Ch 17 Investments

Question 1

amortized cost

Answer 1

The acquisition cost of debt securities adjusted for the amortization of discount or premium, if appropriate. Amortized cost is the valuation amount companies use to account for held-to-maturity debt securities. (p. 953).

Question 2

available-for-sale securities

Answer 2

Debt securities not classified as held-to-maturity or trading securities. Companies report available-for-sale securities at fair value, but do not report changes in fair value as part of net income until after they sell the security. Interest on available-for-sale securities is recorded when earned. Unrealized holding gains and losses on available-for-sale securities are recognized as other comprehensive income and as a separate component of stockholders? equity. (p. 952).

Question 3

consolidated financial statements

Answer 3

Financial statements that treat the parent and subsidiary corporations as a single economic entity. (p. 966).

Question 4

controlling interest

Answer 4

A relationship in which one corporation acquires a voting interest of more than 50 percent in another corporation. The investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a long-term investment on the separate financial statements of the parent. (p. 966).

Question 5

debt securities

Answer 5

Financial securities that represent a creditor relationship with another entity. Examples are U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. (p. 952).

Question 6

effective-interest method

Answer 6

The preferred procedure for computing the amortization of a discount or premium. Under this method, companies compute bond interest expense (revenue) at the beginning of the period (by the effective-interest rate) and then subtract bond interest paid (calculated as the face amount of the bonds times the stated interest rate); the result is the amortization amount. (p. 954).

Question 7

equity method

Answer 7

Method of accounting for investment holdings of 20 percent or more (investments in which the investor and the investee acknowledge a substantive economic relationship). The investor records the investment at cost but adjusts the amount each period for changes in the investee?s net assets. That is, the investor?s proportionate share of the earnings (losses) of the investee periodically increase (decrease) the investment?s carrying value. All dividends received by the investor from the investee decrease the investment?s carrying amount. (p. 965).

Question 8

equity securities

Answer 8

Financial securities that represent ownership interests such as common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants, rights, and call or put options. The cost of equity securities includes the purchase price of the security plus broker?s commissions and other fees incidental to the purchase. (p. 960).

Question 9

exchange for noncash consideration

Answer 9

Transaction in which the medium of exchange is an asset other than cash (e.g., property or services). Companies record equity securities acquired in exchange for noncash consideration at the fair value of the consideration given or the fair value of the security received, whichever is more clearly determinable. (p. 962)(n).

Question 10

fair value

Answer 10

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (p. 953).

Question 11

Fair Value Adjustment

Answer 11

A valuation account that when added to the amortized cost of the investment yields fair value; use of this account enables a company to maintain a record of its amortized cost of available-for-sale and trading securities. (p. 957).

Question 12

fair value method (investments)

Answer 12

Method of accounting for investment holdings of less than 20 percent (investments in which the investor has little or no influence over the investee), assuming that market prices are available subsequent to acquisition. The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities. (p. 961).

Question 13

gains trading

Answer 13

Method of managing net income by selling investment ?winners? in order to report the gains in income, and holding on to the losers. Also referred to as ?cherry picking,? ?snacking,? or ?sell the best and keep the rest.? (p. 959).

Question 14

held-to-maturity securities

Answer 14

Debt securities that the company has the positive intent and ability to hold to maturity. Companies report held-to-maturity securities at amortized cost, recognize interest when earned, and do not recognize unrealized holding gains or losses. (p. 952).

Question 15

holding gain or loss

Answer 15

The net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. (p. 959).

Question 16

impairment (investments)

Answer 16

A loss in value that is other than temporary. Companies should evaluate every investment, at each reporting date, to determine if it has suffered impairment. If a decline in an investment is judged to be other than temporary, a company writes down the cost basis of the individual security to a new cost basis. The company accounts for the write-down as a realized loss and includes the amount in net income. (p. 969).

Question 17

investee

Answer 17

A corporation whose common stock is bought by another corporation (investor) for investment purposes. (p. 961).

Question 18

investor

Answer 18

A corporation that acquires an interest in the common stock of another corporation (investee) for investment purposes. The percentage of the investee voting stock that is held by the investor, which determines the amount of influence the investor has over the investee, generally determines the accounting treatment for the investment. (p. 961).

Question 19

parent

Answer 19

A corporation that has a controlling interest (voting interest of more than 50 percent) in another corporation (the subsidiary) Companies present the investment in the subsidiary as a long-term investment on the financial statements of the parent. (p. 966).

Question 20

reclassification adjustment

Answer 20

Adjustment made when at the end of a period in which a company sold securities, to ensure that gains and losses are not counted twice in comprehensive income. Without such an adjustment, a company might report realized gains or losses as part of net income but also show the gains or losses as part of other comprehensive income in the current or previous periods. Companies generally report reclassification adjustments in the notes to the financial statements. (p. 970).

Question 21

security

Answer 21

A share or other interest in an enterprise or obligation of the issuer that is (1) represented by an instrument issued in bearer or registered form or registered in books maintained by the issuer; (2) is of a type commonly traded on securities exchanges or markets or commonly recognized as a medium for investment; and (3) is one of a class or series of shares, participations, interests, or obligations. (p. 952)(n).

Question 22

significant influence

Answer 22

The ability of an investor corporation to affect the operating and financial policies of an investee corporation, without possessing legal control of the investee. Examples include representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. (p. 964).

Question 23

subsidiary

Answer 23

A corporation in which another corporation (parent) has a controlling interest (voting interest of more than 50 percent). The investment in the subsidiary is presented as a long-term investment on the financial statements of the parent. (p. 966).

Question 24

trading securities

Answer 24

Debt or equity securities bought and held primarily for sale in the near term to generate income on short-term price differences. Companies report trading securities at fair value at each reporting date, with unrealized holding gains and losses recognized as net income. Interest is recorded when earned. (p. 952).

Question 25

anticipated transaction

Answer 25

A type of transaction is which a company accumulates in equity gains or losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby affecting earnings. (p. 988).

Question 26

arbitrageurs

Answer 26

Investors who use derivatives to lock in profits by simultaneously entering into transactions in two or more markets.(p. 979).

Question 27

bifurcation

Answer 27

The separation process required to account for an embedded derivative in another security (e.g., a convertible bond). (p. 989).

Question 28

call option

Answer 28

Gives the holder the right, but not the obligation, to buy shares at a preset price. (p. 980).

Question 29

cash flow hedge

Answer 29

Used by companies to hedge exposures to cash flow risk, which results from the variability in cash flows. Companies account for derivatives used in cash flow hedges at fair value on the balance sheet, but they record gains or losses in equity, as part of other comprehensive income. (p. 987).

Question 30

counterparty

Answer 30

Generally, an investment banker or other company that holds inventories of financial instruments. (p. 981)(n).

Question 31

derivative financial instrument, derivative

Answer 31

A financial instrument that derives its value from the values of other assets or other market-determined indicator. (p. 977).

Question 32

designation

Answer 32

At inception of a hedge, the identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash flows attributable to the hedged risk. (p. 989).

Question 33

documentation

Answer 33

At inception of a hedge, written proof of the hedging relationship. (p. 989).

Question 34

embedded derivative

Answer 34

The option, in a convertible bond, to convert the bond to shares of common stock. (p. 989).

Question 35

fair value hedge

Answer 35

The use of a derivative to offset the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment. (p. 984).

Question 36

forward contract

Answer 36

A type of derivative that gives the holder the right and the obligation to purchase an asset at a preset price at a specific time in the future. (p. 977).

Question 37

futures contract

Answer 37

Gives the holder the right and the obligation to purchase an asset at a preset price for a specified period of time. (p. 987).

Question 38

hedging

Answer 38

The use of derivatives to offset the negative impacts of changes in interest rates, cash flows, or foreign currency exchange rates. (p. 984).

Question 39

highly effective

Answer 39

The degree to which a hedge should offset changes in fair values or cash flows, in order to receive hedge accounting treatment. (p. 990).

Question 40

host security

Answer 40

The basic element of a security that when combined with a derivative creates a hybrid security. For example, a debt security is the host security of a convertible bond. (p. 989).

Question 41

hybrid security

Answer 41

A security that has both the characteristics of debt and equity, such as a convertible bond. (p. 989).

Question 42

interest rate swap

Answer 42

The most common type of swap, in which one party makes payments based on a fixed or floating rate, and the second party does just the opposite. (p. 992).

Question 43

intrinsic value

Answer 43

The difference between the market price and the preset strike price of an option at the grant date. (p. 981).

Question 44

net settlement

Answer 44

A feature of option contracts that allows holders to avoid having to actually buy and sell shares to settle the option and realize the gain. (p. 982)(n).

Question 45

notional amount

Answer 45

The amount of shares available for purchase that is specified in a call option. (p. 981).

Question 46

option contract

Answer 46

A derivative that gives the right but not the obligation to purchase or sell an underlying (p. 978).

Question 47

option premium

Answer 47

The amount paid for shares exercised in a call option. (p. 981).

Question 48

put option

Answer 48

A type of option contract that gives the holder the option (but not the obligation) to sell shares at a preset price. (p. 980)(n).

Question 49

risk management

Answer 49

The company?s objective for entering into a hedge. (p. 989).

Question 50

speculators

Answer 50

Investors in forward contracts, who bet that the price of an asset will rise, thereby increasing the value of the forward contract. (p. 979).

Question 51

spot price

Answer 51

The price to be paid today for assets to be delivered at a future date. (p. 987).

Question 52

strike (exercise) price

Answer 52

The price of shares specified in a call option. (p. 980).

Question 53

swap

Answer 53

A transaction between two parties in which the first party promises to make a payment to the second party. The second party, in turn, promises to make a simultaneous payment to the first party. (p. 991).

Question 54

time value

Answer 54

The option?s value over and above its intrinsic value, reflecting the possibility that the option has a fair value greater than zero. (p. 981).

Question 55

underlying

Answer 55

A specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. (p. 983).

Question 56

risk-and-reward model

Answer 56

A consolidation model in which if a company is involved substantially in the economics of another company, consolidation occurs. (p. 997).

Question 57

special-purpose entity (SPE)

Answer 57

A legal entity created to perform a special activity (issue securities, complete a project, perform R&D activities). The company that creates the SPE guarantees that it or some outside party will eventually perform the activity. Use of the SPE may enable the company that created it to avoid reporting any assets or liabilities related to the activities on its balance sheet. (p. 996).

Question 58

variable-interest entity (VIE)

Answer 58

In the risk-and-reward model, an entity that has one of the following characteristics: (1) insufficient equity investment at risk, (2) stockholders lack decision-making rights, or (3) stockholders do not absorb the losses or receive the normal benefits of a normal stockholder. (p. 997).

Question 59

voting-interest model

Answer 59

A consolidation model in which a company that owns more than 50 percent of another company, consolidation usually occurs. (p. 997).