CHAPTER

17
 INVESTMENTS

• In accounting for investments, entries are

required to record the:

– Acquisition
– Interest/dividends
– Disposal
 TYPES OF INVESTMENTS
1. DEBT
– Bonds, GICs, T-Bills, Commercial Paper
– Typically:
• Come with no ownership or decision-making rights
• Priority claim on the assets of a debtor when insolvent
• Are interest bearing securities that pay a stated annual interest rate on a “face value” or
“principal”
• Interest fully taxable

2. EQUITY
– Stocks, real assets
– Typically:
• Come with ownership and voting rights in a business
• Last to be paid off in a bankruptcy
• Value is linked to expectation of future cash flows of the business
• Some may pay dividends (return of profits to owner) but don’t have to
• Tax favoured status for lower tax brackets

NOTE: Capital gains can be earned on Debt or Equity investments and are only 50%
taxable in Canada.
Do you know the difference between Profit, Interest, Dividends, and Capital gains?
 ACCOUNTING FOR INVESTMENTS

• Accounting for DEBT investments

differs depending on whether
investments are
1. Temporary, or
2. Long-term

• Accounting for EQUITY differs

depending on how much of the
company’s stock you own.
 TEMPORARY VS. LONG-TERM
INVESTMENTS

• Temporary investments are securities, held by a

company, that are

1. Readily marketable (can be sold easily), and

2. Intended to be converted into cash in the near
future (<12mths).

• Investments that do not meet both criteria are

classified as long-term investments.
 TEMPORARY INVESTMENTS
AND THE OPERATING CYCLE
• At the end of their operating cycles, many
companies may have idle cash on hand
(temporarily)
• Until the cash is needed, these companies may
invest the excess funds to earn interest and
dividends.
Invest
Temporary
Sell
Cash Investments

Accounts
Inventory
Receivable
 TEMPORARY INVESTMENTS
AND THE OPERATING CYCLE

• Why would you bother with temporary

investments? Does it make that much of a
difference in revenues?

• Reasons:
– Opportunity cost – Will invest only if no superior
opportunities for money
– Time value of money – avoids inflationary erosion of
purchasing power
– Profitability – MUST understand the cost structure of a
business; observe…
Assume Company A and B are identical, and both have an extra $1
million available for three months this year. Company A lets it sit in
the business’s regular bank account, earning no interest.

Company B invests in a 90-day Bond which pays 8% per annum.

Company A Company B

Net Sales 2,000,000 2,000,000

C.O.G.S. 1,400,000 1,400,000
Gross Profit 600,000 600,000

Selling 225,000 225,000

Administrative 175,000 175,000
Total Operating Expenses 400,000 400,000

Operating Income 200,000 200,000

Interest Revenue - 20,000

Net Income 200,000 220,000

TEMPORARY DEBT INVESTMENTS
NOTE:

I recommend you start a fresh page and make a chart in

your notes like this one (leave enough space for a
journal entry in each section):

Temporary Long-Term

1. Acquiring Bonds

2. Recording Interest Earned

3. Disposing of (selling) Bonds

 TEMPORARY DEBT INVESTMENTS
1. Acquisition
• Kuhl Corporation acquires 50 Doan Inc. 6%, 10-year,
$1,000 bonds on January 1 for $54,000. The bonds pay
interest on December 31.

• The entry to record the temporary investment is:

Date Particulars Debit Credit

Jan. 1 Bonds 54,000
Cash 54,000
 TEMPORARY DEBT INVESTMENTS
2. Interest
• Interest receipts are calculated using the bond’s face or
principal value, which is $50,000 (50 x $1,000).
• The interest for December 31 will be $3,000 ($50,000 x
6%). The entry on December 31 is:

Date Particulars Debit Credit

Dec 31 Cash 3,000
Interest Revenue 3,000
 TEMPORARY DEBT INVESTMENTS
3. Disposal
Assume the Bond is sold for $49,000 on April 30 of year 2.
Step 1: Record interest up to the date of disposal.
Date Particulars Debit Credit
April 30 Interest Receivable 1,000
Year 2 Interest Revenue (4/12 of $3,000) 1,000

Step 2: Dispose of the Bond.

Date Particulars Debit Credit
April 30 Cash 49,000
Loss on Sale of Bond 6,000
Year 2
Interest Receivable 1,000
Bonds 54,000
 LONG-TERM DEBT INVESTMENTS
1. Acquisition
• Market forces determine the price of a bond; this
is almost NEVER the same as the face value
• When you hold bonds for the long-term, you must
recognize the difference in price paid and the face
value.

Date Particulars Debit Credit

Jan. 1 Bonds 50,000
Year 1 Premium on bonds 4,000
Cash 54,000
 LONG-TERM DEBT INVESTMENTS
2. Interest
• As interest accrues, a bond premium (or discount) must be
amortized over the life of the bond, since nothing will be
received for the premium when the bond matures (only the
face value will be paid by the issuer of the bond). This corresponds with
the Matching Principle.
• The straight-line method is used to amortize bond
premiums and discounts. Why?
Date Particulars Debit Credit
Dec 31 Cash 3,000
Year 1 Premium on bonds ($4,000 / 10 years) 400
Interest Revenue (6% x $50,000) - $400 2,600
 LONG-TERM DEBT INVESTMENTS
3. Disposal

• Disposal resembles the process for long-term assets

• When we sell the bond, we must ensure that any discount
or premium is amortized up to the date of disposal
• Then remove any remaining premium/discount and record
any gain or loss on the sale.
• Just like disposing of assets, there are two steps to the
process.
Say on April 30 of year 2, the bond is sold for $49,000
 LONG-TERM DEBT INVESTMENTS
3. Disposal

Step 1: Amortize premium up to the date of disposal.

Date Particulars Debit Credit
April 30 Interest Receivable 1,000.00
Premium on bonds (4/12 of $400) 133.33
Interest Revenue 866.67

Step 2: Dispose of the Bond.

Date Particulars Debit Credit
April 30 Cash 49,000
Year 2 Loss on Sale of Bond 5,466.67
Interest Receivable 1,000
Premium on bonds ($4,000 – 400 – 133.33) 3,466.67
Bonds 50,000
Do Problems:

BE17-2
P17-1A
 ACCOUNTING GUIDELINES FOR
EQUITY INVESTMENTS
NOTE:

Investor’s Ownership
I recommend you start a fresh page and make a chart in
Presumed
Interest in your notes like this one
Investee’s (leave enough spaceAccounting
Influence
journal entry in each section):
for a
Common Shares on Subsidiary Guidelines
<20% 20-50% >50%
Cost Equity Consol.
Less than 20% Insignificant Cost method

1. Acquiring
Between 20% Equity
and 50% Significant Equity method

More than Dividends

2. Recording 50% earned Controlling Equity method for
accounting;
3. Divesting of Equity (selling)
Consolidated
financial
statements for
financial reporting
RECORDING EQUITY INVESTMENTS
HOLDINGS LESS THAN 20%
The Cost Method

• Investment is recorded at cost and revenue is

recognized only when cash dividends are received.
(Same as cost method for Bonds really…)
• Unrealized gains and losses are reported in net
income
 LESS THAN 20%
1. Acquisition
On July 1, 2003, we acquire 1,000 shares (10 percent
ownership) of Beal Corporation at $40 per share plus
brokerage fees of $500. The entry for the purchase is:

Date Particulars Debit Credit

July 1 Equity Investment – Beal Common Shares 40,500
Cash 40,500
 LESS THAN 20%
2. Dividends
• Entries are required for any cash dividends
received during the time the shares are held.

• If we receive a $2 per share dividend on December

1, 2003, the entry is:

Date Particulars Debit Credit

Dec. 1 Cash 2,000
Dividend Revenue 2,000
 LESS THAN 20%
3. Disposal
• When shares are sold, the difference between the net
proceeds from the sale and the cost of the shares is
recognized as a gain or loss.
• Assume we receive $39,500 on the sale of our
investment of Beal common shares on February 10,
2004.
• Because the shares cost $40,500, a loss of $1,000 has
been incurred. The entry to record the sale is:
Date Particulars Debit Credit
Feb. 10 Cash 39,500
Loss on Sale of Investment 1,000
Equity Investment 40,500
 BETWEEN 20% AND 50%
The Equity Method
• The equity method:
• The investment in common shares is initially
recorded at cost, and the investment account is
adjusted annually to show the investor’s equity in the
investee.

• Each year, the investor

1. Debits the investment account and credits revenue
for its share of the investee’s net income and
2. Credits dividends received to the investment
account.

• Why?
 BETWEEN 20% AND 50%
The Equity Method

• What is significant influence?

– Representation on the board of directors
– Participation in the policy-making process
– Material inter-company transactions
– Interchange of managerial personnel
– Provision of technical information
 BETWEEN 20% AND 50%
1. Acquisition

• We acquire 30% of the common shares of Beck

Company for $120,000 on January 1, 2003. The
entry to record this transaction is:

Date Particulars Debit Credit

Jan. 1 Equity Investment 120,000
Cash 120,000
 BETWEEN 20% AND 50%
2. Dividends and Net Income
Beck reports 2003 net income of $100,000 and declares
and pays a $40,000 cash dividend. We are required to
record:
1) Our share of Beck’s net income, $30,000 (30% x $100,000)
Date Particulars Debit Credit
Dec. 31 Equity Investment 30,000
Revenue from Investment 30,000

2) The reduction in the investment account for the dividends

received, $12,000 ($40,000 x 30%). The entries are:
Date Particulars Debit Credit
Dec. 31 Cash 12,000
Equity Investment 12,000
BETWEEN 20% AND 50%
3. Disposal

Same as the Cost Method

(i.e. same as when holdings are less than 20%)
 MORE THAN 50%

• A company that controls (e.g., owns more than 50 %) of

the common shares of another entity is known as a parent
company.

• The company it owns is the subsidiary.

• For this, the equity method of accounting is used to

account for the investment, and consolidated financial
statements are prepared.
 MORE THAN 50%

• Consolidated financial statements present the

assets and liabilities controlled by the parent
company and the combined profitability of any
subsidiaries.

• They are prepared in addition to the financial

statements for each individual company.
 VALUATION AND REPORTING
OF INVESTMENTS

• The value of debt and equity investments may

fluctuate greatly during the time they are held.

• Conservatism principle requires accountants to use

the lower of cost and market rule. (When else is this
used?)

• Application of the LCM rule varies depending

upon whether the investment is temporary or long-
term.
 VALUATION AND REPORTING OF
TEMPORARY INVESTMENTS

• The decline in value from cost to market is

reported as a loss.

• An Allowance to Reduce Cost to Market Value

account is used to record the difference
between the cost and market value.

• The Allowance account is a contra asset and is

deducted from the cost of the investments
 VALUATION AND REPORTING OF
LONG-TERM INVESTMENTS

• Long-term investments should not be

adjusted to reflect temporary fluctuations in
market value.

• Only when a drop is NOT due to temporary

fluctuations should lower of cost and market
be used for long term investments.

• Any write-down to market value is accounted

for on the income statement as a permanent
loss. No allowance account is used.
 COMPREHENSIVE BALANCE SHEET

Assets
CURRENT ASSETS
Cash and cash equivalents $ 1,750
Temporary Investments (lower of cost and market) 25,000
Accounts Receivable $ 35,880
Less: Allowance for Doubtful Accounts (1,600) 34,280
Notes Receivable 30,000
Less: Allowance for Doubtful Notes (2,400) 27,600
Merchandise Inventory 2,500
Supplies 1,350
Prepaid Insurance 1,900
Total Current Assets $ 94,380

INVESTMENTS
Debt Invstments $ 100,000
Equity Investments, at cost 40,000
Equity Investments, at equity 30,000
Total Long-Term Investments 170,000

FIXED ASSETS
Land $ 134,000
Building $ 250,000
Less: Accumulated Amortization (40,000) 210,000
Equipment 85,770
Less: Accumulated Amortization (7,500) 78,270
Patents, net of amortization 80,000
Automobiles 33,350
Total Fixed Assets 535,620

TOTAL ASSETS $ 800,000

 Liabilities and Shareholder's Equity

CURRENT LIABILITIES
Accounts Payable $ 9,088
Bond Interest Payable 6,300
Income Tax Payble 48,000
GST Payable $ 641
Less: GST Recoverable (279) 362
PST Payable 752
Current Portion of Mortgage Payable 4,500
Bank Loan (matures 18 months) 5,000
Total Current Liabilities $ 74,002

LONG-TERM LIABILITIES
Bank Loan (matures 3 years) $ 25,000
Bonds Payable, 7% due 2011 $ 90,000
Less: Bond Discount (5,000) 85,000
Mortgage Payable, net of current portion 150,000
Total Long-Term Liabilities 260,000

SHAREHOLDER'S EQUITY
Contributed Capital
(Share Capital)
$10 Preferred shares, no par value, cumulative, (10,000 authorized, 1,000 issued) $ 50,000
Common Shares, $3 stated value, (unlimited shares authorized, 50,000 shares issued) 150,000
Total Share Capital $ 200,000
(Additional Contributed Capital)
Contributed Capital in excess of stated value - Common Shares 60,000
Total Contributed Capital 260,000

Retained Earnings (full version)

Beginning Balance, January 1, as previously reported $ 102,700
Add: Correction of overstatement of Net Income due to unrecorded sales in prior period,
net of $4,000 income tax expense $ (7,992)
Add: Cumulative effect of a change in accounting principle, completed-contract method to
percentage-of-completion method, net of $20,000 income tax expense. 40,090 32,098
Retained Earnings January 1, as adjusted 134,798
Add: Net Income 241,200
Less: Cash Dividends (150,000)
Less: Stock Dividends (20,000)
Net change in Retained Earnings for the period 71,200
Retained Earnings December 31 205,998

TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $ 800,000

 Do Problems:

P17-7A

Homework:
P17-9A
Submit word processed (use excel)