How many ways are there to use cash generated from the operations companies own?
1. Investing in current operations
2. Investing in temporary (short-term) investments to earn additional revenue
3. Investing in long-term investments in stock of other companies for strategic reasons
What are debt securities?
Debt securities are notes and bonds that pay interest and have a fixed maturity date.
Explain equity securities.
These are preferred and common stock that represent ownership in a company and do not have a fixed maturity date.
What are the primary objectives of temporary investments?
1. earn interest revenue.
2. receive dividends.
3. realize gains from increases in the market price of the securities
However, a company may also invest in the other companies for the purpose of partnering with or controlling them in the long-term. Long-term investments often involve the purchase of a significant portion of the equity securities of another company. Such investments usually have a strategic purpose, such as reduction of costs, expansion, or integration etc.
Why is investing important for companies?
It is a known fact that the main objective of companies is to maximize the shareholders’ wealth and it becomes possible through income maximization. Although the major part of income arises from main operations, investments also generate a part of net income. In order to maximize income through investments, companies must choose the best alternative among many different ones.
How can investments be classified? Explain with a chart.
What are the three groups debt securities classified into based on the intention of a company on investing?
1. Held-to-maturity Securities
2. Available for sale Securities
3. Trading Securities
What is the use of 'effective interest rate'?
The effective interest rate is the interest rate that makes the present value of all future cash receipts equal to the purchase price of security.
How can "Available for sale securities" be measured?
Available for sale securities are measured with their fair values. Any change in value is reflected in balance sheets with the help of unrealized holding gain or loss accounts.
What is classified as a 'trading security'?
When a company purchases a debt security with the aim of reselling for a higher price, this security is classified as trading security.
Explain 'investor' and 'investee'.
In an investment process, the investing party is called “investor” while invested company is called as “investee”.
What is called 'a minority or passive' investment?
When a company invests in another corporation up to 20% of total outstanding shares, it is assumed that the investor company does not possess an important role in determination of company policies. In other words, this investment does not represent a managerial role in invested company.
How can 'significant influence' be described in investment?
Significant influence can be defined as the power to participate and have affect on policy determination process of investee.
Why should investors use the equity method as the accounting treatment?
Investors should use equity method as the accounting treatment for affiliates because an investor has significant influence on decisions that result in success or failure of investee’s operations.
When the rate of ownership in invested company exceeds 50 percent, how does the role of the investor changes?
The investor is assumed to have control over the investee when the rate of ownership in invested company exceeds 50 percent, because in any case the decision is taken by the investor as more than half of the shares belongs to him. The investor company is called parent and the investee is subsidiary.
Explain 'consolidation'.
Consolidation means that parent company adds all financial statement items of the subsidiary to his own financial statements (after some eliminations and adjustments) and prepares a joint financial statement set combining the financial values of the both of the companies.
Explain the role of derivatives in investing.
Derivatives are the contracts that provide payoffs to investors depending on the values of other assets that they are derived from.
Why should derivatives be count as assets or liabilities?
In accounting for derivatives, it should be considered that since derivative contracts refer to the rights or obligations to be exercised in the future, they should be recognized as assets or liabilities. They should be recognized at their fair values in the balance sheet, and any profit realized from price changes should be recognized in the income statement as profit / loss from derivatives.
How can transfers between categories done in an investment?
Whichever pair of investment categories is considered (among all investment alternatives) as non-essential, transfers between categories are accounted for at fair value on the date of transfer. For example, if an investor decides to keep the investment, which is previously recorded as available for sale security until it matures, then the security should be reclassified and accounted for as a held to maturity security.
What are the two most common types of derivative instruments?
Two most common two forms of derivatives are options and forwards or futures contracts. Investing in an option contract gives the investor the right, but not obligation, to buy or sell a predetermined quantity of financial instruments in future at a specified price. While a call option gives right to buy instruments, a put option provides the selling right. If the price of asset does not move in the expected direction, an investor does not exercise the promise and loss is limited to initial margin invested to buy the contract. In the forward contracts, on the other hand, an investor promises to deliver a specified quantity of stocks or commodities at a specified price at maturity for an agreed-upon price. If the price of asset goes in the expected direction an investor generates profit, if the price moves in the opposite direction an investor makes loss.