Investments and Investment Income¶

Investment Motivations¶

“Firms acquire the debt and equity securities of other firms for a variety of reasons.”
- They may use these types of investments as a convenient way to park excess cash needed to fund working capital or long-term assets in the near future. Investing in other company debt or equity is expected to provide a higher return than could be earned by keeping the excess cash in the bank.
- Managers also make investments in other companies for strategic purposes. These types of investments typically involve acquisition of a majority of the equity of another company. The acquiring company’s management then has control over the acquired company, enabling it integrate it into its own operations or to take other actions that improve the performance of the newly-created combined firm.

“Accounting distinguishes between investments that enable one firm to control another, and investments where there is no such transfer of control. One firm controls another if it owns a majority (i.e. more than 50%) of its common equity. As noted above, managers typically view controlling investments as long-term and strategic. These types of investments are called business acquisitions or combinations and are accounted for using the purchase method.”
“In contrast, there is no issue of control when a firm acquires only a small percentage of the common equity of another firm. Investments in corporate debt or equity stakes of less than 20% are usually viewed as not involving control. These types of investments arise when a firm is using the investment as a convenient temporary place to park excess cash. These investments are called marketable securities and are accounted for using either the cost or market method.”
“Investments in the equity of another company that are 20% or more, but less than majority ownership are likely to provide the acquiring firm with some in-between level of control. These types of investments are called equity investments or investments in associated companies and accounted for using the equity method.”

“Marketable Securities are shown as current assets on the balance sheet. They are investments that are”
- Readily marketable
- Expected to be converted to cash within a year
- Have no control implications for the company whose securities are acquired
“Popular marketable security investments include commercial paper and treasury bills. Commercial paper is the name given to a type of short-term interest bearing note issued by corporations. Treasury bills are interest paying short-term obligations sold by the U.S. Treasury. Other forms of marketable securities include the marketable common stock of other companies, corporate promissory notes and corporate bonds.”
“Investments that are not marketable or that are going to be held for longer than a year, but which do not provide the owner with any control rights, are listed as long-term investments rather than marketable securities on the balance sheet. These investments are accounted for at their cost.”

“marketable securities are recorded using either the cost or market methods. The investment intention of the investor in acquiring marketable securities determines which of these methods is used. Therefore, the first step in the marketable security accounting decision is to determine the investor’s intent.”
“Accounting classifies an investor’s intent in one of the following three categories. They are:”
- Hold-to-maturity
- Trading
- Available-for-sale

“Hold-to-maturity marketable securities are debt securities that the investor intends to hold to maturity. These types of marketable securities are accounted for on the balance sheet at their cost.”
Since hold-to-maturity marketable securities are accounted for over their term at their cost, the holder does not record the change in the market value of the note.

“Trading securities are debt and equity securities that the holder intends to sell in the near term as part of a plan to earn profits from short-term movements in the security’s price.”
“Trading securities are accounted for at their market value. That is, at each balance sheet date they are reported at their current market value. Any unrealized gain or loss since the last balance sheet date is included in the income statement as investment income. When the security is eventually sold, any additional gains or loss is also recorded in the income statement as investment income.”

“Available-for-sale securities are debt and equity securities that do not fall into either the hold-to-maturity or trading security categories.”
“Like trading securities, available-for-sale securities are reported on the balance sheet at their market value. However, unlike the case of trading securities, unrealized gains and losses on available-for-sale securities are not shown as Investment Income. Instead they are directly credited/debited to a special shareholders’ equity account called Unrealized gains and losses on Available-for-Sale Securities. When the security is sold and an actual gain or loss is realized, any related unrealized gain or loss recognized to date is eliminated from owners’ equity and the actual gain or loss is recorded in the income statement.”