Investments

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j

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Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.

1.  Which of the following is a description of trading securities?

a.  Investments that are only expected to appreciate
b.  Investments that are held short term and frequently traded
c.  Investments that represent a significant proportion of ownership
d.  Investments with significant influence

Check Your Answer
B.  Trading securities are bonds held short term or equities held with no significant influence.  The intent to hold short-term, less than 20% ownership, and a bid ask quote (reliable FMV), are characteristics of a trading security.
2.  Which of the following is a characteristic of available for sale securities?

a.  they are expected to be held for a period of more than one year
b.  management must hold them for a period of more than one year
c.  they grant significant influence
d.  changes in fair market value are not reported

Check Your Answer
A.  Management intends to hold available for sale bond (only) more than one year; however, they can sell at their discretion.  Bonds carry no significant influence and changes in fair market value are reported in owner’s equity.
3.  Whether or not investors report a share of the investee’s profit or loss depends on

a.  how long the investment will be held
b.  the number of years to maturity
c.  if there is significant influence
d.  the company pays dividends

Check Your Answer
C.  Profits of the investee company are only recorded when the equity method is used.  The equity method is used when there is significant influence (usually > 20% ownership).  Only bond securities have a maturity date. Both methods (FMV and Equity) account for dividends received.
4.  A company that owns 40% of another company will typically use the

a.  fair market value method
b.  equity method
c.  investment method
d.  dividend method

Check Your Answer
B.  40% assumes significant influence.  The equity method is always used when there is significant influence.  (c.) and (d.) are not accounting methods provided by FASB.
5.  Significant influence may be indicated by

a.  holding the office of chairman of the board of directors only
b.  the ability to make all day to day decisions
c.  access to financial information other shareholders do not have
d.  a quote on an exchange

Check Your Answer
C.  Access to financial information other shareholders do not have is an indicator of significant influence.  Holding any seat on the board of directors also indicates significant influence. The management team will make day to day decisions and the level of ownership determines significant influence; the ease of determining fair market value does not matter to the equity method. 
6.  Which type of investment reports changes in fair market value on the income statement?

a.  equities with reliable fair market value
b.  available for sale securities
c.  held to maturity securities
d.  equity method securities

Check Your Answer
A.  Investors that hold equities with a reliable fair market value report changes in fair market value on the income statement.  Available for sale reports changes in fair market value on the balance sheet under owner’s equity. The current fair market value is not relevant for held to maturity bond securities or when the investor holds long-term with significant influence (equity method). 
7.  Investors report unrealized holding losses from an equity security as a decrease 

a.  directly to retained earnings
b.  directly to an owner’s equity account
c.  to net income
d.  to investment expense

Check Your Answer
C.  Unrealized losses for equity securities are reported as a decrease to income in the other revenue/expense section of the income statement.  The account used is “Unrealized holding gain/loss – IS”. Only bonds are classified as available for sale and reported in owner’s equity.
8.  Unrealized holding gains from an available for sale bond is reported as an increase to

a.  owner’s equity
b.  net income
c.  investment revenue
d.  dividend income

Check Your Answer
A.  Unrealized gains for available for sale bonds are recorded to unrealized holding gain – OE, and reported as part of other comprehensive income, which is an owner’s equity account.  The gain or loss is reported on the balance sheet until it is sold and the gain or loss is realized. Investment revenue is reported under the equity method and equity securities pay dividends (bonds pay interest income). 
9.  The investor who sells a trading security for more than original cost will report

a.  a decrease to the investment account for the historical cost
b.  an increase in the investment account for the historical cost 
c.  a reduction to the investment account for the prior period fair value amount
d.  a reduction to the “unrealized holding gain/loss – owner’s equity” account

Check Your Answer
A.  The investment is decreased for the historical cost amount, which will be the balance in the investment account at the time of sale.  Only available for sale bond securities use unrealized holding gain/loss – OE account.
10.  When does management determine the classification of an investment?

a.  at the point of purchase
b.  at the end of each period
c.  at the beginning of each period
d.  when the investment is sold

Check Your Answer
B.  Classification is determined at the end of the period when preparing the financial statements.  The classification (trading or available for sale) must be selected when using the fair market value method.
11.   The company made the following investments in Yellow Corp.  

Quantity Cost per share FMV at end of 1st year FMV at end of 2nd year
Common Stock 10,000 shares $14 $12 $16
Bonds $100,000 par $103,000 $101,000 $102,500

 

Yellow Corp. paid a dividend of $0.75 per share and paid interest of $3,700 at the end of the first year.

A.  Record the following entries for the investment in bonds held as available for sale

1.  Change in fair market value for the 1st year
2.  Change in fair market value for the 2nd year
3.  Interest received at the end of the 1st year

B.  Record the following entries given for the investment in common stock held as trading securities

1.  Change in fair market value for the 1st year
2.  Change in fair market value for the 2nd year
3.  Dividends received at the end of the 1st year

Check Your Answer
A.  

1.  Unrealized Holding G/L – OE     2,000
           Fair Value Adjustment                2,000

2.  Fair Value Adjustment                 1,500
           Unrealized Holding G/L – OE     1,500

3. Cash                                                   3,700
           Interest Revenue                           3,700

B.  

1.  Unrealized Holding G/L – IS       20,000
           Fair Value Adjustment              20,000

2. Fair Value Adjustment                 40,000
           Unrealized Holding G/L – IS   40,000

3. Cash                                                 7,500
           Dividend Revenue                         7,500

12.  The company purchased 10,000 shares representing 35% of Learn, Co. at the beginning of the year for $200,000. On the purchase date, Learn Co. owned a building with a fair market value of $425,000 and a useful life of 20 years that was reported on their balance sheet for a net book value of $250,000.   Learn, Co. earned $45,000 in profits and paid $5,000 in total dividends during the current year. Fair market value at the end of the year was $22 per share.

Record all required entries related to the investment in Learn, Co.

Check Your Answer
Always record the investment at cost

Investment                                 200,000
         Cash                                              200,000

Record share of profits   $45,000 x 35% = $15,750

Investment                                 15,750
         Investment Revenue                     15,750

Record dividends received:   $5,000 total x 35% owned

Cash                                               1,750
         Investment                                        1,750

Eliminate the difference in fair market value and book value of identifiable assets

Investment Expense                    3,063
         Investment                                       3,063

Fair Market Value – Book Value x % purchased / useful life
$425,000 – $250,000 = $175,000 x 35% = $61,250 / 20 years = $3,063

Fair market value was higher; therefore, the company paid more than book value to purchase the investment and the investment must be reduced over time to get to the investee’s book value

Ignore fair market value when using the equity method

13.  On January 1st, the company purchased 10,000 shares of ABC, Inc. for $5 per share.  The investment represented 10% ownership and the company intends to hold the investment long-term.  The following occurred after the original investment:

a.  fair market value on January 31st was $6 per share
b.  fair market value on February 28th was $5.50 per share
c.  dividends received on March 2nd were $0.10 per share  
d.  the investment was sold on March 15th for $6.25 per share

A. Record all of the above transactions related to the investment given the company prepares monthly financial statements

B.  What will be reported on the February 28th income statement related to the investment?

C.  What will be reported on the February 28th balance sheet related to the investment?

Check Your Answer
A.

Investment                                       50,000
         Cash                                                50,000

1/31 

Fair Value Adjustment                   10,000
         Unrealized Holding G/L – IS     10,000

2/28

Unrealized Holding G/L – IS        5,000
         Fair Value Adjustment                  5,000

3/2

Cash                                                  1,000
         Dividend Income                             1,000

3/15

Fair Value Adjustment                 7,500
         Unrealized Holding G/L – IS       7,500

3/15

Cash                                             62,500
         Investment                                  50,000
         Fair Value Adjustment               12,500  

 

Remove the balance when all the investment is sold

B.  Unrealized Holding Loss: ($5,000)

C.
       Investment                        50,000
       Fair Value Adjustment      5,000
       Investment at FMV          55,000        

 

Add the investment at original cost and the current balance of the fair value adjustment to get the Investment balance to report.