Required:

Evaluate the rationale for these two diverse reporting requirements for equity securities. What arguments could be made to support each treatment?

Answer: When securities are actively managed, as trading securities are, with the express intent of profiting from short-term price changes, the gains and losses that result from holding securities during market price changes are appropriate measures of success or lack of success in that endeavor. On the other hand, securities available for sale are held for reasons other than profiting from short-term price changes so holding gains and losses are appropriately included in income only when realized upon sale of the investment. Also, unrealized gains and losses prior to sale may cancel one another out.

Learning Objective: 3 Level of Learning: 2

141. Jaycom Enterprises has invested its excess cash in the stock of several different companies and desires to maximize income over the short-run. Jaycom is unsure about the appropriate investment policy and thus reporting practice to follow.

Required:

What classification procedure and subsequent classification could Jaycom follow in order to meet its objective? How will Jaycom justify its choice to their auditors?

Answer: If Jaycom classifies the securities as available for sale, none of the market value changes would be reflected in net income, while all market value changes would be reflected in net income if Jaycom classifies these securities as trading. This demonstrates how some FASB pronouncements can potentially be used to manipulate earnings. To maximize income the company could classify securities that have decreased in value as available for sale while classifying as trading securities those that have increased in value. One way to justify this would be to argue that securities that were increasing in value could be sold at any time. The managers could also argue that they held declining securities indefinitely or until they felt the decline was over. However, appropriate accounting procedures require that an investor assign a reporting classification to each security at acquisition, with the classification chosen based on the company's intent at that time. Reasons for transfers between classifications must be explained in footnote disclosures.

Learning Objective: 2 Level of Learning: 2

142. Newjohn Company owns stock in several affiliated companies. Investments in of these affiliates are accounted for using the cost method while some are accounted for using the equity method.

Required:

What factors determine which method should be used?

What events are recorded when the equity method is used?

What events are recorded when the cost method is used?

Answer:

In order to use the equity method, Newjohn must be able to exercise significant influence over the affiliated company. If the ownership is less than 20%, then the lack of significant influence would generally be presumed and the cost method would be appropriate. If Newjohn can control the investee, generally represented by an ownership interest greater than 50%, then consolidation would be appropriate.

The acquisition of the subsidiary is recorded the same way under both the cost and the equity methods. Under the cost method, dividends are recorded as revenue by the parent.

The equity method requires that a proportionate share of dividends and reported earnings be recorded as adjustments to respectively decrease and increase the investment account, with the proportion of reported revenue included in net income of the parent. Differences between the price paid for the investment and the underlying book value must be analyzed and amortized, if appropriate.

Learning Objective: 4 Level of Learning: 2