CHAPTER 14
QUESTIONS
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Chapter 14 689
1. Companies make investments in the securities of another company to provide a safety cushion of available funds and to store a temporary excess of cash. Companies also invest in other companies to earn a return, to secure influence, or to gain
control.
2. Statement No. 115 applies to many debt and equity securities. All debt securities with a readily determinable fair value fall under its scope. Debt securities that do not have a readily determinable fair value are accounted for under the rules outlined in FASB Statement No. 114. Equity securities with a readily determinable fair value that are not accounted for (1) using the equity method (i.e., greater than 20% ownership) or (2) as investments in consolidated subsidiaries are accounted for using the rules outlined in Statement No. 115.
3. A security is classified as held to maturity if the business has the intent and the ability to hold the security to maturity.
4. To be classified as a trading security, the security must have a readily determinable fair value and must be purchased and held for the purpose of selling it to generate profits on short-term differences in price.
5. (a) The stated rate of interest is used to determine the amount of the annuity to be received.
(b) The market or effective rate of interest is used in the present-value computations to determine the present value of both the principal sum and the annuity.
6. The effective-interest method computes
interest revenue by multiplying the effective interest rate by the carrying value of the
investment.
7. When a company does not own more than 50% of a company, other factors may be considered to determine if control exists. Such factors include owning a large minority voting interest with no other shareholder owning a significant block of stock or having a majority voting interest in determining who is on the company’s board of directors. When these other factors exist, then control may be assumed and consolidation would be appropriate.
8. (a) Factors that may indicate the ability of a minority-interest investor to exercise significant influence over an investee’s operating and financial policies are as follows:
1. Representation on the board of
directors of the investee.
2. Participation in the policy-making process.
3. Material intercompany transactions between investee and investor.
4. Interchange of managerial personnel between investee and investor.
5. Technological dependency of investee on investor.
6. Substantial minority interest of the investor in an investee whose shares of stock are widely distributed and not concentrated for
control purposes.
(b) Factors that may indicate the inability of an investor with more than 20% of a company’s stock to exercise significant influence over an investee’s operating and financial policies are as follows:
1. Opposition by the investee, such as litigation or complaints to governmental regulatory authorities.
2. An agreement between the investor and the investee under which the investor surrenders significant rights as a shareholder.
3. Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor.
4. The investor needs or wants more financial information to apply the equity method than is available to the investee’s other shareholders, tries to obtain the information, and fails.
5. The investor tries and fails to obtain representation on the investee’s board of directors.
9. A joint venture is accounted for using the equity method for those partners that own 20% or more and not more than 50% of the joint venture. For these joint venture partners, the liabilities of the joint venture do not show up on the balance sheet. Instead, only the net investment in the joint venture shows up on the balance sheet. Thus, the liabilities of the joint venture are “off” the balance sheet of the partners that account for the joint venture using the equity method.
10. FASB Statement No. 115 developed new rules for reporting changes in value; the disclosure varies depending on the classification of the security. For trading securities and available-for-sale securities, a market adjustment account is used on the balance sheet to report the securities at their market values. Held-to-maturity securities are
reported on the balance sheet at their
amortized cost. For trading securities, the change in fair value for the current period is reported on the income statement. The change in value for available-for-sale securities is reported in the equity section on the balance sheet.
11. Market Adjustment is a real account used in valuing investments on the balance sheet. If the fair value of a security that falls under the scope of Statement No. 115 increases, the market adjustment account will be
debited. If the value of the security
decreases, the market adjustment account will be credited. The market adjustment
account is disclosed on the balance sheet either netted against the related securities account or disclosed separately in addition to the securities account.
12. For “other-than-temporary” declines, the cost basis of the security should be reduced by crediting the investment account rather than a market adjustment account. In
addition, the write-down should be recognized as a loss and charged against current income. The new cost basis for the security may not be adjusted upward to its original cost for any subsequent increases in
market value. However, the market adjustment account may be used to record any subsequent increases.
13. The sale of trading securities during the year results in the computed unrealized gain or loss on trading securities being a combination of unrealized gains and losses for the year and reversals of cumulative
unrealized gains and losses from prior years for trading securities sold during the year. The same is true with respect to the computation of unrealized increases and decreases in value for available-for-sale securities.
14. When FASB No. 115 securities are
transferred between categories, the transfer is accounted for at the security’s current fair value. The historical cost of the security is removed from the books along with any
associated market adjustment. The difference between the security’s current fair value and its fair value on the most recent balance sheet date is accounted for differently, depending on the classifications
involved in the transfer.
15. Realized gains on trading securities are subtracted from net income in computing cash from operating activities (when the
indirect method is used). Realized losses are added back to net income. The same is true for unrealized items; unrealized gains on trading securities are subtracted and
unrealized losses on trading securities are added back to net income.
16. Because trading securities, by their very definition, are held to take advantage of short-term differences in price, these
securities are always classified as current. Held-to-maturity securities are always
classified as long-term unless the security is maturing in the current period. The major classification problem arises with available-for-sale securities. These securities can be classified as either current or long-term, depending on the intention and assessments of management.
17. For all securities not classified as trading, the cash flow effects of purchases and sales are disclosed in the Investing section of the statement of cash flows. For securities classified as trading, the purchase and sale of securities are disclosed in the Operating section.
18. FASB Statement No. 115 requires the
following additional disclosures for the
different classifications of securities:
Trading securities—the change in the net unrealized holding gain or loss that is
included in the income statement.
Available-for-sale securities—the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type. In addition, for debt securities the company should disclose information about contractual maturities. Companies need to also disclose the proceeds from sales of
available-for-sale securities, the gross
unrealized gains and losses on those sales, and the basis on which cost was determined in computing unrealized gains and losses. Finally, companies should disclose the change in net unrealized holding gain or loss on available-for-sale securities that has been included in stockholders’ equity during the period.
Held-to-maturity securities—the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost basis by major security type. In addition, the company should disclose
information about contractual maturities.
19. The only significant difference between the provisions of IAS 39 and those of SFAS No. 115 is in the reporting of unrealized gains and losses. Under IAS 39, a company can elect to recognize all unrealized gains and losses—both for trading and available-for-sale securities—in net income for the
period.
20.‡ FASB Statement No. 115 applies to all debt securities for which there is a readily
determinable fair value. Thus, most debt securities would fall under the scope of this pronouncement. Loans often do not have a readily determinable fair value because they are not traded on an exchange as are most debt securities. Thus, the provisions of Statement No. 115 are not applicable to impaired loans. FASB Statement No. 114 addresses the accounting for the impairment of a loan.
‡Relates to Expanded Material.
Chapter 14 689
PRACTICE EXERCISES
PRACTICE 14–1 PURCHASING DEBT SECURITIES
1. Asset approach
Feb. 1
Investment in Trading Securities 50,000
Interest Receivable 333
Cash 50,333
Interest Receivable: $50,000 ´ 0.08 ´ (1/12) = $333
June 30
Cash 2,000
Interest Receivable 333
Interest Revenue 1,667
Cash: $50,000 ´ 0.08 ´ (6/12) = $2,000
2. Revenue approach
Feb. 1
Investment in Trading Securities 50,000
Interest Revenue 333
Cash 50,333
Interest Revenue: $50,000 ´ 0.08 ´ (1/12) = $333
June 30
Cash 2,000
Interest Revenue 2,000
Cash: $50,000 ´ 0.08 ´ (6/12) = $2,000
PRACTICE 14–2 PURCHASING EQUITY SECURITIES
Investment in Available-for-Sale Securities 32,020
Cash 32,020
Investment: (1,000 shares ´ $32) + $20 = $32,020
PRACTICE 14–3 COMPUTING THE VALUE OF DEBT SECURITIES
N = 7 years ´ 2 = 14
I = 12/2 = 6
PMT = $100,000 ´ 0.08 ´ (6/12) = $4,000
FV = $100,000 (the face value is paid at the end of 7 years)
PV = $81,410
PRACTICE 14–4 INTEREST REVENUE FOR HELD-TO-MATURITY SECURITIES
1. Investment in Held-to-Maturity Securities 25,518
Cash 25,518
2. Cash [$20,000 ´ 0.10 ´ (6/12)] 1,000
Investment in Held-to-Maturity Securities 107
Interest Revenue 893
Interest Revenue: $25,518 ´ 0.07 ´ (6/12) = $893
3. Cash 1,000
Investment in Held-to-Maturity Securities 111
Interest Revenue 889
Interest Revenue: ($25,518 – $107) ´ 0.07 ´ (6/12) = $889
PRACTICE 14–5 COST METHOD, EQUITY METHOD, AND CONSOLIDATION
Number of Total Shares
Shares Owned of Investee Company Percentage Accounting
by Investor Company Outstanding Ownership Classification
1. 1,200 10,000 12% Trading or
available for sale
2. 6,000 8,000 75 Consolidation
3. 20,000 55,000 36 Equity method
PRACTICE 14–6 REVENUE FOR TRADING AND AVAILABLE-FOR-SALE SECURITIES
Dividends received on trading and available-for-sale securities are both classified as dividend revenue.
Cash 7,600
Dividend Revenue 7,600
Cash: (2,000 shares ´ $2.50) + (4,000 shares ´ $0.65) = $7,600
PRACTICE 14–7 REVENUE FOR EQUITY METHOD SECURITIES
Because Burton owns more than 20% of Company A stock (2,000/8,000 = 25%), the investment is accounted for using the equity method. Because the purchase price was equal to Burton’s share of the book value of Company A’s equity, there is no excess of purchase price over cost basis.
Year 1
Investment in Company A Stock 27,000
Cash 27,000
Investment in Company A Stock 5,000
Income from Company A Stock 5,000
Income from Company A Stock: $20,000 ´ (2,000 shares/8,000 shares) = $5,000
Cash 1,600
Investment in Company A Stock 1,600
Cash: $0.80 ´ 2,000 shares = $1,600
Year 2
Investment in Company A Stock 6,250
Income from Company A Stock 6,250
Income from Company A Stock: $25,000 ´ (2,000 shares/8,000 shares) = $6,250
Cash 2,000
Investment in Company A Stock 2,000
Cash: $1.00 ´ 2,000 shares = $2,000
PRACTICE 14–8 EQUITY METHOD: EXCESS DEPRECIATION
1. Underlying market value of net assets ($65,000/0.40) $ 162,500
Book value of net assets 120,000
Implied amount of excess value of building $ 42,500
Investor’s interest in net assets 0.40
Amount of excess building value to be depreciated $ 17,000
Depreciation period ÷ 20 years
Annual extra depreciation $ 850
PRACTICE 14–8 (Concluded)
Year 1
Investment in Company B Stock 65,000
Cash 65,000
Investment in Company B Stock 16,000
Income from Company B Stock 16,000
Income from Company B Stock: $40,000 ´ (4,000 shares/10,000 shares) = $16,000
Cash 4,400
Investment in Company B Stock 4,400
Cash: 4,000 shares ´ $1.10 = $4,400
Income from Company B Stock 850
Investment in Company B Stock 850
2. Investment in Company B
Purchase 65,000
Income 16,000 4,400 Dividends
Extra
850 Depreciation
Ending 75,750
PRACTICE 14–9 EQUITY METHOD: COST GREATER THAN BOOK VALUE
1. Underlying market value of net assets ($100,000/0.25) $ 400,000
Book value of net assets 300,000
Implied amount of excess of market over book value $ 100,000
Excess market value identified with:
Inventory $ 10,000
Building 50,000
Goodwill 40,000
Total $ 100,000
Investor’s interest in net assets 0.25
Amount of excess inventory cost this year $ 2,500
Amount of excess building value to be depreciated $ 12,500
Depreciation period ÷ 10 years
Annual extra depreciation $ 1,250
No extra expense is associated with the goodwill, assuming that it is not impaired during the year.
PRACTICE 14–9 (Concluded)
Year 1