CONCEPTUAL
Debt securities reflect a creditor
relationship and include investments in notes, bonds, and
certificates of deposit. Equity securities reflect an owner
relationship and include shares of stock issued by other companies.
Short-term investments in securities are current assets that meet two
criteria: (1) They are expected to be converted into cash within one
year or the current operating cycle of the business,
whichever is longer, and (2) they are readily convertible to cash,
or marketable. All other investments in securities are long term.
Long-term investments also include assets not used in operations and
those held for special purposes, such as land for expansion.
Investments in securities are classified into one of five groups: (1) trading
securities, which are always short-term; (2) debt securities
held-to-maturity; (3) debt and equity securities available-for-sale;
(4) equity securities in which an investor has a significant
influence over the investee; and (5) equity securities in which an
investor has a controlling influence over the investee.
If an investor owns more
than 50% of another company’s voting stock and controls
the investee, the investor’s financial reports are prepared on a
consolidated basis. These reports are prepared as if the company
were organized as one entity.
A foreign exchange rate is the
price of one currency stated in terms of another. An entity with
transactions in a foreign currency when the exchange rate changes between the
transaction dates and their settlement will experience exchange
gains or losses. When a company makes a credit sale to a
foreign customer and sales terms call for payment in a foreign
currency, the company must translate the foreign currency
into dollars to record the receivable. If the exchange rate changes
before payment is received, exchange gains or losses are recognized in
the year they occur. The same treatment is used when a company
makes a credit purchase from a foreign supplier and is required to
make payment in a foreign currency.
ANALYTICAL
Return on total assets has two components: profit margin
and total asset turnover. A decline in one component must be met with an
increase in another if return on assets is to be maintained. Component
analysis is helpful in assessing company performance compared to that
of competitors and its own past.
PROCEDURAL
Investments are initially recorded at cost, and
any dividend or interest from these investments is recorded in
the income statement. Investments classified as trading securities are reported at fair value. Unrealized
gains and losses on trading securities are reported in income. When investments
are sold, the difference between the net proceeds from the sale and the cost of the securities is recognized
as a gain or loss.
Debt securities held-to-maturity
are reported at cost when purchased. Interest revenue is recorded
as it accrues. The cost of long-term held-to-maturity securities
is adjusted for the amortization of any difference between cost
and maturity value.
Debt and equity securities
available-for-sale are recorded at cost when purchased.
Available-for-sale securities are reported at their fair values on the balance
sheet with unrealized gains or losses shown in the equity section. Gains and losses realized on the sale
of these investments are reported in the income statement.
The equity method is used
when an investor has a significant influence over an investee. This usually
exists when an investor owns 20% or more of the investee’s voting stock but not more
than 50%. The equity method means an investor records its share of investee
earnings with a debit to the investment account and a credit to a
revenue account. Dividends received reduce the investment account
balance.
Guidance Answers to Decision
Maker
Money Manager
If you have investments in fixed-rate bonds and notes when interest
rates fall, the value of your investments increases. This is so because the
bonds and notes you hold continue
to pay the same (high) rate while the market is demanding a new lower interest
rate. Your strategy is
to continue holding your
investments in bonds and notes, and, potentially, to increase these holdings through
additional purchases.
Retailer
Your store’s return on assets is 11%, which is similar to the industry norm of 11.2%.
However, disaggregation of return on
assets reveals that your store’s profit margin of 4.4% is much higher than the norm of 3.5%,
but your total asset turnover of 2.5 is much lower than the norm of 3.2.
These results suggest that, as compared
with competitors, you are less efficient in using assets. You need to focus on increasing
sales or reducing assets. You might
consider reducing
prices to increase sales, provided such a strategy does not reduce your return on
assets. For instance, you could
reduce your profit margin to 4% to increase sales. If total asset turnover increases to more
than 2.75 when profit margin is lowered
to 4%, your overall return on assets is improved.
Entrepreneur
You are now less likely to buy Canadian milk products because it takes more
U.S. money to buy a Canadian dollar
(and milk). For instance, the purchase of milk from a Canadian dairy with a $1,000
(Canadian dollars) price would have
cost the U.S. company $700 (U.S. dollars, computed as C$1,000 x US$0.70) before the rate
change, and $800 (US dollars, computed as C$1,000 x US$0.80) after the rate
change.
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