CHAPTER 16
INVESTMENTS
Learning Objectives
1. EXPLAIN HOW TO ACCOUNT FOR DEBT
INVESTMENTS.
2. EXPLAIN HOW TO ACCOUNT FOR STOCK
INVESTMENTS.
CHAPTER REVIEW
Why Corporations Invest
1. Corporations purchase investments because (1) they may have excess cash, (2) they generate
earnings from investment income, and (3) for strategic reasons.
Accounting for Debt Investments
2. (L.O. 1) Debt investments are investments in government and corporation bonds. At acquisition,
debt investments are recorded at cost and all expenditures necessary to acquire these
investments are included in the cost (e.g., brokerage fees). At acquisition, Debt Investments is
debited and Cash is credited for the cost of the investment.
3. Interest revenue must also be recorded on debt investments. Assume Bodhi Company (fiscal year
ends December 31) receives $2,000 interest every six months on a debt investment purchased
April 1, 2014. The following entries are required:
Oct. 1 Cash ………………………………………………………………. 2,000
Interest Revenue ……………………………………….. 2,000
Dec. 31 Interest Receivable …………………………………………… 1,000
Interest Revenue ……………………………………….. 1,000
Accounting for Stock Investments
5. (L.O. 2) Stock investments are investments in the capital stock of corporations. The accounting
for stock investments differs depending on the degree of influence the investor has over the issuing
corporation. The presumed influences based on the investor’s ownership interest and the
accounting guidelines that are to be used are as follows:
Investor’s Ownership Interest Presumed Influence
in Investee’s Common Stock on Investee Accounting Guidelines
Less than 20% Insignificant Cost Method
Holdings Less than 20%
6. In accounting for stock investments of less than 20%, the cost method is used. Under the cost
method, the investment is recorded at cost and revenue is recognized only when cash dividends
are received.
a. At acquisition, stock investments are recorded at cost. Stock Investments is debited and Cash
is credited.
b. When dividends are received, Cash is debited and Dividend Revenue is credited.
Holdings Between 20% and 50%
7. When an investor owns between 20% and 50% of the common stock of a corporation, it is
generally presumed that the investor has a significant influence over the financial and operating
activities of the investee; and therefore the equity method is used. Under the equity method, the
investor does not record its share of the investee income until the investee has earned income.
a. At acquisition, the investor records the investment at cost. Stock Investments is debited and
Cash is credited.
Holdings of More Than 50%
8. (L.O. 4) 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.
Valuation and Reporting of Investments
10. (L.O. 3) For purposes of valuation and reporting at a financial statement date, debt and stock
investments are classified into the following three categories.
a. Trading securities are securities bought and held primarily for sale in the near term to
generate income on short-term price differences.
b. Available-for-sale securities are securities the company may sell sometime in the future.
c. Held-to-maturity securities are debt securities that the investor has the intent and ability to
hold to maturity.
11. The valuation guidelines for the above securities are as follows:
Trading Securities
12. When the trading securities are not sold, the difference between the total cost of the securities
and their total fair value is reported as unrealized gains or losses in the income statement. The
adjusting entry to record an unrealized gain would include a debit to Fair Value Adjustment—
Available-for-Sale
13. If available-for-sale securities are held with the intent to sell them within the next year or operating
cycle, the securities are classified as current assets in the balance sheet. Otherwise, they are
classified as long-term assets in the investments section of the balance sheet.
15. Short-term investments are securities held by a company that are (a) readily marketable and (b)
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.
Balance Sheet Presentation
17. Short-term investments are listed immediately below cash in the current assets section of the
balance sheet. Short-term investments are reported at fair value. Long-term investments are
generally reported in a separate section of the balance sheet immediately below current assets;
and available-for-sale securities are reported at fair value, and investments in common stock
accounted for under the equity method are reported at equity.
18. In the income statement, the following items are reported in the nonoperating activities section:
Other Revenue and Gains Other Expenses and Losses
Interest Revenue Loss on Sale of Investments
Dividend Revenue Unrealized Loss—Income
LECTURE OUTLINE
A. Why Corporations Invest.
1. Corporations purchase investments in debt or stock securities for
several different reasons.
2. To house excess cash until needed.
B. Accounting for Debt Investments.
1. Companies record investments in debt securities when they purchase bonds,
receive or accrue interest, and sell the bonds.
C. Accounting for Stock Investments.
1. 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). The general guidelines for stock
investments are:
TEACHING TIP
Emphasize that evidence of the extent of investor influence is the determining
factor in choosing the proper accounting method.
Investor’s Ownership
Interest in Investee
Less than 20%
Presumed Influence
on Investee
Insignificant
Accounting
Guidelines
Cost method
2. Companies record common stock investments of less than 20% when
they purchase the stock, receive dividends, and sell the stock.
a. Companies record the receipt of dividends with a debit to Cash and
a credit to Dividend Revenue.
3. 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, and the investment
should be accounted for by the equity method.
a. Under the equity method, the investor company initially records the
investment in common stock at cost, and it annually adjusts the invest-
ment account to show the investor’s equity in the investee.
4. A company that owns more than 50% of the common stock of another
entity is known as the parent company and has a controlling interest in the
subsidiary (affiliated) company. When a company owns more than 50%
of the common stock of another company, it usually prepares consolidated
financial statements.
5. Consolidated financial statements present the total assets and liabilities
controlled by the parent company. They also present the total revenues
and expenses of the subsidiary companies. Consolidated statements are
ACCOUNTING ACROSS THE ORGANIZATION
Recently, Procter & Gamble acquired Gillette Company for $53.4 billion. The
common stockholders of Procter & Gamble are in a position to elect the board of
directors of Gillette and, in effect, control its operations.
Where on Procter & Gamble’s balance sheet will you find its investment in
Gillette Company?
Answer: Because Procter & Gamble owns 90% of Gillette, P&G does not report
D. Valuing and Reporting Investments.
1. Companies classify all debt securities and stock investments in which
the holdings are less than 20% into three categories for valuation and
reporting purposes: (1) trading securities, (2) available-for-sale securities,
and (3) held-to–maturity securities.
a. Trading securities are bought and held primarily for sale in the near
term to generate income on short-term price differences.
2. Fair value is the amount for which a security could be sold in a normal
market.
ACCOUNTING ACROSS THE ORGANIZATION
Many companies have equity investments of some type. For example, the total
amount of equity-method investments appearing on company balance sheets is
approximately $403 billion.
Why might the use of the equity method not lead to full disclosure in the financial
statements?
Answer: Under the equity method, the investment in common stock of another
company is initially recorded at cost. After that, the investment account
is adjusted at each reporting date to show the investor’s equity in the
E. Short-Term and Long-Term Investments.
1. Short-term investments (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.
2. Investments that do not meet both criteria are classified as long-term
investments.
a. An investment is readily marketable when it can be sold easily when–
ever the need for cash arises. Short–term paper (CDs, money market
certificates, Treasury bills) meets this criterion as do stocks and
bonds traded on organized securities exchanges (i.e., New York
Stock Exchange).
F. Presentation of Realized and Unrealized Gain or Loss.
1. Companies must report in the income statement in the nonoperating activi-
ties section gains and losses on trading securities, whether realized or
unrealized.
IFRS
A Look at IFRS
Until recently, when the IASB issued IFRS 9, the accounting and reporting for
investments under IFRS and GAAP were for the most part very similar. However,
IFRS 9 introduces new investment classifications and increases the situations
when investments are accounted for at fair value, with gains and losses recorded
in income.
KEY POINTS
• The basic accounting entries to record the acquisition of debt securities, the
receipt of interest, and the sale of debt securities are the same under IFRS and
GAAP.
• Under IFRS, both the investor and an associate company should follow the
same accounting policies. As a result, in order to prepare financial information,
adjustments are made to the associate’s policies to conform to the investor’s
books. GAAP does not have that requirement.
• In general, IFRS requires that companies determine how to measure their
financial assets based on two criteria:
♦ The company’s business model for managing their financial assets; and
♦ The contractual cash flow characteristics of the financial asset.
If a company has (1) a business model whose objective is to hold assets in
order to collect contractual cash flows and (2) the contractual terms of the
financial asset gives specified dates to cash flows that are solely payments of
principal and interest on the principal amount outstanding, then the company
• Equity investments are generally recorded and reported at fair value under
IFRS. Equity investments do not have a fixed interest or principal payment
schedule and therefore cannot be accounted for at amortized cost. In general,
equity investments are valued at fair value, with all gains and losses reported in
income.
• GAAP classifies investments as trading, available-for-sale (both debt and equity
investments), and held-to-maturity (only for debt investments). IFRS uses held-
securities (GAAP) and non-trading equity investments (IFRS) are reported in
other comprehensive income.
• Unrealized gains and losses related to available-for-sale securities are reported
in other comprehensive income under GAAP and IFRS. These gains and
losses that accumulate are then reported in the balance sheet.
LOOKING TO THE FUTURE
As indicated earlier, both the FASB and IASB have indicated that they believe
that all financial instruments should be reported at fair value and that changes in
20 MINUTE QUIZ
True/False
1. To be considered a short-term investment, the investment must be readily marketable
and management should intend to convert the investment into cash within the next year
or operating cycle, whichever is longer.
True False
2. Accounting for short-term investments involves entries for the acquisition, interest and
dividend revenue, and the sale.
True False
3. The accounting guidelines for long-term investments in stock are based on the extent of
the investor’s influence over the operating affairs of the issuing corporation.
True False
4. Under the equity method of accounting, the investment account is credited for the investor’s
share of investee earnings and is debited for dividends received from the investee.
True False
5. A parent/subsidiary relationship exists only when the parent company has a controlling
interest in the subsidiary company.
True False
6. Consolidated financial statements are useful to parent company stockholders and managers
because they indicate the magnitude and scope of operations of the companies under
common control.
True False
7. The Fair Value Adjustment balance could be added to the cost of the investments to
arrive at their fair value.
True False
8. Under the fair value method, companies report the unrealized gain in the income state-
ment for available-for-sale securities.
True False
9. Companies report both realized and unrealized gains and losses on trading securities in
the income statement.
True False
10. Pension funds and banks regularly invest in equity securities for strategic reasons.
True False
Multiple Choice
1. Ross Corporation purchased 6,000 shares of Hunter common stock at $60 per share
plus $7,200 brokerage fees as a short-term investment. The shares were subsequently
sold at $65 per share less $8,400 brokerage fees. The cost of the securities purchased
and gain or loss on the sale were
Cost Gain or Loss
a. $360,000 $30,000 gain
2. A company pays $600,000 for 30% of the common stock of X, Inc. In the first year, X,
Inc. reports net income of $120,000 and pays a cash dividend of $45,000. The balance in
Stock Investments-X, at year end under the equity method is:
a. $577,500.
b. $622,500.
3. The equity method is used when the investor
a. makes long-term investments in stocks.
b. plans to sell the investments within one year.
4. At the end of its first year, the trading securities portfolio consisted of the following securities:
Cost Fair Value
Magnum Corp. $38,000 $40,000
The unrealized loss to be recognized is
a. $2,000.
b. $6,000.
5. Which of the following would not appear in an income statement?
a. Unrealized gain on trading securities.
ANSWERS TO QUIZ
True/False
1. True 6. True
2. True 7. True
Multiple Choice
1. c.