Introduction to Accounting for Investments (Equity and Debt Securities)
Summary
TLDRThis session explores why companies invest in others, such as for diversification or securing operating arrangements. Investments are categorized into debt (like bonds) and equity (like stocks). The accounting treatment varies based on intent and ownership level: held-to-maturity, trading, available-for-sale for bonds; fair value, equity method, or consolidation for equity. The presenter encourages using resources like farhatlectures.com for CPA exam preparation.
Takeaways
- đŒ Companies invest in other companies for various reasons such as entering new markets, diversifying risk, earning a high rate of return, securing operating arrangements, or simply because investing is their core business.
- đ Microsoft's acquisition of LinkedIn is an example of a company investing in another to enter a new market.
- đč Diversification of investments is crucial to mitigate risks, especially when the core business might face downturns.
- đ° Cash is considered the safest investment but offers the lowest return; hence, to earn more, companies invest in other ventures.
- đ Investments can secure critical supply relationships, like electric car manufacturers investing in battery suppliers.
- đŠ Companies like Berkshire Hathaway exist specifically to invest in other companies, showcasing investment as a standalone business model.
- đ Investments are categorized into debt (like bonds) and equity (like stocks), with each requiring different accounting treatments.
- đ Debt investments are classified as held-to-maturity, trading, or available-for-sale based on the company's intent.
- đ Held-to-maturity bonds are reported at amortized cost, ignoring fair value fluctuations since they are intended to be held until maturity.
- đ Trading investments are short-term and reported at fair value, reflecting unrealized gains and losses.
- đ The degree of ownership in an equity investment determines the accounting method: fair value for passive investors, equity method for significant influence, and consolidation for control.
- đ For a comprehensive understanding of accounting for investments, resources like Farhat Lectures offer additional materials aligned with CPA review courses.
Q & A
Why do companies invest in other companies?
-Companies invest in other companies for various reasons such as investing in startups, entering new markets, diversifying risk, earning a high rate of return, securing operating arrangements, or simply because some companies exist to invest in other companies.
What is the difference between debt and equity investments?
-Debt investments involve lending money to another company, typically by buying bonds. Equity investments involve owning a share of another company, typically by purchasing stocks.
What is the significance of the intent behind an investment?
-The intent behind an investment determines how it is classified and accounted for. For example, if a bond is held to maturity, it is classified as held to maturity and reported at amortized cost.
What does it mean to classify an investment as held to maturity?
-Classifying an investment as held to maturity means the investor has no plan to sell the bond and intends to hold it until it matures, reporting it at amortized cost.
What is amortized cost in the context of bond investments?
-Amortized cost refers to the initial purchase price of a bond, adjusted for any premium or discount, and ignoring fair value fluctuations until maturity.
What are the three categories of debt investments?
-The three categories of debt investments are held to maturity, trading, and available for sale.
What is the difference between trading and available for sale investments?
-Trading investments are intended to be sold in the near future, while available for sale investments fall somewhere in between holding to maturity and trading, where the investor might sell if the price is right.
How does the degree of ownership affect how equity investments are accounted for?
-The degree of ownership determines the level of control or influence the investor has over the investee company, which in turn affects the accounting method used, such as fair value, equity method, or consolidation.
What is the equity method of accounting for equity investments?
-The equity method is used when an investor owns between 20% to 50% of a company, indicating significant influence over the investee, and the investment is accounted for based on the investor's share of the net income or losses of the investee.
What is the consolidation method in accounting for investments?
-The consolidation method is used when an investor owns more than 50% of a company, indicating control, and the investee's financial statements are combined with the investor's.
What additional resources are recommended for understanding accounting for investments?
-The script recommends visiting farhatlectures.com for additional resources, multiple-choice questions, and supplemental materials to enhance understanding of accounting for investments.
Outlines
đŒ Accounting for Investments
This paragraph introduces the topic of accounting for investments in other companies. It explains why companies invest, including reasons such as entering new markets, diversifying risk, earning a high rate of return, securing operating arrangements, and being an investment company like Berkshire Hathaway. The speaker emphasizes the importance of understanding the intent behind the investment, which can be either debt or equity. Debt investments are when a company lends money by buying bonds, while equity investments are made through purchasing stocks. The intent could be to hold to maturity, which is the first classification discussed, where the investment is reported at amortized cost, ignoring fair value fluctuations since the bond will mature at face value.
đ Classifications of Debt Investments
This paragraph delves into the classifications of debt investments. It explains that if the intent is to sell the bond, it must be reported at fair value, leading to unrealized gains and losses. There are three categories for bonds: held-to-maturity, trading, and available-for-sale. Held-to-maturity is for bonds intended to be held forever, trading is for bonds expected to be sold in the near future, and available-for-sale is for bonds that might be sold if the price is right. The paragraph also mentions various types of debt securities, focusing on corporate bonds for accounting students. It transitions to equity investments, explaining that the accounting treatment depends on the degree of ownership. For less than 20% ownership, the investment is considered passive, and fair value accounting is used. For between 20% and 50%, significant influence is assumed, leading to the equity method of accounting. Over 50% ownership results in control, necessitating consolidation.
đïž Consolidation and Further Study
The final paragraph summarizes the types of investments and their classifications, which include held-to-maturity, trading, and available-for-sale for debt, and fair value, equity method, and consolidation for equity. It encourages the audience to visit farhatlectures.com for additional resources and practice questions to understand how to account for investments. The speaker advises investing in one's own education, especially for those studying for the CPA exam, and emphasizes the long-term value of a CPA certification.
Mindmap
Keywords
đĄInvestments
đĄAccounting for Investments
đĄDebt Investments
đĄEquity Investments
đĄHeld to Maturity (HTM)
đĄAmortized Cost
đĄFair Value
đĄTrading Securities
đĄAvailable-for-Sale Securities
đĄSignificant Influence
đĄConsolidation
Highlights
Companies invest in other companies for various reasons, such as investing in a startup, diversifying risk, or securing operating arrangements.
Investing in a startup can be a way to buy into a promising new product or enter a new market.
Microsoft's acquisition of LinkedIn is cited as an example of a company entering a new market through investment.
Diversification of investments can help mitigate risk in case a company's core business declines.
Investments can be made to earn a higher rate of return than what is typically offered by cash.
Investing in a supplier can secure critical components or services needed for a company's operations.
Some companies, like Berkshire Hathaway, exist primarily to invest in other companies.
Investments are categorized into debt and equity for accounting purposes.
Bonds are a type of debt investment where the investor lends money to a company.
Equity investments involve purchasing stocks in another company.
The intent of the investment determines how it is classified and reported in financial statements.
Bonds held to maturity are reported at amortized cost, ignoring fair value fluctuations.
Trading investments are bonds that the investor plans to sell in the near future and are reported at fair value.
Available-for-sale investments fall between held-to-maturity and trading, with the possibility of selling if the price is right.
The degree of ownership in an equity investment affects how it is accounted for.
Passive investments in equity, with less than 20% ownership, are accounted for at fair value.
Investments with significant influence, typically between 20% and 50% ownership, are accounted for using the equity method.
Controlling interests, with more than 50% ownership, require the use of the consolidation method in financial reporting.
Farhat Lectures offers additional resources and courses to complement CPA review and accounting education.
The importance of investing in one's own education and practicing accounting skills is emphasized.
Transcripts
hello and welcome to this session in
which we'll discuss accounting for
investments well we're talking about
accounting for investments in other
companies so when one company buys
stocks and another company so why do
companies invest in another company well
there are many reasons why you would do
it but it's very important to get the
big picture why do they do it well one
one reason is to invest in a startup
maybe it's a new company maybe they have
a new product new promising product you
want to buy into that company or
enter a new market for example microsoft
when they wanted to have a social
network what they did rather than
starting one they bought linkedin and
i'm sure you you're both most like
likely a user of microsoft and linkedin
diversify your risk so if you're a
software company you may want to buy
some stocks in a construction company
maybe you want to buy some stocks and
companies that's not related to you
maybe retails
why
now you have some cash on the side and
you don't have any investment in your
company itself
you diversify your risk in case your
business went down your investments will
do well to earn a high rate of return
cash gives you the lowest return
practically zero because with cash you
take no risk so what you want to do if
you want to earn more you would have to
make an investment investment taken risk
you'll invest in other companies
you would also invest to secure what's
called operating arrangement sometime
you might be relied on one supplier on
one important supplier for example
specialized industries like the electric
cars they might have very unique product
very unique parts that they need to
secure from one supplier for example if
you're producing electric car you might
need that battery so what's going to
happen is you will buy you will invest
in your supplier you'll you'll buy some
of those stocks you will be an owner
that's why you would invest to secure
operating arrangement now you are part
of the company you know what's going on
you have a saying
and some companies exist to invest in
other companies that's their job like
berkshire hathaway the the ceo warren
buffett
their company that's all what they do
they take money and they invest that
money in other companies that's their
business and could it could be many
other reasons why company invest in
other companies for the sake of
intermediate accounting financial
accounting or the cpa exam we're gonna
break investments into two types so
we're gonna keep it simple debt and
equity and what we mean by that bonds
it's when you
lend money to another company by their
bond and when we mean by equity is
stocks now bear in mind
those are not the only two type of
investments you can invest in gold you
can invest in real estate you can invest
in cryptocurrency
it doesn't matter once you understand
how bonds and equity work you'll be able
to do accounting for investments for any
other investments so what do we need to
know about the types of of investments
if we are dealing with that the first
one the first thing we have to determine
is what is the intent of the company the
intent of the management when they buy
this bond and hopefully you know what a
bond is bond is when you lend money to
the company when you buy someone's bonus
you're giving them money and
in return they're giving you a piece of
paper they're going to give you this
money back plus interest the question is
you made this investments what is your
intent well it is if your intent
no plan to sell the bond well eventually
you're going to have to give it back to
the company but you have no plan to sell
it in other words you bought that bond
and you're going to hold it to maturity
guess what you classify it as hell to
maturity so health to maturity is the
first classification so when you make
an investment in a bond you can classify
it as health to maturity when do you do
so when you have no plan to sell it
also
how do you report this you would report
it at amortized cost what does amortized
cost mean it means whatever you bought
it at then you amortize the premium or
the discount what does that mean it
means you ignore any fair value
fluctuation bonds go up and down in
value if you plan if you have no plan to
sell it if you plan to hold it until it
mature it's held to maturity therefore
there's no reason to look at fair value
fluctuation why not because if you if we
know anything about bonds from the bonds
chapter
bonds at the end of the of of their life
they mature at face value therefore if
you keep up bringing it up and down
constantly and you're going to hold it
forever forever it's going to be the
face value so why waste your time and
waste your effort knowing you're going
to get the face value at the end of the
day so this is the first classification
of that securities now we're going to
have more classification and by the way
we're going to have a whole session
dealing with health to maturity in the
next session we would look at the
journal entries um when we buy them when
we sell them if they earn us interest so
on and so forth now we're going to look
at other categories of that investments
before we look at the other categories i
would like to remind you whether you are
a student or a cpa candidate to take a
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so what happened if you plan is to sell
the bond so you make an investment you
bought the bond but your plan is to sell
it well what does that mean well under
those circumstances you have to report
the investment and bond at fair value
what does fair value mean fair value
mean you're gonna get unrealized gains
and losses
well under unrealized gain and losses if
it's fair value you're gonna have two
categories you're going to have either
trading
or available for sale category so notice
we have health to maturity one category
trading is true
available for sale is three so those are
the three categories when you have a
bond bond investment or a debt
investment what is trading what's held
to maturity trading as the word trading
suggests you plan to sell it in the near
future trading flipping it that's that's
what that's what trading is well what is
available for sale well if we think
htm is on one end
trading on the other trading a short
term htm hold it forever available for
sale will be some someplace in between
you're not you don't plan to hold it
forever and you don't plan to flip it in
the near future well if the price is
right you might sell it that's available
for sale now let's talk about the type
of that securities that you could have
you can have many
you could have us government securities
those are
bonds debt securities municipal
securities corporate bonds convertible
that commercial paper now for our
purposes as an accounting student we
will deal with corporate bonds
on the other hand if you buy a stock or
equity how do you account for that
investment well it all depends on the
degree of ownership
degree of ownership it means how much do
you control how much do you control of
the company that you purchased
well you might own stocks i own stocks
but what is our controlled degree of
control practically zero because
public companies are extremely extremely
large so you need billions of dollars to
have a saying in those companies and
those major companies that i have right
here on this slide
not bitcoin bitcoin it's not a company
but you unilever apple nestle
proctor and gamble so on and so forth so
if you own if a company owns between
zero to 20 percent of the company we
consider this investment to be
basically minor or you are a passive
investor passive it means you have no
saying in the company if you own up to
20 from an accounting perspective you
have no saying now in the reward in some
companies if you own five percent you
could have a major stake but that's
beside the point from an accounting
perspective you're a passive investor
how do you account for your equity
investment if that's the case fair value
what does fair value mean it means
you're going to have unrealized holding
gains and losses we'll talk about this
in the next session because we're going
to have a session for each of these
categories this is just an introduction
what happened if you own more than 20
percent but up to 50 percent
under those circumstances we assume that
the investor has significant influence
what is significant influence
significant influence means you have a
saying in that company why because you
have enough shares to maybe vote
yourself or someone
your friend or an ally as a on the board
of directors and once you're on the once
you are
a part of the board of directors you
control the company you have some
control you have some saying therefore
you have a significant influence how do
we account for these investments we
account for this and for these
investments under a method called the
equity method and guess what to be
discussed this is going to be one whole
session about the equity method
what happened if you own
more than 50 50 percent plus well once
you own more than 50 percent of a public
company for financial accounting
purposes not for tax purposes for
financial accounting purposes you are in
control you own more than 50 percent
you own the company you can you you
you're the party in charge under those
circumstances you have to consolidate we
have to use the consolidation method now
how does the consolidation method works
well
there's one whole course called advanced
accounting and you'll have to learn how
to do the consolidation so we don't
discuss consolidation for the purpose of
intermediate accounting you need to know
that more than 50 percent gives you
control if you have control you have to
consolidate the investor and the
investee investor it's mean or sometime
it's the parent company the investor is
the parent company and the investor is
the subsidiaries you'll have to
the the subsidiary will be part of the
parent company overall financial
statement so this is what i wanted to
discuss at the beginning of this
introduction introductory session what
type of investments you could have debt
and equity and how do you classify them
well that it could be held to maturity
one
trading two let me just help to maturity
one trading two available for sale three
equity if you're less than twenty
percent you're a passive investment
passive investor we use the fair value
method if you own between 20 to 50 we
use the equity method if you have more
than 50 percent we use the control you
have control we use the consolidation
what should you do now go to farhat
lectures.com work multiple choice
questions look at additional resources
to understand how to account for
investments don't take your
accounting education lightly invest in
yourself learn it practice if you're
studying for the cpa exam invest in my
resources your your cpa is a long-term
investment don't shortchange yourself
good luck study hard and of course stay
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