REPORTING AND ANALYZING INVESTMENTS
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
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
(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
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:
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
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
(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:
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
Stock Investments 64,000
Gain on Sale of Stock
(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
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
(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
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
Study Objective 5 - Indicate how debt and stock investments are valued and reported in the
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
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
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-
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
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
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‖