chapter
13
Investments and Fair Value
Accounting
______________________________________________
OPENING COMMENTS
Chapter 13 discusses the various ways businesses can invest excess cash with the goal of earning
additional cash. These investments can include interest earned on deposits such as CDs, investment in
notes and bonds, or investment in stocks. These investments can be short term or long term, depending on
the need of each individual business. The motivations can range from receiving a higher return on their
money than they can earn by leaving the cash in the bank to taking over the control of another company.
This chapter introduces students to these various options and discusses the accounting methods for each
investment.
After studying the chapter, your students should be able to:
2. Describe and illustrate the accounting for debt investments.
4. Describe and illustrate valuing and reporting investments in the financial statements.
6. Describe and illustrate the computation of dividend yield.
KEY TERMS
accumulated other comprehensive income
available-for-sale securities
business combination
comprehensive income
256 Chapter 13 Investments and Fair Value Accounting
consolidated financial statements
cost method
debt securities
dividend yield
equity method
equity securities
fair value
held-to-maturity securities
investee
investments
investor
other comprehensive income
parent company
subsidiary company
trading securities
unrealized gain or loss
STUDENT FAQS
• Why are investments in stock considered equity investments and investments in bonds considered
debt investments?
• Why do the methods of accounting change for different levels of investment in another company?
• Why are there so many different rules for different investments? Wouldn’t be easier if there were just
one way to record investments?
• What does “fair value” accounting mean?
Chapter 13 Investments and Fair Value Accounting 257
OBJECTIVE 1
Describe why companies invest in debt and equity securities.
SYNOPSIS
A company may have excess cash at certain times of the year that are not needed for current operations.
Instead of letting the cash sit idle, most companies invest their excess cash in temporary investments.
Companies can invest in debt securities or equity securities. These investments are reported in the current
asset section of the balance sheet. The objective of this investing is to earn interest revenue, receive
dividends, and realize gains from increases in the market price of the securities. Long-term investments
made by companies have other purposes, such as reduction of costs, replacement of management,
expansion, and integration.
Key Terms and Definitions
• Debt Securities – Notes and bond investments that provide interest revenue over a fixed maturity.
SUGGESTED APPROACH
This objective provides an overview of ways businesses can invest cash such as in current operations,
short-term investments, and long-term investments.
LECTURE AID—Why Companies Invest
Present students with the following scenario: B-Squared Textiles at year-end has $150,000 in excess cash.
258 Chapter 13 Investments and Fair Value Accounting
GROUP LEARNING ACTIVITY—Investing Cash
Ask your students to work in groups to determine the best way to invest cash for the companies described
on Transparency Master (TM) 13-1.
Company
Cash
Condition
Company 1
$700,000
Very competitive in industry
Up to date with technology
No major debt
Lacks market share
Company 2
Outdated technology
Market share good
No major debt
Concerned about future economic outlook
No major debt
No current operating needs
OBJECTIVE 2
Describe and illustrate the accounting for debt investments.
SYNOPSIS
The purchase of bonds is recorded as a debit to Investments and a credit to Cash. If the bonds are
purchased between interest dates, there may also be a debit to Interest Receivable. When interest is
Relevant Example Exercises and Exhibits
• Example Exercise 13-1 Bond Investment Transactions
• Exhibit 1 – Interest Timeline
SUGGESTED APPROACH
Chapter 13 Investments and Fair Value Accounting 259
DEMONSTRATION PROBLEM—Accounting for Debt Investments
On May 31, 20—, Bellbugg Enterprises invested $60,000 in Johnsonville municipal bonds that pay 8%
interest semiannually on June 30 and December 31 each year. Journalize the entries to record the
purchase of the bonds. Be sure to include the interest accrued.
Record the journal entry for the interest paid on June 30 and the interest revenue on December 31.
INTERNET ACTIVITY—Investing in Bonds
After learning all the intricacies of accounting for bonds, your students may enjoy learning about
opportunities to invest in bonds. You may want to refer them to the following Web sites:
OBJECTIVE 3
Describe and illustrate the accounting for equity investments.
SYNOPSIS
A corporation sometimes purchases the stock of another corporation as an investment. The purchaser is
known as the investor and the company whose stock was purchased is called the investee. If the investor
buys less than 20% of the investee’s stock, they have no control over the investee. It is assumed that the
purchase was primarily to earn dividends and realize gains on stock price increases. Investments of less
than 20% are accounted for by the cost method. Examples of transactions recording the purchase of stock,
receipt of dividends, and sale of stock are shown on page 689 in the text. If the investor purchases
260 Chapter 13 Investments and Fair Value Accounting
Key Terms and Definitions
• Business Combination – A business making an investment in another business by acquiring a
controlling share, often greater than 50%, of the outstanding voting stock of another corporation
by paying cash or exchanging stock.
• Consolidated Financial Statements – Financial statements resulting from combining parent and
subsidiary statements.
• Cost Method – A method of accounting for equity investments representing less than 20% of the
outstanding shares of the investee. The purchase is at original cost, and any gains or losses upon
sale are recognized by the difference between the sale proceeds and the original cost.
Relevant Example Exercises and Exhibits
• Example Exercise 13-2 Stock Investment Transactions
• Example Exercise 13-3 Equity Method
• Exhibit 2 – Stock Investments
• Exhibit 3 – Investment and Dividends
SUGGESTED APPROACH
Remind students that businesses invest in equity securities for one of the following reasons:
1. To receive a return on excess cash.
3. To gain control of another company.
Businesses invest in equity securities by buying stocks either directly from the issuing corporation or
from other investors. Purchases from other investors occur through organized stock exchanges (such as
the New York Stock Exchange) or over the counter. Use the Brainstorming Activity below to explore the
reasons a business would want to acquire control of another business. Securities purchased by a business
Chapter 13 Investments and Fair Value Accounting 261
BRAINSTORMING ACTIVITY—Reasons for Investing in Another Company
Ask your students to brainstorm reasons that a business would want to gain control of another company.
While not presented in the text, at this time you may like to discuss the concepts of horizontal and vertical
integration.
DEMONSTRATION PROBLEM—Equity Investments: Less than 20%
Ownership
The accounting for investments in stocks depends on whether the investor has “significant influence” over
the investee. The equity method is used whenever an investor has significant influence over the operating
and financing activities of another company. The general guideline to determine whether an investor (in
this discussion, another company) has a significant influence is the 20 percent rule. If an investor owns 20
For example, assume that on September 1, Jordan Corporation purchased 1,000 shares of Cumberland,
Inc. as a long-term investment at $15 per share plus a brokerage fee of $60. Jordan’s purchase represents
less than 20 percent of the shares of Cumberland, Inc. On October 18, Jordan received a $0.50 per share
dividend. The journal entries for these events are:
DEMONSTRATION PROBLEM—Equity Investments: 20%–50% Ownership –
Equity Method
When a company invests in stock and obtains between 20 percent and 50 percent of the outstanding stock
of another company, it is deemed to have significant influence over the purchased company. This requires
that the equity method be applied to account for this investment.
262 Chapter 13 Investments and Fair Value Accounting
For example, assume that Jordan Corporation purchased a 30 percent interest in Mini-Marts, Inc. for
$500,000. For the year ended December 31, Mini-Marts reported net income totaling $100,000. On
January 18, Mini-Marts paid a $40,000 cash dividend.
Entry to record the purchase of Mini-Marts Inc. stock:
Investment in Mini-Marts, Inc. Stock………. 500,000
Cash…………………………………. 500,000
LECTURE AID—Equity Investment: More than 50% Ownership
When a company acquires a controlling interest (normally anything over 50 percent) in another company
through investment in the second company’s stock, it must account for this by consolidation of the
statements of the two companies. The text does not pursue consolidation of statements.
However, if you desire to pursue this subject further, TM 13-3 lists the three methods used to combine
businesses. Review this TM with your class. Explain that parent-subsidiary relationships are accounted
Chapter 13 Investments and Fair Value Accounting 263
OBJECTIVE 4
Describe and illustrate valuing and reporting investments in the financial statements.
SYNOPSIS
Trading securities are purchased for their short-term profit potential and reported as current assets. At the
end of the period, these assets may be adjusted to their fair market value due to the objective nature of
their reported price. Any increase in their value is recorded as an unrealized gain on the income statement
and at their fair market value on the balance sheet. The accounting for available-for-sale securities is
similar to the accounting for trading securities. Differences include the recording of changes in the fair
Key Terms and Definitions
• Available-for-Sale Securities – Securities that management expects to sell in the future but
which are not actively traded for profit.
• Fair Value – The price that would be received for selling an asset or paying off a liability, often
Relevant Example Exercises and Exhibits
• Example Exercise 13-4 Valuing Trading Securities at Fair Value
• Example Exercise 13-5 Valuing Available-for-Sale Securities at Fair Value
• Exhibit 4 – Summary of Valuing and Reporting of Investments
264 Chapter 13 Investments and Fair Value Accounting
SUGGESTED APPROACH
Exhibit 3 in the text is an excellent summary of the information provided in this objective. Investments
are categorized based on the intention of the investment. Exhibit 3 is reproduced on TM 13-9. The three
categories are:
1. Trading securities
3. Held-to-maturity securities
Trading securities are current assets intended for short-term investments. The goal is to achieve a higher
rate of return than otherwise available through holding cash. Typically this involves investing in stocks
that can easily be converted to cash as necessary. The return is provided through dividends and increase
of the stock value. The accounting for trade securities involves adjusting the asset value to reflect the true
market value as it changes. Market value can easily be determined through currently traded stock prices.
DEMONSTRATION PROBLEM—Trading Securities
First, cover the difference between a short-term and a long-term investment in stocks. An investment can
be considered short-term (a temporary investment) if two conditions are met: (1) the securities are readily
marketable and can be sold for cash at any time and (2) management intends to sell the securities when
the business needs cash for operations.
Your students will need to know how to record the purchase of short-term stock investments and the
receipt of dividends. Before presenting the journal entries, ask your students to use their accounting
knowledge to “guess” how the following transactions would be journalized.
Chapter 13 Investments and Fair Value Accounting 265
Correct answer:
Sept. 30 Cash…………………………...……..… 1,000
Dividend Revenue.………………. 1,000
GROUP LEARNING ACTIVITY—Trading Securities
Once trading securities have been purchased, they are reported on the balance sheet at their fair market
LECTURE AID—Available-for-Sale Securities
Available-for-sale securities are debt and equity securities that are neither held for trading, nor held to
maturity, nor held for strategic reasons. The accounting for these is similar to the accounting for trade
securities except for the reporting of changes in fair value. Changes in fair value of trade securities are
reported on the income statement as unrealized gains or losses. Changes in fair value of available-for-sale
LECTURE AID—Held-to-Maturity Securities
Held-to-maturity securities are typically notes or bonds purchased for the interest they provide as income.
The intent is to purchase the security and hold it until the maturity date. Revenue is generated through the
interest payments received. The calculations for present value and interest revenue mirror those provided
in Chapter 12 for issuing bonds.
DEMONSTRATION PROBLEM—Investment in Bonds
Smyth Company purchased a $1,000 bond of Whitney Corporation on March 1 at 84 plus a $15
brokerage fee and accrued interest. The bond pays 12 percent interest semiannually, on December 31 and
June 30.
266 Chapter 13 Investments and Fair Value Accounting
Accrued Interest: Assuming that Smyth still owns the bond on June 30, it will receive a $60 check from
Whitney Corporation for six months’ interest. However, Smyth owned the bond for only four months
(March to June). The first two months’ interest should go to the person who owned the bond before
Smyth.
To solve this problem, Smyth will pay the previous owner for two months of interest ($20) when
purchasing the bond. When Smyth receives the full six-month interest payment at the end of June, the
company will be reimbursed for the two months of interest paid to the previous bond owner.
The journal entry to record this bond purchase:
The accrued interest paid to the previous bondholder was debited to the interest revenue account,
establishing a negative balance in that account. The entire six-month interest payment was credited to the
interest revenue account when it was received. This leaves an account balance of $40, the four months of
interest that Smyth earned by holding the bond March 1 through June 30.
Interest Revenue
Interest paid to
previous owner 20
60 Six-month interest payment
40 Four months’ interest earned by Smyth
Chapter 13 Investments and Fair Value Accounting 267
Assume that Smyth determines it should amortize $33 of the bond discount at the end of the first year.
The journal entry to amortize the discount:
Investment in Bonds…………………….. 33
Interest Revenue…………………. 33
Notice that the amortization of the discount increases both the investment in bonds and the interest
revenue accounts. The balance in the Investment in Bonds account after amortization of the discount is
$888, as illustrated below:
Investment in Bonds
Beginning balance 855
Discount amortized 33
Ending balance 888
OBJECTIVE 5
Describe fair value accounting and its effects on the financial statements.
SYNOPSIS
GAAP allows some assets to be recorded at their historical or purchase price, such as inventory and
property, plant, and equipment. Other assets, such as trading and available-for-sale investments, are
recorded at their fair market value. The FASB has allowed this due to the reliability of the fair market
268 Chapter 13 Investments and Fair Value Accounting
values. Recording assets at their fair market values will affect both the balance sheet and the income
statement.
SUGGESTED APPROACH
This objective discusses the possibility and potential consequences of expanding the fair value concept to
all assets, not just the investment assets discussed in this chapter. The FASB is reviewing these options
and continually ruling on the use of fair value.
OBJECTIVE 6
Describe and illustrate the computation of dividend yield.
SYNOPSIS
The dividend yield measures the rate of return to stockholders using the cash dividends they receive from
their investments. It is calculated as: dividend yield = dividends per share of common stock/market price
per share of common stock. Dividend yields vary widely across companies. Corporations focused on
growth tend to retain earnings to fund future growth. Many firms pay no dividends and investors expect
to earn their return through stock price appreciation.
Key Terms and Definitions
Relevant Exercise Examples and Exhibits
• Example Exercise 13-6 Dividend Yield
SUGGESTED APPROACH
TM 13–10 presents questions related to dividend yield. Use these questions to stimulate a class discussion
on dividend policies. In order to answer question 1, your students will need to compute dividend yield.
TMs 13-12 and 13-13 provide suggested answers.
Chapter 13 Investments and Fair Value Accounting 269
APPENDIX—COMPREHENSIVE INCOME
SYNOPSIS
Comprehensive income is all changes in stockholders’ equity during a period. It does not include any
changes resulting from dividends and stockholder’s investments. Other comprehensive income items
include unrealized gains and losses on available-for-sale securities, investments in foreign currencies, and
pension liability adjustments. These items may be reported on the income statement or in a separate
statement of comprehensive income.
Key Terms and Definitions
• Accumulated Other Comprehensive Income – The cumulative effects of other comprehensive
SUGGESTED APPROACH
Describing comprehensive income is a challenge, since it encompasses so many advanced accounting
topics. However, it is important to address this accounting measure. In 1997, the Financial Accounting
Standards Board issued a statement requiring companies to report comprehensive income.
LECTURE AID—Comprehensive Income
The easiest way to explain comprehensive income adjustments is in the context of unrealized gains and
losses on investments. Therefore, you may want to cover this objective after discussing investments in
equity securities.
First, it is important to explain the difference between a realized and an unrealized gain. Assume an
investor purchases a share of Provident Corporation stock for $10. Next, assume the market price of the
stock goes up to $15. If the investor sells the stock for $15, he has a realized gain of $5. If the investor
270 Chapter 13 Investments and Fair Value Accounting
Traditional Net Income
+ Unrealized Gain on Investments
Comprehensive Income
Remind your students that there are other items that affect comprehensive income; however, it is best to
discuss these items (such as foreign currency items and pension liability adjustments) in advanced
accounting courses.
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP – APC Bloom’s EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 2 2 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 3 2 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 4 2 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 5 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 6 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 7 4 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 8 4 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 9 5 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
DQ 10 5 Easy 5 min. Analytic Measurement Corporate Investments Accounting Knowledge
PE 1A Bond investment transactions 2 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 1B Bond investment transactions 2 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 2A Stock investment transactions 3 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 2B Stock investment transactions 3 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 3A Equity method 3 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 3B Equity method 3 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 4A Valuing trading securities at fair value 4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 4B Valuing trading securities at fair value 4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 5A Valuing available-for-sale securities at fair value 4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 5B Valuing available-for-sale securities at fair value 4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
PE 6A Dividend yield 6 Easy 15 min. Analytic Measurement Corporate Investments Accounting Application x x
PE 6B Dividend yield 6 Easy 15 min. Analytic Measurement Corporate Investments Accounting Application x x
EX 1 Entries for investment in bonds, interest, and sale of bonds 2 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 2 Entries for investment in bonds, interest, and sale of bonds 2 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 3 Entries for investment in bonds, interest, and sale of bonds 2 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application x
EX 4 Entries for investment in bonds, interest, and sale of bonds 2 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application x
EX 5 Interest on bond investments 2 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application
EX 6 Entries for investment in bonds, receipt of dividends, and sale of shares 3 Moderate 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 7 Entries for investment in bonds, receipt of dividends, and sale of shares 3 Moderate 5 min. Analytic Measurement Corporate Investments Accounting Application x
EX 8 Entries for stock investments, dividends, and sale of stock 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application x
EX 9 Entries for stock investments, dividends,and sale of stock 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application x
EX 10 Equity method for stock investment 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application x x
EX 11 Equity method for stock investment 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application x x
EX 12 Equity method for stock investment with loss 3 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application
EX 13 Equity method for stock investment 3 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application
EX 14 Missing statement items, trading investments 4 Easy 15 min. Analytic Measurement Corporate Investments Accounting Application
EX 15 Fair value journal entries, trading investments 3,4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 16 Fair value journal entries, trading investments 3,4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 17 Fair value journal entries, trading investments 3,4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 18 Balance sheet presentation, trading investments 4 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application
EX 19 Missing statement items, available-for-sale securities 4 Easy 5 min. Analytic Measurement Corporate Investments Accounting Application
EX 20 Fair value journal entries, available-for-sale investments 3,4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application
EX 21 Fair value journal entries, available-for-sale investments 3,4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application
EX 22 Fair value journal entries, available-for-sale investments 3,4 Easy 10 min. Analytic Measurement Corporate Investments Accounting Application x
EX 23 Balance sheet presentation of available-for-sale investments 4 Easy 15 min. Analytic Measurement Corporate Investments Accounting Application
EX 24 Balance sheet presentation of available-for-sale investments 4 Moderate 15 min. Analytic Measurement Corporate Investments Accounting Application
EX 25 Dividend yield 6 Moderate 15 min. Analytic Measurement Corporate Investments Accounting Application x x
EX 26 Dividend yield 6 Moderate 15 min. Analytic Measurement Corporate Investments Accounting Application x x
EX 27 Dividend yield 6 Moderate 15 min. Analytic Measurement Corporate Investments Accounting Application x x
EX 28 Comprehensive income Appendix Moderate 15 min. Analytic Measurement Corporate Investments Accounting Application
EX 29 Comprehensive income Appendix Moderate 15 min. Analytic Measurement Corporate Investments Accounting Application
PR 1A Debt investment transactions, available-for-sale valuation 2,4 Moderate 1 hour Analytic Measurement Corporate Investments Accounting Application x x
PR 2A Stock investment transactions, trading securities 3,4 Moderate 1 hour Analytic Measurement Corporate Investments Accounting Application x
PR 3A Stock investment, equity method and available-for-sale securities 3,4 Moderate 1.5 hours Analytic Measurement Corporate Investments Accounting Application x
PR 1B Debt investment transactions, available-for-sale valuation 2,4 Moderate 1 hour Analytic Measurement Corporate Investments Accounting Application x x
PR 2B Stock investment transactions, trading securities 3,4 Moderate 1 hour Analytic Measurement Corporate Investments Accounting Application x
PR 3B Stock investment, equity method and available-for-sale securities 3,4 Moderate 1.5 hours Analytic Measurement Corporate Investments Accounting Application x
PR 4B Investment reporting 2,3,4 Moderate 1 hour Analytic Measurement Corporate Investments Accounting Application x
Comprehensive Problem Journalize transactions, prepare financial statements 1,2,3,4,5,6 Challenging 3 hours Analytic Measurement Corporate Investments Accounting Application x
CP 1 Benefits of fair value 5 Easy 5 min. Ethics Industry Corporate Investments Accounting Knowledge
CP 2 International fair value accounting 5 Easy 5 min. Ethics Industry Corporate Investments Accounting Knowledge
CP 3 Ethics and fair value measurement 5 Easy 10 min. Analytic Measurement Corporate Investments Accounting Analysis x
CP 4 Warren Buffet and “look-through” earnings 5 Easy 5 min. Analytic Measurement Corporate Investments Accounting Analysis x
CP 5 Reporting investments 4 Moderate 10 min. Analytic Measurement Corporate Investments Accounting Knowledge x x x
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