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Nature of Financial Instruments


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Criterial Standard
A basis for comparison. A reference point against which other things can be evaluated.
Savings Instruments
Vehicles for money that has been set aside for the future. Usually earn interest and are low risk.
Certificate of Deposit
A time deposit, which is insured with a specific, fixed term and usually a fixed interest rate.
Money Market Account
A deposit account which may have transaction and balance restrictions but typically offers a competitive interest rate.
Interest Bearing Checking Account
A demand deposit account that earns interest on the average daily minimum balance.
Savings Bonds
Nontransferable treasury securities. Although they cannot be traded on the secondary market, they can be cashed before their maturity date.
Corporate Bonds
Debt obligations issued by corporations as an alternative to offering equity ownership by issuing stock.
Government Securities
Debt owed by an level of government.
Municipal Bonds
Interest bearing debt issued by state or local governments to finance operating or capital costs.
Treasury Bonds
Interest-bearing obligations issued by the US Treasury with maturities that range from ten to thirty years from date of issue.
Stock
Capital raised by a corporation through the issue of shares entitling holders to an ownership interest (equity).
Mutual Funds
Investment company that pools the money of many individual investors and uses it to buy a diviersified portfolio of securities.
Equity Fund
Fund that invests in equities more commonly known as stocks. Stock funds are contrasted with bond funds and money funds.
Treasury Bills
Short-term debt securities issued most commonly by the federal government.
Foreign Exchange
One currency is exchanged for another. Enables international transactions to take place.
Portfolio Diversification
A risk management technique that mixes a wide variety of investments within a portfolio. It is the spreading out of investments to reduce risks.
Index Fund
A portfolio of investments that is weighted the same as a stock-exchange index in order to mirror its performance.
(Ownership, right to acquire or dispose)
Equity securities are defined as securities that represent an ownership interest in an enterprise or the right to acquire or dispose of an ownership interest in an enterprise at fixed or determinable prices.
@ Fair Value = Mark to market
Trading and available-for-sale securities must be reported at FV. Changes in the FV of trading and available-for-sale securities result in unrealized holdings gains or losses.
Journal entry to record loss on the income statement:
Unrealized Gains and Losses of Trading securities: included in earnings ( I of I-D-E-A)
Journal entry to record unrealized loss reported in OCI:
Unrealized Gains and Losses of Available-for-sale Securities: Reported in OCI ( P[U]FE)
U.S.GAAP VS. IFRS
Under IFRS, unrealized gains and losses on available- for- sale securities are reported in OCI, except for foreign exchange gains and losses on available-for-sale debt securities, which are reported directly on the IS. Foreign exch…
Held-to-Maturity Securities
Held-to-Maturity Securities are valued at amortized cost.
(permanent declined in FV)
Under U.S.GAAP, if the decline in FV is permanent, the cost basis of the individual security is written down to FV as the new cost basis and the amount of the write-down is accounted…
U.S. GAAP VS. IFRS: Impairment of securities
Under IFRS, an impairment loss is recognized in earnings and the idv.security is written down by either directly reducing the cost basis of the security or through the use of a valuation allowance. Additionally, previo…
Sale of security
A sale of a security from any category results in a realized gain or loss and is reported on the IS for the period. Any unrealized gains or losses in accumulated OCI must be reve…
Journal entry:
Sale of Trading securities
Income tax effect of sale of security
Tax effects of unrealized gains or losses entering into the determination of net income must be reflected in the computation of deferred income taxes, because unrealized gains and losses are not deductible for tax purposes.
Consolidated Financial statements
Consolidated financial statements ignore important legal relationships and emphasize economic substance over form. Consolidated financial statements are an economic truth but a legal fiction.
Criteria of when not to consolidate
DO NOT consolidate when control is not with owners (e.g., under legal reorganization or when control of a subsidiary is with a trustee).
U.S. GAAP VS. IFRS
Under U.S. GAAP, significant transactions during the gap period require disclosure. Under IFRS, the subsidiary financial statements must be adjusted for significant transactions during the gap period.
Degree of control
The degree of control the investor has over the investee dictates how the investor reports the investment in corporate equity securities.
Cost Method/Do Not Consolidate = No significant influence (typically <20%)
The investor accounts for the investment using the cost method (FV method/AFS method) if the investor does not have the ability to exercise significant influence over the investee.
Equity Method/Do Not consolidate = Significant influence but 50% or less ownership (20%-50%)
The investor accounts for the investment using the equity method of accounting if the investor can exercise significant influence over the investee and holds 50% or less of the voting stock.
Consolidate = Control (greater than 50% ownership)
The investor should prepare consolidated financial stmts w/ its investees when the investor has control(>50% ownership) of the subsidiary. Internally, the investor may use either the cost method or the equity method to account for its investments.
Cost method (<20% /does not exercise significant influence)
also known as the fair value method or the available-for-sale method, should be used when the investor owns <20% of the investee's voting stock and does not exercise significant influence.
Note:
if a company owns less than 20% of the stock of an investee company, but exercise significant influence, the equity method must be used.
Balance sheet-Investment in Investee
The carrying amt of the investments acct on the investor's(parent's) books is "original cost" measured by the FV of the consideration given, including legal fees.
Record at cost:
Journal entry to record all costs of acquisition(FV of consideration+legal fees)
Marketable Securities-Adjust to FV
Journal entry to record unrealized loss and adjust to FV at year-end:
Reduce Investment in Investee for Return of Capital Distributions
Journal entry to record a return of capital distribution or liquidating dividend is a dividend in excess of investor's share of retained earnings:
Income Statement
Record cash dividends from the investee's retained earnings. Do not recognize stock dividends (Memo entry only).
Pass Key
The following 3 issues are the most frequently tested "cost" concepts:
Equity method (20%- 50% or exercises significant influence, record at cost)
The investment acct increases by the investor's share of the investee's net inco…
DR: Investment in investee
Investment in Investee using equity method: Journal entry to record at cost (FV of consideration plus legal fees):
DR: Cash
Journal entry to record decrease by the investor's/parent's ownership % of cash dividends from investee (stock dividends reduce unit cost of stock owned in investee):
Stock dividend = Memo entry only
Stock dividend = Memo entry only
JE to record the initial investment of 40%:
Example_Equity method: On Jan 01, year 1, Big corp. acquired a 40% interest in Small company for $300,000. At the date of acquisition, Small Co.'s equity(net assets) had a BV $750,000. During year 1, S…
Investment account = $300,000 +$36,000 - $16,000 = $320,000.
On December 31, Year 1, what is the balance of investment account on the balance sheet?
Goodwill:
Purchase Price if Investment > FV of Equity acquired
Under Equity method, Goodwill Difference is not amortized and No Impairment Test
However, the total equity method investment (including goodwill) must be analyzed at least annually for impairment.
Asset Fair Value Difference (Premium):
FV of Equity Acquired > Book Value of Equity Acquired
JE:
Under Equity method, Asset FV difference (Premium) is amortized over Related Asset life
DR: Intercompany Sales[Parent]
Workpaper Elimination- Intercompany merchandise Transactions
Real Asset
"physical asset", typically tangible; physically observable or touchable item
Financial Asset
represents a promise to distribute cash flows at some future time
Common Equity
sum of the firm's common stock, paid in capital, and retained earnings, which equals the common stockholder's total investment in the firm, at book value
Par Value
the nominal or face value of a stock or bond
Debt
a loan to an individual, company, or government
Discounted Securities
do not pay Interest
Negotiable CD
can be traded to other investors prior to maturity
Eurodollar Deposit
deposit in a foreign bank that is denominated in US dollars
Money market mutual funds
These are like mutual funds, but they invest in different money market instruments like treasury bills and bankers acceptances instead of investing in company stock.
Term Loan
between a firm and financial institution on which the borrower agrees to make a series of payments consisting of interes
Bond
long term debt instrument
Coupon Rate
total interest paid in each year
Government Bonds
Treasury notes or Treasury bonds debt issued by federal, state, or local
Municipal Bond
bond issued by a state or local goverment
Revenue Bond
used to fund projects that generate revenues that are used to make interest payments and repay principals
General Obligation Bond
municipal bond back by the local governments ability to impose taxes
Mortgage Bond
bond backed by fixed assets
Debenture
long term bond that isn't secured by mortgage on a property
Subordinate Debenture
bond that has a claim on assets only after the senior debt has been paid off in the event of liquidation
Zero Coupon Bonds "IODs"
pays no annual interest but is sold at a discount
Junk Bond
high risk, high yield bond used to finance mergers, leverage buyouts, and troubled companies
Indenture
contract between the issuer of a bond and the bond holders
Trustee
official who ensures that the bondholder's interest are protected and that the terms of indenture are carried out
Restrictive Covenant
constrains the actions of the borrower
Cumulative Dividends
protective feature on preferred stock that requires preferred dividends previously not paid to be dispersed before any common stock dividends can be paid
Call Premium
amount in excess of par value that a company must pay when it calls a security
Income Stocks
stocks of firms that traditionally pay large, relatively constant dividends each year
Growth Stocks
stocks that generally pay little or no dividends so as to retain earnings to help fund growth opportunities
Proxy
document giving one person the authority to act for another, typically the power to vote shares of common stock
Proxy Fight
attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote their shares so as to change the management team
Takeover
action whereby a person or group succeeds in ousting a firm's management and take control
Preemptive Right
a provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock
Classified Stock
special designation of common stock; class A, class B, etc.
Founder's Shares
stock owned by the firm's founder that has sole voting rights, but generally pays out only restricted dividends for a specified number of years
Closely Held Corporation
corporation owned by a few that are involved in management
Publicly Owned Corporation
corporation owned by a large number who are not active in managemenr
Derivatives
assets whose value depends on the values of other assets (stocks and bonds)
Option
gives holder the right to buy (sell) an asset at a predetermined price within a certain amount of time
Call Option
buying shares
Put Option
selling shares
Striking Price
price that must be paid when (buying or selling) an option
Convertible Security
usually a bond or preferred stock that is exchangeable for the common stock of the issuing firm
Futures Contract
an arrangement for delivery of an item at some date in the future, where the delivery details are determined when the contract is created
Swap
an agreement to exchange cash flows or assets at some specified time in the future
Hedge Fund
a private pool of funds that is constructed for the purpose of generating a specific range of returns no matter what happens in the general stock market
American Depository Receipts (ADRs)
certificates representing ownership in stocks of foreign companies that are held in trust by a bank located in the country the stock is traded
Foreign Debt
a debt instrument sold by a foreign borrower but denominated in the currency of the country in which it is sold
Eurodebt
debt sold in a country other than the one in whose currency the debt is denominated
LIBOR
the London InterBank Offered Rate is the interest rate offered by the best London banks on deposits of other large, very creditworthy banks
Financial Instruments - Definition
Financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument in another entity.
cash
Financial Asset
Financial Liability
Obligation to pay cash
Derivatives - Conditions
Its value is based on another underlying item (Interest/Exchange rates)
If it meets the following
How can a contract dealing with non financial assets be termed as a derivative
IAS 32 - Presentation of financial instruments
Financial instruments are presented as assets, liabilities or equity
Offsetting - Conditions
ALL CONDITIONS SHOULD BE MET