Appendix E: Investments – Financial Accounting Study Notes

Appendix E: Investments

Introduction to Investments

Investments are financial instruments that companies use to allocate excess cash or to gain influence over other companies. Understanding the classification, measurement, and reporting of investments is essential for accurate financial accounting.

• Reasons for Investing:

  • Excess Cash: Companies invest surplus funds in debt or equity securities to earn additional income.

  • Influence: Acquiring a significant portion of another company’s stock can provide influence over its operations (e.g., securing a reliable supplier).

• Security: Any tradable financial instrument representing ownership (equity) or creditor (debt) relationships.

• Equity Security: Represents ownership in a corporation (e.g., common stock, preferred stock). Income is earned through dividends and capital gains.

• Debt Security: Represents a creditor relationship (e.g., bonds, notes payable). Income is earned through interest payments.

Example: If you purchase 10 shares of stock for $400, receive $1 per share in dividends, and sell the stock at $55 per share, your total income is the sum of dividends and capital gains.

Classification of Investments

Investments in debt or equity securities are classified into three categories, each with distinct accounting treatments:

• Trading Securities: Intended for sale in the near term through active trading.

• Available-for-Sale (AFS) Securities: Held with the intent to sell but not actively traded.

• Held-to-Maturity (HTM) Securities: Debt securities the investor intends to hold until maturity.

Classification	Initial Measurement	Subsequent Measurement	Unrealized Gains/Losses
Trading Security	Cost	Fair Value	Income Statement
Available-for-Sale Security	Cost	Fair Value	Other Comprehensive Income (OCI)
Held-to-Maturity Security	Cost	Amortized Cost	Not Recognized

Investments in Trading Securities

Definition and Income Recognition

Trading securities are investments expected to be sold in the near term. They generate income from dividends and changes in fair value.

• Dividend Revenue: Recognized when received from the investee.

• Unrealized Gains/Losses: Recognized on the income statement at each reporting date based on changes in fair value.

• Realized Gains/Losses: Recognized on the income statement when the security is sold.

Example Journal Entries

• Purchase of Trading Security: Debit Investments, Credit Cash.

• Dividend Received: Debit Cash, Credit Dividend Revenue.

• Unrealized Gain (if fair value increases): Debit Investments, Credit Unrealized Gain (Income Statement).

• Unrealized Loss (if fair value decreases): Debit Unrealized Loss (Income Statement), Credit Investments.

• Sale of Security: Debit Cash, Credit Investments, recognize gain or loss for difference.

Practice Example

If Reset Company purchased trading securities for $152,000 and their fair value is $180,000 at year-end, the balance sheet should report $180,000 (fair value).

Investments in Available-for-Sale (AFS) Securities

Definition and Income Recognition

AFS securities are investments held with the intent to sell but not actively traded. They generate income from dividends and changes in fair value.

• Dividend Revenue: Recognized when received from the investee.

• Unrealized Gains/Losses: Recognized in Other Comprehensive Income (OCI) at each reporting date.

• Realized Gains/Losses: Recognized on the income statement when the security is sold.

Example Journal Entries

• Purchase of AFS Security: Debit Investments, Credit Cash.

• Dividend Received: Debit Cash, Credit Dividend Revenue.

• Unrealized Gain (if fair value increases): Debit Investments, Credit Unrealized Gain (OCI).

• Unrealized Loss (if fair value decreases): Debit Unrealized Loss (OCI), Credit Investments.

• Sale of Security: Debit Cash, Credit Investments, recognize gain or loss for difference.

Practice Example

If Reset Company purchased AFS securities for $152,000 and their fair value is $180,000 at year-end, the balance sheet should report $180,000 (fair value).

Held-to-Maturity (HTM) Investments

Definition and Accounting

HTM securities are debt investments that the investor intends and is able to hold until maturity. They are accounted for at amortized cost, not fair value.

• Interest Revenue: Recognized when earned, based on the stated rate of the bond.

• Premium or Discount Amortization: The difference between purchase price and face value is amortized over the bond’s life.

Bond Pricing and Amortization

• Premium Bond: Purchased above face value (Stated Rate > Market Rate).

• Discount Bond: Purchased below face value (Stated Rate < Market Rate).

• Formula for Amortization Amount:

$\text{Amortization Amount} = \frac{\text{Total Bond Premium or Discount}}{\text{Total Number of Interest Periods}}$

Example Journal Entries

• Purchase of Bond: Debit Investments, Credit Cash.

• Interest Received: Debit Cash, Credit Interest Revenue; adjust for premium/discount amortization.

• Sale of Bond: Recognize gain or loss based on difference between selling price and book value.

Equity Method Investments

Significant Influence and Accounting

When an investor has significant influence over another company (typically 20%-50% ownership), the equity method is used. This method recognizes the investor’s share of the investee’s net income or loss.

• No Influence: Less than 20% ownership – use market method.

• Significant Influence: 20%-50% ownership – use equity method.

• Controlling Interest: More than 50% ownership – use consolidation method (beyond this course).

Equity Method Journal Entries

• Purchase of Investment: Debit Investment, Credit Cash.

• Share of Net Income: Debit Investment, Credit Investment Income (proportionate share of investee’s net income).

• Share of Net Loss: Debit Investment Loss, Credit Investment.

• Dividends Received: Debit Cash, Credit Investment (dividends reduce the carrying value of the investment).

• Sale of Investment: Recognize gain or loss based on difference between selling price and book value.

Formula:

$\text{Investment Income} = \text{Ownership \%} \times \text{Net Income of Investee}$

Practice Example

If a company owns 35,000 of 87,500 shares (40%) of another company, purchased for $400,000, and the investee reports $240,000 net income and pays $60,000 dividends, the carrying value at year-end is:

• Initial Investment: $400,000

• Add: 40% of $240,000 net income = $96,000

• Less: 40% of $60,000 dividends = $24,000

• Ending Carrying Value: $400,000 + $96,000 - $24,000 = $472,000

Summary Table: Investment Classifications

Type	Measurement	Unrealized Gains/Losses	Income Recognition
Trading	Fair Value	Income Statement	Dividends, Realized/Unrealized Gains/Losses
Available-for-Sale	Fair Value	Other Comprehensive Income	Dividends, Realized Gains/Losses
Held-to-Maturity	Amortized Cost	Not Recognized	Interest Revenue, Realized Gains/Losses
Equity Method	Cost + Share of Net Income - Dividends	Not Applicable	Share of Net Income/Loss

Additional info: This summary expands on the provided notes with definitions, formulas, and examples to ensure a comprehensive, self-contained study guide for financial accounting students.