Investments
Key Things to Know
Investors make investments for three primary reasons:
1) appreciation in market value
2) income from interest and dividends
3) significant influence and control
Investments are made in bonds (debt) and equities (stocks)
The journal entry to record all types of investments is:
Investment $$cost, including commissions
Cash $$cost, including commissions
There are two methods used to report investments that are related to the purpose of
making the investment: Fair Market Value Method and Equity Method
Fair Market Value Method: (FASB 115) Records investments made for appreciation and income
Use this method when:
1) You have no significant influence or control (usually owning < 20% indicates) 2) The market price is reliable – there is a bid ask quote, traded on an exchange
There are 3 categories of investments under this method:
1) Held to Maturity : Intend to hold investments in bonds to maturity
2) Trading Securities: Intend to hold for less than one year
3) Available For Sale: Intend to hold for one year or more
Held to maturity:
Do not adjust to fair market value.
Adjust the cost of the bond investment each period for interest using
the amortization schedule, as interest is earned and received
Trading Securities:
Adjust the investment to fair market value at the end of each period
if fair market value is reliable – there is a bid ask quote
The change in fair market value is reported on the income statement
under “other” revenues and expenses – “unrealized gain/loss” account
Record dividends received as dividend income
Available for Sale:
Adjust the investment to fair market value at the end of the period
if fair market value is reliable – there is a bid ask quote
The change in fair market value is reported on the balance sheet as
part of owner’s equity – accumulated gain/loss – an owner’s equity account
Record dividends received as dividend income
Journal entries: Record 2 things each period
1) adjust to fair market value – trading – unrealized gain/loss
- available for sale – accumulated gain/loss
2) record dividends received
Trading Available for sale
Investment
Adjust to FMV Investment
Unrealized Gain/Loss
at end of period Accumulated Gain/Loss
(use investment “T” account)
The investment account will be a debit when the investment goes up
The investment account will be a credit when the investment goes down
The other account is the opposite, debit or credit, for the same amount
Cash
Receive Dividends Cash
Dividend Income Dividend Income
Important to notice: The only difference in trading and available for sale is the account that is used to adjust to fair market value. Trading uses unrealized gain/loss which is reported on the income statement. Available for sale uses accumulated gain/loss which is reported on the balance sheet in owner’s equity.
Equity Method:
Use when you own an equity investment in a company and have significant influence
Significant influence exists when you own > 20%, and you have
- Access to financial information
- Seat(s) on the board of directors
- Influence company policies and procedures
The objective of the equity method is to show the investment as if it represents the owner’s equity in the company you purchased. When the company’s owner’s equity increases (earn income), your investment balance should increase. When the company’s owner’s equity decreases (losses and dividends paid), your investment balance should decrease.
The company’s owner’s equity changes with income and loss and dividends paid.
These are the things that also change your investment balance.
Journal entries are:
“Profit” “Losses”
Profit/Loss Investment in “X” Investment Expense
Investment Income Investment in “X”
Dividends Cash
Received Investment in “X”
When you sell your investment, under both FMV and Equity methods:
1) Record the cash you get as a debit
2) Take the investment off your books at the current balance in your
Investment “T” account times the % you are selling (credit investment)
3) Plug to
realized gain (credit) or realized loss (debit) to balance the entry
Cash (db)
Realized loss (db) or realized gain (cr)
Investment (cr)
Accounts that are reported on the income statement – current year only:
Unrealized Gain/Loss
Realized Gain/Loss
Dividend Income
Accounts that are reported on the balance sheet – cumulative balance:
Investment
Accumulated Gain/Loss (Owner’s Equity)
