Investments in Financial Accounting

Introduction

Investments are a significant component of corporate financial statements. Companies invest in other companies for various strategic and financial reasons, and these investments are classified and accounted for differently depending on the nature and intent of the investment. This guide summarizes the key concepts and accounting methods for investments in equity and debt securities.

Why Companies Invest in Other Companies

Motivations for Investment

Companies invest in the securities of other companies for two primary reasons: short-term financial management and long-term strategic objectives.

• Short-term basis:

  • Utilizing excess cash to earn additional income.

  • Generating interest and dividends, as well as potential gains (or losses) from the sale of securities.

  • Providing liquidity for future operations.

• Long-term strategic reasons:

  • Gaining influence or control over other companies.

Example: Apple Inc.'s investments in other companies contributed about $1.8 billion in extra income and cash in fiscal 2019.

Classification of Investments on the Balance Sheet

Investments are classified as either short-term or long-term assets based on liquidity and management intent.

• Short-term investments:

  • Reported as current assets.

  • Must be liquid and intended to be converted to cash within one year or the current operating cycle.

  • Proceeds may be used to pay current liabilities.

• Long-term investments:

  • If the above criteria are not met, the investment is classified as a long-term asset.

Types of Securities

• Equity Securities: Investments in capital stock (shares of other companies).

• Debt Securities: Investments in bonds or notes payable issued by other companies.

Methods of Accounting for Investments

Equity Investments: Influence Levels

The method of accounting for equity investments depends on the investor's level of influence over the investee, typically determined by the percentage of ownership.

Accounting for Investments in Equity Securities

Insignificant Influence (Fair Value Method)

When the investor owns less than 20% of the investee's voting stock, the investment is accounted for using the fair value method.

• Initial Recognition: Investments are recorded at cost when purchased.

• Dividends Received: Recorded as dividend revenue.

• Adjustments to Fair Value: At each reporting date, investments are adjusted to their current fair market value. Unrealized gains and losses are recognized in other comprehensive income (OCI) or net income, depending on classification.

Example: Apple Inc. purchases 5,000 shares of Intel stock for $100,000. At year-end, if the fair value increases to $110,000, an unrealized gain of $10,000 is recorded.

Formula for Unrealized Gain/Loss:

Significant Influence (Equity Method)

When the investor owns between 20% and 50% of the investee's voting stock, the equity method is used.

• Initial Recognition: Investment recorded at cost.

• Share of Income: Investor recognizes its share of the investee's net income as investment revenue.

• Dividends Received: Recorded as a reduction in the investment account, not as income.

Example: Intel purchases 49% of IM Flash Technologies for $490 million. If IM Flash earns $300 million, Intel records $147 million (49%) as investment revenue.

Formula for Share of Income:

Controlling Influence (Consolidation Method)

When the investor owns more than 50% of the investee's voting stock, the investor is considered to have a controlling interest.

• Parent-Subsidiary Relationship: The investor is the parent company; the investee is the subsidiary.

• Consolidation Accounting: Financial statements of the parent and all subsidiaries are combined into a single set of consolidated financial statements.

• Elimination of Intercompany Accounts: Transactions between parent and subsidiary are eliminated in consolidation.

Example: Intel Corporation consolidates the financial statements of its subsidiaries, such as McAfee, Inc.

Accounting for Investments in Debt Securities

Types of Debt Securities

• Trading Securities: Intended to be held for less than a year; accounted for using the fair value method.

• Available-for-Sale Securities: Intended to be held for more than a year but less than maturity (not covered in detail here).

• Held-to-Maturity Securities: Intended to be held until maturity; accounted for using the amortized cost method.

Held-to-Maturity Debt Securities

Held-to-maturity securities, such as bonds, are recorded at amortized cost and typically classified as long-term assets unless they mature within one year.

• Initial Recognition: Recorded at purchase price (which may be above or below par).

• Interest Revenue: Received semi-annually.

• Amortized Cost: The carrying amount is adjusted over time to reflect the amortization of any premium or discount.

Example: Intel purchases $10,000 of 6% CBS bonds at 95.2 (i.e., $9,520). The bonds mature in four years, and interest is paid semi-annually.

Formula for Amortized Cost:

Summary Table: Investment Accounting Methods

Key Terms

• Equity Securities: Shares of stock representing ownership in a company.

• Debt Securities: Bonds or notes representing a loan to another company.

• Fair Value: The price that would be received to sell an asset in an orderly transaction.

• Unrealized Gain/Loss: Change in value of an investment not yet sold.

• Amortized Cost: The initial cost of an investment adjusted for amortization of premium or discount.

• Consolidation: Combining financial statements of parent and subsidiaries.