An investment income is recorded in the income statement. It’s a credit item that leads to an increase in profit for the business. Most of the time, it’s non-operating income which means the business has not earned investment income through the normal way of earning. Instead, it’s an income that has been earned via activities that are not a normal part of the business.
Businesses can earn investment income through different means that include but are not limited to interest receivable, dividends, capital gains realized from the sale of stocks and other assets, or any additional profit made through non-operating activities. Further, profits on the sale of gold coins are also included in investment income.
Likewise, interest income, dividends income, interest earned on bank accounts, income on stocks owned by mutual funds are also included in the investment income. When it comes to the treatment of these transactions, different countries apply different rules. However, the countries that comply with international financial reporting standards do similar accounting in terms of recognition and presentation.
Strategy for making investment
Investment in other companies can be motivated by many reasons, including excess cash, diversification, vertical and horizontal integration. An organization may cinsider to invest excess cash in money market instruments on a short-term basis instead of keeping it in a bank.
Additionally, companies invest in equity and debt securities of different companies from different sectors of the economy to diversify their sources of profit. Likewise, there may bee strategic reasons to invest in other companies such as acquiring a subsidiary to secure necessary inputs like raw materials, acquiring new technology, or patent etc. In such cases, the investment made for strategic purposes is typically quite significant, exceeding 50% of the company’s outstanding stock to acquire control.
Income Statement Treatment of investment income
There can be different treatments of investment income depending on the nature and type of investment. However, it’s a universal rule that income is credited in the income statement that increases profit. Although there can be different terms of recording and classification for the investment income, some are discussed below.
- Dividends Received – (It’s recorded when the dividend is decleared on shares)
- Interest Income- (It’s recorded when interest is accrued on the loan receivable )
- Equity Method – (It’s recorded when a company has invested in associate)
- Subsidiaries – (It’s recorded when the business can control the decision making of the acquired company)
- Gains and Losses on Investment – (It’s recorded when investment is recorded at fair value)
Following are some of the main types of income recorded in the income statement.
Recognition of Dividends Received
If the business invests in a company for less than a 20% stake, it’s considered to be a normal investment and dividends earned are recognized as income when declared.
Cash received from such dividends is reported under investing activities in the cash flow statement. Following double entry is posted in the accounting system when recording for the investment income (it’s when a company declares dividend)
|Investment income receivable||XXX|
The debit impact is recording for the receivable as the valid expectation to receive economic benefits has been developed that can be recorded. On the other contrary, the credit impact of the transaction is recording of income as it has been earned. It’s in the case of a normal dividend.
Recognition of Interest Income
The accrued amount of interest income is determined by the characteristics of the debt instrument. An investment in securities, bonds, loans results in interest income. Further, when it comes to conventional bonds and non-amortizing loans, interest income equals the product of the periodic interest rate and the principal amount. . In contrast, the interest income amount changes over time.
The following journal entry is passed in the accounting system to record interest income.
The debit impact of the transaction is receipt of cash and credit impact is recording of income. Sometimes, the company may not receive cash; instead, the business has to record interest receivable.
Recognition of income under equity accounting method
As soon as a company purchases 20%-50% of a company’s outstanding common stock, the investee becomes its associate, requiring the investor to account for such investments using the equity method. Under equity method, Investment income is calculated using the equity method as the investor’s proportionate share of the affiliate’s net earnings. Further, dividends from investments do not count as investment income; rather, they are deducted from carrying value.
Initially, an investment in associates is classified at cost. Subsequently, any changes in the value of the investee are recorded in the books of investors. The changes taking place in the equity of investees are reflected in the books of investors.
The following journal entry is relevant in the case of investment in associates.
|Investment in associates||XXX|
The debit impact of the transaction is recording for the investment as the investor as paid cash to acquire the same.
|Investment in associates||XXX|
Given journal entry is passed when investee announces dividend. It leads to a reduction of equity in the books of investors. So, an investee has to reduce its proportion as well. Please note that it’s the same as you have paid a dividend, and equity is reduced. However, it’s up to proportionate of you share in the associates.
The debit impact of the journal entry is receipt of cash as the investee has received cash aginst their investment in the associates. On the other contrary, the credit impact of the transaction is a reduction of investment in associate. It’s becauase of the fact that investor has receive extracted it’s investment in form of dividend.
|Investment in associate||XXX|
The journal entry is passed when the investee needs to record their share in the profit. The debit impact increases the investment amount associates have earned, leading to an increase in economic benefits. On the contrary, the credit impact of the transaction is the recording of income from the profit and loss statement. However, it’s important to note that the recording of income is limited to the proportion of investors.
Overall, investment increases with the profit earned and decreases with the dividend paid. So, net increase of investment in associate is when profit is more than dividend paid.
Based on management’s intention regarding the holding period, debt securities are classified into amortized cost category, fair value through profit and loss. And fair value through other comprehensive income. (IFRS-9)
There are two conditions to record debt instruments in the amortized cost category. These include business model tests and contractual cash flow tests. The business model test means that your investment intention is to collect cash flows until maturity. And contractual cash flow test means that repayment constitutes only principal and interest.
The income earned in amortized cost category is recorded at an effective rate of income. The effective rate is applied on the outstanding balance and the resultant figure is taken to the Financial statement.
Fair value through profit and loss is a default category where debt instruments are classified. As It’s a default category, any profit/loss is directly recorded in the income statement.
Fair value through debt instrument is recorded when business model test and cash flow contractual test is passed. The gain earned on the debt instruments is classified in other comprehensive income.
Recognition of Subsidiaries
It is indicative of a parent-subsidiary relationship when the parent company owns more than a 50% stake of the outstanding stock of the subsidiary company. In fact, it’s about the establishment of control that leads to parent-subsidiary relations.
The parent company prepares consolidated financial statements. Based on the consolidated financial statements, consolidated net income is identified. The parent’s share is separated from the share attributable to the non-controlling interest.
The parent must nevertheless recognize income from its subsidiary in its individual financial statements. Generally, investment income is recognized using the equity method. An equity method recognizes investment income equal to the product of the parent’s holdings and the subsidiary’s income, minus excess amortization of the difference between the fair value of net identifiable assets and the carrying value of those assets.
Recognition of Gains and Losses on Investment (equity investment)
Gains and losses on periodic revaluations of investments are recognized as investment income when they are accounted for using the fair value method based on profit and loss. The realized gains and losses are also recorded on income statements.
However, investments held at fair value through other comprehensive income are subject to gains and losses when they adjust from period to period. As a result of such investments being sold, the unrealized gains or losses, and the unrealized portion held in other comprehensive income, are recognized in investment income.
The business can earn investment income by investing in debt and equity instruments. The income/gain that is usually earned by the business is classified in the profit and loss statement.
Depending on the nature of the investment, there can be different types of income that include dividend income and interest income. The gain earned on the investment can be classified in profit and loss statements and other comprehensive income as well. If an investment is classified at fair value through profit and loss, it’s recorded in the income statement. On the other hand, if an investment is recorded at fair value through OCI, the income is taken to the other comprehensive income.
Frequently asked questions
In how many categories can debt instruments be classified?
The debt instrument can be classified into three categories: fair value through profit and loss, fair value through OCI, and amortized cost.
What are the two main types of income?
Two main types of income include dividend income and interest income. Generally, dividend income is earned on the equity instruments, and interest income is earned on the debt instruments.
What’s the impact of investment income on the cash flow statement?
There is no direct impact on the investment income of the cash flow. However, receipt of the cash under investment income leads to an increase in the business’s cash balance.