Chapter 7: Investments

Companies often invest their spare cash, or buy stakes in other companies for strategic reasons. This chapter explains how such investments in debt securities (bonds) and equity securities (shares) are classified, recorded and reported. The key idea: the accounting depends on what kind of security it is, how long the company intends to hold it and, for shares, how much influence the investor has.

Why companies invest and how investments are classified

The investor owns the bond or share; the investee issued it. A security is a share or interest representing financial value. Debt securities are investments in notes or bonds issued by another company; equity securities are investments in the stock of another company. Companies invest to earn income on excess cash, or as a business strategy, for example to strengthen a relationship with a supplier. Investments the company intends to sell within one year are short-term (current assets); others are long-term.

Investments in debt securities

Three events are recorded: the purchase, the interest revenue, and the disposition at maturity. Smart Touch Learning pays $100,000 on 1 July for $100,000 face value, 9%, five-year bonds and plans to hold them to maturity:

On 31 December it receives six months of interest: 100,000 × 9% × 6/12 = $4,500 (Dr Cash, Cr Interest revenue). At maturity it receives the face value: Dr Cash 100,000, Cr Held-to-maturity debt investments 100,000. Because the bonds were bought at face value, interest revenue equals the cash interest. In the exercise Swisher Brothers buys $800,000 of 5% bonds at face value: each semi-annual payment is 800,000 × 5% × 6/12 = $20,000.

Equity securities without significant influence (fair value method)

Smart Touch Learning buys 1,000 shares of Yellow Corporation at $26.16 (less than 20%): Dr Equity investments 26,160, Cr Cash 26,160. A cash dividend of $0.16 per share brings in $160: Dr Cash, Cr Dividend revenue. Later it sells 800 shares for $25,000. Their cost was 800 × 26.16 = $20,928, so it records a gain on disposal of $4,072. The investee's net income is not recorded by the investor.

Equity securities with significant influence (equity method)

With 20% to 50% ownership the investor's share of the investee's results is treated as its own:

• Purchase: record the investment at cost.
• Investee's net income: increase the investment and record revenue for the investor's percentage share.
• Dividends received: decrease the investment account (the investee pays out part of the value the investor already recognised), no revenue.

Smart Touch Learning pays $400,000 for 40% of Kline. Kline pays a $50,000 dividend: Dr Cash 20,000, Cr Equity investments 20,000. Kline earns $125,000: Dr Equity investments 50,000, Cr Revenue from investments 50,000. The investment is now 400,000 − 20,000 + 50,000 = $430,000. If one tenth of this holding is later sold for $40,000, the carrying amount sold is $43,000 and a loss of $3,000 results.

Controlling interest (consolidation)

With more than 50% of the voting stock the investor is the parent company and the investee the subsidiary. The parent prepares consolidated statements that combine the balance sheets and income statements of both companies as if they were one entity. The mechanics are outside the scope of this course.

Reporting debt and equity securities at fair value

Fair value is the price at which the investment could be sold on the market. At each balance sheet date, trading and AFS debt investments (and equity investments without significant influence) are adjusted to fair value through a fair value adjustment account. The difference is an unrealized holding gain or loss: unrealized because the investment has not been sold.

• Trading: Smart Touch Learning's trading investments cost $26,160 and are worth $24,000 at year end. Unrealized loss of $2,160: Dr Unrealized holding loss, Cr Fair value adjustment. The loss appears under Other income and (expenses) on the income statement, so it reduces net income.
• Available-for-sale: AFS investments that cost $60,000 are worth $64,000. The $4,000 unrealized gain is not part of net income; it goes to other comprehensive income and accumulates in a separate line in stockholders' equity.
• Held-to-maturity: reported at amortized cost; fair value changes are ignored because the company will hold the bonds until they are repaid anyway.

Comprehensive income is the change in total stockholders' equity from all sources other than owners' investments and dividends. It is net income plus other comprehensive income items: unrealized holding gains and losses on AFS investments, foreign currency translation adjustments, gains and losses on post-retirement benefit plans and deferred gains or losses on derivatives.

When an investment is sold, the gain or loss is computed against its cost; the fair value adjustment is ignored in that calculation.

Rate of return on total assets

A company finances its assets with debt (creditors) and equity (stockholders). The rate of return on total assets measures the return to both groups, so interest expense, the creditors' return, is added back to net income:

Kohl's: (801 + 256) / 12,929 = 8.2%. Compare ROA from chapter 1 (net income only): 6.2%.