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3 ACCOUNTING FOR TRADING AND AVAILABLE-
FOR-SALE SECURITIES
Account for the purchase,
recognition of revenue, and
sale of trading and
Four issues are associated with accounting for securities: (1) accounting for the purchase, (2) ac-
available-for-sale securities.
counting for the revenue earned, (3) accounting for the sale, and (4) accounting for the changes
in value. The first three issues are fairly straightforward and are presented in this section. Ac-
counting for changes in the value of securities is discussed in the following section. The time
line in Exhibit 12-6 illustrates the important business issues associated with buying and selling
investment securities.

Accounting for the Purchase of Securities
Investments in securities, like all other assets, are recorded at cost when purchased. This is the
case whether the security being purchased is debt or equity or whether it is being held with the
intent to sell it quickly or hold it for the long term. Cost includes the market price of the se-
curity plus any extra expenditures required in making the purchase (such as a stockbroker’s fee).
577
f578 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities



Time Line of Business Issues Associated with Buying and Selling Investment
exhibit 12-6
Securities




SECURITIES SECURITIES
SECURITIES
SECURITIES
SECURITIES SECURITIES
SECURITIES
SECURITIES
SECURITIES SECURITIES
SECURITIES
SECURITIES




EARN SELL
PURCHASE CHANGES
a return securities
securities in the value
on securities of securities



To illustrate the accounting for securities, we will use the following information through-
out the chapter. On July 1, 2002, Far Side, Inc. purchased the following securities:


Cost (including
Security Type Classification Broker’s Fees)

1 Debt Trading $ 5,000
2 Equity Trading 27,500
3 Debt Available-for-sale 17,000
4 Equity Available-for-sale 9,200



The initial entry to record the investments is as follows:

Investment in Trading Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,500
Investment in Available-for-Sale Securities . . . . . . . . . . . . . . . . . . . . . 26,200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,700


Though investments in securities are all recorded at cost, each of the four classifications of se-
curities is accounted for differently subsequent to purchase. As a result, separate accounts are used
to record the initial purchase. Management purchased Securities 1 and 2 with the intent of
fyi earning a return on the investment and selling the securities should the need for cash arise.
BERKSHIRE HATHAWAY pur- Therefore, those securities are classified as “trading.” Securities 3 and 4 were also purchased
to earn a return on excess cash, but management has classified them as “available-for-sale.”
chased with cash over $22 bil-
While the journal entry illustrated above combines all securities of the same classification
lion of securities in 1999.
into one account, subsidiary records will be kept for each individual security purchased.

Accounting for the Return Earned on an Investment
When a firm invests in the debt or equity of another firm with the intent of earning a return
on its investment, how that return is accounted for varies depending on the classification of the
investment. Recall from Chapter 10 that when debt securities are sold, a premium or discount
can arise as a result of differences between the stated rate of interest and the market rate of in-
terest. The resulting premium or discount must then be amortized over the life of the invest-
ment, thereby affecting the amount of interest expense recorded by the issuer. Theoretically, the
purchaser of that debt security must also account for the difference between the purchase price
and the eventual maturity value. In the discussion that follows, however, we are assuming that
the time for which the investor anticipates holding debt securities classified as “trading” or as
“available-for-sale” is not long enough for any amortization of premium or discount to materi-
578 f579
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities


ally affect interest expense. Amortization of premiums and discounts on debt securities is illus-
trated for “held-to-maturity” securities in the expanded material section of this chapter.
With this caveat in mind, the accounting for dividends and interest received on trading and
available-for-sale securities becomes relatively straightforward. Cash received relating to interest
and dividends is credited to Interest Revenue and Dividend Revenue, respectively. Interest earned
but not yet received or dividends that have been declared but not paid are also recorded as rev-
enue with a corresponding receivable. Continuing our example, interest and dividends received
during 2002 relating to Far Side’s securities investments were as follows:

fyi Security Interest Dividends
BERKSHIRE HATHAWAY re-
1 $225
ported interest, dividends, and
2 $825
other investment income earned 3 850
of $1.4 billion during 1999. 4 644


The appropriate journal entry to record the receipt of interest and dividends is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,544
Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,075
Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,469



Accounting for the Sale of Securities
Suppose that Far Side sells all of its investment in Security 2 for $28,450 on October 31, 2002.
As Security 2 was purchased for $27,500, the security has increased in value and that increase
must be recorded. The journal entry to record the sale is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,450
Investment in Trading Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,500
Realized Gain on Sale of Trading Securities. . . . . . . . . . . . . . . . . . . 950


If Security 2 had been sold for less then $27,500, a loss would have been recorded. If a bro-
ker’s fee had been charged on the transaction, the fee would reduce the amount of cash received
and decrease the gain recognized. If the broker’s fee exceeded $950, a loss would be recorded
on the books of the seller.
At the end of the accounting period, any gain or loss on the sale of securities must be in-
cluded on the income statement. In the above example, the “Realized Gain on Sale of Trading
Securities” would be included with Other Revenues and Expenses on the income statement.
Note the term realized. Realized gains and losses indicate that an arm’s-length transaction has
realized gains and losses
Gains and losses resulting occurred and that the securities have actually been sold. This distinction is important because
from the sale of securities in in the next section we focus on accounting for unrealized gains and losses—those gains and losses
an arm’s-length transaction.
that occur while a security is still being held and no arm’s-length transaction has taken place.
On its statement of cash flows, BERKSHIRE HATHAWAY reported proceeds of $8,864 mil-
lion from the sale of debt securities and equity securities. On its income statement, the company
reported net realized gains of $1,365 million from the sale of securities. With this information, we
can compute the historical cost of the securities sold during the period. Proceeds of $8,864 million
less a gain of $1,365 million indicate that the cost of the securities was $7,499 million. A summary
journal entry indicating the effects of these transactions for Berkshire Hathaway is as follows:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,864
Available-for-Sale Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,499
Realized Gain on Sale of Securities . . . . . . . . . . . . . . . . . . . . . . . . . . 1,365
579
f580 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities



business environment essay


Following the Bond Market Bonds are bonds trading in the marketplace, it also gives the high
sold in a variety of markets. Original is- and low prices for 2000 and 1999.
sues of bonds, both industrial and gov- The listings for specific bonds give the stated in-
ernmental, are usually sold by an in- terest rate, the year of maturity, the current yield (ef-
vestment banking group, referred to as fective rate), the sales volume for that trading date
the underwriters. Bonds are then traded (with 000s omitted), the closing price for the day, and
in the marketplace, either on the New the net change from the closing price on the previous
York Bond Exchange or over-the- day that the bond market was open. Looking at the
counter through brokers who make a IBM bond issue listed, we can deduce the following:
market for a particular company’s the bonds have a stated interest rate of 7¼% and ma-
bonds. Following is an excerpt from The Wall Street ture in 2002. The current yield (effective interest) on
Journal showing some composite information re- the bonds is 7.2%. Trading volume for the day was
garding bond transactions, as well as price quotations $35,000 face value, and the market price of the bonds
for specific bond issues. The composite information at the end of the day was 100Âľ% (100.75%) of face
gives investors a sense of the overall activity level of value, a decrease of ¼ point from the previous day’s
the bond market in relation to previous years. In this closing price. Thus, each $1,000 bond was selling for
case, it shows that sales through October 24, 2000, $1,007.50.
were lower than in either 1999 or 1998 for compara-
ble time periods. Using a representative sample of Source: The Wall Street Journal, October 25, 2000.


U.S. EXCHANGE BONDS
Tuesday, October 24, 2000
Quotations as of 4 p.m. Eastern Time
SALES SINCE JAN. 1
New York
2000 . . . ................................ $1,912,572,000
1999 . . . ................................ $2,659,930,000
1998 . . . ................................ $3,139,412,000
AMEX
2000 . . . ................................ $86,633,000
1999 . . . ................................ $144,567,000
1998 . . . ................................ $220,938,000



Dow Jones Bond Averages
— 1999 — — 2000 — — — — 2000 — — — — — 1999 — —
High Low High Low Close Chg. %Yld Close Chg.
106.88 96.80 97.01 93.23 20 Bonds 95.71 0.32 8.23 98.55 0.08
104.72 94.96 95.09 90.69 10 Utilities 94.18 0.03 7.93 95.86 0.18
109.44 98.31 99.86 95.53 10 Industrials 97.25 0.61 8.54 101.23 0.03

Cur Net Cur Net
Bonds Yld. Vol. Close Chg. Bonds Yld. Vol. Close Chg.
ChaseM 63/408 7.1 3 95 /8 FordCr 63/808 7.0 10 903/4 13/4
1

ChespkE 95/805 9.6 10 993/4 13/4 GMA 63/402 6.8 18 991/2 5/
8
ChespkE 91/806 9.5 25 961/8 /2 GMA 57/803 6.0 9 973/4 ...
1

ChespkE 81/212 9.8 40 87 ... GMA dc6s11 6.9 14 871/2 3/
4
ChiqBr 10s09 20.8 10 48 11/8 GMA zr12 ... 1 3901/2 1/
4
CitigpCap 73/436 8.7 10 89 1 GMA zr15 ... 1 3151/8 /8
7

vjClardg 113/402f ... 10 697/8 13/8 vjGenesH 93/405f ... 200 111/4 21/8
ClrkOil 91/204 10.5 28 901/8 15/8 HewlPkd zr17 ... 6 711/8 27/8
Coeur 63/804 cv 56 291/8 37/8 Honywll zr01 ... 5 9317/32 17/32
Consec 81/803 10.3 20 787/8 17/8 Honywll zr07 ... 65 62 3/
4
Conseco 101/402 14.6 22 701/8 ... Honywll zr09 ... 10 53 ... ...
ConNG 6s10 6.8 25 887/8 13/8 IBM 71/402 7.2 35 1003/4 1/
4
DelcoR 85/807 9.9 20 87 /8 IBM 6.45s07 6.6 30 981/4 13/8
7

DevonE 4.9s08 cv 9 911/4 13/4 IPap dc51/812 6.9 26 74Âľ 3/
4
Dole 7s03 7.5 20 931/4 3/ KaufB 93/803 9.7 66 963/4 5/
4 8
Dole 77/813 9.0 43 88 1/ KaufB 73/404 8.2 25 94 2
8
DukeEn 57/801 5.9 30 99 ... KaufB 95/806 9.8 117 983/8 3/
8
DukeEn 67/823 7.7 1 891/4 3/ KentE 41/204 cv 40 85 ...
4
DukeEn 71/225 7.9 35 951/2 1/ KerrM 71/214 cv 14 97 1/
8 8
DukeEn 7s33 7.8 50 90 1/ Leucadia 81/405 8.4 12 98 1/
4 2
Finova 91/802 12.2 105 75 5 Leucadia 77/806 8.5 20 923/4 ...
Florsh 123/402 36.6 20 347/8 17/8 Leucadia 73/413 8.8 11 881/2 3
580 f581
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities




to summarize
Investments in debt and equity securities are recorded at cost, which includes
the fair value of the securities plus any other expenditures required to purchase
the securities. When purchased, the securities are classified into one of four
categories: held-to-maturity, equity method, trading, or available-for-sale se-
curities. Revenues from securities take the form of interest, dividends, or gains
or losses from selling the securities and are included under Other Revenues
and Expenses on the income statement.




4 ACCOUNTING FOR CHANGES IN THE VALUE OF
SECURITIES
Account for changes in the
value of securities.
Investments in debt and equity securities are initially recorded at cost. If the value of a security
changes after it is purchased, should that change in value be recorded on the investor’s books?
As stated previously in the chapter, the answer is “it depends.” It depends on management’s in-
tent regarding that security. In the case of trading and available-for-sale securities, changes in
market value are recorded on the books of the investor. For held-to-maturity securities and eq-
uity method securities, changes in value are not recorded unless they are considered permanent.
To illustrate the accounting for changes in value of securities, we will continue the Far Side ex-
ample. On December 31, 2002, the following market values were available:5


Market Value
Security Classification Historical Cost (December 31, 2002)
1 Trading $ 5,000 $ 5,200
3 Available-for-sale 17,000 16,700
4 Available-for-sale 9,200 9,250




Changes in the Value of Trading Securities
At the end of 2002, Far Side computes the market value of its trading securities portfolio and
compares it to the historical cost of the portfolio. In this instance, market value is $200 greater
than historical cost. The journal entry to record this increase in value is:

Market Adjustment—Trading Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Unrealized Gain on Trading Securities—Income . . . . . . . . . . . . . . . . . . . 200


unrealized gains and losses This journal entry recognizes the $200 increase in the value of the trading securities and
Gains and losses resulting
records the unrealized gain on the income statement. Unrealized gains and losses indicate that
from changes in the value
the securities have changed in value and are still being held. This journal entry also introduces
of securities that are still
a new account—Market Adjustment—Trading Securities. This account is combined with the
being held.
trading securities account and reported on the balance sheet. Thus, the balance sheet will reflect
Market Adjustment—Trad-
the trading securities at their fair market value. Why not adjust the trading securities account
ing Securities An account
directly instead of creating this market adjustment account? The reason is that the use of a val-
used to track the difference
uation account, Market Adjustment—Trading Securities, allows a record of historical cost to be
between the historical cost
and the market value of a
company’s portfolio of trad-
ing securities. 5 Remember that Security 2 was sold on October 31, 2002.
581
f582 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities


maintained. With this approach, a company can easily determine realized and unrealized gains.
Perhaps the most important reason for keeping a record of historical cost is that, for tax pur-
poses, only realized gains and losses are relevant. Other decisions made within a firm also rely
on this historical cost information.

In Chapter 7, we were
Changes in the Value of Available-for-Sale Securities
not to write inventory up if its value in-
creased, though we were to write it down if A market adjustment account is also employed when adjusting available-for-
sale securities to their fair market value. However, the change in value is not
its value declined. In Chapter 9, we were
recorded on the income statement but is instead recorded in the account “Un-
not to write property, plant, and equipment
realized Increase/Decrease in Value of Available-for-Sale Securities—Equity.”
up if its value increased, though we were to The “equity” used in the account title refers to the fact that this account is dis-
write it down if its value declined. Why can closed in the stockholders’ equity section of the balance sheet, and its balance
is carried forward from year to year. To illustrate, the available-for-sale portfo-
we write up the value of securities if their
lio of Far Side has a fair market value of $25,950 at year-end and a historical
price increases above the original cost?
cost of $26,200. The appropriate adjustment is:


Unrealized Increase/Decrease in Value of Available-for-Sale
Securities—Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Market Adjustment—Available-for-Sale Securities . . . . . . . . . . . . . . . . 250



This journal entry adjusts the portfolio of available-for-sale securities to its fair market value at
year-end and records the difference in the equity account.


Subsequent Changes in Value
Assume that no securities were bought or sold by Far Side, Inc., during 2003. At the end of
2003, its portfolio of securities had the following fair market values:


Market Value
Security Classification Historical Cost (December 31, 2003)
1 Trading $ 5,000 $ 4,850
3 Available-for-sale 17,000 16,900
4 Available-for-sale 9,200 9,150



The value of the trading securities has declined to $4,850. Since the market adjustment ac-
count relating to trading securities should reflect the difference between historical cost and mar-
ket, an entry is made to adjust the balance in Market Adjustment—Trading Securities from its
previous $200 debit balance to the required $150 credit balance ($5,000 $4,850). Where did
this $200 debit balance come from? It came from the adjusting entry made on December 31,
2002. Remember that the market adjustment account is a real (balance sheet) account and is
not closed at the end of an accounting period. Its balance carries forward from year to year. The
required adjusting entry is:


Unrealized Loss on Trading Securities—Income . . . . . . . . . . . . . . . . . . . . . 350
Market Adjustment—Trading Securities. . . . . . . . . . . . . . . . . . . . . . . . . . 350


When this entry is posted, the Market Adjustment—Trading Securities T-account will appear
as follows:
582 f583
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities


Market Adjustment—
Trading Securities

12/31/02 200
Adjustment 350
12/31/03 150


The $150 credit balance will be netted against the $5,000 balance in the trading se-
caution
curities account and disclosed on the balance sheet as “Investment in Trading Securities
The amount of the adjustment (net)” for $4,850. The $350 unrealized loss will be included in the current period’s net
for the current period depends income and reported on the income statement. This adjustment procedure ensures that
on the balance in the market changes in the value of the trading securities portfolio are reflected in the period in which
those changes in value occurred.
adjustment account. Don’t for-
A similar procedure is employed in valuing the available-for-sale securities portfolio, ex-
get to factor that balance into
cept that the stockholders’ equity account is used instead of the income statement account.
your calculations.
For Far Side, the market value of the available-for-sale securities portfolio is $26,050. In com-
paring this to the historical cost of $26,200, a $150 credit balance in the market adjustment ac-
count is required. Take a moment and read the information again. An adjustment to get to a $150
credit balance is required—not an adjustment of $150. Given the previous credit balance in Mar-
ket Adjustment—Available-for-Sale Securities of $250, the following adjusting entry is required:

Market Adjustment—Available-for-Sale Securities. . . . . . . . . . . . . . . . . . . . 100
Unrealized Increase/Decrease in Value of Available-for-Sale
Securities—Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100


Once this entry is posted, Market Adjustment—Available-for-Sale Securities will have the re-
quired $150 credit balance as follows:

Market Adjustment—
Available-for-Sale Securities

12/31/02 250
Adjustment 100
12/31/03 150


When individual securities from a portfolio are sold, a realized gain or loss is recognized for
the difference between the original cost of the securities and the selling price, without regard to
previous adjustments made to a market adjustment account. At the end of the period, the cost
of the remaining securities is compared to the fair market value of the remaining securities, and
the market adjustment account is updated to account for the difference.
As mentioned earlier, BERKSHIRE HATHAWAY classifies all of its securities as available-
for-sale. To determine how well Warren Buffett has managed the portfolio during the year, the
financial statement reader must review both the income statement and the statement of stock-
holders’ equity. Comparing the performance of the company’s portfolio of securities for the years
1997 through 1999 results in the following (in millions):

1997 1998 1999

Realized investment gains
(from the income statement) . . . . . . . . . . . . . . . . . . . $ 1,106 $2,415 $1,365
Unrealized appreciation of investments
(from the statement of shareholders’ equity) . . . . . . . 10,574 3,011 (795)
Total portfolio performance . . . . . . . . . . . . . . . . . . . . . $11,680 $5,426 $ 570
583
f584 Investments In Debt And Equity Securities
Part 3 EM Investing and Financing Activities


This declining performance, particularly in 1999, prompted Mr. Buffett to state the following
in his 1999 letter to shareholders:


The numbers ... show just how poor our 1999 record was. We had the
worst absolute performance of my tenure and, compared to the S&P,
the worst relative performance as well. Relative results are what concern
us: Over time, bad relative numbers will produce unsatisfactory absolute
results. Even Inspector Clouseau could find last year’s guilty party: your
Chairman.




to summarize
When the value of a trading or available-for-sale security changes, that change
is reflected on the balance sheet using a market adjustment account. For trad-
ing securities, the unrealized gain or loss is reflected on the income statement
for the period. For available-for-sale securities, the unrealized increase or de-
crease is recorded in a stockholders’ equity account.




In this section of the chapter, we turn our attention to some of the complexities

associated with purchasing debt and equity securities. First, we examine held-
to-maturity securities and how any associated premium or discount associated

with these securities is amortized. We also address the issue of purchasing a
debt security between interest payment dates. The accounting issues associated
with an equity security accounted for under the equity method are also presented.


5 ACCOUNTING FOR HELD-TO-MATURITY
SECURITIES
Account for held-to-
maturity securities.
Held-to-maturity securities are debt securities issued by companies to raise needed funding for ex-
pansion, acquisitions, or other business reasons. Bonds (discussed in Chapter 10 from the point of
view of the issuer) are by far the most common type of debt instrument that can be readily bought
and sold. Because bonds represent the most common type of publicly traded debt instrument, the
following discussion will focus on bonds purchased as investments to be held to maturity.

Accounting for the Initial Purchase
Bonds can be purchased at amounts either above face value (at a premium), below face value
(at a discount), or at face value. Regardless of the purchase price, like all other assets, bonds are
initially recorded at cost. The cost is the total amount paid to acquire the bonds; this includes
the actual price paid for the bonds and any other purchasing expenditures, such as commissions
or broker’s fees.
To illustrate, assume that Far Side, Inc., purchased a fifth security and classified it as held-to-
maturity. Security 5 consists of twenty $1,000 bonds of Chicago Company. The bonds were issued
584 f585
Investments In Debt And Equity Securities EM Chapter 12
Investments in Debt and Equity Securities


on July 1, 2002, and will mature five years from the date of issuance. The bonds will pay interest
at a stated annual rate of 12%, with payments to be made semiannually on June 30 and December
31. In determining the value of the bonds, the present value of these future cash flows must be de-
termined at the market rate on the date of the purchase. Assuming the market rate on bonds of sim-
ilar risk is 16%, the purchase price of the bonds is obtained by adding the present value of $20,000
(received 10 periods in the future and discounted at 8%) to the present value of the annuity of the
10 interest payments of $1,200 each (discounted at 8%). The reason 8% is used is that interest is
received semiannually; recall that in calculating present value, you must halve the interest rate (16%/2)
for semiannual compounding periods. Likewise, you must double the number of years to determine
the number of periods (5 years 2 periods per year = 10 periods). The calculations are:
1. Semiannual interest payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,200
Present value of an annuity of 10 payments of
$1 at 8% (Table II, page 484). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.7101
Present value of interest payments . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,052
2. Principal (face value) of bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000
Present value of $1 received 10 periods in the
future discounted at 8% (Table I, page 483) . . . . . . . . . . . . . . . . . . 0.4632
Present value of principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,264
3. Total present value of investment . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,316

In this example, 16% is the effective rate of interest because that is the amount of interest
actually earned; 12% is the stated, or nominal, rate of interest on Chicago Company’s bonds.
Note that the 12% stated rate determines the size of the annuity payments ($20,000 0.12
½ year) but not the purchase price of the bonds; the purchase price varies according to market
conditions. The 16% effective rate depends on three amounts: the purchase price, the interest
payments, and the face value of the bonds. The $17,316 bond price is the amount that earns
Far Side exactly 16%. The journal entry to record the acquisition is:

Investment in Held-to-Maturity Securities . . . . . . . . . . . . . . . . . . . . . . 17,316
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,316


Note that the investment account is debited for the cost of the bonds with no separate
amount shown for the discount of $2,684 ($20,000 $17,316). Although the discount could
be recorded in a separate contra-asset account, in practice it is more common for investors to
record the asset cost in the investment account as shown.

Accounting for Bonds Purchased between Interest Dates
The preceding entry assumes that the investing company purchased the bonds on the issuance
date, which was also the beginning date for the first interest period. In many cases, however, the
date bonds are actually issued does not coincide with an interest date. Further, investors often
acquire bonds in the “secondary market”; that is, they purchase bonds from other investors rather
than from the issuing company. The secondary market for bonds includes the New York Bond
Exchange and the over-the-counter bond market as described in the Business Environment Es-
say on page 580. Since bonds are traded actively in this market each weekday, investors often
acquire bonds between interest dates.
An investor who buys bonds between interest dates, either from the issuing company or in
the secondary market, has to pay for the interest that has accrued since the last interest payment
date. As explained in Chapter 10, this is necessary because whoever owns the bonds at the time
interest is paid receives interest for one full interest period, usually six months, regardless of how
long the bonds have been held.
To illustrate, we will assume that Far Side purchased the Chicago Company bonds in the
secondary market for $17,316 on November 1, 2002. Semiannual interest of $1,200 ($20,000
0.12 ½) is paid on the bonds on June 30 and December 31 of each year. On December
31, 2002, Far Side will receive $1,200 even though the bonds were purchased only two months
585
f586 Investments In Debt And Equity Securities
Part 3 EM Investing and Financing Activities



Investing between Interest Dates
exhibit 12-7

June 30
December 31
$1,200
$1,200
interest
November 1 interest
received by
purchase received by
Far Side
date
July 1 Far Side




$400 interest $1,200 interest
$800 interest earned
earned by Far Side earned by Far Side
by previous investor



earlier. Since the previous owner is entitled to 4 months’ interest on November 1, Far Side will
have to pay that individual or company the interest for the period July 1 to October 31. This
is illustrated in Exhibit 12-7.
The entry to record the investment in bonds on November 1 (between interest dates) is:

Investment in Held-to-Maturity Securities . . . . . . . . . . . . . . . . . . . . . . 17,316
Bond Interest Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,116
Purchased $20,000 of Chicago Company bonds for $17,316
and paid four months’ accrued interest.


When Far Side receives $1,200 in interest on December 31, it will make the following entry:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Interest Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Received interest on Chicago Company bonds.



Accounting for the Amortization of Bond Discounts and
Premiums
Only in those rare instances when the stated interest rate of a bond is exactly equivalent to the
prevailing market (or yield) rate for similar investments is a bond purchased at face value. At all
other times, bonds are purchased either at a discount (below face value) or at a premium (above
face value). Because the face amount of a bond is received at maturity, discounts and premiums
must be written off (amortized) over the period that a bond is held.
As you learned in Chapter 10, there are two common methods of amortizing bond dis-
counts and premiums: the straight-line method and the effective-interest method. Because
straight-line amortization is simpler, it will be used first to illustrate the amortization process;
then the effective-interest method will be described.
To illustrate the straight-line amortization of a bond
STRAIGHT-LINE AMORTIZATION
straight-line amortization A
method of systematically discount, we will assume again that Far Side purchased the Chicago Company $20,000, 12%,
writing off a bond discount
five-year bonds for $17,316 on the issuance date, July 1, 2002. The entry to record this invest-
or premium in equal
ment was given on page 585. Far Side will record amortization of $268.40 ($2,684/5 years
amounts each period until
½) on each interest date. Thus, every six months, beginning on December 31, 2002, Far Side
maturity.
will make the following entry:
586 f587
Investments In Debt And Equity Securities EM Chapter 12
Investments in Debt and Equity Securities



Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200.00
Investment in Held-to-Maturity Securities. . . . . . . . . . . . . . . . . . . . 268.40
Bond Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,468.40
Received semiannual bond interest and amortized
bond discount.


At the end of five years, the investment in the held-to-maturity securities account will have a
balance of $20,000.
The discount amortization is revenue earned on the bonds; when the bonds mature, Far Side
will receive $20,000 (the face value) in return for an original investment of $17,316. It is this ad-
ditional revenue of $2,684 that increases the return the investor actually earns from the 12% stated
interest rate to the effective interest rate of 16%. The following analysis shows how this works:
Maturity value to be received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000
Interest to be received ($1,200 10 payments) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Total amount to be received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000
Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,316
Total interest revenue to be earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,684

Interest earned per year:
Stated amount of interest ($20,000 0.12) . . . . . . . . . . . . . . . . . . . . . . . . . $2,400.00 12%
Additional interest from discount ($2,684/5 years) . . . . . . . . . . . . . . . . . . . . 536.80 4%*
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,936.80 16%
*This is an approximation; with the straight-line method, the actual interest earned each year changes.

When accounting for the amortization of a bond discount, a company must be careful to
amortize the discount only over the period the bonds are actually held. For example, if Far Side
had purchased the Chicago Company bonds four months after the issuance date, the discount
would have been amortized over a period of 56 months (4 full years plus 8 months of the first
year). The amortization for the first year would then have been approximately $383.43 ($2,684
8/56), and the amortization for each of the succeeding four years would be approximately

$575.14 ($2,684 12/56).
Accounting for the amortization of a premium on investments is essentially the opposite of
accounting for a discount. Amortization of a premium decreases revenue earned, and the effect
of the amortization entry is to reduce Investment in Held-to-Maturity Securities to the face value
of the bonds by the maturity date.
To illustrate the amortization of a bond premium by the investor, assume that Far Side ac-
quired the $20,000, 12%, five-year Chicago Company bonds for $21,540 on July 1, 2002, the
date of issuance. The entry to record the purchase is:

Investment in Held-to-Maturity Securities . . . . . . . . . . . . . . . . . . . . . . . . 21,540
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,540
Purchased $20,000 of Chicago Company bonds for $21,540.


At each interest payment date, beginning December 31, 2002, Far Side will make the follow-
ing entry:

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Investment in Held-to-Maturity Securities . . . . . . . . . . . . . . . . . . . . . . 154
Bond Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,046
Received semiannual bond interest and amortized bond premium
($1,540/5 years 1/2).
587
f588 Investments In Debt And Equity Securities
Part 3 EM Investing and Financing Activities


The effect of the amortization entries is to reduce the return earned on the bonds from the
stated annual interest rate of 12% to the rate actually earned on the investment (approximately
10%).

To illustrate the computations involved in using
EFFECTIVE-INTEREST AMORTIZATION
the effective-interest amortization method, we will again consider Far Side’s purchase of the
effective-interest amortiza-
tion A method of systemati- 12%, five-year, $20,000 bonds of Chicago Company for $17,316 on the issuance date. The
cally writing off a bond pre-
amount of discount amortized in each of the five years using the effective-interest method is
mium or discount that takes
computed as shown in Exhibit 12-8.
into consideration the time
In the computation, column (2) represents the cash received at the end of each interest pe-
value of money and results
riod; column (3) shows the amount of effective interest earned, which is the amount that will
in an equal rate of amorti-
zation for each period. be reported on the income statement each period; column (4) is the difference between columns
(3) and (2) and so represents the amortization; and column (5) shows the investment bal-
fyi ance that will be reported on the balance sheet at the end of each period. Note that the
interest rate used to compute the actual interest earned is the effective rate of 8% (16%/2)
Note the similarities between
and not the stated rate of 12%. Also note that the total discount is the same as it was
this table and the amortization
when the straight-line method was used, $2,684.
tables prepared in Chapter 10.
When bonds are purchased at a discount, the amount of amortization increases each
The computations are identi-
successive period. This is so because the investment balance of the bonds increases, and
cal—the only difference is that
a constant interest rate times an increasing balance results in an increasing amount of
in Chapter 10, we were paying
interest income. If bonds are purchased at a premium, the effective-interest amortiza-
cash, whereas in Chapter 12, tion method will involve a constant interest rate being multiplied by a declining in-
we are receiving cash. vestment balance each period. The result will be a decline in actual interest earned each
period.
Since the effective-interest amortization method takes into account the time value of money,
and thus shows the true revenue earned each period (whereas the straight-line method repre-
sents only approximations), companies normally should use the effective-interest amortization
method. As an exception to this rule, companies are allowed to use the straight-line method
when the two methods produce amortization amounts that are not significantly different. Be-
cause that is often the case, both methods continue to be used.




Amortization Table for Chicago Company Bonds
exhibit 12-8


(1) (2) (3) (4) (5)
Amount of
Cash Interest Actually Earned Amortization Investment
Time Period Received (0.16 x ½ Investment Balance) (3) (2) Balance

Acquisition date $17,316
Year 1, first six months $1,200 (0.08 $17,316) $1,385 $ 185 17,501
Year 1, second six months 1,200 (0.08 $17,501) 1,400 200 17,701
Year 2, first six months 1,200 (0.08 $17,701) 1,416 216 17,917
Year 2, second six months 1,200 (0.08 $17,917) 1,433 233 18,150
Year 3, first six months 1,200 (0.08 $18,150) 1,452 252 18,402
Year 3, second six months 1,200 (0.08 $18,402) 1,472 272 18,674
Year 4, first six months 1,200 (0.08 $18,674) 1,494 294 18,968
Year 4, second six months 1,200 (0.08 $18,968) 1,517 317 19,285
Year 5, first six months 1,200 (0.08 $19,285) 1,543 343 19,628
Year 5, second six months 1,200 (0.08 $19,628) 1,572* 372 20,000
$2,684
*Difference due to rounding.
588 f589
Investments In Debt And Equity Securities EM Chapter 12
Investments in Debt and Equity Securities



Accounting for the Sale or Maturity of Bond Investments
If bonds are held until their maturity date, the accounting for the proceeds at maturity includes
a debit to Cash and a credit to the investment account for the principal amount. For example,
if Far Side, Inc., holds the $20,000, 12% bonds from Chicago Company to maturity, the en-
try to record the receipt of the bond principal on the maturity date will be:


Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Investment in Held-to-Maturity Securities. . . . . . . . . . . . . . . . . . . . . 20,000
Received the principal of Chicago Company bonds at maturity.


This entry assumes, of course, that all previous receipts of interest and bond amortizations have
been properly recorded.
Because held-to-maturity securities are usually traded on major exchanges, thus providing
a continuous and ready market, they can be sold to other investors prior to their maturity. When
these securities are sold prior to their maturity, the difference between the sales price and the
investment balance is recognized as a gain or loss on the sale of the investment.
To illustrate, we will assume that Sawyer Company purchased ten $1,000, 8%, five-year
bonds of REX Company. We will also assume that the bonds were originally purchased on Jan-
uary 1, 2002, at 101% of their face value; on January 1, 2003, Sawyer showed a balance of
$10,040 for these bonds. If the bonds are sold on that day for $10,300, the entry to record the
sale and recognize the gain is (assuming no sales commission):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,300
Gain on Sale of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
Investment in Held-to-Maturity Securities. . . . . . . . . . . . . . . . . . . . . 10,040
Sold the REX bonds for $10,300.


If held-to-maturity securities are sold prior to their maturity date, it is important that the amor-
tization of the bond premium or discount be recorded up to the date of sale. If the amortization of
the discount or premium is not updated, the gain or loss recognized on the sale will be incorrect.




to summarize
Accounting for investments in held-to-maturity securities involves four steps: (1)
accounting for the purchase of the securities, (2) accounting for interest received
on the securities, (3) accounting for amortization of the premium or discount,
and (4) accounting for the sale or maturity of the securities. Amortization of pre-
miums and discounts is usually accounted for by the simple straight-line amor-
tization method or the theoretically more correct effective-interest method. The
amortization adjusts the interest earned on the bonds from the stated to the ef-
fective rate. Investments in held-to-maturity securities are generally reported at
cost (adjusted for premium or discount amortization), regardless of whether the
current market value is less than or greater than their historical cost. When held-
to-maturity securities are sold before maturity, the premium or discount must
be amortized to the date of sale; a gain or loss would be reflected in the income
statement for the difference between the selling price and the carrying value on
the date of sale. Debt securities held until maturity result in no gain or loss on
retirement because the carrying value after amortization of a premium or dis-
count should be equal to the face value of the securities.
589
f590 Investments In Debt And Equity Securities
Part 3 EM Investing and Financing Activities



6 ACCOUNTING FOR EQUITY INVESTMENTS
USING THE EQUITY METHOD
Account for securities using
the equity method.
When enough of the outstanding common stock of a company is purchased by another com-
pany, the acquiring company may have the ability to significantly influence the operating deci-
sions of the investee. If the ability to influence is present, then accounting standards require the
use of the equity method in accounting for the investment. As stated previously, significant in-
fluence is presumed if a company owns between 20 and 50% of a company. Keep in mind that
the percentage ownership criterion serves only as a guideline. The ability to influence is the key
criterion. For example, assume that a company owns 35% of a firm that is headquartered in a
foreign country whose government is undergoing a period of volatility. Some of the radical lead-
ers in that country are calling for more internal investment and less outside interference from
U.S. corporations. These leaders, if able to gain positions of power, have threatened to expro-
priate (take over all operations owned by U.S. companies). Even though the U.S. company meets
the percentage ownership criterion, it may not be able to significantly influence the operations
of the foreign subsidiary. Consider another example of a firm whose ownership is widespread,
with no single shareholder owning more than 2% of the corporation. If one stockholder were
able to acquire 15% of the outstanding common stock, that investor might be able to influence
the decisions of the investee simply because of the size of the ownership percentage relative to
that of all other stockholders. The important point is that the ability to influence is the key cri-
terion for using the equity method of accounting.
Under the equity method, dividend payments represent a return of investment; they do not
represent revenue, as they do when accounting for trading or available-for-sale securities. Rev-
enue is recognized when the investee company has earnings. When earnings are announced, the
carrying (book) value of the investment is increased because the investor owns a fixed percent-
age of a company that is worth more now than it was when the investment was originally made.
In accounting for investments with the equity method, the original investment is first
fyi recorded on the books at cost and is subsequently modified to reflect the investor’s share
of the investee’s reported income, losses, and dividends. In this way, book value is in-
Although temporary changes
creased to recognize the investor’s share of earnings and decreased by the dividends re-
in the value of equity method
ceived or to recognize the investor’s share of losses. Temporary changes in value of in-
securities are not accounted
vestments accounted for using the equity method are not recorded.
for, permanent changes are
There are two reasons why the procedures employed under the equity method are
recognized. This treatment is
preferred over those used when accounting for trading or available-for-sale securities. First,
consistent with the concept of
the equity method assumes that significant influence can be exerted. Thus, the account-
asset impairment discussed in
ing procedures prevent the investing company from manipulating earnings by dictating
Chapter 9. the dividend policy of the investee. For a trading or available-for-sale security, where div-
idend payments are reported as revenue, an influential investor could increase its income
by putting pressure on the investee to pay larger and more frequent dividends. With the equity
method, dividends do not affect earnings. Second, the equity method provides more timely
recognition of the investee’s earnings and losses than do the procedures employed for trading or
available-for-sale securities.

caution Illustrating the Equity Method
A common mistake in account-
To illustrate the accounting for the equity method, we will use the following information:
ing for equity method securi-
Kimball, Inc. purchases 20% (2,000 shares) of Holland Enterprises outstanding common
ties is to debit or credit the in-
stock (10,000 shares), paying $100 per share. Later in the year, Kimball receives a dividend
vestment account for the entire
of $2.50 per share; at year-end Kimball receives Holland’s income statement showing that
amount of the investee’s in-
the company earned $50,000 for the year. To ensure that you understand how the equity
come or dividends. Remember, method differs from the accounting demonstrated earlier in the chapter, we will proceed
the investor accounts only for with two scenarios: (1) Kimball is not able to exercise significant influence on Holland and,
as a result, classifies the security as available-for-sale, and (2) Kimball is able to exercise sig-
its share of the investee’s in-
nificant influence and uses the equity method. The accounting for this purchase of stock
come and dividends.
and subsequent events is shown in Exhibit 12-9. Column 1 shows the journal entries as-
590 f591
Investments In Debt And Equity Securities EM Chapter 12
Investments in Debt and Equity Securities



Accounting for Equity Securities
exhibit 12-9


(1) (2)
Available-for-Sale Security Equity Method Security

Accounting for the Investment in Available-for-Sale Investment in Equity Method
initial purchase of Securities . . . . . . . . . . . . . . . . . . 200,000 Securities . . . . . . . . . . . . . . . . 200,000
the stock Cash . . . . . . . . . . . . . . . . . . . . 200,000 Cash . . . . . . . . . . . . . . . . . . 200,000
Payment of a $2.50 Cash . . . . . . . . . . . . . . . . . . . . . . 5,000 Cash . . . . . . . . . . . . . . . . . . . . 5,000
per share dividend by Dividend Revenue . . . . . . . . . . 5,000 Investment in Equity
Holland Company Method Securities . . . . . . . . 5,000
Announcement by No entry Investment in Equity
Holland of net income Method Securities . . . . . . . . . . 10,000
for the year of $50,000 Revenue from Investments. . 10,000
Holland stock is Market Adjustment— No entry
selling at $102 per Available-for-Sale Securities . . . . 4,000
share at year-end Unrealized Increase
in Available-for-Sale
Securities—Equity . . . . . . . . . . 4,000



suming that the Holland stock is considered an available-for-sale security. Column 2 illustrates
the equity method. It is assumed that the Holland stock is selling for $102 per share at year-end.
Although accounting for the holding of equity method securities is different from the
fyi accounting for available-for-sale or trading securities, accounting for the sale of a stock in-
vestment is the same regardless of the classification. If the selling price exceeds the bal-
COCA-COLA, a company in
ance in the investment account, the difference is recognized as a gain. If the selling price
which BERKSHIRE HATHAWAY
is less than the recorded investment balance, the difference is recognized as a loss. To il-
owns over 8%, has a number of
lustrate, assume that Kimball sells its 2,000 shares of Holland Enterprises stock (previ-
subsidiaries that it accounts for
ously accounted for under the equity method) for $225,000 shortly after the year-end
using the equity method. In
recognition of its $10,000 share of Holland’s earnings. The entry to record the sale is:
1999, Coca-Cola reported eq-
uity income from those sub-
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
sidiaries of a negative $184 mil-
Investment in Equity Method Securities . . . . . . . . . . . . . . . . 205,000
lion accounted for using the
Realized Gain on Sale of Investment . . . . . . . . . . . . . . . . . . 20,000
equity method.


The $205,000 is obtained by adding Kimball’s share of Holland’s reported net income to the
original investment cost and subtracting the dividends received from Holland ($200,000
$10,000 $5,000).



to summarize
All investments in stock are initially accounted for at cost. However, because
different levels of investment provide different degrees of influence over in-
vestee companies, accounting for subsequent events relating to the investee
will differ depending on the degree of influence. When the percentage of out-
standing voting common stock owned is sufficient to exercise influence (as is
usually true with ownership of 20 to 50%), the equity method is used. This
method involves increasing the book value of the investment for earnings and
decreasing it for dividends and losses.
591
f592 Investments In Debt And Equity Securities
Part 3 EOC Investing and Financing Activities




review of learning objectives

Understand why companies invest in other compa- Account for changes in the value of securities. When
1 4
nies. Companies invest in the debt and equity securities the market value of a security changes, the classifica-
of other companies for a variety of reasons. The primary rea- tion of the security determines whether the change in value
son is to earn a return on invested funds. Bonds and stocks is recorded on the financial statements. With held-to-matu-
offer a higher potential return for investors than the interest rity securities and equity method securities, because the in-
rates offered by government-backed securities or savings rates tent of management is to hold these types of securities for
offered by banks and other financial institutions. Along with long periods of time, changes in market value are not recog-
the potential for higher returns comes the prospect of higher nized. For securities classified as trading, any unrealized gains
risks; the investor faces the possibility of earning little return and losses are recognized on the income statement. A mar-
or even losing money. Besides earning a return, companies in- ket adjustment account is offset against Investment in Trad-
vest in the securities of other companies for additional reasons, ing Securities to value the securities at their fair market value
including establishing a long-term business relationship, en- on the balance sheet. Available-for-sale securities are also ad-
suring an adequate supply of raw materials, ensuring a sales justed to fair market value using a market adjustment ac-
network for inventory, or gaining access to developed assets, count. However, the offset is recorded in a stockholders’ eq-
such as software programs or oil reserves. uity account.

Understand the different classifications for securities.
2 Debt and equity securities are classified according to man-
agement’s intent in holding the securities. If the securities are
being held for the short term with the intent to sell the securi- Account for held-to-maturity securities. The purchase
5
ties if cash is needed, the securities are accounted for as “trad- price of a held-to-maturity security may be less than face
ing” securities. If debt securities are expected to be held until value, resulting in a discount, or it may be more than face
they mature, the securities are classified as “held-to-maturity.” value, resulting in a premium. The discount or premium is
If equity securities are purchased with the intent of being able amortized over the life of the bond by adjusting the cost up-
to significantly influence the operating decisions of the investee ward if purchased at a discount and downward if purchased
(ownership of between 20 and 50% of outstanding common at a premium. Adjusting the cost of the bond up or down en-
stock typically reflects the ability to significantly influence), the sures that the recorded cost will be equal to the face value of
securities are accounted for using the equity method. Debt and the bond at the maturity date. This adjustment is accom-
equity securities not classified as trading, held-to-maturity, or plished through the amortization of the premiums and dis-
equity method securities are classified as “available-for-sale.” The counts, which adjusts the interest earned on the bonds from
importance of these distinctions becomes clear when changes in the stated to the effective rate. Bond discounts and premiums
the value of the securities are accounted for by the investor. can be amortized using either the straight-line or the effec-
tive-interest method. The latter is theoretically more correct,
Account for the purchase, recognition of revenue, and but if the differences between the two are insignificant, either
3 sale of trading and available-for-sale securities. In- can be used.
vestments in securities are initially recorded at cost. Cost in-
cludes the fair market value of the securities as well as broker’s Account for securities using the equity method. If
6
fees. For trading and available-for-sale securities, dividends or ownership of the outstanding stock of another company
interest earned is recorded as revenue. For held-to-maturity se- gives the investor the ability to significantly influence the com-
curities and equity method securities, the recognition of rev- pany (as generally happens with 20 to 50% ownership), the
enue is more complex. When a security is sold, regardless of equity method is used to account for the investment. With the
its classification, its carrying (book) value is compared to the equity method, the purchase is recorded at cost. The invest-
selling price to determine any realized gain or loss on the sale. ment balance (its book value) is decreased by dividends and
These realized gains and losses are disclosed on the income losses and increased by the investor’s share of the investee com-
statement with Other Revenues and Expenses. pany’s earnings.
592 f593
Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12




key terms and concepts

available-for-sale securities 574 held-to-maturity security 573
consolidated financial statements Market Adjustment—Trading
574 Securities 581
effective-interest amortization 588
debt securities 572 realized gains and losses 579
straight-line amortization 586
equity method 574 trading securities 574
equity securities (stock) 573 unrealized gains and losses 581




review problem

On January 1, 2003, Schultz, Inc., purchased the following securities:
Investments in Debt and
Equity Securities
Security Type Classification Cost

1 Debt Trading $2,500
2 Debt Trading 1,500
3 Equity Trading 1,750
4 Debt Available-for-sale 4,300
5 Equity Available-for-sale 2,750


On March 31, one-half of Security 2 was sold for $900. During the year, interest and dividends
were received as follows:

Security Interest Dividends

1 $200
2 85
3 none
4 435
5 $200


The following fair market values are available on December 31, 2003. Schultz had no balance
in its market adjustment accounts on January 1, 2003.

Security Market Value

1 $2,400
2 950
3 1,600
4 4,250
5 2,900


Record all necessary journal entries to account for these investments during 2003.
Required:
To account for these investments, four events must be accounted for:
Solution
1. The initial purchase on January 1.
2. The sale of one-half of Security 2 on March 31.
3. The receipt of interest and dividends during the year.
4. The changes in value as of December 31.
593
f594 Investments In Debt And Equity Securities
Part 3 EOC Investing and Financing Activities


The initial purchase
Jan. 1 Investment in Trading Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,750
Investment in Available-for-Sale Securities . . . . . . . . . . . . . . . . . . . . 7,050
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,800
To record the purchase of trading and available-for-sale securities.

The sale of one-half of Security 2 on March 31
Mar. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900
Realized Gain on Sale of Securities. . . . . . . . . . . . . . . . . . . . . . . . . . 150
Investment in Trading Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . 750
Sold one-half of Security 2 ($750 book value) for $900.
Recorded the $150 realized gain ($900 $750).

The receipt of interest and dividends during the year
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 920
Interest Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
Dividend Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Received $720 in interest during the year and $200 in dividends.
Note: Even if cash were not received by year-end, the interest and dividends earned
would need to be recorded, with the offsetting debit to a receivable account(s).

The changes in value as of December 31, 2003
Dec. 31 Unrealized Loss on Trading Securities . . . . . . . . . . . . . . . . . . . . . . . . . 50
Market Adjustment—Trading Securities . . . . . . . . . . . . . . . . . . . . . . 50
To account for the difference between book value
($5,000) and fair market value ($4,950) of trading securities.
Note: Remember that one-half of Security 2 was sold during the year.


Dec. 31 Market Adjustment—Available-for-Sale Securities . . . . . . . . . . . . . . . . 100
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities—Equity . . . . . . . . . . . . . . . . . . . . . . . . 100
To account for the difference between book value ($7,050) and
fair market value ($7,150) of available-for-sale securities.




discussion questions

1. Why do firms invest in assets that are not directly re- 7. Identify the different types of returns an investor can
lated to their primary business operations? realize when investing in debt and equity securities.
2. Describe the risk and return trade-off of investments. 8. When a security is sold, what information must be
3. What are the four different classifications of debt and known to account for that transaction?
equity securities? 9. What is the difference between a realized gain or loss
4. When will a security be classified as “trading”? and an unrealized gain or loss?
5. What types of securities can be classified as “held-to- 10. What does the account “Market Adjustment” represent?
maturity”? 11. How are changes in the value of trading securities ac-
6. To be classified as an equity method security, the in- counted for on the books of the investor?
vestor must typically own at least a certain percentage 12. How are changes in the value of available-for-sale secu-
of the outstanding common stock of the investee. rities accounted for on the books of the investor?
What is that minimum percentage? That percentage 13. What is the process for adjusting the value of a trading
of ownership represents the investor’s ability to do or available-for-sale security after a valuation account
what? has been established?
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Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12


14. Why aren’t premiums and discounts on available-for- 19. Why does the amortization of a discount increase the
sale securities amortized? amount of interest revenue earned on a held-to-matu-
15. Why aren’t changes in the value of held-to-maturity rity security?
and equity method securities accounted for on the 20. Why must an investor purchasing held-to-maturity se-
books of the investor? curities between interest payment dates pay the previous
16. How does the accounting for changes in the value of owner for accrued interest on those securities?
trading and available-for-sale securities differ? 21. Why is the effective-interest amortization method theo-
retically superior to the straight-line method?
22. What is the key criterion for using the equity method
of accounting for equity securities?
23. What guidelines have been provided to determine if the
17. What future cash inflows is a company buying when it ability to significantly influence the decisions of an in-
purchases a held-to-maturity security? vestee exists?
18. When would a company be willing to pay more than 24. How does the equity method of accounting for securi-
the face amount (a premium) for a held-to-maturity se- ties differ from the procedures employed for a trading
curity? security?




discussion cases

CASE 12-1 WHICH INVESTMENT SHOULD WE MAKE?
Pentron Data Corporation has a significant amount of excess cash on hand and has decided to
make a long-term investment in either debt or equity securities. After a careful analysis, the in-
vestment committee has recommended to the company treasurer that Pentron purchase either
one of the following two investments. The first investment involves purchasing sixty $1,000,
8% bonds issued by the Andrea Company. The bonds mature in four years, pay interest semi-
annually, and are currently selling at 92. The second investment alternative involves purchasing
3,000 shares of Franklin Corporation common stock at $30 per share (including brokerage fees).
The investment committee believes that the Franklin stock will pay an annual dividend of $3.50
per share and is likely to be salable at the end of four years for $36 per share.
Discuss the following questions:
1. If Pentron wants to earn 12% per year, should it make either investment?
2. Which of the two investments would you advise the treasurer to invest in assuming the
inherent risk is approximately equal? Your decision should be based on which investment
provides the more attractive return, ignoring income tax effects.

CASE 12-2 CLASSIFICATION OF SECURITIES
Memphis Company has just purchased five securities; it intends to hold the stock until the price
increases to a sufficiently high level, at which time it plans to sell the stock. In fact, it is unlikely
that the company will hold the securities for more than a few months. Nevertheless, Memphis’s
management has decided to classify the securities as available-for-sale rather than as trading se-
curities. Why is Memphis choosing this type of classification, and would you allow it if you were
the auditor?
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Part 3 EOC Investing and Financing Activities




exercises

EXERCISE 12-1 INVESTMENT IN TRADING SECURITIES—JOURNAL ENTRIES
Prepare the journal entries to account for the following investment transactions of Clyde
Company:

2002
July 1 Purchased 200 shares of Nickle Company stock at $36 per share plus a brokerage
fee of $450. The Nickle stock is classified as trading.
Oct. 31 Received a cash dividend of $1.50 per share on the Nickle Company stock.
Dec. 31 At year-end, Nickle Company stock had a market price of $33 per share.
2003
Feb. 20 Sold 100 shares of the Nickle Company stock for $37 per share.
Oct. 31 Received a cash dividend of $1.70 per share on the Nickle Company stock.
Dec. 31 At year-end, Nickle Company stock had a market price of $39 per share.


EXERCISE 12-2 INVESTMENT IN TRADING SECURITIES—JOURNAL ENTRIES
In June 2003, Hatch Company had no investment securities but had excess cash that would
not be needed for nine months. Management decided to use this money to purchase trad-
ing securities as a short-term investment. The following transactions relate to the invest-
ments:
July 16 Purchased 4,000 shares of Eli Corporation stock. The price paid, including bro-
kerage fees, was $41,880.
Sep. 23 Received a cash dividend of $0.90 per share on the Eli stock.
28 Sold 2,000 shares of Eli Corporation stock at $11 per share. Paid a selling com-
mission of $160.
Dec. 31 The market value of Eli’s stock was $11.25 per share.
Given these data, prepare the journal entries to account for Hatch’s investment in Eli Corpo-
ration stock.


EXERCISE 12-3 INVESTMENT IN AVAILABLE-FOR-SALE SECURITIES—JOURNAL
ENTRIES
Wishbone Corporation made the following available-for-sale securities transactions:
Jan. 14 Purchased 2,000 shares of Clarke Corporation common stock at $31.60 per
share.
Mar. 31 Received a cash dividend of $0.30 per share on the Clarke Corporation stock.
Aug. 28 Sold 800 shares of Clarke Corporation stock at $37.50 per share.
Dec. 31 The market value of the Clarke Corporation stock was $36 per share.
Prepare journal entries to record the transactions.


EXERCISE 12-4 INVESTMENT IN SECURITIES
In January 2001, Solitron, Inc., determined that it had excess cash on hand and decided to
invest in Horner Company stock. The company intends to hold the stock for a period of
three to five years, thereby making the investment an available-for-sale security. The following
transactions took place in 2001, 2002, and 2003.
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Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12


2001
Jan 17 Purchased 2,750 shares of Horner Company stock for $89,500.
May 10 Received a cash dividend of $1.30 per share on Horner Company stock.
Dec. 31 The market value of the Horner Company stock was $30 per share.
2002
May 22 Purchased 750 shares of Horner Company stock at $40 per share.
July 18 Received a cash dividend of $0.90 per share on the Horner Company stock.
Dec. 31 The market value of the Horner Company stock was $42 per share.
2003
June 7 Received a cash dividend of $1 per share on the Horner Company stock.
Oct. 5 Sold the Horner Company stock at $27 per share for cash.
Dec. 31 The market value of the Horner Company stock was $25 per share.
Prepare the journal entries required to record each of these events.

EXERCISE 12-5 INVESTMENT IN EQUITY SECURITIES
During 2001, Litten Company purchased trading securities as a short-term investment. The
costs of the securities and their market values on December 31, 2003, are listed below:

Market Value
Security Cost (December 31, 2003)

A $ 65,000 $ 81,000
B 100,000 54,000
C 220,000 226,000


Litten had no trading securities in the years before 2003. Before any adjustments related to
these trading securities, Litten had net income of $300,000 in 2003.
1. What is net income (ignoring income taxes) after making any necessary trading security
adjustments?
2. What would net income be if the market value of Security B were $95,000?

EXERCISE 12-6 INVESTMENT IN DEBT AND EQUITY SECURITIES
In February 2003, Packard Corporation purchased the following securities. Prior to these pur-
chases, Packard had no portfolio of investment securities.

Security Type Classification Cost

1 Debt Trading $11,500
2 Equity Trading 9,000
3 Equity Available-for-sale 7,250
4 Debt Available-for-sale 12,300


During 2003, Packard received $2,400 in interest and $1,800 in dividends. On December
31, 2003, Packard’s portfolio of securities had the following market values:

Security Fair Market Value

1 $12,000
2 8,750
3 7,500
4 12,500


Prepare the journal entries required to record each of these transactions.
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Part 3 EOC Investing and Financing Activities



EXERCISE 12-7 INVESTMENT IN DEBT AND EQUITY SECURITIES
CIB, Inc., purchased the following securities during 2003:

Security Type Classification Cost

1 Debt Trading $1,200
2 Equity Trading 1,750
3 Debt Available-for-sale 2,100
4 Equity Available-for-sale 900
5 Debt Held-to-maturity 5,500


During 2003, CIB received interest of $700 and dividends of $300 on its investments. On
September 29, 2003, CIB sold one-half of Security 1 for $800. On December 31, 2003, the
portfolio of securities had the following fair market values:

Security Fair Market Value

1 $ 850
2 1,800
3 2,000
4 950
5 6,000


CIB had no balance in its market adjustment accounts at the beginning of the year.
Prepare the journal entries required to record the purchase of the securities, the receipt of
interest and dividends, the sale of securities, and the adjustments required at year-end.

EXERCISE 12-8 INVESTMENT IN SECURITIES—CHANGES IN VALUE
Sharp, Inc., had the following portfolio of investment securities on January 1, 2003:

Fair Market Value
Security Type Classification Historical Cost (1/1/03)

1 Debt Trading $1,000 $ 800
2 Equity Trading 1,250 1,100
3 Debt Trading 1,700 1,650
4 Debt Available-for-sale 2,200 2,150
5 Debt Held-to-maturity 1,800 1,750


Appropriate adjustments have been made in prior years. No securities were bought or sold
during 2003. On December 31, 2003, Sharp’s portfolio of securities had the following fair
market values:

Fair Market Value
Security (12/31/03)

1 $ 650
2 1,200
3 1,700
4 2,250
5 1,850


Prepare the necessary adjusting entry(ies) on December 31, 2003.
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Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12



EXERCISE 12-9 INVESTMENT IN SECURITIES—CHANGES IN VALUE
Atlantic, Inc., held the following portfolio of securities on December 31, 2002 (the end of its
first year of operations):

Market Value
Cost (12/31/02)
Trading securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,700 $17,500
Available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,350 22,000
Held-to-maturity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 15,700


No additional securities were bought or sold during 2003. On December 31, 2003, Atlantic’s
securities had a fair market value of:
Trading securities . . . . . . . . . . . . . . . . . . . . $18,250
Available-for-sale securities . . . . . . . . . . . . 22,500
Held-to-maturity securities . . . . . . . . . . . . . 15,300

Prepare the entries required at the end of 2002 and 2003 to properly adjust Atlantic’s portfo-
lio of securities.

EXERCISE 12-10 ACCOUNTING FOR THE PURCHASE OF SECURITIES
The Fishing Store is a chain of sporting goods stores. The Fishing Store is interested in using
some of its excess cash to invest in securities. It decides to buy the following securities:

Security Type Price

Fea Company Available-for-sale $ 4,000
Herdsman, Inc. Trading 7,500
Lenny Company Available-for-sale 3,200
White Company Held-to-maturity 10,000


Prepare the journal entry to record the purchase of these securities.

EXERCISE 12-11 ACCOUNTING FOR THE SALE OF SECURITIES
Jerrod Company owns the following securities, which it is interested in selling:

Security Type Cost Market Adjustments Market Price

Monsen Company Available-for-sale $ 4,000 $ 300 increase $ 5,000
Jensen Company Trading 7,500 1,000 decrease 5,500
Stic Company Available-for-sale 3,200 500 increase 4,000
Larouse Company Held-to-maturity 10,000 None 11,000


Prepare the journal entry to record the sale of these securities.




EXERCISE 12-12 HELD-TO-MATURITY SECURITY PRICE DETERMINATION
1. How much should an investor pay for $100,000 of debenture bonds that pay interest
every six months at an annual rate of 8%, assuming that the bonds mature in 10 years
and that the effective interest rate at the date of purchase is also 8%?
2. How much should an investor pay for $100,000 of debenture bonds that pay $5,000 of
interest every six months, have a maturity date in 10 years, and are sold to yield 8% in-
terest, compounded semiannually?
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Part 3 EOC Investing and Financing Activities



EXERCISE 12-13 HELD-TO-MATURITY SECURITY PRICE DETERMINATION
Flat Rock Corporation has decided to purchase bonds of Vicon Corporation as a long-term
investment. The eight-year bonds have a stated rate of interest of 10%, with interest payments
being made semiannually. How much should Flat Rock be willing to pay for $35,000 of the
bonds if:
1. A rate of return of 12% is deemed necessary to justify the investment?
2. A rate of return of 8% is considered to be an adequate return?

EXERCISE 12-14 INVESTMENTS IN HELD-TO-MATURITY SECURITIES
Control Group purchased thirty $1,000, 10%, 20-year bonds of Natchez Corporation on Jan-
uary 1, 2003, as a long-term investment. The bonds mature on January 1, 2023, and interest
is payable every January 1 and July 1. Control Group’s reporting year ends December 31, and
the company uses the straight-line method of amortizing premiums and discounts.
Make all necessary journal entries relating to the bonds for 2003, assuming:
1. The purchase price is 104% of face value.
2. The purchase price is 94% of face value.

EXERCISE 12-15 STRAIGHT-LINE AMORTIZATION OF PREMIUM
On their issuance date, Color Company purchased 20 $1,000, 8%, five-year bonds of Mor-
ton Company as a long-term investment for $21,706. Interest payments are made semiannu-
ally. Prepare a schedule showing the amortization of the bond premium over the five-year life
of the bonds. Use the straight-line method of amortization.

EXERCISE 12-16 EFFECTIVE-INTEREST AMORTIZATION OF PREMIUM
Assume the same facts as in Exercise 12-15. Prepare a schedule showing the amortization of
the bond premium over the five-year life of the bonds. Use the effective-interest method of
amortization. (HINT: The effective rate of interest earned on the bonds is 6% compounded
semiannually.)




EXERCISE 12-17 INVESTMENTS IN STOCK—EQUITY METHOD

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