Recording of Unrealized Gain or Loss on Financial Statements - DOC by lja61768

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									                                    APPENDIX D


   REPORTING AND ANALYZING INVESTMENTS


                                     Chapter Outline

Study Objective 1 - Identify the reasons corporations invest in stocks and debt securities.

               Corporations invest in debt or equity securities for one of three reasons:

                1.      They have excess cash that they do not need for immediate purposes.
                        Excess cash may result from seasonal fluctuations in sales or from
                        economic cycles. Excess cash is usually invested in low-risk, highly liquid
                        securities, most often short-term government securities.
                2.      Some companies generate a significant portion of their earnings from
                        investment income. Pension funds and mutual funds are corporations that
                        also regularly invest to generate earnings.
                3.      There may be strategic reasons, such as a corporation's desire to establish a
                        presence in another industry or to purchase a controlling interest in another
                        company.

Find a company in the SEC filings and look at the financial statements and accompanying
notes (http://www.sec.gov/edgar/searchedgar/webusers.htm) to determine the company’s
mix of debt and equity investments.

Study Objective 2 - Explain the accounting for debt investments.

               Debt investments are investments in government and corporation bonds. Three
                entries are associated with debt investments: (1) recording the acquisition, (2)
                recording the interest revenue, and (3) recording the sale.

               Acquisition costs include all expenditures necessary to acquire the investment,
                such as the price paid plus brokerage fees (commissions). If a company purchases
                bonds for $71,000 plus commissions of $2,000, then the journal entry is:

                Debt Investments                           73,000
                        Cash                                              73,000
                (To record purchase of bonds)
               Note that there is no separate account for fees or commissions: The purchase price
               and the commissions are debited to the asset account.

              When bond interest is received, the debit is to Cash and the credit is to Interest
               Revenue (an Other Revenues and Gains item on the income statement). If interest
               is accrued, then the entry is a debit to Interest Receivable and a credit to Interest
               Revenue.

              When bonds are sold, any difference between net proceeds (sales price less fees)
               and the cost of the bonds is recorded as a gain or loss. If bonds with a cost of
               $23,000 are sold for a net amount of $19,000, then the entry is as follows:

               Cash                                        19,000
               Loss on Sale of Debt Investments             4,000
                       Debt Investments                                  23,000
               (To record sale of bonds at a loss)

               The Loss account appears on the income statement as an Other Expenses and
               Losses item. A gain appears on the income statement as an Other Revenues and
               Gains item.

Study Objective 3 - Explain the accounting for stock investments.

              Stock investments are investments in the capital stock of corporations. An
               investment portfolio consists of securities (stock and/or debt) of several different
               corporations held by an investor company.

              Accounting for stock investments is based on the extent of the investor's
               influence over the operating and financial affairs of the issuing corporation (the
               investee). Guidelines are as follows:

               1.      If the investor holds less than 20% of the investee's common stock,
                       then there is a presumed insignificant influence on the investee, and the
                       cost method is used.
               2.      If the investor holds between 20% and 50% of the investee's common
                       stock, then there is a presumption of significant influence on the investee,
                       and the equity method is used.
               3.      If the investor holds more than 50% of the investee's common stock,
                       then the investor has a presumed controlling influence, and consolidated
                       financial statements are prepared.

              For holdings of less than 20%, the cost method is used. The investment is
               recorded at cost, and revenue is recognized only when cash dividends are received.
               As is true for debt investments, cost includes all expenditures necessary to acquire
               the investments, including the price paid plus brokerage fees (commissions). If a
               corporation acquires 3,000 shares of common stock at $20 per share plus
               $4,000 in commissions, then the journal entry is:
    Stock Investments                            64,000
            Cash                                                64,000
    (To record purchase of stock)

    Note that once again there is no separate account for fees or commissions: the
    purchase price and the commissions are debited to the asset account.

    If dividends of $1.50 per share are received, then the journal entry is:

    Cash                                          4,500
            Dividend Revenue                                     4,500
    (To record receipt of dividends)

    Dividend Revenue is an Other Revenues and Gains item in the income statement.

    If the shares of stock are sold for net proceeds of $70,000, then the journal entry
    is:

    Cash                                         70,000
            Stock Investments                                   64,000
            Gain on Sale of Stock
                Investments                                      6,000
    (To record sale of stock)

    A gain on sale appears on the income statement as an Other Revenues and Gains
    item. A loss on sale appears on the income statement as an Other Expenses and
    Losses item.

   For holdings between 20% and 50%, the equity method is used. The investment
    is recorded initially at cost and is adjusted annually to show the investor's equity in
    the investee. The investor debits the investment account and increases (credits)
    revenue for its share of the investee's net income. The investor debits Cash and
    credits the investment account for the amount of any dividends received. With this
    method, the investor is essentially purchasing an interest in the investee's
    Retained Earnings account. Anything which makes that account increase, such as
    net income, is reflected in the investor's investment account as an increase, and
    anything which makes that account decrease, such as net loss or payment of
    dividends, is reflected in the investor's investment account as a decrease.

    Ranger Corporation purchased 35% of the common stock of Sorter
    Corporation for $225,000. The journal entry is:

    Stock Investments                          225,000
            Cash                                              225,000
    (To record purchase of Sorter stock)

    For the year, Sorter reported $150,000 of net income and paid dividends of
    $30,000. The journal entries for Ranger are:
               Stock Investments                         52,500
                        Revenue from Investment
                            in Sorter Corporation                       52,500
               (To record 35% equity in Sorter's
                net income)

               Cash                                      10,500
                       Stock Investments                                10,500
               (To record dividends received)

               After these entries, the balance in Stock Investments totals $267,000:
               $225,000 + $52,500 – $10,500.

Study Objective 4 - Describe the purpose and usefulness of consolidated financial statements.

              A parent company is a company that owns more than 50% of the common stock
               of another entity. A subsidiary (affiliated) company is the entity whose stock is
               owned by the parent company. The parent company has a controlling interest in
               the subsidiary company.

              Consolidated financial statements are prepared, if a company owns more than
               50% of the common stock of another company. These statements present the assets
               and liabilities controlled by the parent company and the aggregate revenues and
               expenses of the subsidiary companies. They are presented in addition to the
               financial statements for each of the individual parent and subsidiary companies.

              Consolidated financial statements are especially useful to the stockholders, board
               of directors, and management of the parent company.

Look up a consolidated financial statement on the internet that is different from the
companies listed at the bottom of page D-7, such as NYSE:YUM. Identify the corporation’s
subsidiary companies.

Study Objective 5 - Indicate how debt and stock investments are valued and reported in the
              financial statements.

              Debt and stock investments (in which the holdings are less than 20%) are
               classified into three categories for purposes of valuation and reporting at a
               financial statement date:
               1.       Trading securities are bought and held primarily for sale in the near term
                        to generate income on short-term price differences.
               2.       Available-for-sale securities are those where the intent is to sell them
                        sometime in the future.
               3.       Held-to-maturity securities are debt securities that the investor has the
                        intent and ability to hold to maturity. Notice that this category includes
                        only debt securities because stocks do not have a maturity date.
   Trading securities are reported at fair value (called mark-to-market
    accounting), and changes from cost are reported as part of net income. Since the
    securities have not been sold, the changes are reported as unrealized gains or
    losses, calculated as the difference between the total cost of the securities and their
    total fair value. Trading securities are classified as a current asset.

    Consider the following example. A corporation owns three trading securities with
    a total cost of $89,000. On the financial statements date, their total fair market
    value is $97,000. The journal entry to record this unrealized gain is:

    Market Adjustment—Trading                     8,000
             Unrealized Gain—Income                              8,000
    (To record unrealized gain on trading
     securities)

    The use of the Market Adjustment—Trading account enables the company to
    maintain a record of the investment cost. Since this account in this situation has a
    debit balance, it will be added to the investments account on the balance sheet to
    give the fair value of the investments. Note that is it the fair value of the
    investments that is reported on the balance sheet. The Unrealized Gain—Income
    account is reported on the income statement under Other Revenues and Gains.

    If instead the investments had had a fair value of $88,000, then the journal entry
    would have been a debit to Unrealized Loss—Income and a credit to Market
    Adjustment—Trading for $1,000. The Unrealized Loss—Income account is
    reported on the income statement under Other Expenses and Losses. Since Market
    Adjustment—Trading would have had a credit balance in this instance, it is
    subtracted from the investments account on the balance sheet to give the fair value
    of the investments.

    Both unrealized gain and loss accounts are closed at the end of the accounting
    period. The market adjustment account is carried forward into future periods and
    adjusted accordingly.

   Available-for-sale securities are reported at fair value with changes reported in
    the stockholders' equity section of the balance sheet. If the intent is to sell the
    securities within the next year or operating cycle, then they are classified as current
    assets. Otherwise, they are classified as long-term assets in the investments section
    of the balance sheet.

    Consider the following example. A corporation owns three securities, considered
    to be available-for-sale, with a total cost of $89,000. On the financial statements
    date, their total fair market value is $97,000. The journal entry to record this
    unrealized gain is:

    Market Adjustment—Available-For-Sale              8,000
            Unrealized Gain or Loss—Equity                       8,000
    (To record unrealized gain on available-
               for-sale securities)

               The Market Adjustment account is added to the investments account to give the
               fair value of the investments. The Unrealized Gain or Loss—Equity account is
               added to stockholders' equity on the balance sheet, not to income on the income
               statement as is the case with trading securities.

               If instead the investments had had a fair value of $88,000, then the journal entry
               would have been a debit to Unrealized Gain or Loss—Equity and a credit to
               Market Adjustment—Available-For-Sale for $1,000. The resulting unrealized loss
               would be reported on the balance sheet as a contra equity account, meaning that it
               is subtracted from stockholders' equity. At that point, since Market Adjustment—
               Available-For-Sale has a credit balance, it is subtracted from the investments
               account on the balance sheet to give the fair value of the investments.

               The Unrealized Gain or Loss account is carried forward to future periods, not
               closed, and is adjusted with the market adjustment account to show the difference
               between cost and fair value at the financial statements date.

Study Objective 6 - Distinguish between short-term and long-term investments.

              For balance sheet presentation, investments must be classified as either short-term
               or long-term.

              Short-term investments are those that are readily marketable (can be sold easily
               whenever the need for cash arises) and intended to be converted into cash within
               the next year or operating cycle, whichever is longer. Short-term investments are
               listed immediately below Cash in the current assets section of the balance
               sheet because of their high liquidity (nearness to cash). They are reported at fair
               value.

              Long-term investments are reported in a separate section of the balance sheet
               immediately below current assets. Long-term investments in available-for-sale
               securities are reported at fair value, and investments in common stock accounted
               for under the equity method are reported at equity.

              In the income statement, gains and losses, both realized and unrealized, as well as
               interest and dividend revenue, are reported in the nonoperating section. On the
               balance sheet, an unrealized gain or loss on available-for-sale securities is reported
               as a separate component of stockholders' equity. The latter presentation serves
               two purposes: it reduces the volatility of net income due to fluctuations in fair
               value, and it informs the financial statement user of the gain or loss that would
               occur if the securities were sold at fair value. Unrealized gains and losses on
               available-for-sale securities must be reported in comprehensive income.

              On the statement of cash flows, information on the cash inflows and outflows
               resulting from investment transactions is reported in the ―Investing activities‖
               section.

								
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