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Investments in Equity and Debt Securities

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					Lesson 11
An investment in equity securities refers to an investment in or the purchase of a company's common or preferred stock. Stocks are called equity securities because they provide holders with ownership rights or equity interests in a company. When stocks are purchased, returns on investment come in the form of dividends and any gains on the subsequent sale of the stock. An investment in debt securities refers to an investment in or the purchase of corporate or government issued bonds. They're referred to as debt securities because upon issuance a liability, or debt, is recorded on the books of the issuing company or governmental entity. When bonds are purchased, the investor becomes an owner of debt, or, in effect, a lender with rights to receive future payments of principal and interest.

Lesson 11
Investments in Equity and Debt Securities

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In some cases, companies invest in the securities of other companies to simply make better use of excess cash, or cash that's temporarily available due to seasonal operations. For example, a company manufacturing sporting goods sold primarily in the summer months will probably experience an annual cash flow cycle that looks something like this: Excess cash available
for short-term investment.

Some companies invest in the stocks and bonds of other companies, because that's the essence of their business. Investment companies and mutual funds exist solely to make investments in debt and equity securities of other companies. Mutual funds take in cash obtained from investors upon issuance of their own stock and then invest those funds in the stocks and/or bonds of other companies. Investors in mutual funds benefit when the value of the stocks and bonds held by the fund increase in value, or dividends and interest are earned. Some companies also invest in the stock of other companies for strategic reasons. If enough shares are purchased a company can obtain significant influence or even outright control over another company's operations. That's why some company's wishing to enter into new industries, or seeking to secure necessary supplies or outlets for distribution, will often acquire large percentages of the outstanding shares of other companies.

Mar.

June

Sept.

Dec.

Mar.

Short-term financing required to cover cash shortfalls.

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Accounting for Investments in Equity Securities
Under current accounting standards, companies may use different methods of accounting for investments in equity securities depending on the intent behind the investment. That intent's reflected in the following classifications used to determine an investment's appropriate accounting method: Trading Securities: Includes all shares of stock purchased as part of an active trading program. That means these shares are frequently bought and sold based on short-term price fluctuations. Companies investing in trading securities are, in effect, playing the market in an attempt to maximize investment returns. Available-for-Sale Securities: Includes all shares of stock held with the intent to sell if future cash needs arise. No effort is made to take advantage of temporary price fluctuations. The strategy here is to buy and hold for a more extended period of time. (This classification specifically excludes any shares that may provide a company with significant influence or control over another company.)

Accounting for Investments in Equity Securities
Under current accounting standards, companies may use different methods of accounting for investments in equity securities depending on the intent behind the investment. That intent's reflected in the following classifications used to determine an investment's appropriate accounting method: Securities that provide a company with significant influence over another company's operations: Significant influence is generally assumed when 20-50% of the outstanding common stock of another company is owned. However, other criteria may also be considered when making this determination. (These securities are also sometimes called "equity method securities" because they're accounted for using an equity method of accounting.) Securities that provide a company with a controlling interest over another company: This usually requires ownership of at least 51% of a company's outstanding common stock, although effective control can sometimes be achieved with a lower percentage.

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11-1

Investment in Trading Securities
Example: On November 15th, 20X7, Crown Investments purchased 1,000 shares of IBM common stock at a price of $20 a share, plus brokerage fees of $400. The shares are classified by Crown as trading securities given plans to sell the stock as soon as the price increases and shares can be sold at a profit. Journal entry to record purchase:
Investment in Trading Securities Cash 20,400 20,400

In most cases, companies invest in a portfolio of stocks.
General Ledger
Investment in Trading Securities
12/31/X6 0 xxx xxx 12/31/X7 122,000 xxx xxx

Subsidiary Ledger
Investment in Trading Securities
IBM
12/31/X6 11/15/X7 12/31/X7 0 20,400 20,400 12/31/X6 6/12/X7 12/31/X7

ATT
0 35,200 35,200

All costs incurred in the purchase of an asset are included as part of the asset's historical cost.

Intel
12/31/X6 5/11/X6 12/31/X7 0 40,800 40,800 12/31/X6 2/26/X7 12/31/X7

Microsoft
0 25,600 25,600

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Adjust Crown's investment in trading securities to its fair market value given the following market values on 12/31/X7
At 12/31/X7:
IBM FMV $21,000 Historical cost $20,400 Increase (decrease) $ 600 ATT $40,500 $35,200 $ 5,300 Intel $35,300 $40,800 ($5,500) MSoft $31,200 $25,600 $ 5,600 Total $128,000 $122,000 $ 6,000

For financial reporting purposes, any increase or decrease in the fair market value of a company's investment in trading securities is to be reported in the company's financial statements.

12/31/X7 adjusting entry to record the effect of this net increase in value:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities 6,000 6,000

Because these securities remain unsold at the end of the year, the increased value is "unrealized," but it is recognized (recorded) and included on the company's income statement under the category of other revenues and expenses.
Crown Investments Balance Sheet 12/31/X7

Current Assets: Investments in trading securities Add: Market adjustment

$122,000 $ 6,000 $128,000

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Assume for just a moment that the fair market value of the investment had actually declined to $120,000 from its $122,000 historical cost. 12/31/X7 adjusting entry:
Unrealized Loss - Trading Securities Market Adjustment - Trading Securities
Crown Investments Balance Sheet 12/31/X7

Why use this Market Adjustment account? Why not just debit and credit the Investment in Trading Securities account directly when adjusting it for changing values? This approach allows the investment general ledger control account and its related subsidiary ledger accounts to be maintained at historical costs, and having those costs readily available can facilitate our subsequent accounting when the stock is actually sold and also helps in the preparation of a company's income tax return. For income taxes, no gains or losses are recorded until securities are sold, and the amount of the gain or loss is then based on the difference between the selling price and the stock's original cost. Having the investment account serve as a record of that original cost can be beneficial.

2,000 2,000

Current Assets: Investments in trading securities Less: Market adjustment

$122,000 (2,000) $120,000

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On 1/20/X8, Crown sells its IBM shares at a price of $23 a share less a $500 brokerage commission. Journal entry:
Cash ($23,000 - $500) Investments in Trading Securities Realized Gain on Sale of Trading Securities 22,500 20,400 2,100

Assume that no other trading securities are bought or sold during the current year 20X8 except for the IBM shares we've just accounted for. Also assume that the market value of Crown's remaining trading securities based on exchange prices at 12/31/X8 are as follows:
ATT FMV at 12/31/X7 $40,500 FMV at 12/31/X8 $34,500 Unrealized gain (loss) ($ 6,000) Intel MSoft $35,300 $31,200 $41,500 $28,000 $ 6,200 ($ 3,200) Total $107,000 $104,000 ($ 3,000)

At 12/31/X7:

IBM FMV $21,000 Historical cost $20,400 Increase (decrease) $ 600

ATT $40,500 $35,200 $ 5,300

Intel $35,300 $40,800 ($5,500)

MSoft $31,200 $25,600 $ 5,600

Total $128,000 $122,000 $ 6,000

12/31/X8 Adjusting entry:
Unrealized Loss - Trading Securities Market Adjustment - Trading Securities 3,600* 3,600

* Include the correction of the $600 of over-recorded gain.

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There's an even easier way to come up with this same adjustment…. that's done by taking the balances in the company's investment and market adjustment accounts before any adjusting entry, and then making the adjustment that's necessary to properly state those accounts in the company's balance sheet.
Investment in Trading Securities
12/31/X7 12/31/X8 122,000 20,400 Sold IBM shares 101,600

Summary of balance sheet approach to adjustment: 1. Identify the ending balances in the investment in trading securities and market adjustment accounts before the year-end adjustment. 2. Determine the appropriate ending balance for the market adjustment account (the amount of the difference between the market value and historical cost of the company's investment in trading securities at the end of the year).

Market Adjustment - Trading Securities
12/31/X7 12/31/X8 6,000 3,600 Adjusting entry 2,400

FMV at 12/31/X8 Historical cost Differences

ATT $34,500 $35,200 $ 5,300

Intel $41,500 $40,800 ($5,500)

MSoft $28,000 $25,600 $ 5,600

Total $104,000 $101,600 $ 2,400

3. An entry is then made to adjust the market adjustment account to that balance with any increase or decrease recorded as an unrealized gain or loss, respectively.

12/31/X8 Adjusting entry:
Unrealized Loss - Trading Securities Market Adjustment - Trading Securities 3,600 3,600

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Problem #11-1

Classifications of Investments in Equity Securities On occasion, a company making an investment in trading securities will receive dividends on their investment. When that happens: Journal entry:
Cash Dividend Revenues XXX XXX

Note the four possible securities classifications requiring different methods of accounting for an investment in the stock of another company and describe the criteria for classification.

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11-3

Problem 11-1 - Answer

Problem #11-2

Classifications of Investments in Equity Securities
1. Trading Securities: Stock purchased with the intent to make a return on investment in the short-term. 2. Available-for-Sale Securities: Stock purchased and held with the intent to sell if and when future cash needs arise. Although investors in availablefor-sale securities hope for increasing stock values over time, the timing of sale is based on cash needs rather than on short-term market fluctuations in price. (This classification excludes shares that provide a company with significant influence or control over the affairs of another company.) 3. Securities that provide significant influence in another company's operations (Equity Method Securities): Stock purchased and held with the intent to significantly influence the operations of the company invested in. Unless there is evidence to the contrary, ownership of at least 20% and not more than 50% of a company's outstanding common stock represents the ability to significantly influence a company. 4. Securities that provide a controlling interest over another company: Stock purchased and held to exercise effective control over another company (usually more than 50% ownership).

Investment in Trading Securities
Prepare journal entries to record the following investment transactions entered into by the Clark Company:
20X5: 2/15 Purchased 1,000 shares of General Motors ("GM") stock at a price of
$60 a share, plus a 1% brokerage commission. Clark has no significant influence over GM affairs and classifies the stock as trading securities. 8/10 Sold 200 GM shares for $70 a share, less a $100 brokerage fee. 9/30 Received a $400 cash dividend on the GM stock. 12/31 GM shares are trading on the NYSE at $55 a share. (Clark has no investment in trading securities other than the GM shares.)

20X6: 3/11 Sold 200 GM shares for $58 a share, less a $100 brokerage fee.
9/30 Received a $200 cash dividend on the GM stock. 12/31 GM shares are selling on the NYSE at $75 a share. (Clark has no investment in trading securities other than the GM shares.)

Prepare: 1. Clark's balance sheet presentation of the investment in trading securities at 12/31/X6 2. Clark's income statement presentation of all revenues and expenses associated with the investment in trading securities for the year ended 12/31/X6

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Problem 11-2 - Answer

Problem 11-2 - Answer

Investment in Trading Securities
20X5 Entries: 2/15 Purchased 1,000 shares of General Motors ("GM") stock at a price of $60 a share, plus a 1% brokerage commission.
Investment in Trading Securities Cash ($60,000 + $600) 60,600 60,600

12/31 GM shares are trading on the NYSE at $55 a share. (Clark has no investment in trading securities other than the GM shares.)
Unrealized Loss - Trading Securities Market Adjustment - Trading Securities 4,480 4,480

FMV at 12/31/X5 (800 shares x $55) $44,000 Historical cost (800 shares x $60.60) $48,480 ($4,480) Decrease in value

8/10 Sold 200 GM shares for $70 a share, less a $100 brokerage fee.
Cash ($14,000 - $100) Investment in Trading Securities Realized Gain on Sale of Trading Securities
* $60,600 1,000 shares = $60.60 cost per share $60.60/share x 200 shares = $12,120

20X5 Entries: 3/11 Sold 200 GM shares for $58 a share, less a $100 brokerage fee.
Cash ($11,600 - $100) Realized Loss on Sale of Trading Securities Investment in Trading Securities
* $60.60/share x 200 shares = $12,120

13,900 12,120* 1,780

11,500 620

12,120*

9/30 Received a $400 cash dividend on the GM stock.
Cash Dividend Revenues 400 400

9/30 Received a $200 cash dividend on the GM stock.
Cash Dividend Revenues 200 200

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Problem 11-2 - Answer

Problem 11-2 - Answer Clark Company Balance Sheet 12/31/X6

12/31 GM shares are trading on the NYSE at $75 a share. (Clark has no investment in trading securities other than the GM shares.)
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities
FMV at 12/31/X6 (600 shares x $75) Historical cost (600 shares x $60.60) Market adjustment

13,120 13,120
$45,000 $36,360 $ 8,640

Current Assets: Investments in trading securities Add: Market adjustment
or

$ 36,360 $ 8,640 $ 45,000

Current Assets: Investment in trading securities, at market $ 45,000 Investment in Trading Securities

Market Adjustment - Trading Securities
4,480 4,480 Adjusting entry 13,120 12/31/X6 8,640 Adjusting entry 12/31/X5

2/15/X5 12/31/X5 12/31/X6

60,600 12,120 48,480 12,120 36,360 3/11/X6 8/10/X5

Market Adjustment - Trading Securities
4,480 Adjusting entry 4,480 Adjusting entry 13,120 12/31/X6 8,640 12/31/X5

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Problem 11-2 - Answer Clark Company Income Statement for the year ended 12/31/X6

Problem #11-3

Investment in Trading Securities Given the following balances for Cross, Inc at 12/31/X3:
DR $ 200 (620) 13,120 $ 12,700 CR

Other revenues and expenses: Dividend revenues Realized loss on sale of trading securities Unrealized gain - trading securities

Investment in trading securities Market adjustment - trading securities

$ 84,000 $ 4,000

Prepare the year-end adjustments to record any unrealized gains or losses on trading securities at 12/31/X4 and 'X5 given the following information:
Securities held at 12/31/X4
Historical cost FMV at 12/31/X4 A $20,000 $22,000 B $30,000 $26,000 C $25,000 $25,000 Total $75,000 $73,000

Securities held at 12/31/X5
Historical cost FMV at 12/31/X5 A $20,000 $27,000 C $25,000 $26,000 D $10,000 $17,000 Total $55,000 $70,000

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Problem 11-3 - Answer

Problem 11-3 - Answer

Investment in Trading Securities
Adjustment at 12/31/X4:
Unrealized Loss - Trading Securities Market Adjustment - Trading Securities 6,000 6,000

Investment in Trading Securities
Adjustment at 12/31/X5:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities 17,000 17,000

Market Adjustment - Trading Securities
12/31/X3 4,000 6,000 Adjusting entry 2,000 12/31/X4

Market Adjustment - Trading Securities
12/31/X3 4,000 6,000 Adjusting entry 2,000 Adjusting entry 17,000 12/31/X5 15,000 12/31/X4

Securities held at 12/31/X4
Historical cost FMV at 12/31/X4 A $20,000 $22,000 B $30,000 $26,000 C $25,000 $25,000 Total $75,000 $73,000 ($2,000)

Securities held at 12/31/X5
Historical cost FMV at 12/31/X5 A $20,000 $27,000 C $25,000 $26,000 D $10,000 $17,000 Total $55,000 $70,000 $15,000

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Investment in Available-for-Sale Securities
(Equity securities included in this category are stocks bought and held with the intent to sell when future cash needs arise.)
The accounting for an investment in available-for-sale securities is almost exactly the same as it is for an investment in trading securities. In fact, the only distinction is in the disclosure of unrealized gains or losses on changing stock values over time.
Available-for-sale securities are recorded as an investment at the purchase price paid plus any additional incidental costs of acquisition including brokerage or other fees. Any realized gains and losses on the subsequent sale of shares are included with other revenues and expenses on the company's income statement along with any dividend revenues. A market adjustment account is used to adjust the historical cost of the company's investment to its current fair market value at the end of each accounting period. However, with available-for-sale securities, the resulting unrealized gain or loss associated with that adjustment is not reflected in the company's income statement and closed to retained earnings. Instead, it bypasses the income statement and is reflected directly on a cumulative basis in the owners' equity section of the balance sheet as part of accumulated other comprehensive income.

Example: Assume that at the end of 20X6, NRN Corporation has:
DR CR

Investment in available-for-sale securities Market adjustment - available-for-sale securities 12/31/X6: FMV of securities Historical cost

$100,000 $ 5,000

$105,000 $100,000

Also assume that at the end of 20X7, the investment account has the same $100,000 balance but the fair market value of the securities held has increased to $113,000.
Market Adjustment - Available-for-Sale Securities
12/31/X6 Adjusting entry 12/31/X7 5,000 8,000 13,000

Entry at Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities 12/31/X7:
Unrealized Gain/Loss - Available-for-Sale Securities
5,000 8,000 13,000 12/31/X6 Adjusting entry 12/31/X7

8,000 8,000

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Crown Investments Balance Sheet 12/31/X7

Problem #11-4

Accounting for Trading vs. Available-for-Sale Securities
On 12/31/X1, Moore Company owned 1,000 shares of stock in General Electric ("GE") with an original cost of $30 and a fair market value of $28 per share.
Assuming the shares are classified as:

Assets:
Investment in available-for-sale securities Plus: Market adjustment $ 100,000 13,000 $ 113,000

A. Trading securities B. Available-for-sale securities

Owners' Equity:
Accumulated other comprehensive income: Unrealized gain on available-for-sale securities $ 13,000

1. Prepare entries to record Moore's 20X2 sale of 300 GE shares at a price of $32/share along with the appropriate year-end adjustment given a market price of $35/share at 12/31/X2. (Assume the company has no other investments in equity securities and entered into no other transactions involving GE stock during the year.) 2. Prepare Moore's 12/31/X2 balance sheet and income statement disclosures. Question: Why might a company experiencing declining values on newly purchased equity securities be inclined to classify them as available-for-sale rather than trading securities regardless of their future plans? What kind of problem might this present to the company's auditor?

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Problem 11-4 - Answer

Problem 11-4 - Answer

Accounting for Trading vs. Available-for-Sale Securities
A. Trading securities: 1. Entry to record the sale of 300 GE shares at $32/share:
Cash (300 x $32) Investment in Trading Securities (300 x $30) Realized Gain on Sale of Trading Securities * $30 x 300 shares = $9,000 9,600 9,000* 600

2.

Moore Company Balance Sheet 12/31/X2 Investment in trading securities, at market $ 24,500

Current Assets:

12/31/X2 adjusting entry to reflect market value of investment:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities Market Adjustment - Trading Securities
2,000 Adjusting entry 12/31/X2 5,500 3,500 12/31/X1

5,500 5,500

Moore Company Income Statement for the year ended 12/31/X2

Other revenues and expenses:
Realized gain on sale of trading securities Unrealized gain - trading securities $ $ 600 5,500 6,100

12/31/X2: Historical cost (700 x $30) FMV at 12/31/X2 (700 x $35) Adjustment

GE

$21,000 $24,500 $ 3,500

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Problem 11-4 - Answer

Problem 11-4 - Answer

B. Available-for-sale securities: 1. Entry to record the sale of 300 GE shares at $32/share:
Cash (300 x $32) Investment in Available-for-Sale Securities Realized Gain on Sale of Available-for-Sale Securities * $30 x 300 shares = $9,000 9,600 9,000* 600

2.
Assets: Stockholders' Equity:

Moore Company Balance Sheet 12/31/X2 $ 24,500

Investment in available-for-sale securities, at market Accumulated other comprehensive income: Unrealized gain on available for sale securities
Unrealized Gain/Loss - Available-for-Sale Securities
12/31/X1 2,000 5,500 3,500 Adjusting entry 12/31/X2

12/31/X2 adjusting entry to reflect market value of investment:
Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities 5,500 5,500

$ 3,500

Market Adjustment - Available-for-Sale Securities
2,000 Adjusting entry 12/31/X2 5,500 3,500 12/31/X1

12/31/X2: Historical cost (700 x $30) FMV at 12/31/X2 (700 x $35) Adjustment

GE

$21,000 $24,500 $ 3,500

Moore Company Income Statement for the year ended 12/31/X2 Other revenues and expenses: Realized gain on sale of available-for-sale securities $ 600

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Problem 11-4 - Answer

Equity Method of Accounting
The required approach when a company acquires significant influence over the affairs of another company. Significant influence is presumed when 2050% of a company's outstanding common stock is owned, although other criteria may be considered when making this determination.
Under the equity method: 1. An investment in the securities of another company is initially recorded at its cost. 2. That cost is then subsequently adjusted up for the investor's percentage interest in the company's reported profits and down for its share of reported losses. 3. Any dividend receipts are accounted for as reductions in the investment's adjusted cost. 4. No year-end adjustment is made for changing stock values unless a permanent decline occurs. 5. Upon sale of shares, the difference between net proceeds received and the stocks' book value (adjusted cost) is recorded as a realized gain or loss.

Question: Why might a company experiencing declining values on newly purchased equity securities be inclined to classify them as available-for-sale rather than trading securities regardless of their future plans?
Answer: Classification as available-for-sale securities would allow the company to exclude any unrealized losses from its income statement and EPS calculations. The inclusion of those losses in reported net income might negatively influence the public's perception of management performance and cause a decline in the company's stock valuation.

What kind of problem might this present to the company's auditor?
Answer: Since accounting for unrealized gain and losses depends on management intent, auditors may be forced to rely on management's word rather than any tangible evidence in expressing an opinion on the appropriateness of the company's financial reporting. An auditor might look to a company's past trading history, current liquidity and future cash flow projections to try and verify management's stated intent, but ultimately a certain degree of trust will have to be involved.

The key elements in this equity method approach are the adjustments made the investment's cost for percentage interests in reported profits and losses, along with reductions made for dividend receipts.

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Example: Assume Bass Enterprises buys significant influence over a supplier of merchandise with the 40% purchase of its outstanding common stock for $200,000 cash.
Investment in Equity Method Securities Cash 200,000 200,000

The supplier's reported profits for the year totaled $30,000.
Investment in Equity Method Securities Investment Revenues (40% x $30,000) 12,000 12,000

A $5,000 cash dividend is received on the investment.
Cash Investment in Equity Method Securities 5,000 5,000

When a company buys more than 50% of another company's stock or otherwise has effective control over its operations, then consolidated financial statements are prepared in which all of the assets, liabilities, revenues and expenses of the subsidiary are combined on the financial statements of the parent company.

The entire investment is sold for $230,000 cash.
Cash Investment in Equity Method Securities Gain on Sale of Investment
* $200,000 + $12,000 - $5,000 = $207,000

230,000 207,000* 23,000

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Problem #11-5

Problem 11-5 - Answer

Comparison of Methods of Accounting for Investments in Equity Securities

Comparison of Methods of Accounting for Investments in Equity Securities

During the year 20X8, Jordan, Inc. purchased 20% of the common stock of Carson Corporation at a price of $112,000, net of all brokerage fees. Assuming:
1. Carson's reported net income for the year amounted to $60,000. 2. Jordan received $6,000 of cash dividends on its investment in the Carson stock. 3. The Carson shares have a $120,000 market value at the end of the year. 4. Jordan had no other investments in securities during the year.

A. Available-for-sale securities
Purchased securities:
Investment in Available-for-Sale Securities Cash 112,000 112,000

Received dividends:
Cash Dividend Revenues 6,000 6,000

Prepare all of Jordan's investment-related entries for the year if the Carson shares:
A. Are classified as available-for-sale securities. B. Provide Jordan with significant influence over Carson's affairs.

Year-end valuation adjustment:
Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities 8,000 8,000

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Problem 11-5 - Answer

B. Significant influence
Purchased securities:
Investment in Equity Method Securities Cash 112,000 112,000

Recognized share of Carson's reported net income:
Investment in Equity Method Securities Investment Revenues (20% x $60,000) 12,000 12,000

Debt Securities
(Bonds issued by other companies or governmental entities.)

Received dividends:
Cash Investment in Equity Method Securities 6,000 6,000

Year-end valuation adjustment:

No entry

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Accounting for an Investment in Bonds
Depends on the company's intent reflected in three possible classifications. Trading Securities: The company's intent is to actively buy and sell bonds to maximize returns on investment. Available-for-Sale Securities: The company's intent is to buy and hold the bonds until future cash needs arise. Held-to-Maturity Securities: The company's intent is to hold the bonds until the final principal payment is received.

Accounting for an Investment in Bonds
Example: On September 30th, 20X6, Damron, Inc. purchased in a secondary market, $100,000 of 8%, 3-year, term bonds with interest payable semi-annually on June 30th and December 31st of each year through maturity on December 31st, 20X7. Upon purchase, Damron paid a price of 97 (97% of the $100,000 face value), plus $2,000 of accrued interest.
Bonds Issued 1/1/X5 Bonds Purchased 6/30 9/30 12/31/X6
$4,000

6/30 $4,000

12/31/X5 $4,000

6/30 $4,000

Bonds Mature 12/31/X7

($2,000) ($97,000)

$4,000

$4,000 $100,000

Journal entry to record the purchase of the bonds:

Investment in Trading Securities Interest Receivable Cash

97,000 2,000

99,000

Bonds purchased at a discount produce a higher effective rate of return than the stated interest rate provided for in the bonds. In fact, bonds are priced at a discount when market interest rates exceed the bond's stated rate. When market rates are lower than the stated interest rate then bonds are priced at a premium. From an accounting standpoint, this $3,000 discount, or additional interest should be recognized or amortized to revenue over the remaining 15-month term of the bonds.

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12/31/X6 interest receipt:
Cash Interest Receivable Interest Revenue 4,000 2,000 2,000

Assume that on 12/31/X6 the fair market value of the bonds, or in other words, the price these bonds could be sold for in a secondary market, has increased from 97 to 101 or 101% of their $100,000 face value.

If Damron sold the bonds at this point in time:
Cash Investment in Trading Securities Realized Gain on the Sale of Trading Securities 101,000 97,600 3,400

12/31/X6 discount amortization:
Investment in Trading Securities Interest Revenue 600 600

Straight-line amortization: $3,000 15 months = $200/month $200 x 3 months = $600 Effective Interest Method: Assuming the $97,000 purchase price produced an effective interest rate of 10.62% compounding semiannually.
Bond Face Value Unamort. Discount Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Discount Amort.

This increase in the value of the bonds to $101,000 is a direct result of decreasing effective interest rates demanded by investors. As market interest rates the value of existing bonds Think of it this way; if bonds bearing 8% interest are attractive when market interest rates are at 8%, consider how much more attractive those bonds are when market interest rates are only 6%. On the other hand, if rates rise to 10%, no one wants 8% bonds unless they're priced at a discount. As market interest rates the value of existing bonds In this case, where the $100,000 of bonds have increased in value from $97,000 in September to $101,000 at the end of December, market interest rates must have decreased making the 8% bonds more attractive to investors.

Period

3 mo. 100,000 - 3,000 = 6 mo. 100,000 - 2,425 = 6 mo. 100,000 - 1,244 =

97,000 x 10.62% x 3/12 = 2,575 - 2,000 = 575 97,575 x 10.62% x 6/12 = 5,181 - 4,000 = 1,181 98,756 x 10.62% x 6/12 = 5,244 - 4,000 = 1,244

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11-8

Assume these bonds increased in value but are not sold based on Damron's belief that short-term interest rates will continue to fall and the bonds will be worth even more in the near future. Given that these bonds are included in the classification of trading securities on the company's balance sheet, an adjustment must be made to reflect these bonds along with all of the other trading securities at their current fair market value. If these bonds are the only trading securities held during the year, Adjusting entry at 12/31/X6:
Market Adjustment - Trading Securities Unrealized Gain - Trading Securities
FMV of bonds Historical cost Difference $101,000 $ 97,600 $ 3,400

Damron, Inc Balance Sheet 12/31/X6

Assets:
Investment in trading securities Add: Market adjustment Damron, Inc Income Statement for the year ended 12/31/X6 $ 97,600 3,400 $101,000

3,400 3,400

Other revenues and expenses:
Interest revenues Unrealized gain - trading securities $ $ 2,600 3,400 6,000

Market Adjustment - Trading Securities
12/31/X5 Adjusting entry 12/31/X6 0 3,400 3,400

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Investment in Bonds Classified as Available-for-Sale Securities
In this case, the accounting is exactly the same as it was for bonds classified as trading securities, except for the disclosures required for unrealized gains or losses on changing bond values over time. When accounting for bonds classified as available-for-sale securities, the total net unrealized gain or loss on stocks and bonds included in that classification is reported on a cumulative basis in the owners' equity section of the company's balance sheet.

Held-to-Maturity Securities
The accounting for an investment in bonds classified as held-tomaturity securities is exactly the same as it is for trading and available-for-sale securities except that no adjustment is made to reflect the bonds at their current fair market value at the end of an accounting period. As a result, no unrealized gains or losses are ever recorded.
Upon final collection of the principal:
Cash Investment in Held-to-Maturity Securities XXX XXX

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Problem #11-6

Problem 11-6 - Answer

Accounting for an Investment in Bonds

3/1/X5: Bond purchase-

Accounting for an Investment in Bonds
49,000 500 49,500 1,500 500 1,000 400 400

Investment in Held-to-Maturity Securities Interest Receivable ($50,000 x 6% x 2/12) Cash

On 3/1/X5, Otto, Inc. paid $49,000 (yielding 8.53% effective interest) plus accrued interest to acquire $50,000 of previously issued, 6% term bonds, maturing on December 31st of the current year. Assuming the bonds are held to maturity and semi-annual interest payments are received on June 30th and December 31st, prepare all of Otto's bond-related entries for the year-ended 20X5.

6/30/X5: Interest receiptCash ($50,000 x 6% x 6/12) Interest Receivable Interest Revenue

Discount amortization*Investment in Held-to-Maturity Securities Interest Revenue

Straight-line amortization: $1,000 discount 10 months = $100/month $100 x 4 months = $400
Effective Interest Method:
Period Bond Face Value Unamort. Discount Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Discount Amort.

4 mo. 50,000 - 1,000 = 49,000 x 8.53% x 4/12 = 1,393 - 1,000 = 393 6 mo. 50,000 607 = 49,393 x 8.53% x 6/12 = 2,107 - 1,500 = 607 * This entry on 6/30 is not mandatory. A single entry made on 12/31/X5 for the full $1,000 discount would be an acceptable alternative under both methods.

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11-9

Problem 11-6 - Answer

Problem #11-7

12/31/X5: Interest receiptCash Interest Revenue 1,500 1,500

Accounting for an Investment in Bonds
On May 1, 20X5, ATT issued bonds with a total face value of $100,000,000 bearing interest at 8%. The bond indenture provides for interest payments to be made on 11/1 and 5/1 of each year through maturity, May 1, 20X9. Prepare journal entries on the dates noted below from the standpoint of an investor acquiring $20,000 of the ATT bonds for $20,480 on the date of issuance yielding an effective interest rate of 7.3%. (Assume the bonds are classified as available-for-sale securities.)

Discount amortizationCash Interest Revenue 1,500 1,500

Straight-line amortization: $100 x 6 months = $600
Effective Interest Method:
Period Bond Face Value Unamort. Discount Carrying Value of Investment

1. 2. 3. 4.

Bond issuance on 5/1/X5. Collection of interest and effective interest amortization of the bond premium on 11/1/X5. Adjusting entry(ies) required for the bond interest earned on 12/31/X5. Adjusting entry at 12/31/X5 assuming an existing $4,000 credit balance in the investor's market adjustment account and the following information:

Available-for-Sale Securities
Effect. Rate Effect. Interest Stated Interest Discount Amort.
GM Stock GE Stock ATT Bonds Total

4 mo. 6 mo.

50,000 - 1,000 = 50,000 607 =

49,000 x 8.53% x 4/12 = 1,393 - 1,000 = 49,393 x 8.53% x 6/12 = 2,107 - 1,500 =

393 607

Receipt of principal:
Cash Investment in Held-to-Maturity Securities 50,000 50,000

Historical cost $15,000 $19,000 $20,410 $54,410 FMV at 12/31/X5 $13,000 $17,000 $22,000 $52,000 5. Collection of interest and amortization of the bond premium on 5/1/X6. 6. Sale of the bonds on 5/1/X6 at a price of 105. 7. Adjusting entry at 12/31/X6 given the following information: Available-for-Sale Securities
GM Stock GE Stock Total

Historical cost FMV at 12/31/X6

$15,000 $17,000

$19,000 $20,000

$34,000 $37,000

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Problem #11-7

Problem 11-7 - Answer

Questions: A. What is the balance in the investor's Unrealized Gain/Loss - Availablefor-Sale Securities account at 12/31/X6 and where does it appear on the company's financial statements? B. If the ATT bonds had been classified with the investor's trading securities, how would the accounting in this problem have been different? C. Why is no adjustment made for current year-end fair market values when bonds are classified as held-to-maturity securities?

Accounting for an Investment in Bonds
1. Bond issuance on 5/1/X5.
Investment in Available-for-Sale Securities Cash 20,480 20,480

2. Collection of interest and straight-line amortization of the bond premium on 11/1/X5.
Cash (20,000 x 8% x 6/12) Interest Revenues Interest Revenues Investment in Available-for-Sale Securities 800 800 52 52

Effective Interest Method:
Period Bond Face Value Unamort. Premium Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Premium Amort.

6 mo.

20,000 +

480

=

20,480 x

7.3%

x 6/12 =

748

-

800

=

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58

Problem 11-7 - Answer

Problem 11-7 - Answer

3. Adjusting entry(ies) required for bond interest earned on 12/31/X5.
Interest Receivable (20,000 x 8% x 2/12) Interest Revenues Interest Revenues Investment in Available-for-Sale Securities 267 267 18 18

4. Adjusting entry at 12/31/X5 assuming a $4,000 credit balance in the investor's market adjustment account and the following information: Available-for-Sale Securities
GM Stock GE Stock ATT Bonds Total

Effective Interest Method:
Period Bond Face Value Unamort. Premium Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Premium Amort.

Historical cost FMV at 12/31/X5

$15,000 $13,000

$19,000 $20,410 $17,000 $22,000 Difference

$54,410 $52,000 ($2,410)

Market Adjustment - Available-for-Sale Securities
4,000 Adjusting entry 1,590 2,410 12/31/X5 12/31/X5

6 mo. 6 mo.

20,000 + 20,000 +

480 428

= =

20,480 x 20,428 x

7.3% 7.3%

x 6/12 = x 6/12 =

748 746

-

800 800

= =

52 54

Amortization for two months of 2nd 6-month period: $54 x 2/6 = $18 Adjusting entry:

Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities

1,590 1,590

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11-10

Problem 11-7 - Answer

Problem 11-7 - Answer

5. Collection of interest and amortization of the bond premium on 5/1/X6.
Cash (20,000 x 8% x 6/12) Interest Receivable Interest Revenues Interest Revenues Investment in Available-for-Sale Securities 800 267 533 36 36

6. Sale of the bonds on 5/1/X6 at a price of 105.
Cash Investment in Available-for-Sale Securities Realized Gain on the Sale of Available-for-Sale Securities 21,000 20,374 626

ATT Bonds

Effective Interest Method:
Period Bond Face Value Unamort. Premium Carrying Value of Investment Effect. Rate Effect. Interest Stated Interest Discount Amort.

5/1/X5

20,480 52 18 11/1/X5 12/31/X5 5/1/X6

6 mo. 6 mo.

20,000 + 20,000 +

480 428

= =

20,480 x 20,428 x

7.3% 7.3%

x 6/12 = x 6/12 =

748 746

-

800 800

= =

52 54

12/31/X5 5/1/X6

20,410 36 20,374

Amortization for last four months of 2nd 6-month period: $54 x 4/6 = $36

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Problem 11-7 - Answer

Problem 11-7 - Answer

Questions:
7. Adjusting entry at 12/31/X6 given the following information: Available-for-Sale Securities
GM Stock GE Stock Total

A. What is the balance in the investor's Unrealized Gain/Loss - Availablefor-Sale Securities account at 12/31/X6 and where does it appear on the company's financial statements?
Answer: The unrealized gain or loss account is a balance sheet account that maintains a corresponding balance to the investment's market adjustment account, except that it's opposite in terms of debits and credits. Given this market adjustment account balance at 12/31/X6,
Market Adjustment - Available-for-Sale Securities
4,000 Adjusting entry Adjusting entry 12/31/X6 1,590 2,410 5,410 3,000 12/31/X5 12/31/X5

Historical cost FMV at 12/31/X6

$15,000 $19,000 $17,000 $20,000 Difference

$34,000 $37,000 $ 3,000

Market Adjustment - Available-for-Sale Securities
4,000 Adjusting entry Adjusting entry 12/31/X6 1,590 2,410 5,410 3,000 12/31/X5 12/31/X5

Adjusting entry:
Market Adjustment - Available-for-Sale Securities Unrealized Gain/Loss - Available-for-Sale Securities 5,410 5,410

the unrealized gain/loss account balance has a credit balance or cumulative gain to date of $3,000, appearing as part of the company's accumulated other comprehensive income in the owners' equity section of its balance sheet.

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Problem 11-7 - Answer

Problem #11-8

Question
B. If the ATT bonds had been classified with the investor's trading securities, how would the accounting in this problem have been different?
Answer: Besides the use of different account titles, the bonds would have been excluded from any adjustment of available-for-sale securities to their FMV and included in any adjustment for the company's trading securities. That means the change in the difference between the bonds' adjusted historical cost and FMV would have been included in the company's income statement and ending retained earnings balance.

If you thought interest rates were going to increase in the future, would you buy bonds today?

C. Why is no adjustment made for current year-end fair market values when bonds are classified as held-to-maturity securities?
Answer: No adjustment is made because no gain or loss will ever be incurred if the bonds are held to maturity. Ultimately the full book value of the bonds will be collected at maturity.,

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11-11

Problem 11-8 - Answer

Question If you thought interest rates were going to increase in the future, would you buy bonds today?
Answer: It depends. If you plan to sell the bonds prior to maturity, then the value of the bonds will decrease as interest rates rise and a loss will be incurred upon sale. That loss will offset a portion of interest earned and reduces the investment's overall return. If you plan to hold the bonds to maturity, then no gain or loss will be incurred but you will earn a lower interest rate over the term of the bonds than you would have otherwise earned if you had waited for rates to rise before making the investment. The problem with waiting, however, is that no interest is earned prior to the bond purchase unless an alternative investment can be made in the interim. If, however, an investor plans to hold a bond to maturity and is satisfied in earning today's effective interest rate over the term of the bonds, then an investment today probably makes sense.

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