11-115-1

Investments and Fair Value Accounting

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Student Version

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Describe why companies invest in debt and equity securities.

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Investing Cash in Temporary Investments

Debt securities are notes and bonds that pay interest and have a fixed maturity date. Equity securities are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.

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Investing Cash in Temporary Investments

These debt securities and equity securities are termed Investments, or Temporary Investments, and are reported in the Current Assets section of the balance sheet.

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Investing Cash in Long-Term Investments

Long-term investments often involve the purchase of a significant portion of the stock of another company. Such investments have a strategic purpose:1. Reduction of costs2. Replacement of management3. Expansion4. Integration

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Describe and illustrate the accounting for debt investments.

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Purchase of BondsHomer Company purchases $18,000 of U.S. Treasury bonds direct from a Federal Reserve Bank at their par value on March 17, 2010 (45 days after the last interest payment date). The bonds have an interest rate of 6%, payable on July 31 and January 31.

$18,000 × 6% × (45/360)

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Interest Revenue

On July 31, Homer Company receives a semiannual interest payment of $540 ($18,000 × 6% × ½).

($540 – $135) or [$18,000 × 6% × (135/360)]

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Homer Company’s accounting period ends on December 31. The following adjusted entry is required to record the accrued interest:

Accrued Interest

Homer Company would report Interest Revenue on its 2010 income statement at $855 ($405 + $450).

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Homer Company receives interest of $540 on January 31, 2011. Notice that Interest Receivable is credited for $450 to reflect this is a receivable from 2010. Interest Revenue of $90 is the interest earned from January 1 through January 31, 2011.

Semiannual Receipt of Interest

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On January 31, 2011, Homer Company sells Treasury bonds at 98. The sale results in a loss of $360.

Sale of Bonds

Proceeds from sale ($18,000 × 98%) $17,640Less book value (cost) of the bonds 18,000Loss on sale of bonds $(360)

Reported as part of Other Income (Loss) on the income statement

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Describe and illustrate the accounting for equity investments.

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Investments of less than 20% of the investee’s outstanding stock are accounted for by using the cost method.

Less Than 20% Ownership

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On May 1, Bart Company purchases 2,000 shares of Lisa Company common stock at $49.90 per share plus a brokerage fee of $200.

Purchase of Stock (Cost Method)

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On July 31, Bart Company receives a dividend of $0.40 per share from Lisa Company.

Receipt of Dividends (Cost Method)

Dividend Revenue is reported as part of Other Income on Bart Company’s income statement.

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On September 1, Bart Company sells 1,500 shares of Lisa Company stock for $54.50 per share, less a $160 commission.

Sale of Stock (Cost Method)

Proceeds from sale [(54.50 × 1,500 shares) – $160 $81,590Book value (cost) of the stock ($100,000/2,000 shares) × 1,500 75,000Gain on sale of investments $ 6,590

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If the investor purchases between 20% and 50% of the outstanding stock of the investee, the investor is considered to have significant influence over the investee and the investment is accounted for using the equity method.

Between 20% and 50% Ownership

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Simpson Inc. purchased a 40% interest in Flanders Corporation’s common stock on January 2, 2010, for $350,000.

Purchase of Stock (Equity Method)

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For the year ending on December 31, 2010, Flanders Corporation reported net income of $105,000.

Recording Investee Net Income (Equity Method)

Income of Flanders Corporation, if significant, is reported as Other Income on Simpson Inc.’s income statement.

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During the year, Flanders declared and paid cash dividends of $45,000.

Recording Investee Dividends (Equity Method)

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11-2115-21

On January 1, 2011, Simpson Inc. sold Flanders Corporation’s stock for $400,000 a gain of $26,000 calculated as follows:

Sale of Stock (Equity Method)

Proceeds from sale $400,000Book value of stock investment 374,000Gain on sale $ 26,000

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If the investor purchases more than 50% of the outstanding stock of the investee, the investor is considered to have control over the investee. The purchase is termed a business consolidation.

More Than 50% Ownership

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Describe and illustrate valuing and reporting investments in the financial statements.

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Maggie Company purchased a portfolio of trading securities during 2009. On December 31, 2009, the cost and fair values of the securities were as follows:

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Trading Securities

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The adjusting entry on December 31, 2009, to record the fair value of the securities is as follows:

The Unrealized Gain on Trading Investments, if significant, is reported on the income statement.

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On September 10, 2010, Maggie Company purchases 300 shares of Zane Inc. as a trading security for $12 per share, including a brokerage commission.

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On December 31, 2010, the cost and fair valuation of the portfolio of trading securities are as follows:

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Based on the above analysis, the adjusting entry on December 31, 2010, is as follows:

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The valuation allowance for trading investments account after the December 31, 2010, adjusting entry has a credit balance of $3,100.

Valuation Allowance for Trading Investments2009

Dec. 31 Adj. 1,300Dec. 31 Bal. 1,3002010

Jan. 1 Bal. 1,3002010

Dec. 31 Adj. 4,400Dec. 31 Bal. 3,100

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11-3115-31

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Held-to-maturity securities are debt investments, such as notes or bonds, that a company intends to hold until their maturity date.

Held-To-Maturity Securities

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Available-for-sale securities are debt and equity securities that are not classified as trading or held-for-maturity securities.

Available-For-Sale Securities

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Maggie Company purchased securities during 2009 as available-for-sale securities instead of trading securities. On December 31, 2009, the cost and fair values of the securities are as follows:

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The adjusting entry on December 31, 2009, to record the fair value of the securities is as follows:

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On September 10, 2010, Maggie Company purchases 300 shares of Zane Inc. as an available-for-sale security for $12 per share, including brokerage commission.

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On December 31, 2010, the cost and fair valuation of the portfolio of available-for-sale securities are as follows:

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Describe fair value accounting and its implications for the future.

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Fair Value Accounting

Fair value is the price that would be received for selling an asset or paying off a liability. Fair value assumes that the asset is sold or the liability paid off under normal rather than under distress conditions.

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Disadvantages of Fair Value Accounting

Several potential disadvantages include the following:1. Fair value may not be readily obtainable

for some assets or liabilities resulting in subjectivity.

(continued)

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2. Fair values make it more difficult to compare companies if companies use different methods of determining (measuring) fair values.

3. Using fair values will result in more fluctuations in accounting reports because fair values normally change from year to year.

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