Investments

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

1.  One reason an investor makes an investment is to achieve

a.  appreciation in market value
b.  income from interest and dividends
c.  significant influence and control
d.  all of the above

Check Your Answer
D.  All of the items listed are reasons investors make investments.
2.  Investments are an exchange of cash for 

a.  a future cash flow
b.  one share of ownership
c.  significant ownership in a company
d.  all of the above

Check Your Answer
D.  An investor makes an investment to obtain any of the answers stated. 
3.  Acceptable method(s) investors use to account for investments is (are) the

a.  fair market value method
b.  fair appreciation method
c.  equity method
d.  a. and c.

Check Your Answer
D.  FASB has provided two primary methods to account for investments; fair market value method and the equity method.  Which method the investor uses depends on whether the investor has significant influence.
4.  The fair market value method is used when

a.  there is no significant influence
b.  the market value cannot be reliably determined
c.  ownership is greater than 20%
d.  the investor has a seat on the board of directors and significant ownership

Check Your Answer
A.  The fair market value method is used when there is no significant influence (normally, but not always, less than 20% ownership) and there is a reliable FMV.  

(b.) use the cost method (c.) ownership of greater than 20% generally indicates the investor has significant influence.  

5.  The equity method is used when

a.  there is significant influence
b.  the fair market value can be reliably determined
c.  ownership is less than 20%
d.  the fair market value cannot be reliably determined

Check Your Answer
A.  The equity method is used when there is significant influence.  Generally significant influence comes with ownership of greater than 20%.  Fair market value is not relevant when the equity method is used.  
6.  Which of the following fall into the held to maturity classification?

a.  bonds
b.  equities
c.  a purchase of 100% of a company\
d.  all long-term debt

Check Your Answer
A.  Bonds are the only investments that have a “maturity”.  The maturity date is the date the company repays the investor the maturity value (amount loaned).
7.  Trading securities are 

a.  bonds held for one year or less
b.  equities the investor always intends to hold for more than one year
c.  traded by an investment firm only
d.  securities that appreciate rapidly

Check Your Answer
A.  Trading securities consist of bonds management intends to hold for one year or less.  Equities are always accounted for as trading securities regardless of how long the investor intends to hold the investment. All companies that invest in equity securities with a reliable fair market value must account for them as trading securities.

Trading securities do not always appreciate rapidly, they may also depreciate. 

8.  Available for sale securities are

a.  equities held for one year or less
b.  bonds held for more than one year and less than to maturity
c.  equities traded frequently by an investment firm 
d.  equities management expects to appreciate slowly

Check Your Answer
B.   Available for sale securities are bonds that management intends to hold for more than one year.   The rate of appreciation does not affect classification. Bonds are the only investments that are accounted for as available for sale securities.
9.  The change in market value of an investment in equity securities is reported on

a.  the cash flow statement
b.  the income statement
c.  the balance sheet
d.  the statement of stockholders’ equity

Check Your Answer
B.  Changes in market value of an equity security are reported on the income statement.
10.  The change in market value of an available for sale security for the current year is reported on

a.  the income statement
b.  the balance sheet
c.  the statement of stockholder’s equity
d.  both b. and c.

Check Your Answer
C.  Changes in market value of an available for sale security are recorded as a change to owner’s equity and all changes to owner’s equity are reported on the statement of owner’s equity.  The gain or loss will most likely fluctuate between now and when the security is sold so the gain/loss is not yet reported on the income statement as earnings. The cumulative change is reported on the balance sheet in owner’s equity; however, is not the change this year.  Bonds are the only securities that are classified as available for sale securities.
11.  Dividends received when using the equity method are reported 

a.  with an increase (credit) to dividend revenue
b.  with an increase (debit) to investment
c.  with a decrease (credit) to investment
d.  with an increase (credit) to gain on investment

Check Your Answer
C.  Dividends received by an investor with significant influence are considered a return of capital.   The investment decreases as the investee’s owner’s equity decreases.
12.  Dividends received when using the fair market value method are reported

a.  with an increase (credit) to dividend revenue
b.  with an increase (debit) to investment
c.  with a decrease (credit) to investment
d.  with an increase (credit) to unrealized holding gain on investment

Check Your Answer
A.  The investment was made for income and/or appreciation when the fair market value method is used.  Receiving cash from investments held for income/appreciation is recorded as dividend income on the income statement.  Unrealized holding gains and losses occur when the fair market value changes.
13. “Significant influence” as applicable to the equity method is indicated by

a.  having access to financial information other shareholders do not
b.  the ability to make all operating decisions for the company
c.  ownership of all outstanding shares of the company
d.  relationships with all suppliers to the company

Check Your Answer
A.   Investors do not have access to financial information of a privately held company unless they have significant influence.  Significant influence occurs with the ability to influence top level management decisions (not all decisions).
14.  Equity securities frequently traded on an exchange are reported

a.  on the income statement at fair market value
b.  on the balance sheet at historical cost
c.  on the balance sheet at fair market value
d.  in the footnotes listed by name

Check Your Answer
C.  The fair market value is used to account for equity securities with a reliable fair market value (traded on an exchange).  The fair market value method requires investments to be reported at fair market value on the balance sheet. Footnotes provide only a summary of and not a detail list of names of securities held and traded.
15.  When recording a holding gain on a security currently held as available for sale the

a.  investment account is decreased (credit)
b.  realized gain on sale of investment is recorded with a credit
c.  unrealized holding gain (income statement) is increased with a debit
d.  unrealized holding gain (owner’s equity) is increased with a credit

Check Your Answer
D.  Changes in fair market value of available for sale securities are reported on the balance sheet as part of owner’s equity.  Both the adjustment to fair value account (debit) and the unrealized holding gain account (credit) increase. A realized gain on sale will not be reported as long as the investment is held LT (b.).
16.  When recording a holding loss on a security currently held as a trading security

a.  the fair value adjustment account is increased (debit)
b.  a gain on sale of investment is recorded with a debit
c.  an unrealized holding gain/loss (income statement) is recorded with a debit
d.  an unrealized holding gain (owner’s equity) is recorded with a credit

Check Your Answer
C.  Changes in fair market value of trading securities are reported on the income statement under other revenues/expenses.  An income statement account is used to record the holding loss. When a loss occurs, the fair value adjustment account decreases (credit) and unrealized holding loss is recorded with a debit.  All equity securities are accounted for as trading securities.
17.  The only difference in how a trading investment and an available for sale investment is recorded is

a.  how dividends are reported
b.  available for sale is not adjusted to fair market value
c.  where the unrealized holding gains or losses are reported
d.  how much is reported for unrealized gain or loss

Check Your Answer
C.  Changes in market value, the unrealized gain or loss, are reported differently.  Trading securities are reported on the income statement. Available for sale securities (bonds only) are reported in owner’s equity.  Dividends are reported as dividend revenue for both. Both are adjusted to fair market value when FMV is reliable. The amount of the gain or loss is the same.
18.  When using the equity method, the investment value reported on the balance sheet attempts to represent

a.  the ownership % of the owner’s equity of the company invested in
b.  the fair market value of the investment
c.  the total book value of the company that made the investment
d.  none of the above

Check Your Answer
A.  The investment value should represent ownership in the company that is equivalent to the % owned x total investee’s owner’s equity.   The investment value will change when owner’s equity changes. Fair market value is not relevant and is not used in this method. A long-term investment made for influence will not be sold for a long time. 
19.  When using the equity method, the investor’s share of profits is recorded with

a.  an increase to the investment account (debit)
b.  a decrease to the investment account (credit)
c.  an increase to unrealized holding gain/loss – owner’s equity (credit)
d.  a decrease in investment revenues (debit)

Check Your Answer
A.  Profits are recorded as an increase to the investment account (debit) and an increase to the investment revenue account (credit).  When profits go up, the company’s owner’s equity increases and the investment amount increases also.  Changes in fair market value are not recorded when using the equity method (c.)
20.  Items that change the investment value when using the equity method are

a.  changes in fair market value and additional purchases
b.  dividends received and changes in fair market value
c.  dividends received and profit or loss of the investee company 
d.  only dividends received

Check Your Answer
C.  The investment amount changes when the owner’s equity of the investee company changes.  Their owner’s equity changes with profits, losses, and dividends paid to investors. Changes in fair market value are not recorded using the equity method.

The equity method also records the elimination of the difference in book value and fair market of identifiable assets and liabilities.