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# Investments - Securities Markets and Transactions

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Andre Khan is a stockbroker who lives with his wife, Sasha, and their five children in Milwaukee, Wisconsin. Andre firmly believes that the only way to make money in the market is to follow an aggressive investment posture - for example, to use margin trading. In fact, Andre himself has built a substantial margin account over the years. He currently holds \$75,000 worth of stock in his margin account, though the debit balance in the account amounts to only \$30,000. Recently, Andre uncovered a stock that, on the basis of extensive analysis, he feels is about to take off.

The stock, Running Shoes (RS), currently trades at \$20 per share. Andre feels it should soar to at least \$50 within a year. RS pays no dividends, the prevailing initial margin requirement is 50%, and margin loans are now carrying an annual interest charge of 10%. Because Andre feels so strongly about RS, he wants to do some pyramiding by using his margin account to purchase 1,000 shares of the stock.

a. What is the present margin position (in percent) of Andre's account?
b. Andre buys the 1,000 shares of RS through his margin account (bear in mind that this is a \$20,000 transaction).
i. What will the margin position of the account be after the RS transaction if Andre follows prevailing initial margin (50%) and uses \$10,000 of his money to buy the stock?
ii. What if he uses only \$2,500 equity and obtains a margin loan for the balance (\$17,500)?
iii. How do you explain the fact that the stock can be purchased with only 12.5% margin when the prevailing initial margin requirement is 50%?

c. Assume that Andre buys 1,000 shares of RS stock at \$20 per share with a minimum cash investment of \$2,500 and that the stock does take off and its price rises to \$40 per share in 1 year.
i. What is the return on invested capital for this transaction.
ii. What return would Andre have earned if he had bought the stock without margin - that is, if he had used all his own money?

#### Solution Summary

The Solution explains earning higher income by using borrowed funds to purchase securities.

\$2.19

## 20 MCQ: investment income, trading securities, dividends, bonds, equities, market

1. Poster Inc. owns 35 percent of Elliott Corporation. During the calendar year 2003, Elliott had net earnings of \$300,000 and paid dividends of \$36,000. Poster mistakenly accounted for the investment in Elliott using the cost method rather than the equity method of accounting. What effect would this have on the investment account and net income, respectively?

A. Understate, overstate
B. Overstate, understate
C. Overstate, overstate
D. Understate, understate

2. Marino Corporation purchased the following portfolio of trading securities during 2008 and reported the following balances at December 31, 2008. No sales occurred during 2008. All declines are considered to be temporary.

Security Cost Market Value at 12/31/08
X \$ 80,000 \$ 82,000
Y 140,000 132,000
Z 32,000 28,000

The only transaction in 2009 was the sale of security Z for \$34,000 on December 31, 2009. The market values for the other securities at December 31, 2009 were the same as at December 31, 2008. Marino's entry to record the sale of security Z would include

A. a credit of \$2,000 to Realized Gain on Sale of Trading Securities.
B. a debit of \$2,000 to Realized Gain on Sale of Trading Securities.

3. At the beginning of the year, a company had a debit balance in the account Market Adjustment-Trading Securities. During the year the company didn't buy or sell any trading securities, but at the end of the year the related market adjustment account had a credit balance. This change indicates

A. a loss on the income statement was recognized.
B. a gain on the income statement was recognized.
C. the value of the investment account increased.
D. the value of the investment account decreased.

4. When an investor uses the cost method to account for investments in common stock, cash dividends received by the investor from the investee should normally be recorded as

A. a deduction from the investment account.
B. dividend revenue.
C. an addition to the investor's share of the investee's profit.
D. a deduction from the investor's share of the investee's profit.

For each situation listed in questions 5-8, indicate by letter the appropriate financial statement element being discussed.
5. The net assets of an entity

A. Investment by owners C. Owners' equity
B. Distributions to owners D. Revenues

6. An increase in net assets through the issuance of stock

A. Investment by owners C. Owners' equity
B. Distributions to owners D. Revenues

7. The payment of a dividend

A. Investment by owners C. Owners' equity
B. Distributions to owners D. Revenues

8. Items offering future value to an entity

A. Investment by owners C. Owners' equity
B. Distributions to owners D. Revenues

9. Edwards Company began business in February of 2007. During the year, Edwards purchased the three trading securities listed below. On its December 31, 2007, balance sheet, Edwards appropriately reported a \$4,000 credit balance in its Market Adjustment- Trading Securities account. There was no change during 2008 in the composition of Edward's portfolio of trading securities. Pertinent data are as follows:

Security Cost Market Value December 31, 2008

A \$120,000 \$126,000
B 90,000 80,000
C 160,000 157,000
\$370,000 \$363,000

What amount of loss on these securities should be included in Edward's income statement for the year ended December 31, 2008?

A. \$0 C. \$7,000
B. \$3,000 D. \$11,000

10. On January 1, 2008, Capitech Corporation acquired Logirun, Inc. as a long-term investment
for \$250,000 (a 30 percent common stock interest in Logirun). On that date, Logirun had net assets with a book value and current market value of \$800,000. During 2008, Logirun reported net income of \$90,000 and declared and paid cash dividends of \$20,000. What is the maximum amount of income that Capitech should report from this investment for 2008?

A. \$6,000 C. \$26,750
B. \$21,000 D. \$27,000

For each situation listed in questions 11-12, indicate by letter the appropriate accounting assumption being discussed.

11. When preparing the financial statements for MacNeil & Sons, the accountant included certain personal assets of MacNeil and his sons in preparing the statements.

A. Stable monetary units C. Going concern
B. Specific economic entity D. Arm's-length transactions

12. The operations of Uintah Savings and Loan are being evaluated by the federal government.
During their investigations, government officials have determined that numerous loans made by top management were unwise and have seriously endangered the future of the savings and loan.

A. Stable monetary units C. Going concern
B. Specific economic entity D. Arm's-length transactions

13. On October 1, Dennis Company purchased \$200,000 face value 12 percent bonds for 98 plus accrued interest and brokerage fees and classified them as held-to-maturity securities. Interest is paid semiannually on January 1 and July 1. Brokerage fees for this transaction were \$700.

At what amount should this acquisition of bonds be recorded?
A. \$196,000 C. \$202,000
B. \$196,700 D. \$202,700

For each situation listed in questions 14-17, indicate by letter the appropriate qualitative characteristic or accounting concept applied.

14. All payments out of petty cash are debited to miscellaneous expense.

A. Materiality C. Economic entity
B. Representational faithfulness D. Historical cost

15. Periodic payments of \$1,500 per month for services of H. Hay, who is the sole proprietor of the company, are reported as withdrawals.

A. Materiality C. Economic entity
B. Representational faithfulness D. Historical cost

16. Investments in equity securities are initially recorded at cost.

A. Materiality C. Economic entity
B. Representational faithfulness D. Historical cost

17. A note describing the company's possible liability in a lawsuit is included with the financial
statements even though no formal liability exists at the balance sheet date.

A. Materiality C. Economic entity
B. Representational faithfulness D. Historical cost

18. In March of 2007, Moon Corp. bought 45,000 shares of McMahon Corp.'s listed stock for
\$450,000 and classified the shares as available-for-sale securities. The market value of these shares had declined to \$300,000 by December 31, 2007. Moon changed the classification of these shares to trading securities in June of 2008 when the market value of this investment in McMahon's stock had risen to \$345,000. How much should Moon include as a loss on transfer of securities in its determination of net income for 2008?

A. \$0 C. \$105,000
B. \$45,000 D. \$150,000

19. Walsh, Inc. began business on January 1, 2007, and at December 31, 2007, Walsh had the following investment portfolios of equity securities:

Aggregate cost \$150,000 \$225,000
Aggregate market value 120,000 185,000

None of the declines is judged to be other than temporary. Unrealized losses at December 31, 2007, should be recorded with corresponding charges against

Income Stockholders' Equity
A. \$70,000 \$0
B. \$40,000 \$30,000
C. \$30,000 \$40,000
D. \$0 \$70,000

20. Martin Co. purchased the following portfolio of trading securities during 2007 and reported
the following balances at December 31, 2007. No sales occurred during 2007. All declines are considered to be temporary.

Security Cost Market Value at 12/31/2007
X \$ 80,000 \$ 82,000
Y 140,000 132,000
Z 32,000 28,000

The carrying value of the portfolio at December 31, 2007, on Martin Co.'s balance sheet would be

A. \$222,000. C. \$242,000.
B. \$240,000. D. \$252,000

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