Guided Study: Investments in Financial Accounting

Study Guide - Smart Notes

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Q1. Why do companies invest in the securities of other companies? (True or False: Companies may invest in the securities of other companies to gain influence or control.)

Background

Topic: Reasons for Corporate Investments

This question tests your understanding of the strategic reasons companies invest in other companies, such as gaining influence or control.

Key Terms:

Influence: The ability to affect decisions or policies of another company.
Control: The power to direct the activities of another company, usually through ownership of voting stock.

Step-by-Step Guidance

Consider the strategic motivations for investing in another company (e.g., access to resources, market expansion, or financial returns).
Think about how owning shares can provide influence or control over another company’s decisions.
Recall that "influence" typically means the ability to participate in policy and decision-making, while "control" means the ability to direct those decisions.

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Q2. What two criteria must an investment meet to be classified as a current asset?

Background

Topic: Classification of Investments

This question is about the requirements for classifying investments as current assets on the balance sheet.

Key Terms:

Current Asset: An asset expected to be converted to cash or used up within one year or the operating cycle, whichever is longer.
Liquidity: How quickly an asset can be converted to cash.

Step-by-Step Guidance

Recall the definition of a current asset in financial accounting.
Think about the importance of liquidity and the company’s intent regarding the investment.
Identify the two main criteria: (1) the investment’s liquidity, and (2) the investor’s intent to convert or use the investment within a specific timeframe.

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Q3. What are equity securities and debt securities?

Background

Topic: Types of Securities

This question tests your understanding of the difference between equity and debt securities as investment vehicles.

Key Terms:

Equity Securities: Investments in the ownership (capital stock) of another company.
Debt Securities: Investments in bonds or notes payable, representing a creditor relationship.

Step-by-Step Guidance

Recall that equity securities represent ownership, while debt securities represent a loan or credit relationship.
Think about examples of each: stocks for equity, bonds/notes for debt.
Consider how each type of security is reported and valued on the financial statements.

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Q4. Describe the level of influence based on percentage ownership of voting stock.

Background

Topic: Levels of Influence in Investments

This question is about how the percentage of ownership in another company’s voting stock determines the level of influence.

Key Terms:

Insignificant Influence: Less than 20% ownership.
Significant Influence: More than 20% but less than 50% ownership.
Controlling Influence: More than 50% ownership.

Step-by-Step Guidance

Recall the thresholds for each level of influence (insignificant, significant, controlling).
Think about how these levels affect accounting methods (e.g., fair value, equity method, consolidation).
Match each percentage range to the correct level of influence.

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Q5. What method does U.S. GAAP require for equity securities with insignificant influence?

Background

Topic: Accounting for Equity Securities

This question tests your knowledge of the accounting method required for equity investments where the investor has insignificant influence.

Key Terms:

Fair Value Method: Accounting method where investments are reported at their current market value.
Insignificant Influence: Typically less than 20% ownership.

Step-by-Step Guidance

Recall the ownership threshold for insignificant influence.
Think about the accounting method used for such investments under U.S. GAAP.
Identify the method that requires reporting investments at fair market value.

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Q6. What are unrealized gains?

Background

Topic: Gains and Losses on Investments

This question is about understanding the concept of unrealized gains in investment accounting.

Key Terms:

Unrealized Gain: An increase in the value of an investment that has not yet been sold.
Fair Market Value: The price at which an asset would sell in an orderly transaction between market participants.

Step-by-Step Guidance

Consider what happens when the market value of an investment increases but the investment is not sold.
Think about the difference between realized and unrealized gains.
Define unrealized gains in your own words based on these concepts.

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Q7. What are unrealized losses?

Background

Topic: Gains and Losses on Investments

This question is about understanding the concept of unrealized losses in investment accounting.

Key Terms:

Unrealized Loss: A decrease in the value of an investment that has not yet been sold.
Fair Market Value: The current price of the investment in the market.

Step-by-Step Guidance

Consider what happens when the market value of an investment decreases but the investment is not sold.
Think about the difference between realized and unrealized losses.
Define unrealized losses in your own words based on these concepts.

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Q8. How are investments in equity securities reported on the balance sheet, regardless of unrealized gains or losses?

Background

Topic: Reporting Investments

This question tests your understanding of how investments are reported on the balance sheet under U.S. GAAP.

Key Terms:

Fair Value: The amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.
Balance Sheet: A financial statement that reports a company's assets, liabilities, and equity at a specific point in time.

Step-by-Step Guidance

Recall the requirement for reporting equity securities under the fair value method.
Think about whether unrealized gains or losses affect the reporting basis.
State the reporting requirement for these investments on the balance sheet.

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Q9. How are realized and unrealized gains and losses on investments in equity securities reported on the income statement?

Background

Topic: Income Statement Reporting

This question is about the presentation of gains and losses from investments on the income statement.

Key Terms:

Realized Gain/Loss: The profit or loss from selling an investment.
Unrealized Gain/Loss: The change in value of an investment that has not been sold.
Other Income: A section of the income statement where non-operating gains and losses are reported.

Step-by-Step Guidance

Recall the difference between realized and unrealized gains/losses.
Think about where non-operating items are reported on the income statement.
Identify the section where these gains and losses are typically reported.

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Q10. True or False: An investor owning between 20% and 50% of the investee’s voting stock will more than likely hold one or more seats on the board of directors of the investee company.

Background

Topic: Significant Influence

This question tests your understanding of the implications of significant ownership in another company.

Key Terms:

Significant Influence: The power to participate in the financial and operating policy decisions of the investee.
Board of Directors: A group of individuals elected to represent shareholders and oversee the activities of a company.

Step-by-Step Guidance

Recall the ownership percentage that typically confers significant influence.
Think about the rights and privileges that come with significant influence, such as board representation.
Decide whether the statement is generally true or false based on these concepts.

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Q11. With the equity method, how are profits and losses of the investee recorded on the investor’s financial statements?

Background

Topic: Equity Method Accounting

This question is about how the equity method affects the investor’s financial statements.

Key Terms:

Equity Method: An accounting method where the investor recognizes its share of the investee’s profits and losses.
Investor’s Income: The portion of the investee’s net income attributable to the investor.

Step-by-Step Guidance

Recall how the equity method works for investments with significant influence.
Think about where the investor’s share of the investee’s profits and losses is reported.
Describe how these amounts affect the investor’s income statement and balance sheet.

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Q12. Show the journal entry for Company A’s purchase of 40% of Company B for $400 million using the equity method.

Background

Topic: Journal Entries for Investments

This question tests your ability to record the initial investment in another company using the equity method.

Key Terms:

Equity-method Investment: The account used to record the investment under the equity method.
Journal Entry: The accounting record of a transaction.

Step-by-Step Guidance

Identify the accounts affected: the investment account and cash.
Determine the amounts to debit and credit based on the purchase price.
Set up the journal entry, debiting the investment and crediting cash.

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Q13. In a controlling interest, what are the investor and investee companies called?

Background

Topic: Consolidation and Control

This question is about the terminology used when one company controls another.

Key Terms:

Parent Company: The company that controls another company.
Subsidiary: The company that is controlled by another company.

Step-by-Step Guidance

Recall the definitions of parent and subsidiary companies.
Think about the ownership structure that leads to these designations.
Match the correct term to the investor and investee.

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Q14. What is consolidation accounting?

Background

Topic: Consolidated Financial Statements

This question tests your understanding of the process of combining financial statements for companies under common control.

Key Terms:

Consolidation Accounting: The process of combining the financial statements of a parent and its subsidiaries.
Financial Statements: Reports that summarize the financial position and performance of a company.

Step-by-Step Guidance

Recall why consolidation is necessary when one company controls another.
Think about what is combined in the consolidation process.
Define consolidation accounting in your own words.

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Q15. What four statements are combined in consolidated financial statements?

Background

Topic: Consolidated Financial Statements

This question is about identifying the main financial statements included in a consolidated set.

Key Terms:

Balance Sheet
Income Statement
Statement of Stockholders’ Equity
Cash Flow Statement

Step-by-Step Guidance

Recall the four primary financial statements prepared by companies.
Think about which statements would be combined for a parent and its subsidiaries.
List the four statements included in consolidated financial statements.

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Q16. In consolidated statements, whose accounts are the assets, liabilities, revenues, and expenses of each subsidiary added to?

Background

Topic: Consolidation Process

This question tests your understanding of how the consolidation process works in practice.

Key Terms:

Parent Company Accounts: The accounts of the controlling company.
Subsidiary Accounts: The accounts of the controlled company.

Step-by-Step Guidance

Recall the purpose of consolidated financial statements.
Think about which company’s accounts serve as the base for consolidation.
Identify whose accounts the subsidiary’s balances are added to.

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Q17. What kind of businesses are the major investors in debt securities such as bonds?

Background

Topic: Debt Securities Investors

This question is about identifying the types of businesses that commonly invest in debt securities.

Key Terms:

Debt Securities: Investments in bonds or notes payable.
Financial Institutions: Organizations such as banks, pension funds, mutual funds, and insurance companies.

Step-by-Step Guidance

Recall which types of organizations typically have large amounts of capital to invest.
Think about the role of financial institutions in the bond market.
List examples of major investors in debt securities.

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Q18. What are the three categories that investment in debt securities can be placed in?

Background

Topic: Classification of Debt Securities

This question tests your knowledge of the categories used to classify debt securities for accounting purposes.

Key Terms:

Trading Securities: Bought and held primarily for sale in the near term.
Available-for-Sale Securities: Not classified as trading or held-to-maturity.
Held-to-Maturity Securities: Debt securities the company intends and is able to hold until maturity.

Step-by-Step Guidance

Recall the three main categories for debt securities under U.S. GAAP.
Think about the intent behind each category (trading, available-for-sale, held-to-maturity).
List the three categories and their main characteristics.

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Q19. How long does an investor company intend to hold debt securities categorized as available-for-sale?

Background

Topic: Available-for-Sale Securities

This question is about the holding period for available-for-sale debt securities.

Key Terms:

Available-for-Sale: Debt securities not classified as trading or held-to-maturity.
Holding Period: The length of time an investment is intended to be held.

Step-by-Step Guidance

Recall the definition of available-for-sale securities.
Think about the difference between short-term (trading), long-term (held-to-maturity), and intermediate holding periods.
Describe the intended holding period for available-for-sale securities.

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Q20. How are held-to-maturity debt securities reported?

Background

Topic: Held-to-Maturity Securities

This question is about the accounting method used for held-to-maturity debt securities.

Key Terms:

Amortized Cost: The initial cost of the investment adjusted for the amortization of any premium or discount.
Held-to-Maturity: Debt securities the company intends and is able to hold until maturity.

Step-by-Step Guidance

Recall the definition of held-to-maturity securities.
Think about how these securities are valued on the balance sheet.
Identify the method used to report these securities.

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Q21. True or False: Bonds of publicly traded companies are not traded on the open market as stocks are.

Background

Topic: Bond Market Trading

This question tests your understanding of the liquidity and trading of bonds compared to stocks.

Key Terms:

Bonds: Debt securities issued by companies or governments.
Open Market: A public financial market where securities are bought and sold.

Step-by-Step Guidance

Recall whether bonds are traded on public exchanges or over-the-counter markets.
Think about the similarities and differences between bond and stock trading.
Decide if the statement is true or false based on your understanding.

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Q22. How do market prices of bonds fluctuate with market interest rates?

Background

Topic: Bond Pricing and Interest Rates

This question is about the relationship between bond prices and market interest rates.

Key Terms:

Bond Price: The current market value of a bond.
Market Interest Rate: The prevailing rate of interest in the market for similar securities.
Inverse Relationship: When one variable increases, the other decreases.

Step-by-Step Guidance

Recall the basic principle that bond prices and market interest rates move in opposite directions.
Think about why this relationship exists (e.g., opportunity cost, fixed coupon payments).
Describe the nature of the relationship between bond prices and interest rates.