Chapter 12: Reporting and Analyzing Investments – Financial Accounting Study Notes

Reporting and Analyzing Investments

Classifying Investments

Debt Investments

Debt investments are financial assets where the investor lends money to another entity and expects repayment with interest.

• Examples: Guaranteed investment certificates, term deposits, bonds, commercial paper, and other debt securities.

• Interest Income: Earn interest over time.

• Principal Repayment: Borrower is usually obligated to return the original investment (principal).

Equity Investments

Equity investments represent ownership in another company, typically through shares.

• Examples: Preferred and common shares of other corporations.

• Income: May or may not earn any income (e.g., dividends).

• No Principal Repayment: No obligation to return principal.

Why Companies Invest

Companies invest for several strategic and financial reasons:

• Excess Cash: To utilize cash not needed for immediate operating assets.

• Investment Income: To generate cash from interest, dividends, or capital gains.

• Influence or Control: To purchase an interest in another company and exercise influence or control.

Types of Investments

Non-Strategic Investments

Non-strategic investments are made primarily for income or capital gains, not for influence or control.

• Purpose: To earn income or capital gains (trading investments).

• Includes: Both debt and equity investments.

• Classification: Short-term or long-term, depending on liquidity and management's intent.

Strategic Investments

Strategic investments are made to influence or control another company, typically through equity securities.

• Type: Only equity securities (normally common shares).

• Purpose: To influence or control operations of another company.

• Classification: Generally long-term investments.

This model requires investments to be adjusted to fair value at each reporting date.

• Carrying Amount: Changes with market price fluctuations.

• Unrealized Gains/Losses: Recorded in the statement of income.

• Formula:

$\text{Fair Value} - \text{Carrying Amount} = \text{Unrealized/realized gain (loss)}$

• Adjusting Journal Entry: Usually made at year end.

• Realized Gains/Losses: Reported when investment is sold.

Equity Method (More than 20%)

When an investor owns 20% to 50% of another company's common shares, it is presumed to have significant influence and uses the equity method.

• Initial Recognition: Investment recorded at cost in "Investment in Associates" account.

• Annual Adjustment: Investment account adjusted for investor's share of associate's net income or loss (increases or decreases account).

• Dividends: Dividends earned decrease the investment account.

Example Journal Entries:

• To record purchase: Jan 1: Investment in Associates $120,000; Cash $120,000

• To record share of net income: Dec 31: Investment in Associates $30,000; Income from Associates $30,000

• To record dividends: Dec 31: Cash $12,000; Investment in Associates $12,000

Cost Model

Used when fair value is not available, typically for private companies or non-publicly traded shares.

• Investment recorded at cost and not adjusted until sold.

• Dividend income is recognized when declared.

• Used under certain circumstances (e.g., ASPE in Canada).

Example Journal Entries:

• To record purchase: Long-Term Investments $40,000; Cash $40,000

• To record dividend: Dividend Income $2,000; Cash $2,000

• To record sale: Cash $30,000; Realized Loss on Investments $10,000; Long-Term Investments $40,000