Lecture 21

Inter-corporate Investments
 Announcements: Exam #3
• Homework #4 is live, due 12/3 at 9am
• Quiz #3 covers material since Quiz #2
– Practice quiz posted
• Recitation:
– Practice Quiz #3 - 23, 26, 27;
– Tax Supplement I
– HW #3 12-15
• Next class is a review session
– no new material
 Goals of Today’s Class
• Accounting for investments in other firms
– Debt investments
– Equity investments

• Financial disclosures:
– Deere Co.
 Investments
• The accounting for investments by one firm in the debt or equity
securities of other firms can be very complicated.
– We will only consider the case where the investment securities are
marketable (i.e. have an observable market value).
– Accounting depends on intent and type of security (i.e. debt or equity).

• There are three aspects of the accounting for investments that need to
be examined to understand how inter-corporate investments impact
on the financial reports of investing firms:
1) Valuation at acquisition
2) Valuation subsequent to acquisition as the securities are
held by the investor
3) Recognition of income – accounting both for distributions
receivable or received and for changes in the market value of
the securities subsequent to acquisition.
Types of Intercorporate Investment

Type of Ownership
Ownership Amount
Majority > 50%
Active
Minority 20% - 50%
Focus is only
Active on these two
categories
Minority < 20% for this
course.
Passive
 Trivia Question
Is a company’s investment in debt securities:

a) Active Investment By definition, debt holders have

no say in the functioning of a
b) Passive Investment company.

c) Depends
 Accounting at Acquisition
• The accounting for inter-corporate
investments is the same in all cases – the
investment is recorded and reported at
cost, at the fair value of what was paid to
acquire the securities
Passive Ownership
 Investments – Intent ?
Debt Equity
Held-to-Maturity Investments that the Not Applicable
company has positive
(HTM) intent and ability to hold Why?
till maturity

Trading Held primarily for sale in the near term to generate

income on short term price differences

Available-for-Sale Investments that are not classified as held-to-

maturity or available-for-sale.
(AFS)
 Accounting for Marketable Securities:

• Four types of journal entries:

1. Entries to record acquisition

2. Entries to record receipts of interest or
dividends
3. Entries to record changes in market prices of
the investments
4. Entries to record sale
 Accounting for Marketable Securities:
HELD-TO-MATURITY
Example: On January 01, 2010, ABC Inc.
purchases 10,000 bonds that were issued
with a face value $1,000 ; 2-year maturity,
pays interest semiannually at a coupon rate
of 10%. The bonds were issued to yield 12%.

How much would ABC pay for this bond?

PV of coupon payments @ 4 periods, 6% discount rate + PV of $ 10 million
face value @ 4 periods, 6% discount rate = $9,653,500

(Note: The numbers have been rounded off to match textbook Pg 489-490)
 Accounting for Marketable Securities:
HELD-TO-MATURITY
To record acquisition:

1/1/10 Investment in Mkt. Securities (HTM) 9,653,500

Cash 9,653,500

To record coupon receipts:

6/30/10 Cash 500,000

Investment in Mkt. Securities (HTM) 79,207
Interest revenue 579,207

Interest revenue = Beg. Balance of Investment * 6%

= 9,653,500 * 6%
 Accounting for Marketable Securities:
HELD-TO-MATURITY
To record price increases:

Suppose on 6/30/2010 the value of the securities increase by $500,000.

No adjustments are made for HTM securities.

i.e. NO JOURNAL ENTRY

 Accounting for Marketable Securities:
HELD-TO-MATURITY
Let us move ahead to December 2010.

To record coupon receipts:

12/31/10 Cash 500,000

Investment in Mkt. Securities (HTM) 83,959
Interest revenue 583,959

Interest revenue = Beg. Balance of Investment * 6%

= (9,653,500+79,207) * 6%
 Accounting for Marketable Securities:
HELD-TO-MATURITY

Suppose the securities are sold on 1/1/2011 for $9,600,000

To record gain/loss on sale:

1/1/2011 Cash 9,600,000

(Realized) Loss on Sale 216,666
Investment in Mkt. Securities (HTM) 9,816,666

(9,653,500+79,207+ 83,959) = 9,816,666

Realized Gains/Losses are recorded in the income statement

 Accounting for Marketable Securities:
TRADING
Example:
Orange Inc. has a portfolio of securities consisting
of stocks (bonds) that cost the company $160
million on 1/1/2010. The market values of the
portfolio were $167 million on 12/31/2010 and
$155 million on 12/31/2011. During 2010, the
securities generated a dividend (interest) of $5
million that were not yet paid out in cash. These
securities were sold for $168 million on 2/2/2012.

Orange Inc. decided to account for this investment

as Trading Securities.
 Accounting for Marketable Securities:
TRADING
To record acquisition:

1/1/10 Investment in Mkt. Securities (Trading) 160

Cash 160

To record dividend (interest) receipts:

12/31/10 Dividend (Interest) Receivable 5

Dividend (Interest) revenue 5

Dividend (Interest) revenue is recorded in the Income Statement

 Accounting for Marketable Securities:
TRADING
To adjust the book value to market value as of 12/31/2010 (i.e. $167)
(ADJUSTING ENTRY AT THE END OF THE YEAR):
12/31/10 Allowance to adjust to market: Trading 7
Unrealized Holding Gain 7

Recorded in the Income Statement

•The Allowance Account is a companion account to the Investments account.

•Net Value of Investments = Balance in Allowance Account + Book Value of Investments
•The Allowance Account can have a debit or a credit balance. Debit increases value of
investments and credits decrease the value of investments.
•The ending balance in the Allowance Account should be such that at the end of the
period Net Value = Market Value
•In this case, Market value = 167, Book Value = 160 => Allowance should have a ending
balance of $7. Since the beginning value is zero, we debit $7.
 Accounting for Marketable Securities:
TRADING
To adjust the book value to market value as of 12/31/2011 (i.e. $ 155)
(ADJUSTING ENTRY AT THE END OF THE YEAR):
12/31/11 Unrealized Holding Loss 12
Allowance to adjust to market: Trading 12
Recorded in the Income Statement

•The ending balance in the Allowance Account should be such that at the end of the
period Net Value = Market Value
•In this case, Market value = 155, Book Value = 160 => Allowance should have a ending
balance of negative (credit) $5. Since the beginning value is positive (debit) balance
of $7, we need to credit $12 to the account.
 Accounting for Marketable Securities:
TRADING
To record sale on 2/2/2012 for $168:
2/2/12
Cash $168
Investment in Mkt. Securities (Trading) $160
Realized Gains $8

Recorded in the Income Statement

However, we need to also close the Allowance Account associated with these securities.
Because the allowance account captures the net unrealized gains and losses that have
been recognized in the past, we make the following journal entry:

Recorded in the Income Statement

Allowance to adjust to market: Trading $5

Adjustment Previously Recognized Unrealized Holding Loss $5
 Accounting for Marketable Securities:
AVAILABLE-FOR-SALE
Example:
Orange Inc. has a portfolio of securities consisting
of stocks (bonds) that cost the company $160
million on 1/1/2010. The market values of the
portfolio were $167 million on 12/31/2010 and
$155 million on 12/31/2011. During 2010, the
securities generated a dividend (interest) of $5
million that were not yet paid out in cash. These
securities were sold for $168 million on 2/2/2012.

Orange Inc. decided to account for this investment

as Available for Sales Securities.
 Accounting for Marketable Securities:
AVAILABLE-FOR-SALE
To record acquisition:

1/1/10 Investment in Mkt. Securities (AFS) 160

Cash 160

To record dividend (interest) receipts:

12/31/10 Dividend (Interest) Receivable 5

Dividend (Interest) revenue 5

Dividend (Interest) revenue is recorded in the Income Statement

 Accounting for Marketable Securities:
AVAILABLE-FOR-SALE
To adjust the book value to market value as of 12/31/2010 (i.e. $167):

12/31/10 Allowance to adjust to market: AFS 7

Unrealized Holding Gain 7

NOT Recorded in the Income Statement.

INSTEAD recorded as a part of Other Comprehensive Income (OCI) which is
in Shareholders’ Equity Section of Balance Sheet (See Lecture 19).

Same as in Trading
 Accounting for Marketable Securities:
AVAILABLE-FOR-SALE
To adjust the book value to market value as of 12/31/2011 (i.e. $ 155)
(ADJUSTING ENTRY AT THE END OF THE YEAR):
12/31/11 Unrealized Holding Loss 12
Allowance to adjust to market: Trading 12
Recorded as OCI
 Accounting for Marketable Securities:
AVAILABLE-FOR-SALE
To record sale on 2/2/2012 for $168:
2/2/12
Cash $168
Investment in Mkt. Securities (AFS) $160
Realized Gains $8

Recorded in the Income Statement

However, we need to also close the Allowance Account associated with these securities.
Because the allowance account captures the net unrealized gains and losses that have
been recognized in the past, we make the following journal entry:

Recorded as OCI

Allowance to adjust to market: AFS $5

Adjustment Previously Recognized Unrealized Holding Loss $5
 Note…
The major difference between Trading and AFS is that the
unrealized gains and losses flow through the Income
Statement for Trading securities where as it goes directly to
OCI i.e. Balance Sheet for AFS.

What implications might this have for income numbers and

retained earnings in these cases ?

NI is more volatile due to Trading securities.

Retained earnings under AFS (as against Trading ) does not
include the unrealized gains/losses. This number is in OCI.
Harder example…
 An Example:

Investor Corporation holds the portfolio of securities described below, at the specified
dates.

December 31, 2005 December 31, 2006

Cost Market Cost Market
$20,000 $22,000 $5,000 $4,500

The securities were purchased on January 1, 2005

During 2005, interest earned (dividends receivable) was $1,200

During 2006, securities costing $15,000, were sold in 2006 for $16,000. The unrealized
gain on these securities at the end of the prior year was $1,600.

Required:

1. Assume that the securities are long-term bonds and they qualify as securities held-to-maturity. Prepare journal entries to record
the transactions and events each year. Assume all the bonds were acquired at their face values, such that there is no discount or
premium to amortize.

2. Assume that the portfolio is comprised entirely of trading securities. Prepare journal entries to record the transactions and events
each year.

3. Assume that the portfolio is comprised entirely of securities available-for-sale. Prepare journal entries to record the transactions
and events each year.
 Accounting for Marketable Securities:
HELD-TO-MATURITY
2005: To record acquisition of held-to-maturity securities
Investment in marketable securities: held-to-maturity 20,000
Cash 20,000

2005: To record interest earned

Interest receivable 1,200
Investment Income – Interest revenue (income) 1,200

2005: To adjust for change in market value (year-end adjusting entry)

No Entry for Held-to-maturity securities

2006: To record sale of securities

Cash 16,000
Investment in marketable securities: he ld-to-maturity 15,000
Investment Income – (Realized) Gain on sale of 1,000
securities

Gains/Losses resulting from changes in the market va lue of

held-to-maturity securities are recognized only when the
securities are sold.

2006: To adjust for change in market value (year-end adjusting entry)

No Entry for Held-to-maturity securities
Financial Statement Disclosure –
Held-to-Maturity Securities:
Income Statement (for the year)
2005 2006
Interest income 1,200 ---

(Realized) Gain (loss) --- 1,000

Balance Sheet (at year-end)

2005 2006
Non-current Assets
Investment in securities, held-to-maturity, net of
unamortized premium or discount (see footnote) 20,000 5,000

(Note that the reported value is the original cost)

•
•
•
Shareholders’ Equity

Retained Earnings
(includes cumulative interest income, realized
gains and losses and gains and losses from
permanent impairments recognized in the current
and prior periods)
 Accounting for Marketable Securities:
TRADING
2005: To record acquisition of trading securities
Investment in marketable securities: trading B/S 20,000
Cash 20,000

2005: To record interest (dividends) earned

Interest (Dividends) receivable B/S 1,200
Investment Income – Interest (Dividend) I/S 1,200
revenue/income

2005: To adjust the net book value of the trading portfolio to market value (year-end adjusting e
Allowance to adjust to market: trading B/S 2,000
Unrealized holding gain I/S 2,000

2006: To record sale of securities and adjust the Allowance account

Cash 16,000
Investment in marketable securities: trading B/S 15,000
(Realized) Gain on sale of securities I/S 1,000

Adjustment for unrealized gain (recognized in prior periods) I/S 1,600

Allowance to adjust to market: trading B/S 1,600

(Following this entry, the Allowance account has a 400 debit

balance)

2006: To adjust the net book value of the trading portfolio to market value (year-end adjusting e
Unrealized hold loss I/S 900
Allowance to adjust to market: trading B/S 900
(Following this entry, the Allowance account has a 500
credit balance)
 Financial Statement Disclosure –
Trading Securities:

Income Statement (for the year)

2005 2006
Interest (Dividend) income (revenue) 1,200 ---
Net Income includes both
realized and unrealized gains
(Realized) Gain (loss) --- 1,000
Adjustment for unrealized loss (gain) (1,600)
recognized in prior periods
Unrealized gain (loss) 2,000 (900)
Net Gain – Trading securities 2,000 (1,500)

Reported at market value

Balance Sheet (at year-end)
2005 2006
Current Assets
Investment in securities, trading, at cost 20,000 5,000
Allowance to adjust to market (see footnote) 2,000 (500)
22,000 4,500
•
•
•
Shareholders’ Equity

Retained Earnings
(includes cumulative interest and dividend income, realized
gains and losses and unrealized gains and losses recorded in
current and prior periods)
 Accounting for Marketable Securities:
AVAILABLE-FOR-SALE

Just like TRADING but replace

“unrealized gain” with OCI

(Following this entry, the Allowance account has a 400 debit balance)

(Following this entry, the Allowance account has a 500 credit balance)
Financial Statement Disclosures –
Available-for-sale Securities:
Minority Active Ownership
 Equity method
• No influence < Significant influence < Control
• Significant influence:
– “The equity method tends to be most appropriate if an
investment enables the investor to influence the
operating or financial decisions of the investee. The
investor then has a degree of responsibility for the
return on its investment, and it is appropriate to
include in the results of operations of the investor its
share of the earnings or losses of the investee…”
– 20% < shares owned < 50% rules is a guideline
 Equity method accounting
• Initial book value of the investment is the
purchase price (historical cost)
• After the acquisition date, the investor
recognizes two transactions:
– To recognize the affiliate’s earnings:
Dr. Investment in Affiliate (A+) X
Cr. Equity in Earnings (NI+) X
– To recognize the affiliate’s dividend payments:
Dr. Cash (A+) Y
Cr. Investment in Affiliate (A-) Y
 Exercise
XYZ company acquired some of the 65,000 shares of outstanding
common stock (no-par) of Target Corporation during 2011 as a long-
term investment. The annual accounting period for both companies
ends December 31. The following transactions occurred during 2011:

Jan 10 Purchased 22,750 shares of Target common stock at $11 per

share
Dec 31 a. Received the 2011 financial statements of Target
Corporation that reported net income of $80,000
b. Target Corporation declared and paid a cash dividend of
$0.60 per share
c. Determined the market price of Target stock to be $10 per
share

Journal entries?
 Exercise
Jan 10:
Dr. Investment in Target (A+) 250,250*
Cr. Cash (A-) 250,250
*250,250 = $11 x 22,750

Dec 31:
a. Dr. Investment in Target (A+) 30,333*
Cr. Equity in Target’ Earnings (NI+) 30,333
*30,333 = (22,750/65,000) x $80,000
b. Dr. Cash (A+) 13,650*
Cr. Investment in Target (A-) 13,650
*13,650 = 22,750 x $0.60

Ending balance: 250,250 + 30,333 – 13,650 = 266,933

c. No Journal Entry
Financial Disclosure

Deere & Co.

 Case Study - Deere Co.
• Answer the following questions using the attached
financial statement information for Deere:
1. Suppose Deere’s available-for-sale investments had always
been classified as trading securities ever since they were
purchased. By how much would retained earnings differ from
that reported by Deere at the end of fiscal 2005? (Hint:
Unrealized gain on marketable securities is after tax.)
2. What was the historical cost of marketable securities
purchased during fiscal 2005?
3. What was the historical cost of marketable securities that were
sold or that matured during fiscal 2005?
4. What was the gain or loss on sales and maturities of
marketable securities during fiscal 2005?
DEERE & COMPANY
CONSOLIDATED BALANCE SHEET
As of October 31, 2005 and 2004
(In millions of dollars except per share amounts)

2005 2004
ASSETS
Cash and cash equivalents $ 2,258.2 $ 3,181.1
Marketable securities 2,449.7 246.7
Receivables from unconsolidated affiliates 18.4 17.6
Trade accounts and notes receivable - net 3,117.8 3,206.9
Financing receivables - net 12,869.4 11,232.6
Restricted financing receivables - net 1,457.9
Other receivables 561.1 663.0
Equipment on operating leases - net 1,335.6 1,296.9
Inventories 2,134.9 1,999.1
Property and equipment - net 2,364.8 2,161.6
Investments in unconsolidated affiliates 106.7 106.9
Goodwill 1,088.5 973.6
Other intangible assets - net 18.3 21.7
Prepaid pension costs 2,662.7 2,493.1
Other assets 430.9 515.4
Deferred income taxes 628.1 528.1
Deferred charges 133.8 109.7

Total Assets $ 33,636.8 $ 28,754.0

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES
Short-term borrowings $ 6,883.8 $ 3,457.5
Payables to unconsolidated affiliates 140.8 142.3
Accounts payable and accrued expenses 4,384.2 3,973.6
Health care claims and reserves 128.4 135.9
Accrued taxes 214.3 179.2
Deferred income taxes 62.7 62.6
Long-term borrowings 11,738.8 11,090.4
Retirement benefit accruals and other liabilities 3,232.3 3,319.7
Total liabilities 26,785.3 22,361.2
STOCKHOLDERS’ EQUITY
Common stock, $1 par value (authorized – 600,000,000 shares; issued –
268,215,602 shares in 2005 and 2004), at stated value 2,081.7 2,043.5
Common stock in treasury, 31,343,892 shares in 2005 and 21,356,458 shares
in 2004, at cost (1,743.5) (1,040.4)
Unamortized restricted stock compensation (16.4) (12.7)
Retained earnings 6,556.1 5,445.1
Total 6,877.9 6,435.5
Minimum pension liability adjustment (108.9) (57.2)
Cumulative translation adjustment 70.6 9.1
Unrealized gain (loss) on derivatives 6.2 (6.4)
Unrealized gain on investments 5.7 11.8
Accumulated other comprehensive income (loss) (26.4) (42.7)
Total stockholders’ equity 6,851.5 6,392.8

Total Liabilities and Stockholders’ Equity $ 33,636.8 $ 28,754.0

DEERE & COMPANY
STATEMENT OF CONSOLIDATED CASH FLOWS
For the Years Ended October 31, 2005, 2004 and 2003
(In millions of dollars)

2005 2004 2003

Cash Flows from Operating Activities
Net income $ 1,446.8 $ 1,406.1 $ 643.1
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for doubtful receivables 26.1 51.4 106.8
Provision for depreciation and amortization 636.5 621.0 631.4
Undistributed earnings of unconsolidated affiliates (4.1) 20.7 (5.5)
Provision (credit) for deferred income taxes (49.3) 385.0 33.1
Changes in assets and liabilities:
Trade, notes and financing receivables related to sales of
equipment (468.6) (863.7) 497.9
Inventories (324.1) (501.3) (72.8)
Accounts payable and accrued expenses 336.9 872.7 (184.9)
Retirement benefit accruals/prepaid pension costs (312.0) (1,245.7) (175.9)
Other (71.6) (250.1) 163.3
Net cash provided by operating activities 1,216.6 496.1 1,636.5

Cash Flows from Investing Activities

Collections of receivables 8,076.5 7,611.6 6,844.0
Proceeds from sales of financing receivables 55.2 2,206.8 1,704.0
Proceeds from maturities and sales of marketable securities 1,065.0 66.7 76.4
Proceeds from sales of equipment on operating leases 399.1 444.4 514.5
Proceeds from sales of businesses 50.0 90.6 22.5
Cost of receivables acquired (10,488.8) (10,493.5) (9,421.8)
Purchases of marketable securities (3,276.3) (79.6) (118.2)
Purchases of property and equipment (512.6) (363.8) (309.6)
Cost of operating leases acquired (342.0) (290.6) (258.9)
Acquisitions of businesses, net of cash acquired (169.7) (192.9) (10.6)
Increase in receivables from unconsolidated affiliates (68.7) (6.8)
Other (29.6) (.1) (32.4)
Net cash used for investing activities (5,173.2) (1,069.1) (996.9)

Cash Flows from Financing Activities

Increase (decrease) in short-term borrowings 1,814.3 (356.0) 126.9
Proceeds from long-term borrowings 3,805.4 2,189.5 3,312.9
Principal payments on long-term borrowings (1,509.7) (2,312.7) (2,542.7)
Proceeds from issuance of common stock 153.6 250.8 174.5
Repurchases of common stock (918.9) (193.1) (.4)
Dividends paid (289.7) (246.6) (210.5)
Other (1.9) (.4) (1.8)
Net cash provided by (used for) financing activities 3,053.1 (668.5) 858.9

Effect of Exchange Rate Changes on Cash (19.4) 38.1 71.1

Net Increase (Decrease) in Cash and Cash Equivalents (922.9) (1,203.4) 1,569.6
Cash and Cash Equivalents at Beginning of Year 3,181.1 4,384.5 2,814.9
Cash and Cash Equivalents at End of Year $ 2,258.2 $ 3,181.1 $ 4,384.5
7. MARKETABLE SECURITIES
All marketable securities are classified as available-for-sale, with unrealized gains and losses shown as a component
of stockholders’ equity. Realized gains or losses from the sales of marketable securities are based on the specific
identification method.

The amortized cost of marketable securities at October 31 in millions of dollars follow:

1) Suppose Deere’s available-for-sale investments had always been
classified as trading securities ever since they were purchased. By how
much would retained earnings differ from that reported by Deere at the
end of fiscal 2005?
(Hint: Unrealized gain on marketable securities is after tax.)
2) What was the historical cost of marketable securities
purchased during fiscal 2005?
3) What was the historical cost of marketable securities that
were sold or that matured during fiscal 2005?
4) What was the gain or loss on sales and maturities of
marketable securities during fiscal 2005?
 Next Class
• Review