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Chapter 15

Investments

Review of Learning Objectives

LO1 Identify and explain the management issues related to investments.

Investments are recorded on the date on which the transaction occurs, at which time there is either a transfer of funds or a definite obligation to pay. Investments are recorded at cost, or purchase price, including any commissions or fees. After the purchase, the balance sheet value of investments is adjusted to reflect subsequent conditions. Investments are classified as short term or long term; trading, available-for-sale, or held-to-maturity securities; and noninfluential and noncontrolling, influential but noncontrolling, or controlling investments. These classifications play an important role in accounting for investments. Noninfluential and noncontrolling investments represent less than 20 percent ownership; influential but noncontrolling investments represent 20 percent to 50 percent ownership; and controlling investments represent more than 50 percent ownership. A company should disclose its accounting policies for investments and related details in the notes to its financial statements. Managers must avoid using their knowledge of a company’s planned investment transactions for personal gain.

LO2 Explain the financial reporting implications of short-term investments.

Short-term investments in stocks are classified as trading securities or available-for-sale securities. Trading securities, which are debt or equity securities bought and held principally for the purpose of being sold in the near term; are classified as current assets on the balance sheet and are valued at fair value. Unrealized gains or losses on trading securities appear on the income statement. Available-for-sale securities, which are debt or equity securities that do not meet the criteria for either trading or held-to-maturity securities, are accounted for in the same way as trading securities with two exceptions: (1) an unrealized gain or loss is reported as a special item in the stockholders’ equity section of the balance sheet; (2) if a decline in the value of a security is considered permanent, it is charged as a loss on the income statement.

LO3 Explain the financial reporting implications of long-term investments in stock and the cost-adjusted-to-market and equity methods used to account for them.

The cost-adjusted-to-market method is used to account for noninfluential and noncontrolling investments in stock. With this method, investments are initially recorded at cost and are then adjusted to market value by using an allowance account. The equity method is used to account for influential but noncontrolling investments. With this method, the investment is initially recorded at cost and is then adjusted for the investor’s share of the company’s net income or loss and subsequent dividends. Consolidated financial statements are required when an investing company has legal and effective control over another company. Control exists when the parent company owns more than 50 percent of the voting stock of the subsidiary.

LO4 Explain the financial reporting implications of consolidated financial statements.

Consolidated financial statements are useful to investors and others because they treat the parent company and its subsidiaries as an integrated economic unit. When a consolidated balance sheet is prepared at the date of acquisition, a work sheet entry is made to eliminate the investment from the parent company’s financial statements and the stockholders’ equity section of the subsidiary’s financial statements. The assets and liabilities of the two companies are combined. If the parent owns less than 100 percent of the subsidiary, minority interest equal to the percentage of the subsidiary owned by minority stockholders multiplied by the subsidiary’s net assets appears on the consolidated balance sheet. If the cost of the parent’s investment in the subsidiary is greater than the subsidiary’s book value, an amount equal to the excess of cost over book value is allocated to undervalued subsidiary assets and to goodwill. If the cost of the parent’s investment in the subsidiary is less than book value, the excess of book value over cost should be used to reduce the book value of the subsidiary’s long-term assets (other than long-term marketable securities).

When consolidated income statements are prepared, intercompany sales, purchases, interest income, interest expense, and other income and expenses from intercompany transactions must be eliminated to avoid double counting of these items.

The financial statements of foreign subsidiaries must be restated in terms of the parent company’s reporting currency before consolidated financial statements can be prepared.

LO5 Explain the financial reporting implications of debt investments.

Held-to-maturity securities are debt securities that management intends to hold to their maturity date; they are valued on the balance sheet at cost adjusted for the effects of interest. Long-term investments in bonds fall into two categories: available-for-sale securities, which are recorded at cost and subsequently accounted for at fair value, and held-to-maturity securities.

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