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or used as part of a company’s operating activities.
cle, is longer than a year. An operating cycle is the period from
The company uses those assets to produce and sell
the time cash is paid for inventory until the inventory is sold and
goods and services. Accounts receivable and inven-
converted back to cash. In these cases, the company uses the
tories are examined in Chapter F13 when we con-
longer operating cycle, rather than the fiscal year, as a basis for
sider operating activities. (Prepaid expenses were
determining its current assets.
discussed in an earlier chapter.) Cash is created and
F404 SECTION F2: Analysis and Interpretation of Financial Accounting Information
407
Investing Activities

used in all types of activities. We consider the effects of investing activities on cash in
this chapter.
Long-term assets include assets a company uses to produce and sell its products.
These assets provide benefits to a company that extend beyond the coming fiscal year
or operating cycle. Long-term assets usually are divided into four categories, though
some companies choose not to invest in all four categories.
Long-term investments are investments in financial securities. These securities are
debt or equity issued by other companies or organizations.
Property, plant, and equipment includes investments in tangible assets, such as
equipment, buildings, and land, that a company intends to use in the future to pro-
duce or sell its products. The amount paid for these assets, their cost, is reported on
the balance sheet or in a note to the balance sheet. In addition, the amount of depre-
ciation recorded on the assets since they were acquired is reported as accumulated de-
preciation, either on the balance sheet or in a note. The difference between the cost of
these assets and accumulated depreciation is the amount actually used to compute to-
tal assets on the balance sheet. This amount generally is referred to as net property,
plant, and equipment or net fixed assets. The cost of these assets sometimes is referred
to as gross property, plant, and equipment.
The source of financing for plant assets does not affect the way the assets are re-
ported on the balance sheet. Whether a company pays for the assets from cash it has
accumulated, borrows money from creditors, or issues stock, the assets are still reported
as plant assets. Plant assets acquired by capital leases also are included as part of prop-
erty, plant, and equipment and are depreciated along with other assets.
Intangible assets are those that provide legal rights or benefits to a company. These
assets include patents, copyrights, trademarks, and goodwill. A company benefits from
these assets because it controls rights to certain property, processes, brands, or markets
that give the company an advantage relative to its competitors.
Other assets include miscellaneous resources that are important to a particular
company. These may include long-term receivables, long-term prepaid assets, build-
ings and equipment that a company is attempting to sell, and natural resources, such
as timber, oil, or minerals.
The total amount reported by a company for its assets is the sum of current and
long-term assets.
We will consider accounting for each of these types of assets in the sections that
follow. We begin the discussion with plant assets, because these are the most common
type of long-term assets and the most important for most companies.



PROPERTY, PLANT, EQUIPMENT
AND
Plant assets include the land, buildings, and equipment a company uses in its operat-
OBJECTIVE 2
ing activities. Mom’s Cookie Company reported plant assets of $518,837 in 2005 (see
Apply appropriate Exhibit 1). That amount was net (after subtraction) of accumulated depreciation.
measurement rules to the The transactions associated with plant assets include their purchase and disposal
purchase, depreciation, and their valuation on the balance sheet at the end of each fiscal period. The pur-
and disposal of plant chase and disposal of plant assets are recorded at cost, the amount paid for the as-
assets.
sets or received when the assets are sold. The disposal of plant assets usually results
in cash inflow and recognition of a gain or loss. Plant assets are reported on the bal-
ance sheet at cost less accumulated depreciation. Companies provide information
about primary categories of plant assets in their balance sheets or in notes to their fi-
nancial statements.
Land does not depreciate because it is not consumed. Companies generally buy
land for office, manufacturing, and other facilities. Land used for these purposes is re-
ported as part of property, plant, and equipment. The cost of consuming natural re-
sources—oil or timber, for example—is described later in this chapter.
F405
CHAPTER F11: Investing Activities
408 Investing Activities

Plant Asset Cost
The cost of plant assets includes the amount paid for the assets plus the cost of trans-
portation, site preparation, installation, and any construction necessary to make the as-
sets usable for their intended purpose. The cost of land includes the cost of preparing
the land for construction and use. Improvements to the land (such as paving and light-
ing) are treated as separate assets and are depreciated along with other plant assets.




Case In Point
Reporting Long-Term Assets
Krispy Kreme Doughnuts provided the following information about its property and
equipment in its 2002 annual report.

In thousands
Jan. 28, 2001 Feb. 3, 2002
Land $11,144 $ 14,823
Buildings 29,637 39,566
Machinery and equipment 65,119 86,683
Leasehold improvements 10,440 13,463
Construction in progress 556 1,949
116,896 156,484
Less: accumulated depreciation 38,556 43,907
Property, and equipment, net $78,340 $112,577




To illustrate, assume that on Sept. 12, 2005,
LEARNING NOTE
Mom’s Cookie Company purchased a small parcel of
If a capital lease is used to acquire plant assets, the present value
property. The company paid $40,000 for the prop-
of the future lease payments at the time the property is acquired
erty, which included a building and office equipment.
is used as the cost of the assets.
In addition, the company spent $10,000 in October
to renovate the building.
To account for this acquisition, Mom’s Cookie Company must separate the
$400,000 cost of the property into its components: land, building, and equipment. This
separation is necessary because the building and equipment will be depreciated, whereas
the land will not be depreciated. The cost of the property is assigned to components on
the basis of the relative fair market values of the various assets acquired. For example,
assume that Mom’s Cookie Company has the property appraised and determines that
70% should be allocated to the building, 20% to the land, and 10% to the equipment.
It would record the $400,000 purchase as follows:




ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Sept. 12, 2005 Land 80,000
Buildings 280,000
Equipment 40,000
Cash 400,000
F406 SECTION F2: Analysis and Interpretation of Financial Accounting Information
409
Investing Activities

Assume that the $10,000 renovation cost included $7,500 for replacement of the
building’s roof and $2,500 for painting. Both of these costs relate to the building. How-
ever, the costs fall into two categories: those that extend the life or enhance the value
of the property ($7,500 for roof replacement) and those that are ordinary repairs or
maintenance ($2,500 for painting). Expenditures made to acquire new plant assets or
to extend the life or enhance the value of existing plant assets are known as capital
expenditures. Capital expenditures are recorded as assets because they create future
benefits. Expenditures to repair or maintain plant assets that do not extend the life
or enhance the value of the assets are known as operating expenditures. Operating ex-
penditures are recorded as expenses because they are costs associated with the use or
consumption of a resource.
Accordingly, the $10,000 renovation cost is recorded as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Oct. 31, 2005 Buildings 7,500
Maintenance Expense 2,500
Cash 10,000




In addition to purchase and renovation costs, interest on debt used to finance the
construction of assets is included as part of the cost of these assets. For example, if
Mom’s Cookie Company borrowed $100,000 at 8% for one year to finance construc-
tion of a building, the $8,000 interest paid on the loan would be assigned to the build-
ings account. This interest is capitalized (recorded as an asset) because it is part of the
cost of constructing the asset. The total cost of the building, including interest, is de-
preciated over its useful life.


Depreciation
Buildings, equipment, and other plant assets that are consumed are depreciated over
their estimated useful lives. Depreciation is the process of allocating the cost of plant
assets to expense over the fiscal periods that benefit from their use. Because the actual
consumption of a plant asset usually is impossible to determine, depreciation involves
arbitrary allocations of costs. These allocations attempt to match the cost of consum-
ing plant assets with the periods that benefit from using the assets. However, assump-
tions normally must be made about how much of the asset has been consumed. A variety
of depreciation methods exist, but most fall into three general categories:
• Straight-line depreciation allocates an equal amount of the cost of a plant asset
to expense during each fiscal period of the asset’s expected useful life.
• Accelerated depreciation allocates a larger portion of the cost of a plant asset to
expense early in the asset’s life.
• Units-of-production depreciation produces a level amount of depreciation ex-
pense per unit of output (rather than per fiscal period).

Straight-Line Depreciation. Suppose that Mom’s Cookie Company purchased equip-
ment on January 1, 2004 at a cost of $50,000. Management expects the equipment to
have a useful life of four years. At the end of four years, it expects to sell the equipment
for $2,000 (called its residual value) and replace it with new equipment. The amount
of depreciation the company should record over the life of the equipment is $48,000:
cost minus residual value ($50,000 $2,000). Residual or salvage value is the amount
F407
CHAPTER F11: Investing Activities
410 Investing Activities

management expects to receive for an asset at the end of the asset’s useful life. This
amount may result from selling or trading in the asset. The residual value is zero for
many assets.
Straight-line depreciation allocates $12,000 ($48,000 4) of the cost to deprecia-
tion expense each year over the life of the asset:

Straight-line depreciation expense (cost residual value) expected life of asset

During 2004, Mom’s Cookie Company would record depreciation expense on the
equipment as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Depreciation Expense 12,000
Accumulated Depreciation 12,000




Accumulated Depreciation is a contra-asset account that offsets Equipment. The net or
book value of a plant asset is the net cost of the asset after accumulated depreciation
has been subtracted. A depreciation schedule describes the depreciation and book value
of an asset over the asset’s useful life. Exhibit 2 provides a depreciation schedule for the
equipment purchased by Mom’s Cookie Company in 2004.


Exhibit 2 Beginning Book Depreciation Accumulated Ending Book
Straight-Line Year Value Expense Depreciation Value
Depreciation Schedule
2004 $50,000 $12,000 $12,000 $38,000
2005 38,000 12,000 24,000 26,000
2006 26,000 12,000 36,000 14,000
2007 14,000 12,000 48,000 2,000




An equal amount of depreciation is recorded each fiscal period. At the end of four
years, the book value of the asset is $2,000, the amount that management expects to re-
ceive for the asset. The total amount of depreciation a company records each fiscal pe-
riod is the sum of the amounts recorded for all of its individual plant assets. Therefore,
a company prepares a depreciation schedule for each major type of plant asset.
Because depreciation is an estimation process, the amounts may change over time.
For example, at the end of 2005, Mom’s Cookie Company’s managers may decide that
they will be able to use the equipment for three more years (for a total life of five years),
at which time the equipment will have a residual value of $2,000. As a result of this
change in estimate, the equipment depreciation schedule would be revised as shown in
Exhibit 3.
Depreciation expense for 2006 through 2008 is determined as follows:

Revised depreciation expense (book value residual value) estimated useful life
$8,000 ($26,000 $2,000) 3 years

A change in estimate affects depreciation in periods after the change is made. Amounts
recorded in previous periods are not revised.
F408 SECTION F2: Analysis and Interpretation of Financial Accounting Information
411
Investing Activities

Exhibit 3 Beginning Book Depreciation Accumulated Ending Book
Revised Straight-Line Year Value Expense Depreciation Value
Depreciation Schedule
2004 $50,000 $12,000 $12,000 $38,000
2005 38,000 12,000 24,000 26,000
*2006 26,000 8,000 32,000 18,000
*2007 18,000 8,000 40,000 10,000
*2008 10,000 8,000 48,000 2,000

*Changed from Exhibit 2.




Straight-line depreciation is easy to compute and provides a reasonable estimate of
the consumption of most plant assets. Consequently, it is the most commonly used
method for determining depreciation in financial reports of major corporations.

Accelerated Depreciation. Accelerated depre-
ciation allocates more depreciation expense to the
Depreciation Methods Used by Major U.S.
earlier years of an asset’s estimated life than to the
Corporations for Financial Reporting
later years. Several methods of computing accel-
erated depreciation are commonly used. One fre-
quently used method is referred to as double-
declining-balance. Double-declining-balance de-
12% preciation allocates to depreciation expense twice
the straight-line rate times the book value of an
asset. The straight-line rate is 1 divided by the es-
82% 5% Straight-line
timated useful life of the asset. Thus, an asset with
1% Accelerated a life of four years has a straight-line rate of 1/4,
or 25%. Double this rate would be 2/4, or 50%.
Units-of-producton
To illustrate, if Mom’s Cookie Company used
Other
double-declining-balance depreciation for the
equipment purchased at the beginning of 2004, it
(Data source: AICPA, Accounting Trends and Techniques, 2001)
would compute depreciation for each year of the
life of the asset as shown below.

Double-declining-balance depreciation expense book value (2 expected useful life)

The asset cannot be depreciated below its residual value, which is $2,000. Thus, the
amount of depreciation expense recorded in 2007, the last year of the equipment’s life,
is $4,250 ($6,250 $2,000), the amount needed to fully depreciate the asset, leaving a
book value equal to the residual value.

Year Depreciation Expense Book Value Depreciation Rate
2004 $25,000 $50,000 2/4
2005 12,500 25,000 2/4
2006 6,250 12,500 2/4
2007 4,250
Note that book value, not cost, is used and the residual value is not subtracted
in the calculation. For example, at the beginning of 2004, the original cost of
$50,000 equals the book value. At the beginning of 2005, the book value is now
$25,000 ($50,000 cost minus $25,000 accumulated depreciation).

Mom’s Cookie Company should record $48,000 of depreciation over the life of the
asset, just as when straight-line depreciation is used. The depreciation method does not
change the total amount of depreciation recorded. It changes the amount allocated to
each fiscal year.
F409
CHAPTER F11: Investing Activities
412 Investing Activities

Exhibit 4 provides a depreciation schedule for the equipment, assuming double-
declining-balance depreciation.


Exhibit 4 Beginning Book Depreciation Accumulated Ending Book
Double-Declining- Year Value Expense Depreciation Value
Balance Depreciation
2004 $50,000 $25,000 $25,000 $25,000
Schedule
2005 25,000 12,500 37,500 12,500
2006 12,500 6,250 43,750 6,250
2007 6,250 4,250 48,000 2,000*

*The residual value




USING EXCEL
A spreadsheet contains functions for calculating depreciation. In Excel, the functions
can be selected by clicking on the Function Ć’x button and selecting the Financial cat-
For Calculating
egory. The SLN function calculates straight-line depreciation, and the DDB function
Depreciation
calculates double-declining-balance depreciation. Double-clicking on the function
name brings up a dialog box. Enter the cost, salvage value, and life of the asset. The
life should be expressed in the appropriate time units (years or months for example),
depending on the period for which depreciation expense is being calculated. For dou-
ble-declining-balance depreciation, the period for which the depreciation is being cal-
culated must also be entered. The period is a number relative to the beginning of the
SPREADSHEET
asset’s life. For example, if depreciation is being calculated on an annual basis, the
first year of an asset’s life would be 1, the second year 2, and so forth. A dialog box
appears below showing the data for an asset with a cost of $10,000, a salvage value
of $1,000, and a life of five years. The calculation is for the first year of the asset’s
useful life (Period 1). If the function were selected from cell A1, the cell would re-
port the amount calculated by the function of $4,000.




Reasons for Using Accelerated Depreciation. Accelerated depreciation methods
are used for two primary reasons. In some cases, an asset is more useful earlier in its
life than later, and the useful life may be difficult to estimate. For example, computer
equipment becomes obsolete quickly. Accordingly, a company may accelerate the de-
preciation of computer equipment to ensure that most of the cost has been depreciated
when the equipment is replaced.
F410 SECTION F2: Analysis and Interpretation of Financial Accounting Information
413
Investing Activities

A second, and more common, reason for using accelerated depreciation is for tax
purposes. Depreciation expense is deductible in computing taxable income and income
taxes. For example, assume that in 2004, Mom’s Cookie Company reported $100,000
of income before depreciation and taxes. Exhibit 5 describes the effects on Mom’s
Cookie Company’s income taxes of using straight-line and accelerated depreciation.


Exhibit 5 Straight-Line Accelerated
Comparison of Straight-
Income before depreciation and taxes $100,000 $100,000
Line and Accelerated
Depreciation expense 12,000 25,000
Depreciation Methods
Pretax income 88,000 75,000
in 2004
Income taxes (35%) 30,800 26,250
Net income $ 57,200 $ 48,750




In 2004, straight-line depreciation expense (from Exhibit 2) results in higher pre-
tax income, income taxes, and net income. Because double-declining-balance depreci-
ation expense (from Exhibit 4) is higher in the earlier years, the taxable (pretax) income,
income taxes, and net income are lower than under the straight-line method. For tax
purposes, a company prefers to report lower pretax income and pay lower income taxes.
Therefore, companies commonly use accelerated depreciation methods for tax purposes
as a way of postponing the tax obligation. The specific method used depends on income
tax regulations. Companies typically report the maximum amount of depreciation per-
mitted by law for tax purposes. Larger amounts of depreciation expense reduce tax pay-
ments in the current fiscal period, thereby reducing cash outflows for tax purposes. By
reducing its cash outflows, a company preserves more of its cash for other purposes.
For financial reporting purposes, companies prefer to report higher amounts of net
income in the earlier years. Therefore, they generally use straight-line depreciation in
preparing their financial statements. Companies may use straight-line depreciation
when preparing their financial statements and accelerated depreciation when prepar-
ing their tax returns. Small companies often use accelerated depreciation methods for
both purposes to avoid the need for two sets of accounting records. Note that over the
life of the asset, the same total amount of depreciation expense is recognized under the
straight-line method as under the accelerated methods. Thus, the same amount of to-
tal income tax is paid under those methods.
Companies disclose the accounting methods they use for recording and depreciat-
ing their plant assets in notes to their financial statements. These notes identify the de-
preciation method used and provide other relevant information.




Case In Point
Disclosure of Depreciation Policy
In its 2002 annual report, Krispy Kreme provided the following description of its de-
preciation policy:
Property and equipment are stated at cost less accumulated depreciation. Major re-
newals and betterments are charged to the property accounts while replacements,
maintenance, and repairs which do not improve or extend the lives of the respective
assets are expensed currently. Interest is capitalized on major capital expenditures
during the period of construction.

Depreciation of property and equipment is provided on the straight-line method over
the estimated useful lives: Buildings—15 to 35 years; Machinery and equipment—3
to 15 years; Leasehold improvements—lesser of useful lives of assets or lease term.
F411
CHAPTER F11: Investing Activities
414 Investing Activities

The difference between straight-line and accelerated depreciation is a major source
of deferred taxes. Deferred taxes are taxes that a company would owe if it used the
same methods for preparing its tax return that it used for preparing its financial state-
ments. For example, using the Exhibit 5 information, Mom’s Cookie Company would
record its taxes for 2004 as:



ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Income Tax Expense 30,800
Income Tax Payable 26,250
Deferred Tax Liability 4,550




Income tax payable is the amount Mom’s Cookie Company owes based on its tax
return. Income tax expense is the amount of tax it would owe if straight-line depreci-
ation had been used for tax purposes. The difference between the payable and the ex-
pense is recorded as Deferred Taxes. Deferred taxes
are the taxes Mom’s Cookie Company has deferred
LEARNING NOTE (postponed) to some future period by using acceler-
ated depreciation for tax purposes. Because the com-
Occasionally, a company will record a deferred tax charge. This
pany expects to pay these taxes in the future, they are
charge appears on the balance sheet as a long-term asset. It rep-
recorded as a long-term liability. Companies fre-
resents a prepayment of taxes that the company will owe in the
quently report deferred taxes as long-term liabilities
future.
on their balance sheets.

Units-of-Production Depreciation. Some companies use the units-of-production
method to depreciate production equipment and facilities across units of output. For
example, suppose that at the beginning of 2005, Mom’s Cookie Company purchased a
truck to deliver goods to customers. The truck cost $30,000. Management expects the
useful life of the truck to be 100,000 miles, at which time it will be sold for $10,000,
and a new truck will be acquired. Rather than depreciating the truck over time, it will
be depreciated based on mileage. A depreciation rate per mile for the truck can be com-
puted as follows:

Units-of-production depreciation rate (cost residual value) estimated units
$0.20 per mile ($30,000 $10,000) 100,000 miles

If the truck were driven 12,000 miles in 2005, Mom’s Cookie Company would
record depreciation expense of $2,400 (12,000 miles $0.20 per mile).
Companies often use the units-of-production method for production equipment.
Also, it often is used by transportation and airline companies for depreciating trucks,
automobiles, and airplanes.

Book and Market Value of Plant Assets. The book value of plant assets is the cost
of the assets less accumulated depreciation. This amount is not an indication of the
market value of the assets, which may be much higher than the book value in some
cases. For example, land and buildings purchased by a company often increase in value
over time because of inflation, increased demand for property, and increased con-
struction costs. This difference between the market and book value of assets is an un-
recorded asset. The market value of a company’s stock is likely to include investors’
estimates of the value of this unrecorded asset.
F412 SECTION F2: Analysis and Interpretation of Financial Accounting Information
415
Investing Activities

Disposing of Plant Assets
To dispose of plant assets—by retiring or selling them—a company must eliminate their
cost and accumulated depreciation from its accounting records. For example, suppose
that Mom’s Cookie Company sells equipment on February 10, 2005. The equipment
cost the company $20,000 when purchased. Accumulated depreciation on the equip-
ment at the time it is sold is $14,000, and the company receives $8,000 for the equip-
ment. It would record the sale as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 10, 2005 Cash 8,000
Accumulated Depreciation 14,000
Equipment 20,000
Gain on Asset Sale 2,000




This transaction eliminates the cost of the asset ($20,000) from Mom’s Cookie
Company’s accounts. Also, it eliminates the accumulated depreciation taken on the as-
set ($14,000). The difference between the amount received ($8,000) and the book value
of the asset at the time of the sale ($6,000 $20,000 $14,000) is recorded as a gain.
This gain is reported as nonoperating income on the company’s 2005 income state-
ment. If the book value at the time of the sale had been greater than the amount re-
ceived, Mom’s Cookie Company would have recorded a Loss on Asset Sale.




1 SELF-STUDY PROBLEM Banana Boat Company purchased equipment on January 1, 2004
at a cost of $400,000. The equipment had an expected life of three
years and could be used to produce one million units of product. Its estimated resid-
ual value was $40,000. Income before depreciation and taxes in 2004 was $2 million.
The company’s tax rate was 35%.

Required
A. Prepare a depreciation schedule for the equipment for its three-year life, using
straight-line and double-declining-balance depreciation methods.
B. Determine the amount of depreciation expense the company would record in 2004
if the units-of-production method were used and 300,000 units were produced.
C. Which of the three methods would result in the lowest tax liability for 2004?
The solution to Self-Study Problem 1 appears at the end of the chapter.



NATURAL RESOURCES
Paper, petroleum, and mining companies, among others, invest in natural resources.
OBJECTIVE 3
They purchase or lease land that contains timber, oil, or minerals. The cost of the land
Apply appropriate mea- primarily reflects those natural resources.
surement rules to the The amount a company reports for natural resources on its balance sheet is the cost
purchase and use of nat- of the asset less depletion. Depletion is the systematic allocation of the cost of natural
ural resources. resources to the periods that benefit from their use. Assume that Silicon Company
bought land containing minerals on April 1, 2004, for $8 million. The company would
record the transaction as follows:
F413
CHAPTER F11: Investing Activities
416 Investing Activities


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Apr. 1, 2004 Mineral Rights 8,000,000
Cash 8,000,000




Assume that the company estimated that the land contained 80,000 tons of min-
erals when it was purchased. The estimated cost per ton was $100 ($8,000,000 80,000
tons). In 2004, Silicon mined the land and removed 16,000 tons of the minerals. These
minerals then were sold to customers. The value of the asset consumed during 2004,
$1.6 million ($100 16,000 tons), would be recorded in this way:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Cost of Goods Sold 1,600,000
Mineral Rights 1,600,000




The amount reported by Silicon on its 2004 balance sheet for Mineral Rights would
be $6,400,000 ($8,000,000 cost $1,600,000 accumulated depletion). The amount of
the asset reported would decrease each year as additional minerals are mined and ac-
cumulated depletion increases.
This example assumes that the land has no real value apart from the value of the
mineral deposits. If the land does have other value, that value would be recorded as a
separate asset. Only the value of the minerals would be depleted.
GAAP require that companies report natural resources at their book value (cost
accumulated depletion). The market value of natural resources is not reported on the
financial statements, although some companies disclose information about the current
value of those assets in notes to their financial statements. Remember that market value
can be much higher than book value. Companies that own oil and timber reserves, for
example, have experienced dramatic increases in the market value of those resources in
recent years because of rising demand. The market value of a company’s stock reflects
the unrecorded value of those assets.



LONG-TERM SHORT-TERM INVESTMENTS
AND
This section examines accounting for investments in debt and equity securities. It con-
OBJECTIVE 4
siders transactions and reporting issues for both short-term and long-term investments.
Apply appropriate
measurement rules to the
Types of Securities
purchase, valuation, and
sale of long-term and
Companies often invest in securities issued by other organizations. Securities include
short-term investments.
common and preferred stocks, bonds, certificates of deposit, and notes. Stocks are re-
ferred to as equity securities. Other securities are debt securities. If securities are read-
ily exchangeable for cash (can be sold easily) they are marketable securities. A company
F414 SECTION F2: Analysis and Interpretation of Financial Accounting Information
417
Investing Activities

never reports its own debt or equity securities as assets. Instead, those securities are re-
ported as liabilities (debt) and stockholders’ equity (equity securities).
Companies invest in marketable securities for many reasons. When there is a tem-
porary surplus of cash, the cash is invested on a short-term basis to earn a return un-
til cash is needed. Long-term investments meet different needs. Some are used to fund
the future repurchase or repayment of a company’s own debt or to provide for fu-
ture retirement and other employee benefits. Often, investments in other companies
are made to gain access to markets, resources, and technology controlled by these
companies.
GAAP differentiate between two types of investments:
(1) investments that give the investor significant influence or control over the com-
pany issuing the securities, and
(2) investments that do not.

Investments That Yield Significant Influence or Control. These investments are
always reported as a long-term asset. A company acquires significant influence over an-
other company when it holds a large block of the second company’s voting securities.
Generally, this means 20% to 50% of the outstanding shares of common stock. When
significant influence occurs, the equity method is used. A company acquires control
over another firm by holding a very large block (usually a majority) of its voting secu-
rities. In this situation, the consolidation method is used. The equity and consolidation
methods are discussed in the final section of this chapter.

Investments That Do Not Yield Significant Influence or Control. GAAP identify
three categories of investments that do not yield significant influence or control. Each
is treated differently in the financial statements. The three categories are as follows:
1. Held-to-maturity securities are investments in debt securities that the investor has
the intent and ability to hold until the debt’s maturity date. They are reported on
the balance sheet as a long-term asset except during the year just prior to maturity
when they should be reported as a current asset.
2. Trading securities are investments in either debt or equity securities that a com-
pany buys and sells on a regular basis. They are reported on the balance sheet un-
der current assets.
3. Available-for-sale securities are investments in securities that a company could sell
but that it does not trade regularly. These investments are reported as a current as-
set or noncurrent asset, depending on management’s expectation regarding when
the investments will be sold.
All investments in securities are recorded initially at cost. Cost includes brokerage
commissions, fees, and taxes. (For illustrative purposes in this chapter, these additional
costs are assumed to be zero.) Held-to-maturity securities (always debt securities) are
reported on the balance sheet at amortized cost: original cost adjusted for amortiza-
tion of premium or discount. Trading securities and available-for-sale securities are
reported on the balance sheet at current market value. This is referred to as mark-to-
market accounting.


Held-To-Maturity Securities
Only debt securities may fall into this category. To illustrate, assume that Big Foods
Corporation bought Mom’s Cookie Company bonds on January 1, 2005. Big Foods
paid $208,201 for the bonds which mature in 2009 at their face value of $200,000. The
bonds pay annual interest of 8%. Interest payments are made on December 31. Big
Foods intends to hold these bonds long-term and records the purchase of this invest-
ment as follows:
F415
CHAPTER F11: Investing Activities
418 Investing Activities


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 1, 2005 Long-Term Investment 208,201
Cash 208,201




On December 31, 2005, Big Foods receives its first interest payment. The amount
received is $16,000 (8% $200,000 face value). Recall from our discussion in Chapter
F9 that when bonds are issued at a price different from par, the premium or discount
must be amortized. The interest earned each period is adjusted as the premium or dis-
count is amortized over the life of the bonds. Because Big Foods paid $208,201 for
Mom’s Cookie Company’s bonds, it would amortize the $8,201 premium over the life
of the bonds. Big Foods has determined that $1,426 of premium should be amortized
upon receipt of the first interest payment. It would record the amortization along with
the interest earned as follows:



ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2005 Cash 16,000
Long-Term Investment 1,426
Interest Income 14,574




Cash received ($16,000) less the amortization ($1,426) during the period is re-
ported as interest income for the period ($14,574). Assume Big Foods plans to hold
the bonds until they mature in 2009. The bonds would be classified as held-to-ma-
turity securities. At the end of its 2005 fiscal year, Big Foods must report its invest-
ment on the balance sheet at amortized cost of $206,775 ($208,201 cost $1,426
amortization).


Trading Securities and Available-for-Sale Securities—Investments
in Debt
If, instead, the bonds are held as trading securities or available-for-sale securities, they
will be reported on the balance sheet at current market value. When the investment’s
amortized cost is different from its current market value, an unrealized holding gain
or loss is recognized. The holding gain or holding loss is unrealized because actual sale
of the investment has not yet occurred. Unrealized holding gains or losses are an in-
dication of the gain or loss that would occur if the investment were sold at the bal-
ance sheet date.
To illustrate, assume the December 31, 2005 market price of Mom’s Cookie Com-
pany bonds owned by Big Foods is $205,000. An adjusting entry is needed to update
the balance in the long-term investment account from amortized cost of $206,775
($208,201 $1,426) to current market value of $205,000. That entry would appear as
follows:
F416 SECTION F2: Analysis and Interpretation of Financial Accounting Information
419
Investing Activities


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2005 Unrealized Holding Loss* 1,775*
Long-Term Investment 1,775



*Amortized cost ($206,775) current market value ($205,000) $1,775 unrealized holding loss. This is included as part of
Other Comprehensive Income in the stockholders’ equity section of the balance sheet.


The only difference in accounting for trading securities and available-for-sale secu-
rities is in how the Unrealized Holding Loss (or Gain) is reported in the financial state-
ments. Trading securities are expected to be sold in the near future. Therefore, for trading
securities, the unrealized holding gain or loss is reported on the income statement as
part of net income. This gives an early signal to readers as to the likely outcome when
the securities are sold. Available-for-sale securities are not expected to be sold in the
near future. Therefore, the unrealized holding gain or loss is reported as part of Other
Comprehensive Income in the stockholders’ equity section of the balance sheet.


Trading Securities and Available-for-Sale Securities—Investments
in Equity
The accounting for trading securities and available-for-sale securities is very similar.
Both are recorded initially at cost and reported on the balance sheet at current market
value. Assume that Big Foods Corporation purchased 10,000 shares of Mom’s Cookie
Company common stock for $12 per share on October 1, 2005. Assume these are avail-
able-for-sale securities that are not expected to be sold anytime soon. Big Foods would
record the purchase as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Oct. 1, 2005 Long-Term Investment 120,000
Cash 120,000




On December 31, 2005, the closing market price of Mom’s Cookie Company stock
was $14 per share. Thus, the value of Big Foods’ investment has increased by $20,000 [($14
$12) 10,000 shares)]. Big Foods would record the increase in market value as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2005 Long-Term Investment 20,000
Unrealized Holding Gain* 20,000*



*This is included as part of Other Comprehensive Income in the stockholders’ equity section of the balance sheet.
F417
CHAPTER F11: Investing Activities
420 Investing Activities

Because these are available-for-sale securities, the Unrealized Holding Gain is re-
ported on the balance sheet as a component of stockholders’ equity. It is not part of
net income. If the securities had been trading securities, the Unrealized Holding Gain
would be reported on the income statement as part of net income. Either way, the Long-
Term Investment will be reported on the balance sheet at current market value.
Big Foods’ December 31, 2005 financial statements will combine the long-term in-
vestments and unrealized holding gain (or loss) accounts for both of its long-term in-
vestments. Big Foods owns bonds with a market value of $205,000 and stock with a
market value of $140,000. Therefore, assuming both securities are available-for-sale, Big
Foods will report its investments as shown in Exhibit 6.


Exhibit 6
Balance Sheet
Balance Sheet Excerpts
December 31, 2005
and Supporting
Computations for Big Assets Stockholders’ equity
Foods Corporation for Long-term investments $345,000 Other comprehensive income $18,225
Long-Term Investments
Computations
Cost of bonds $208,201 Unrealized holding loss on
Amortization of premium (1,426) bonds $ (1,775)
Unrealized holding loss (1,775) Unrealized holding gain on
Cost of stock 120,000 stock 20,000
Unrealized holding gain 20,000 Net unrealized holding gain $18,225
Long-term investments $345,000




If the investments were trading securities, the only difference would be that the
$18,225 unrealized holding gain ($20,000 $1,775) would be reported on the income
statement rather than as part of other comprehensive income. In either case, Big Foods
also would disclose the cost of its long-term investments ($328,201 $208,201 for
bonds $120,000 for stock) on the balance sheet or in a note.
When Big Foods sells an investment, it records a realized gain or loss that is re-
ported in computing net income on its income statement. For example, assume Big
Foods’ management changes its mind and sells Mom’s Cookie Company stock on April
20, 2006, at a price of $17 per share. Big Foods has earned $50,000 on its investment
[($17 $12) 10,000 shares]. It records the transaction as follows:



ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Apr. 20, 2006 Cash 170,000
Unrealized Holding Gain* 20,000*
Long-Term Investment 140,000
Investment Income 50,000




*This is included as part of Other Comprehensive Income in the stockholders’ equity section of the balance sheet.



This transaction records the realized gain ($50,000) and eliminates the long-term
investment in stock and unrealized holding gain amounts that were recorded during
2005. The long-term investment amount of $140,000 is the cost ($120,000) plus the
F418 SECTION F2: Analysis and Interpretation of Financial Accounting Information
421
Investing Activities

increase in market value that was added to the account on December 31, 2005 ($20,000).
The realized gain ($50,000) would be reported by Big Foods as nonoperating income
on its income statement for 2006. This is the amount Big Foods actually earned from
its investment in Mom’s Cookie Company stock.
As noted previously, the rules described above do not apply when a company owns
a significant or controlling interest in another company. A company is considered by
GAAP to have significant influence over another company when it owns 20% to 50%
of the other company’s common stock. This level of ownership suggests that the in-
vestor can influence management decisions of the is-
suing company. Therefore, special accounting rules,
LEARNING NOTE
known as the equity method, are used to account for
Occasionally a firm will acquire nonmarketable securities. This
these investments. These rules are summarized in the
means there is no active market for the security and it cannot
appendix to this chapter.
readily be converted to cash. GAAP require the cost method be
If a company owns more than 50% of the com-
used to account for these investments. Under the cost method,
mon stock of another corporation, it controls the
the investment is recorded at cost and no further adjustments are
other corporation. In this situation, the investor is
made to the investment account. Dividends or interest received
the parent corporation and the issuer of the stock is
on such an investment are recorded as Investment Income.
a subsidiary of the parent. The parent includes the
subsidiary as part of its consolidated financial state-
ments. That is, the financial statements of the parent treat the parent and subsidiary
corporations as though they were one company. A summary of accounting for consol-
idations appears at the end of this chapter.


Short-Term Investments
Investments in short-term marketable securities are accounted for at market value. In-
vestments are classified as short-term if management expects to sell the investments
during the coming fiscal year. Short-term investments are reported as current assets.
Therefore, they are separated from long-term investments on the balance sheet. The ac-
counting procedures to record the purchase price and end-of-period adjustment for
current market price are identical to those for long-term investments.
Exhibit 7 summarizes the appropriate treatment for investments in securities.


Exhibit 7 Accounting Treatment of Unrealized
Investments in Type of Investment Recorded Method Holding Gain (Loss)
Marketable Securities
Acquires significant At cost Equity none
influence

Acquires control At cost Consolidation none

Held-to-maturity At cost Amortized cost none

Trading At cost Mark to market Reported on income state-
ment as Other Income

Available-for-sale At cost Mark to market Report on balance sheet in
Other Comprehensive Income




2 SELF-STUDY PROBLEM Delta Can Company purchased 10,000 shares of Flatland Alu-
minum Company’s common stock on June 1, 2004. Delta paid
$230,000 for the stock. On December 1, 2004, Delta received a dividend check from
Flatland for $25,000. The market value of Flatland’s stock on December 31, 2004, the
F419
CHAPTER F11: Investing Activities
422 Investing Activities

end of Delta’s fiscal year, was $27 per share. On December 1, 2005, Delta received a
dividend check from Flatland for $30,000. The market value of Flatland’s stock on De-
cember 31, 2005, was $26 per share. Delta sold its investment in Flatland on March 5,
2006, for $245,000. Delta owned 5% of Flatland’s common stock and had planned to
keep its investment long term.

Required
A. Using the format presented in this chapter, record all transactions for Delta in-
volving its investment in Flatland and explain the purpose of each transaction.
B. Calculate the amounts Delta would report on its 2004 and 2005 balance sheets for
its investment in Flatland.
The solution to Self-Study Problem 2 appears at the end of the chapter.




INTANGIBLE ASSETS
Intangible assets include legal rights, such as copyrights, patents, brand names, and
OBJECTIVE 5
trademarks that a company owns. The purchase price and/or legal fees associated with
Explain accounting issues acquiring those rights are recorded as assets and, with the exception of goodwill, are
associated with intangible amortized over the life of the assets, usually on a straight-line basis.
and other long-term GAAP require that intangibles other than goodwill be amortized over a period of
assets. 40 years or less. (The longer the amortization period, the lower the expense recognized
each year.) A company that purchases intangible assets for $1 million and amortizes
those assets over 40 years would recognize $25,000 of amortization expense each year.
U.S. GAAP do not allow companies to report the estimated market value of their
brand names, trademarks, and other intangibles as part of their assets. Only the costs
associated with those items can be reported as assets on the balance sheet. Neverthe-
less, brand names and trademarks can be among a corporation’s most valuable re-
sources. For example, the Coca-Cola brand name has been estimated at a value of more
than $25 billion. Many companies would report much higher asset and stockholders’
equity amounts if they could include the market value of intangible assets. Great Britain
and certain other countries allow corporations to report the estimated market value of
intangible assets, which is why some British companies report higher asset and equity
INTERNATIONAL
values than their U.S. counterparts.
An intangible asset reported by many companies is goodwill. Goodwill is the ex-
cess of the purchase price of a company over the fair market value of its net assets
(assets liabilities). To illustrate, assume that Big Foods Corporation purchased Value-
Right Company on January 1, 2005, for $5 million. As part of the purchase negotia-
tion, Value-Right Company’s assets and liabilities were appraised and were determined
to have current market values of $8 million and $3.5 million, respectively. Accordingly,
the purchase resulted in Big Foods’ recognizing $500,000 of goodwill:

Market value of Value-Right Company assets $8,000,000
Market value of Value-Right Company liabilities 3,500,000
Market value of Value-Right Company net assets $4,500,000
Amount paid by Big Foods Corporation $5,000,000
Market value of Value-Right Company net assets 4,500,000
Goodwill (excess of amount paid over market value) $ 500,000

Goodwill is common when one company purchases another company. Often the
amount paid is greater than the value of identifiable assets. The purchaser is buying a
company, not individual assets. The company as a whole may have more value than the
sum of its assets because it is an established business. Its managers, employees, customers,
suppliers, brand recognition, and other components add value that is not recognized on
the balance sheet. Accordingly, goodwill is recorded as an indication of this value.
F420 SECTION F2: Analysis and Interpretation of Financial Accounting Information
423
Investing Activities

Goodwill remains on a company’s balance sheet at cost unless the value of the
goodwill is impaired. Goodwill is impaired when it becomes apparent the investment
is less valuable than the purchaser originally expected. The balance of the goodwill ac-
count should be written down, and a loss should be recognized for the amount of the
impairment.


OTHER LONG-TERM ASSETS
Long-term assets that are not included in one of the other primary categories (plant as-
sets, long-term investments, or intangible assets) are considered other long-term assets.
An example of this type of asset is deferred charges. Deferred charges are the as-
sets that result when a company prepays expenses that produce long-term benefits.
Deferred charges typically are amortized over future periods. Start-up costs—the costs
of the legal fees, support services, and advertising necessary to start a new business, di-
vision, or project—often are capitalized and reported as deferred charges. These costs
are recorded as Organizational Costs or a similar asset account.
Certain other assets do not fit into standard asset categories. For example, plant as-
sets that a company has removed from service and is trying to sell are listed as other
assets, not as plant assets.
Some assets are specific to an industry or company—for example, software devel-
opment costs in the computer industry. A description of those assets often is provided
in the notes to the financial statements.
Most assets are recorded at cost when they are purchased. This cost is expensed
over the life of the asset as the asset is consumed or as its value declines. When an as-
set is sold, a gain or loss equal to the difference between the book value of the asset and
its selling price is recognized.


FINANCIAL REPORTING INVESTING ACTIVITIES
OF
Investing activities affect the balance sheet, income statement, and statement of cash
OBJECTIVE 6
flows as described in Exhibit 8. Long-term assets (items a through d) appear on the bal-
Summarize the effects of ance sheet. The accumulated amount of holding gains and losses (item e) appears as
investing activities on a an adjustment to stockholders’ equity.
company’s financial The income statement is affected by depreciation and amortization expense (item
statements. f), interest income (item g), and gains and losses from the sale of plant assets, long-
term investments, and other long-term assets (item h).
Both the operating activities and the investing activities sections of the statement
of cash flows are affected by investing activities. Depreciation and amortization expense
(item i) is added to net income in computing operating cash flow using the indirect
method. These are noncash expenses. Also, in computing operating cash flows, gains
from the sale of long-term assets are subtracted and losses are added (item j). All cash
flows associated with the sale of long-term assets are included in investing activities
(items k, l, and m). Therefore, in terms of the operating activities section, the gain or
loss is treated as a noncash item so that it is not included twice. Gains do not increase
operating cash flows and losses do not reduce operating cash flows.
Cash received from the sale of long-term assets (items k, l, and m) and cash paid
for long-term assets (items n, o, and p) are reported as investing activities. The total of
these cash outflows and inflows is net cash from (for) investing activities (item q).
Exhibit 9 contains the investing activities section of Mom’s Cookie Company’s state-
ment of cash flows for 2005. These amounts help explain changes in the company’s long-
term assets as presented on its balance sheet (Exhibit 1). Though the numbers on the
cash flow statement do not always explain all changes in long-term assets, they should
explain most of these changes. Some balance sheet changes are associated with noncash
transactions. However, most changes in long-term assets involve the receipt or payment
of cash and are reported in the investing activities section of the statement of cash flows.
F421
CHAPTER F11: Investing Activities
424 Investing Activities

Exhibit 8 Financial Statement Presentation of Investing Activities



Balance Sheet Income Statement
Assets Operating revenues
Current assets Operating expenses, except depreciation
(a) Long-term investments and amortization expense
(b) Property, plant, and equipment (f) Depreciation and amortization expense
(c) Intangible assets Operating income
(d) Other assets Interest expense
Liabilities (g) Interest income
Stockholders’ Equity (h) Gains or (losses) from sale
Common stock of long-term assets
Retained earnings Pretax income
(e) Net holding gains (losses) Income taxes
Net income
Statement of Cash Flows
Cash flow from operating activities:
Net income
(i) Add depreciation and amortization expense
(j) (Subtract gains) add losses from sale of long-term assets
Other adjustments
Net cash flow from operating activities
Cash flow from (for) investing activities:
(k) Sale of property, plant, and equipment
(l) Sale of investments
(m) Other (purchases) or sales of long-term assets
(n) (Capital expenditures)
(o) (Purchase of investments)
(p) (Acquisitions)
(q) Net cash flow from (for) investing activities




Exhibit 9
Investing Activities from
Cash flow from (for) investing activities:
Mom’s Cookie
Purchase of property and equipment $(365,000)
Company’s Statement
Sale of property and equipment 8,000
of Cash Flows
Purchase of investments (6,000)
Sale of investments 2,000
Net cash flow for investing activities $(361,000)




3 SELF-STUDY PROBLEM Silicon Company reported the following transactions for the year
ended December 31, 2004:
• Sale of plant assets with a book value of $22,000 for $16,000, reporting a loss of
$6,000
• Sale of securities with a book value of $10,000 for $14,000, reporting a gain of $4,000
• Depreciation and amortization expense of $8,000
• Interest and dividends from investments of $2,000
• Acquisitions of plant assets for $35,000
• Acquisitions of long-term investments for $10,000
• Net income of $50,000
F422 SECTION F2: Analysis and Interpretation of Financial Accounting Information
425
Investing Activities

Required Prepare the operating and investing sections of Silicon’s cash flow statement,
assuming that no other activities affected those sections. You can assume that Silicon
received cash for the interest and dividend income in 2004.
The solution to Self-Study Problem 3 appears at the end of the chapter.




OTHER INVESTMENT ISSUES
Companies, especially large corporations, often own significant interests in other com-
panies. As a general rule, if a company owns 20% to 50% of the common stock of an-
other company, it is considered by GAAP to have significant influence over that company.
If a company owns more than 50% of another company, it owns a controlling interest in
the company. The following sections summarize accounting rules for these situations.


Equity Method
When one company owns 20% to 50% of the common stock of another company, it
normally uses the equity method to account for its investment. The investment is
recorded at cost. For example, assume that Big Foods Corporation purchased 30,000
shares of Little Market Corporation’s 100,000 shares of common stock at a price of
$20 per share on January 1, 2004. Big Foods Corporation would record the purchase
as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 1, 2004 Long-Term Investment 600,000
Cash 600,000




At the end of the 2004 fiscal year, Little Market reported a net income of $500,000
and paid dividends of $200,000. Under the equity method, Big Foods records 30% (the
percentage of stock it owns) of Little Market’s net income as investment income:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Long-Term Investment 150,000
Investment Income 150,000




Little Market’s net income increases its retained earnings. Therefore, the book value
of Little Market increases by $500,000. Big Foods recognizes 30% of this increase as an
increase in the value of its investment.
Dividends paid by Little Market reduce Little Market’s retained earnings and book
value. Therefore, Big Foods recognizes 30% of this decrease as a decrease in the value
of its investment:
F423
CHAPTER F11: Investing Activities
426 Investing Activities


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Cash 60,000
Long-Term Investment 60,000




In this transaction, Big Foods receives cash from Little Market, but the value of Big
Foods’ investment decreases in proportion to the decrease in Little Market’s retained
earnings.
The equity method is appropriately named because it adjusts the investment ac-
count of the investor in proportion to changes in the book value of the investee’s stock-
holders’ equity. It ignores changes in market value. Investments that use the equity
method often are listed separately from other investments on a company’s balance sheet
or are described in a note to the financial statements. Also, income from equity method
investments often is separated from other income on a company’s income statement.
It is labeled equity income or a similar title. Investment income is a nonoperating-in-
come item for most companies.


Consolidations
If a corporation owns more than 50% of the common stock of another company, it
normally reports consolidated financial statements. These statements are issued by the
parent corporation and include the financial activities of the parent and its subsidiaries.
The process of consolidating a parent and its subsidiaries can be complex. Account bal-
ances for the parent and all of its subsidiaries are combined. Any intercompany trans-
actions, such as sales by a subsidiary to the parent or a loan from the parent to the
subsidiary, are eliminated. Only transactions of the parent and its subsidiaries with ex-
ternal parties are reported in the consolidated statements.
If the parent corporation does not own 100% of the common stock of a subsidiary,
the portion that the parent does not own is known as minority interest or noncon-
trolling interest. The portion of a subsidiary’s stockholders’ equity that belongs to non-
controlling stockholders (owners other than the parent) is reported on the consolidated
balance sheet as noncontrolling interest. This amount often appears after liabilities and
before stockholders’ equity. The portion of a subsidiary’s net income that belongs to
noncontrolling stockholders is reported on the consolidated income statement as non-
controlling interest in income. This amount is subtracted in determining the parent’s
consolidated net income because it is the portion of the subsidiary’s net income not
earned by the parent.




REVIEW SUMMARY of IMPORTANT CONCEPTS


1. Investing activities involve the acquisition, use, and disposal of long-term assets.
a. Long-term investments are investments in stocks and bonds of other companies
that managers expect to hold for longer than the coming fiscal year.
b. Property, plant, and equipment are tangible assets used in a company’s production
and selling activities.
c. Intangible assets are legal rights that a company has exclusive use of to create future
profits.
d. Other long-term assets are miscellaneous items that are not included in another cat-
egory (e.g., property held for disposal).
F424 SECTION F2: Analysis and Interpretation of Financial Accounting Information
427
Investing Activities

2. Investments in plant assets are the most important long-term assets for most companies.
a. Plant assets are recorded at cost when they are acquired.
b. Plant assets are depreciated over their estimated useful lives.
(1) Straight-line depreciation is used for financial reporting by most companies.
(2) Accelerated depreciation methods often are used for computing taxable income.
(3) Units-of-production depreciation may be used for machinery and equipment
that has an estimated life in terms of units of activity rather than time.
c. Plant assets are reported on the balance sheet at their book value (cost minus accu-
mulated depreciation).
d. When plant assets are sold, a gain or loss equal to the difference between the book
value and the sale price of the assets is recognized.

3. Natural resources are recorded at cost, and depletion expense is recorded as the re-
sources are consumed.

4. Long-term and short-term investments involve investments in debt or equity securities
of other companies.
a. Investments in securities are recorded at cost.
b. Interest income is recorded in the period earned and usually is reported as nonop-
erating income.
c. Investments in debt securities are reported on the balance sheet at cost if the debt is
to be held to maturity or at market value if it is not to be held to maturity.
d. Investments in equity securities are reported at market value on the balance sheets
of most companies.
e. Holding gains or losses generally are reported as adjustments to stockholders’ eq-
uity.
f. Special accounting methods (the equity method and consolidation) are used when
one company owns a significant interest (20% or more) in another company.

5. Intangible assets include legal rights, such as patents and copyrights, and goodwill.
a. Intangible assets are recorded at cost and, except for goodwill, are amortized over
their useful lives, not to exceed 40 years.
b. Goodwill is the excess of the purchase price of a company over the market value of
that company’s net assets (assets minus liabilities).
c. Goodwill is not amortized but is written down in value, and a loss is recognized, if
its value is impaired.

6. Other long-term assets include deferred charges, plant assets held for sale, organization
costs, and specialized assets that are not classified in one of the other asset categories.

7. Investing activities affect a company’s balance sheet (particularly assets), income state-
ment (depreciation and amortization expense, investment income, and gains and losses
from sale of assets), and statement of cash flows (particularly the investing activities
section).

8. As a general rule, special accounting methods are used when a company owns 20% or
more of the common stock of another corporation.
a. The equity method is used for investments of 20% to 50%.
b. Consolidation is used when a company owns more than 50% of another company’s
common stock.




DEFINE TERMS and CONCEPTS DEFINED in this CHAPTER


accelerated depreciation (F406) mark-to-market accounting (F414)
capital expenditures (F406) operating expenditures (F406)
deferred charges (F420) straight-line depreciation (F406)
depletion (F412) units-of-production depreciation (F406)
goodwill (F419)
F425
CHAPTER F11: Investing Activities
428 Investing Activities


SELF-STUDY PROBLEM SOLUTIONS
SSP11-1 A. Straight-line depreciation schedule ($400,000 $40,000) 3 years $120,000 per
year



Beginning Book Depreciation Accumulated Ending Book
Year Value Expense Depreciation Value

2004 $400,000 $120,000 $120,000 $280,000
2005 280,000 120,000 240,000 160,000
2006 160,000 120,000 360,000 40,000




Double-declining-balance depreciation schedule ($400,000 2/3 $266,667)
($133,333 2/3 $88,889)



Beginning Book Depreciation Accumulated Ending Book
Year Value Expense Depreciation Value

2004 $400,000 $266,667 $266,667 $133,333
2005 133,333 88,889 355,556 44,444
2006 44,444 4,444 360,000 40,000




B. Units-of-production depreciation rate ($400,000 $40,000) 1,000,000 units
$0.36 per unit. Depreciation expense for 2004 300,000 units $0.36 $108,000.
C.
Double-
Declining- Units-of-
Straight-Line Balance Production
Income before depreciation and taxes $2,000,000 $2,000,000 $2,000,000
Depreciation expense 120,000 266,667 108,000
Income before taxes 1,880,000 1,733,333 1,892,000
Income taxes (35%) 658,000 606,667 662,200
Net income $1,222,000 $1,126,666 $1,229,800

Double-declining-balance results in the lowest income tax liability for 2004.
F426 SECTION F2: Analysis and Interpretation of Financial Accounting Information
429
Investing Activities

SSP11-2 A.

ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
June 1, 2004 Long-Term Investment 230,000
Cash 230,000
Dec. 1, 2004 Cash 25,000
Investment Income 25,000
Dec. 31, 2004 Long-Term Investment 40,000
Unrealized Holding
Gain (Loss)* 40,000*
Dec. 1, 2005 Cash 30,000
Investment Income 30,000
Dec. 31, 2005 Unrealized Holding
Gain (Loss)* 10,000*
Long-Term Investment 10,000
Mar. 5, 2006 Cash 245,000
Unrealized Holding
Gain (Loss)* 30,000*
Long-Term Investment 260,000
Investment Income 15,000


*This is included as part of Other Comprehensive Income in the stockholders’ equity section of the balance sheet.



The transaction of 6/1/04 records the investment at cost. The transactions of 12/1/04
and 12/1/05 recognize dividends received as realized investment income. This income
is reported on the income statement in computing net income for each fiscal year. The
transaction of 12/31/04 records the increase in market value of the investment. This in-
crease is an unrealized holding gain; it is not included as part of net income because an
actual sale of the investment has not occurred. The transaction of 12/31/05 records a
decrease in market value that is an unrealized holding loss. The loss is not included in
computing net income because a sale has not occurred. The transaction of 3/5/06 rec-
ognizes a gain on the sale of the investment. This gain is reported as part of net income
because the investment has been sold. Realized income and gains (or losses) are recorded
when resources are received or investments are sold. Holding gains and losses are
recorded when the market value of investments changes during a fiscal period, but the
investments have not been sold.
B.

2004 2005

Cost of investment $230,000 $230,000
Holding gain 40,000 40,000
Holding loss (10,000)
Market value of investment $270,000 $260,000
F427
CHAPTER F11: Investing Activities
430 Investing Activities

SSP11-3
Silicon Company
Statement of Cash Flows
For the Year Ended December 31, 2004

Cash flow from operating activities
Net income $ 50,000
Adjustments for noncash items:
Depreciation and amortization expense 8,000
Loss from sale of plant assets 6,000
Gain from sale of investments (4,000)
Net cash flow from operating activities $ 60,000

Cash flow for investing activities
Capital expenditures $(35,000)
Sale of plant assets 16,000
Purchase of investments (10,000)
Sales of investments 14,000
Net cash flow for investing activities $(15,000)




Interest and dividend income is part of net income. Assuming that cash was received for the
interest and dividends, no adjustment would be made for this amount.




Thinking Beyond the Question
How do we account for investing activities?


This chapter described various types of long-term assets and how companies
account for the acquisition, use, and disposal of these assets. Which assets a
company invests in can be important decisions that affect the performance of
the company. How do investing decisions affect a company’s profitability and
value?




QUESTIONS
Archer Company produces sporting goods equipment. Identify and describe briefly the types
Q11-1
of assets Archer is likely to own and report on its financial statements. (Hint: You may find
Obj. 1
it helpful to review Exhibit 1 in this chapter.)
The gross amount of property, plant, and equipment is usually different from the net amount
Q11-2
of property, plant, and equipment. Explain the difference between the two terms and what
Obj. 1
they represent. In what way is one or the other of these terms related to book value?
Old Treetrunk is an exotic brand of whiskey. It is aged for 13 years in old tree trunks to give
Q11-3
it the smooth taste for which it is well known. The manufacturer of this product makes noth-
Obj. 1
ing else. The company’s office equipment typically lasts for about eight years before replace-
ment. Under what asset category should the office equipment be reported on a classified
balance sheet?
Does it make sense to you that the cost of interest incurred to finance the construction of as-
Q11-4
sets is included as part of the cost of the asset? Why or why not?
Obj. 2
F428 SECTION F2: Analysis and Interpretation of Financial Accounting Information
431
Investing Activities

Q11-5 Do you agree that the units-of-production method always results in more rapid depreciation
of an asset than does the straight-line method? Explain.
Obj. 2

What is the difference between a capital expenditure and an operating expenditure? Explain
Q11-6
how each is accounted for and why the treatment is different.
Obj. 2

A friend says, “The accounting terms depletion and depreciation describe basically the same
Q11-7
thing.” Do you agree or disagree? Why?
Obj. 3

The term depletion expense seldom appears on income statements, even if the company is a

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