Investments

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Hard Test

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

1.    Which of the following is correct?

a.  holding gains related to investments accounted for under the fair market value method are always reported on the income statement
b.  holding gains related to investments accounted for under the fair market value method are always reported on the balance sheet
c.  unrealized holding gains related to investments accounted for using the equity method are not recorded until the investment is sold
d.  dividend revenue is recorded when using the equity method

Check Your Answer
C.  Changes in fair market value are not recorded at the end of each period using the equity method.   All unrecorded appreciation/depreciation is recorded when the investment is sold. The equity method records dividends received as a reduction to the investment.  Holding gains under the fair market method are reported on the balance sheet or the income statement, depending on how long management intends to hold the investment and the type of investment (stocks or bonds). 
2.  When accounting for a passive investment

a.  dividends received reduce the investment account
b.  the ownership interest grants significant influence
c.  unrealized holding gains are never recorded
d.  none of the above

Check Your Answer
D.  A passive investment is one where significant influence does not exist (b.) and the fair market value method is used.   Changes in fair market value are recorded (c.) and dividends received are recorded as dividend revenue (a.)
3.  When using the fair market value method, an increase in income is recognized when

a.  profits are earned by the company invested in
b.  dividends are declared 
c.  the market value changes for an investment in a bond held long term
d.  the market value changes and the investor has significant influence

Check Your Answer
B.  The fair market value method recognized income when dividends are declared (receivable) and fair market value increases for a security held short-term (c.)   

(a.) is recorded when using the equity method. 

4.  Investors report securities on the balance sheet at fair market value if

a.  the security is held long term with no significant influence
b.  there is a reliable fair market value and no significant influence
c.  there is significant influence
d.  Both a. & b.

Check Your Answer
D.  Investors using the fair market value method report investments at fair market value on the balance sheet.   The fair market value method is used when there is no significant influence and there is a reliable fair market value.   Equity method securities (significant influence) are typically held long term and are not reported at fair market value.
5.  The investor reports the appreciation in fair value of an equity investment as

a.  a realized gain on sale in the period of sale only
b.  always to unrealized gain on the balance sheet
c.  always to unrealized gain on the income statement
d.  not enough information to determine

Check Your Answer
D.  How appreciation is accounted for is first determined by whether or not the investor has significant influence.   If there is no significant influence, the change in fair market value (appreciation) is reported either on the income statement or the balance sheet depending on the classification (trading or available for sale).  Securities owned with significant influence can also appreciate in market value and the appreciation is not reported.
6.  Selling an equity method investment for more than original cost always results in

a.  a realized gain
b.  a realized loss
c.  an unrealized gain
d.  not enough information to determine

Check Your Answer
D.  Historical cost is adjusted for profits and losses, dividends, and the difference in fair market value and book value. The adjusted cost of an equity method investment may be less than cash received (gain) or higher (loss).  The original historical cost is no longer relevant when determining the gain or loss when the investment is sold.
7.  When the fair value of an equity investment is not reliable and there is no significant influence, the investment should be reported at

a.  historical cost
b.  fair market value
c.  cost adjusted for % of profits and dividends
d.  amortized cost

Check Your Answer
A.  When there is no significant influence the equity method is not used and (c) is not done.  When fair market value is not reliable, the investment remains at historical cost. Amortized cost relates only to bonds. (d.)
8.  When an equity security is reported using the cost method, gains and losses are reported

a.  when the fair market value changes
b.  when dividends are received
c.  when the investment is sold
d.  when the investors share of the investee’s profits is recorded

Check Your Answer
C.  The cost method is used when there is no significant influence and there is no reliable fair market value.  The cost method does not adjust to fair market value and the investment balance remains at historical cost until it is sold.  When the investment is sold a realized gain or loss on sale will occur. (d.) occurs with the equity method.
9.  Cash flows related to purchasing and selling long-term investments are reported on the

a.  balance sheet
b.  income statement
c.  cash flow statement
d.  statement of stockholder’s equity

Check Your Answer
C.  The amount of cash paid to purchase and received from selling an investment is reported in the investing activities section of the cash flow statement.  The gain or loss on the sale is not a cash flow and is reported on the income statement. The statement of stockholder’s equity reports transactions that occur directly with owners of the company. 
10.  An available for sale security is

a.  a debt security with the intent to hold for more than one year and less than to maturity
b.  a debt security with the intent to hold until the investor repays the entire amount owed to the investor
c.  a security that cannot be sold during the current year
d.  one the company intends to sell as soon as it can find a buyer

Check Your Answer
A.  Available for sale securities are investments in bonds the investor intends to hold for more than one year and less than to maturity.  Management’s intend is to hold the bond for more than one year; however, the accounting method does not prevent the company from selling should the intent change. 
11.  On January 1st of the prior year, the company purchased 10,000 shares (20%) of Old, Corp. for $20 per share.  Old Corp. reported a loss of $100,000 during the prior year and profits of $20,000 during the current.  Old Corp. paid total dividends of $10,000 per share at the end of both years. The market value of Old Corp. was $15 per share at the end of the prior year and $13 per share at the end of the current year.  

A.  Record the required journal entries for both years for the company related to the investment given there is significant influence.

B.  Record the required journal entries for both years for the company related to the investment given there is no significant influence.

C.  What will the investor report on the balance sheet and the income statement at the end of the current year under the equity method and the fair market value method?

Check Your Answer
A. 

Investment                           200,000
       Cash                                        200,000

Prior Year:

Investment Expense             20,000
       Investment                               20,000     

($100,000 loss x 20% owned)

Cash                                           2,000
       Investment                                   2,000

($10,000 x 20%)
total dividend x % owned

Current Year:

Investment                             4,000
       Investment Revenue                    4,000

($20,000 profit x 20% owned)

Cash                                          2,000
       Investment                                    2,000

($10,000 x 20%)

B. 

Investment                          200,000
       Cash                                            200,000

Prior Year:

Unrealized Holding G/L – IS     50,000
       Fair Value Adjustment              50,000    

($5 drop x 10,000 shares)

Cash                                           2,000
       Dividend Income                        2,000

Current Year:

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

($2 drop x 10,000 shares)

Cash                                              2,000
       Dividend Income                        2,000

C. Equity Method

Balance Sheet
       Investment    $180,000 see below

Income Statement
       Investment Revenue $4,000

Fair Market Value Method

Balance Sheet
       Investment    $130,000 

Income Statement
       Unrealized Holding Loss ($20,000)
       Dividend Income                $  2,000

Equity Method Investment balance = 
200,000 – 20,000 – 2,000 + 4,000 – 2000 = 180,000

12.  Dell Corporation bought 14,000 shares of Bequik Corp. for $20 per share on May 1, 20X1.  The fair market value of a share of Bequik was $21 on December 31, 20X1 and $18 on December 31, 20X2.  Bequik paid dividends of $0.50 per share on December 31st of each year. Dell Corporation sold 8,000 shares for $27 each on March 31, 20X3.

1.  Prepare all required journal entries related to the investment on 12/31/20X1.
2.  Prepare all required journal entries related to the investment on 12/31/20X2.
3.  Prepare the required journal entry(s) related to the investment on March 31, 20X3.
4.  What will Dell Corporation report on the income statement for the year ended December 31, 20X1?
5.  What will Dell Corporation report on the balance sheet related to this investment on December 31, 20X1?

Check Your Answer
A. 1.   

Investment                                  280,000
       Cash                                                280,000

Fair Value Adjustment                  14,000
       Unrealized Holding G/L – IS        14,000

Cash                                                     7,000
       Dividend Income                              7,000

A. 2.  

Unrealized Holding G/L – IS         42,000
       Fair Value Adjustment                  42,000

Cash                                                      7,000
       Dividend Income                              7,000

A.3. 

Fair Value Adjustment                 126,000
       Unrealized Holding G/L – IS     126,000

($27-$18 = $9 x 14,000)

Cash                                           216,000
       Investment                                 160,000    
       Fair Value Adjustment              56,000    

(280,000 cost x 57% rounded)
(98,000 balance x 57% rounded)

Sold 8,000 of 14,000 shares = 57% rounded

Fair Value Adjustment is  
14,000 – 42,000 + 126,000 = 98,000 balance

A.4. 

Unrealized Gain      14,000
Dividend Income       7,000

A.5.

Investment                              280,000
Fair Value Adjustment             14,000
Investment at FMV                294,000

 

13.  The company purchased bonds of Jack Co. at the beginning of the year for a cost of $210,000.   Fair market value at the end of year one was $223,000. The company earned $7,400 interest and received $7,800 interest during year one.  

A.  Record all journal entries related to the investment for the first year given the company intends to hold the bonds to maturity.  

B.  Record all journal entries related to the investment for the first year given the company intends to hold the bonds to for three years.

C.  State the line items and amounts the investor will report on the financial statements at the end of the first year given the company intends to hold the bonds to maturity and for three years. 

Check Your Answer
A. 

Investment                                    210,000
       Cash                                                210,000

Cash                                                    7,800
       Investment in Bond                             400
       Interest Revenue                               7,400

No Adjustment to FMV

B. 

Investment                                   210,000
       Cash                                                210,000

Cash 7,800
       Investment in Bond                     400
       Interest Revenue                               7,400

Fair Value Adjustment                   13,400
            Unrealized Holding G/L – OE            13,400

(210,000 – 400 = 209,600 adjusted cost 
– 223,000 FMV = 13,400 adjustment

C. 

Held to Maturity Fair Market Value – LT
Investment 209,600 223,000
Interest Revenue 7,400 7,400
Unrealized H Gain 0 13,400
14.  At the beginning of year 1, the company purchased 10,000 shares of common stock (20%) of Bright, Inc. for $200,000.  The company’s intent was to hold long term at the end of year one and then short term at the end of year 2. At the beginning of year 3, the company obtained significant influence.  Information related to Bright, Co. for the 3 years follows:

Year 1 Year 2 Year 3
Net Income 200,000 (300,000) 250,000
Dividends Paid 5,000 1,000 10,000
Assets FMV > BV (10 year life) 80,000 90,000 (50,000)
FMV of stock price 12/31 $22 $25 $35

A.  Record the entries related to the investment for all 3 years.

Check Your Answer
Year 1:    

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

 

Cash                                                     1,000
       Dividend Income                               1,000

(20% x total dividends of $5,000)

Year 2: 

Fair Value Adjustment                  30,000
       Unrealized Holding G/L – IS       30,000

Cash                                                        200
       Dividend Income                                  200

(20% x total dividends of $1,000)

Year 3: Significant Influence

Investment                                      50,000
       Investment Revenue                      50,000

(250,000 x 20%)

Cash                                                     2,000
       Investment                                         2,000

(10,000 x 20%)

Investment Expense                         1,600
       Investment                                          1,600

80,000 x 20% = 16,000 / 10 years = 1,600
Only the difference at the time of purchase to gain significant influence is relevant