FINANCIAL ACCOUNTING II

CHAPTER TWO ACCOUNTING FOR LONG-TERM INVESTMENTS

2.0 Introduction Long-term
investments involve acquisition of securities primarily to obtain some control and

to foster business relationships with other enterprises rather than holding them for sale in near future to benefit from fluctuations in market values. For example, equity securities: common stocks and preferred stocks that the investor acquires aiming to obtain ownership interest of other businesses can be classified as long-term investments. Likewise, Debt securities, such as Bonds, that the enterprise has the positive intent and ability to hold to maturity instead of hold them for trading is long term investments are long- term assets because they do not represent resources available to meet working capital needs. Generally, businesses enterprise may make long-term investments in securities of other companies for many reasons. Among these are: To create close ties to major suppliers or to retail outlets. Serve as a means of gaining control of a competitor To enhance its own income. To acquire ownership of a company with a strong cash position. To diversify the business risk.

Long term investments are different from short-term investments in the nature and purpose of the investment. Investments that are readily marketable and that may be sold without disrupting business relationships or impairing the operations of the business enterprise are classified as current assets or short term investments. Investments in debt and equity

securities held for the purpose of selling them in the near future are classified as Temporary or short-term investments.

PREPARED BY: FIREZER A.

FINANCIAL ACCOUNTING II The accounting procedures for investments involve measurement, recognition, and disclosure. Long Term Investments are generally classified as either debt securities or equity securities. The first section presents accounting for investments on equity securities and presents the cost and equity method of accounting; the second section covers accounting for , debt securities; and the remainder of the chapter presents accounting for stock warrants & rights and stock dividends.

2.1 ACQUISITION COST OF LONG-TERM INVESTMENTS

Acquisition Cost of Long term investments in securities describes fair value of (cash and cash equivalent) all economic considerations such as cash, non cash assets, or stocks and others used in the transaction. These may include the acquisition price plus brokerage fees and other expenditures incurred in the transaction.

2.2 Accounting for long term investments in common stock

Investors make long term investment in Common Stocks primarily to obtain general ownership in a corporation, a right to share in the corporations profits and right to vote at shareholder meetings and to benefit from increase in value of shares over time through capital gains. Shares of stock may be acquired on the open market from a firms stockholders, from the issuing corporation, or from stockbrokers. METHODS OF ACCOUNTING FOR COMMON STOCKS Depending on benefits or returns of investments that investor wishes to measure, the accounting treatment for the investment subsequent to acquisition may be different. There are three alternative methods of accounting for long-term investment in common stocks. These methods are:
1.

Cost method under this method, investment income consists only of dividends received.

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FINANCIAL ACCOUNTING II
2.

Equity method under this method, Investment income consists of the investors proportionate share of the investees net income.

3.

Market value method under this method, investment income includes dividends received and changes in the market value of the investment. The market value method is advised to short-term investments. However, it is much less appropriate for longterm investments. By definition, long-term investments are not held to take advantage of short-term fluctuations in market prices. Therefore, either the cost method or the equity method generally is used to account for long-term investments in common stock.

Selecting Between Cost and Equity methods of Accounting The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines which should be used between cost and equity method of accounting treatment for the investment. . Investments by one corporation in the common stock of another and the accounting method to be used can be classified according to the percentage of the voting stock of the investee held by the investor. Accordingly, COST Method is used when an investor has little or no influence over the investee; it is presumed that the investor has insignificant control if an interest is less than 20%.When an investor has a holding interest of between at least 20% in an investee corporation, the investor is generally deemed to exercise significant influence over operating and financial policies of the investee. The FASB has also listed other factors to consider in determining whether an investor can exercise significant influence over an investee. In instances of significant influence, the investor is required to account for the investment using the equity method. The COST METHOD OF ACCOUNTING FOR INVESTMENTS IN COMMON STOCKS

Cost method is applied when the investor lacks the ability to significantly influence the investees financial and operating policies. As a rule of thumb, this situation occurs when the

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FINANCIAL ACCOUNTING II investor owns less than 20% of a corporations outstanding voting common stock. In this case, the investor cannot influence the investees dividend policy, and the only portion of the investees dividend policy, and the only portion of the investees income that reaches the investor is the dividends paid by the investee.

Recording investments in common stocks and investment income

Upon acquisition, the investment is recorded at Cost. It continues to be carried and reported at cost in the investments account until it is either partially or entirely disposed of, or until some fundamental change in conditions makes it clear that the value originally assigned can no longer be justified. The investment account under this method is, thus, not adjusted for investor's share of investee's income. The accounting Entries to record the long term investment debits Investment Ledger Account and credits cash or other accounts for the fair value on the date of transaction. Investment in common stocks of xxx Company Cash/other assets/liabilities/ stocks xxxx xxxx

Under cost method of accounting investment income consists only of dividends. Ordinary cash dividends declared or received from the investee are recorded as dividend revenue or investment income and an adjustment is not made to investment account. The accounting Entries to record the investment income debits dividends receivable or cash Ledger Account and credits dividend revenue accounts for the investors proportionate share of investees dividends. Dividends receivable Dividends income XX XX

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FINANCIAL ACCOUNTING II

Example: On Jan 1, Year 1, P Co acquired 15 % shares of S Co outstanding common stocks for

$ 200,000 in cash. During the year S Co's reported net income of $700,000 and paid cash dividend of $280,000. INSTRUCTION: Record the investment and investment income (dividends received) in the books of investor company (P-Co). a. Recording the investments Investment in common stocks of S- Company Cash b. Recording investment income Under cost method investment income is limited to only dividends received, $42,000 (15% x 280,000) Dividends receivable Dividends income 42,000 42,000 200,000 200,000

Accounting for special events for accepted departure from cost basis
Under cost method of accounting, long-term investments in common stock should be maintained in Investment ledger account at cost. However, the following events cause accepted departure from cost basis.
1.

Liquidating Dividends: - are dividends received above the investors proportionate share

of investees net income (maximum ordinary dividends to investor) of the period. When the dividends received by the investor in subsequent periods exceed its share of investees earnings for such periods, the dividends should be accounted for as a reduction of the investment-carrying amount or a return of investment rather than as investment revenue.

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FINANCIAL ACCOUNTING II Such dividends are called liquidating dividends. Receipt of such dividends is recorded by a credit to the investment ledger account.

Example: P Co acquired 20% stock of S Co on January 1; Year 1 and S Co's net income for year
1 was $10,000. During the year S Co Paid cash dividend of 15,000. Instruction: 1. Compute the following for P-Company a. Dividends received
b.

Ordinary dividends

c. Liquidating dividend 2. Prepare journal entries to record a. Investment income b. Dividends received Solutions: 1 a. dividends received = (% of equity acquired) x investee total dividends) = 20% x 15,000 = $ 3000

1 b. Ordinary dividends = (% of equity acquired) x (investee net income) = 20% x 10,000 = $ 2000

1 c. Liquidating dividends = dividends received maximum ordinary dividends = 3,000 2,000 =1,000 2 a. Journal entries to record investment income: Investment in S- common stocks 2,000

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FINANCIAL ACCOUNTING II Investment income 2,000

2 b. Journal entries to record dividends received: Cash Dividends revenue Investment income
PERMANENT DECLINE IN VALUE OF INVESTMENT

3,000 2,000 1,000

Operating losses of the investee that reduce the investees net assets substantially and seriously impair its future prospects all recorded as losses by the investor. A portion of the long-term investment has been lost, and this fact is recorded by reducing the carrying amount of the investment for the investors proportionate share of investees net loss.

2. Valuation at Lower of Cost or Market

When aggregate market value of a Long Term investment accounted by cost method is below aggregate cost, it should be valued at the Lower of Cost or Market. The difference between the cost and market is recorded as a debit to Unrealized loss in long term investment in securities and credited to Allowance to reduce long-term investments to market account. Unlike in short-term investments, unrealized loss balance is not included in Net Income determination instead it is reported in a balance sheet as reduction in stock holders equity of the firm. Allowance account balance is also reported in a balance sheet but as contra asset account to respected investment ledger account. Example: Assume that on January 5, 2000 A Co. Invested $300,000 in the Com/stock of Bcompany. The aggregate market value of the investments was $240,000 and $270,000 on December 31, 2000 and 2001 respectively. The journal entries to record the acquisition and the valuation at LCM are: Jan1/2000 : recording the acquisition of securities

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FINANCIAL ACCOUNTING II Investment B-Co securities Cash $300,000 $300,000

Dec31/2000: recording the adjustment to LCM Value: Unrealized Loss in long-term investments $60,000 $60,000

Allowance to reduce long-term investments to market

Dec31/2001: recording adjustment to LCM Allowance to reduce long-term investments to market Unrealized Loss in long-term investments $30,000 $30,000

The Equity Method : Accounting for Long-Term Investments in

Common Stock
When an investor Company acquires sufficient ownership in the voting stock of an investee Company to have significant influence over the affairs of the investee, the investment is accounted for using the equity method. In the absence of evidence to the contrary, investments in which the investor company owns 20 percent or more of the outstanding voting stock of the investee Company, the investor company is presumed to have significant influence over the investee company. Thus, when an investor has an investment in the common stock of an investee company that results in significant influence over the investee, the investment is accounted for by the equity method.

Accounting for cost of long term Investments and Investment Incomes

Under equity method, the investment is originally recorded at the cost of the shares acquired but is subsequently adjusted each period for changes in the net assets of the investee. That

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FINANCIAL ACCOUNTING II is, the investments carrying amount is periodically increased (decreased) by the investors proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee. Accounting entries to record long term investment in common stock debits investment ledger account and credits different accounts representing the items used to acquire the securities such as cash, non cash assets, debt securities etc Investment in common stocks of xxx Company Cash/non-cash assets/ liabilities xxxx xxxx Fair value of items given out

Under equity method investment income consists of investors proportionate share of investees net income. The equity method recognizes that investee net income (net loss) increase (decrease) investee net assets thus increasing (decreasing) investors value of investment in investee common stocks. Accounting entries to record investment income debits investment ledger account and credits investment income account for the investors proportionate share of investee income. However, the entries will be reversed when the investee reports net loss. Investment in common stocks of xxx Company Investment income xxxx xxxx investors % share of Investee income Under equity method dividends represent conversion of some or all investments in to cash or return of investments. Therefore, the investment ledger account will be adjusted down or decreased for percentage share of investor from dividends declared or paid by the investee. Accounting entries to record l investment income debits cash or dividend receivables and credits investment ledger account for the investors proportionate share of investee dividends. Cash/dividends receivable xxxx xxxx investors % share of
Investee dividends PREPARED BY: FIREZER A.

Investment in common stocks of xxx Company

FINANCIAL ACCOUNTING II

Illustration:
Assume that on January 1, 2005 A.U.C. acquired 30% of the Common Stock of Access Bank for $500,000 which corresponded with carrying amount of Access Banks net assets. On Dec 31/2005 Access reported Net Income of $150,000 and declared and paid dividends of $60,000. A.U.C. accounts its investment under Equity Method as follows: Jan 1/05: Recording investment in common stocks Investment in Access Bank Cash Dec 31/05: Recording investment income and dividends paid a) Investment in Access Bank Investment income b) Cash Investment in Access Bank 18000 $18,000 $45000 45 000 $500,000 $500,000

EXERCISE: The following transactions were occurred in the years 2004 and 2005.
- Jan 5, 2004 CABU Company acquired 24,000 shares (25% of BATU company common stock) at cost of Br 10 a share. - Dec 31, 2005 BATU Company reported net income of Br 100,000 - Jan 20.2005 BATU company announced and paid a cash dividend of BR 60,000. Required Present the journal entries required to account for the investment in the books of CABU

Special Problems in the Application of Equity Method

The following four problems may arise in the application of the Equity Method and need special consideration 1. Intra-company profit (Gain): Is any unrealized profit (gain) or Loss resulting from transaction completed between investor and investee must be excluded from Net Income of investor until realized by a transaction. PREPARED BY: FIREZER A.

FINANCIAL ACCOUNTING II
There for investor company should recognize investee income for the proportionate share after excluding intracompany profit or gain. Such a sale may include merchandise, plant or intangible assets to affiliates. Assume that on Jan 1/2004 A-Co. with 30% equity of B-Co acquired merchandise from B-Co. (investee) for $75000B. The merchandise cost $55,000 to B. Co. and none of this merchandise was sold by A. Co. to its customers on that year. Assume further that investee reported Net Income of $120,000 and that no dividend was declared or paid. The following journal entries are made by A. Co. under the Equity Method of Accounting: 1. Investment in B. Co. Investment income [(120,000-(75000-55,000)] x0.30 To record 30% of N.I of B. Co. after elimination of $20,000 unrealized intra company G.P (75000-55000)of $20,000 remaining in A.Co. Inventories $30,000 $30,000

2. Cost different from carrying amount of Equity Acquired

When the acquisition cost of an investment differs from the carrying amount of the investees identifiable net assets adjustments may have to be made to the investment income recorded by an investor.

a. Cost in excess of equity acquired

When the acquisition cost of an investment exceeds the carrying amount of the investees equity or identifiable net assets, it implies that some identifiable assets of investee are under valued and needs up ward adjustments. Because identifiable assets are under amortized or depreciated the income reported by investee is overstated. Therefore, the excess cost should be amortized over the economic lives of the assets so as to adjust net income of investee. The following is the J/E. for amortization of excess of cost over underlying equity acquired: Procedures: 1. Compute the excess of cost over carrying amount of equity acquired

2. allocate the excess cost to identifiable assets of investee 3. amortize the allocated cost over the remaining economic life of the respective identifiable assets 4. Deduct the amortization of the period from net income of the year. 5. record investors proportionate share of investee adjusted income

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FINANCIAL ACCOUNTING II
Investment in investee Co. Investment Income $XXX $XXX

b. Cost Less than Equity Acquired:

If an investor acquires an investment in Com/stock a cost less than the underlying equity, its assumed that specific identifiable assets of the investee are overvalued and that such excess of underlying equity over cost is to be allocated to investment income over the economics lives of the assets as shown below: (follow the above procedure but for up ward adjustment) Investment in investee Co. Investment income (0) $XXX $XXX

3. Investors closing entries under Equity Method

Investors using the Cost Method of Accounting for investment in common stock close Dividend Revenue Ledger A/C to the Retained Earnings A/C. But investors that use the equity method of accounting for investments in com/Stock close balances of the investment income A/C to Retained Earnings only if the investee declared dividends in the amount of investors share of investee Net Income. An Investment income not paid as dividends by the investee is closed to an investors Retained Earnings of Investee Ledger A/C than to Retained Earnings since Undistributed Earnings of an investee are not available for declaration of dividends by an investor to its share holders instead it simply represents earning kept in investee. Sample journal entries: a. closing investment income to income summary xxxx investors % share of xxxx investee income

Investment income Income summary

b. closing income summary to retained earnings: Income summary Retained earnings of investee Retained earnings xxxx (investors % share of income) xxxx (undistributed earnings) xxxx (dividends received or declared)

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FINANCIAL ACCOUNTING II

4. Retroactive Application of Equity Method

If an investor acquires sufficient voting stock ( 20%) to influence an investee in a series of acquisitions rather than a single one, the equity method of accounting is applied retroactively when the investor has acquired 20% of the investees common stock. I.E.
a)

the accounting method is changed from cost to equity

b) the equity method is retroactively applied to the initial date of investment

ACCOUNTING FOR LONG=TERM INVESTMENTS IN BONDS Overview of Bonds

Bonds are means of dividing long-term debt in to a number of small units. By dividing the debt into a smaller unit, amounts of money larger than which could be borrowed from a single source may be obtained from a large number of investors. The Bond indenture is the written specific promises or the contract made between the corporation (issuer) and the bondholders. bondholders A bond contract OR Bond Indenture represents a promise to pay a principal and a series of interest payments for receiving certain amount today.

1 -4 4

Nt r obns a e f od u
AB ds une ae t o I sac D n t
I vs r net o by g ui n bns od
Bn C tfct od e i i a r e Bn Sln Pc od ei g r e l i

Bro i g o w r n Cm n op y a i si g su n Bns od

Sbe unPros us qe t ei d
I vs r net o by g ui n I od Bns Bro i g o w r n Cm n op y a i si g su n Bns od

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FINANCIAL ACCOUNTING II On the date the bonds are acquired, the investor pays the purchasing price of the bond, and the maker issues the bond certificate. In subsequent periods, the investor receives periodic interest from issuer for lending their money. At the maturity date of the bond, the investor may collect back face amount of the bonds from the issuer.
3.3 Accounting for acquisition of bonds and interest revenues 1Determining the Selling Price or proceeds of bonds When all bonds of an issue mature at the same time, they are called term bonds. In a typical term bond contract, the issuer promises two essentially different kinds of future payments (1) the payment of a fixed amount (face amount or principal) on a specified date: and (2) the periodic payment of interest, usually at six-month intervals, in an amount expressed as a percentage of the face amount of the bonds. A bond is valued as the present value of the stream of interest payments (an annuity) plus the present value of the par value, which is the principal amount for the bond, and is received by the investor on the bonds maturity date. The proceeds from bonds therefore represent the present value of the annuity of interest payments (at the

contractual rate of interest), and the present value of the redemption (face) value, both measured at the market rate of interest at
issue date.

t%

3 .

Bonds value

INT

INT

INT

INT F

Bond value =

(1 + r )
t =1 d

INT

(1 + rd ) N
F + (1 + r ) N d

1 1 N (1 + rd ) = INT rd
=

INT PVIFA rd , N + F PVIFrd , N .

) (

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FINANCIAL ACCOUNTING II Here INT = dollars of interest paid each Period calculated at t%, F = Face value, or maturity, value, which is typically $1,000, rd = market or yield interest rate on the bond, and N = number of periods until the bond matures.
When a corporation issues bonds, the price that buyers are willing to pay for the bonds depends on the following three factors: 1. 2. 3. The face amount (or principle), which is the amount due at maturity (usually $1,000). The periodic interest to be paid (printed on the bond)called the coupon rate, or contract rate. The market rate (also called the effective rate) of interest on bonds of similar quality.

Relationship between market rate and coupon rate Because market rates may fluctuate on a daily basis but the contract rate is the rate that is printed on the bond (it is the rate promised to the bondholders by the corporation) by the time the bonds reach the market, it is very possible that the market rate has changed. These differences between the nominal rate and the yield rate thus are adjusted by changes in the price at which the bonds are issued. Therefore, depending on the relationship between the current interest rate and the bonds coupon rate, a bond can sell at its par value, at a discount, or at a premium. If the effective or market interest rate is identical to the nominal or coupon rate, the bonds will sell at face amount. If the effective interest rate is higher than the nominal rate, the bonds will sell at a discount, meaning the cash received will be less than the face amount of the bonds. (Zero-coupon bonds pay no interest and thus are issued at a deep discount). Conversely, if the effective interest is less than the nominal rate, the bonds will sell at a premium, meaning S te in rethera received will be greater than the faceeb nofs se ta d te st cash is te T amount d the bonds. h o lls:

A o em rk t ra b v a e te

Aa p m m t re iu
(C sh re eiv is g ate th n fa e a c ed re r a c am u t) on

E u l tom rk t ra qa a e te

A fa a o n t ce m u t
(C ash re eiv is eq a to fa e c ed ul c am u t) on

B lo m rk t ra e w a e te
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Aa d t isco n ut
(C sh re e e is le th fac a c iv d ss an e am n ou t)

FINANCIAL ACCOUNTING II

Why this is true??? Lets assume you were deciding between investing in bonds of Company A, or the bonds of

If Company A had a higher contract rate than Company B, you would choose Company A, all other factors being equal, because you would earn a higher amount of interest with Company A. However, you might invest in the bonds of Company B if you could buy the bonds at a discount (an amount less than face value). Keep in mind that this means you are able to buy the bonds at less than face value (i.e., less than $1,000), but you still receive $1,000 back at maturity. Similarly, bonds sell at a premium because their contract rate is higher than the market rate. In this case, you pay more than the face amount (i.e., more than $1,000) to purchase the bonds, but you still get only $1,000 back at maturity. You would purchase at premium because you earn more interest than you would earn on bonds of similar quality.

Example 1: ACQUISITION OF Bonds at Face Amount

MARKET RATE = CONTRACT RATE

For example, A-Company acquired a 15-year, $1,000, 15% bond paying interest annually, when the appropriate market interest rate, rd, is 15 percent. Alternative 1: Utilizing the formula above, we find:

Cost or price of BONDS

1 1 15 (1 + 0.15) $150 = 0.15

$1,000 + 15 (1 + 0.15)

= $150(5.8474) + $1,000(0.1229) = $877.11 + $122.90 = $1,000.01 $1,000. Alternative 2: we can use present value concept: The price of a bond is found by adding together the

present value of the bonds coupon payments and the present value of the bonds face value.
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FINANCIAL ACCOUNTING II
P.V of Face Amount $1,000 due in fifteen yrs compounded annually at 15 %, = (1000,000x0.1229) = $ 122.90 P.V of fifteen annual interest payments of $150 compounded annually 15% = ($150x 5.8474) Total present value of bonds = $877.11

= $1,000.00

Journal entries: to record bonds payable issued at face amount. Investment in Bonds Cash 1,000 1000

EXAMPLE 2:- ACCOUNTING FOR Acquisition of Bonds at DISCOUNT & PREMIUM. On January 1, Year 1, A- company Acquired a $ 200,000, 5 year, 8% term bond of B-Company at the following yield rates of interest:: Case 1: at 9% market rate Case 2: at 7% market rate

Instruction: for each of the above independent cases: 1. Compute the cost of investment in Bonds 2. Compute discount or premium on the bonds date 3. Compute the carrying amount of the bonds on acquisition date

4. Prepare journal entries in the books of A-Company to record acquisition of or investment in bonds.

Solutions:

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FINANCIAL ACCOUNTING II
1. Cost of Bonds = (P.V of Face amount) + (P.V of periodic interest)

Case 1:

at 9%

Case 2: at 7%

P.V of Face Amount at 9%,5 period =

(200,000x0.649931)

P.V of Face Amount at 7%,5 period = (200,000x0.712986) = $ 14,2597.20 P.V of $16,000 every year for = $

129,986.20 P.V of $16,000 every year for 5 yrs at 9% $62,234.42

Cost of Bonds 192,220.62

= ($16,000x3.88965

5yrs. at 7% $65,603.15
Cost of Bonds

= ($16,000 x 4.100197) =

208,200.35

N:B. The price of a bond issue is determined by: The present value of the annuity of interest payments (at the contractual rate of interest), and the present value of the redemption (face) value,

Both discounted at the market rate of interest at

issue date.

Interest payments are calculated as: (Face value of bond issue * contractual interest rate)

2. DISCOUNT OR PREMIUMS Case 1: Proceeds of Bonds - Face Amount Discount Case 2: Proceeds of Bonds Premium = 192,220.62 200,000 = $ 7,779.38 7,779.38

- Face Amount = 208,200.35 200,000= $ 8,200.35 8,200.35

3. Carrying Amount of the bonds on issuance date

Case 1: Bonds issued at a discount (at 9%) Face Amount of 8% Bonds due in 5 years $ 200,000 Case 2: Bonds issued at a premium (at 7%) Face Amount of 8% Bonds due in 5 years$ 200,000

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FINANCIAL ACCOUNTING II
Less: discount Carrying 192,220 $7779.38 amt. Add: Premium Carrying $208,200.35 $ 8,200.35 Amt.

4. Journal entries to record issuance: Case 1:

Investment in Bonds Cash 192,220 192,220

Case 2:

Investment in Bonds Cash

208,200 208,200

3.3.3 Accounting for Bond Interest Revenue

Because differences between the effective rate and the nominal rate of interest are reflected in bond prices, the amount of premium or discount affects the periodic interest revenue. If bonds are acquired at a yield rate greater than the nominal rate, the discount represents an additional amount of interest benefit that will be received by the investor at maturity because of investors willingness to receive lower interest than the market during the term of the bonds. Similarly if the bonds are acquired at a yield rate less than the nominal rate, the premium represents an additional cost paid by bond holders for the right to receive higher annual interest than the market and is viewed as a reduction in the effective interest revenue. The present value of the bonds on the date of acquisition differs from their face amount because the market rate of interest differs from the periodic interest payments provided for in the bond contract. There fore, the process of amortizing the bond discount or premium in conjunction with the computation of periodic interest revenue is a means of recording the change in the carrying amount of the bonds as they approach maturity. In the bond discount
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FINANCIAL ACCOUNTING II case, the increase in the carrying amount of the bonds is caused by the decrease in bond discount through amortization. Similarly, in the bond premium case, the decrease in the carrying amount of the bonds is caused by the decrease in bond premium through amortization. There are two methods of amortization discount and premium on bonds: 1. Interest Method, and 2. Straight Line Method

1. Interest Method of Amortization for Term Bonds

In this method, the bond interest revenue in each accounting period is equal to the effective interest revenue, i.e., the effective rate of interest applied to the carrying amount of investment in bonds at the beginning of the period. It is theoretically sound and an acceptable method. The carrying amount of bonds at a discount increase as it reaches maturity and the interest revenue increases as it is calculated on increasing carrying amount. But the carrying amount of investment in bonds at a premium decreases as they reach maturity and the periodic interest revenue decrease. Under this method; Bond interest revenue is computed first by multiplying the carrying value of investments in bonds at the beginning of period by the effective interest rate. Interest Expense = Carrying Amount of bonds x market interest rate

The bond discount or premium amortization is then determined by comparing the bond interest with the interest to be paid. The Computation of the amortization is as follows:
Bond Interest revenue
Carrying value of Bonds at Beginning of period

Face Bond Interest received

Effective Interest

amount of bonds

rate

Stated Interest rate

Amortization Amount

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FINANCIAL ACCOUNTING II

Theoretically, bond interest expense in every accounting period must equal the effective interest expense by applying yield rate on the carrying amount of bonds. The carrying amount of bonds issued at a discount increase as it reaches maturity and the interest expense increases. But the carrying amount of bonds issued at a premium decreases as they reach maturity and the periodic interest expenses decrease. For example, the discount and premium amortization for the bonds of A-Company are presented below.

Case 1: Discount Amortization Table

Discount Date: End of Year Interest Revenue Interest Rev.at 8% computed at effective rate 9% Discount Amortization: Int. Rev Int. Pmt Balance. Carrying Amount

Issuance

$16,000 16,000 16,000 16,000 16,000

17,299.86 17,416.84 17,544.36 17,683.35 17,834.85

1,299.86 1,416.84 1,544.36 1,683.35 1,834.87

7779.38 6,479.52 5,062.68 3,518.32 1,834.97 -

192,220.62 193,520.48 194,937.32 196,481.68 198,165.03 199,999.92

End of Year 1
2 3 4 5

Journal Entries to record interest expense and amortization of the first period Yr 1. Cash Investment in Bonds 1,299.86 $16,000

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FINANCIAL ACCOUNTING II
Interest revenue 17,299.86

Case 2: Premium Amortization Table

Date:

Interest received

Interest revenue computed at effective rate 9%

Premium Amortization Int. Rev Int. Pmt 1,425.98 1,525.79 1,632.60 1,748.88 1,867.71 8,200.35 208,200.35 206,774.37 205,248.58 203,615.98 201,867.71 200,000.00 Premium Bal. Carrying Amt.

Issuance

$16,000 16,000 16,000 16,000 16,000

14,574.02 14,474.21 14,367.40 14,251.12 14,130.70

End of Year 1
2 3 4 5

Journal Entries to record interest expense and amortization of the first period 31/12/1 Cash Investment in Bonds Interest revenue 2. Straight- Line Method of Amortization $16,000 1,425.98 14,574.02

Under this method the additional interest benefit (discount) or reduction of interest of interest (premium) may be allocated evenly over the term of the bonds. It results in uniform periodic interest revenue. The use of straight-line method is acceptable if it is applied to immaterial amounts of discount or premium. The additional on reduction of interest revenue are allocated evenly over the term of the life of the bonds. The following session presents discount and premium amortization for A-Company.
PREPARED BY: FIREZER A.

FINANCIAL ACCOUNTING II

Case 1: Discount Amortization Table

Date

Interest received

Disct. Amortization (1/5th ) 1,555.88 1,555.88 1,555.88 1,555.88 1,555.88

Interest Revenue.

Discount Balance

Carrying Amount

Issuance End of Year 1 2 3 4 5

16,000 16,000 16,000 16,000 16,000

17,555.88 17,555.88 17,555.88 17,555.88 17,555.88

7,779.38 6,223.5 4,667.62 3,111.74 1,555.86 -

192,220.62 193,776.50 195,332.38 196,888.26 198,444.14 200,000.00

Yr 1. Cash Investment in Bonds Bond interest revenue

$ 16,000.00 1,555.88 17,555.88

Case 2: Premium Amortization Table

PREPARED BY: FIREZER A.

FINANCIAL ACCOUNTING II

Interest Date Received 8% Issuance

Premium Amortization

Int. Revenue at 7%

Premium Bal. 8,200.35

Carrying Amount

208,200.35 206,506.28 204,920.21 203,280.14 201,640.00 200,000.00

End of Year 1
2 3 4 5

16,000 16,000 16,000 16,000 16,000

1,640.07 1,640.07 1,640.07 1,640.07 1,640.00

14,359.93 14,359.93 14,359.93 14,359.93 14,359.93

6,560.28 4,920.21 3,280.14 1,640.07

31/12/1 Cash Interest Revenue Investment in Bonds

$16,000 $14359.93 1,555.88

Bonds Issued Between Interest Dates Bonds are usually not issued on an interest date, and semiannual interest payments are more typical. Two new problems arise: accounting for accrued interest from the most recent interest payment date and computing the price of the bonds. In principle, the investor should pay to the issuer both the cost of the bond plus accrued interest from the last date of interest to date of acquisition. On the next date of interest, the investor collects both the accrued interest paid to the issuer plus additional interest for holding the bonds during the remaining periods. i.e. from acquisition date to the next date of interest.

Assume that on March 1, year 5 G. Co. acquired 12% bonds with face amount of $1000, 000. The bonds mature in 10 years and interest is paid semi annually on June 30 and December 31. The prevailing interest rate is 10%. PREPARED BY: FIREZER A.

FINANCIAL ACCOUNTING II

Instruction: 1. Compute the cost of bonds. 2. Compute the accrued interest for the two months (dec. 31- march 1year 5) 3. present journal entries to record acquisition of bonds

Solution A. Cost of bonds:

P.V of Face Amount discounted at 5%,20 periods

(100,000x0.649931)

= 129,986.20

P.V of $6,000 interest for 20 periods discounted 6,000 x3.88965 ) Cost of Bonds

at 5%

($

$62,234.42

B. Accrued interest paid for two months (from dec.31 March.1) (100,000x 12% x 2/12) --------------------------Journal Entries: Investment in Bonds Interest receivable Cash 2,000

= 2,000

Accounting for Additional Issues

1. Accounting for Stock Warrants and rights
A stock warrant is a certificate issued by a Corporation conveying and guarantying the owners or holders rights to acquire shares of certain number of its Common Stock at a specified price in a specified period.

PREPARED BY: FIREZER A.

FINANCIAL ACCOUNTING II
a. accounting for warrants acquired in open market When warrants are acquired in open markets, the acquisition price, plus brokerage fees and other incidental costs are debited to investments in stock warrants and credited to cash and other items used in the transaction. Two accounting entries are usually prepared for stock warrants. i.e. at the time of acquisition and at the time of exercising the rights to acquire the shares of issuer company. To record acquisition of warrants and right xxxxx xxxx

Investment in stock warrants of xxx co. Cash/ other accounts

To record rights exercised to acquire shares of common stocks: xxxx (cost of rights used plus additional cost such as share price) Investment in stock warrants Cash/other assets xxxx xxx of common stock

Investment in Common stocks of xxxx co.

PREPARED BY: FIREZER A.