Accounting for Investments

Many companies purchase securities of other companies to hold as an investment. Sometimes, these investments are acquired with temporary excess cash that the firm is holding for some specific future plan. In other cases, the firm might acquire the stock of other companies for long- term reasons (to diversify, to acquire new product lines, to secure raw materials needed for inventory, to acquire management, etc.). Accounting for these many types of investments can be complex.

A. Investments in Equity Securities (stock of other companies) First, what is a debt or equity investment? Debt investments are when the firm purchases the debt of other companies (e.g., when the firm acquires a bond payable issued by another company). In such cases, the firm hopes to receive periodic cash interest payments. Further, if the firm intends to hold this investment for a short period of time (less than the maturity date), the firm might hope that the investment will increase in value. On the other hand, if the firm holds the debt until maturity, the firm will receive the face value at maturity and the cash interest revenue over the debt’s outstanding life. Equity investments include investments that the firm makes in the voting common stock of other companies. For instance, GE might acquire 10% of the stock of another company to diversify its earnings stream. Gains from holding equity investments arise for various reasons. First, the value of the stock can increase (but it can also decrease, look at Amazon). Second, most firms pay cash dividends on their stock. Third, the firm might be acquiring operating or financial synergies. There are many issues related to the accounting for equity investments. When a firm acquires the voting stock of other companies, two characteristics of the purchase are very important: 1) After the purchase, does the firm have significant influence over the acquired company? And 2) Does the firm have control over the other company? Imagine that you purchase a few shares of Microsoft’s stock. Can you influence any of Microsoft’s operating policies? If you called up Bill Gates, he would probably not return your calls. Assume that you keep purchasing additional shares. At some point, you will purchase enough shares that you can vote someone on or off the company’s board of directors. As you purchase a larger percentage of the company’s stock, you gain influence over that company. Eventually, as you purchase enough voting shares, you have control. Clearly, we can assume that you have control when you acquire at least 50% of another companies voting stock. Lower levels of ownership may result in control as well, but are less well- defined. At what point does a firm a firm gain significant influence over another company? This is a subjective issue. In general, the following guidelines help determine the level of influence.  Is the investor represented on the board of directors?  What is the size of the investment relative to other investors?  Does the investor participate in the decisions of the investee?  Is the investee dependent on the investor for personnel or technology?  Are there intercompany transactions between the investor and investee?

The current rules, established by APB Opinion 18, use the level of ownership as a guideline to determine significant influence. If the firm owns 20% or more of another firm’s voting stock, we assume the firm has significant influence unless we have reason to believe otherwise. The following table illustrates the methods used for various percentage ownership levels.

1 Level of Ownership Level of Influence Accounting Method and Control Less than 20% No significant Influence, Mark to Market No control 20% to 50% Significant Influence Equity Method No control Greater than 50% Significant Influence, Purchase Method and Control (consolidation)

There are three methods used to account for equity investments: mark to market, the equity method, and the purchase method of consolidating statements. We will discuss each of these methods.

Mark to Market method If the firm acquires less than 20% of the voting stock of another company, the company uses the mark to market method to account for the investments. If the firm intends to hold the shares for a short period of time, what is the most relevant value to report on the balance sheet? At cost? At market? Most likely, this investment will be reported in current assets (i.e. items expected to be converted to cash within a year). In this case, the market value of the investment is more relevant to users of the financial statements, since the market value is closer to the amount of cash the firm will receive when it sells the investment. Therefore, all equity investments (under 20% ownership) will be reported on the balance sheet at their market values. But this does not mean that the change in market value of the investment during the year will necessarily be reported as an unrealized gain or loss on the Income Statement. To preserve the equality of the basic accounting equation, if we change one number on the balance sheet, some other account must change. The FASB initially wanted all changes in value for equity investments (where the firms owned less than 20%) to be reported as unrealized gains or losses on the Income Statement. However, many companies with 15 to 19% investment ownership claimed this would create too much volatility in their earnings (i.e. from recording the changes in value of the investments to market value as a gain or loss), especially, they argued, when the investment was not likely to be sold in the near future. Under pressure, the FASB created two categories of equity investments with less than 20% ownership. The first category includes trading securities. These are short- term investments held for short-term price movements or merely as a temporary use of the firm’s cash. The intent is to sell these investments in the near future. All other equity investments (with less than 20% ownership) are considered available for sale. While trading securities will always be considered current assets, available for sale securities can be either current assets or long-term assets. However, the primary difference between the two is how unrealized gains and losses (from the change in value of the security) are reported. For instance, if you acquire a 10% interest in K- mart for $40 million dollars in July 2001 and the price of the stock increases to $42 by the end of the year, you have an unrealized gain of $2 million since the stock has not yet been sold. Unrealized gains and losses are reported on the income statement for trading securities, while unrealized gains and losses from available for sale securities are reported in the stockholders’ equity section on the balance sheet (and will only affect income when the securities are ultimately sold).

2 Investment income and changes in value of the investment– Mark to Market Method: Generally, the firm benefits from owning an investment in an equity security either because the firm receives dividends or the price of the investment changes. When the firm receives dividends from either trading or available for sale securities, the dividend is recorded as Dividend Income, and reported on the income statement. However, changes in the value of the investment (unrealized gains and losses) are reported differently. The change in value (unrealized gains or losses) of the trading security is recognized in income in the year of change while the available for sale security’s unrealized gains and losses are not. See the example on the next page. Sale of Securities: Realized gains and losses from the sale of trading and available for sale securities are complicated because of how unrealized gains and losses are reported. Remember that unrealized gains and losses from trading securities have already been recognized in eanings in the year the change occurred. Therefore, when the trading investment is sold, the difference between the cash received and the carrying value of the investment is recorded as a realized gain or loss on sale. The carrying value of the investment is the adjusted cost basis of the investment (original cost plus or minus any unrealized gains and losses from the investment recognized in earnings since the date the investment was acquired). On the other hand, since no changes in value from available for sale securities have been recognized in earnings, the entire change in value of the investment gets recorded as a realized gain or loss on the date the available for sale security is sold. Therefore, when the available for sale investment is sold, the difference between the cash received and the original cost of the investment is recorded as a realized gain or loss on sale.

Equity Method Simple Equity Method If a firm acquires 20 to 50% of the voting stock of another company, the equity method is generally used to account for the investment. With such a high percentage of ownership, it is assumed that the firm has significant influence over the operating and dividend policies of the company whose stock has been acquired. Initially, we demonstrate the simple equity method in which we assume that the fair value of the investment is also equal to the value of the assets and liabilities recorded on the investee’s balance sheet. Because of this assumption, the firm recognizes income from the investment of the following amount:

Investment Income = (Percentage owned)(Reported income of the investee firm).

For example, suppose you acquired 40% of Sub Company for $100,000. Sub Company’s balance sheet on this date is as follows:

Sub Company Balance Sheet – Date of Acquisition Assets Liabilities and Equity Buildings $ 300,000 Short-term debt $ 50,000 Common Stock $100,000 ______Retained Earnings 150,000 250,000 Total assets $ 300,000 Total Liabilities and Equity $ 300,000

The following journal entry is made on the Investor’s books:

3 Investment in Sub Company (BS) $100,000 Cash (BS) $100,000 Note that under the simple equity method, 40% of the stockholders’ equity (or net assets) is equal to the amount paid for the investment, or $100,000. In the year after acquisition, Sub Company reported $50,000 of net income. The amount of investment income recognized on the books would be $20,000, (0.4 x $50,000 = $20,000). The investor would record the following entry:

Investment in Sub Company (BS) $20,000 Investment Income (IS) $20,000

When you receive dividends from the investment, this is considered a return of your investment under the equity method. You would reduce the investment account by the amount of cash dividends received. Continuing the Sub Company example, suppose Sub Company paid a $30,000 cash dividend, the investor would record the following entry:

Cash ($30,000 x .4) $12,000 Investment in Sub Company (BS) $12,000

Notice that after the acquisition, the Investment in Sub Company account changed twice during the year: it increases by the amount of investment income and decreases by the amount of dividends received. This may appear strange at first. We recognize earnings from the investment based on the other firm’s net income and not based on the amount of dividends we receive. Recall that it was assumed that we could influence the investee’s dividend policies. Therefore, we could potentially manipulate earnings by increasing or decreasing the investee dividends paid. At the end of the year, the stockholders’ equity section of Sub Company would be:

Stockholders Equity – Sub Company Begin of End of Year Year Common stock $100,000 $100,000 Retained earnings 150,000 170,000 Total $250,000 $270,000

Note that stockholders’ equity increased by $20,000 ($50,000 net income minus $30,000 dividends) during the year. Thus the investor’s share of this increase is 40% of $20,000, or $8,000 which is exactly the increase recorded on the investor’s books for the Investment in Sub Company account. In general, no changes in value of the equity investment are recorded on the books (i.e. no unrealized gains or losses are recorded). However, SFAS No. 159 allows firms to record changes in the value of these investments on the books if an irrevocable option to do so is exercised.

Complete Equity Method In the previous section, we have assumed that the market value of the net assets of the acquired firm is equal to the book value. We now relax this assumption and assume that the fair value of the net assets (as well as the value implied by the purchase price) exceeds the book value.

4 Suppose that an investor purchases 30% of SMC Company for $12,000 on January 1, 2007, and records the following journal entry for the investment.

Equity investment in SMC $12,000 Cash $12,000

Suppose that the recorded book value of the net assets on SMC’s books does not equal their fair values. The balance sheet of SMC on the date of acquisition is:

Balance Sheet Book Value Fair Value Difference Cash $3,000 $3,000 - 0 - Building (net remaining life 10 years) 30,000 37,500 7,500 Land 6,000 7,000 1,000 Brandname ______6,000 6,000 Total Assets $39,000 $53,500 $14,500

Debt 21,000 21,000 - 0 -

Book value of net assets $18,000 $14,500 Fair value of net identifiable assets $32,500

Why does the investor pay $12,000 for 30% of this company? The implied value for SMC can be computed as follows:

Implied value = (purchase price divided by the percentage purchased) = ($12,000/0.30) = $40,000 Thus a 30% interest in a firm that has a market value of $40,000 would be $12,000. There are two reasons why the market value might be more than the recorded book value of the net assets. First, the book value of certain assets, such as buildings and land, are lower than their fair values (for instance, the building has a fair value of $37,500 and a book value of $30,000). Taking these differences into account, a thirty percent interest in the net fair values of SMC would be:

(0.30 X $32,500) = $9,750. This amount is still less than the purchase price of $12,000. The remaining difference is purchased goodwill. Goodwill represents a measure of the firm’s ability to earn above normal profits. Thus the total goodwill associated with SMC is computed as follows:

Total goodwill = (Total implied value less the fair value of net assets) = ($40,000 less $32,500) = $7,500

The investor’s portion is 30% of $7,500, or $2,250. Why does this matter to the investor? Unlike the simple equity method illustrated earlier, if the investee’s recorded book value differs from fair value, the investor must record additional depreciation on the fair value of the depreciable assets. In addition, if intangible assets are recorded, additional amortization is likely if the intangibles have definite lives, and potential impairment losses if the intangibles (like goodwill) have indefinite lives. The final complication involves subsequent year’s entries made by SMC for

5 impairment losses or gains and losses on sales of assets. The discussion of sales of inventories that have been written up or down is deferred until chapter 6.

Because of these issues, the firm recognizes income from the investment based on the following computation:

Investment income in Sub Company includes the following: 1. Percentage of reported income of Sub Company, 2. Subtract additional depreciation expense from depreciable asset write-ups, 3. Subtract additional amortization from definite life intangibles recorded, 4. Add or subtract adjustments for gains/losses recorded by Sub Company. 5. Subtract adjustments for impairment losses on indefinite life intangibles.

End of Year Journal Entries Using the Equity Method- Investor Suppose SMC reports the following income statement for 2007.

Income Statement - SMC For 2007 Investor’s % Revenues $ 20,000 $ 6,000 Cost of sales 8,000 2,400 Depreciation expense 3,000 900 Tax expense 2,700 810 Net income $ 6,300 $ 1,890

The investor would record 30% of SMC net income as Income from Equity Investment as follows (equity income = .30 x $6,300 = 1,890):

Investor Entry for reported net income Equity Investment in SMC (BS) 1,890 Income from equity investments (IS) 1,890

However, the investor also needs to record additional depreciation expense based on the fair values of the assets purchased at the beginning of the year. The fair value of the building is $37,500 with a 10 year remaining life. Depreciation expense based on this value would be $3,750 rather than $3,000 as recorded by SMC. Thus the investor needs an additional entry to reflect 30% of $750, or $225 as additional depreciation expense. This entry is:

Additional depreciation expense entry - Investor Income from equity investments (IS) 225 Equity Investment in SMC (BS) 225

An alternative approach would be to compute the net increase in the investment account of $1665 by preparing an income statement for SMC using the implied values in the acquisition. Ignoring income tax effects, this approach is illustrated:

6 Income Statement – For 2007 for SMC Original Using Implied Book Value Values Revenues $ 20,000 $ 20,000 Cost of sales 8,000 8,000 Depreciation expense 3,000 3,750 Tax expense 2,700 2,700 Net income $ 6,300 $ 5,550

Investor’s percentage 30% 30% Investor’s share of income 1,890 1,665

Thus instead of making the two journal entries above, the investor could just make the following entry:

Investor Entry for reported net income Equity Investment in SMC (BS) 1,665 Income from equity investments (IS) 1,665

This second approach for preparing the journal entries needed under the equity method might be preferred if there are many adjustments needed to the books because of differences between implied and book values.

Subsequent years – Equity method Suppose SMC reported the following income statement for the second year following the purchase of SMC. Income Statement For 2008 Revenues $30,000 Cost of sales (14,000) Depreciation expense (3,000) Gain on sale of building 2,000 Tax expense (3,900) Net income $ 11,100

SMC provided the following additional information: The building was sold for $26,000 at the end of 2008 and replaced by a more modern building. The book value of the asset sold was $24,000. Recall that on the date the investor purchased 30% of SMC, the book value of the building was $30,000 and was being depreciated $3,000 a year. How do these events affect the journal entries needed by the investor? Recall that on the investor’s books, the building was recorded at fair value on the date of acquisition and that depreciation has been recorded on the investor’s books based on the fair value.

7 On SMC’s Books On Investor’s Books Building $30,000 $37,500 Less: Depreciation- Year One 3,000 3,750 Depreciation- Year Two 3,000 3,750 Book value on date sold 24,000 30,000 Cash received 26,000 26,000 Gain (Loss) $ 2,000 ($ 4,000)

The income statement for SMC adjusted for fair values is as follows:

Income Statement Book Values Fair values Revenues $30,000 $30,000 Cost of sales (14,000) (14,000) Depreciation expense (3,000) (3,750) Gain (loss) on sale of building 2,000 (4,000) Tax expense (3,900) (3,900) Net income 11,100 4,350 Investor’s percentage 30% 30% Investor’s share of income 3,330 1,305

The investor’s share of SMC’s income is 30% of 4,350 or $1,305. Alternatively, this can be computed as follows: This indirect approach begins with reported net income and computes the differences between the items in the income statements reported above.

Income as reported by SMC 11,100 Less: Additional depreciation expense (3,750-3,000) (750) Less: gain or loss adjustment (2000 gain to a 4,000 loss) (6,000) Income as adjusted 4,350 Investor’s percentage 30% Investor’s share of income 1,305

The journal entry needed by the investor is as follows:

Investor entry for adjusted net income Equity Investment in SMC (BS) 1,305 Income from equity investments (IS) 1,305

Alternatively, three entries could have been recorded as follows:

Equity Investment in SMC (BS) (.30)($11,100) 3,330 Income from equity investments (IS) 3,330

Income from equity investments (IS) (.30)($750) 225 Equity Investment in SMC (BS) 225

8 Income from equity investments (IS) (.30)($6,000) 1,800 Equity Investment in SMC (BS) 1,800

Notice that the impact on the investment account is the same regardless of the approach used. The investment account increased by $1,305 ($3,330 – $225 - $1,800 = $1,305).

Impairment losses recorded by SMC versus impairment losses recorded by the investor Recall that on the date the investor purchased 30% of SMC, the fair value included an intangible asset for brandname. This intangible was not recorded on the books of SMC. Thus the investor needs to determine if this intangible is impaired subsequently, and the investor may need to record an impairment loss even though SMC does not even test whether this asset’s value is impaired (because it is not recorded on SMC’s books). In addition, SMC may determine that the carrying value of certain assets reported on its balance sheet are impaired and record an entry for impairment losses. However, on the date of acquisition, the investor will have recorded the impaired asset in the investment account at its fair value. Thus SMC may need to record an impairment loss when the investor might not have to record a loss, or vice versa. Because of these and similar scenarios, additional adjustments may be needed to the investment account. For example, suppose that the brand name intangible asset recorded by the investor for $1,800 (or 30% of $6,000) became worthless. SMC does not record any entry on the books for impaired value since the brand name was not recorded on its books. However, the investor needs to record the impairment loss. Suppose that the income statement at the end of the third year reflected these transactions as follows:

Income statements using book value and implied value at the end of year 3 (and ignoring other differences between book and fair values):

SMC Income Statement Book Values Fair values Revenues $40,000 $40,000 Cost of sales (20,000) (20,000) Depreciation expense (4,000) (4,000) Impairment loss (6,000) Tax expense (3,000) (3,000) Net income 13,000 7,000 Investor’s percentage 30% 30% Investor’s share of income 3,900 2,100

Thus the entry needed on the books of the investor would be:

Equity Investment in SMC (BS) 2,100 Income from equity investments (IS) 2,100

Alternatively, the investor could make two entries; one to record 30% of the $13,000 reported income of $3,900 as income from equity investment and a second entry to record the investor’s share of the implied impairment loss $1,800 (or 30% of $6,000).

9 Income tax considerations are addressed in the appendices to Chapters 2, 4, and 5 in the book, and appendices to Chapters 6 and 6 online.

Summary Only investments with less than a 20% ownership interest are adjusted to market value at the end of the accounting year, unless an irrevocable option is elected under SFAS No. 159. The typical accounting for various levels of ownership is summarized as follows:

Balance Sheet Valuation and Income Statement Impact Unrealized changes in the value of the investment during the year Category Valuation Changes in Value of Income Statement Method Security during year Impact of Change in Value Less than 20% a. Trading – Unrealized Ownership The investment Compute unrealized gains and losses a. Trading account is gains or losses recognized in earnings. reported at b. AFS – Unrealized b. Available for sale market value gains and losses (mark to market) reported in equity on the Balance Sheet 20% to 50% The investment Not recognized* Not recognized* Ownership: account is NOT Significant reported at influence market value (equity method)* Greater than 50% The investment Not recognized Not recognized ownership or other account is NOT evidence of control reported at market value (Purchase method -consolidation) * Unless the irrevocable option allowed under SFAS No. 159 is chosen.

10 Mechanics of adjusting trading and available for sale securities to market value

How do firms adjust the value of the trading and available for sale securities to market value? Most companies keep the investment account at original cost and use an ‘Allowance to Market’ account to adjust the value to market. For instance, suppose an investment is purchased for $45,000. At the end of the first year, the investment has a market value of $47,000 and at the end of the second year the investment has a market value of $41,000. The following schedule lists the value of the investment and the change in the value of the investment on the relevant dates.

Purchase Date Year One Year Two Investment $45,000 $47,000 $41,000

Change in value (unrealized) $2,000 ($6,000)

The change in value is the amount of unrealized gain or loss that should be recorded in each year. In year one, the value of the investment increased $2,000 (the original cost to the end of year one market value of $47,000). In year two, the investment dropped in value by $6,000 (from the beginning of year two market value of $47,000 to the end of year two market value of $41,000). Note that that change in value is recorded in the year in which the change occurs.

The investment would be reported on the balance sheet for these years as follows:

Balance Sheet Year One Year Two Investment (at original cost) $45,000 $45,000 Allowance to market 2,000 (4,000) Net Investment, at market $47,000 $41,000

Trading Security If the investment was classified as a trading security, an unrealized gain of $2,000 would be recognized on the income statement in year one and an unrealized loss of $6,000 would be recognized on the income statement in year two. The following entries would be recorded:

Year One Allowance to market 2,000 Unrealized gain (IS) 2,000 Year Two Unrealized loss (IS) 6,000 Allowance to market 6,000

Available for Sale Security If the investment was classified as an available for sale security, an unrealized gain of $2,000 would be reported in stockholders’ equity on the balance sheet in year one and an unrealized loss of $6,000 would be reported in stockholders’ equity on the balance sheet in year two. Thus, at the end of year two, there would be a cumulative net unrealized loss of $4,000 reported in

11 stockholders’ equity as “other comprehensive income” on the balance sheet. The following entries would be recorded:

Year One Allowance to market 2,000 Unrealized gain (BS) 2,000 Year Two Unrealized loss (BS) 6,000 Allowance to market 6,000

Notice that the entries for both the trading and the available for sale security are the same. The difference is where the unrealized gains and losses are reported (income statement for trading and the balance sheet for available for sale securities).

Numerical Example: Trading, Available for Sale, and Equity Method Your company is going to invest in a new company called ‘Lawn Chair Lift (LCL)’. This company specializes in attaching hot air balloons to lawn chairs to allow people the opportunity to view their neighborhood in the comfort of a lawn chair. The following information is available about LCL Company for the first three years.

At the beginning of year one, the LCL Balance Sheet was as follows:

Assets (depreciable over 10 years) $100,000

Liabilities $60,000 Owners’ Equity Common Stock $1 par $10,000 Retained Earnings 30,000 40,000 Total liabilities and Equity $100,000

LCL Year-end information:

Year 1 Year 2 Year 3 Market value per share $7 $9 $7.2 Dividends paid per share $2 $2 $2 Net income reported $40,000 $60,000 $30,000 EPS $4 $6 $3

Assume that dividends are paid at year-end.

Your company’s income, excluding any investment transactions, was $7,000 in each year.

Required: Case A: You buy 10% of the voting common stock of LCL (1,000 shares) for $6 a share. The investment is classified as trading securities.

12 Case B: You buy 10% of the voting common stock of LCL (1,000 shares) for $6 a share. The investment is classified as available for sale securities. Case C: You buy 30% of the voting common stock of LCL (3,000 shares) for $6 a share.

The first step: For each investment, determine the method used to account for the investment.

If less than 20%, use the mark to market method. Then determine if the investment is a trading or available for sale security. Case A is trading and Case B is available for sale.

If between 20 and 50 percent, use the equity method. Case C presents and equity method illustration.

13 Year One – Journal Entries

Trading Securities Available for Sale Securities Equity Method

Entries Entries Entries Investment 6,000 Investment 6,000 Investment 18,000 Cash 6,000 Cash 6,000 Cash 18,000

Yr end: Yr. End Yr. End Cash 2,000 Cash 2,000 Investment 12,000 Dividend Income 2,000 Dividend Income 2,000 Equity Income 12,000

Cash 6,000 Allow. to mkt 1,000 Allow. to mkt 1,000 Investment 6,000 Unrealized gain (IS) 1,000 Unrealized gain (BS) 1,000

Balance Sheet Balance Sheet Balance Sheet Assets: Assets: Assets: Investments 6,000 Investments 6,000 Investments $24,000 Allow. To mkt 1,000 Allow. To mkt 1,000 (18,000 + 12,000 – 6,000) Net investment $ 7,000 Net investment $ 7,000

Equity: Unrealized gain $1,000

Income Statement Income Statement Income Statement Income before Invest. 7,000 Income before Invest. 7,000 Income before Invest. 7,000 Dividend income 2,000 Dividend income 2,000 Equity Income 12,000 Unrealized gain 1,000 ______Income before tax 10,000 Income before tax 9,000 Income before tax 19,000

14 Year Two – Journal Entries

Trading Securities Available for Sale Securities Equity Method

Entries Entries Entries

Yr end: Yr. End Yr. End Cash 2,000 Cash 2,000 Investment 18,000 Dividend Income 2,000 Dividend Income 2,000 Equity Income 18,000

Cash 6,000 Allow. to mkt 2,000 Allow. to mkt 2,000 Investment 6,000 Unrealized gain (IS) 2,000 Unrealized gain (BS) 2,000

Balance Sheet Balance Sheet Balance Sheet Assets: Assets: Assets: Investments 6,000 Investments 6,000 Investments $36,000 Allow. To mkt 3,000 Allow. To mkt 3,000 (24,000 + 18,000 – 6,000) Net investment $ 9,000 Net investment $ 9,000

Equity: Unrealized gain $3,000

Income Statement Income Statement Income Statement Income before Invest. 7,000 Income before Invest. 7,000 Income before Invest. 7,000 Dividend income 2,000 Dividend income 2,000 Equity Income 18,000 Unrealized gain 2,000 ______Income before tax 11,000 Income before tax 9,000 Income before tax 25,000

15 Year Three – Journal Entries

Trading Securities Available for Sale Securities Equity Method

Yr end: Yr. End Yr. End Cash 2,000 Cash 2,000 Investment 9,000 Dividend Income 2,000 Dividend Income 2,000 Equity Income 9,000

Unrealized loss (IS)1,800 Cash 6,000 Allow. to mkt 1,800 Unrealized loss (BS) 1,800 Investment 6,000 Allow. to mkt 1,800 Balance Sheet Balance Sheet Balance Sheet Assets: Assets: Assets: Investments 6,000 Investments 6,000 Investments $39,000 Allow. To mkt 1,200 Allow. To mkt 1,200 (36,000 + 9,000 – 6,000) Net investment $ 7,200 Net investment $ 7,200

Equity: Unrealized gain $3,000 Unrealized loss 1,800 Net unrealized gain 1,200 Income Statement Income Statement Income Statement Income before Invest. 7,000 Income before Invest. 7,000 Income before Invest. 7,000 Dividend income 2,000 Dividend income 2,000 Equity Income 9,000 Unrealized loss (1,800) ______Income before tax 8,200 Income before tax 9,000 Income before tax 16,000

Sale of Trading and Available for Sale Security Assume that the trading securities and the available for sale securities are sold during year four for $8,300 cash. Prepare the journal entries to record the sale and determine the amount of the realized gain or loss on sale for each investment.

Trading Security Cash 8,300 Investment (original cost) 6,000 Allowance to market 1,200 Realized gain on sale (IS) 1,100

Available for Sale Security Cash 8,300 Unrealized gain, net (BS) 1,200 Investment (original cost) 6,000 Allowance to market 1,200 Realized gain on sale (IS) 2,300

16 Note that the total gain for these securities is $2,300. The gains and losses from the trading security are recognized in the period the change took place. For example, $1,000 and $2,000 of unrealized gains were reported in years one and two, an unrealized loss of $1,800 in year three, and finally a realized gain of $1,100 was recognized in year four (a total net gain of $2,300). However, for the available for sale security, the entire gain is recognized only when the security was sold in year four.

Purchase Method – Consolidated Statements When you acquire over 50% of the voting stock of another company, you have control over that company. In this case, you must prepare consolidated financial statements. This means that you combine both companies’ income statements and balance sheets as if they were one company. The income recognized from the investment may be computed in any of three ways: cost, simple equity, or complete equity. No changes in the value of the investment are recognized.

The reason that all three alternatives are acceptable for investments that will be consolidated is because the consolidated numbers will be identical, regardless of which method is used on the books of the parent. The difference lies in making the appropriate consolidating entries, a topic addressed in chapters 4 through 9. When these entries are completed, the investment account will be zero (eliminated).

Our focus here is on the entries made on the books of the parent company (investor). To illustrate, suppose that Python Corporation purchases 80% of the outstanding stock of Sudan Company for $268,000 in cash. Immediately prior to the purchase, Sudan Company had the following balance sheet:

Assets Liabilities and Equity

Current assets ……………….. $90,000 Liabilities ……………………$100,000 Land ………………………… 80,000 Common stock, $5 par ……… 100,000 Building and equipment (net).. 170,000 Paid-in capital in excess of par. 20,000 ______Retained earnings …………… 120,000 Total assets ………………… $340,000 Total liabilities and equity $340,000

Book values approximated market values except for the building and equipment, which are worth $190,000 with a remaining life of 10 years. Any goodwill resulting from the purchase will be reviewed periodically for impairment. Let us begin by preparing a Computation and Allocation (CAD) Schedule for any differences between the value implied by the purchase price for this investment and book values.

17 Computation and Allocation of Difference between Implied and Book Value Acquired

Parent Non- Entire Share Controlling Value Share Purchase price and implied value* 268,000 67,000 335,000 Less: Book value of equity acquired: Common stock 80,000 20,000 100,000 Additional paid-in-capital 16,000 4,000 20,000 Retained earnings 96,000 24,000 120,000 Total book value 192,000 48,000 240,000 Difference between implied and book value 76,000 19,000 95,000 Increase in PPE (16,000) (4,000) (20,000) Balance 60,000 15,000 75,000 Record goodwill (60,000) (15,000) (75,000) Balance - 0 - - 0 - - 0 -

* $268,000/80% = $335,000 implied value

Python would record the investment with the following entry, regardless of whether Python is using the cost, simple equity, or complete equity method.

Investment in Sudan 268,000 Cash 268,000

Now, assume that Sudan Company reported the following changes in retained earnings during 2006 and 2007.

Retained earnings, January 1, 2006 …………………… $120,000 Add 2006 net income …………………………………. $ 40,000 Less 2006 dividends …………………………………... 24,000 16,000 Balance, December 31, 2006 ……………………….. $136,000 Add 2007 net income …………………………………. $ 45,000 Less 2007 dividends …………………………………... 21,600 23,400 Balance, December 31, 2007 ………………………. $159,400

Consider the journal entries that Python Corporation would make to record this information relative to its 80% investment during 2006 and 2007 under (a) the simple equity method, (b) the complete equity method, and (c) the cost method.

18 (a) Assuming that Python is accounting for its investment under the simple equity method, it would make the following entries:

Investment in Sudan 32,000 Equity income 32,000 To record Python’s share of Sudan’s 2006 net income (40,000 × 0.80)

Cash 19,200 Investment in Sudan 19,200 To record Python’s share of Sudan’s 2006 dividend (24,000 × 0.80)

Investment in Sudan 36,000 Equity income 36,000 To record Python’s share of Sudan’s 2007 net income (45,000 × 0.80)

Cash 17,280 Investment in Sudan 17,280 To record Python’s share of Sudan’s 2007 dividend (21,600 × 0.80)

(b) If Python is using the complete equity method (which would be required if consolidated statements were not being prepared for any reason), it would make the following entries:

Investment in Sudan 30,400 Equity income 30,400 To record Python’s share of Sudan’s 2006 net income adjusted for additional deprecation on PPE write-up (40,000 × 0.80) - ((20,000 × 0.80)/10)

Cash 19,200 Investment in Sudan 19,200 To record Python’s share of Sudan’s 2006 dividend (24,000 × 0.80)

Investment in Sudan 34,400 Equity income 34,400 To record Python’s share of Sudan’s 2007 net income adjusted for additional deprecation on PPE write-up (45,000 × 0.80) - ((20,000 × 0.80)/10)

Cash 17,280 Investment in Sudan 17,280 To record Python’s share of Sudan’s 2007 dividend (21,600 × 0.80)

19 (c) Finally, let’s assume that Python is accounting for its investment under the cost method, knowing that the consolidating entries will serve to provide the appropriate income amounts in the consolidated financial statements. Under this method, Python would make the following entries:

No entry for Python’s share of Sudan’s 2006 net income

Cash 19,200 Dividend Income 19,200 To record Python’s share of Sudan’s 2006 dividend (24,000 × 0.80)

No entry for Python’s share of Sudan’s 2007 net income

Cash 17,280 Dividend Income 17,280 To record Python’s share of Sudan’s 2007 dividend (21,600 × 0.80)

A. Investments in Debt Securities (bonds, government securities, etc.)

Balance Sheet Valuation Income Statement Impact

1. Held to maturity Reported at cost

2. Trading securities Reported at Market Value Unrealized gain or loss recognized in earnings in the year of the change in value 3. Available for sale Reported at Market Value Unrealized gain or loss reported on the balance sheet in the year of the change in value

Interest income is recognized from debt securities on an accrual basis.

On the following pages, the balance sheet and footnotes from the Genentech Inc. annual report dated December 31, 1999 are presented.

20 Genentech, Inc. Annual Report CONSOLIDATED BALANCE SHEETS (dollars in thousands, except par value)

DECEMBER 31 1999 1998 ------

Assets: Current assets: Cash and cash equivalents $ 337,682 $ 281,162 Short-term investments 405,003 606,544 Accounts receivable - trade (net of allowances of: 1999-$15,767; 1998-$14,661) 120,497 79,411 Accounts receivable - other (net of allowances of: 1999-$3,184; 1998-$2,757) 61,054 47,480 Accounts receivable - related party 33,234 22,850 Inventories 275,245 148,626 Deferred tax assets 81,922 38,849 Prepaid expenses and other current assets 11,870 17,036 ------Total current assets 1,326,507 1,241,958 Long-term marketable securities 1,214,757 716,888 Property, plant and equipment, net 730,086 700,249 Goodwill (net of accumulated amortization of: 1999-$690,887; 1998-none) 1,628,722 - Other intangible assets (net of accumulated amortization of: 1999-$1,062,181; 1998-$28,614) 1,453,268 65,033 Other long-term assets 201,101 131,274 ------Total assets $ 6,554,441 $ 2,855,402 ======

Liabilities and stockholders' equity: Current liabilities: Accounts payable $ 33,123 $ 40,895 Accrued liabilities - related party 14,960 10,945 Other accrued liabilities 436,044 239,487 ------Total current liabilities 484,127 291,327 Long-term debt 149,708 149,990 Deferred tax liabilities 626,466 43,782 Other long-term liabilities 11,335 26,458 ------Total liabilities 1,271,636 511,557

Commitments and contingencies

Stockholders' equity: Preferred stock, $0.02 par value; authorized: 100,000,000 shares; none issued - - Special Common Stock, $0.02 par value; outstanding: 1999-none; 1998-100,987,262 - 1,010 Common stock, $0.02 par value; authorized: 300,000,000 shares; outstanding: 1999-258,110,279 and 1998-153,242,018 5,162 1,532 Additional paid-in capital 7,191,766 1,588,990 Retained earnings (accumulated deficit) (2,173,622) 693,050 Accumulated other comprehensive income 259,499 59,263 ------Total stockholders' equity 5,282,805 2,343,845 ------Total liabilities and stockholders' equity $ 6,554,441 $ 2,855,402 ======

See notes on the following page (we have highlighted the investment related accounts in the balance sheet above).

21 Genentech, Inc. Annual Report

Note 1: Accounting Policies Investment securities are classified into one of three categories: held-to- maturity, available-for- sale, or trading. Securities are considered held-to- maturity when we have the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost, including adjustments for amortization of premiums and accretion of discounts. Securities are considered trading when bought principally for the purpose of selling in the near term. These securities are recorded as short- term investments and are carried at market value. Unrealized holding gains and losses on trading securities are included in interest income. Securities not classified as held-to-maturity or as trading are considered available- for-sale. These securities are recorded as either short-term investments or long-term marketable securities and are carried at market value with unrealized gains and losses included in accumulated other comprehensive income in stockholders' equity. If a decline in fair value below cost is considered other than temporary, such securities are written down to estimated fair value with a charge to marketing, general and administrative expenses. The cost of all securities sold is based on the specific identification method.

22 Genentech, Inc. Annual Report

INVESTMENT SECURITIES

Securities classified as trading, available-for-sale and held-to-maturity at December 31, 1999 and 1998 are summarized below. Estimated fair value is based on quoted market prices for these or similar investments.

Gross Gross Estimated Amortized Unrealized Unrealized Fair December 31, 1999 Cost Gains Losses Value ------(thousands)

TOTAL TRADING SECURITIES (carried at estimated fair value) $ 252,608 $ 101 $ (2,649) $ 250,060 ======SECURITIES AVAILABLE-FOR-SALE (carried at estimated fair value): Equity securities $ 97,818 $ 499,800 $ (17,780) $ 579,838 U.S. Treasury securities and obligations of other U.S. government agencies maturing: between 5-10 years 41,385 - (2,432) 38,953 Corporate debt securities maturing: within 1 year 144,996 7 (165) 144,838 between 1-5 years 350,652 151 (5,623) 345,180 between 5-10 years 137,366 - (7,550) 129,816 Other debt securities maturing: within 1 year 8,044 2,122 (61) 10,105 between 1-5 years 85,022 - (1,816) 83,206 between 5-10 years 39,342 - (1,578) 37,764 ------TOTAL AVAILABLE-FOR-SALE $ 904,625 $ 502,080 $ (37,005) $1,369,700 ======

SECURITIES HELD-TO-MATURITY (carried at amortized cost):

Corporate debt securities maturing: within 1 year $ 115,687 $ - $ (79) $ 115,608 ------TOTAL HELD-TO-MATURITY $ 115,687 $ - $ (79) $ 115,608 ======

23 Genentech, Inc. Annual Report

The carrying value of all investment securities held at December 31, 1999 and 1998 is summarized below (in thousands):

Security 1999 1998 ------

Trading securities $ 250,060 $ 239,901 Securities available-for-sale maturing within one year 154,943 250,956 Securities held-to-maturity maturing within one year - 115,687 ------Total short-term investments $ 405,003 $ 606,544 ======

Securities available-for-sale maturing between 1-10 years, including equity securities $1,214,757 $ 716,888 ------Total long-term marketable securities $1,214,757 $ 716,888 ======

In 1999, proceeds from the sales of available-for-sale securities totaled $627.1 million; gross realized gains totaled $19.4 million and gross realized losses totaled $1.8 million. In 1998, proceeds from the sales of available- for-sale securities totaled $431.0 million; gross realized gains totaled $9.5 million and gross realized losses totaled $1.8 million. We recorded charges of $13.4 million in 1999, $20.2 million in 1998 and $4.0 million in 1997, to write down certain available- for-sale biotechnology equity securities for which the decline in fair value below cost was other than temporary.

Net change in unrealized holding gains (losses) on trading securities included in net income totaled ($6.1) million in 1999, $7.4 million in 1998 and ($3.8) million in 1997.

The marketable debt securities we hold are issued by a diversified selection of corporate and financial institutions with strong credit ratings. Our investment policy limits the amount of credit exposure with any one institution. Other than asset-backed securities, these debt securities are generally not collateralized. We have not experienced any material losses due to credit impairment on our investments in marketable debt securities in the years 1999, 1998 and 1997.

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