financial
performance.
B. It can be separated into two components: profit margin and total
asset turnover.
C. Return on total assets is calculated as profit margin x total asset
turnover.
D. Profit margin is calculated as net income divided by net sales. It
reflects the percent of net income in each dollar of net sales.
E. Total asset turnover is calculated as net sales divided by average
total assets. It reflects a company’s ability to produce net sales
from total assets.
F. Generally, if a company is to maintain or improve its return on
total assets, it must meet any decline in either profit margin or
total asset turnover with an increase in the other. If not, return on
assets will decline.
VI. Investments in International Operations (Appendix C-A)
Some entities’ operations occur in so many different countries that the
companies are called multinationals.
A. Exchange Rates between Currencies
The price of one currency stated in terms of another currency is
called a foreign exchange rate.
B. Sales and Purchases Listed in a Foreign Currency
1. When a U.S. company makes a credit sale to an international
customer, accounting for the sale and the accounts receivable
is straightforward if sales terms require the international
customer’s payment in U.S. dollars.
2. If sale terms require (or allow) payment in a foreign currency,
the U.S. company must account for the sale and the account
receivable in a different manner.
a. The sales price must be translated from the foreign
Appendix C – Investments and International Operations
APP C-8
Appendix Outline
Notes
currency to dollars by multiplying the sales price (stated in
the foreign currency) by the exchange rate on the date of
the sale; entry (for U.S. company) for sale of merchandise
on credit: debit Accounts Receivable, credit Sales
b. If the receivable is still outstanding at the end of the end of
the accounting period, the receivable must again be
translated from the foreign currency to dollars by
multiplying the sales price (stated in the foreign currency)
by the exchange rate at the end of the accounting period.
Entry assuming the amount of the receivable (when
translated) is higher: debit Accounts Receivable, credit
Foreign Exchange Gain.
3. When payment is received from the foreign customer, the U.S.
company will immediately exchange the payment into dollars.
Entry assuming the amount of the payment (when translated)
is lower: debit Cash, debit Foreign Exchange Loss, credit
Accounts Receivable.
4. The balance in the Foreign Exchange Gain (or Loss) account
is reported on the income statement and closed to the Income
Summary account at year-end.
C. Consolidated Statements with International Subsidiaries
Before preparing consolidated statements, the parent must
translate financial statements of a foreign subsidiary into U.S.
dollars.
Appendix C – Investments and International Operations
APP C-9
Appendix C – Alternate Demonstration Problem #1
2013
Jan
1
Purchased 8,000 shares (20%) of Investee Company’s outstanding
stock at a cost of $150,000.
May
31
Investee Company declared and paid a cash dividend of $1.50 per
share.
Dec
31
Investee Company announced that its net income for the year was
$100,000.
2014
Oct
1
Investee Company declared and paid a cash dividend of $1.00 per
share.
Dec
31
Investee Company announced that its net income for the year was
$80,000.
2015
Jan
1
Investor Corporation sold all of its shares of Investee Company
for $178,000 cash.
Required:
Prepare journal entries on Investor Corporation’s books using the equity
method, which assumes that Investor has significant influence over
Investee Company.
Appendix C – Investments and International Operations
APP C-10
Solution: Appendix C – Alternate Demonstration Problem #1
2013
Jan
1
Long-Term Investment—Investee Stock ..
150,000
Cash ………………………………………………
150,000
May
31
Cash ……………………………………………………
12,000
Long-Term Investment—Investee Stock
12,000
Dec
31
Long-Term Investment—Investee Stock ..
20,000
Earnings from Long-Term Investment
—Investee Stock ………………………….
20,000
2014
Oct
1
Cash ……………………………………………………
8,000
Long-Term Investment—Investee Stock
8,000
Dec
31
Long-Term Investment—Investee Stock ..
16,000
Earnings from Long-Term Investment
—Investee Company ……………………
16,000
2015
Jan
1
Cash ……………………………………………………
178,000
Long-Term Investment—Investee Stock
166,000
Gain on Sale of Investments …………..
12,000