1 Unit Three Accounting for Long term Investments Objectives of long term investments Usually, a business enterprise may make long term investments in the securities of other companies for many reason[.]
Unit Three Accounting for Long term Investments Objectives of long term investments Usually, a business enterprise may make long term investments in the securities of other companies for many reasons For example, investments may be used to create close ties to major suppliers or retail outlets The rights of ownership inherent in common stock investments give an investor investing in such securities a degree of influence or control over the management of the investee Thus, many enterprises use investments in common stocks as a means of gaining control over competitors, acquiring ownership of a company with a strong cash position, or diversifying their investment portfolio by acquiring an ownership interest in investees in order to obtain dividend revenue and capital appreciations Consolidated financial statements A company that acquires a controlling interest in the common stock of another company is termed as the parent company while the controlled company which sales investment securities is said to be the subsidiary company The investment in the common stock of the subsidiary is a long term investment for the parent company In reporting these issues, in addition to the separate financial statements prepared for the parent and the subsidiary company, consolidated financial statements are often prepared to reflect such investment conditions When such financial statements represent more than one corporation, we refer to them as consolidated financial statements Accounting for acquisition costs of long term investments The cost of an investment in long term investment securities includes the acquisition price plus brokerage fees and any other expenditure that may be incurred in the transaction If assets other than cash are given in payment for the securities and the current fair value of such noncash assets is unknown, the current market price of the securities may be used to establish the cost of the securities acquired and the value of the noncash assets given in exchange When neither a market price for the securities nor the current fair value of the assets given in exchange is known, accountants must rely on independent appraisals to establish values for recording the transaction Furthermore, if two or more securities are acquired for a lump sum or single price, the total cost should be allocated among the various securities If the various securities acquired are publicly traded, the existing market prices serve as the basis for apportionment or allocation of the total cost Such type of cost apportionment is termed as relative market value allocation Example: Assume that Hawassa’s Company acquires from Adama’s Company 100 units of five shares of common stock and one share of preferred stock each, at a price of Br 240 a unit, when the common stock and preferred stock are trading at Br 30 and Br 100 a share, respectively Required: Compute the cost allocated to each kind of security Solution: Total cost of acquisition = 100 x 240 = Br 24,000 Market price of each unit = (Br 30 x 5) + (Br 100 x 1) = Br 250 The portion of the cost allocated to the common stock = Br 150 x Br 24,000 Br 250 = Br 14,400 The portion of the cost allocated to the preferred stock = 100 x Br 24,000 250 = Br 9,600 If only one class of the stock is publicly traded, that class usually is recorded at its market value, and the remaining portion of the cost is considered as the cost of the other class When either class of stock trade in the open market, the apportionment of the cost may have to be delayed until current fair values or market values of the securities are established Methods of accounting for long term investment in common stock It is vital to remark here that stock investments are investments in the capital stock of a corporation When a company holds stock of several different corporations, the group of securities is identified as investment portfolio The return on investment in common stock consists of the stream of dividend received from the investment and a portion of net income retained in the company which will increase the investees stockholder’s equity Accounting for investments in common stock depends on the extent of the investor’s influence over the operating and financial affairs of the issuing corporation (the investee) The accounting method applied will differ based on the degree of influence The following table shows ownership interest, presumed influence on investee and the appropriate accounting guidelines for long term investments in common stocks Investor’s ownership interest in investee’s common stock Degree of influence on investee Accounting guidelines Less than 20% Insignificant (no control) Cost method Between 20% and 50% Significant influence Equity method Greater than 50% Control Consolidated financial statement The cost method of accounting for long term investment in common stocks As presented in the above table, the cost method of accounting for the investment in common stock is appropriate when an investor owns only a small portion (for example, less than 20%) of the total outstanding common stock of an investee so that the investor has little or no influence over the investee In this case, the investor cannot influence the investee’s dividend policy, and the only portion of the investee’s income that reaches the investor is the dividends paid by the investee Thus, when the investor has little or no influence over the investee, the dividends received represent the only return realized by the investor Under this method a long term investment is originally recorded and reported at cost It continues to be carried and reported at cost in the investments account until it is either partially or entirely disposed of, or until some fundamental change in conditions makes it clear that the value originally assigned can no longer be justified Revenue is recognized by the investor only to the extent of dividends received In this case, it is assumed that the investor purchased the stock primarily to earn dividends or realize gains on price increases of the stock The entries for stock investment under cost method are illustrated for various investment scenarios as indicated in discussions that follow Purchase of stock To illustrate, assume that on June 2, 2010, Jegol Corporation acquired 10,000 shares (10% ownership) of Sheger Corporation common stock at Br 50 per share plus brokerage fees of Br 10,000 Required: Pass the entry for the purchase Solution: June 2, 2010: Investments in Sheger Co common stock…….510,000 Cash………………………………………………510,000 (To record purchase of 10,000 shares of Sheger Company common stock) Recording dividends During the time the company holds the stock, it makes entries for any cash dividends received Thus, if Jegol Corporation receives a Br per share dividend on December 31, the entry is: December 31 Cash (10,000 × Br 3)…………… 30,000 Dividend Revenue………………………… 30,000 (To record receipt of a cash dividend) Jegol Corporation reports dividend revenue under “other revenues and gains” in the income statement However, if a material portion of the dividends received represents a distribution of investee’s earnings realized prior to the time the stock was acquired, that portion of the dividends is a return of capital (a liquidating dividend), not revenue Because liquidating dividends represent a return of capital, receipt of such dividends by the investor is recorded by a credit to the investment ledger account To illustrate the accounting for a liquidating dividend, assume that Alexander Company acquired 15% of outstanding common stock of Duran Company early in Year During Year 1, Duran reported net income of Br 100,000 and paid a cash dividend of Br 150,000 Because the dividend exceeded by a material amount the net income of Duran for the period Alexander owned Duran common stock, Alexander records the dividend as follows: Cash (Br 150,000 x 0.15)…………………………… 22,500 Dividend revenue (Br 100,000 x 0.15)………………….15, 000 Investment in Duran Company Common Stock……….… 7,500 (To record receipt of dividend, including distribution of Br 7,500 in excess of net income since the investment was acquired) The equity method of accounting for long-term investments in common stock When an investor Company acquires sufficient ownership in the voting stock of an investee Company to have significant influence over the affairs of the investee Company but less than a controlling interest, the investment is accounted for using the equity method The investment is originally recorded at the cost of the shares acquired but is subsequently adjusted each period for changes in the net assets of the investee That is, the investment’s carrying amount is periodically increased (decreased) by the investor’s proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee The equity method recognizes that investee earnings increase investee net assets that underlie the investment, and that investee losses and dividends decrease these net assets Conceptually, the equity method treats the investee company as if it were condensed into one balance sheet item and one income statement item and then merged into the investor company at the proportion owned by the investor In the absence of evidence to the contrary, investments in which the investor company owns 20 percent or more of the outstanding voting stock of the investee Company, the investor company is presumed to have significant influence over the investee company Thus, when an investor has an investment in the common stock of an investee company that results in significant influence but not control over the investee, the investment is accounted for by the equity method To illustrate the equity method of accounting, assume that on January 2, year 1, Investor Company acquired 40% of the common stock of Lee Company for Br 300,000, which corresponded with the carrying amount of Lee’s net asset On December 31, year1, Lee reported net income of Br 70,000 (including a Br 10,000 extraordinary gain) and declared and paid dividend of Br 30,000 Investor Company accounts for its investment in Lee Company as follows (disregarding income tax effects): Year Jan Investment in Lee company common stock……………….300,000 Cash ………………………………………………… 300,000 (To record acquisition of 40% of common stock of Lee company at carrying amount of Lee’s net assets) Dec 31 Investment in Lee company common stock………………….28, 000 Investment Income (ordinary)………………24,000 Investment income (extraordinary)…… 4,000 [To record 40% of net income of Lee company for year (60,000 x 40% = Br 24,000; 10,000 x 40% = Br 4,000] Dec 31 Cash (30,000 x 40%) ………………………………….12,000 Investment in Lee company common stock…………12,000 (To record dividend received from Lee Company) After the foregoing journal entries have been posted, the investment and investment income ledger accounts appear as follows (before closing entries for the investment income accounts): Investment in lee company common stock Date Explanation Debit Jan Cost of investment 300,000 Dec Share of net income (Br 70,000 x 31 0.40) Credit Balance Year 300,000 28,000 dr 12,000 31 Dividends Received (Br 30,000 x 328,000 dr 0.40) 316,000 dr Investment income (ordinary) Date Explanation Debit Credit Balance 24,000 24,000 cr Credit Balance 4,000 4,000 cr Year Dec Share of net income (Br 60,000 x 31 0.40) Investment income (extraordinary) Date Explanation Debit Year Dec Share of net income (Br 10,000 x 31 0.40) Note that the net effect of Investor’s accounting for Lee’s net income and dividends was to increase the balance of the investment ledger account by Br 16,000 This correspondents with 40% of the increase in Lee’s net assets as a result of undistributed earnings during Year [(Br 70,000 – Br 30,000) x 0.40 = Br 16,000) Example The following transactions were occurred in the years 2010 and 2011: Jan 5, 2010: Selam Company acquired 24, 000 shares (20% of Alex Company common stock) at a cost of Br 10 per share Dec 31, 2010: Alex Company reported net income of Br 100, 000 Jan 20, 2011: Alex Company announced and paid a cash dividend of Br 60, 000 Dec 31, 2011: Alex Company reported a net loss of Br 30, 000 Required: Present the journal entries required to account for the investment in the books of Selam Company, using a) Cost method of accounting b) Equity method of accounting Solution: a) Cost Method of Accounting b) Equity Method Accounting (1) Jan 5, 2010 (1) Jan 5, 2010 Investment in Alex Company Investment in Alex Company Common Stock (24,000 x 10) 240, 000 Common stock…………… 240, 000 Cash ……………….240,000 Cash ……………….240,000 (2) Dec 31, 2010 No entry (3) Jan 20, 2011 Cash (20% x Br 60, 000)…… 12,000 Investment income…………….12,000 (4) Dec 31, 2011 No entry (2) Dec 31, 2010 Investment in Alex Company Common Stock (20% x Br 100,000)…….20,000 Investment income…………… 20,000 (3) Jan 20, 2011 Cash……………………….12,000 Investment in Alex Company Common Stock…………… 12, 000 (4) Dec 31, 2011 Loss on investment (20% x 30,000)………… 6, 000 Investment in Alex Company Common Stock……………… 6, 000 Problems in the application of the equity method Four problems may arise in the application of the equity method of accounting Let us see them separately: Intercompany profits (gains) or losses: These are resulted from transaction between the investor and the investee For example, an investor or an investee may sell merchandise or, less frequently, plant or intangible assets to its affiliate If so, any unrealized profit (gain) or loss must be excluded from the net income of the investor To illustrate, assume that on November 30, year 2, Investor Company sold merchandise costing Br 50, 000 to 30,000 0.375 On Lee Company for Br 80, 000, or for a gross profit rate of 371/2% 80,000 December 31, year 2, the inventories of Lee included Br 60, 000 (at billed price) of this merchandise In addition, on December 31, year 2, Lee sold merchandise that cost Br 30,000 to Investor for Br 50,000; none of this merchandise was sold by Investor to its customers on that date If Lee reported net income of Br 95,000 (none of which was an extraordinary item) for year 2, but did not declare or pay dividends for that year Investor Company has a 40% ownership in Lee Company Under the equity method, the following journal entries are required on December 31, year Investment in Lee Company Common stock [(Br 95,000 – Br 20,000) x 0.40]………….30, 000 Investment income…………………………………………….…30, 000 [To record 40% of net income of Lee Company for year after elimination of Br 20,000 unrealized gross profit (Br 50,000 – Br 30, 000 = Br 20,000) remaining in investor’s inventories on December 31, year 2] Income summary (Br 60, 000 x 0.375)……………………… 22,500 Deferred gross profit on sales……………………………………22,500 (To defer unrealized gross profit attribute to merchandise in Lee Company’s inventories on Dec 31, year 2) The net effect of the two foregoing journal entries is to reduce investor’s net income by Br 30,500, computed as follows: Investor’s share of unrealized gross profit of Lee Company (Br 20,000 x 0.40)Br 8,000 Investor’s unrealized gross profit on sales to Lee Company (60,000 x 0.375)… .22,500 Total reduction of investor’s net income……………………………………… Br 30,500 A review of the foregoing illustration of intercompany profits emphasizes the necessity of excluding unrealized intercompany profits (gains) and losses from an investor’s net income The investor’s ability to influence the operating and financial policies of an investee enables the investor to determine to a large degree the quantity and unit price of merchandise sold by investor to investee, and vice versa Obviously, if unrealized intercompany profits were not eliminated from the investor’s net income, the investor might reach the desired earnings per share amount merely by selling merchandise to, or purchasing merchandise from, an investee Cost in excess of equity acquired: - Often an investor will pay more than the underlying equity of an investment because current fair values of the investee’s identifiable assets may be larger than their carrying amounts, or because the investee has unrecorded goodwill or other intangible assets In either case, the excess amount would be amortized over the economic lives of the undervalued assets or the unrecorded assets as follows: Investment income (ordinary) ……………………………xxx Investment in investee company common stock…………………… xxx (To adjust investment income for amortization of excess of cost over underlying equity of investee’s net assets) Cost less than equity acquired: - When an investor acquires an investment in common stock at a cost less than the underlying equity, it is assumed that specific identifiable assets of the investee are overvalued If these assets have limited economic lives, the investor allocates the excess of the underlying equity over cost to investment income over the economic lives of the assets as follows: Investment in investee company common stock………………xxx Investment income (ordinary)………………………………………………….xxx (To adjust investment income for amortization of excess of underlying equity of investee’s net assets over cost) 10 Assume an Investor invested in Br 100,000 of five year, 7% term bond on January 2, year The bond promised to pay Br 100,000 at the end of the five years and Br.7, 000 (7% x Br.100, 000) annual interest The bond pays interest annually Required Under the following three alternative effective rate of interest, determine the acquisition cost of the bond and give the appropriate journal entries for the investor i If the effective market interest rate is 7% ii If the effective market interest rate is 6% iii If the effective market interest rate is 8% Solution i Effective rate (r) = 7% PV Br 100,000 (1 + 0.07) ) (1 + 0.07) 0.07 Br 7,000(1 PV Br.100,000 Since the bond nominal rate is equal to the effective rate, the acquisition price of the bond is the same as the face value The following is the appropriate journal entry in the book of the investor Year Jan Investment in issuer company bonds…………………………100,000 Cash……………………………………………………………… 100,000 (To record the acquisition of bonds at a face value) ii Effective rate (r) = 6% PV Br 100,000 (1 0.06) ) (1 0.06) 0.06 Br 7,000(1 PV Br.104,213 14 Since the effective rate is less than the nominal rate, the bond is said to be acquired at Premium The Premium amount is Br.4, 213 (Br.104, 213 - Br.100, 000) The journal entry to record the acquisition is as follows: Year Jan Investment in issuer company bonds…………………………104,213 Cash……………………………………………………………… 104,213 (To record the acquisition of bonds at a premium) iii Effective rate (r) = 8% PV Br 100,000 (1 0.08) ) (1 0.08) Br 96,007 0.08 Br 7,000(1 Since the effective rate is greater than the nominal rate, the bond is said to be acquired at discount The discount amount is Br.3, 993 (Br.100, 000 - Br.96, 007) The journal entry to record the acquisition is as follows: Year Jan Investment in issuer company bonds…………………………96,007 Cash………………………………………………………… 96,007 (To record the acquisition of bonds at a discount) Acquisition of bonds between interest rates Dear learners! Interest on a bond contract accrues with the passage of time in accordance with the provisions of the contract The issuer pays the contractual rate of interest on the stated date to the investor owning the bond on that date If bonds are purchased between interest payment dates, the investor who acquires a bond between interest payment dates must pay the owner the market price plus the interest accrued since the last interest payment date The investor will collect this interest plus the additional interest earned by holding the bond to the next interest date Example On July 1, an investor acquired bonds having a Br 10,000 face value of Geda Company, which had been issued several years ago The bond contract provides for interest at 8% a 15 year, payable semiannually on April and October The market rate of interest is higher than 8% at the present time, and the bonds are currently quoted at 97 3/4 plus accrued interest for three months Required Pass the journal entry for the investor to record the purchase of the bonds and accrued interest Solution: Investment in Geda Company Bonds (Br 10,000 x 0.9775) ………….… 9,775 Interest receivable (Br 100, 000 x 0.08x 3/12)………………………….… 200 Cash…………………………………………………………………………9,975 (To record acquisition of 10,000 bonds plus accrued interest of Br 200 for three months) The Br 200 paid by the investor for accrued interest may be debited to interest revenue; if so, when the first Br 400 interest payment (Br 10,000 x 0.08 x 6/12 = Br 400) is received on October 1, the entire amount is credited to interest revenue Discount and premium on long-term investments in bonds On the date of acquisition of bonds, the investment ledger account is debited for the cost of acquiring the bonds, including brokerage and other fees, but excluding any accrued interest A separate discount or premium ledger account as a valuation account is not usually used The subsequent treatment of the investment might be handled in one of the three ways: 1) the investment might be carried at cost, ignoring the accumulation of discount or amortization of premium; 2) the investment ledger account balance might be revalued periodically to reflect market value changes; or 3) The discount or premium might be accumulated or amortized to reflect the change in the carrying amount of the bonds based on the effective rate of interest prevailing at the time of acquisition 16 The first alternative is used primarily in accounting for short-term bond investments, for convertible bonds, and for other bonds for which the discount or premium is insignificant The second alternative is not in accord with the present interpretation of the realization principle or the concept of conservatism, especially during periods of rising bond prices When the investment in bonds is in jeopardy because of serious cash shortages of the issuer, it generally is acceptable to write the investment down to its expected net realizable value and to recognize a loss The third alternative is the preferred treatment for long-term investments in bonds This approach recognizes that the interest revenue represented by the discount, or the reduction in interest revenue represented by the premium, accrues over the term of the bonds This method is consistent with the principle that requires assets other than cash and receivables to be recorded at cost Interest revenue The periodic interest payments provided for in a bond contract represents the total interest revenue to an investor holding a bond to maturity only if the investor acquired the bond at its face amount If an investor acquires a bond at a premium, the amount received on maturity of the bond will be less than the amount of the initial investment, thus reducing the cumulative interest revenue by the amount of the premium Similarly, if the bond is acquired at a discount, the amount received at maturity will be larger than the initial investment, thereby increasing the cumulative interest revenue by the amount of the discount When an investor intends to hold bonds to maturity, there is little logic in treating the discount or premium as a gain or loss occurring on the maturity date Rather, the increase in the carrying amount of the bonds as a discount disappears should be viewed as part of the revenue accruing to the investor over the entire period the bonds are owned Similarly, the decrease in value when a premium disappears is a cost the investor is willing to incur during the holding period to receive periodic interest payment higher than the market rate at the time the bonds were acquired Thus, the amount of discount or premium is viewed as an integral part of the periodic interest revenue earned by the investor The accumulation of a discount increase periodic interest revenue, and the amortization of a premium decrease periodic interest revenue The investor should 17 accumulate discount and amortize premium in order to properly measure interest revenue periodically Methods of discount accumulation or premium amortization There are two methods used to accumulate discount and amortize premium These are interest method and straight line methods The following section discusses about these two methods exhaustively Interest method This method produces a constant rate of return on the investment in bonds The interest revenue is computed for each interest period by multiplying the balance of the investment at the beginning of the period by the effective interest rate at the time the investment was made The accumulation of the discount (or amortization of the premium) thus is 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑑 − 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡 𝑏𝑦 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑎𝑚𝑚𝑜𝑟𝑡𝑖𝑧𝑒𝑑 = 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑑 𝑏𝑦 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 Straight-line method The discount or premium is spread uniformly over the term of the bonds The periodic discount to be accumulated or premium to be amortized = Total premiumdiscount number of periods Periodic interest revenue = Periodic cash receipt + discount accumulated Or periodic cash receipt - premium amortized Example Addis Company acquired Br 1,000,000, 10% bonds of Tana Company that will mature after 25 years The bonds yield 12% compounded semi-annually The bonds pay interest semi-annually starting six months from date of acquisition Required: Based on the above information: Compute the periodic interest to be collected on the investment Compute the acquisition price of the bonds 18 Compute the amount of the periodic accumulation of discount using the straight line method Present the journal entry necessary to record the acquisition of the bonds Present the journal entry necessary to record receipt of interest at the end of the first six-month period using (a) the interest method and (b) the straight-line method Present the journal entry necessary to record receipt of interest at the end of the second six-month period using (a) the interest method and (b) the straight-line method Solution: Periodic interest to be collected = Br 1,000,000 x 0.1 x ½ = Br 50, 000 Present value of Br 1000,000 discounted at 6% for 50 six-month periods (Br 1,000,000 x 0.054288)……………………………………… Br 54,288 Add: Present value of ordinary annuity of 50 rents of Br 50,000 discounted at 6% (50,000 x 15.761861)……………………… 788,093 Acquisition price of bonds………………… ……………………… Br 842,381 Or PV PV P (1 + r) n Br 1000,000 (1 0.06) 50 I (1 ) (1 + r) n r ) (1 0.06) 50 0.06 Br 50,000(1 PV = Br 842,381 Discount = Br 1,000, 000 – Br 842,381 = Br 157,619 Amount of periodic accumulation of discount using the straight line method = Br 157, 619 50 = Br 3,152 Journal entry to record acquisition Investment in Tana Company bonds………………………………… 842,381 19 Cash……………………………………………………………………842,381 Journal entry to record receipt of interest at the end of the first six-month period a Interest method Cash…………………………………………50, 000 Investment in Tana Company bonds……… 543 Interest Revenue………………………………………50, 543 Computation of discount accumulated: Interest Revenue (Br 842,381 x 12/100 x ½) = Br 50,543 Less: Interest receipt ……………………… 50, 000 Accumulation of discount………………… Br 543 b Straight-line method Cash……………………………………… 50, 000 Investment in Tana Company bonds……… 3, 152 Interest Revenue………………………………………53, 152 At the end of the second six-month period a Interest method Cash…………………………………………50, 000 Investment in Tana Company bonds………… 575 Interest Revenue………………………………………50, 175 Computation of discount accumulated: Interest revenue (Br 842,381 + Br 543) x 12/100 x ½ = Br 50,575 Less: Interest receipt…………………………………… 50, 000 Accumulation of discount……………………………… Br 575 b Straight-line method Cash…………………………………………50, 000 Investment in Tana Company bonds………… 3,152 Interest revenue………………………………………….53, 152 Refer to the previous example of Addis Company and assume that the bonds yield 8% compounded semiannually 20