Appendix D Investments

Transcription

1 REVIEW QUESTIONS Appendix D Investments Question D-1 (LO D-1) A company might invest in another company to (1) receive dividends, earn interest, and gain from the increase in the value of their investment, (2) temporarily invest excess cash created by operating in seasonable industries, or (3) build strategic alliances, increase market share, or enter new industries. Question D-2 (LO D-1) Companies can gain from the increase in the value of their investment. Even without receiving dividends, investors still benefit when companies reinvest earnings, leading to even more profits in the future and eventually higher stock prices. Many companies also make investments for strategic purposes to develop closer business ties, increase market share, or expand into new industries. Question D-3 (LO D-1) Companies in seasonal industries often invest excess funds generated during the busy season and draw on these funds in the slow season. Question D-4 (LO D-1) PepsiCo purchased Tropicana in order to diversify beyond soft drinks. Question D-5 (LO D-1) The flip side of an investment in equity securities is the issuance of stock. Question D-6 (LO D-1) The method depends on the level of influence. An insignificant level of influence results in the use of the fair value method. A significant, but not controlling, level of influence results in the use of the equity method. A controlling level of influence results in the use of the consolidation method. Question D-7 (LO D-2) The two categories are trading securities and available-for-sale securities. Question D-8 (LO D-2) Dividends received are accounted for as dividend revenue under the fair value method. Question D-9 (LO D-2) An unrealized holding gain is the gain in value while holding the investment, while a realized gain is recognized in cash (or the right to receive cash) after the investment has been sold. Solutions Manual, Appendix D D-1

2 Answers to Review Questions (continued) Question D-10 (LO D-2) The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as trading or available-for-sale. Trading securities are reported at fair value, and resulting holding gains and losses are included in the determination of net income for the period. Question D-11 (LO D-2) The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as trading or available-for-sale. Available-for-sale securities are reported at fair value, and resulting holding gains and losses are not included in the determination of net income for the period. Rather, they are reported as part of other comprehensive income. Question D-12 (LO D-3) The equity method is used when an investor control investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee s voting shares. Question D-13 (LO D-3) The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to recognize revenue again when earnings are distributed as dividends. Question D-14 (LO D-4) These statements combine the parent s and subsidiary s operating activities as if the two companies were a single reporting company, even though both companies continue to operate as separate legal entities. Question D-15 (LO D-4) It is appropriate to consolidate financial statements of two companies when the parent company owns a controlling interest (more than 50%) in the voting stock of the subsidiary. Question D-16 (LO D-5) The flip side of an investment in debt securities is the issuance of debt, such as bonds. Question D-17 (LO D-5) If bonds are purchased at a discount, the carrying value of the investment in bonds and the amount recorded for interest revenue will increase over time. Recall that interest revenue is calculated as the carrying value of the bond times the market interest rate. As carrying value increases, interest revenue also increases. D-2 Financial Accounting, 3e

3 Answers to Review Questions (continued) Question D-18 (LO D-5) If bonds are purchased at a premium, the carrying value of the investment in bonds and the amount recorded for interest revenue will decrease over time. Recall that interest revenue is calculated as the carrying value of the bond times the market interest rate. As carrying value decreases, interest revenue also decreases. Question D-19 (LO D-5) When interest rates go down, the value of a bond with fixed interest payments goes up because the fixed interest payments are now more attractive to investors. Question D-20 (LO D-5) Investments in debt securities are classified as held-to-maturity, trading, or available-forsale securities. Held-to-maturity securities are debt securities that the company expects to hold until they mature, which means until they become payable. Trading securities are securities that the investor expects to sell in the near future. These investments are adjusted to fair value with the unrealized gain or loss included in net income. Available-for-sale securities are investments that do not fit the other two categories; they are not expected to be sold in the near future, yet they are not expected to be held to maturity either. These investments are adjusted to fair value with the unrealized gain or loss included in comprehensive income. Solutions Manual, Appendix D D-3

4 BRIEF EXERCISES Brief Exercise D-1 (LO D-1) X X X 1. To invest excess cash created by operating in seasonal industries. 2. To increase employees morale. 3. To build strategic alliances. 4. To reduce government regulation. 5. To receive interest and dividends. Brief Exercise D-2 (LO D-2) September 1 Debit Credit Investments (150 shares $13) 1,950 Cash 1,950 (Purchase common stock) November 1 Cash (150 shares $17) 2,550 Investments (150 shares $13) 1,950 Gain (difference) 600 (Sell investments above recorded amount) D-4 Financial Accounting, 3e

5 Brief Exercise D-3 (LO D-2) December 28 Debit Credit Investments 485,000 Cash 485,000 (Purchase common stock) Unrealized Holding Loss Net Income 2,000 Investments 2,000 (Adjust investments to fair value) Brief Exercise D-4 (LO D-2) December 28 Debit Credit Investments 485,000 Cash 485,000 (Purchase common stock) Unrealized Holding Loss Other Comprehensive Income 2,000 Investments 2,000 (Adjust investments to fair value) Solutions Manual, Appendix D D-5

6 Brief Exercise D-5 (LO D-2) These are trading securities and are reported at their fair value, $20,000. We know this because actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as trading securities. Of course, the equity method isn t appropriate because 1,000 shares of GE certainly don t constitute significant influence. Investments in trading securities are reported at fair value. Brief Exercise D-6 (LO D-2) These are available-for-sale securities and are reported at their fair value, $20,000. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as trading securities. The GE shares have been held for over a year. They are classified as available-forsale since all investments in debt and equity securities that don t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn t appropriate either because 1,000 shares of GE certainly don t constitute significant influence. Investments in available-for-sale securities are reported at fair value. Brief Exercise D-7 (LO D-3) An investor should account for net income from an equity method investee as an increase in its investments account and an increase in equity income. Therefore, Strong String s reported net income of $20 million will increase investments and equity income for Wendy Day Kite Company by $8 million (= $20 million 40%). Brief Exercise D-8 (LO D-3) An investor should account for dividends from an equity method investee as a reduction in its investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to recognize revenue again when earnings are distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investee s net assets, reflecting the fact that the investor s ownership interest in those net assets declined proportionately. Wendy Day s cash increased by $4 million (= $10 million 40%). Its investment account declined by the same amount. There is no effect on the income statement. D-6 Financial Accounting, 3e

7 Brief Exercise D-9 (LO D-4) Wendy Day would report total inventory of $22,000 in the consolidated financial statements. Since Wendy Day owns all of the outstanding stock in Strong String Company, Wendy Day will combine their total inventory of $14,000 with Strong String s total inventory of $8,000 in Wendy Day s consolidated financial statements. Brief Exercise D-10 (LO D-5) 1. Debit Credit January 1 Investments 40,000 Cash 40,000 (Purchase bonds) 2. June 30 Cash 1,400 Interest Revenue 1,400 (Receive semiannual interest revenue) ($1,400 = $40,000 7% ½) Solutions Manual, Appendix D D-7

8 Brief Exercise D-11(LO D-5) 1. Debit Credit January 1 Investments 37,282 Cash 37,282 (Purchase bonds) 2. June 30 Cash ($40,000 7% ½) 1,400 Investments (difference) 91 Interest Revenue ($37,282 8% ½) 1,491 (Receive semiannual interest revenue) Brief Exercise D-12 (LO D-5) 1. Debit Credit January 1 Investments 42,975 Cash 42,975 (Purchase bonds) 2. June 30 Cash ($40,000 7% ½) 1,400 Investments (difference) 111 Interest Revenue ($42,975 6% ½) 1,289 (Receive semiannual interest revenue) D-8 Financial Accounting, 3e

9 EXERCISES Exercise D-1 (LO D-1) T 1. A reason companies invest in other companies is to build strategic alliances. F 2. All companies are required to pay dividends to their investors. F 3. When market interest rates increase, the market value of a bonds increases as well. T 4. One way for a company to expand operations into a new industry is to acquire the majority of another company s common stock that already operates in that industry. T 5. Stocks typically have greater upside potential, providing a higher average return to their investors over the long-run than do bonds. F 6. Companies purchase debt securities primarily for the dividend revenue they provide. Solutions Manual, Appendix D D-9

10 Exercise D-2 (LO D-2) Requirement 1 December 20 Debit Credit Investments 1,500,000 Cash 1,500,000 (Purchase common stock) December 28 Cash 6,000 Dividend Revenue 6,000 (Receive cash dividends) Unrealized Holding Loss Net Income 60,000 Investments (300,000 shares $0.20 per share) 60,000 (Adjust investments to fair value) Note: The investments decreased in value $0.20 per share from $5.00 per share ($1,500,000/300,000 shares) to $4.80 per share. Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in net income. Requirement 2 Balance of the investments account on : $1,500,000 60,000 = $1,440,000. D-10 Financial Accounting, 3e

11 Exercise D-3 (LO D-2) Requirement 1 February 1 Debit Credit Investments 2,400 Cash 2,400 (Purchase common stock) June 15 Cash (50 shares $14) 700 Loss (difference) 100 Investments (50 shares $16) 800 (Sell investments below recorded amount) October 31 Cash (100 shares $0.50 per share) 50 Dividend Revenue 50 (Receive cash dividends) Unrealized Holding Loss Other Comprehensive Income 400 Investments (100 shares [$16 $12]) 400 (Adjust investments to fair value) Requirement 2 The balance of the investment account on is $1,200, equal to the 100 remaining shares times $12 per share fair value. The balance of the investment account can be verified by posting all journal entries to a t-account. Investments 2, ,200 Solutions Manual, Appendix D D-11

12 Exercise D-4 (LO D-2) Requirement 1 March 1 Debit Credit Investments (3,000 shares $62) 186,000 Cash 186,000 (Purchase common stock) July 1 Cash ($1.25 3,000 shares) 3,750 Dividend Revenue 3,750 (Receive cash dividends) October 1 Cash (750 shares $70) 52,500 Investments (750 shares $62) 46,500 Gain (difference) 6,000 (Sell investments above recorded amount) Investments (2,250 shares $13) 29,250 Unrealized Holding Gain Other Comprehensive Income 29,250 (Adjust investments to fair value) Requirement 2 The balance of the investment account on is $168,750, equal to the 2,250 remaining shares times $75 per share fair value. The balance of the investment account can be verified by posting all journal entries to a t-account. Investments 186,000 46,500 29, ,750 D-12 Financial Accounting, 3e

13 Exercise D-5 (LO D-2) Requirement 1 Comprehensive income is an expansion of the familiar net income. Most revenues, expenses, gains, and losses are included in net income. A few less traditional gains and losses, though, are reported outside the income statement in the more inclusive statement of comprehensive income in which we report all changes in stockholders equity other than those caused by investments by stockholders and payment of dividends. Comprehensive income includes net income as well as other comprehensive income. The most frequent items in other comprehensive income are the unrealized holding gains and losses on investments. Requirement 2 Sales Revenue $ 260,000 Operating expenses (140,000) Gain on sale of investments 13,000 Net income 133,000 Other comprehensive income: Unrealized holding loss (17,000) Comprehensive income $ 116,000 Solutions Manual, Appendix D D-13

14 Exercise D-6 (LO D-3) January 1 Debit Credit Investments 700,000 Cash 700,000 (Purchase common stock) Investments 40,000 Equity Income 40,000 (Earn equity income) ($40,000 = $160,000 25%) Cash 15,000 Investments 15,000 (Receive cash dividends) ($15,000 = $60,000 25%) D-14 Financial Accounting, 3e

15 Exercise D-7 (LO D-3) January 1 Debit Credit Investments 600,000 Cash 600,000 (Purchase common stock) Investments 45,500 Equity Income 45,500 (Earn equity income) ($45,500 = $130,000 35%) Cash 14,000 Investments 14,000 (Receive cash dividends) ($14,000 = $40,000 35%) Under the equity method, no adjustment is made to fair value. Solutions Manual, Appendix D D-15

16 Exercise D-8 (LO D-2, D-3) Requirement 1 Purchase: Debit Credit Investments 360,000 Cash 360,000 (Purchase common stock) Net income: Dividends: Cash 15,000 Dividend Revenue 15,000 (Receive cash dividends) ($15,000 = $ ,000 shares 20%) Fair value adjustment: Investments 15,000 Unrealized Holding Gain Other Comprehensive Income (Adjust investments to fair value) ($15,000 = $375,000 $360,000) 15,000 D-16 Financial Accounting, 3e

17 Exercise D-8 (concluded) Requirement 2 Purchase: Debit Credit Investments 360,000 Cash 360,000 (Purchase common stock) Net income: Investments 27,000 Equity Income 27,000 (Earn equity income) ($27,000 = $135,000 20%) Dividends: Cash 15,000 Investments 15,000 (Receive cash dividends) ($15,000 = $ ,000 shares 20%) Fair value adjustment: No adjustment is made under the equity method Solutions Manual, Appendix D D-17

18 Exercise D-9 (LO D-4) X X 1. 10% of the common stock of Beta % of the bonds of Gamma % of the common stock of Delta % of the bonds of Epsilon % of the common stock of Zeta % of the bonds of Eta % of the common stock of Theta. D-18 Financial Accounting, 3e

19 Exercise D-10 (LO D-5) Requirement 1 (1) (2) (3) (4) Increase in Interest Revenue Carrying Value Carrying Value Market Rate (3) (2) Cash Carrying Date Received Value Face Amount Prior Carrying Stated Rate Value + (4) 1/ 1 $159,869 6/30 $ 6,125 $ 6,395 $ ,139 12/31 6,125 6, ,420 Requirement 2 January 1 Investments 159,869 Cash 159,869 (Purchase bonds) (5) June 30 Cash ($175,000 7% ½) 6,125 Investments (difference) 270 Interest Revenue ($159,869 8% ½) (Receive semiannual interest revenue) Cash ($175,000 7% ½) 6,125 Investments (difference) 281 Interest Revenue ($160,139 8% ½) (Receive semiannual interest revenue) 6,395 6,395 Solutions Manual, Appendix D D-19

20 Exercise D-11 (LO D-5) Requirement 1 (1) (2) (3) (4) Decrease in Interest Revenue Carrying Value Carrying Value Market Rate (2) (3) Cash Carrying Date Received Value Face Amount Prior Carrying Stated Rate Value (4) 1/ 1 $ 549,001 6/30 $ 17,500 $ 16,470 $ 1, ,971 12/31 17,500 16,439 1, ,910 Requirement 2 January 1 Investments 549,001 Cash 549,001 (Purchase bonds) June 30 Cash ($500,000 7% ½) 17,500 Investments (difference) 1,030 Interest Revenue ($549,001 6% ½) 16,470 (Receive semiannual interest revenue) Cash ($500,000 7% ½) 17,500 Investments (difference) 1,061 Interest Revenue ($547,971 6% ½) 16,439 (Receive semiannual interest revenue) (5) D-20 Financial Accounting, 3e

21 PROBLEMS: SET A Problem D-1A (LO D-2) Requirement 1 January 2 Debit Credit Investments 105,000 Cash 105,000 (Purchase common stock) February 14 Investments 7,200 Cash 7,200 (Purchase preferred stock) May 15 Cash (300 shares $62) 18,600 Loss (difference) 2,400 Investments (300 shares $70) 21,000 (Sell investments below recorded amount) December 30 Cash 900 Dividend Revenue 900 (Receive cash dividends) (1,200 shares $0.50) + (600 shares $0.50) Solutions Manual, Appendix D D-21

22 Problem D-1A (concluded) Requirement 1 (concluded) Investments 3,600 Unrealized Holding Gain Other Comprehensive Income (Adjust investments in common stock to fair value) ($3,600 = 1,200 shares $3) Investments 1,200 Unrealized Holding Gain Other Comprehensive Income (Adjust investments in preferred stock to fair value) ($1,200 = 600 shares $2) 3,600 1,200 Requirement 2 The balance of the Investments account on is $96,000, equal to the 1,200 remaining common shares times $73 per share fair value plus the 600 preferred shares times $14 per share fair value. D-22 Financial Accounting, 3e

23 Problem D-2A (LO D-3) ($ in millions) Purchase: Debit Credit Investments 178 Cash 178 (Purchase common stock) Net income: Investments Equity Income (Earn equity income) ($32.50 = $130 25%) Dividends: Cash 9.35 Investments 9.35 (Receive cash dividends) ($9.35 = $ million shares 25%) Solutions Manual, Appendix D D-23

24 Problem D-3A (LO D-5) Requirement 1 (1) (2) (3) (4) Increase in Interest Revenue Carrying Value Carrying Value Market Rate (3) (2) Cash Carrying Date Received Value Face Amount Prior Carrying Stated Rate Value + (4) 1/ 1 $ 133,984 6/30 $ 4,500 $ 4,689 $ ,173 12/31 4,500 4, ,369 (5) Requirement 2 January 1 Investments 133,984 Cash 133,984 (Purchase bonds) June 30 Cash ($150,000 6% ½) 4,500 Investments (difference) 189 Interest Revenue ($133,984 7% ½) 4,689 (Receive semiannual interest revenue) Cash ($150,000 6% ½) 4,500 Investments (difference) 196 Interest Revenue ($134,173 7% ½) 4,696 (Receive semiannual interest revenue) D-24 Financial Accounting, 3e

25 Requirement 3 Cash 145,000 Gain (difference) 10,631 Investments 134,369 (Sell bonds before maturity) Requirement 4 Bond prices move in the opposite direction of market interest rates. Since bond prices went up between the beginning and end of the year, market interest rates must have decreased. Solutions Manual, Appendix D D-25

26 Problem D-4A (LO D-5) Requirement 1 Investments ,000 Cash ,000 (Purchase bonds) Requirement 2 Cash ($180,000 8% ½)... 7,200 Investments Interest revenue ($152,000 10% ½)... 7,600 (Receive semiannual interest revenue) Requirement 3 Cash ($180,000 8% ½)... 7,200 Investment Interest revenue ([$152, ] 10% ½) 7,620 (Receive semiannual interest revenue) Requirement 4 Since these are held-to-maturity securities, Justin Investor reports its investment in the, balance sheet at its amortized cost that is, its book value: Investments: $152, = $152,820 Increases and decreases in the fair value between the time a debt security is acquired and the day it matures are relatively unimportant if sale before maturity isn t an alternative. For this reason, if an investor has the intent to hold the securities to maturity, investments in debt securities are classified as held-to-maturity and reported at amortized cost rather than fair value in the balance sheet. D-26 Financial Accounting, 3e

27 PROBLEMS: SET B Problem D-1B (LO D-2) Requirement 1 February 2 Debit Credit Investments 52,500 Cash 52,500 (Purchase common stock) February 4 Investments 19,200 Cash 19,200 (Purchase preferred stock) July 15 Cash (400 shares $40) 16,000 Investments (400 shares $35) 14,000 Gain (difference) 2,000 (Sell investments above recorded amount) November 30 Cash 2,290 Dividend Revenue 2,290 (Receive cash dividends) (1,100 shares $1.10) + (600 shares $1.80) Solutions Manual, Appendix D D-27

28 Problem D-1B (concluded) Requirement 1 (concluded) Unrealized Holding Loss Other Comprehensive Income 4,400 Investments 4,400 (Adjust investments in common stock to fair value) ($4,400 = 1,100 shares $4 decrease per share) Unrealized Holding Loss Other Comprehensive Income 1,200 Investments 1,200 (Adjust investments in preferred stock to fair value) ($1,200 = 600 shares $2 decrease per share) Requirement 2 The balance of the Investments account on is $52,100, equal to the 1,100 remaining common shares times $31 per share fair value plus the 600 preferred shares times $30 per share fair value. D-28 Financial Accounting, 3e

29 Problem D-2B (LO D-3) ($ in millions) Purchase: Debit Credit Investments 52 Cash 52 (Purchase common stock) Net income: Investments 2.7 Equity Income 2.7 (Earn equity income) ($2.7 = $9 30%) Dividends: Cash 1.5 Investments 1.5 (Receive cash dividends) ($1.5 = $ million shares 30%) Solutions Manual, Appendix D D-29

30 Problem D-3B (LO D-5) Requirement 1 (1) (2) (3) (4) Increase in Interest Revenue Carrying Value Carrying Value Market Rate (3) (2) Cash Carrying Date Received Value Face Amount Prior Carrying Stated Rate Value + (4) 1/1 $ 419,422 6/30 $ 15,750 $ 16,777 $ 1, ,449 12/31 15,750 16,818 1, ,517 (5) Requirement 2 January 1 Investments 419,422 Cash 419,422 (Purchase bonds) June 30 Cash ($450,000 7% ½) 15,750 Investments (difference) 1,027 Interest Revenue ($419,422 8% ½) 16,777 (Receive semiannual interest revenue) Cash ($450,000 7% ½) 15,750 Investments (difference) 1,068 Interest Revenue ($420,449 8% ½) 16,818 (Receive semiannual interest revenue) D-30 Financial Accounting, 3e

31 Requirement 3 Cash 415,000 Loss (difference) 6,517 Investments 421,517 (Sell bonds before maturity) Requirement 4 Bond prices move in the opposite direction of market interest rates. Since bond prices went down between the beginning and end of the year, market interest rates must have increased. Solutions Manual, Appendix D D-31

32 Problem D-4B (LO D-5) Requirement 1 Investments ,728 Cash ,728 (Purchase bonds) Requirement 2 Cash ($130,000 7% ½)... 4,550 Investments Interest revenue ($124,728 8% ½)... 4,989 (Receive semiannual interest revenue) Requirement 3 Cash ($130,000 7% ½)... 4,550 Investments Interest revenue ([$124, ] 8% ½) 5,007 (Receive semiannual interest revenue) Requirement 4 Since these are held-to-maturity securities, Tsunami Sushi reports its investment in the, balance sheet at its amortized cost that is, its book value: Investments: $124, = $125,624 Increases and decreases in the fair value between the time a debt security is acquired and the day it matures are relatively unimportant if sale before maturity isn t an alternative. For this reason, if an investor has the intent to hold the securities to maturity, investments in debt securities are classified as held-to-maturity and reported at amortized cost rather than fair value in the balance sheet. D-32 Financial Accounting, 3e