17 Investments CONCEPTS FOR ANALYSIS 17
CONCEPTS FOR ANALYSIS
CA17-1 (Issues Raised about Investment Securities) You have just started work for Warren Co. as part of the controller’s group involved in current financial reporting problems. Jane Henshaw, controller for Warren, is interested in your accounting background because the company has experienced a series of financial reporting surprises over the last few years. Recently, the controller has learned from the company’s auditors that there is authoritative literature that may apply to its investment in securities. She assumes that you are familiar with this pronouncement and asks how the following situations should be reported in the financial statements.
Situation 1: Trading debt securities in the current assets section have a fair value that is $4,200 lower than cost.
Situation 2: A trading debt security whose fair value is currently less than cost is transferred to the available-for-sale category.
Situation 3: An available-for-sale debt security whose fair value is currently less than cost is classified as noncurrent but is to be reclassified as current.
Situation 4: The company’s portfolio of held-to-maturity debt securities consists of the bonds of one company. At the end of the prior year, the fair value of the security was 50% of original cost, and this reduction in fair value was reported as an impairment.
However, at the end of the current year, the fair value of the security had appreciated to twice the original cost.
Situation 5: The company has purchased some equity securities that it plans to hold for less than a year. The fair value of the securities is $7,700 below its cost.
Instructions
What is the effect upon carrying value and earnings for each of the situations above? Assume that these situations are unrelated.
CA17-2 (Equity Securities) Lexington Co. has the following securities outstanding on December 31, 2017 (its first year of operations).
Cost Fair Value
Greenspan Corp. stock $20,000 $19,000
Summerset Company stock 9,500 8,800
Tinkers Company stock 20,000 20,600 $49,500 $48,400
During 2018, Summerset Company stock was sold for $9,200, the difference between the $9,200 and the “fair value” of $8,800 being recorded as a “Gain on Sale of Investments.” The market price of the stock on December 31, 2018, was Greenspan Corp. stock $19,900; Tinkers Company stock $20,500.
Instructions
(a) What justification is there for valuing equity securities at fair value and reporting the unrealized gain or loss as part of net income?
(b) How should Lexington Co. report this information in its financial statements at December 31, 2017? Explain.
(c) Did Lexington Co. properly account for the sale of the Summerset Company stock? Explain.
(d) Are there any additional entries necessary for Lexington Co. at December 31, 2018, to reflect the facts on the financial statements in accordance with generally accepted accounting principles? Explain.
(AICPA adapted)
CA17-3 (Financial Statement Effect of Securities) Presented below are three unrelated situations involving equity securities.
Situation 1: A debt security, whose fair value is currently less than cost, is classified as available-for-sale but is to be reclassified as trading.
Situation 2: A noncurrent held-to-maturity portfolio with an aggregate fair value in excess of cost includes one particular debt security whose fair value has declined to less than one-half of the original cost. The decline in value is considered to be permanent.
Situation 3: The portfolio of trading debt securities has a cost in excess of fair value of $13,500. The available-for-sale debt portfolio has a fair value in excess of cost of $28,600.
Instructions
What is the effect upon carrying value and earnings for each of the situations above?
CA17-4 (Investment Accounted for under the Equity Method) On July 1, 2018, Fontaine Company purchased for cash 40% of the outstanding common stock of Knoblett Company. Both Fontaine Company and Knoblett Company have a December 31 yearend.
Knoblett Company, whose common stock is actively traded in the over-the-counter market, reported its total net income for the year to Fontaine Company and also paid cash dividends on November 15, 2018, to Fontaine Company and its other stockholders.
Instructions
How should Fontaine Company report the above facts in its December 31, 2018, balance sheet and its income statement for the year then ended? Discuss the rationale for your answer.
(AICPA adapted)
CA17-5 WRITING (Equity Investment) On July 1, 2017, Selig Company purchased for cash 30% of the outstanding common stock of Spoor Corporation. Both Selig and Spoor have a December 31 year-end. Spoor Corporation, whose common stock is actively traded on the NASDAQ exchange, paid a cash dividend on November 15, 2017, to Selig Company and its other stockholders.
It also reported its total net income for the year of $920,000 to Selig Company.
Instructions
Prepare a one-page memorandum of instructions on how Selig Company should report the above facts in its December 31, 2017, balance sheet and its 2017 income statement. In your memo, identify and describe the method of valuation you recommend. Provide rationale where you can. Address your memo to the chief accountant at Selig Company.
CA17-6 ETHICS (Fair Value) Addison Manufacturing holds a large portfolio of debt securities as an investment. The fair value of the portfolio is greater than its original cost, even though some debt securities have decreased in value. Sam Beresford, the financial vice president, and Angie Nielson, the controller, are near year-end in the process of classifying for the first time this securities portfolio in accordance with GAAP. Beresford wants to classify those securities that have increased in value during the period as trading securities in order to increase net income this year. He wants to classify all the securities that have decreased in value as held-to-maturity.
Nielson disagrees. She wants to classify those debt securities that have decreased in value as trading securities and those that have increased in value as held-to-maturity. She contends that the company is having a good earnings year and that recognizing the losses will help to smooth the income this year. As a result, the company will have built-in gains for future periods when the company may not be as profitable.
Instructions
Answer the following questions.
(a) Will classifying the portfolio as each proposes actually have the effect on earnings that each says it will?
(b) Is there anything unethical in what each of them proposes? Who are the stakeholders affected by their proposals?
(c) Assume that Beresford and Nielson properly classify the entire portfolio into trading, available-for-sale, and held-tomaturity categories. But then each proposes to sell just before year-end the securities with gains or with losses, as the case may be, to accomplish their effect on earnings. Is this unethical?
