On my previous post, I have talked about Journal Entry for Temporary Investment[Equity and Debt Securities], in this post I will discuss Journal Entry for Equity and Debt Securities of Long Investment enriched with case examples for easier understanding. Enjoy!

Journal Entries For Long-Term Investments: Debt Securities

Long-term investments in debt securities consist of bonds or other debt instruments whose principal is payable after 1 year or the operating cycle [whichever is longer], and there is no intention to sell them before the due date. Thus, condition 2 mentioned earlier for marketable securities has not been met. Therefore, these instruments are subject to amortization of premiums and discounts.

Example-1

A company purchases a 5-year, 10%, \$100,000, long-term bond at par, on January 1, 20X9. The journal entry is:

[Debit]. Investment in Long-term Debt Securities = \$100,000
[Credit]. Cash = \$100,000

Every December 31, an entry must be made either to accrue interest on the bond, or to record the actual receipt of interest, if this date is an interest payment date.

Example-2

In the previous example, if December 31 is an interest payment date, and interest is payable annually, the journal entry would be:

[Debit]. Cash = \$10,000
[Credit]. Interest Revenue = \$10,000

If interest is payable annually on June 30, the journal entry on December 31 would be:

[Debit]. Interest Receivable = \$5,000
[Credit]. Interest Revenue = \$5,000*
(Note: *To accrue six months of interest: \$100,000 × 10% × 6/12)

When the bond matures, an entry would be made debiting Cash and crediting the investment account. If the bond is purchased at a price above or below the par value, the investment account would be debited at par, and the difference would go to a premium or discount account, which would be amortized over the life of the bond. Amortization can be calculated under either the straight-line method or the effective interest method. In this post we will use the simpler, straight-line method.

If the bond is purchased at a premium, the amortization entry debits the Interest Revenue account, thus reducing the interest earned. Conversely, if the bond was purchased at a discount, Interest Revenue would be increased.

Example-3

The Lie Dharma Company purchases a \$100,000 par, 10% bond at 102 on January 1. The interest is payable annually on December 31 and the bond matures in 10 years. The premium is \$2,000, and the annual amortization is \$200 (\$2,000/10).

The journal entries are:

On Jan. 1

[Debit]. Investment in Long-term Debt Securities = \$100,000
[Credit]. Cash = \$102,000

On Dec. 31:

[Debit]. Cash = \$10,000
[Credit]. Interest Revenue = \$10,000

On Dec. 31:

[Debit]. Interest Revenue = \$200

The net interest revenue is \$9,800 = \$10,000 ? \$200

Example-4

Assume the same information as in the previous example except that the bond was purchased at 98. The journal entries are:

On Jan. 1:

[Debit]. Investment in Long-term Debt Securities = \$100,000
[Credit]. Cash = \$98,000
[Credit]. Bond Discount = \$2,000

On Dec. 31:

[Debit]. Cash = \$10,000
[Credit]. Interest Revenue = \$10,000

On Dec. 31:

[Debit]. Discount = \$200
[Credit]. Interest Revenue = \$200

The net interest revenue is \$10,200 = \$10,000 + \$200.

The premium account acts as an addition to the investment account on the balance sheet, while the discount account acts as a minus (a contra). Thus, in the previous example, the balance sheet after the first year would appear as follows:

Investment in Long-term Debt Securities = \$100,000
Less: Discount (\$2,000 ? \$200 = 1,800
Net Investment = \$ 98,200

If the bond is purchased between interest dates, its price will be increased by the amount of the accrued interest. This increase should be debited to the Interest Revenue account since, in effect, it causes a decrease in the interest earned.

Example-5

A company purchases a \$100,000, 12%, 10-year bond at par on April 1. The bond pays interest annually on December 31. Thus interest in the amount of \$3,000 has accrued [\$100,000 × 12% × 14]. This journal entry is:

[Debit]. Investment in Long-term Debt Securities = \$100,000
[Debit]. Interest Revenue = \$3,000
[Credit]. Cash = \$103,000

On December 31, the journal entry for the receipt of the interest would be:

[Debit]. Cash = \$12,000
[Credit]. Interest Revenue = \$12,000*
(Note: *100,000 x 12% = \$12,000)

The net interest revenue is thus only \$9,000 = \$12,000 ? \$3,000.

If the bond investment is sold before it reaches maturity, the investment account and its related premium or discount should be closed. If the selling price is greater than the book value of the bond, a gain should be recognized. Otherwise, a loss should be recognized. The “book value” is the investment account plus any premium, minus any discount.

Example-6

Assume the same information as in the previous example except that the bond was purchased at 98 and sold for \$95,000. The journal entry is:

[Debit]. Cash = \$95,000
[Debit]. Loss on Sale of Securities = \$4,000
[Debit]. Discount = \$1,000
[Credit]. Investment in Long-term Debt Securities = \$100,000

Journal Entries for Long-Term Investments: Equity Securities

Long-term investments in equity securities involve the purchase of stock to be held on a long-term basis. If Company A purchases more than 50% of the outstanding stock of Company B, then the statements of both companies generally should be consolidated. This is discussed in detail in Advanced Accounting. In this post we will discuss situations involving a purchase of 50% or less.

There are two methods of accounting for these investments. They are:

• The cost method
• The equity method

If as a result of this purchase Company A acquiressignificant influenceover Company B, then the equity method should be used. Otherwise, the cost method is more appropriate.

FYI: The accounting profession, in APB Opinion No. 18, has ruled that a purchase of between 20 and 50% of the stock is presumed to lead to significant influence, unless the facts clearly indicate otherwise.

Under the equity method, when Company B [the “subsidiary”] earns income, it is as if Company A [the “parent”] also earns income, and thus Company A must make a journal entry for its share of this income. Furthermore, dividends received from the subsidiary are not considered to be income but withdrawals, and therefore the investment account must be reduced.

Under the cost method, the parent does not earn income when the subsidiary earns income, and dividends received are treated as revenue rather than withdrawals.

Example-1

Parent Company purchases 30% of Subsidiary Company’s 100,000 outstanding shares [30,000 shares] for \$100,000. During the next year, Subsidiary earns \$50,000 net income and distributes a cash dividend of 25 cents per share. If we assume that Parent has no significant influence and, therefore, the cost method is appropriate, the journal entries for these transactions would be:

[Debit]. Investment in Long-term Equity Securities = \$100,000
[Credit]. Cash = \$100,000
(Note: No entry for the \$50,000 earnings would be made].

[Debit]. Cash = \$7,500
[Credit]. Investment Revenue = \$7,500*
(Note: *0.25 × 30,000 = \$7,500)

The investment account balance is \$100,000.

If in the previous example there is significant influence, and thus the equity method must be used, the journal entries would be:

[Debit]. Investment in Long-term Equity Securities = \$100,000
[Credit]. Cash = \$100,000

[Debit]. Investment in Long-term Equity Securities = \$15,000
[Credit]. Investment Revenue = \$15,000
(Note: 30% of \$50,000 earnings)

[Debit].Cash = \$7,500
[Credit]. Investment in Long-term Equity Securities = \$7,500

The investment account balance would now show \$107,500 = \$100,000 + \$15,000 ? \$7,500.

Notice that this differs from the \$100,000 balance under the cost method. If the subsidiary incurs a loss instead of earning net income, the parent would debit an account called Investment Loss and credit the investment account.

It often happens that the price a parent pays for the stock of a subsidiary is greater than the book value. This is usually a result of an understatement of the plant assets on the subsidiary’s books, and sometimes it is due to unrecorded goodwill of the subsidiary. (For a discussion of goodwill, see Part I of this book). Under the equity method, these understatements must be accounted for, and they will have an effect on the amount of the subsidiary income to be recognized by the parent.

Example-2

Company A buys 30% of Company B’s outstanding stock for \$40,000. The net worth (stockholders’ equity) of Company B, according to its books, is \$100,000. Since 30% of \$100,000 is only \$30,000, Company A has overpaid for this investment by \$10,000. Let us assume that \$6,000 of this difference is due to an understatement in the asset building (whose remaining life is 10 years) and \$4,000 is due to unrecorded goodwill. Let us also assume there is significant influence.

In addition to the above, Company B earned \$50,000 net income during the first year after this purchase. The journal entries are:

For the purchase:

[Debit]. Investment in Long-term Equity Securities = \$40,000
[Credit]. Cash = \$40,000

For the recognition of Company B income:

[Debit]. Investment in Long-term Equity Securities = \$15,000
[Credit]. Investment Revenue = \$15,000*
(Note: *\$50,000 x 0.30 = \$15,000)

For the recognition of the effect of depreciation:

[Debit]. Investment Revenue = \$600
[Credit]. Investment in Long-term Equity Securities 600
Building depreciation: \$6,000/10 years = \$600

(Note: Under current accounting rules, goodwill is no longer amortized, it is impaired instead).

FYI: On December 31 of every year, all investments, except those accounted for by the equity method, must be evaluated via a comparison of their costs to their December 31 market values.