NIKKI KLIMA WEEK 3 INDIVIDUAL ASSIGNMENT

1 Distinguish between a debt security and an equity security.

A security is a negotiable instrument representing financial value. Debt securities (such as banknotes, bonds and d
derivative contracts, such as forwards, futures, options and swaps. Simply stated, debt securities represent the ind
represent ownership of the issuing company.

26 What are the main distinctions between a traditional financial instrumnt and derivative financial instrument?
A traditional financial instrument is a trading security equity (stock) or debt (bond). A derivative financial instrume
The instrument has one or more underlyings and an identified payment provision. An underlying is a specified inte
other market-related variable. Payment is determined by the interaction of the underlying with the face amount o
contract. For example , the university purchased a call option when ABC inc. shares are trading at $100 per share.
of ABC inc. at an option price of $100 per share and expires in 120 days. When the stock value increases before th
underlying is the stock price. The instrument requires little or no investment at the inception of the contract. For
described in characteristic #1 which is an amount far less than if the 1,000 shares were purchased as a direct inves
in the call option example, the university can realize a prifit, or loss, on the call option whithout taking possession o
transaction costs associated with derivatives.

Companies use derivative instruments, primarily to hedge their positions or instruments in the underlying commod
physical agri commodities or exporters hedging their positions in foreign curencies. Thus, derivatives can be a usef
instruments can be quite risky if used for pure speculation. Any objective assessment of financial derivatives has t
to manage economic and financial risk. Derivatives are invaluable in separating the bearing of risk from the natura
or from ones economic situation. For example, derivatives markets allow inventories of commodities and securitie
fluctuation. The traditional role of future markets as vehicles for hedging commodity risk has been extended to m
exposure to price risk than do traditional commodities). Derivatives make it possible for firms to obtain financing w
debt into the form that is desired. Today, a firm wishing to borrow dollars at a fied interest rate for 5 years may fin
currency forwards and an interest rate swap to offset the exchange rate risk and turn the floating rate liability into
as banknotes, bonds and debentures) and equity securities consist of common stocks, and
securities represent the indebtnedness or borrowing by the issuing company and equity securities

e financial instrument?
erivative financial instrument is different as it must have three characteristics.
nderlying is a specified interest rate, secrity price, commoity price, index of prices or rates, or
ng with the face amount or number of shares, or other units specified in the derivative
trading at $100 per share. The contract gives the university the option to purchase 1,000 shares
k value increases before the end of the month, the value of the call option increases. In this case, the
ption of the contract. For example, the universit paid a small premium to purchase the call option
purchased as a direct investment. The instrumnet requires or permits net settlement. As indicated
hithout taking possession of the shares. This net settlement feature serves to reduce the

in the underlying commodity, such as agri businesses hedging their underlying positions in
s, derivatives can be a useful instrument if used for the purpose of hedging. However, such
financial derivatives has to convlude that these markets have contributed greatly to our ability
ing of risk from the natural exposure to that rist that results from ones ownership of risky assets
commodities and securities to be carried without the necessity of also bearing the risk of price
k has been extended to many kinds of financial instruments (that entail much greater aggregate
firms to obtain financing wherever and however it is cheapest and to transform the resulting
est rate for 5 years may find it cheaper to borrow Japanese yen at a floating rate and to use
e floating rate liability into one whith fixed interest rate.
 E17-1 (Investment Classifications) For the following investments identify whether they are:
1. Trading Securities
2. Available-for-Sale Securities
3. Held-to-Maturity Securities
Each case is independent of the other.
(a) A bond that will mature in 4 years was bought 1 month ago when the price dropped. As soon as
the value increases, which is expected next month, it will be sold.
(b) 10% of the outstanding stock of Farm-Co was purchased. The company is planning on eventually
getting a total of 30% of its outstanding stock.
(c) 10-year bonds were purchased this year. The bonds mature at the first of next year.
(d) Bonds that will mature in 5 years are purchased. The company would like to hold them until they
mature, but money has been tight recently and they may need to be sold.
(e) Preferred stock was purchased for its constant dividend. The company is planning to hold the
preferred stock for a long time.
(f) A bond that matures in 10 years was purchased. The company is investing money set aside for
an expansion project planned 10 years from now.

Hold to maturity securities are debt securities which are the enterprise has the intent and ability to hold to maturit
Trading securities are debt and equity securities held principally for selling them in the near term.
Available for sale securities include all other debt an dquity secruities.

A) TRADING SECURITIES
B) AVAILABLE-FOR SALE SECURITIES
C) TRADING SECURITIES
D) AVAILABLE-FOR SALE SECURITIES
E) AVAILABLE-FOR SALE SECURITIES
F) HELD-TO MATURITY SECURITIES
n eventually

m until they

d ability to hold to maturity.

ear term.
 E17-7 (Trading Securities Entries) On December 21, 2006, Bucky Katt Company provided you with
the following information regarding its trading securities.
31-Dec-06
Investments (Trading) Cost Fair Value Cost FMV
Clemson Corp. stock $20,000 $19,000 20000 19100
Colorado Co. stock 10,000 9,000 (1,000)
Buffaloes Co. stock 20,000 20,600 20000
600 20500
Total of portfolio $50,000 $48,600 40000 39600
Previous securities fair value adjustment balance –0–
Securities fair value adjustment—Cr. $(1,400)

During 2007, Colorado Company stock was sold for $9,400. The fair value of the stock on December 31,
2007, was: Clemson Corp. stock—$19,100; Buffaloes Co. stock—$20,500.

(a) Prepare the adjusting journal entry needed on December 31, 2006.
(b) Prepare the journal entry to record the sale of the Colorado Company stock during 2007.
(c) Prepare the adjusting journal entry needed on December 31, 2007

A) Date Debit Credit

12/31/2006 Unrealized holding gain or loss 1400
Securities fair vlaue adjustment 1400
To adjust the trading securities to
market value

B) Date Debit Credit

12/31/2007 Cash 9400
Realized loss on sale 600
Trading securities 10000
To record the sale of Colorado at a loss

C) Date Debit Credit

12/31/2007 Securities 1000
Unrealized holding gain or loss 1000
To adjust the valuation account to
amount at 12-31-07
E17-12 (Journal Entries for Fair Value and Equity Methods) Presented on page 890 are two independent
situations.
Situation 1
Conchita Cosmetics acquired 10% of the 200,000 shares of common stock of Martinez Fashion at a total
cost of $13 per share on March 18, 2007. On June 30, Martinez declared and paid a $75,000 cash dividend.
On December 31, Martinez reported net income of $122,000 for the year. At December 31, the market price
of Martinez Fashion was $15 per share. The securities are classified as available-for-sale.
Situation 2
Monica, Inc. obtained significant influence over Seles Corporation by buying 30% of Seles’s 30,000 outstanding
shares of common stock at a total cost of $9 per share on January 1, 2007. On June 15, Seles
declared and paid a cash dividend of $36,000. On December 31, Seles reported a net income of $85,000
for the year.
Instructions
Prepare all necessary journal entries in 2007 for both situations.

Situation 1

To record the purchase of 200,000 shares of Martinez Fashion at a cost of $13 per share:

18-Mar Available- for- sale Securities 2,600,000

Cash 2,600,000
(200,000 x 13 = 2,600,000)

To record the dividend revenue from Martinez Fashion:

30-Jun Cash 7,500

Dividend Income 7,500
(total dividend is 75,000 and Conchita has 10% shares)

To record the investment at fair value:

The market price is $15 and the total number of shares are 200,000. The gain is (15-13) = $2 x 200,000 = 400,000

Securities Fair adjustment (available-for sale) 400,000

Unrealized holding gain or loss-eqity 400,000

Situation 2
To record the purchase of 30% of Seles corporation's common stock: since there is significant influence, it will be
recorded as an investment under the equity method

1-Jan Investment in Seles Corp. stock 81,000

Cash 81,000
(total shares are 30,000. 30% of these are 9,000
and the price is $9 per share. Total is 81,000)

To record the receipt of cash dividends from Seles Corporaton:

15-Jun Cash 10,800

Investment in Seles Corp. Stock 10,800
(the dividend amount is 30% of 36,000= 10,800)

To record Monica's share (30%) of Seles Corporation's net income of 85,000:

31-Dec Investment in Seles Corp stock 25,500

Income from investment 25,500
(the income is 30% of the income of Monica. The
income is 85,000. 30% of this is 85,000 x 30%=25,500)
are two independent

nez Fashion at a total

$75,000 cash dividend.
mber 31, the market price

Seles’s 30,000 outstanding

et income of $85,000

hare:

-13) = $2 x 200,000 = 400,000

significant influence, it will be