Investments and Fair Value Accounting

Transcription

1 C H A P T E R 15 Investments and Fair Value Accunting Financial Accunting 14e Warren Reeve Duchac human/istck/360/getty Images

2 Investing Cash in Current Operatins Cash may be used t replace wrn-ut equipment r t purchase new, mre efficient and prductive equipment. In additin, cash may be reinvested in the cmpany t expand its current peratins. Cash may be used t pay: Expenses. Suppliers f merchandise and ther assets. Interest t creditrs. Dividends t stckhlders.

3 Investing Cash in Temprary Investments Instead f letting excess cash remain idle in a checking accunt, mst cmpanies invest their excess cash in securities such as: Debt securities, which are ntes and bnds that pay interest and have a fixed maturity date. Equity securities, which are preferred and cmmn stck that represent wnership in a cmpany and d nt have a fixed maturity date. Investments in debt securities and equity securities, termed investments r temprary investments, are reprted in the Current Assets sectin f the balance sheet. The primary bjective f investing in temprary investments is t earn interest revenue, receive dividends, r realize gains frm increases in the market price f the securities.

4 Investing Cash in Lng-Term Investments Lng-term investments ften invlve the purchase f a significant prtin f the stck f anther cmpany. Such investments usually have a strategic purpse: Reductin f csts. Replacement f management. Expansin. Integratin.

5 Accunting fr Debt Investments Debt securities include ntes and bnds issued by crpratins and gvernmental rganizatins. Mst cmpanies invest excess cash in bnds as investments t earn interest revenue. The accunting fr bnd investments includes recrding the fllwing: Purchase f bnds Interest revenue Sale f bnds

6 Purchase f Bnds The purchase f bnds is recrded by debiting an investments accunt fr the purchase price f the bnds, including any brkerage cmmissins. A brkerage cmmissin is the fee charged by the agent wh arranges the transactin between the buyer and seller. If the bnds are purchased between interest dates, the purchase price includes accrued interest since the last interest payment. This is because the seller has earned the accrued interest, but the buyer will receive the accrued interest when it is paid.

7 Sale f Bnds The sale f a bnd investment nrmally results in a gain r lss. If the prceeds frm the sale exceed the bk value (cst) f the bnds, then a gain is recrded. If the prceeds are less than the bk value (cst) f the bnds, a lss is recrded. The gain r lss n the sale f bnd investments is reprted as part f Other Incme (Lss) n the incme statement.

8 Accunting fr Equity Investments A cmpany may invest in the preferred r cmmn stck f anther cmpany. The cmpany investing in anther cmpany s stck is the investr. The cmpany whse stck is purchased is the investee. The percent f the investee s utstanding stck purchased by the investr determines the degree f cntrl that the investr has ver the investee. This, in turn, determines the accunting methd used t recrd the stck investment. The percent f the investee s utstanding stck purchased by the investr determines the degree f cntrl that the investr has ver the investee. This, in turn, determines the accunting methd used t recrd the stck investment.

9 Cst Methd: Less Than 20% Ownership Investments f less than 20% f the investee s utstanding stck are accunted fr by using the cst methd. Under the cst methd, entries are recrded fr the fllwing transactins: Purchase f stck Receipt f dividends Sale f stck

10 Equity Methd: Between 20% 50% Ownership Investment f between 20% and 50% are accunted fr using the equity methd. Under the equity methd, the stck is recrded initially at its cst, including any brkerage cmmissins. Under the equity methd, the investment accunt is adjusted fr the investr s share f the net incme and dividends f the investee. These adjustments are as fllws: Net incme: The investr recrds its share f the net incme f the investee as an increase in the investment accunt. Its share f any net lss is recrded as a decrease in the investment accunt. Dividends: The investr s share f cash dividends received frm the investee decreases the investment accunt.

11 Cnslidatin: Mre Than 50% Ownership (slide 1 f 2) If the investr purchases mre than 50% f the utstanding stck f the investee, the investr is cnsidered t have cntrl ver the investee. The purchase is termed a business cmbinatin. In this case, it is assumed that the investr purchased the stck f the investee primarily fr strategic reasns, such as t prduce mre efficiently, diversify prduct lines, expand gegraphically, r acquire knw-hw.

12 Cnslidatin: Mre Than 50% Ownership (slide 2 f 2) A crpratin wning all r a majrity f the vting stck f anther crpratin is called a parent cmpany. The crpratin that is cntrlled is called the subsidiary cmpany. At the end f the year, the financial statements f the parent and subsidiary are cmbined and reprted as a single cmpany. These cmbined financial statements are called cnslidated financial statements.

13 Valuing and Reprting Investments Debt and equity securities are financial assets that are ften traded n public exchanges such as the New Yrk Stck Exchange. As a result, their market value can be bserved and, thus, bjectively determined. Fr this reasn, generally accepted accunting principles (GAAP) allws sme debt securities, and requires equity securities where there is less than a 20% wnership interest t be valued in the accunting recrds and financial statements at their fair market values. These securities are classified as fllws: Trading securities Available-fr-sale securities Held-t-maturity securities

14 Trading Securities (slide 1 f 3) Trading securities are debt and equity securities that are purchased and sld t earn shrt-term prfits frm changes in their market prices. Trading securities are ften held by banks, mutual funds, insurance cmpanies, and ther financial institutins. Because trading securities are held as a shrt-term investment, they are reprted as a current asset n the balance sheet.

15 Trading Securities (slide 2 f 3) Trading securities are valued as a prtfli (grup) f securities using the securities fair values. Fair value is the market price that the cmpany wuld receive fr a security if it were sld. A change in the fair value f the prtfli (grup) f trading securities is recgnized as an unrealized gain r lss fr the perid. If the fair value f the prtfli f trading securities was less than the cst: The adjustment wuld debit Unrealized Lss n Trading Investments and credit Valuatin Allwance fr Trading Investments fr the difference. Unrealized Lss n Trading Investments wuld be reprted n the incme statement as Other Expenses. Valuatin Allwance fr Trading Investments wuld be shwn n the balance sheet as a deductin frm Trading Investments (at cst).

16 Trading Securities (slide 3 f 3) Over time, the valuatin allwance accunt is adjusted t reflect the difference between the cst and fair value f the prtfli. Thus, increases in the valuatin allwance accunt frm the beginning f the perid will result in an adjustment t recrd an unrealized gain. Likewise, decreases in the valuatin allwance accunt frm the beginning f the perid will result in an adjustment t recrd an unrealized lss.

17 Available-fr-Sale Securities (slide 1 f 4) Available-fr-sale securities are debt and equity securities that are neither held fr trading, held t maturity, nr held fr strategic reasns. Changes in the fair values f available-fr-sale securities are reprted as part f stckhlders equity and, thus, excluded frm the incme statement.

18 Available-fr-Sale Securities (slide 2 f 4) The valuatin allwance and unrealized gain are reprted n the balance sheet as fllws:

19 Available-fr-Sale Securities (slide 3 f 4) If the fair value f the prtfli f available-fr-sale securities was less than the cst: The adjustment wuld debit Unrealized Gain (Lss) n Available-fr-Sale Investments and credit Valuatin Allwance fr Available-fr-Sale Investments fr the difference. Unrealized Gain (Lss) n Available-fr-Sale Investments wuld be reprted in the Stckhlders Equity sectin as a negative item. Valuatin Allwance fr Available-fr-Sale Investments wuld be shwn n the balance sheet as a deductin frm Available-fr-Sale Investments (at cst).

20 Available-fr-Sale Securities (slide 4 f 4) Over time, the valuatin allwance accunt is adjusted t reflect the difference between the cst and fair value f the prtfli. Thus, increases in the valuatin allwance frm the beginning f the perid will result in an adjustment t recrd an increase in the valuatin and unrealized gain (lss) accunts. Likewise, decreases in the valuatin allwance frm the beginning f the perid will result in an adjustment t recrd decreases in the valuatin and unrealized gain (lss) accunts.

21 Held-T-Maturity Securities (slide 1 f 2) Held-t-maturity securities are debt investments, such as ntes r bnds, that a cmpany intends t hld until their maturity date. Held-t-maturity securities are primarily purchased t earn interest revenue. If a held-t-maturity security will mature within a year, it is reprted as a current asset n the balance sheet. Held-t-maturity securities maturing beynd a year are reprted as nncurrent assets.

22 Held-T-Maturity Securities (slide 2 f 2) Only securities with maturity dates, such as crprate ntes and bnds, are classified as held-t-maturity securities. Equity securities are nt held-t-maturity securities because they have n maturity date. Held-t-maturity bnd investments are recrded at their cst, including any brkerage cmmissins. If the interest rate n the bnds differs frm the market rate f interest, the bnds may be purchased at a premium r discunt. In such cases, the premium r discunt is amrtized ver the life f the bnds. Held-t-maturity bnd investments are reprted n the balance sheet at their amrtized cst.

23 Fair Value Accunting Fair value is the price that wuld be received fr selling an asset. Fair value assumes that the asset is sld under nrmal business cnditins. Generally accepted accunting principles require trading and available-fr-sale investments t be recrded at their fair value.

24 Effect f Fair Value Accunting n the Financial Statements: Balance Sheet When an asset is reprted at its fair value, any difference between the asset s riginal cst r prir perid s fair value must be reprted in a valuatin allwance. Changes in the fair value f available-fr-sale securities are included as part f stckhlders equity thrugh the cmprehensive incme and accumulated ther cmprehensive incme accunts.

25 Effect f Fair Value Accunting n the Financial Statements: Incme Statement Althugh trading securities are reprted at fair value in the balance sheet, changes in their fair values are nt reprted as part f stckhlders equity; rather, the unrealized gains r lsses are reprted n the incme statement.

26 Financial Analysis and Interpretatin: Dividend Yield The dividend yield measures the rate f return t stckhlders, based n cash dividends. Dividend yield is mst ften cmputed fr cmmn stck because preferred stck has a stated dividend rate. In cntrast, the cash dividends paid n cmmn stck nrmally vary with the prfitability f the crpratin. The dividend yield is cmputed as fllws: Dividend Yield = Dividends per Share f Cmmn Stck Market Price per Share f Cmmn Stck

27 Appendix: Cmprehensive Incme Cmprehensive incme is defined as all changes in stckhlders equity during a perid, except thse resulting frm dividends and stckhlders investments. Cmprehensive incme is cmputed by adding r subtracting ther cmprehensive incme t (frm) net incme, as fllws: Other cmprehensive incme items include unrealized gains and lsses n available-fr-sale securities as well as ther items such as freign currency and pensin liability adjustments. The cumulative effect f ther cmprehensive incme is reprted n the balance sheet, as accumulated ther cmprehensive incme.