Appendix E: Investments – Financial Accounting Study Notes

Appendix E: Investments

Introduction

This section covers the accounting for investments, focusing on why companies invest in other companies, and the methods used to account for equity and debt securities. Understanding these concepts is essential for analyzing financial statements and making informed business decisions.

Why Companies Invest in Other Companies

Purposes of Investments

• Short-term investments: Companies use excess cash to earn additional income through interest, dividends, and gains on securities. These investments can be quickly converted to cash for operational needs.

• Long-term strategic investments: Companies may invest to gain influence or control over other companies, supporting strategic business objectives.

Example: Apple Inc.'s consolidated balance sheet shows that cash and investments in other companies make up about 35.7% of its total assets, highlighting the significance of such investments.

Classification on the Balance Sheet

• Short-term investments: Reported as current assets if they are liquid and intended to be converted to cash within one year or the operating cycle.

• Long-term investments: Classified as long-term assets if they do not meet both criteria for short-term classification.

Types of Securities

• Equity securities: Investments in the capital stock of other companies.

• Debt securities: Investments in bonds or notes payable issued by other entities.

Methods of Accounting for Equity Investments

Overview by Percentage of Ownership

• Insignificant influence: Less than 20% ownership.

• Significant influence: 20% to 50% ownership.

• Controlling influence: More than 50% ownership.

Investments with Insignificant Influence

Accounting Treatment

• Investments are measured at fair value.

• Unrealized gains and losses are recognized in other income/(expense), net.

• Dividends received are recorded as dividend revenue.

• The cost of securities sold is determined using the specific identification method.

Example: Apple Inc. Purchases Intel Stock

• Apple buys 5,000 shares of Intel at $20 per share ($100,000 total), owning less than 1% of Intel (insignificant influence).

• Dividends received are recorded as income.

• At year-end, investments are adjusted to fair market value (e.g., if the value rises to $22 per share, the investment is adjusted to $110,000).

• Unrealized gains/losses are recognized before the securities are sold.

• When sold, realized gains/losses are recognized based on the difference between sale price and carrying amount.

Investments with Significant Influence

Equity Method

• Used when the investor owns 20% to 50% of the investee’s voting stock.

• The investor records its share of the investee’s profits and losses in its income statement.

• Dividends received reduce the carrying amount of the investment.

Example: Intel’s Investment in I M Flash Technologies

• Intel buys 49% of I M Flash Technologies for $490 million.

• If I M Flash Technologies reports $300 million net income, Intel records 49% ($147 million) as income.

• Dividends paid by the investee reduce the investment account.

Investments with Controlling Influence

Consolidation Accounting

• Investor owns more than 50% of the investee’s voting stock, gaining control.

• The investor is called the parent company; the investee is the subsidiary.

• Financial statements of the parent and subsidiaries are combined into a single set, eliminating intercompany accounts.

• This provides a comprehensive view of the group’s operations.

Example: Intel Corporation is the parent of McAfee, Inc., as shown in the ownership structure diagram above.

Additional info: Intel owned controlling interests in nearly 30 subsidiaries at the end of fiscal 2022, including Intel Capital Corporation, Mobileye Global Inc., Intel Semi Conductors Ltd., Intel Asia Holding Limited, Arizona Fab LLC, and Altera Corporation.

Accounting for Investments in Debt Securities

Types of Debt Securities

• Trading securities: Intended to be held for less than a year.

• Available-for-sale securities: Intended to be held for more than a year but not until maturity.

• Held-to-maturity securities: Intended to be held until maturity.

Held-to-Maturity Securities

• Reported using the amortized cost method.

• Interest is received semi-annually.

• Usually issued in $1,000 denominations; prices quoted as a percentage of par.

• Market rate > face rate: bonds sell at a discount.

• Market rate < face rate: bonds sell at a premium.

Example: Intel Capital Purchases Bonds

• Intel Capital buys $10,000 of 6% CBS bonds at 95.2 on April 1, 2024, intending to hold until maturity (April 1, 2028).

• Interest is paid semi-annually (April 1 and October 1).

• At year-end, the investment is reported at amortized cost, reflecting any premium or discount amortization.

Summary Table: Methods of Accounting for Investments

Ownership Percentage	Influence	Accounting Method
Less than 20%	Insignificant	Fair Value Method
20% to 50%	Significant	Equity Method
More than 50%	Controlling	Consolidation

Key Formulas

• Unrealized Gain/Loss: $\text{Unrealized Gain/Loss} = \text{Fair Value at Year-End} - \text{Cost}$

• Realized Gain/Loss on Sale: $\text{Realized Gain/Loss} = \text{Sale Price} - \text{Carrying Amount}$

• Equity Method Income Recognition: $\text{Investor's Share of Income} = \text{Investee Net Income} \times \text{Ownership Percentage}$

• Bond Price Calculation (at Discount or Premium): $\text{Bond Price} = \text{Face Value} \times \text{Quoted Price \%}$