Equity Securities Classified as Current Two criteria must be met for an investment in a security to be considered current and thus warrant inclusion

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1 BUS210 Accounting for Investment Decisions: Short-term and Long-term Investments including Trading Securities, Available for Sale, Cost, Equity, and Consolidations

2 Equity Securities Classified as Current Two criteria must be met for an investment in a security to be considered current and thus warrant inclusion as a current asset: 1. The investment must be readily marketable. 2. Management must intend to convert the investment into cash within the time period of current assets (one year or the operating cycle, whichever is longer).

3 Trading and Available-for-Sale Securities Investments in readily marketable equity securities are classified into one of two categories: (1)Trading securities (TS-current asset) or (2) Available-for-sale securities (AFS-current or long-term depending on management s intention).

4 JEs for Trading and Available-for-Sale Securities Purchasing Trading and Available-for-Sale Securities - Recorded on the balance sheet at cost, including acquisition costs Declaration and Receipt of Dividends recorded as a receivable and revenue Sale of Securities if proceeds exceed balance sheet value, a realized gain is recognized, otherwise a realized loss

5 E8-1 Accounting for short-term equity securities Monroe Auto Supplies engaged in several transactions involving short-term equity securities during 2011, shown on the following list. The company had never invested in equity securities prior to All securities are classified as trading securities. 1. Purchased 1,000 shares of IBM for $50/share. 2. Purchased 500 shares of GM for $80/share. 3. Sold 750 shares of IBM for $60/share. 4. Received dividend of $1.50/share from GM. Assume declared in previous period.

6 E8-1 Accounting for short-term equity securities 5. Purchased 200 shares of Xerox for $40/share. 6. Sold remaining 250 IBM shares for $30/share. 7. Sold the 200 shares of Xerox for $58/share. 8. Sold the 500 GM shares for $60/share. What effect did these transactions have on the company s 2011 net income?

7 Permanent Market Value Declines Investments sometimes suffer a permanent market value decline; the price declines and is not expected to recover. In such cases, the security should be written down to its market value, and a realized loss that reduces net income should be recognized immediately whether the security is classified as trading or available-for-sale.

8 Mark-to-Market Rule: Price Changes of Trading Securities on Hand at Accounting Period end Adjusting journal entries restate the balance sheet values of the securities to reflect their current market values. These adjustments give rise to unrealized gains and losses In the case of trading securities, these gains or losses are considered temporary accounts, appear on the income statement, and are reflected in retained earnings.

9 Mark-to-Market Rule: Price Changes of AFS on Hand at the End of the Accounting Period In the case of available-for-sale securities, the unrealized price changes are considered permanent accounts and are carried in the shareholders equity section of the balance sheet.

10 Mark-to-Market Accounting and Comprehensive Income In a move toward pure mark-to-market accounting, the FASB now requires companies to provide a statement of comprehensive income. The statement of comprehensive income must disclose total comprehensive income, which includes all nonowner-related changes in shareholders equity that do not appear on the income statement and are not reflected in the balance of retained earnings. Trying to measure changes in wealth (A=L+SHE) as well as income (R-E)

11 BE8-1 Short-term Investments The following table was taken from the 2012 annual report of Merck & Company (dollars in millions). a. What is comprehensive income and how does it differ from net income? b. This table indicates that Merck carries certain kinds of investments on its balance sheet. What are they, and what happens to the values of those investments in 2012,2011, and 2010? Net income $6,168 $6,272 $861 Other comprehensive income (loss) Net unrealized (loss) 52 (10) (2) Other (1,602) 94 (447) Comprehensive income $4,618 $6,356 $412

12 BE8-2 Available-for-sale securities On the statement of comprehensive income within it 2012 annual report, Bristol-Myers Squibb included a $12 million line item behind availablefor-sale securities. During 2012 the company maintained a portfolio of marketable securities in the current asset section of the balance sheet of nearly $1,173 million. Required: Explain the event that led to the $12 million amount listed on the statement of comprehensive income, and where else on the financial statements this amount would be reflected.

13 E8-2 Mark-to-Market Accounting The following was extracted from the current asset section of the balance sheets of four different companies. Wearever Fabrics Frames Corp. Pacific Transport There were no transactions in short-term equity securities during 2015, and as of , the controllers of each company collected the following information. Video Magic Trading Securities $800,000 $490, ,000 $210,000 Available-for-Sale Securities 130,000 40, ,000 85,000 Short-term Equity Investments 930, , , ,000 Wearever Fabrics Frames Corp. Pacific Transport Video Magic Trading Securities $820,000 $480,000 $625,000 $220,000 Available-for-Sale Securities 122,000 52, ,000 88,000 Short-term Equity Investments 942,000 $532, ,000 $308,000

14 E8-2 Mark-to-Market Accounting continued a. Compute the total change in the accounts of each of the four companies due to the market value changes in their equity investments. b. Compute the effect on 2015 reported income for each of the companies due to the market value changes in their equity investments. c. Explain why the answers to (a) and (b) are not the same.

15 E8-2 Mark-to-Market Accounting continued d. How would 2015 reported income change for each company if each chose to use the fair market value option for the available-for-sale securities?

16 P8-1 Applying mark-to-market rule to equity securities O Leary Enterprises began investing in short-term equity securities in The following information was extracted from its 2014 internal financial records. Houser and Miller were classified as trading securities, while Letter and Nordic were classified as available-for-sale securities. a. Compute the effect on reported 2014 income from all investment transactions and price changes. b. Compute the effect on reported income if O Leary Enterprises exercised the fair market value option for all its investments.

17 P8-1 Applying mark-to-market rule to equity securities continued Security Purchases Sales Total Dividends Received Market Value per share Houser Company $40 $25 Miller, Inc. 85 $35 Letter Books 30 $46 Nordic Equipment 50 $90

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19 E8-4 Short-term investment account across time periods On Wadsworth Company purchased 20 shares of ZZZ for $8 per share. Wadsworth held the investment for the remainder of 2014, and as of 12.31, the per share market value of ZZZ had risen to $10. During 2015, Wadsworth sold 10 shares of ZZZ for $9 each, and at the end of 2015, the per-share market price of the remaining 10 shares was $12. During 2016, the remaining shares of ZZZ were sold for $14 each. Assume that Wadsworth held no other equity investments during this time period. a. Complete the chart. The first column assumes that the investment was classified as trading securities; the second column assumes the investment was classified as available-for-sale securities. b. Comment on the differences.

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21 E8-4 Short-term investment account across time periods continued Trading Available-for-Sale 2014 income balance sheet investment value 2015 income balance sheet investment value 2016 income Total income( )

22 E8-3 Mark-to-Market Accounting continued a. Prepare journal entries for each transaction, excluding the June 30 AJE. Use the asset account Short-term Investments and assume that dividends were declared and paid on the same day. b. Prepare the June 30 AJE and describe the effect on reported income, assuming that: (1) Able and Baker shares are both considered trading securities; (2) Able is considered a trading security, and Baker is considered available-forsale security; (3) Able is considered an available-for-sale security, and Baker is considered a trading security; and (4) both Able and Baker are considered available-for-sale securities. c. What combination in (b) depicts management as most successful in the current period?

23 E8-3 Mark-to-Market Accounting The following information relates to the activity in the short-term investment account of Lido International which held no shortterm investments as of January Jan 28 Purchased 10 shares of Able Co. stock at $14/share. 2. Feb 18 Purchased 20 shares of Baker Co. stock at $26/share. 3. Mar 15 Received dividends from Able Co. of $1/share. 4. April 29 Sold 5 shares of Able Co. for $15/share. 5. May 18 Received dividends from Baker Co. of $2/share. 6. June 1 Sold 5 shares of Baker Co. for $22 per share. June 30 Market value Able Co. is $17/share. Market value of Baker Co. is $20/share. (1) Assume Able and Baker shares are both considered trading securities;

24 E8-3 Mark-to-Market Accounting The following information relates to the activity in the short-term investment account of Lido International which held no shortterm investments as of January Jan 28 Purchased 10 shares of Able Co. stock at $14/share. 2. Feb 18 Purchased 20 shares of Baker Co. stock at $26/share. 3. Mar 15 Received dividends from Able Co. of $1/share. 4. April 29 Sold 5 shares of Able Co. for $15/share. 5. May 18 Received dividends from Baker Co. of $2/share. 6. June 1 Sold 5 shares of Baker Co. for $22 per share. June 30 Market value Able Co. is $17/share. Market value of Baker Co. is $20/share. Assume (2) Able is considered a trading security, and Baker is considered available-for-sale security;

25 E8-3 Mark-to-Market Accounting The following information relates to the activity in the short-term investment account of Lido International which held no short-term investments as of January Jan 28 Purchased 10 shares of Able Co. stock at $14/share. 2. Feb 18 Purchased 20 shares of Baker Co. stock at $26/share. 3. Mar 15 Received dividends from Able Co. of $1/share. 4. April 29 Sold 5 shares of Able Co. for $15/share. 5. May 18 Received dividends from Baker Co. of $2/share. 6. June 1 Sold 5 shares of Baker Co. for $22 per share. June 30 Market value Able Co. is $17/share. Market value of Baker Co. is $20/share. Assume (3) Able is considered an available-for-sale security, and Baker is considered a trading security;

26 E8-3 Mark-to-Market Accounting The following information relates to the activity in the short-term investment account of Lido International which held no shortterm investments as of January Jan 28 Purchased 10 shares of Able Co. stock at $14/share. 2. Feb 18 Purchased 20 shares of Baker Co. stock at $26/share. 3. Mar 15 Received dividends from Able Co. of $1/share. 4. April 29 Sold 5 shares of Able Co. for $15/share. 5. May 18 Received dividends from Baker Co. of $2/share. 6. June 1 Sold 5 shares of Baker Co. for $22 per share. June 30 Market value Able Co. is $17/share. Market value of Baker Co. is $20/share. Assume (4) both Able and Baker are considered available-for-sale securities.

27 Long-term Equity Investments

28 Inter-corporate Equity Investments 3 Categories of Equity Investors: Passive Investors: Less than 20% of the outstanding voting stock. Use Mark-to-Market method if shares are readily marketable. Otherwise, use Cost method. Influential Investors: 20% to 50% of the outstanding voting stock. Use the Equity method. Controlling Investors: More than 50% of the outstanding voting stock. Use the Equity method, along with Consolidation.

29 Long-Term Equity Investments

30 Passive(<20%): Mark-to-Market Method & Cost Method Recap 1. Record initial investment at cost. 2. Dividends received are recognized as income on IS. If no dividends are received, then no income is recorded. 3. At the end of each period, the investment is adjusted to market value with the increase or decrease in market value reported as an: Unrealized gain or loss on the IS (and closed to RE) if investments are held in a trading account, i.e. Trading securities are a current asset). Unrealized gain or loss not on IS but in a special SHE account for Unrealized Holding Gains or Losses and reported as part of Comprehensive Income if investments held in an AFS portfolio. 4. If securities are not readily marketable, the Cost Method is used, which includes only Steps 1 &2 above. Under the cost method, investment only written down if there is an other than temporary loss in value, i.e., a permanent write down or the investment is sold.

31 Influential (20-50%): Equity Method Recap 1. Record investment at original cost. 2. At year-end, the Investor s proportionate share of Investee s net income or loss is recognized by Investor as investment income on IS and offset by an increase or decrease in the equity investment account. [i.e., single line consolidation] 3. Dividends received are recognized as a reduction in the investment account (not as dividend income on IS). 4. The investment is not marked to market; however, the market value is disclosed in the footnotes. 5. If there is goodwill implied by the purchase price, it is not amortized or evaluated for impairment separately from the investment. 6. If more than 20% equity does not result in significant influence, the investment should not be accounted for by the equity method, but by the mark-to-market method, if readily marketable.

32 The Cost Method- Market value hard to determine

33 E8-8 Cost Method Mystic Lakes Food Company began investing in equity securities for the first time in During 2014, the company engaged in the following transactions involving equity securities. Assume that the stock of Thayers International and Bayhe Enterprises is not considered marketable that ownership is less than 20 percent of the equity. Prepare journal entries to record these transactions.

34 E Purchased 10,000 shares of Thayers International for $26 per share. 2. Purchased 25,000 shares of Bayhe Enterprises for $35 per share. 3. Thayers International declared a $2-per-share dividend to be paid at a later date.

35 E Sold 4,500 shares of Bayhe Enterprises for $30 per share. 5. Sold 8,000 shares of Thayers International for $32 per share.

36 The Equity Method

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38 E8-10 Equity Method On January 1, Nover Solar Systems purchased 10,000 shares of Reilly Inc for $190,000. The investment represented 25% of Reilly s outstanding common stock. Nover intended to hold the investment indefinitely. During the year, Reilly earned net income of $75,000, and during the next year Reilly suffered a net loss of $6,000. Reilly paid dividends both years of $1.50 per share. a. Prepare all relevant entries that Nover would have recorded during both years. b. Compute the book value of Nover s long-term equity investment account at the end of both years.

39 E8-12 Equity Method Inference from FS Mainmont Industries uses the equity method for its long-term equity investments from affiliates. The following information from the financial statements of Mainmont refers to an investment in the securities of Tumbleweed Construction, a company owned 30% by Mainmont Long-term investment in equity securities $29,000 $25,000 Income from equity securities 12,000 7,000 Mainmont neither purchased nor sold any equity securities during a. How much net income did Tumbleweed Construction earn during 2014? b. What was the dollar amount of the total dividend declared by Tumbleweed during 2014? c. Provide the journal entries recorded by Mainmont during 2014 with respect to its investment in Tumbleweed.

40 Consolidation Method Controlling investments of more than 50% are accounted for by the Equity method and then the parent and subsidiary financials are consolidated on a spreadsheet at the end of the accounting period. 1. The Investment account balance on the Investor s balance sheet is replaced with the Investor s share of the actual assets and liabilities of the Investee plus any goodwill implied by the Investor s purchase. 2. The assets and liabilities of the investee attributable to the non-controlling shareholders are added to the Investor s balance sheet along with the noncontrolling interest equity in those net assets, based on the fair market value of the non-controlling equity on the acquisition date. Any goodwill implied by such mark to fair value would also be recognized. [Minority Interest liability] 3. The income statement of the investee company is combined with the income statement of the investor. The equity income of the Investee recognized by the Investor is eliminated to avoid double counting this income. The total net income is apportioned between the net income attributable to the controlling shareholders and non-controlling shareholders. [Minority interest income] 4. Goodwill recognized in the consolidated financials is not amortized; however, if goodwill becomes impaired, it is written down. Goodwill must be evaluated each period of possible impairment.

41 Business Combinations Two Ways to Obtain Control: Asset acquisition-all the company s net assets are acquired directly from the company-the books of acquired company are closed and only one set of books remain. Stock acquisition-a controlling interest in another firm s voting common stock is acquired two sets of books remain and an Investment in Sub account is carried on the acquirer s books.

42 Stock Acquisition and Consolidated Financial Statements A business acquisition occurs when an investor company acquires a controlling interest (more than 50 percent of the voting stock) in another company. The companies continue as separate legal entities, the investor company is referred to as the parent company, and the investee company is called the subsidiary. A Corp + B Corp = Consolidated A and B A merger, or business combination, occurs when two or more companies combine to form a single legal entity.

43 Asset Acquisition-Purchase Method All identifiable net assets (assets less liabilities assumed) are recorded at their FMV, both tangible and intangible (assuming a controlling interest is acquired). Goodwill is created when the price paid exceeds the FMV of the net assets acquired. A gain is recorded when the price paid is less than the FMV of the net assets acquired. Direct acquisition costs (costs paid to consultants) and indirect acquisition costs (internal costs) are expensed. A single combined entity exists, no consolidation process is necessary.

44 Legal Forms of Business Combinations Statutory consolidation (100% ownership) A Corp + B Corp = C Corp (new company) Statutory merger (100% ownership) A Corp + B Corp = A Corp