Investments in Debt and Equity Securities

Chapter 13

I nvestments arise when one corporation with excess cash invests in another corporation by purchasing stock or bonds of the second company and holding it long term. Profitable companies generate huge amounts of cash and commonly use their excess cash to make investments. Like an individual investor, they may invest in CD’s, T-bills, or stock or bonds of another corporation.

Corporations may make investments in bonds or stock of a second company for various reasons including:

Corporations have excess cash and may wish to park the cash

temporarily

Corporations with excess cash wish to generate earnings from investment

income

Corporations with excess cash may wish to invest for strategic reasons,

e.g. vertical or horizontal expansion

Investments in debt and equity securities are classified as either short term or long term. A corporate bond is an example of a debt security and common stock is an example of an equity security. Short-term investments are expected to be held one year or less and long-term investments are expected to be held for more than one year.

Short-term and long-term investments must further be classified as trading securities, available-for-sale securities, or held to maturity securities.

Trading Securities can be either debt or equity securities. They are always short term and classified as a current asset on the balance sheet. The accounting method used is the fair value method. Report market value on the balance sheet and report the difference between cost and market value as an unrealized gain or loss on the income statement.

Please review the example on Page 598. Note that if the market value of trading securities has risen from the purchase to the balance sheet date, then the following journal entry is recorded:

Market Adjustment – Trading Securities

Unrealized Gain on Trading Securities

On the balance sheet the Market Adjustment – Trading Securities account is combined with the Trading Securities account to report market value as of the balance sheet date. If the market value is less than cost then the journal entry would take the following form:

Unrealized Loss on Trading Securities

Market Adjustment – Trading Securities

The Market Adjustment – Trading Securities account balance would be combined with the Trading Securities account to report the reduced market value on the balance sheet.

Available-for-Sale Securities are all securities not classified as held-to-maturity or trading securities. They can be either debt or equity securities and should be reported using the fair value method. The difference between cost and market gives rise to unrealized gains or losses which are reported in the stockholders’ equity section of the balance sheet (not on the income statement). See Pages 598-9.

Held-to-Maturity Investments are debt instruments which pay interest and which management intends to hold to maturity. The accounting method used for held-to-maturity securities is Amortized Cost. Held-to-Maturity securities can either be short or long term depending on the holding period plans of management. Further discussion of Held-to-Maturity Investments occurs in intermediate accounting.

Trading Securities can be either debt or equity securities. They are always short term and classified as a current asset on the balance sheet. The accounting method used is the fair value method. Report market value on the balance sheet and report the difference between cost and market value as an unrealized gain or loss on the income statement. Please review the example on Page 598.

It a debt instrument qualifies as a trading security, it is recorded by debiting Debt Investments at cost. As interest is earned Cash or Interest Receivable is debited and Interest Revenue is credited. When bonds are sold Cash is debited, the Debt Investments Account is credited, and a gain or loss is recorded on the sale of the debt instruments.

Available-for-Sale Securities are all securities not classified as held-to-maturity or trading securities. They can be either debt or equity securities and should be reported using the fair value method. The difference between cost and market gives rise to unrealized gains or losses which are reported in the stockholders’ equity section of the balance sheet. See Pages 599-601.

Held-to-Maturity Investments are debt instruments which pay interest and which management intends to hold to maturity. The accounting method used for held-to-maturity securities is Amortized Cost. Held-to-Maturity securities can either be short or long term depending on the holding period plans of management. Further discussion of this topic occurs in Intermediate Accounting.

I nvestments in stock arise when one corporation (investor) purchases stock in another corporation (investee). The original stock investment is always recorded at cost. As set forth below, GAAP requires different accounting treatment for stock investments depending on the amount of ownership by the investor:

Less than 20% ownership Cost Method

20-50% ownership Equity Method

More than 50% ownership Consolidation

For holdings of less than 20%, acquisition of stock is recorded at cost by debited a Stock Investments Account. When dividends are received Cash is debited and Dividend Revenue is credited. Finally, when stock is sold, Cash is debited, Stock Investments is credited, and the gain or loss is recorded.

However, when an investor corporation acquires 20-50% of the outstanding stock of the investee corporation, the equity method of accounting is used. Note that the purchase of the investment is again recorded at cost by debited a Stock Investments Account. However, net income earned by the investee results in a debit to the Stock Investment Account and a credit to Equity-Method Investment Revenue. The amount is based on the percentage of ownership of the investee corporation. When dividends are paid by the investee, Cash is debited on the books of the investor corporation and the Stock Investment Account is credited (not Dividend Revenue). The theory behind the Equity Method of Accounting is that based on the investor’s ownership share, the investor can and does influence the investee’s financial performance. Thus net income earned by the investee should result in an increase in the Stock Investment Account and the payment of dividends should result in a decrease in the Stock Investment Account. See Pages 593-4.

Many large corporations own controlling interests (>50%) in smaller companies.   Consolidation accounting is a method of combining the financial statements of the parent corporation with those of the majority owned subsidiaries.   The result is a single set of financial reports in the name of the consolidated parent corporation, i.e. Consolidated Financial Statements of Nordstrom.    In the consolidation process certain accounts resulting from internal transactions (internal to the consolidated entity) are eliminated to prevent double counting.   See the Chapter 13 Appendix beginning on Page 605.   In preparing consolidated financial statements it is helpful to use a worksheet such as the example on Page 607.   Note that the consolidated entity does not have its own set of books and records. W orksheets are used to combine the parent and subsidiaries financial statements.