Albrecht Ch 10 SM Final.docx
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AlbrechtCh10SMFinal
CHAPTER10
DISCUSSIONQUESTIONS
1.Thereareseveralreasonsforafirmtomakeinvestmentsinassetsnotdirectlyrelatedtotheprimaryoperationsofitsbusiness(thatis,investmentsinassetsotherthanproperty,plant,equipment,andinventory).Companiesusuallymakeshort-terminvestmentsbecauseofatemporarysurplusofcash.Theymakelong-terminvestmentseither
becausetheybelievethatpurchased
investmentsprovideagoodreturnonmoneyinvestedorbecausetheywanttogaininfluenceorcontroloverinvesteecompanies.
2.Theriskandreturntrade-offofinvestmentsisthatinvestorsmustusuallydecidewhethertheywantapotentiallyhigherreturnwithmoreriskoralowerreturnwithlessrisk.Mostinvestmentsfallsomewherealongarisk-returncontinuum.Investmentsthatprovidehighreturnsbuthavelowriskaredesirable,butrare.
3.TheFASBhasdefinedfourdifferentclassificationsfordebtandequitysecurities:
tradingsecurities,available-for-salesecurities,held-to-maturitysecurities,andequitymethodsecurities.
4.Asecuritywillbeclassifiedastradingiftheinvestorismakingtheinvestmentwiththeintentofsellingthesecurityshouldtheneedforcasharise,ortorealizeshort-termprofitsshouldthepriceofthesecurityincrease.
5.Asecuritywillbeclassifiedasheld-to-maturityiftheinvestorintendstoholdthesecurityuntilitmatures.Thiscriterionmeansthatonlydebtsecuritiescanbeclassifiedasheld-to-maturity,asequitysecuritiestypicallydonotmature.Ifadebtsecurityisclassifiedasheld-to-maturity,anypremiumordiscountassociatedwiththesecuritymustbeamortizedoverthelifeofthedebtsecurity.
6.Tobeclassifiedasanequitymethodsecurity,aninvestormusttypicallyownbetween20and50%oftheoutstandingcommonstockoftheinvestee.Ownershipofbetween20and50%generallyindicatestheabilityoftheinvestortosignificantlyinfluencethe
operationsanddecisionsoftheinvestee.
7.Whenaninvestorpurchasesdebtandequitysecurities,twotypesofreturnsmayberealized.Thefirsttypeofreturnisthereceiptofinterest(inthecaseofdebt)ordividends(inthecaseofequity).Thesecondtypeofreturnisfromanincreaseinthepriceofthesecurity.Torealizethistypeofreturn,theinvestormustsellthesecurity.
8.Whenasecurityissold,thesellermusthaveseveralpiecesofinformationtoproperlyaccountforthetransaction.Thesellermustknowthesellingpriceaswellasthehistoricalcostofthesecurity.Thedifference
betweenthesetwoamountsresultsinarealizedgainorlossonthesale.
9.Thedifferencebetweenarealizedgainorlossandanunrealizedgainorlossrelatestotheaccountingconceptofarm’s-lengthtransactions.Theterm“realized”indicatesthatanarm’s-lengthtransactionhastakenplaceandasecurityhasbeensold.Arealizedgainindicatesthatthesecuritywassoldformorethanitshistoricalcost,whilearealizedlossmeansthatthesecuritywassoldforlessthanitsoriginalpurchaseprice.Anunrealizedgainmeansthatthepriceofthesecuritybeingheldhasincreasedaboveitshistoricalcost,butthesecurityhasnotbeensold.Ifthesecurityisstillbeingheldandthepricefallsbelowitshistoricalcost,anunrealizedlosshasoccurred.
10.Theaccount“MarketAdjustment”isusedtovaluebothtradingandavailable-for-salesecuritiesattheirmarketvalue.Tradingandavailable-for-salesecuritiesareinitially
recordedattheirhistoricalcost,andastheirvaluechanges,thehistoricalcostremainsthesameonthebooks.Toreflectmarketvaluesonthebooks,themarketadjustmentaccountisusedtorecordbothincreasesanddecreasesinvalue.Aseparatemarketadjustmentaccountisusedforbothtradingandavailable-for-salesecurities.
11.Changesinthevalueoftradingsecurities,bothincreasesanddecreases,arerecordedonthebooksoftheinvestor.Priorto1994,onlydeclinesbelowhistoricalcostwere
recordedonthebooks.In1994,however,theruleswerechangedtoallowcompaniestorecordbothincreasesanddecreasesinvalue.Attheendofeachaccountingperiod,themarketvalueoftheportfoliooftradingsecuritiesiscomparedtoitshistoricalcost,andthedifferenceisrecordedinthemarketadjustmentaccount.Theoffsettingcredit(inthecaseofincreasesinvalue)ordebit(inthecaseofdecreasesinvalue)isrecordedinanincomestatementaccountasanunrealizedgainorloss.
12.Accountingforchangesinthevalueofavailable-for-salesecuritiesissimilartotheproceduresappliedwhenaccountingfortradingsecuritieswithoneimportantdifference.Insteadofrecordinganyunrealizedincreasesordecreasesinvalueonthe
incomestatement,unrealizedincreases
anddecreasesinvaluearerecordedinastockholders’equityaccount,Unrealized
Increase/DecreaseinValueofAvailable-for-SaleSecurities—Equity.Thus,thejournalentrytorecordunrealizedchangesinvaluealwayscontainsthestockholders’equityaccountandthemarketadjustment—available-for-salesecuritiesaccount.
13.Themarketadjustmentaccountcanbefurtheradjusted;however,theadjustmentaccountshouldalwaysreportthetotalnetchangeinthevalueofthesecurity.Forexample,ifasecuritythatcost$200roseinvalueto$300duringthefirstperiodandthento$350duringthesecondperiod,themarketadjustmentaccountwouldshowabalanceof$150attheendofthesecondperiod.
14.Premiumsanddiscountsonavailable-for-salesecuritiesarenotamortizedbecauseitisassumedthattradingandavailable-for-salesecuritieswillnotbeheldlongenoughtowarranttheneedtoamortizeapremiumordiscount.
15.Changesinthevalueofheld-to-maturityandequitymethodsecuritiesarenotaccountedforonthebooksoftheinvestor.Forheld-to-maturitysecurities,theinvestorintendstoholdthedebtsecurityuntilitmatures,andasaresult,changesinvaluewillnotaffecttheeventualmaturityvalueofthesecurity.Forequitymethodsecurities,theinvestorisholdingthesecurityforthepurposeofbeingabletoinfluencetheoperatingdecisionsoftheinvesteeonalong-termbasis.Thus,temporarychangesinvalueofequitymethodsecuritiesareignoredforaccountingpurposes.
16.Theonlydifferencebetweentheaccountingfortradingsecuritiesandavailable-for-salesecuritiesliesinunrealizedchangesinvalueofthosesecurities.Fortradingsecurities,thechangesinvaluearerecordedontheincomestatement.Foravailable-for-salesecurities,theunrealizedchangesinvaluearerecordedinastockholders’equityaccount.
17.*Whenbuyingaheld-to-maturitysecurity,aninvestorpurchasestherighttoreceivetwodifferenttypesoffuturecashreceipts.First,theinvestorreceivesperiodicinterestpaymentsoverthelifeofthesecurity;second,theinvestorreceivesthefaceamount(principal)ofthesecurityatmaturity.
18.*Acompanywouldusuallybewillingtopaymorethanthefaceamount(apremium)foraheld-to-maturitysecuritywhentheinterestrateonthesecurityishigherthanthemarketrateofinterestforsimilarinvestments.Thepayingofahigherpricereducesthestatedrateofinteresttoapointwhereitapproximatesthemarketrateofinterest.
19.*Theamortizationofadiscountincreasestheamountearnedonaheld-to-maturitysecuritybecauseatmaturityinvestorsreceivethefacevalue,whichishigherthantheamountoriginallypaid.Theseincreasedproceedsmustberecognizedoverthelifeofthesecuritythroughamortization.Theamortizationofadiscountincreasesinterestfromastatedratetoahighereffectiverate.
20.*Aninvestorpurchasingheld-to-maturitysecurities(typicallybonds)betweeninterestdatesmustpayforaccruedinterestbecauseatthenextinterestpaymentdateafull
period’sinterestwillbereceived,eventhoughthesecuritieshavebeenheldforonlyaportionoftheperiod.Becausethesecuritiesaresoldinrelativelysmalldenominationsandareusuallyownedbynumerousindividuals,itisalmostimpossibleforacompanytoknowwhoboughthowmanybondsonwhichdates.Therefore,withmanyheld-to-maturitysecurities,whoeverownsthesecuritiesontheinterestpaymentdatereceivesthefullperiod’sinterest.
*Relatestoexpandedmaterial.
21.*Theeffective-interestamortizationmethodistheoreticallysuperiortothestraight-lineamortizationmethodbecauseittakesintoconsiderationthetimevalueofmoney.Withtheeffective-interestmethod,theamountofinterestrecognizedistheeffectiveinterestratetimestheamountofmoneyactually
beingborrowedatanyperiodoftime.Thestraight-linemethodisonlyanapproximationofthetruerateofinterest.
22.*Thekeycriterionforusingtheequitymethodistheabilityoftheinvestortoinfluencetheoperationsordecisionsoftheinvestee.
23.*Theaccountingprofessionhasprovidedguidelinestodetermineiftheabilityto
significantlyinfluencetheoperatingdecisionsofaninvesteeexists.Theprimaryguidelineisdegreeofownership.Iftheinvestorownsbetween20and50%ofacorporation’soutstandingcommonstock,itisassumedthattheinvestorisabletosignificantlyinfluencetheinvestee.Thus,unlessevidenceexiststothecontrary,ownershipofbetween20and50%wouldrequiretheuseoftheequitymethod.
24.*Whenaninvestorpurchasesatradingsecurity,revenueisrecognizedwheninterestor
dividendsarereceived.Againorloss(unrealized)isrecordedwhenthesecurity’spricechangesinvalue.Foraninvestmentaccountedforundertheequitymethod,revenueisrecognizedwhentheinvesteereportsincomefortheperiod.Thisrecognitionservestoincreasetheinvestmentaccount.Theinvestmentaccount