ACCOUNTING FOR INVESTMENTS

Learning Objectives:

By the end of this lesson, you should be able to:

1. Apply methods of valuation of investments

2. Recognise investments into books of accounts

3. Present investments in financial statements

4. Evaluate the effect of factoring and invoice discounting on accounts receivables

Introduction

To achieve efficient use of all resources, management of a business enterprise frequently turns
unproductive cash balance into productive resources through the purchase of short-term
investments. Such investments held by an enterprise for the purpose of earning a return on cash
resources are characterised by their saleability at a readily determinable price. Stocks and bonds,
which are not widely held or frequently traded usually, do not meet the marketability test;
consequently, securities of this type are not considered under short-term investments.

Investments in securities of other companies purchased as a means of exercising influence or control

over the operations of such companies should not be considered as part of short-term investments.

In summary, short-term investments, which are classified in the balance sheet, as current assets
must be readily saleable and should not be, held for purpose of bolstering business relations with
the issuing entity. On the other hand, there is no requirement that the investment be held for a
limited time only or that management express its intent as to the duration of the holding.

The objectives of acquiring short-time investments are twofold:

(i ) to maximise the return on invested capital

(ii) to minimise the risk of loss from price fluctuations.

The basis of distinction between the asset categories of short-term investments and long-term
investments lies in the nature and purpose of the investment. Investments that are readily
marketable and which can be sold without disrupting business relationships or impairing the
operating efficiency of the business enterprise are classified as current assets.

Investments made to foster operational relationships with other enterprises are classified as long-
term investments. Also, investments that do not meet the test of ready marketability are considered
long-term, even if these investments do not promote business relationships. Long-term investments
usually are listed below the current asset section of the balance sheet.

The main accounting principles to observe with regard to accounting for investments are:

1. Distinguish properly between income and capital due from the investment

2. Where investments are purchased or sold, adjustment must be made in the accounts with regard
to the accruing income.
3. Investments should not be valued at more than cost, but if the values have fallen below cost
(apart from temporary fluctuations), provision should be made for the depreciation sustained

Classification of Investments

• Intangible assets (IAS 38)

• Financial instruments (IAS 39)
• Investment property (IAS 40)
• Debt and equity instruments (IAS 25)

1. Intangible assets are identifiable non-monetary assets without physical substance held for use in
the production or supply of goods or services for rental to others or for administration

(a) Royalties,

(b) Copy right

(c) Trademarks,

(d) Patent rights, etc

2. A financial instrument is any contract that gives rise to both a financial asset of one enterprise
and a financial liability or equity instrument of another enterprise.

3. Investment property incorporate land and buildings or apart of either or both held by the owner
or a lessee under a finance lease to earn rentals or for capital appreciation or both rather than for
use in production or sale in the ordinary course of business.

4. Debt and equity represent claims to assets of a business entity and include ordinary shares,
preference shares, debentures, promissory notes, commercial papers, etc

Recording transactions in short-term investments

In summary, short-term investments, which are classified in the balance sheet, as current assets
must be readily saleable and should not be, held for purpose of bolstering business relations with
the issuing entity. On the other hand, there is no requirement that the investment be held for a
limited time only or that management express its intent as to the duration of the holding At
acquisition, short-term investments are recorded at cost, the price of the item being in the market
plus any costs incident to the acquisition, such as brokerage commissions and transfer taxes. Bonds
acquired between interest dates are traded on the basis of the market price plus the interest
accrued since the most recent interest payment. The accrued interest is a separate asset, which is
purchased with the bonds.

Note: The cost of these two assets should be separated to achieve a clear picture of the results of
the investment in bonds.

Illustration

On March 31 2002, Ruiru Limited placed an order with a broker to buy 100,Kshs 100,000,10%
Safaricom bonds which mature on January 31,2005, with interest dates July 31 and January 31.The
bonds were purchased on the same day at 104 plus accrued interest of Kshs 166,667 for two
months. The brokerage commission was Kshs 1,000,000. Compute the total cost of the bonds and
the total cash outlay.
Classification of Financial Instruments

• Held for trading investments

• Held to maturity investments
• Available for sale investments
• Loans and receivables originated by the enterprise

1. Held to maturity investments- are assets with a fixed or determinable payments and fixed
maturity that an enterprise has a positive intend and ability to hold to maturity.

It is worthwhile to note that all investments except those held to maturity are adjusted to their fair
values on each reporting date. Fair value of an investment is the amount for which an investment
could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length
transaction.

2. Held for trading investments- are those investments acquired for generating a profit from the
short-term fluctuations in price or dealer’s margin. Derivative instruments are taken as such assets
unless they are obtained for hedging purposes. Such instruments are held for the purpose of
profiting from short-term price changes. The following accounting procedures are adopted for such
investments:

• They are reported at fair values

• The gains and losses that occur since the last reporting date are recognized during the
current reporting period
• Holding gains and losses are included in earnings

3. Available for sale investments – it is taken as a financial asset that does not properly belong in any
of the other three categories. The following accounting procedures are adopted:

• The holding gains and losses from available for sale investments are included in earnings
when they are realized on sale.
• Sometimes, these unrealized gains/losses are offset by subsequent losses or gains. An
offsetting entry is made in the accounts
• A loss inherent in an investment other than temporary impairment is recognized in earnings
even though the security has not been sold.

4. Loans and receivables originated by the enterprise- are financial assets created by the enterprise
by providing money, goods or services to a debtor.

Recognition of Investments

1. Initially, an enterprise should recognize an investment on its balance sheet when it becomes party
to the contractual provisions of the instrument.

2. They should either be recognized at the trade date or settlement date. Trade date is the date that
an enterprise commits to purchase the asset. Settlement date is the date the asset is delivered to
the enterprise. When this date is used, the firm has to account for any change in fair value of the
asset to be received during the period between the trade date and the settlement date.

The diagram below indicates the various accounting issues for the various types of investments:
 Category Valuation Unrealized Holding Gain and Loss
Amortized
Held - to - Maturity cost Not recognized
Trading Securities Fair Value Recognized in net income
Available - for - Sale Fair Value Recognized as other comprehensive income

Example:

On January 1, 2007, ABC Company purchased 12% bonds, having a maturity value of Sh.300,000, for
Sh.322,744. The bonds provide the bondholders with a 10% yield. They are dated January 1, 2007,
and mature January 1, 2012, with interest receivable December 31 of each year. ABC Company uses
the effective-interest method to allocate unamortized discount or premium. The bonds are classified
in the held-to-maturity category.

Using the above information.

a) Prepare the journal entry at the date of the bond purchase.

b) Prepare a bond amortization schedule
c) Prepare the journal entry to record the interest received and the amortization for 2007 &
2008.

Solution

Example

Assume the same information as above except that the securities are classified as available-for-sale.
The fair value of the bonds at December 31 for 2007 and 2008 is Sh.320,500and Sh.309,000,
respectively.

a) Prepare the journal entry at date of bond purchase.

b) Prepare the journal entries to record the interest received and recognition of fair value for
2007.
c) Prepare the journal entry to record recognition of fair value for 2008.

Solution

Investment in Debt and Equity Instruments:

Equity securities are securities representing ownership interests such as common, preferred, or
other capital stock.

Investments by one corporation in the common stock of another can be classified according to
percentage ownership

1. Holdings of less than 20% (fair value method): In such

cases, if market prices are available, the investment is valued and reported subsequent to
acquisition using the fair value method if they are Available-for-sale securities. As with available-for-
sale debt securities, the net unrealized gains or losses is recorded in an Unrealized Holding Gain or
Loss—Equity account that is recognized as other comprehensive income and is reported as a
separate component of stockholders’ equity until realized. For the trading equity securities, the
unrealized holding gains or losses are reported as part of net income in an Unrealized Holding Gain
or Loss—Income account.
2. b) Holdings between 20% and 50% (equity method): The investment account is increased
(decreased) by the investor’s share of the earnings (losses) of the investee and decreased by all
dividends received. The investor also treats a proportionate share of the investee’s extraordinary
items as its own extraordinary items. Under the equity method, fair values are not used. The
difference between the investor’s initial cost and the investor’s proportionate share of the
underlying book value of the investee at date of acquisition is amortized. This may be attributable to
undervalued depreciable assets and/or unrecorded goodwill. If the investee’s net income includes
extraordinary items, the investor recognizes its proportionate share of both the ordinary and
extraordinary components.

3. Holdings of more than 50% (consolidated statement): Holding over 50%. Generally consolidated.
Financial statement presentation of investments. Changes in unrealized gains and losses related to
available-for-sale securities are reported as part of other comprehensive income, and reflected as a
separate component of stockholders’ equity.

The following definitions relate to the investment in equity instruments:

Cum dividend- buying an investment plus the right to receive dividend that has accrued on the
investment up to the date of the next dividend payment.

Ex dividend- a person sells the investment but retains the right to receive the dividend/interest that
has accrued on that investment up to the day of sale (the buyer receives the investment minus the
right to receive the dividend)

Bonus issue- is a dividend issued in lieu or in addition to cash dividend. A company may wish to
retain reserves rather than distribute to shareholders. This has no effect on assets and liabilities of
the firm as the effect is felt only in the shareholders’ funds.

Rights issue- this enables the shareholders to subscribe for more shares in a company in which they
already have an investment, free of brokerage and stamp duty. This represents a sale of new shares
to what is hopefully a rather more ready market than the public at large.

The following accounts are commonly maintained when accounting for investments:

Investment account- is used to record the investment in terms of both the income interest that has
accrued on it at the time of purchase as well as the capital amount being invested in (par). If an
investment is purchased cum dividend, the income in the investment account is debited with the
dividend accrued from the last dividend date to the date of purchase. The balance of the purchase
price is taken to the capital section of the investment account.

The vice versa applies when an investment is sold under similar circumstances. If the purchase terms
are ex-div, debit capital with ex-div price, then as soon as the amount of dividend is known, debit
capital and credit income with the dividend accrued from the date of purchase to the next dividend
date.

Profit and loss account- is used to capture the interest/dividend income on a particular investment.

Cash account

Impairment of Value.

If the decline is judged to be other than temporary, the cost basis of the individual security is written
down to a new cost basis.
The amount of the write-down is accounted for as a realized loss. For debt securities, the
impairment test is to determine whether it is probable that the investor will be unable to collect all
amounts due according to the contractual terms.

For equity securities, guidelines are less precise. Any time realizable value is lower than carrying
amount, an impairment must be considered.

• Transfers Between Categories

Transfers between categories are accounted for at fair value. The” fair value rule” assures that a
company cannot escape recognition of fair value by simply