Answer – Financial Instruments

This is the answers for Quiz – Financial Instruments.

Question 1

If Company A purchases 100 shares in Company B for $1.00 each, and it plans to sell them for a quick gain.

1. What type of asset should Company A classify on the Balance Sheet?
   Answer: Held-for-trading or Trading Securities or Short-term Investments
2. If Company B’s share price then increases to $1.10, what should Company A record on its Income Statement and Cash Flow Statement?
   Answer: Unrealized Gains / (Losses) = $10
3. If Company A sells Company B’s share at $1.10, what should Company A record on its Income Statement and Cash Flow Statement?
   Answer: It will also record a Realized Gain if it sells the Securities at this point, but that’s true of any investment.
   Realised Gaines / (Losses) = $10

Detailed Answer:

Assume a 24% tax rate.

1. Income Statement
   1. Unrealized Gain = $10
   2. Pre-Tax Income = $10
   3. Net Income = $7.6
2. Cash Flow Statement
   1. Net Income = $7.6
   2. Unrealized Gain (non-cash item) = ($10)
   3. Operating Cash Flow = ($2.4)
3. Balance Sheet
   1. Total Assets = ($7.6)
      1. Cash = ($2.4)
      2. Short-term Investments = $10
   2. Total Liabilities and Equity
      1. Retained Earnings = $7.6
4. Intuition
   1. The company paid taxes on an Unrealized Gain. Those taxes reduced its Cash balance, but it hasn’t received any Cash because it hasn’t sold anything yet

Question 2

Company A purchases 100 shares of Company B for $1.00 each, but it does not plan to sell those shares quickly.

1. What type of asset should Company A classify on the Balance Sheet?
   Answer: “Available for Sale” Securities on its Balance Sheet
2. If Company B’s share price increases to $1.10, and Company A has not yet sold anything, what happen to Income Statement, Cash Flow Statement and Balance Sheet?
   Answer:
   Income Statement = No changes (but unrealised gains / losses are recorded in Other Comprehensive Income)
   
   Cash Flow Statement = No changes
   
   Balance Sheet = Long-Term Investments are up by $10, and Other Comprehensive Income (AOCI) on the L&E side is also up by $10
   
   

Question 3

Company A buys $100 of Company B’s 10-year bonds and plans to hold them until the bonds mature in 10 years.

1. What type of asset should Company A classify on the Balance Sheet?
   Answer: Held-to-Maturity
2. If the fair market value of these bonds increases from $100 to $110, what should Company A record on its Income Statement and Cash Flow Statement?
   Answer: Nothing changes. Unrealized gains and losses are not reported at all with HTM securities. So if you hold a bond in a company and you plan to hold it for ten years until it matures completely and it’s paid back, even if the market value of that bond goes up or down because of changes in interest rates for example, you’re not going to report any of that on the financial statements.
3. Upon maturity of the bond, if Company A were to sell these bonds for $110, what should Company A record on its Income Statement?
   Answer: Company A would record a Realized Gain of $10 on the Income Statement and make it flow through the rest of the statements.

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