Finance Chapter 12 - Financial Investments
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Questions and Answers

What is the definition of fair value under GAAP?

  • The amount an independent buyer is willing to pay for an asset. (correct)
  • The estimated average cost of an asset.
  • The historical cost adjusted for inflation.
  • The value determined by management's hypothetical scenario.

    • Which valuation method is used for assets actively traded on financial markets?

  • Mark-to-model
  • Estimated value method
  • Historical cost method
  • Mark-to-market (correct)

    • What does Level 2 of the fair value hierarchy rely on?

  • Observable inputs other than quoted prices. (correct)
  • Management's internal estimates.
  • Historical data adjusted for market changes.
  • Quoted prices in active markets.

    • How are passive investments recorded when acquired?

    <p>At the cost of acquisition on the purchase date.</p> Signup and view all the answers

    When a passive investment is sold, how is the gain or loss calculated?

    <p>Gain or loss = Proceeds from sale - Book value of investment.</p> Signup and view all the answers

    What is an example of a Level 3 input in the fair value hierarchy?

    <p>Management estimates or assumptions for an operating asset.</p> Signup and view all the answers

    What type of companies do investors in passive investments typically not possess?

    <p>Sufficient shares to influence management decisions.</p> Signup and view all the answers

    What is reported as a component of other income on the income statement?

    <p>Gains or losses from the sale of passive investments.</p> Signup and view all the answers

    What is one reason companies purchase the debt and equity securities of other companies?

    <p>To strategically penetrate or expand in the market</p> Signup and view all the answers

    What characterizes an investor with passive influence over an investee company?

    <p>Ownership of less than 20% of voting stock</p> Signup and view all the answers

    Which level of influence is presumed with ownership between 20% to 50% of voting stock?

    <p>Significant Influence</p> Signup and view all the answers

    What determines the accounting treatment for financial investments?

    <p>The type and amount of securities purchased</p> Signup and view all the answers

    What is a characteristic of controlling influence?

    <p>Ability to affect the strategic corporate direction</p> Signup and view all the answers

    Which accounting treatment is applied for passive investments in equity securities?

    <p>Fair Value through Net Income</p> Signup and view all the answers

    Why might a company choose to engage in financial investments?

    <p>To enhance relationships with other organizations</p> Signup and view all the answers

    Under which condition can control be presumed even with less than 50% ownership?

    <p>Through legal agreements</p> Signup and view all the answers

    What is a characteristic of significant influence?

    <p>Influence derived through legal agreements and percentage of stock owned</p> Signup and view all the answers

    How does the degree of influence affect accounting treatment for investments?

    <p>It determines the classification as Trading or Available-for-Sale Securities</p> Signup and view all the answers

    What is the amount of the unrealized loss that is recognized in the investment asset?

    <p>$13,000</p> Signup and view all the answers

    Where is the unrealized loss recorded in the financial statements?

    <p>Accumulated Other Comprehensive Income</p> Signup and view all the answers

    What is the typical accounting treatment for passive equity investments?

    <p>Fair Value through Income</p> Signup and view all the answers

    What condition indicates the existence of significant influence by the investor over the investee?

    <p>Ability to affect financial or operating policies</p> Signup and view all the answers

    In what scenario is the Equity Method applied by the investor?

    <p>When significant influence exists</p> Signup and view all the answers

    How are the shares of the investee's dividends treated under the Equity Method?

    <p>As income by the investor</p> Signup and view all the answers

    Which of the following is NOT true about the Fair Value Adjustment for available-for-sale investments?

    <p>Unrealized gains are recognized in income immediately.</p> Signup and view all the answers

    Which of the following best describes a rationale for making investments with significant influence?

    <p>Establishing long-term relationships for strategic benefits.</p> Signup and view all the answers

    What is the total amount of current assets after consolidation?

    <p>$65,000</p> Signup and view all the answers

    Which adjustment is made to eliminate Technix’s equity during consolidation?

    <p>Subtract $40,000 from contributed capital</p> Signup and view all the answers

    After elimination adjustments, what is the consolidated total liabilities?

    <p>$38,000</p> Signup and view all the answers

    What is the total amount of consolidated assets after all adjustments?

    <p>$251,000</p> Signup and view all the answers

    What entry does WebPros make to record the semi-annual interest income from the Technix bonds?

    <p>Interest Income 25,000; Cash 25,000</p> Signup and view all the answers

    What was the initial investment made by WebPros in Technix?

    <p>$100,000</p> Signup and view all the answers

    What happens to the value of Technix bonds in WebPros' financial statements if the company intends to hold them to maturity?

    <p>The investment remains reported at its initial cost</p> Signup and view all the answers

    If WebPros classifies its Technix bonds as trading securities, which of the following statements is true?

    <p>The value is adjusted to fair value in the financial statements.</p> Signup and view all the answers

    Which of the following best describes available-for-sale securities?

    <p>Intended to be held for capital gains and interest revenue.</p> Signup and view all the answers

    How does a rise in market interest rates affect the fair value of WebPros' Technix bonds?

    <p>The fair value will decrease to $487,000.</p> Signup and view all the answers

    What is the best accounting treatment for the Technix bonds if WebPros does not have the intent to hold them to maturity?

    <p>They should be marked to market value as trading or available-for-sale securities.</p> Signup and view all the answers

    What impact does the classification of Technix bonds as trading securities have on the income statement?

    <p>Interest income is included, and any price changes result in gains or losses being recognized.</p> Signup and view all the answers

    Which method should WebPros use if the fair value of Technix bonds is affected by market conditions but they plan to hold them long-term?

    <p>Held-to-maturity method</p> Signup and view all the answers

    What is the total amount that WebPros invested to acquire a 40% interest in Technix?

    <p>$60,000</p> Signup and view all the answers

    How much income share does WebPros recognize from Technix's $8,000 net income using the equity method?

    <p>$3,200</p> Signup and view all the answers

    If Technix paid $6,000 in dividends, what will be WebPros' share of the dividends?

    <p>$2,400</p> Signup and view all the answers

    Under what condition does GAAP require consolidation of financial statements?

    <p>When the investor owns more than 50% of the voting common stock</p> Signup and view all the answers

    What affects the year-end balance of WebPros' investment in Technix after recording income and dividends?

    <p>Investment income and dividends received</p> Signup and view all the answers

    Which of the following is NOT considered in consolidation accounting for an investor with control?

    <p>Report the investor's net income</p> Signup and view all the answers

    What is the impact of recognizing investment income on the Investment in Technix account?

    <p>It increases the investment account</p> Signup and view all the answers

    What method should be used to account for an investment where an investor owns more than 50% of the voting common stock?

    <p>Consolidation method</p> Signup and view all the answers

    Study Notes

    Chapter 12 - Financial Investments

    • Companies purchase debt and equity securities for various reasons, including short-term investment of excess cash, strategic alliances, and market expansion.
    • Accounting for financial investments depends on both the type and amount of securities purchased, as well as the degree of influence or control the investor exerts over the investee company.
    • Different levels of influence/control exist, including passive (<20% of outstanding voting stock), significant influence (20% to 50% of outstanding voting stock), and control (>50% of outstanding voting stock).
    • Passive investments are recorded at cost on the purchase date and gains/losses are reported in other income when the investment is sold.

    Fair Value

    • Fair value is defined as the amount an independent buyer would pay for an asset based on an active market (mark-to-market) or when there is no active market (mark-to-model).
    • The fair value hierarchy has three levels:
      • Level 1: Quoted prices in active markets for identical assets/liabilities
      • Level 2: Observable inputs other than Level 1 (e.g., quoted prices for similar assets/liabilities or interest rates)
      • Level 3: Unobservable inputs only available to the reporting entity (e.g., management estimates).

    Investment Treatment and Effects

    • Trading Securities: Active buying/selling for profit; fair value changes reported to income statement.
    • Available-for-Sale Securities: Held for capital gains/interest/dividends; fair value changes reported to accumulated other comprehensive income (AOCI).
    • Held-to-Maturity Securities: Held to maturity; cost method used on the balance sheet; no gains/losses recognized on income statement during holding period.
    • Investors who intend to hold a debt security to maturity report it at cost, not fair value.

    Passive Equity Investments

    • Investments in equity of another company are accounted for as Fair Value through Net Income, similar to trading debt securities. Unrealized gains/losses are reported in income.

    Investments with Significant Influence (Equity Method)

    • Significant influence exists when an investor can affect the financing or operating policies of the investee. Reasons for investment include strategic alliances, expansion to new locations or participating in research & development (R&D) to reduce risk..
    • Investments with significant influence are not reported at fair value; rather, the investment is initially recorded at cost. The investor reports their share of income or losses. Dividends received are recorded as a reduction of the investment balance.

    Investments with Control (Consolidation)

    • Applicable when an investor owns more than 50% of the voting common stock.
    • GAAP requires consolidation of the investor and investee's balance sheets. Intercompany transactions are eliminated. Assets and liabilities are combined.

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    Description

    Dive into Chapter 12 on Financial Investments, exploring the reasons companies invest in debt and equity securities, and the accounting methods involved. Understand the different levels of influence and the fair value concept, including how investments are recorded and reported. This chapter lays the groundwork for understanding investment strategies and market dynamics.

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