Lecture 7 - Investments

Question 1

What is an investment?

Answer 1

• Is an asset to the investor

Question 2

Mention 3 reasons that companies invest

Answer 2

1) If they have excess cash they will not need immediately - in hope to earn some additional income - quick return

2) Longer strategic investments such as obtaining the ability to influence or control another company

3) Move up or down the value chain (supplier, distributer) to obtain a steady stream of raw materials and secure a distribution channel

Question 3

Mention the 3 types of Equity Investments and their characteristics

Answer 3

1) Financial Assets
-Typically short-term
-Less than 20% ownership = passive investment
-Investor has no role in operations

2) Investments in Associates/Affiliates
- Ownership between 20- 50 %
-Typically long-term
- Investor can significantly influence operations, decisions and policies long-term
-Investors are called associates or equity affiliates

3) Investment in Subsidiaries
-Ownership more than 50%
-Long-term
-A great deal of influence + control long-term
-Called Subsidiary and Parent Company

Question 4

Explain Trading Securities and what their purpose is (5)

Answer 4

-A common term for short-term investments in marketable securities - such as shares

• Measured by default at fair value through profit or loss

-Hold them for a short term <12 months, sell them and earn a profit

-Collect dividends

-Next most liquid asset after cash

Question 5

Mention the 3 levels of fair value hierarchy:

Answer 5

Level 1: Quoted prices in an active market for identical assets
Level 2: Estimates based on other observable inputs
Level 3: Estimates based on unobservable estimates

Question 6

How and when do you record unrealized gains or losses (trading securities)

Answer 6

-At the reporting date they are reported on the balance sheet at their current fair market value

Unrealized gain = when the new value is greater than the initial recorded value - has same effect as revenue = will increase equity.
-Debit investment for the gained amount
-Credit ‘Unrealized gain on investment’ (shareholders’ equity account

-On the income statement it is recorded as ‘other revenue, gains and losses’ - will contribute to net income

Question 7

Explained what Realized Gains and Losses are and how they are reported

Answer 7

Realized gain = sales price higher than the carrying amount

Realized loss = the opposite
-Debit cash for the sales price
-Debit ‘loss on sale of investment’ for remaining amount
-Credit Investment for full amount
-Write: Investment sold at loss

Question 8

Explain the Equity Method:

-When is it used
-What is done

Answer 8

1) In case of significant influence: 20-50% ownership - an associate/affiliate

2) Investment is initially recognized at cost and hereafter adjusted for the post-acquisition change in the investors share of net assets of the investee.

Question 9

Equity Method Recordings:

Tell which accounts to debit and credit and for how much in the following cases:

1) Record initial investment
2) Record income/loss
3) Record dividends from associates
4) Sell equity investment in associate

Answer 9

1)
D: Equity investment in associate - price
C: Cash - price
To purchase equity-method investment

2) Income
D: Equity investment in Associate
(net income x percentage of ownership)
C: Income from associate
To record investment revenue

3)
D: Cash (total dividends x percentage of ownership)
C: Equity investment in associate
To receive cash dividends on equity-method investment

4) With loss
D: Cash - sales price
D: Loss on sale of investment (difference between carrying amount and sales price)
C: Equity investment in Associates
Sold investment in affiliate

Question 10

Explain the Consolidation Method and when it is used (5)

Answer 10

-A method of combining financial statements of all companies

-Assets, liabilities, revenues and expenses are added to the parent’s account

-Intercompany transactions are eliminated in the consolidated statements

-The elimination adjustment is made to off-set the intercompany transaction such that values are not double-counted at the consolidated level

-Used in case of controlling influence - >50% ownership

Question 11

Which 5 elements does the Consolidated Financial Statements consist of?

What is from the parent and what is from the subsidiary?

Answer 11

1) Parent’s assets
2) Subsidiary’s assets
3) Parent’s liabilities
4) Subsidiary’s liabilities
5) Parent’s equity