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CHAPTER 12
DISCUSSION QUESTIONS
1. There are several reasons for a firm to make 7. When an investor purchases debt and equity
investments in assets not directly related to
the primary operations of its business (that is,
investments in assets other than property,
plant, equipment, and inventory). Companies
usually make short-term investments be-
cause of a temporary surplus of cash. They
make long-term investments either
because they believe that purchased
investments provide a good return on money
8.
invested or because they want to gain influ-
ence or control over investee companies.
2. The risk and return trade-off of investments
is that investors must usually decide whether
they want a potentially higher return with
more risk or a lower return with less risk.
Most investments fall somewhere along a
9.
risk-return continuum. Investments that pro-
vide high returns but have low risk are desir-
able, but rare.
3. The FASB has defined four different classifi-
cations for debt and equity securities: trading
securities, available-for-sale securities, held-
to-maturity securities, and equity method se-
curities.
4. A security will be classified as trading if the
investor is making the investment with the
intent of selling the security should the need
for cash arise, or to realize short-term profits
should the price of the security increase.
5. A security will be classified as held-to-
maturity if the investor intends to hold the
10.
security until it matures. This criterion means
that only debt securities can be classified as
held-to-maturity, as equity securities typically
do not mature. If a debt security is classified
as held-to-maturity, any premium or discount
associated with the security must be amor-
tized over the life of the debt security.
6. To be classified as an equity method securi-
ty, an investor must typically own between
20 and 50% of the outstanding common
stock of the investee. Ownership of between
20 and 50% generally indicates the ability of
11.
the investor to significantly influence the
operations and decisions of the investee.
433
securities, two types of returns may be rea-
lized. The first type of return is the receipt of
interest (in the case of debt) or dividends (in
the case of equity). The second type of re-
turn is from an increase in the price of the
security. To realize this type of return, the in-
vestor must sell the security.
When a security is sold, the seller must have
several pieces of information to properly ac-
count for the transaction. The seller must
know the selling price as well as the histori-
cal cost of the security. The difference
between these two amounts results in a rea-
lized gain or loss on the sale.
The difference between a realized gain or
loss and an unrealized gain or loss relates to
the accounting concept of arm’s-length
transactions. The term ―realized‖ indicates
that an arm’s-length transaction has taken
place and a security has been sold. A rea-
lized gain indicates that the security was sold
for more than its historical cost, while a rea-
lized loss means that the security was sold
for less than its original purchase price. An
unrealized gain means that the price of the
security being held has increased above its
historical cost, but the security has not been
sold. If the security is still being held and the
price falls below its historical cost, an unrea-
lized loss has occurred.
The account ―Market Adjustment‖ is used to
value both trading and available-for-sale se-
curities at their market value. Trading and
available-for-sale securities are initially
recorded at their historical cost, and as their
value changes, the historical cost remains
the same on the books. To reflect market
values on the books, the market adjustment
account is used to record both increases
and decreases in value. A separate market
adjustment account is used for both trading
and available-for-sale securities.
Changes in the value of trading securities,
both increases and decreases, are recorded
on the books of the investor. Prior to 1994,
only declines below historical cost were
recorded on the books. In 1994, however,
434
the rules were changed to allow companies
to record both increases and decreases in
value. At the end of each accounting period,
the market value of the portfolio of trading
securities is compared to its historical cost,
and the difference is recorded in the market
adjustment account. The offsetting credit (in
the case of increases in value) or debit (in
the case of decreases in value) is recorded
in an income statement account as an un-
realized gain or loss.
12. Accounting for changes in the value of
available-for-sale securities is similar to the
procedures applied when accounting for
trading securities with one important differ-
ence. Instead of recording any unrealized
increases or decreases in value on the
income statement, unrealized increases
and decreases in value are recorded in a
stockholders’ equity account, Unrealized
Increase/Decrease in Value of Available-for-
Sale Securities—Equity. Thus, the journal
entry to record unrealized changes in value
always contains the stockholders’ equity ac-
count and the market adjustment—available-
for-sale securities account.
13. The market adjustment account can be
further adjusted; however, the adjustment
account should always report the total net
change in the value of the security. For ex-
ample, if a security that cost $200 rose in
value to $300 during the first period and then
to $350 during the second period, the mar-
ket adjustment account would show a bal-
ance of $150 at the end of the second period.
14. Premiums and discounts on available-for-
sale securities are not amortized because it
is assumed that trading and available-for-
sale securities will not be held long enough
to warrant the need to amortize a premium
or discount.
15. Changes in the value of held-to-maturity and
equity method securities are not accounted
for on the books of the investor. For held-to-
maturity securities, the investor intends to
hold the debt security until it matures, and as
a result, changes in value will not affect
the eventual maturity value of the security.
For equity method securities, the investor
is holding the security for the purpose of
being able to influence the operating deci-
sions of the investee on a long-term basis.
Thus, temporary changes in value of equity
Chapter 12
method securities are ignored for accounting
purposes.
16. The only difference between the accounting
for trading securities and available-for-sale
securities lies in unrealized changes in value
of those securities. For trading securities,
the changes in value are recorded on the in-
come statement. For available-for-sale se-
curities, the unrealized changes in value are
recorded in a stockholders’ equity account.
17.* When buying a held-to-maturity security, an
investor purchases the right to receive two
different types of future cash receipts. First,
the investor receives periodic interest pay-
ments over the life of the security; second,
the investor receives the face amount (prin-
cipal) of the security at maturity.
18.* A company would usually be willing to pay
more than the face amount (a premium) for
a held-to-maturity security when the interest
rate on the security is higher than the market
rate of interest for similar investments. The
paying of a higher price reduces the stated
rate of interest to a point where it approx-
imates the market rate of interest.
19.* The amortization of a discount increases the
amount earned on a held-to-maturity security
because at maturity investors receive the
face value, which is higher than the amount
originally paid. These increased proceeds
must be recognized over the life of the secu-
rity through amortization. The amortization of
a discount increases interest from a stated
rate to a higher effective rate.
20.* An investor purchasing held-to-maturity
securities (typically bonds) between interest
dates must pay for accrued interest because
at the next interest payment date a full
period’s interest will be received, even
though the securities have been held for only
a portion of the period. Because the securi-
ties are sold in relatively small denomina-
tions and are usually owned by numerous
individuals, it is almost impossible for a
company to know who bought how many
bonds on which dates. Therefore, with many
held-to-maturity securities, whoever owns
the securities on the interest payment date
receives the full period’s interest.
*Relates to expanded material.
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