CHAPTER 12

Investments in
Debt and Equity
Securities
 Learning Objective 1

Understand why
companies invest in
other companies.
 A Cash Flow Pattern
Companies often need cash flow from
sources other than their own operations
because the company’s own cash flow
might vary greatly over the course of a year.

Insufficient cash
1/1 6/30 (relieved by 12/31
short-term
borrowing)
Average
Cash
Needs
Excess cash
(used for short- Actual Cash on Hand
term investments)
 What Are Some Other Reasons
Companies Invest Their Excess
Cash?
 To earn a return.
 Banks give a fixed return.
 Investing in stocks or bonds of other
companies may earn a higher rate of
return (and demand a higher degree of
risk).
 The ability to ensure a supply of raw
materials.
 To influence a board of directors.
 To diversify their product offerings.
 Less expensive than R&D.
 Learning Objective 2

Understand the
different
classifications for
securities.
Define the Two Classifications for
Securities.
Debt Securities
Financial instruments issued by a company
that carry with them a promise of interest
payments and the repayment of principal.
Equity Securities (Stock)
Shares of ownership in a corporation that can
change significantly in value and that provide
for a return to investors in the form of
dividends.
Classifying Securities

Investments

Debt Equity
 Classifying Securities—Matching
Equity Method Securities
Held-to-Maturity Securities
Held-to-Maturity Securities
Debt securities purchased by an investor with the
intent of holding the securities until they mature.
Equity Method Securities
Method used to account for an investment in the
stock of another company when significant
influence can be imposed (presumed when 20 to
50 percent of the outstanding voting stock is
owned).
 Classifying Securities—Matching
Trading Securities
Available-for-Sale Securities
Trading Securities
Debt and equity securities purchased with the
intent of selling them should the need for cash
arise or to realize short-term gains.
Available-for-Sale Securities
Debt and equity securities not classified as
trading, held-to-maturity, or equity method
securities.
 Classifying Securities

Investments

Debt Equity

Held-to- Trading Available- Equity

Maturity for-Sale Method
 Classifying Securities

Investments

Debt Equity

Held-to- Available- Equity

Maturity Trading for-Sale Method
 Classifying Securities—
Fill in the Chart
Reporting of
Classification Disclosed at Changes in FMV
Fair value Income
Trading statement

Available- Fair value Stockholders’

for-Sale equity
Held-to- Amortized cost Not recognized
Maturity
Equity Cost adjusted for Not recognized
Method changes in net
assets of investee
 Learning Objective 3

Account for the

purchase, recognition of
revenue, and sale of
trading and available-
for-sale securities.
 Purchase of Securities
Caribou Corp. purchased the
following securities on January 1,
2003. Record the appropriate entry.
Cost
(including
Type Classification broker’s fees)
1 Debt Trading $ 3,000
2 Equity Trading 15,500
3 Debt Available-for-sale 10,000
4 Equity Available-for-sale 7,300
 Purchase of Securities
Cost
(including
Type Classification broker’s fees)
1 Debt Trading $ 3,000
2 Equity Trading 15,500
3 Debt Available-for-sale 10,000
4 Equity Available-for-sale 7,300

Investment in Trading Securities . . . . . . . . . . 18,500

Investment in Available-for-Sale Securities. . 17,300
Cash . . . . . . . . . . . . . . . . . . . . . . 35,800
Purchased debt and equity securities.
Accounting for Return Earned on
an Investment
Buffalo Corp. earned the following return on
their owned securities. Record the journal
entry.
Security Interest Dividends
1 Debt $270
2 Equity $895
3 Debt 920
4 Equity 560
Cash. . . . . . . . . . . . . . . . . . . . . . . . . 2,645
Interest Revenue. . . . . . . . . . . . . 1,190
Dividend Revenue. . . . . . . . . . . . 1,455
Received interest and dividend revenues.
Accounting for the Sale of Securities
Buffalo Corp. sold Security 2 for $17,000.
The historical cost was $15,500. Record
the entry. Cost
(including
Type Classification broker’s fees)
1 Debt Trading $ 3,000
2 Equity Trading 15,500
3 Debt Available-for-sale 10,000
4 Equity Available-for-sale 7,300

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . .17,000
Investment in Trading Securities. . . 15,500
Realized Gain on Sale of Securities 1,500
Sold Security 2 for $17,000.
 What Are Realized Gains and
Losses?
Gains and losses resulting from
the sale of securities in an arm’s-
length transaction.
At the end of the
accounting period, any
gain or loss on the
sale of securities must
be included on the
income statement.
 Learning Objective 4

Account for changes

in the value of
securities.
 What Are Unrealized Gains
and Losses?

Gains and losses resulting from

changes in the value of securities
that are still being held.
 Accounting for Changes in Value
— Trading Securities
The following market values were recorded
for Buffalo Corp.’s portfolio on December
31, 2003. Record the changes in the values
of the securities.
Historical Market Value
Type Cost 12/31/03

1 Trading $ 3,000 $ 2,800

3 Available-for-sale 10,000 10,500
4 Available-for-sale 7,300 9,250

Unrealized Loss on Trading Securities . . . 200

Market Adjustment, Trading Securities 200
Recorded market adjustment for trading securities.
 Accounting for Changes in Value
— Available-for-Sale

Historical Market Value

Type Cost 12/31/03

1 Trading $ 3,000 $ 2,800

3 Available-for-sale 10,000 10,500
4 Available-for-sale 7,300 9,250

Market Adjustment, Available-for-Sale Securities. 2,450

Unrealized Increase in Value of
Available-for-Sale Securities . . . . 2,450
Recorded market adjustment for available-for-sale
securities.
 Subsequent Changes
in Value
The following market values were recorded
for Buffalo Corp.'s portfolio on December
31, 2004. Record the subsequent change in
the trading security.
Historical Market Value
Type Cost 12/31/04

1 Trading $ 3,000 $ 3,100

3 Available-for-sale 10,000 10,300
4 Available-for-sale 7,300 9,500

Market Adjustment, Trading Securities. . . . 300

Unrealized Gain on Trading Securities . 300
Recorded market adjustment for trading security.
 Expanded Material
Learning Objective 5

Account for held-to-

maturity securities.
Example: Initial Purchase of Held-
to-Maturity Securities
The Moose Company purchased a 5-
year, $500,000 bond and received
interest payments of 10 percent, payable
semiannually. Assume the effective rate
is 12 percent. Record the investment.
1. Semiannual interest payments$ 25,000
Present value of interest annuity $184,002

2. Principal of bonds $500,000

Present value of bonds 279,197

3. Present value of investment $463,199

Example: Initial Purchase of Held-
to-Maturity Securities
1. Semiannual interest payments$ 25,000
Present value of interest annuity $184,002

2. Principal of bonds $500,000

Present value of bonds 279,197

3. Present value of investment $463,199

Investment in Held-to-Maturity
Securities. . . . . . . . . . . . . . . . . . . . . 463,199
Cash. . . . . . . . . . . . . . . . . . . . . 463,199
Purchased a $500,000 bond as an investment.
 Bonds Purchased
Between Interest Dates
Assume the bond purchased by the
Moose Company paid interest on July 1
and January 1 of each year. If the
Moose Company purchased the bond
on April 31, 2003, how will the purchase
be recorded?

Investment in Held-to-Maturity
Security. . . . . . . . . . . . . . . . . . . . .463,199
Bond Interest Receivable . . . . . . . .16,667
Cash. . . . . . . . . . . . . . . . . . . . . . 479,866
Purchased a $500,000 bond as an investment and
paid four months’ accrued interest.
 Accounting for Amortization of
Premiums and Discounts. Define.
Straight-Line Amortization
A method of systematically writing off a bond
discount or premium in equal amounts each
period until maturity.
Effective-Interest Amortization
A method of systematically writing off a bond
premium or discount that takes into
consideration the time value of money and
results in an equal rate of amortization for
each period.
 Straight-Line Amortization
The Rhinoceros Company purchased a
12 percent, 5-year, $10,000 bond for
$8,658 on the issuance date. The
interest payments are made
semiannually. Using the straight-line
method, record the first interest
payment received.

Cash. . . . . . . . . . . . . . . . . . . . . . . . 600.00
Investment in Held-to-Maturity
Securities. . . . . . . . . . . . . . . . . . . . 134.20
Bond Interest Revenue . . . . . . 734.20
Received bond interest and amortized discount.
Effective-Interest Amortization

The Rhinoceros Company purchased a

Hint:$10,000 bond for
12 percent, 5-year,
$8,658 on the issuance date. The
interestWon’t you are
payments needmade
an
amortization
semiannually and the market rate is 16
percent. Usingtable?
the effective-interest
method, record the first interest
payment received.
 Effective-Interest Amortization
Cash Interest Amortized Investment
Payment Received Earned Amount Balance
(0.16 x 0.5 x Balance) $ 8,658
1 $600 $693 $ 93 8,751
2 600 700 100 8,851
3 600 708 108 8,959
4 600 717 117 9,076
5 600 726 126 9,202
6 600 736 136 9,338
7 600 747 147 9,485
8 600 759 159 9,644
9 600 772 172 9,816
10 600 784 184 10,000
 Effective-Interest Amortization
The Rhinoceros Company purchased a
12 percent, 5-year, $10,000 bond for
$8,658 on the issuance date. The
interest payments are made
semiannually and the market rate is 16
percent. Using the effective-interest
method, record the first interest
payment received.
Cash. . . . . . . . . . . . . . . . . . . . . . . . 600
Investment in Held-to-Maturity
Securities. . . . . . . . . . . . . . . . . . . . 93
Bond Interest Revenue . . . . . . . 693
Received bond interest and amortized discount.
 Sale or Maturity of Bonds
The Rhinoceros Company holds the
bond until maturity. Record the entry
for the receipt of the bond principal.

Cash. . . . . . . . . . . . . . . . . . . . . . . . 10,000
Investment in Held-to-Maturity
Securities. . . . . . . . . . . . . . . . . 10,000
Received the principal of bond at maturity.
 Sale or Maturity of Bonds
What journal entry is required if the
Rhinoceros Company sells the bond
for $9,900 before maturity when the
balance in the bond account is
$9,800?

Cash. . . . . . . . . . . . . . . . . . . . . . . . 9,900
Gain on Sale of Bond. . . . . . . . 100
Investment in Held-to-Maturity
Securities. . . . . . . . . . . . . . . . . . 9,800
Sold bond for $9,900.
 Expanded Material
Learning Objective 6

Account for
securities using the
equity method.
 Illustrating the Equity Method
Brown Tree Co. purchased 100 shares of
Koala Corp. common shares at $2 per
share, representing a 20 percent ownership
in the company. Record Brown Tree’s
transactions using both the available-for-
sale method and the equity method.

Available-for-Sale Method
Investment in Available-for-Sale
Securities . . . . . . . . . . . . . . . . . . . . . . . 200
Cash. . . . . . . . . . . . . . . . . . . . . . . . 200

Equity Method
Investment in Equity Method Securities 200
Cash. . . . . . . . . . . . . . . . . . . . . . . . 200
 Illustrating the Equity Method
Brown Tree Co. purchased 100 shares of
Koala Corp. common shares at $2 per
share, representing a 20 percent
ownership in the company. Record the
$0.80 per share dividend.
Available-for-Sale Method
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Dividend Revenue . . . . . . . . . . . . . 80

Equity Method
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Investment in Equity Method
Securities. . . . . . . . . . . . . . . . . . . 80
 Illustrating the Equity Method
Brown Tree Co. purchased 100 shares of
Koala Corp. common shares at $2 per share,
representing a 20 percent ownership in the
company. Koala Corp. announces a $10,000
earnings for the year. Record the
appropriate entries.

Available-for-Sale Method
No entry.

Equity Method
Investment in Equity Method Securities. 2,000
Revenue from Investments. . . . . . . . 2,000