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Deciphering Investment Accounting for the U.S. FAR CPA Exam

Kyle Ashcraft

Investments play a significant role in the financial statements of many companies. Whether it’s acquiring equity in other businesses or holding various forms of debt securities, these financial instruments can make or break a company’s balance sheet. For those preparing for the Financial Accounting and Reporting (FAR) section of the CPA exam, it’s critical to understand the intricacies of accounting for investments under U.S. Generally Accepted Accounting Principles (U.S. GAAP).

Definitions

Investments

Investments refer to assets that a company acquires with the intent of earning a return.

Investments can be broadly classified into:

1. Equity Investments

2. Debt Investments

Accounting Methods for Equity Investments

Based on the ownership percentage, different accounting methods are employed:

1. 0-20% Ownership (Cost Method or Fair Value Method): When an entity owns less than

20% of another company, the investment can either be recorded at cost or fair value.

Under the fair value method, any changes in value are recognized in the income

Statement.

2. 20-50% Ownership (Equity Method): Ownership between 20% and 50% generally

indicates significant influence over the investee. The equity method is used where the

investment is initially recorded at cost and subsequently adjusted for the investor's

share of net income or loss of the investee.

3. Over 50% Ownership (Consolidation Method): When ownership exceeds 50%, the

the investor has control, and the financial statements of the two entities are consolidated.

Accounting for Debt Investments

Debt investments are generally categorized into:

1. Held-to-Maturity: Accounted for at amortized cost.

2. Available-for-Sale (AFS): Accounted for at fair value, with unrealized gains or losses recognized in other comprehensive income.

3. Trading Securities: Accounted for at fair value, with unrealized gains or losses recognized in income.

Examples

Example 1: Journal Entry for 0-20% Equity Investment at Cost

Suppose a company invests $10,000 in a business and owns 15% of it. The entry would be:

  • Debit Investment in XYZ $10,000

  • Credit Cash $10,000

Example 2: Journal Entry for Equity Method

If the investee reports a net income of $20,000, and the investor owns 30%, the entry would

by:

  • Debit Investment in XYZ $6,000

  • Credit Equity in Investee Income $6,000

Example 3: Journal Entry for Consolidation Method

Under consolidation, all assets, liabilities, revenues, and expenses of the investee would be

combined with those of the investor. Separate journal entries are not typically made for

consolidation; instead, financial statements are aggregated.

Example 4: Journal Entry for Held-to-Maturity Debt Investment

Investment in a 10-year bond of $10,000 would be:

  • Debit Investment in Bonds $10,000

  • Credit Cash $10,000

Example 5: Journal Entry for AFS Investment

If an AFS security's fair value increases by $500:

  • Debit Investment in AFS $500

  • Credit Unrealized Holding Gain (OCI) $500

    Disclosures

Companies are required to disclose their accounting policies for investments, the nature and

risks associated with them, and how fair values are determined.