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Unformatted text preview: CHAPTER 12 DISCUSSION QUESTIONS 1. There are several reasons for a firm to make investments in assets not directly re- lated to the primary operations of its busi- ness (that is, investments in assets other than property, plant, equipment, and invent- ory). Companies usually make short-term in- vestments because of a temporary surplus of cash. They make long-term investments either because they believe that purchased investments provide a good return on money invested or because they want to gain influence or control over investee com- panies. 2. The risk and return trade-off of investments is that investors must usually decide wheth- er they want a potentially higher return with more risk or a lower return with less risk. Most investments fall somewhere along a risk-return continuum. Investments that provide high returns but have low risk are desirable, but rare. 3. The FASB has defined four different classi- fications for debt and equity securities: trad- ing securities, available-for-sale securities, held-to-maturity securities, and equity meth- od securities. 4. A security will be classified as trading if the investor is making the investment with the intent of selling the security should the need for cash arise, or to realize short-term profits should the price of the security increase. 5. A security will be classified as held-to-matur- ity if the investor intends to hold the security until it matures. This criterion means that only debt securities can be classified as held-to-maturity, as equity securities typic- ally do not mature. If a debt security is clas- sified as held-to-maturity, any premium or discount associated with the security must be amortized over the life of the debt secur- ity. 6. To be classified as an equity method secur- ity, an investor must typically own between 20 and 50% of the outstanding common stock of the investee. Ownership of between 20 and 50% generally indicates the ability of the investor to significantly influence the operations and decisions of the investee. 7. When an investor purchases debt and equity securities, two types of returns may be realized. The first type of return is the re- ceipt of interest (in the case of debt) or di- vidends (in the case of equity). The second type of return is from an increase in the price of the security. To realize this type of return, the investor must sell the security. 8. When a security is sold, the seller must have several pieces of information to prop- erly account for the transaction. The seller must know the selling price as well as the historical cost of the security. The difference between these two amounts results in a realized gain or loss on the sale. 9. The difference between a realized gain or loss and an unrealized gain or loss relates to the accounting concept of arms-length transactions. The term realized indicates that an arms-length transaction has taken place and a security has been sold. A real- ized gain indicates that the security was sold...
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This note was uploaded on 11/16/2009 for the course ACCOUNTING 2101 taught by Professor Malkie during the Spring '09 term at ITT Tech Flint.

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