Chapter 12 Investments 1 Why Corporations Invest a Corporations may have extra cash that it does not need for immediate purchase of operating assets Company will get a greater return by investing money than by holding it in the bank i Invest in low risk highly liquid securities short term government securities b To generate earnings from investment income c For strategic reasons A company can exercise some influence over a customer or supplier by purchasing a significant but not controlling interest in that company i Or purchase a controlling amount in a company in order to enter a new industry without incurring the costs and risks associated with starting from scratch 2 Debt Investments Investments in government and corporation bonds Record 1 the acquisition 2 the interest revenue and 3 the sale a At acquisition the cost principle applies Costs include all expenditures necessary to acquire these investments such as price and brokerage fees i Kuhl Corporation acquires 50 Doan Inc 8 10 year 1 000 bonds on January 1 2011 for 54 000 including brokerage fees of 1 000 1 Debt Investments 54 000 54 000 ii The Doan Inc bonds pay interest of 2 000 semiannually on July 1 and January 1 Cash 1 Cash 2 000 50 000 x 8 x Interest Revenue 2 000 iii Kuhl s fiscal year ends on December 31 it accrues the 2 000 interest earned since July 1 1 Interest Receivable 2 000 Interest Revenue 2 000 iv On January 1st the company reports the receipt of interest 1 Cash 2 000 a Interest Receievable 2 000 b When Kuhl sells the bonds it credits the investment account for the cost of the bonds i Kuhl Corporation receives net proceeds of 58 000 on the sale of the Doan Inc bonds on January 1 2012 after receiving the interest due The securities cost 54 000 so the company realizes a 4 000 gain 1 Cash 58 000 Debt Investments Gain of Sale 54 000 4 000 3 Stock Investments Investments in the capital stock of other corporations a Investment Portfolio When a company holds stock and or debt of several different corporations b Holdings of Less Than 20 Use the cost method by recording the investment at cost and recognizing revenue only when cash dividends are received i On July 1 2011 Sanchez Corporation acquires 1 000 shares 10 ownership of Beal Corporation common stock Sanchez pays 40 per share plus brokerage fees of 500 1 Stock Investments Cash 40 500 40 5000 2 Sanchez receives 2 per share dividend on December 31 a Cash 2 000 Dividend Revenue 2 000 c When a company sells a stock investment it recognizes as a gain or a loss the difference between the net proceeds from the sale sales price brokerage fees i Assume that Sanchez Corporation receives net proceeds of 39 500 on the sale of its Beal stock on February 10 2012 Because the net stock cost 40 500 Incurred a loss of 1 000 1 Cash 39 500 Loss 1 000 Stock Investments 40 500 d Holdings Between 20 and 50 The investor has significant influence over the financial and operating activities of the investee and uses the EQUITY method or records the share of the net income of the investee in the year when it is earned i Investor initially records the investment in common stock at cost Then it annually adjusts the investment account to show the investor s equity in the investee 1 Debits the investment account credits revenue for its share of net income 2 Credits the investment account for the amount of dividends received 3 Miller Corporation acquires 30 of the common stock of Beck Company for 120 000 on January 1 2011 a Stock Investments Cash 120 000 120 000 4 Beck reports net income of 100 000 It declares and pays a 40 000 cash dividend Records its share of Becks income 30 000 30 x 100 000 and the reduction in the investment account for the dividends received 12 000 40 000 x 30 a Stock Investments 30 000 Revenue from Investment 30 000 b Cash 12 000 Stock Investments 12 000 e Holdings of More than 50 i A company that owns more than 50 of the common stock of another entity is known as the parent company has a controlling interest prepares consolidated financial statements 1 These statements indicate the magnitude and scope of operations of the companies under common control ii The entity whose stock the parent company owns is called the subsidiary company 4 Valuing and Reporting Investments a Valuation should be at cost at fair value or at the lower of cost or market value i Fair value offers the best approach because it represents the expected cash realizable value of securities b Categories of Securities ii Fair Value The amount for which a security could be sold in a normal market i Trading Securities Bought and held primarily for sale in the near term to generate income on short term price differences At fair value with changes reported in net income 1 Changes are reported as unrealized gains or losses because the securities have not yet been sold a Difference between total cost of trading securities and their total fair value cost fair value loss b Market Adjustment Trading Unrealized Gain Income x x ii Available for Sale Securities Held with the intent of selling them sometime in the near future At fair value with changes reported in the stockholders equity section 1 Procedure for determining fair value and the unrealized gain or loss for these securities is the same as for trading securities a BUT gains or losses are reported as a separate component of stockholder s equity b Unrealized Loss Equity x Market Adjustment Available for Sale iii Held To Maturity Securities Debt securities that the investor has the intent and ability x to hold to maturity At amortized cost 5 Balance Sheet Presentation Investments are either short term or long term a Short Term Investments Marketable Securities Securities held by a company that is readily marketable and intended to be converted into cash within the next year or operating cycle whichever is longer i Readily Marketable It can be sold easily whenever the need for cash arises ii Intended to Convert Management intends to sell the investment within the next year or operating cycle whichever is longer 1 Usually satisfied when the investment is considered a resource that the investor will use whenever the need for cash arises b Long Term Investments Those that do not meet either of the above criteria available for sale securities that are reported at fair value c Presentation of Realized and Unrealized Gains or Losses i In income statement companies report gains and losses in the non operating activities ii Unrealized gain or loss on available
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