Appendix D
Investments in Other Investments in Other CorporationsCorporations
© 2009 The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin Slide 2
Why Do Companies Invest?
1. Companies transfer excess cash into investments to produce higher income. Some companies are set up to produce income from investments.
2. Companies us investments to even out seasonal fluctuations in cash. Such investments in securities are referred to as passive investment.
3. Some companies invest with the purpose of influencing, but not controlling the company’s policies and activities.
4. Managers may want to control another company, either by purchasing it directly or by becoming a majority shareholder.
1. Companies transfer excess cash into investments to produce higher income. Some companies are set up to produce income from investments.
2. Companies us investments to even out seasonal fluctuations in cash. Such investments in securities are referred to as passive investment.
3. Some companies invest with the purpose of influencing, but not controlling the company’s policies and activities.
4. Managers may want to control another company, either by purchasing it directly or by becoming a majority shareholder.
Passive investments are made to earn a high rate of return on funds that may be needed in the future. This
category includes debt securities (bonds and notes) and equity securities (stock).
Passive Equity InvestmentsPresumed to be passive if the investing company owns less
than 20% of the other company’s outstanding voting
shares.
Passive Debt InvestmentsInvestments in debt securities are always considered to be
passive.
Reporting Using Market Value Method
Reporting Using Market Value Method
Hold to Maturity?Hold to
Maturity?
Reporting at Amortized CostReporting at Amortized Cost
Yes
No
Passive Investments in Debt and Equity Securities
McGraw-Hill/Irwin Slide 4
Active investments are those in which a company owns enough stock in another business to influence or control that business. Significant influence is presumed to exist
if the investing company owns from 20 to 50% of the outstanding voting shares.
The equity method is used to measure and
report this type of active investment.
The equity method is used to measure and
report this type of active investment.
Investments in Stock for Significant Influence
McGraw-Hill/Irwin Slide 5
Investments in Stock for Control
Control is the ability to determine the operating and financial policies of another company through ownership of its voting stock. For all practical purposes, control is presumed when the investing company owns more that
50% of the outstanding voting stock.
These investments are accounted for by combining the two companies using the
consolidated statement method.
These investments are accounted for by combining the two companies using the
consolidated statement method.
McGraw-Hill/Irwin Slide 6
Debt Investments Held to Maturity: Amortized Cost Method
Assume that on October 1, 2010, Washington Post paid the par value of $100,000,000 for 8% bonds due to mature on October 1, 2015. The 8% interest is paid each September 30th. Management plans to hold the bonds for five years,
until they mature.
Debit CreditInvestments Held-to-Maturity (+A) 100,000,000 Cash (-A) 100,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYCash -100,000,000 Investments – Held-to-Maturity (-A) +100,000,000
McGraw-Hill/Irwin Slide 7
Debt Investments Held to Maturity: Amortized Cost Method
On December 31, 2010, Washington Post will prepare an adjusting entry to accrue interest for three months
($100,000,000 × 8% × 3/12).
Debit CreditInterest Receivable (+A) 2,000,000 Interest Revenue (+R, +OE) 2,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYInterest Receivable +2,000,000 Interest Revenue +2,000,000
McGraw-Hill/Irwin Slide 8
Debt Investments Held to Maturity: Amortized Cost Method
On September 30, 2011, Washington Post will receive a full year of interest. Revenue recognized in 2011 is
($100,000,000 × 8% × 9/12).
Debit CreditCash (+A) 8,000,000 Interest Revenue (+R, +OE) 6,000,000 Interest Receivable (-A) 2,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYCash +8,000,000 Interest Revenue +6,000,000Interest Receivable -2,000,000
McGraw-Hill/Irwin Slide 9
Debt Investments Held to Maturity: Amortized Cost Method
On October 1, 2015, Washington Post will receive the principal amount of the investment as the bonds mature.
Debit CreditCash (+A) 100,000,000 Investment Held-to-Maturity (-A) 100,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYCash +100,000,000 Investment Held-to-Maturity -100,000,000
If the bond investment were sold before maturity, any difference between market value and book value would be reported as a gain or loss on sale.If the bond investment were sold before maturity, any difference between market value and book value would be reported as a gain or loss on sale.
McGraw-Hill/Irwin Slide 10
Securities Available for Sale: Market Value Method
Classified Passive InvestmentsClassified Passive Investments
Trading SecuritiesTrading securities are traded actively, with the objective of generating short-term profits on changes in the securities price. They are classified as
current assets on the balance sheet.
Trading SecuritiesTrading securities are traded actively, with the objective of generating short-term profits on changes in the securities price. They are classified as
current assets on the balance sheet.
Securities Available for SaleMost companies do not
actively trade the securities of other companies. They invest to earn a return on funds they may need in the near future.
These securities may be classified as either current
assets or noncurrent assets depending on the intent of management to sell them
within one year.
Securities Available for SaleMost companies do not
actively trade the securities of other companies. They invest to earn a return on funds they may need in the near future.
These securities may be classified as either current
assets or noncurrent assets depending on the intent of management to sell them
within one year.
McGraw-Hill/Irwin Slide 11
Recording and ReportingSecurities Available for Sale
On January 2, 2010, Washington Post purchased 1,000,000 shares of Internet Financial News (IFN)
common stock for $60 per share. The 1,000,000 shares represents 10% of the outstanding shares. These
securities are classified by management as available for sale and are considered a passive investment.
Debit CreditSecurities Available for Sale (+A) 60,000,000 Cash (-A) 60,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYCash -60,000,000 Securities Available for Sale +60,000,000
McGraw-Hill/Irwin Slide 12
Recording and ReportingSecurities Available for Sale
Investments in equity securities earn a return fro two sources: (1) increase in the market price and (2)
dividend income. On December 15, 2010, Washington Post received a $1 per share cash dividend from IFN.
Debit Credit
Cash (+A) 1,000,000 shares × $1 per share 1,000,000 Investment Income (+R, +OE) 1,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY
Cash +1,000,000 Investment Income +1,000,000
McGraw-Hill/Irwin Slide 13
Recording and ReportingSecurities Available for Sale
At the end of the accounting period, passive investments are reported on the balance sheet at their market value.
On December 31, 2010, IFN stock was trading at $58 per share in the open market.
Debit CreditUnrealized Gain (Loss) on Investment (-OE) 2,000,000 Market Value Allowance (-A) 2,000,000
McGraw-Hill/Irwin Slide 14
Recording and ReportingSecurities Available for Sale
Market Value Allowance12/31/09 0
AJE 2,000,00012/31/10 2,000,000
McGraw-Hill/Irwin Slide 15
Recording and ReportingSecurities Available for Sale
Now let’s assume that Washington Post held the IFN securities through the year 2011. At the end of 2011, the stock had a market value of $61 per share. On December
31, 2011, we must make an adjusting entry to state the investment at market value.
Debit CreditMarket Value Allowance (+A) 3,000,000 Unrealized Gain (Loss) on Investment (+OE) 3,000,000
December 31, 2011 Shares Per Share TotalMarket value 1,000,000 $ 61 $ 61,000,000 Cost 1,000,000 $ 60 60,000,000 Balance Needed in Allowance $ 1,000,000 Current Balance in Allowance (2,000,000)Amount of Adjusting Entry $ 3,000,000
McGraw-Hill/Irwin Slide 16
Washington PostPartial Balance SheetDecember 31, 2011
Assets Investment in marketable securities $ 60,000,000 Market value allowance 1,000,000 Net investment $ 61,000,000 Stockholders' Equity Other comprehensive income Unrealized gain on investments $ 1,000,000
Recording and ReportingSecurities Available for Sale
Market Value Allowance12/31/09 0
AJE 2,000,00012/31/10 2,000,000
AJE 3,000,00012/31/11 1,000,000
McGraw-Hill/Irwin Slide 17
Recording and ReportingSecurities Available for Sale
Now let’s assume that on March 17, 2012,Washington Post sold all of its investment in IFN for $64 per share.
Debit CreditCash (+A) 64,000,000 Securities Available for Sale (-A) 60,000,000 Gain on Sale of Investment (+R, +OE) 4,000,000
McGraw-Hill/Irwin Slide 18
Comparing Available-For-Sale and Trading Securities
The impact of unrealized holding gains or losses on the financial statements depends on whether an investment is a
trading security or a security available for sale.
The impact of unrealized holding gains or losses on the financial statements depends on whether an investment is a
trading security or a security available for sale.
Available-for-Sale SecuritiesThe unrealized gain (loss) account is reported as a separate component of
stockholders’ equity, under Other Comprehensive Income. It
is not reported on the income statement.
Available-for-Sale SecuritiesThe unrealized gain (loss) account is reported as a separate component of
stockholders’ equity, under Other Comprehensive Income. It
is not reported on the income statement.
Trading SecuritiesThe unrealized gain (loss) is
included in each period’s income statement. Holding gains
increase income and holding losses decrease net income. The unrealized gain (loss) account is
closed to retained earnings at the end of the period.
Trading SecuritiesThe unrealized gain (loss) is
included in each period’s income statement. Holding gains
increase income and holding losses decrease net income. The unrealized gain (loss) account is
closed to retained earnings at the end of the period.
McGraw-Hill/Irwin Slide 19
{
In some cases, influence or control may exist with less than 20% ownership.
In some cases, influence or control may exist with less than 20% ownership.
Investor Ownership of Investee Shares
Outstanding
0% 20% 50% 100%
Cost or Market Value
MethodEquity Method
Consolidated Financial Statements
Accounting for Influential Investments
McGraw-Hill/Irwin Slide 20
{Significant influence is generally assumed with
20% to 50% ownership.
Investor Ownership of Investee Shares
Outstanding
0% 20% 50% 100%
Equity Method
Consolidated Financial Statements
Accounting for Influential Investments
Cost or Market Value
Method
McGraw-Hill/Irwin Slide 21
Recording Investments Under the Equity Method
Original investment is recorded at cost.The investment account is increased by a
proportionate share of investee’s net income, or decreased by proportionate share of investee’s net loss.
The investment account is decreased by dividends declared for the period.
Original investment is recorded at cost.The investment account is increased by a
proportionate share of investee’s net income, or decreased by proportionate share of investee’s net loss.
The investment account is decreased by dividends declared for the period.
McGraw-Hill/Irwin Slide 22
Recording Investments Under the Equity Method
In 2010, Washington Post purchased 4,000,000 shares of the outstanding voting stock of Internet
Financial News (IFN) for $60 per share. Washington Post purchased 40% of the voting stock of IFN and was presumed to have significant influence over the
investee.
Debit CreditInvestment in Affiliates (+A) 240,000,000 Cash (-A) 240,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYCash -240,000,000 Investment in Affiliates +240,000,000
McGraw-Hill/Irwin Slide 23
Recording Investments Under the Equity Method
During 2010, IFN reported net income of $50,000,000. Washington Post’s share of net
income is $20,000,000 (40% × $50,000,000). The journal entry is:
Debit CreditInvestment in Affiliates (+A) 20,000,000 Equity in Investee Earnings (+R, +OE) 20,000,000
ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYInvestment in Affiliates +20,000,000 Equity in Earnings +20,000,000
McGraw-Hill/Irwin Slide 24
Investments with Controlling Interests: Consolidated Statements
Required when investor’s ownership exceeds 50% of investee.
1. Vertical integration. One company acquires another company that operates on a different level in the distribution channel.
2. Horizontal growth. Companies operate on the same level of the distribution channel.
3. Synergy. Two companies operating together may be more profitable than two companies operating separately.
McGraw-Hill/Irwin Slide 25
What are Consolidated Statements?When one company purchases all the assets and liabilities of another
company and the acquired company goes out of existence, the acquisition is called a merger. When the acquired company remains
in business, the company that gains control over it by acquiring all or a majority of the voting stock is called the parent company. The other
company is called a subsidiary company. When one company acquires another, results of their operations must be reported together, in consolidated statements. Consolidated financial
statements combine the operations of two or more companies into a single set of statements usually identified by the term “consolidated” in
the statement title.
When one company purchases all the assets and liabilities of another company and the acquired company goes out of existence, the
acquisition is called a merger. When the acquired company remains in business, the company that gains control over it by acquiring all or a majority of the voting stock is called the parent company. The other
company is called a subsidiary company. When one company acquires another, results of their operations must be reported together, in consolidated statements. Consolidated financial
statements combine the operations of two or more companies into a single set of statements usually identified by the term “consolidated” in
the statement title.