Accounting for Investment Income
Investment income refers to the amount earned on investments in common stock, bonds or other financial instruments of outside companies in the forms of dividends, interest and capital gain. In most cases, investment income is recognized in income statement.
Companies have multiple reasons for investing in other companies, including the availability of excess cash, diversification, vertical and/or horizontal integration, etc. At the most basic level, companies invest excess cash on short-term basis in money market instruments instead of keeping it in the bank. Further, companies invest in equity and debt securities of different companies from different sectors of the economy to diversify sources of its net income. There are also strategic reasons to make investment in other companies, for example to acquire a subsidiary to secure its major inputs such as raw material, to acquire an innovative new technology or patents, etc. For strategic purposes, the investment made is normally quite significant, i.e. in excess of 50% of the outstanding shares of common stock of the investee.
Recognition of Dividends Received
Investments that amount to less than 20% of the outstanding common stock of the investee are accounted for using the fair value method (also called cost method). Dividends declared by the investee are recognized in the income statement in the period in which they are declared. In the cash flow statement, any receipts are recognized net cash flows from operating activities.
Example: Dividends Received
Lee Company invested $10 million in Kimber, Inc. by purchasing 1 million shares. During the first year, Kimber, Inc. declared dividends of $0.5 per share. Lee Company would record the income using the following journal entry:
|Cash (1,000,000 × $0.5)||$500,000|
In case of liquidating dividends, some portion of the dividends result in a reduction of the investment’s carrying amount.
Preferred dividends, i.e. dividends declared on preferred stock depend on the features of the preferred stock. For example, in case of a conventional preferred stock, preferred dividends are recognized in the period in which they are declared.
Recognition of Interest Income
Interest income is the income earned on investment in debt securities such as money market securities, bonds, loans, etc. Accrual of interest income depends on the characteristics of the debt instrument. For example, in case of non-amortizing loans and conventional bonds, interest income equals the product of principal amount and the periodic interest rate. But in case of amortizing loans and zero-coupon bonds, etc., recognition of interest income depends on the opening carrying value of the loan and the effective interest rate and the interest income amount changes with time. The recognition of investment income is further complicated when the debt securities are sold at a discount or premium.
Example: Interest Income
You purchased 10,000 of $1,000 par value bonds of Grace’s Secret. The bonds pay 6% interest semi-annual. You will recognize the periodic coupon payment using the following journal entry:
|Cash (10,000 × $1,000 × 6%/2)||$300,000|
Investment Income under Equity Method
If a company purchases 20%-50% of the outstanding common of a company, the investee becomes its associate and it must apply the equity method to account for such investments. Under the equity method, investment income equals the investor’s proportionate share in the net income of the associate. Dividends from investments recognized under the equity method do not constitute investment income, instead they reduce the carrying value of the investment.
Example: Share in Income of Associate
Polly Company (PC) purchased 40% stake in Michael Company (MC) on 1 January 2017 for $4 million. During the financial year ended 31 December 2017, MC earned net income of $800,000 and declared dividends of $600,000.
PC must recognize investment income equal to the 40% of $800,000:
|Investment in Michael Company (40% × $800,000)||$320,000|
|Share in income from associate||$320,000|
Income from Subsidiaries
If a company own 50% or more outstanding common stock of another company, it constitutes a parent-subsidiary relationship. In most cases, the parent is required to prepare the consolidated financial statements. The consolidated financial statements show consolidated net income and bifurcates it into the parent’s share and the share attributable to the non-controlling interest. However, in its individual financial statements, the parent must recognize the income from subsidiary. The most common method is the complex equity method, an equity method which recognizes investment income equal to the product of the parent’s holding and the subsidiary’s income after adjusting it for excess amortization of the differential between the fair value of net identifiable assets the carrying value of those assets.
Recognition of Gains and Losses on Investment
Gains and losses on periodic revaluation of investments accounted for using fair value through profit and loss are also recognized as part of investment income. At the time of sale of such investments, the realized gains and losses are also reflected in income statement.
However, gains and losses arising on period to period adjustment of investments that are held at fair value through other comprehensive income are recognized directly in equity. When such investments are sold, the unrealized portion held in other comprehensive income and the realized gain or loss since the last reporting date is recognized income as part of the investment income.