Ch. 5 Long Term Investments

Question 1

What are the three levels of ownership for accounting purposes, what is the corresponding % ownership, and which type of accounting method is used to record that ownership?

All three initial stock purchases are recorded at ____?

Answer 1

Passive, significant influence, control

Passive:

Less than 20%. Fair Value Method or (rarely) cost method

Significant Influence

20% to 50%. Equity method

Control

Greater than 50%. The investors consolidates its financial results with the investee’s financial results

Initial stock purchases are recorded at acquistion cost, which includes brokers fees.

Question 2

Using the fair value method, securities must be classified as which two types? Explain each of the two types.

What happens at every reporting period for reporting using the fair-value method for the two types of securities?

Answer 2

Trading or Available for sale.

Trading securities are securities that can be bought and sold relatively quickly. Available for sale securities are securities that aren’t trading securities.

Both types of securities are revalued according to its new value, EVEN IF that results in a gain.

Question 3

Gains and losses for trading securities flow to which statement?

Available-for-sale securities’ gains and losses flow to which statement?

Example:

An investor purchases stock for $100. At the next few reporting periods, the following values result- $110, $90, $150. The investor cashes out at $150. Show the journal entries if classified as a Trading Security.

Answer 3

1. Income statement
2. Balance sheet in AOCI

Example:

($100) Cash

$100 Investment

Then

$10 Investment

$10 Gain (unrealized) (owner’s equity)

Then

($20) investment

($20) Loss (unrealized) (owner’s equity)

Then

$60 investment

$60 gain (unrealized) (owner’s equity)

$150 cash

($150) investment

Question 4

Example:

An investor purchases stock for $100. At the next few reporting periods, the following values result- $110, $90, $150. The investor cashes out at $150. Show the journal entries if classified as an Available-for-sale Security.

Answer 4

($100) Cash

$100 investment

Then

$10 investment

$10 AOCI

Then

($20) investment

($20) AOCI

Then

$60 investment

$60 AOCI

Then

$150 cash

($150) investment

($50) AOCI

$50 gain

It is when the investment is sold that the gain is recognized in the income statement and removed from the balance sheet (AOCI).

Question 5

What should I generally understand about AOCI?

Answer 5

It holds the unrealized gains and losses to the firm’s economic position.

Question 6

How are adjustments using the equity method derived?

Example:

Assume an investor buys 25% of an investee for $100. After 1 year, the investee reports $20 of NI. Make the journal entries.

How does this method differ from the fair-value method?

What determines whether equity method investments are a part of operating or non-operating income?

Answer 6

1. Identify what % of ownership occurs
2. Multiply that % of ownership to the NI and adjust based on that

Example:

($100) cash

$100 investment

Then

$5 investment

$5 investment income

This is different from the fair value method because the investment is not marked to market, but rather the investment account is adjusted based on the investee’s NI. Also, the resulting increase flows to investment income, rather than a gain or AOCI.

Also, the investment income can be a part of the investor’s operating income if the investor and investee are in the same business. If they are different business types, then it would go to non-operating income

Question 7

How is Control ownership recognized?

Example: Make the entry

Assume an investor buys a controlling stake in a firm for $80 cash.

Investee’s Assets/Liabilities

Cash 30

Inventory 20

Fixed Assets 50

Liabilities 50

Answer 7

The investor consolidates ONLY the assets and liabilities of the investee into its own, since anything greater than 50% represents control. It is important to remember to adjust for goodwill based on the acquisition value of the investee.

Example:

($80) cash

$80 investment

($80) Investment

30 Cash

20 Inventory

50 Fixed Assets

30 Goodwill

50 Liabilties

Question 8

What are identifiable intangible assets, and what are amortizable intangible assets?

Answer 8

Identifiable intangible assets have specific, known rights such as patents, copyrights, and logos.

Amortizable intangible assets have a definite life span.

Question 9

Is Goodwill amortized? If not, then how is it adjusted?

What method is used to amortize intangible assets?

Answer 9

No, but it is tested for impairment.

Straight line amortization.

Question 10

How is the acquisition of fixed assets and the resulting freight, and trials runs accounted for?

Example:

Assume a company buys a machine with debt. The PV of the cash payments is $10,000. The firm will pay $11,000 to the bank in one year. Make the entry.

Answer 10

They are capitalized.

Example:

$10,000 machine

$10,000 note payable

Then

($11,000) cash

($10,000) NP

($1000) interest expense

Question 11

When is interest expense capitalized in regard to fixed assets?

What is the formula for Total Interest?

What is the formula for interest to capitalize?

Example:

A company spends $1,500,000 to build a facility. It has $5,000,000 in debt. The interest rate on the debt is 10%. Make the entry to capitalize interest expense.

Answer 11

Interest is capitalized when firms construct assets for its own use.

Total Interest=principal x rate x time

Capitalized interest= expenditure x rate x time

Example:

Total interest = $5,000,000 x 10% x 1 = $500,000

Capitalized Interest = $1,500,000 x 10% x 1 = $150,000

Interest expense = $350,000

Journal Entries

$150,000 Building (CIP)

$500,000 interest payable

($350,000 interest expense)

Question 12

What are the two types of R&M, and how are they treated differently?

Example: A firm spends $1000 to conduct R&M. Show the two scenarios of ordinary R&M vs extraordinary R&M

Answer 12

Ordinary and extraordinary.

Ordinary repairs are expensed, whereas extraordinary repairs are capitalized.

Example

Ordinary

($1000) Cash

($1000) R&M expense

Extraordinary

($1000) cash

1000 equipment

Question 13

Is land depreciated?

What is book value of PP&E?

Answer 13

No, land is NOT depreciated.

Book value = Acquisition cost - Accumulated Depreciation

Question 14

What are the two main methods of depreciation?

What is salvage value?

What is the depreciable value?

Answer 14

Straightline and double declining balance.

Salvage value is the value at which a company plans to sell a piece of equipment at the end of it’s useful life.

Depreciable value = Acquisition cost - salvage value.

Question 15

Example:

A company buys a piece of equipment for $1,200. The salvage value is $300. The useful life is 3 years. What are the entries to record the purchase and the depreciation in the first year?

Answer 15

($1,200) cash

$1,200 equipment

Then

($300) AD

($300) Depreciation expense

Question 16

Why would a company want to utilize double declining balance as a method for depreciation?

Explain double declining balance concept.

Answer 16

Companies recognize that little R&M will be spent in the early years of the asset, but it will have greater R&M as the asset gets older. Thus, depreciation expense will be greater in the beginning, offset by low R&M. Conversely, in the latter years high R&M will be offset by low depreciation expense.

A factor of 2 is applied to the straightline rate. For example, if the useful life is three years, then 1 year of depreciation via straightline will be 1/3. However, for a double declining balance method, it would be 2/3. That 2/3 would be used for future years’ calculations.

Question 17

Explain the process of capitalizing depreciation for an asset to inventory.

How would you reconcile depreciation between the IS and Cash Flow?

Answer 17

If a piece of equipment or building is used for production, the depreciation for that will be capitalized to inventory and then expensed via COGS.

I would add the depreication in the IS and compare it with the cash flow statement as well as look in note disclosures, etc. I have to recognize that depreciation is hidden in COGS and sometimes SG&A. Therefore, IS depreciation will not always tie to cash flow depreciation.

Question 18

What do restructurings typically refer to?

Example:

Assume a headcount reduction is about to occur and the expect cost of severance packages is $1,000,000. Make the entries.

Answer 18

Restructurings typically refer to severance packages for headcount reductions.

Example:

$1,000,000 restructuring liability

($1,000,000) restructuring expense

Then

($1,000,000) cash

($1,000,000) restructuring liability

Question 19

What are impairments?

Example:

A company buys a piece of machinery for $36,000. It used straightline depreciation over two years with no residual/salvage value. After year 1, due to changes in the economy, the asset needs to be written down to $14,000. Currently, the book value is $18,000, which is the historical cost minus 1 year of depreciation. Make the entry.

Answer 19

Impairments occur when the future benefits of the asset are not expected to occur. thus, they must be written down. This also applies to Goodwill.

Example:

($4,000) machine

($4,000) impairment loss

Question 20

Example:

A firm purchased machinery for $50,000. The asset had a $5,000 residual value over a 5 year estimated life. The firm uses the double declining balance method. After 2 years, the company sells the machine for $25,000. (Current book value is $18,000). Make the entry to record the disposition.

Answer 20

($50,000) machine

$32,000 AD

$25,000 cash

$7,000 gain (owner’s equity)

Question 21

What is the formula to derive gains/losses on sale of equipment?

Answer 21

Sale price - book value

book value = historical cost - accumulated depreciation