I've attached the question as a word file, thanks!

JWCL165_c12_568-611.qxd 8/12/09 8:29 AM Page 568 12 Investments Chapter STUDY OBJECTIVES After studying this chapter, you should be able to: 1 Discuss why corporations invest in debt and stock securities. 2 Explain the accounting for debt investments. 3 Explain the accounting for stock investments. 4 Describe the use of consolidated financial statements. 5 Indicate how debt and stock investments are reported in financial statements. 6 Distinguish between short-term and long-term investments. The Navigator The Navigator Scan Study Objectives Read Feature Story Read Preview Read text and answer p. 573 p. 578 Work Comprehensive Do it! p. 581 Do it! p. 584 p. 587 Review Summary of Study Objectives Answer Self-Study Questions Complete Assignments Feature Story \"IS THERE ANYTHING ELSE WE CAN BUY?\" In a rapidly changing world you must change rapidly or suffer the consequences. In business, change requires investment. A case in point is found in the entertainment industry. Technology is bringing about innovations so quickly that it is nearly impossible to guess which technologies will last and which will soon fade away. For example, will both satellite TV and cable TV survive, or will just one succeed, or will both be replaced by something else? Or consider the publishing industry. Will paper newspapers and magazines be replaced by online news via the World Wide Web? If you are a publisher, you have to make your best guess about what the future holds and invest accordingly. Time Warner, Inc. (www.timewarner.com) lives at the center of this arena. It is not an environment for the timid, and Time Warner's philosophy is anything 568 JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 569 but that. It might be characterized as, \"If we can't beat you, we will buy you.\" Its mantra is \"invest, invest, invest.\" A list of Time Warner's holdings gives an idea of its reach. Magazines: People, Time, Life, Sports Illustrated, and Fortune. Book publishers: Time-Life Books, Bookof-the-Month Club, Little, Brown & Co, and Sunset Books. Television and movies: Warner Bros. (\"ER,\" \"Without a Trace,\" the WB Network), HBO, and movies like Harry Potter and the Goblet of Fire, and Batman Begins. Broadcasting: TNT, CNN news, and Turner's library of thousands of classic movies. Internet: America Online and AOL Anywhere. Time Warner owns more information and entertainment copyrights and brands than any other company in the world. The merger of America Online (AOL) with Time Warner, one of the biggest mergers ever, was originally perceived by many as the gateway to the future. In actuality, it was a financial disaster. It is largely responsible for much of the decline in Time Warner's stock price, from a high of $95.80 to a recent level of $14.07. Ted Turner, who was at one time Time Warner's largest shareholder, lost billions of dollars on the deal and eventually sold most of his shares. The Navigator Inside Chapter 12... How Procter & Gamble Accounts for Gillette (p. 577) And the Correct Way to Report Investments Is...? All About You: A Good Day to Start Saving (p. 580) (p. 586) 569 JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 570 Preview of Chapter 12 Time Warner's management believes in aggressive growth through investing in the stock of existing companies. Besides purchasing stock, companies also purchase other securities such as bonds issued by corporations or by governments. Companies can make investments for a short or long period of time, as a passive investment, or with the intent to control another company. As you will see in this chapter, the way in which a company accounts for its investments is determined by a number of factors. The content and organization of Chapter 12 are as follows. Investments Accounting for Debt Investments Why Corporations Invest Cash management Investment income Strategic reasons Recording acquisition of bonds Recording bond interest Recording sale of bonds Accounting for Stock Investments Holdings of less than 20% Holdings between 20% and 50% Holdings of more than 50% Valuing and Reporting Investments Categories of securities Balance sheet presentation Realized and unrealized gain or loss Classified balance sheet The Navigator WHY CORPORATIONS INVEST Corporations purchase investments in debt or stock securities generally for one of three reasons. First, a corporation may have excess cash that it Discuss why corporations invest does not need for the immediate purchase of operating assets. For examin debt and stock securities. ple, many companies experience seasonal fluctuations in sales. A Cape Cod marina has more sales in the spring and summer than in the fall and winter. At the end of an operating cycle, the marina may have cash on hand that is temporarily idle until the start of another operating cycle. It may invest the excess funds to earn a greater return than it would get by just holding the funds in the bank. Illustration 12-1 depicts the role that such temporary investments play in the operating cycle. STUDY OBJECTIVE 1 Illustration 12-1 Temporary investments and the operating cycle Invest Cash Accounts Receivable 570 Sell Inventory Temporary Investments JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 571 Why Corporations Invest 571 Excess cash may also result from economic cycles. For example, when the economy is booming, General Electric generates considerable excess cash. It uses some of this cash to purchase new plant and equipment and pays out some of the cash in dividends. But it may also invest excess cash in liquid assets in anticipation of a future downturn in the economy. It can then liquidate these investments during a recession, when sales slow and cash is scarce. When investing excess cash for short periods of time, corporations invest in low-risk, highly liquid securitiesmost often short-term government securities. It is generally not wise to invest short-term excess cash in shares of common stock because stock investments can experience rapid price changes. If you did invest your shortterm excess cash in stock and the price of the stock declined significantly just before you needed cash again, you would be forced to sell your stock investment at a loss. A second reason some companies purchase investments is to generate earnings from investment income. For example, banks make most of their earnings by lending money, but they also generate earnings by investing in debt. Conversely, mutual stock funds invest primarily in equity securities in order to benefit from stock-price appreciation and dividend revenue. Third, companies also invest for strategic reasons. A company can exercise some influence over a customer or supplier by purchasing a significant, but not controlling, interest in that company. Or, a company may purchase a noncontrolling interest in another company in a related industry in which it wishes to establish a presence. For example, Time Warner initially purchased an interest of less than 20% in Turner Broadcasting to have a stake in Turner's expanding business opportunities. At a later date Time Warner acquired the remaining 80%. Subsequently, Time Warner merged with AOL and became AOL Time Warner, Inc. Now, it is again just Time Warner, Inc., having dropped the \"AOL\" from its name in late 2003. A corporation may also choose to purchase a controlling interest in another company. For example, as the Accounting Across the Organization box on page 577 shows, Procter & Gamble purchased Gillette. Such purchases might be done to enter a new industry without incurring the tremendous costs and risks associated with starting from scratch. Or a company might purchase another company in its same industry. In summary, businesses invest in other companies for the reasons shown in Illustration 12-2. Illustration 12-2 Why corporations invest Reason Typical Investment To house excess cash until needed Low-risk, high-liquidity, short-term securities such as government-issued securities To generate earnings I need 1,000 Treasury bills by tonight Debt securities (banks and other financial institutions) and stock securities (mutual funds and pension funds) To meet strategic goals Stocks of companies in a related industry or in an unrelated industry that the company wishes to enter JWCL165_c12_568-611.qxd 572 8/8/09 8:46 PM Page 572 Chapter 12 Investments ACCOUNTING FOR DEBT INVESTMENTS STUDY OBJECTIVE 2 Explain the accounting for debt investments. Debt investments are investments in government and corporation bonds. In accounting for debt investments, companies make entries to record (1) the acquisition, (2) the interest revenue, and (3) the sale. Recording Acquisition of Bonds A L SE 54,000 54,000 At acquisition, the cost principle applies. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus brokerage fees (commissions), if any. Assume, for example, that Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2011, for $54,000, including brokerage fees of $1,000. The entry to record the investment is: Jan. 1 Cash Flows 54,000 Debt Investments Cash (To record purchase of 50 Doan Inc. bonds) 54,000 54,000 Recording Bond Interest A L SE 2,000 The Doan, Inc. bonds pay interest of $2,000 semiannually on July 1 and January 1 ($50,000 8% 12). The entry for the receipt of interest on July 1 is: July 1 2,000 Rev Cash Flows 2,000 A L SE 2,000 Dec. 31 Cash Flows no effect 2,000 2,000 Cash Flows L 2,000 2,000 If Kuhl Corporation's fiscal year ends on December 31, it accrues the interest of $2,000 earned since July 1. The adjusting entry is: 2,000 Rev A Cash Interest Revenue (To record receipt of interest on Doan Inc. bonds) Interest Receivable Interest Revenue (To accrue interest on Doan Inc. bonds) 2,000 2,000 Kuhl reports Interest Receivable as a current asset in the balance sheet. It reports Interest Revenue under \"Other revenues and gains\" in the income statement. Kuhl reports receipt of the interest on January 1 as follows. SE Jan. 1 Cash Interest Receivable (To record receipt of accrued interest) 2,000 2,000 2,000 A credit to Interest Revenue at this time is incorrect because the company earned and accrued interest revenue in the preceding accounting period. Recording Sale of Bonds When Kuhl sells the bonds, it credits the investment account for the cost of the bonds. Kuhl records as a gain or loss any difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds. Assume, for example, that Kuhl Corporation receives net proceeds of $58,000 on the sale of the Doan Inc. bonds on January 1, 2012, after receiving the interest due. JWCL165_c12_568-611.qxd 8/11/09 9:27 PM Page 573 Accounting for Stock Investments 573 Since the securities cost $54,000, the company realizes a gain of $4,000. It records the sale as: A Jan. 1 Cash Debt Investments Gain on Sale of Debt Investments (To record sale of Doan Inc. bonds) 58,000 54,000 4,000 L SE 58,000 54,000 4,000 Rev Cash Flows 58,000 Kuhl reports the gain on sale of debt investments under \"Other revenues and gains\" in the income statement and reports losses under \"Other expenses and losses.\" before you go on... Do it! Jan. 1 July 1 July 1 Waldo Corporation had the following transactions pertaining to debt investments. Debt Investments Purchased 30, $1,000 Hillary Co. 10% bonds for $30,000, plus brokerage fees of $900. Interest is payable semiannually on July 1 and January 1. Received semiannual interest on Hillary Co. bonds. Sold 15 Hillary Co. bonds for $15,000, less $400 brokerage fees. (a) Journalize the transactions, and (b) prepare the adjusting entry for the accrual of interest on December 31. Solution (a) Jan. 1 July 1 July 1 (b) Dec. 31 Debt Investments Cash (To record purchase of 30 Hillary Co. bonds) 30,900 30,900 Cash Interest Revenue ($30,000 .10 6/12) (To record receipt of interest on Hillary Co. bonds) 1,500 Cash Loss on Sale of Debt Investments Debt Investments ($30,900 15/30) (To record sale of 15 Hillary Co. bonds) Action Plan Record bond investments at cost. Record interest when received and/or accrued. When bonds are sold, credit the investment account for the cost of the bonds. Record any difference between the cost and the net proceeds as a gain or loss. 14,600 850 Interest Receivable Interest Revenue ($15,000 .10 6/12) (To accrue interest on Hillary Co. bonds) 1,500 15,450 750 Related exercise material: BE12-1, E12-2, E12-3, and Do it! 12-1. 750 The Navigator ACCOUNTING FOR STOCK INVESTMENTS Stock investments are investments in the capital stock of other corporaSTUDY OBJECTIVE 3 tions. When a company holds stock (and/or debt) of several different cor- Explain the accounting for stock porations, the group of securities is identified as an investment portfolio. investments. The accounting for investments in common stock depends on the extent of the investor's influence over the operating and financial affairs of the issuing corporation (the investee). Illustration 12-3 (next page) shows the general guidelines. JWCL165_c12_568-611.qxd 574 8/8/09 8:46 PM Page 574 Chapter 12 Investments Illustration 12-3 Accounting guidelines for stock investments Investor's Ownership Interest in Investee's Common Stock Presumed Influence on Investee Accounting Guidelines Less than 20% Insignificant Cost method Between 20% and 50% Significant Equity method More than 50% Controlling Consolidated financial statements Companies are required to use judgment instead of blindly following the guidelines.1 On the following pages we will explain the application of each guideline. Holdings of Less than 20% HELPFUL HINT The entries for investments in common stock also apply to investments in preferred stock. A L SE In accounting for stock investments of less than 20%, companies use the cost method. Under the cost method, companies record the investment at cost, and recognize revenue only when cash dividends are received. RECORDING ACQUISITION OF STOCK INVESTMENTS At acquisition, the cost principle applies. Cost includes all expenditures necessary to acquire these investments, such as the price paid plus any brokerage fees (commissions). Assume, for example, that on July 1, 2011, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock. Sanchez pays $40 per share plus brokerage fees of $500. The entry for the purchase is: 40,500 40,500 July 1 Cash Flows 40,500 Stock Investments Cash (To record purchase of 1,000 shares of Beal Corporation common stock) 40,500 40,500 RECORDING DIVIDENDS During the time Sanchez owns the stock, it makes entries for any cash dividends received. If Sanchez receives a $2 per share dividend on December 31, the entry is: A L SE 2,000 Dec. 31 2,000 Rev Cash Flows 2,000 Cash (1,000 $2) Dividend Revenue (To record receipt of a cash dividend) 2,000 2,000 Sanchez reports Dividend Revenue under \"Other revenues and gains\" in the income statement. Unlike interest on notes and bonds, dividends do not accrue. Therefore, companies do not make adjusting entries to accrue dividends. 1 Among the questions that are considered in determining an investor's influence are these: (1) Does the investor have representation on the investee's board? (2) Does the investor participate in the investee's policy-making process? (3) Are there material transactions between the investor and investee? (4) Is the common stock held by other stockholders concentrated or dispersed? JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 575 Accounting for Stock Investments RECORDING SALE OF STOCK When a company sells a stock investment, it recognizes as a gain or a loss the difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the stock. Assume that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal stock on February 10, 2012. Because the stock cost $40,500, Sanchez incurred a loss of $1,000. The entry to record the sale is: Feb. 10 Cash Loss on Sale of Stock Investments Stock Investments (To record sale of Beal common stock) A L 575 SE 39,500 39,500 1,000 1,000 Exp 40,500 40,500 Cash Flows 39,500 Sanchez reports the loss under \"Other expenses and losses\" in the income statement. It would show a gain on sale under \"Other revenues and gains.\" Holdings Between 20% and 50% When an investor company owns only a small portion of the shares of stock of another company, the investor cannot exercise control over the investee. But, when an investor owns between 20% and 50% of the common stock of a corporation, it is presumed that the investor has significant influence over the financial and operating activities of the investee. The investor probably has a representative on the investee's board of directors, and through that representative, may exercise some control over the investee. The investee company in some sense becomes part of the investor company. For example, even prior to purchasing all of Turner Broadcasting, Time Warner owned 20% of Turner. Because it exercised significant control over major decisions made by Turner, Time Warner used an approach called the equity method. Under the equity method, the investor records its share of the net income of the investee in the year when it is earned. An alternative might be to delay recognizing the investor's share of net income until the investee declares a cash dividend. But that approach would ignore the fact that the investor and investee are, in some sense, one company, making the investor better off by the investee's earned income. Under the equity method, the investor company initially records the investment in common stock at cost.After that, it annually adjusts the investment account to show the investor's equity in the investee. Each year, the investor does the following: (1) It increases (debits) the investment account and increases (credits) revenue for its share of the investee's net income.2 (2) The investor also decreases (credits) the investment account for the amount of dividends received. The investment account is reduced for dividends received, because payment of a dividend decreases the net assets of the investee. RECORDING ACQUISITION OF STOCK INVESTMENTS Assume that Milar Corporation acquires 30% of the common stock of Beck Company for $120,000 on January 1, 2011. Milar records this transaction as: Jan. 1 2 Stock Investments Cash (To record purchase of Beck common stock) 120,000 120,000 Or, the investor increases (debits) a loss account and decreases (credits) the investment account for its share of the investee's net loss. HELPFUL HINT Under the equity method, the investor recognizes revenue on the accrual basisi.e., when it is earned by the investee. A 120,000 120,000 Cash Flows 120,000 L SE JWCL165_c12_568-611.qxd 576 8/8/09 8:46 PM Page 576 Chapter 12 Investments RECORDING REVENUE AND DIVIDENDS For 2011, Beck reports net income of $100,000. It declares and pays a $40,000 cash dividend. Milar records (1) its share of Beck's income, $30,000 (30% $100,000) and (2) the reduction in the investment account for the dividends received, $12,000 ($40,000 30%). The entries are: A L SE 30,000 Dec. 31 30,000 Rev Cash Flows no effect A L SE 12,000 12,000 Dec. 31 Cash Flows (1) Stock Investments Revenue from Investment in Beck Company (To record 30% equity in Beck's 2010 net income) (2) Cash Stock Investments (To record dividends received) 30,000 30,000 12,000 12,000 12,000 After Milar posts the transactions for the year, its investment and revenue accounts will show the following. Illustration 12-4 Investment and revenue accounts after posting Revenue from Investment in Beck Company Stock Investments Jan. 1 Dec. 31 120,000 30,000 Dec. 31 Bal. Dec. 31 12,000 Dec. 31 30,000 138,000 During the year, the net increase in the investment account was $18,000. As indicated above, the investment account increased by $30,000 due to Milar's share of Beck's income, and it decreased by $12,000 due to dividends received from Beck. In addition, Milar reports $30,000 of revenue from its investment, which is 30% of Beck's net income of $100,000. Note that the difference between reported revenue under the cost method and reported revenue under the equity method can be significant. For example, Milar would report only $12,000 of dividend revenue (30% $40,000) if it used the cost method. Holdings of More than 50% A company that owns more than 50% of the common stock of another entity is known as the parent company. The entity whose stock the parent Describe the use of consolidated company owns is called the subsidiary (affiliated) company. Because of its financial statements. stock ownership, the parent company has a controlling interest in the subsidiary. HELPFUL HINT When a company owns more than 50% of the common stock of another comIf parent (A) has three pany, it usually prepares consolidated financial statements. These statements prewholly owned subsidiaries sent the total assets and liabilities controlled by the parent company. They also (B, C, & D), there are four present the total revenues and expenses of the subsidiary companies. Companies separate legal entities. From the viewpoint of the prepare consolidated statements in addition to the financial statements for the parent and individual subsidiary companies. shareholders of the As noted earlier, when Time Warner had a 20% investment in Turner, it reparent company, there ported this investment in a single line itemOther Investments. After the merger, is only one economic entity. Time Warner instead consolidated Turner's results with its own. Under this STUDY OBJECTIVE 4 JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 577 Accounting for Stock Investments 577 approach, Time Warner included Turner's individual assets and liabilities with its own: Its plant and equipment were added to Time Warner's plant and equipment, its receivables were added to Time Warner's receivables, and so on. ACCOUNTING ACROSS THE ORGANIZATION How Procter & Gamble Accounts for Gillette Recently, Procter & Gamble Company acquired Gillette Company for $53.4 billion. The common stockholders of Procter & Gamble elect the board of directors of the company, who, in turn, select the officers and managers of the company. Procter & Gamble's board of directors controls the property owned by the corporation, which includes the common stock of Gillette. Thus, they are in a position to elect the board of directors of Gillette and, in effect, control its operations. These relationships are graphically illustrated here. Controlling Group Procter & Gamble Company Board of Directors Separate Legal Entities Control Procter & Gamble Company Procter & Gamble Company Elects Gillette Company Board of Directors Single Economic Entity Control Gillette Company Where on Procter & Gamble's balance sheet will you find its investment in Gillette Company? Consolidated statements are useful to the stockholders, board of directors, and managers of the parent company. These statements indicate the magnitude and scope of operations of the companies under common control. For example, regulators and the courts undoubtedly used the consolidated statements of AT&T to determine whether a breakup of AT&T was in the public interest. Listed below are three companies that prepare consolidated statements and some of the companies they have owned. One, Disney, is Time Warner's arch rival. Toys \"R\" Us, Inc. Cendant Kids \"R\" Us Babies \"R\" Us Imaginarium Toysrus.com Howard Johnson Ramada Inn Century 21 Coldwell Banker Avis The Disney Company Capital Cities/ABC, Inc. Disneyland, Disney World Mighty Ducks Anaheim Angels ESPN Illustration 12-5 Examples of consolidated companies and their subsidiaries JWCL165_c12_568-611.qxd 578 8/11/09 9:44 PM Page 578 Chapter 12 Investments before you go on... Stock Investments Do it! Presented below are two independent situations. 1. Rho Jean Inc. acquired 5% of the 400,000 shares of common stock of Stillwater Corp. at a total cost of $6 per share on May 18, 2011. On August 30, Stillwater declared and paid a $75,000 dividend. On December 31, Stillwater reported net income of $244,000 for the year. 2. Debbie, Inc. obtained significant influence over North Sails by buying 40% of North Sails' 60,000 outstanding shares of common stock at a cost of $12 per share on January 1, 2011. On April 15, North Sails declared and paid a cash dividend of $45,000. On December 31, North Sails reported net income of $120,000 for the year. Action Plan Presume that the investor has relatively little influence over the investee when an investor owns less than 20% of the common stock of another corporation. In this case, net income earned by the investee is not considered a proper basis for recognizing income from the investment by the investor. Presume significant influence for investments of 20%-50%. Therefore, record the investor's share of the net income of the investee. Prepare all necessary journal entries for 2011 for (1) Rho Jean Inc. and (2) Debbie, Inc. Solution (1) May 18 Aug. 30 (2) Jan. 1 Apr. 15 Dec. 31 Stock Investments (20,000 $6) Cash (To record purchase of 20,000 shares of Stillwater Co. stock) Cash Dividend Revenue ($75,000 5%) (To record receipt of cash dividend) Stock Investments (60,000 40% $12) Cash (To record purchase of 24,000 shares of North Sails' stock) 120,000 120,000 3,750 3,750 288,000 288,000 Cash Stock Investments ($45,000 40%) (To record receipt of cash dividend) 18,000 Stock Investments ($120,000 40%) Revenue from Investment in North Sails (To record 40% equity in North Sails' net income) 48,000 18,000 48,000 Related exercise material: BE12-2, BE12-3, E12-4, E12-5, E12-6, E12-7, E12-8, and Do it! 12-2. The Navigator VALUING AND REPORTING INVESTMENTS The value of debt and stock investments may fluctuate greatly during the time they are held. For example, in one 12-month period, the stock price of Indicate how debt and stock Dell Computer Corp. hit a high of $30.77 and a low of $18.87. In light of investments are reported in such price fluctuations, how should companies value investments at the financial statements. balance sheet date? Valuation could be at cost, at fair value (market value), or at the lower-of-cost-or-market value. Many people argue that fair value offers the best approach because it represents the expected cash realizable value of securities. Fair value is the amount for which a security could be sold in a normal market. Others counter that, unless a STUDY OBJECTIVE 5 JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 579 Valuing and Reporting Investments security is going to be sold soon, the fair value is not relevant because the price of the security will likely change again. Categories of Securities For purposes of valuation and reporting at a financial statement date, companies classify debt and stock investments into three categories: 579 INTERNATIONAL NOTE A recent U.S. accounting standard gives companies the \"option\" of applying fair value accounting, rather than historical cost, to certain types of assets and liabilities. This makes U.S. accounting more similar to international standards. 1. Trading securities are bought and held primarily for sale in the near term to generate income on short-term price differences. 2. Available-for-sale securities are held with the intent of selling them sometime in the future. 3. Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.3 Illustration 12-6 shows the valuation guidelines for these securities. These guidelines apply to all debt securities and all stock investments in which the holdings are less than 20%. Trading Held-to-maturity Available-for-sale \"We'll hold the stock for a while to see how it performs.\" \"We'll sell within ten days.\" At fair value with changes reported in net income \"We intend to hold until maturity.\" At fair value with changes reported in the stockholders' equity section TRADING SECURITIES Companies hold trading securities with the intention of selling them in a short period (generally less than a month). Trading means frequent buying and selling. Companies report trading securities at fair value, and report changes from cost as part of net income. The changes are reported as unrealized gains or losses because the securities have not been sold. The unrealized gain or loss is the difference between the total cost of trading securities and their total fair value. Companies classify trading securities as current assets. Illustration 12-7 shows the cost and fair values for investments Pace Corporation classified as trading securities on December 31, 2011. Pace has an unrealized gain of $7,000 because total fair value of $147,000 is $7,000 greater than total cost of $140,000. Trading Securities, December 31, 2011 Investments Cost Fair Value Unrealized Gain (Loss) Yorkville Company bonds Kodak Company stock $ 50,000 90,000 $ 48,000 99,000 $ (2,000) 9,000 Total 3 Illustration 12-6 Valuation guidelines $140,000 $147,000 $ 7,000 This category is provided for completeness. The accounting and valuation issues related to heldto-maturity securities are discussed in more advanced accounting courses. At amortized cost HELPFUL HINT The fact that trading securities are short-term investments increases the likelihood that they will be sold at fair value (the company may not be able to time their sale) and the likelihood that there will be realized gains or losses. Illustration 12-7 Valuation of trading securities JWCL165_c12_568-611.qxd 580 8/8/09 8:46 PM Page 580 Chapter 12 Investments A L SE 7,000 Pace records fair value and unrealized gain or loss through an adjusting entry at the time it prepares financial statements. In this entry, the company uses a valuation allowance account, Market AdjustmentTrading, to record the difference between the total cost and the total fair value of the securities. The adjusting entry for Pace Corporation is: Dec. 31 Market AdjustmentTrading Unrealized GainIncome (To record unrealized gain on trading securities) 7,000 Rev Cash Flows no effect 7,000 7,000 Use of a Market AdjustmentTrading account enables Pace to maintain a record of the investment cost. It needs actual cost to determine the gain or loss realized when it sells the securities. Pace adds the Market AdjustmentTrading balance to the cost of the investments to arrive at a fair value for the trading securities. The fair value of the securities is the amount Pace reports on its balance sheet. It reports the unrealized gain in the income statement in the \"Other revenues and gains\" section.The term \"Income\" in the account title indicates that the gain affects net income. If the total cost of the trading securities is greater than total fair value, an unrealized loss has occurred. In such a case, the adjusting entry is a debit to Unrealized LossIncome and a credit to Market AdjustmentTrading. Companies report the unrealized loss under \"Other expenses and losses\" in the income statement. The market adjustment account is carried forward into future accounting periods. The company does not make any entry to the account until the end of each reporting period.At that time, the company adjusts the balance in the account to the difference between cost and fair value. For trading securities, it closes the Unrealized Gain (Loss)Income account at the end of the reporting period. ACCOUNTING ACROSS THE ORGANIZATION And the Correct Way to Report Investments Is...? Percent of Companies The accompanying graph presents an estimate of the percentage of companies on the major exchanges that have investments in the equity of other entities. As the graph indicates, many companies have equity investments Investments in the Equity of Other Companies of some type. These investments can be substantial. For example, the 100 91.1% total amount of equity-method investments appearing on company Presenting consolidated financial statements balance sheets is approximately $403 billion, and the amount shown 80 Reporting equity method in the income statements in any one year for all companies is approxinvestments imately $38 billion. 60 Reporting available-for-sale investments Reporting trading investments 37.4% 40 Why might the use of the equity method not lead to full disclosure in the financial statements? 23.5% 20 6.2% 0 Source: \"Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers,\" United States Securities and Exchange CommissionOffice of Chief Accountant, Office of Economic Analyses, Division of Corporation Finance (June 2005), pp. 36-39. Categorized by Accounting Treatment JWCL165_c12_568-611.qxd 8/11/09 9:28 PM Page 581 Valuing and Reporting Investments 581 AVAILABLE-FOR-SALE SECURITIES As indicated earlier, companies hold available-for-sale securities with the ETHICS NOTE intent of selling these investments sometime in the future. If the intent is to Some managers seem to sell the securities within the next year or operating cycle, the investor classi- hold their available-for-sale fies the securities as current assets in the balance sheet. Otherwise, it classi- securities that have experienced fies them as long-term assets in the investments section of the balance sheet. losses, while selling those that Companies report available-for-sale securities at fair value. The proce- have gains, thus increasing dure for determining fair value and the unrealized gain or loss for these secu- income. Do you think this is rities is the same as for trading securities. To illustrate, assume that Ingrao ethical? Corporation has two securities that it classifies as available-for-sale. Illustration 12-8 provides information on their valuation.There is an unrealized loss of $9,537 because total cost of $293,537 is $9,537 more than total fair value of $284,000. Available-for-Sale Securities, December 31, 2011 Investments Cost Fair Value Campbell Soup Corporation 8% bonds Hershey Corporation stock $ 93,537 200,000 $103,600 180,400 $10,063 (19,600) $293,537 $284,000 $(9,537) Total Unrealized Gain (Loss) Illustration 12-8 Valuation of availablefor-sale securities Both the adjusting entry and the reporting of the unrealized gain or loss for Ingrao's available-for-sale securities differ from those illustrated for trading securities. The differences result because Ingrao does not expect to sell these securities in the near term. Thus, prior to actual sale it is more likely that changes in fair value may change either unrealized gains or losses. Therefore, Ingrao does not report an unrealized gain or loss in the income statement. Instead, it reports it as a separate component of stockholders' equity. In the adjusting entry, Ingrao identifies the market adjustment account with available-for-sale securities, and it identifies the unrealized gain or loss account with stockholders' equity. Ingrao records the unrealized loss of $9,537 as follows: Dec. 31 Unrealized Gain or LossEquity Market AdjustmentAvailable-for-Sale (To record unrealized loss on availablefor-sale securities) A SE 9,537 Exp 9,537 If total fair value exceeds total cost, Ingrao debits Market Adjustment Available-for-Sale and credits Unrealized Gain or LossEquity. For available-for-sale securities, the company carries forward the Unrealized Gain or LossEquity account to future periods. At each future balance sheet date, Ingrao adjusts the market adjustment account to show the difference between cost and fair value at that time. L 9,537 9,537 Cash Flows no effect ETHICS NOTE Recently the SEC accused investment bank Morgan Stanley of overstating the value of certain bond investments by $75 million. The SEC stated that, in applying market value accounting, Morgan Stanley used its own moreoptimistic assumptions rather than relying on external pricing sources. before you go on... Do it! Some of Powderhorn Corporation's investment securities are classified as trading securities and some are classified as available-for-sale. The cost and market value of each category at December 31, 2011, are shown on the next page. Trading and Available-forSale Securities JWCL165_c12_568-611.qxd 582 8/8/09 8:46 PM Page 582 Chapter 12 Investments Cost Trading securities Available-for-sale securities Action Plan Mark trading securities to fair value and report the adjustment in current-period income. Mark available-for-sale securities to fair value and report the adjustment as a separate component of stockholders' equity. Fair Value Unrealized Gain (Loss) $93,600 $48,800 $94,900 $51,400 $1,300 $2,600 At December 31, 2010, the Market AdjustmentTrading account had a debit balance of $9,200, and the Market AdjustmentAvailable-for-Sale account had a credit balance of $5,750. Prepare the required journal entries for each group of securities for December 31, 2011. Solution Trading securities: Unrealized LossIncome Market AdjustmentTrading (To record unrealized loss on trading securities) *$9,200 $1,300 7,900* 7,900 Available-for-sale securities: Market AdjustmentAvailable-for-Sale Unrealized Gain or LossEquity (To record unrealized gain on available-for-sale securities) **$5,750 $2,600 8,350** 8,350 Related exercise material: BE12-4, BE12-5, BE12-6, BE12-7, E12-10, E12-11, E12-12, and Do it! 12-3. The Navigator Balance Sheet Presentation In the balance sheet, companies classify investments as either short-term or long-term. SHORT-TERM INVESTMENTS Short-term investments (also called marketable securities) are securities held by a company that are (1) readily marketable and (2) intended to be Distinguish between short-term converted into cash within the next year or operating cycle, whichever is and long-term investments. longer. Investments that do not meet both criteria are classified as longterm investments. STUDY OBJECTIVE 6 HELPFUL HINT Trading securities are always classified as shortterm. Available-for-sale securities can be either short-term or long-term. Readily Marketable. An investment is readily marketable when it can be sold easily whenever the need for cash arises. Short-term paper4 meets this criterion. It can be readily sold to other investors. Stocks and bonds traded on organized securities exchanges, such as the New York Stock Exchange, are readily marketable. They can be bought and sold daily. In contrast, there may be only a limited market for the securities issued by small corporations, and no market for the securities of a privately held company. Intent to Convert. Intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer. Generally, this criterion is satisfied when the investment is considered a resource that the investor will use whenever the need for cash arises. For example, a ski resort may invest idle cash during the summer months with the intent to sell the securities to buy supplies and equipment shortly before the winter season. This investment is considered short-term even if lack of snow cancels the next ski season and eliminates the need to convert the securities into cash as intended. 4 Short-term paper includes (1) certificates of deposit (CDs) issued by banks, (2) money market certificates issued by banks and savings and loan associations, (3) Treasury bills issued by the U.S. government, and (4) commercial paper (notes) issued by corporations with good credit ratings. JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 583 Valuing and Reporting Investments 583 Because of their high liquidity, short-term investments appear immediately below Cash in the \"Current assets\" section of the balance sheet. They are reported at fair value. For example, Pace Corporation would report its trading securities as shown in Illustration 12-9. Illustration 12-9 Presentation of short-term investments PACE CORPORATION Balance Sheet (partial) Current assets Cash Short-term investments, at fair value $ 21,000 147,000 LONG-TERM INVESTMENTS Companies generally report long-term investments in a separate section of the balance sheet immediately below \"Current assets,\" as shown later in Illustration 12-12 (page 585). Long-term investments in available-for-sale securities are reported at fair value. Investments in common stock accounted for under the equity method are reported at their equity value. HELPFUL HINT In a recent survey of 600 large U.S. companies, 242 reported short-term investments. Presentation of Realized and Unrealized Gain or Loss Companies must present in the financial statements gains and losses on investments, whether realized or unrealized. In the income statement, companies report gains and losses in the nonoperating activities section under the categories listed in Illustration 12-10. Interest and dividend revenue are also reported in that section. Other Revenue and Gains Interest Revenue Dividend Revenue Gain on Sale of Investments Unrealized GainIncome Illustration 12-10 Nonoperating items related to investments Other Expenses and Losses Loss on Sale of Investments Unrealized LossIncome As indicated earlier, companies report an unrealized gain or loss on availablefor-sale securities as a separate component of stockholders' equity. To illustrate, assume that Dawson Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $100,000. Illustration 12-11 shows the balance sheet presentation of the unrealized loss. Illustration 12-11 Unrealized loss in stockholders' equity section DAWSON INC. Balance Sheet (partial) Stockholders' equity Common stock Retained earnings Total paid-in capital and retained earnings Less: Unrealized loss on available-for-sale securities Total stockholders' equity $3,000,000 1,500,000 4,500,000 100,000 $4,400,000 Note that the loss decreases stockholders' equity. An unrealized gain is added to stockholders' equity. Reporting the unrealized gain or loss in the stockholders' equity section serves two purposes: (1) It reduces the volatility of net income due JWCL165_c12_568-611.qxd 584 8/11/09 9:45 PM Page 584 Chapter 12 Investments to fluctuations in fair value. (2) It informs the financial statement user of the gain or loss that would occur if the securities were sold at fair value. Companies must report items such as this, which affect stockholders' equity but are not included in the calculation of net income, as part of a more inclusive measure called comprehensive income.We discuss comprehensive income briefly in Chapter 14. Classified Balance Sheet We have presented many sections of classified balance sheets in this and preceding chapters. The classified balance sheet in Illustration 12-12 (page 585) includes, in one place, key topics from previous chapters: the issuance of par value common stock, restrictions of retained earnings, and issuance of long-term bonds. From this chapter, the statement includes (highlighted in red) short-term and long-term investments. The investments in short-term securities are considered trading securities. The long-term investments in stock of less than 20% owned companies are considered available-for-sale securities. Illustration 12-12 also includes a long-term investment reported at equity and descriptive notations within the statement, such as the basis for valuing merchandise inventory and one note to the statement. before you go on... Financial Statement Presentation of Investments Do it! Identify where each of the following items would be reported in the financial statements. 1. Interest earned on investments in bonds. 2. Market adjustmentavailable-for-sale. 3. Unrealized loss on available-for-sale securities. 4. Gain on sale of investments in stock. 5. Unrealized gain on trading securities. Use the following possible categories: Balance sheet: Action Plan Classify investments as current assets if they will be held for less than one year. Report unrealized gains or losses on trading securities in income. Report unrealized gains or losses on available-for-sale securities in equity. Report realized earnings on investments in the income statement as \"Other revenues and gains\" or as \"Other expenses and losses.\" Current assets Investments Property, plant, and equipment Intangible assets Current liabilities Long-term liabilities Stockholders' equity Income statement: Other revenues and gains Other expenses and losses Solution Item 1. Interest earned on investments in bonds. 2. Market adjustmentavailable-for-sale 3. Unrealized loss on available-for-sale securities 4. Gain on sale of investments in stock 5. Unrealized gain on trading securities Financial Statement Category Income statement Balance sheet Balance sheet Other revenues and gains Investments Stockholders' equity Income statement Income statement Other revenues and gains Other revenues and gains Related exercise material: BE12-6, BE12-7, BE12-8, E12-10, E12-11, E12-12, and Do it! 12-4. The Navigator JWCL165_c12_568-611.qxd 8/8/09 8:46 PM Page 585 585 Valuing and Reporting Investments Illustration 12-12 Classified balance sheet PACE CORPORATION Balance Sheet December 31, 2011 Assets Current assets Cash Short-term investments, at fair value Accounts receivable Less: Allowance for doubtful accounts $ 21,000 147,000 $ 84,000 4,000 80,000 Merchandise inventory, at FIFO cost Prepaid insurance 43,000 23,000 Total current assets Investments Investments in stock of less than 20% owned companies, at fair value Investment in stock of 20-50% owned company, at equity $ 314,000 50,000 150,000 Total investments Property, plant, and equipment Land Buildings Less: Accumulated depreciation 200,000 800,000 200,000 600,000 Equipment Less: Accumulated depreciation 180,000 54,000 126,000 200,000 Total property, plant, and equipment Intangible assets Goodwill 926,000 270,000 Total assets $1,710,000 Liabilities and Stockholders' Equity Current liabilities Accounts payable Federal income taxes payable Bond interest payable $ 185,000 60,000 10,000 Total current liabilities Long-term liabilities Bonds payable, 10%, due 2022 Less: Discount on bonds $ 255,000 300,000 10,000 Total long-term liabilities 290,000 Total liabilities Stockholders' equity Paid-in capital Common stock, $10 par value, 200,000 shares authorized, 80,000 shares issued and outstanding Paid-in capital in excess of par value 545,000 800,000 100,000 Total paid-in capital Retained earnings (Note 1) Total paid-in capital and retained earnings Add: Unrealized gain on available-for-sale securities 900,000 255,000 Be sure to read 1,155,000 Total stockholders' equity Total liabilities and stockholders' equity Note 1. Retained earnings of $100,000 is restricted for plant expansion. all about Y 10,000 1,165,000 $1,710,000 *U A Good Day to Start Saving on page 586 for information on how topics in this chapter apply to you. JWCL165_c12_568-611.qxd 8/8/09 8:46 PM all about Y Page 586 *U A Good Day to Start Saving C Compared to citizens in many other nations, Americans are very poor savers. It isn't that we don't know that we should save. It is just that we would rather spend. When is a good time to get serious about saving? Maybe you should start saving when you've graduated and have a good job, but then there will be those student loans to pay off, and your car loans as well. Maybe you should start after you've purchased your first homeand furnished it. Oh, and you might have kids, so you might wait until after they've gone off to college. You get the picture: There's always a reason not to start saving. Given that, today is as good a day as any to start saving. *About the Numbers The message to start saving early has been presented in many different ways. The chart below presents the facts in very blunt terms. When you are 25 years old, if you start putting $300 per month into an investment earning 8%, by the age of 65 you will have accumulated more than $1 million. But if you wait until age 55, you will accumulate only about $55,000. Notice the sharp drop-off between ages 25 and 35. Accumulated Value at Age 65 of $300 Monthly Investment Started at Different Ages $1,200,000 $1,000,000 $800,000 $600,000 $400,000 * * Some Facts Only about 48% of people in their twenties whose employers have a 401(k) plan participate in that plan. [401(k) plans allow you to put part of your pretax salary into investments. The investment and its earnings are not taxed until you withdraw them in retirement.] Many employers automatically enroll employees in 401(k) plans when they hire them. * Only 40% of working couples currently are covered by pension plans, but 61% of workers expect to get income from a company pension plan. * More than half of workers age 55 and older have less than $50,000 in retirement savings. * 80% of individuals between the ages of 18 to 26 said that, if given $10,000, they would deposit the money into a traditional bank savings account rather than invest in the stock market. Many stated that they are intimidated by the stock market, and choose to give up the added returns the stock market offers over the long run, rather than face the market. $200,000 $0 Age 25 Age 35 Age 45 Age 55 *What Do You Think? You've got $3,000 in credit card bills at an 18% interest rate. Your employer has a 401(k) plan in which it will match your contributions, up to 10% of your annual salary. Should you pay off your credit card bills before you start putting money into the 401(k)? YES: Paying off an 18% debt, and thus avoiding 18% interest payments, is essentially equivalent to earning 18% on investments. Reducing your debts reduces your financial vulnerability. NO: You need to get in the savings habit as soon as possible. You should take part of the money you would have used to pay off your debt each month and instead put it into the 401(k). Sources: Kelly Greene, \"Workers' Views on Retirement May Be Too Rosy,\" Wall Street Journal, April 4, 2006, p. D2; Ron Lieber, \"Getting Younger Folk to Save,\" Wall Street Journal, June 17, 2006, p. B1; Eric A. Henon, \"Why and How Generation Y Saves and Spends,\" Benefits & Compensation Digest, February 2006, pp. 30-32. * 586 The authors' comments on this situation appear on page 610. JWCL165_c12_568-611.qxd 8/8/09 8:47 PM Page 587 Comprehensive Do it! 587 Comprehensive Do it! In its first year of operations, DeMarco Company had the following selected transactions in stock investments that are considered trading securities. June 1 July 1 Sept. 1 Nov. 1 Dec. 15 Purchased for cash 600 shares of Sanburg common stock at $24 per share, plus $300 brokerage fees. Purchased for cash 800 shares of Cey common stock at $33 per share, plus $600 brokerage fees. Received a $1 per share cash dividend from Cey Corporation. Sold 200 shares of Sanburg common stock for cash at $27 per share, less $150 brokerage fees. Received a $0.50 per share cash dividend on Sanburg common stock. At December 31, the fair values per share were: Sanburg $25 and Cey $30. Instructions (a) Journalize the transactions. (b) Prepare the adjusting entry at December 31 to report the securities at fair value. Solution to Comprehensive (a) June 1 July 1 Sept. 1 Nov. 1 Dec. 15 (b) Dec. 31 Do it! Stock Investments Cash (600 $24) $300 (To record purchase of 600 shares of Sanburg common stock) 14,700 Stock Investments Cash (800 $33) $600 (To record purchase of 800 shares of Cey common stock) 27,000 Cash (800 $1.00) Dividend Revenue (To record receipt of $1 per share cash dividend from Cey Corporation) Cash (200 $27) $150 Stock Investments ($14,700 200/600) Gain on Sale of Stock Investments (To record sale of 200 shares of Sanburg common stock) 14,700 27,000 800 800 5,250 4,900 350 Cash (600 200) $0.50 Dividend Revenue (To record receipt of $0.50 per share dividend from Sanburg Corporation) 200 Unrealized LossIncome Market AdjustmentTrading (To record unrealized loss on trading securities) 2,800 200 2,800 Investment Cost Fair Value Sanburg common stock Cey common stock $ 9,800 27,000 $10,000 24,000 $ $36,800 $34,000 $(2,800) Totals Unrealized Gain (Loss) 200 (3,000) The Navigator Action Plan Include the price paid plus brokerage fees in the cost of the investment. Compute the gain or loss on sales as the difference between net selling price and the cost of the securities. Base the adjustment to fair value on the total difference between the cost and the fair value of the securities. JWCL165_c12_568-611.qxd 588 8/8/09 8:47 PM Page 588 Chapter 12 Investments SUMMARY OF STUDY OBJECTIVES 1 Discuss why corporations invest in debt and stock securities. Corporations invest for three primary reasons: (a) They have excess cash. (b) They view investments as a significant revenue source. (c) They have strategic goals such as gaining control of a competitor or moving into a new line of business. 2 Explain the accounting for debt investments. Companies record investments in debt securities when they purchase bonds, receive or accrue interest, and sell the bonds. They report gains or losses on the sale of bonds in the \"Other revenues and gains\" or \"Other expenses and losses\" sections of the income statement. 3 Explain the accounting for stock investments. Companies record investments in common stock when they purchase the stock, receive dividends, and sell the stock. When ownership is less than 20%, the cost method is used.When ownership is between 20% and 50%, the equity method should be used. When ownership is more than 50%, companies prepare consolidated financial statements. 4 Describe the use of consolidated financial statements. When a company owns more than 50% of the common stock of another company, it usually prepares consolidated financial statements. These statements indicate the magnitude and scope of operations of the companies under common control. 5 Indicate how debt and stock investments are reported in financial statements. Investments in debt and stock securities are classified as trading, available-for-sale, or held-to-maturity securities for valuation and reporting purposes.Trading securities are reported as current assets at fair value, with changes from cost reported in net income. Available-for-sale securities are also reported at fair value, with the changes from cost reported in stockholders' equity. Available-for-sale securities are classified as short-term or long-term depending on their expected future sale date. 6 Distinguish between short-term and long-term investments. Short-term investments are securities that are (a) readily marketable and (b) intended to be converted to cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classified as long-term investments. The Navigator GLOSSARY Available-for-sale securities Securities that are held with the intent of selling them sometime in the future. (p. 579). Held-to-maturity securities Debt securities that the investor has the intent and ability to hold to their maturity date. (p. 579). Consolidated financial statements Financial statements that present the assets and liabilities controlled by the parent company and the total revenues and expenses of the subsidiary companies. (p. 576). Investment portfolio A group of stocks and/or debt securities in different corporations held for investment purposes. (p. 573). Controlling interest Ownership of more than 50% of the common stock of another entity. (p. 576). Cost method An accounting method in which the investment in common stock is recorded at cost, and revenue is recognized only when cash dividends are received. (p. 574). Debt investments Investments in government and corporation bonds. (p. 572). Equity method An accounting method in which the investment in common stock is initially recorded at cost, and the investment account is then adjusted annually to show the investor's equity in the investee. (p. 575). Fair value Amount for which a security could be sold in a normal market. (p. 578). Long-term investments Investments that are not readily marketable or that management does not intend to convert into cash within the next year or operating cycle, whichever is longer. (p. 582). Parent company A company that owns more than 50% of the common stock of another entity. (p. 576). Short-term investments Investments that are readily marketable and intended to be converted into cash within the next year or operating cycle, whichever is longer. (p. 582). Stock investments Investments in the capital stock of other corporations. (p. 573). Subsidiary (affiliated) company A company in which more than 50% of its stock is owned by another company. (p. 576). Trading securities Securities bought and held primarily for sale in the near term to generate income on short-term price differences. (p. 579). Preparing Consolidated Financial Statements APPENDIX Most of the large U.S. corporations are holding companies that own other corporations. They therefore prepare consolidated financial statements that combine the separate companies. JWCL165_c12_568-611.qxd 8/8/09 8:47 PM Page 589 Appendix Preparing Consolidated Financial Statements 589 Consolidated Balance Sheet Companies prepare consolidated balance sheets from the individual balance sheets of their affiliated companies. They do not prepare consolidated statements from ledger accounts kept by the consolidated entity because only the separate legal entities maintain accounting records. All items in the individual balance sheets are included in the consolidated balance sheet except amounts that pertain to transactions between the affiliated companies.Transactions between the affiliated companies are identified as intercompany transactions. The process of excluding these transactions in preparing consolidated statements is referred to as intercompany eliminations. These eliminations are necessary to avoid overstating assets, liabilities, and stockholders' equity in the consolidated balance sheet. For example, amounts owed by a subsidiary to a parent company and the related receivable reported by the parent company would be eliminated. The objective in a consolidated balance sheet is to show only obligations to and receivables from parties who are not part of the affiliated group of companies. To illustrate, assume that on January 1, 2011, Powers Construction Company pays $150,000 in cash for 100% of Serto Brick Company's common stock. Powers Company records the investment at cost, as required by the cost principle. Illustration 12A-1 presents the separate balance sheets of the two companies immediately after the purchase, together with combined and consolidated data.5 Powers obtains the balances in the \"combined\" column are obtained by adding the items in the separate balance sheets of the affiliated companies. The combined totals do not represent a consolidated balance sheet, because there has been a double counting of assets and owners' equity in the amount of $150,000. Illustration 12A-1 Combined and consolidated data POWERS COMPANY AND SERTO COMPANY Balance Sheet January 1, 2011 Assets Current assets Investment in Serto Company common stock Plant and equipment (net) Total assets Powers Company Serto Company Combined Data Consolidated Data $ 50,000 $ 80,000 $130,000 $130,000 150,000 325,000 145,000 150,000 470,000 -0- 470,000 $525,000 $225,000 $750,000 $600,000 $ 50,000 300,000 175,000 $ 75,000 100,000 50,000 $125,000 400,000 225,000 $125,000 300,000 175,000 $525,000 $225,000 $750,000 $600,000 Liabilities and Stockholders' Equity Current liabilities Common stock Retained earnings Total liabilities and stockholders' equity The Investment in Serto Company common stock that appears on the balance sheet of Powers Company represents an interest in the net assets of Serto. As a result, there has been a double counting of assets. Similarly, there has been a double counting in stockholders' equity, because the common stock of Serto Company is completely owned by the stockholders of Powers Company. 5 We use condensed data throughout this material to keep details at a minimum. HELPFUL HINT Eliminations are aptly named because they eliminate duplicate data. They are not adjustments. JWCL165_c12_568-611.qxd 590 8/8/09 8:47 PM Page 590 Chapter 12 Investments The balances in the consolidated data column are the amounts that should appear in the consolidated balance sheet.The double counting has been eliminated by showing Investment in Serto Company at zero and by reporting only the common stock and retained earnings of Powers Company as stockholders' equity. USE OF A WORKSHEETCOST EQUAL TO BOOK VALUE The preparation of consolidated balance sheets is usually facilitated by STUDY OBJECTIVE 7 the use of a worksheet. As shown in Illustration 12A-2, the worksheet for Describe the content of a a consolidated balance sheet contains columns for (1) the balance sheet worksheet for a consolidated data for the separate legal entities, (2) intercompany eliminations, and balance sheet. (3) consolidated data.All data in the worksheet relate to the preceding example in which Powers Company acquires 100% ownership of Serto Company for $150,000. In this case, the cost of the investment, $150,000, is equal to the book value $150,000 ($225,000 $75,000) of the subsidiary's net assets. The intercompany elimination results in a credit to the Investment account maintained by Powers Company for its balance, $150,000, and debits to the Common Stock and Retained Earnings accounts of Serto Company for their respective balances, $100,000 and $50,000. Illustration 12A-2 WorksheetCost equal to book value Powers Company.xls File Edit View Insert Format A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 HELPFUL HINT As in the case of the worksheets explained earlier in this textbook, consolidated worksheets are also optional. Tools B Data Window C Help D E F POWERS COMPANY AND SUBSIDIARY WorksheetConsolidated Balance Sheet January 1, 2011 (Acquisition Date) Powers Serto Assets Company Company Current assets 50,000 80,000 Investment in Serto Company common stock 150,000 Plant and equipment (net) 325,000 145,000 Totals 525,000 225,000 Liabilities and Stockholders' Equity Current liabilities Common stockPowers Company Common stockSerto Company Retained earningsPowers Company Retained earningsSerto Company Totals 50,000 300,000 Eliminations Dr. Cr. 150,000 75,000 100,000 100,000 50,000 225,000 50,000 150,000 175,000 525,000 150,000 Consolidated Data 130,000 -0- 470,000 600,000 125,000 300,000 -0- 175,000 -0- 600,000 It is important to recognize that companies make intercompany eliminations solely on the worksheet to present correct consolidated data. Neither of the affiliated companies journalizes or posts the eliminations. Therefore, eliminations do not affect the ledger accounts. Powers Company's investment account and Serto Company's common stock and retained earnings accounts are reported by the separate entities in preparing their own financial statements. USE OF A WORKSHEETCOST ABOVE BOOK VALUE The cost of acquiring the common stock of another company may be above or below its book value. The management of the parent company may pay more than JWCL165_c12_568-611.qxd 8/8/09 8:47 PM Page 591 Appendix Preparing Consolidated Financial Statements book value for the stock. Why? Because it believes the fair market values of identifiable assets such as land, buildings, and equipment are higher than their recorded book values. Or it may believe the subsidiary's future earnings prospects warrant a payment for goodwill. To illustrate, assume the same data used above, except that Powers Company pays $165,000 in cash for 100% of Serto's common stock. The excess of cost over book value is $15,000 ($165,000 $150,000). Powers recognizes this amount separately in eliminating the parent company's investment account, as shown in Illustration 12A-3. Total assets and total liabilities and stockholders' equity are the same as in the preceding example ($600,000). However, in this case, total assets include $15,000 of Excess of Cost Over Book Value of Subsidiary. The disposition of the excess is explained in the next section. Edit View Insert A 1 2 3 4 5 6 7 8 9 10 11 Format Tools B Data Window C D HELPFUL HINT The consolidated worksheet is another good spreadsheet application. This is a good worksheet to attempt since the required instructions are very straightforward. Illustration 12A-3 WorksheetCost above book value Powers Company.xls File 591 Help E F POWERS COMPANY AND SUBSIDIARY WorksheetConsolidated Balance Sheet January 1, 2011 (Acquisition Date) Powers Serto Consolidated Eliminations Dr. Cr. Company Company Data Assets 115,000 Current assets 35,000 80,000 Investment in Serto Company common stock 165,000 165,000 -0- 470,000 Plant and equipment (net) 325,000 145,000 Excess of cost over book value of subsidiary 15,000 15,000 12 Totals 525,000 225,000 600,000 13 14 15 Liabilities and Stockholders' Equity 16 Current liabilities 75,000 50,000 125,000 17 Common stockPowers Company 300,000 300,000 18 Common stockSerto Company 100,000 100,000 -0- 175,000 175,000 19 Retained earningsPowers Company 50,000 50,000 -0- 20 Retained earningsSerto Company 21 Total