Ch17
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Ch17

Course Number: ADMS 101, Fall 2010

College/University: York University

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CHAPTER 17 I NVESTMENTS LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. Understand the procedures for discount and premium amortization on bond investments. Identify the categories of equity securities and describe the accounting and reporting treatment for each...

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NVESTMENTS LEARNING CHAPTER 17 I OBJECTIVES After studying this chapter, you should be able to: 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. Understand the procedures for discount and premium amortization on bond investments. Identify the categories of equity securities and describe the accounting and reporting treatment for each category. Explain the equity method of accounting and compare it to the fair value method for equity securities. Describe the accounting for the fair value option. Discuss the accounting for impairments of debt and equity investments. Explain why companies report reclassification adjustments. Describe the accounting for transfer of investment securities between categories. 2 3 4 5 6 7 8 Whos in Control Here? The Coca-Cola Company (Coke) owns 36 percent of the shares of Coca-Cola Enterprises (a U.S. bottling business); PepsiCo Inc. owns 46 percent of The Pepsi Bottling Group (PBG) and 41 percent of PepsiAmericas. These bottling businesses are very important to Coca-Cola and PepsiCo because they are the primary distributors of Coke and Pepsi products. In return, these companies depend on Coca-Cola and PepsiCo to provide significant marketing and distribution development support. Indeed, it can be said that Coca-Cola and PepsiCo control the bottling companies, who would not exist without their support. However, because The Coca-Cola Company and PepsiCo own less than 50 percent of the shares in these companies, they do not prepare consolidated financial statements. Instead, Coca-Cola and PepsiCo account for these investments using the equity method. Under the equity method, for example, Coca-Cola reports a single income item for its profits from the bottlers, and only the net amount of its investment in the balance sheet. 856 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Equity-method accounting gives Coca-Cola and PepsiCo pristine balance sheets and income statements, by separating the assets and liabilities and the profit margins of these bottlers from its beverage-making business. Whats more, the International Accounting Standards Board (IASB) has issued IAS No. 28, which requires that companies use the equity method. Previously, many international companies were permitted to use either the equity method or proportional consolidation for investments similar to Cokes and Pepsis. It is good news that both U.S. and international companies are following the same rules. (On the negative side, however, some of these companies should be consolidated but are not.) A final point: In response to a recent FASB pronouncement, companies are now starting to consolidate more of their 20 to 50 percentowned investments. Consolidation of entities, such as the Coke and Pepsi bottlers, may be required if the risks and rewards of those investments accrue primarily to Coke and Pepsi. [1] In fact, Coke has consolidated some of its bottling companies, which should result in the reporting of more complete information on these affiliated companies. PREVIEW OF CHAPTER 17 As our opening story indicates, U.S. and international standard-setters are studying the measurement, recognition, and disclosure for certain investments. In this chapter we address the accounting for debt and equity investments. Appendices to this chapter discuss the accounting for derivative instruments, variable-interest entities, and fair value disclosures. The content and organization of this chapter are as follows. INVESTMENTS INVESTMENTS IN DEBT SECURITIES Held-to-maturity securities Available-for-sale securities Trading securities INVESTMENTS IN EQUITY SECURITIES Holdings of less than 20% Holdings between 20% and 50% Holdings of more than 50% Fair value option OTHER REPORTING ISSUES Impairment of value Reclassification adjustments Transfers between categories Fair value controversy Summary 857 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 858 Chapter 17 Investments INVESTMENT ACCOUNTING APPROACHES Companies have different motivations for investing in securities issued by other companies.1 One motivation is to earn a high rate of return. For example, companies like Coca-Cola and PepsiCo can receive interest revenue from a debt investment or dividend revenue from an equity investment. In addition, they can realize capital gains on both types of securities. Another motivation for investing (in equity securities) is to secure certain operating or financing arrangements with another company. As in the opening story, Coca-Cola and PepsiCo are able to exercise some control over bottler companies based on their significant (but not controlling) equity investments. To provide useful information, companies account for investments based on the type of security (debt or equity) and their intent with respect to the investment. As indicated in Illustration 17-1, we organize our study of investments by type of security. Within each section, we explain how the accounting for investments in debt and equity securities varies according to management intent. ILLUSTRATION 17-1 Summary of Investment Accounting Approaches Types of Security Debt (Section 1) Equity (Section 2) Management Intent No plans to sell Plan to sell Plan to sell Exercise some control Valuation Approach Amortized cost Fair value Fair value Equity method SECTION 1 I NVESTMENTS I N DEBT SECU R ITI ES Debt securities represent a creditor relationship with another entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security. Companies group investments in debt securities into three separate categories for accounting and reporting purposes: Objective1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. Held-to-maturity: Debt securities that the company has the positive intent and ability to hold to maturity. Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences. Available-for-sale: Debt securities not classified as held-to-maturity or trading securities. Illustration 17-2 (on page 859) identifies these categories, along with the accounting and reporting treatments required for each. See the FASB Codification section (page 908). A security is a share, participation, or other interest in property or in an enterprise of the issuer or an obligation of the issuer that has the following three characteristics: (a) It either is represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer. (b) It is of a type commonly traded on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment. (c) It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations. [2] 1 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Held-to-Maturity Securities 859 Unrealized Holding Gains or Losses Not recognized Category Held-to-maturity Valuation Amortized cost Other Income Effects Interest when earned; gains and losses from sale. Interest when earned; gains and losses from sale. Interest when earned; gains and losses from sale. ILLUSTRATION 17-2 Accounting for Debt Securities by Category Trading securities Fair value Recognized in net income Available-for-sale Fair value Recognized as other comprehensive income and as separate component of stockholders equity Amortized cost is the acquisition cost adjusted for the amortization of discount or premium, if appropriate. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. [3] Underlying Concepts Companies report some debt securities at fair value not only because the information is relevant but also because it is reliable. HELD-TO-MATURITY SECURITIES Only debt securities can be classified as held-to-maturity. By definition, equity Objective2 securities have no maturity date. A company like Starbucks should classify a Understand the procedures for debt security as held-to-maturity only if it has both (1) the positive intent and discount and premium amortiza(2) the ability to hold those securities to maturity. It should not classify a debt tion on bond investments. security as held-to-maturity if it intends to hold the security for an indefinite period of time. Likewise, if Starbucks anticipates that a sale may be necessary due to changes in interest rates, foreign currency risk, liquidity needs, or other asset-liability management reasons, it should not classify the security as heldCalculator Solution for to-maturity.2 Bond Price Companies account for held-to-maturity securities at amortized cost, not fair value. If management intends to hold certain investment securities to maturity and has no Inputs Answer plans to sell them, fair values (selling prices) are not relevant for measuring and eval10 N uating the cash flows associated with these securities. Finally, because companies do not adjust held-to-maturity securities to fair value, these securities do not increase the volatility of either reported earnings or reported capital as do trading securities and 5 I available-for-sale securities. To illustrate the accounting for held-to-maturity debt securities, assume that 92,278 ? PV Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2009, at a discount, paying $92,278. The bonds mature January 1, PMT FV 4,000 2 The FASB defines situations where, even though a company sells a security before maturity, it has constructively held the security to maturity, and thus does not violate the held-to-maturity requirement. These include selling a security close enough to maturity (such as three months) so that interest rate risk is no longer an important pricing factor. However, companies must be extremely careful with debt securities held to maturity. If a company prematurely sells a debt security in this category, the sale may taint the entire held-to-maturity portfolio. That is, a managements statement regarding intent is no longer credible. Therefore the company may have to reclassify the securities. This could lead to unfortunate consequences. An interesting by-product of this situation is that companies that wish to retire their debt securities early are finding it difficult to do so. The holder will not sell because the securities are classified as held-to-maturity. 100,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 860 Chapter 17 Investments 2014 and yield 10%; interest is payable each July 1 and January 1. Robinson records the investment as follows: January 1, 2009 Held-to-Maturity Securities Cash 92,278 92,278 Robinson uses a Held-to-Maturity Securities account to indicate the type of debt security purchased. As indicated in Chapter 14, companies must amortize premium or discount using the effective-interest method unless some other methodsuch as the straight-line methodyields a similar result. They apply the effective-interest method to bond investments in a way similar to that for bonds payable. To compute interest revenue, companies compute the effective-interest rate or yield at the time of Underlying Concepts investment and apply that rate to the beginning carrying amount (book value) The use of some simpler method for each interest period. The investment carrying amount is increased by the that yields results similar to the amortized discount or decreased by the amortized premium in each period. effective-interest method is an Illustration 17-3 shows the effect of the discount amortization on the interapplication of the materiality concept. est revenue that Robinson records each period for its investment in Evermaster bonds. ILLUSTRATION 17-3 Schedule of Interest Revenue and Bond Discount Amortization Effective-Interest Method 8% BONDS PURCHASED TO YIELD 10% Cash Received $ 4,000a 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 $40,000 a 6 $4,000 $100,000 .08 12 6 $4,614 $92,278 .10 12 c $614 $4,614 $4,000 d $92,892 $92,278 $614 Date 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 7/1/12 1/1/13 7/1/13 1/1/14 Interest Revenue $ 4,614b 4,645 4,677 4,711 4,746 4,783 4,823 4,864 4,907 4,952 $47,722 Bond Discount Amortization $ 614c 645 677 711 746 783 823 864 907 952 $7,722 Carrying Amount of Bonds $ 92,278 92,892d 93,537 94,214 94,925 95,671 96,454 97,277 98,141 99,048 100,000 b Robinson records the receipt of the first semiannual interest payment on July 1, 2009 (using the data in Illustration 17-3), as follows: July 1, 2009 Cash Held-to-Maturity Securities Interest Revenue 4,000 614 4,614 Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2009, as follows. December 31, 2009 Interest Receivable Held-to-Maturity Securities Interest Revenue 4,000 645 4,645 Again, Illustration 17-3 shows the interest and amortization amounts. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Available-for-Sale Securities 861 Robinson reports its investment in Evermaster bonds in its December 31, 2009, financial statements, as follows. Balance Sheet Current assets Interest receivable Long-term investments Held-to-maturity securities, at amortized cost Income Statement Other revenues and gains Interest revenue $ 9,259 $ 4,000 $93,537 ILLUSTRATION 17-4 Reporting of Held-toMaturity Securities Sometimes a company sells a held-to-maturity debt security so close to its maturity date that a change in the market interest rate would not significantly affect the securitys fair value. Such a sale may be considered a sale at maturity and would not call into question the companys original intent to hold the investment to maturity. Lets assume, as an example, that Robinson Company sells its investment in Evermaster bonds on November 1, 2013, at 9934 plus accrued interest. The discount amortization from July 1, 2013, to November 1, 2013, is $635 (46 $952). Robinson records this discount amortization as follows. November 1, 2013 Held-to-Maturity Securities Interest Revenue 635 635 Illustration 17-5 shows the computation of the realized gain on the sale. Selling price of bonds (exclusive of accrued interest) Less: Book value of bonds on November 1, 2013: Amortized cost, July 1, 2013 Add: Discount amortized for the period July 1, 2013, to November 1, 2013 Gain on sale of bonds $99,750 $99,048 635 99,683 $ 67 ILLUSTRATION 17-5 Computation of Gain on Sale of Bonds Robinson records the sale of the bonds as: November 1, 2013 Cash Interest Revenue (4/6 102,417 $4,000) 2,667 99,683 67 Held-to-Maturity Securities Gain on Sale of Securities The credit to Interest Revenue represents accrued interest for four months, for which the purchaser pays cash. The debit to Cash represents the selling price of the bonds plus accrued interest ($99,750 $2,667). The credit to Held-to-Maturity Securities represents the book value of the bonds on the date of sale. The credit to Gain on Sale of Securities represents the excess of the selling price over the book value of the bonds. AVAILABLE-FOR-SALE SECURITIES Companies, like Amazon.com, report available-for-sale securities at fair value. It records the unrealized gains and losses related to changes in the fair value of available-for-sale debt securities in an unrealized holding gain or loss account. Amazon adds (subtracts) this amount to other comprehensive income for the period. Other comprehensive income is then added to (subtracted from) accumulated other comprehensive income, which is shown as a separate component of Underlying Concepts Recognizing unrealized gains and losses is an application of the concept of comprehensive income. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 862 Chapter 17 Investments stockholders equity until realized. Thus, companies report available-for-sale securities at fair value on the balance sheet, but do not report changes in fair value as part of net income until after selling the security. This approach reduces the volatility of net income. Calculator Solution for Bond Price Inputs Answer N I PV PMT FV 10 Example: Single Security To illustrate the accounting for available-for-sale securities, assume that Graff Corporation purchases $100,000, 10 percent, five-year bonds on January 1, 2009, with interest payable on July 1 and January 1. The bonds sell for $108,111, which results in a bond premium of $8,111 and an effective interest rate of 8 percent. Graff records the purchase of the bonds as follows.3 January 1, 2009 Available-for-Sale Securities Cash 108,111 108,111 4 ? 108,111 5,000 100,000 Illustration 17-6 discloses the effect of the premium amortization on the interest revenue Graff records each period using the effective-interest method. 10% BONDS PURCHASED TO YIELD 8% Cash Received $ 5,000a 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 $50,000 a 6 $5,000 $100,000 .10 12 6 $4,324 $108,111 .08 12 c $676 $5,000 $4,324 d $107,435 $108,111 $676 ILLUSTRATION 17-6 Schedule of Interest Revenue and Bond Premium Amortization Effective-Interest Method Date 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 7/1/12 1/1/13 7/1/13 1/1/14 Interest Revenue $ 4,324b 4,297 4,269 4,240 4,210 4,178 4,145 4,111 4,075 4,040 $41,889 Bond Premium Amortization $ 676c 703 731 760 790 822 855 889 925 960 $8,111 Carrying Amount of Bonds $108,111 107,435d 106,732 106,001 105,241 104,451 103,629 102,774 101,885 100,960 100,000 b The entry to record interest revenue on July 1, 2009, is as follows. July 1, 2009 Cash Available-for-Sale Securities Interest Revenue 5,000 676 4,324 At December 31, 2009, Graff makes the following entry to recognize interest revenue. December 31, 2009 Interest Receivable Available-for-Sale Securities Interest Revenue 5,000 703 4,297 As a result, Graff reports revenue for 2009 of $8,621 ($4,324 3 $4,297). Companies generally record investments acquired at par, at a discount, or at a premium in the accounts at cost, including brokerage and other fees but excluding the accrued interest. They generally do not record investments at maturity value. The use of a separate discount or premium account as a valuation account is acceptable procedure for investments, but in practice companies do not widely use it. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Available-for-Sale Securities 863 To apply the fair value method to these debt securities, assume that at year-end the fair value of the bonds is $105,000 and that the carrying amount of the investments is $106,732. Comparing this fair value with the carrying amount (amortized cost) of the bonds at December 31, 2009, Graff recognizes an unrealized holding loss of $1,732 ($106,732 $105,000). It reports this loss as other comprehensive income. Graff makes the following entry. December 31, 2009 Unrealized Holding Gain or LossEquity Securities Fair Value Adjustment (Available-for-Sale) 1,732 1,732 Graff uses a valuation account instead of crediting the Available-for-Sale Securities account. The use of the Securities Fair Value Adjustment (Available-for-Sale) account enables the company to maintain a record of its amortized cost. Because the adjustment account has a credit balance in this case, Graff subtracts it from the balance of the Available-for-Sale Securities account to determine fair value. Graff reports this fair value amount on the balance sheet. At each reporting date, Graff reports the bonds at fair value with an adjustment to the Unrealized Holding Gain or LossEquity account. Example: Portfolio of Securities To illustrate the accounting for a portfolio of securities, assume that Webb Corporation has two debt securities classified as available-for-sale. Illustration 17-7 identifies the amortized cost, fair value, and the amount of the unrealized gain or loss. AVAILABLE-FOR-SALE DEBT SECURITY PORTFOLIO DECEMBER 31, 2010 Investments Watson Corporation 8% bonds Anacomp Corporation 10% bonds Total of portfolio Previous securities fair value adjustment balance Securities fair value adjustmentCr. Amortized Cost $ 93,537 200,000 $293,537 Fair Value $103,600 180,400 $284,000 Unrealized Gain (Loss) $ 10,063 (19,600) (9,537) 0 $ (9,537) ILLUSTRATION 17-7 Computation of Securities Fair Value Adjustment Available-for-Sale Securities (2010) The fair value of Webbs available-for-sale portfolio totals $284,000. The gross unrealized gains are $10,063, and the gross unrealized losses are $19,600, resulting in a net unrealized loss of $9,537. That is, the fair value of available-for-sale securities is $9,537 lower than its amortized cost. Webb makes an adjusting entry to a valuation allowance to record the decrease in value and to record the loss as follows. December 31, 2010 Unrealized Holding Gain or LossEquity Securities Fair Value Adjustment (Available-for-Sale) 9,537 9,537 Webb reports the unrealized holding loss of $9,537 as other comprehensive income and a reduction of stockholders equity. Recall that companies exclude from net income any unrealized holding gains and losses related to available-for-sale securities. Sale of Available-for-Sale Securities If a company sells bonds carried as investments in available-for-sale securities before the maturity date, it must make entries to remove from the Available-for-Sale Securities account the amortized cost of bonds sold. To illustrate, assume that Webb Corporation sold the Watson bonds (from Illustration 17-7) on July 1, 2011, for $90,000, at which time it had an amortized cost of $94,214. Illustration 17-8 (on page 864) shows the computation of the realized loss. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 864 Chapter 17 Investments ILLUSTRATION 17-8 Computation of Loss on Sale of Bonds Amortized cost (Watson bonds) Less: Selling price of bonds Loss on sale of bonds $94,214 90,000 $ 4,214 Webb records the sale of the Watson bonds as follows. July 1, 2011 Cash Loss on Sale of Securities Available-for-Sale Securities 90,000 4,214 94,214 Webb reports this realized loss in the Other expenses and losses section of the income statement. Assuming no other purchases and sales of bonds in 2011, Webb on December 31, 2011, prepares the information shown in Illustration 17-9. ILLUSTRATION 17-9 Computation of Securities Fair Value Adjustment Available-for-Sale (2011) AVAILABLE-FOR-SALE DEBT SECURITY PORTFOLIO DECEMBER 31, 2011 Investments Anacomp Corporation 10% bonds (total portfolio) Previous securities fair value adjustment balanceCr. Securities fair value adjustmentDr. Amortized Cost $200,000 Fair Value $195,000 Unrealized Gain (Loss) $(5,000) (9,537) $ 4,537 Webb has an unrealized holding loss of $5,000. However, the Securities Fair Value Adjustment account already has a credit balance of $9,537. To reduce the adjustment account balance to $5,000, Webb debits it for $4,537, as follows. December 31, 2011 Securities Fair Value Adjustment (Available-for-Sale) Unrealized Holding Gain or LossEquity 4,537 4,537 Financial Statement Presentation Webbs December 31, 2011, balance sheet and the 2011 income statement include the following items and amounts (the Anacomp bonds are long-term investments but are not intended to be held to maturity). ILLUSTRATION 17-10 Reporting of Available-forSale Securities Balance Sheet Current assets Interest receivable Investments Available-for-sale securities, at fair value Stockholders equity Accumulated other comprehensive loss Income Statement Other revenues and gains Interest revenue Other expenses and losses Loss on sale of securities $ $ xxx 4,214 $ xxx $195,000 $ 5,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Trading Securities 865 Some favor including the unrealized holding gain or loss in net income rather than showing it as other comprehensive income.4 However, some companies, particularly financial institutions, note that recognizing gains and losses on assets, but not liabilities, introduces substantial volatility in net income. They argue that hedges often exist between assets and liabilities so that gains in assets are offset by losses in liabilities, and vice versa. In short, to recognize gains and losses only on the asset side is unfair and not representative of the economic activities of the company. This argument convinced the FASB. As a result, companies do not include in net income these unrealized gains and losses. [4] However, even this approach solves only some of the problems, because volatility of capital still results. This is of concern to financial institutions because regulators restrict financial institutions operations based on their level of capital. In addition, companies can still manage their net income by engaging in gains trading (i.e., selling the winners and holding the losers). WHAT IS FAIR VALUE? In the fall of 2000, Wall Street brokerage firm Morgan Stanley told investors that rumor of big losses in its bond portfolio were greatly exaggerated. As it turns out, Morgan Stanley also was exaggerating. As a result, the SEC accused Morgan Stanley of violating securities laws by overstating the value of certain bonds by $75 million. The overvaluations stemmed more from wishful thinking than reality, in violation of generally accepted accounting principles, the SEC said. In effect, Morgan Stanley valued its positions at the price at which it thought a willing buyer and seller should enter into an exchange, rather than at a price at which a willing buyer and a willing seller would enter into a current exchange, the SEC wrote. Especially egregious, stated one accounting expert, were the SECs findings that Morgan Stanley in some instances used its own more optimistic assumptions as a substitute for external pricing sources. What that is saying is: Fair value is what you want the value to be. Pick a number . . . Thats especially troublesome. As indicated in the text, the FASB is assessing what is fair and what isnt when it comes to assigning valuations. Concerns over the issue caught fire after the collapses of Enron Corp. and other energy traders that abused the wide discretion given them under fair value accounting. Investors recently have expressed similar worries about some financial companies, which use internaland subjectively designedmathematical models to come up with valuations when market quotes arent available. Source: Adapted from Susanne Craig and Jonathan Weil, SEC Targets Morgan Stanley Values, Wall Street Journal (November 8, 2004), p. C3. What do the numbers mean? TRADING SECURITIES Companies hold trading securities with the intention of selling them in a short period of time. Trading in this context means frequent buying and selling. Companies thus use trading securities to generate profits from short-term differences in price. Companies generally hold these securities for less than three months, some for merely days or hours. Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. Similar to held-to-maturity or available-forsale investments, they are required to amortize any discount or premium. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. In short, the FASB says to adjust the trading securities to fair value, at each reporting date. In addition, companies report the change in value as part of net income, not other comprehensive income. 4 In Chapter 4, we discussed the reporting of other comprehensive income and the concept of comprehensive income. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 866 Chapter 17 Investments To illustrate, assume that on December 31, 2010, Western Publishing Corporation determined its trading securities portfolio to be as shown in Illustration 17-11. (Assume that 2010 is the first year that Western Publishing held trading securities.) At the date of acquisition, Western Publishing recorded these trading securities at cost, including brokerage commissions and taxes, in the account entitled Trading Securities. This is the first valuation of this recently purchased portfolio. ILLUSTRATION 17-11 Computation of Securities Fair Value Adjustment Trading Securities Portfolio (2010) TRADING DEBT SECURITY PORTFOLIO DECEMBER 31, 2010 Investments Burlington Northern 10% bonds GM Corporation 11% bonds Time Warner 8% bonds Total of portfolio Previous securities fair value adjustment balance Securities fair value adjustmentDr. Cost $ 43,860 184,230 86,360 $314,450 Fair Value $ 51,500 175,200 91,500 $318,200 Unrealized Gain (Loss) $ 7,640 (9,030) 5,140 3,750 0 $3,750 I NTERNATIONAL I NSIGHT iGAAP provides for classification as trading, available-for-sale, or heldto-maturity for all types of financial assets. U.S. GAAP applies these classifications only to securities. The total cost of Western Publishings trading portfolio is $314,450. The gross unrealized gains are $12,780 ($7,640 $5,140), and the gross unrealized losses are $9,030, resulting in a net unrealized gain of $3,750. The fair value of trading securities is $3,750 greater than its cost. At December 31, Western Publishing makes an adjusting entry to a valuation allowance, referred to as Securities Fair Value Adjustment (Trading), to record the increase in value and to record the unrealized holding gain. December 31, 2010 Securities Fair Value Adjustment (Trading) Unrealized Holding Gain or LossIncome 3,750 3,750 Because the Securities Fair Value Adjustment account balance is a debit, Western Publishing adds it to the cost of the Trading Securities account to arrive at a fair value for the trading securities. Western Publishing reports this fair value amount on the balance sheet. When securities are actively traded, the FASB believes that the investments should be reported at fair value on the balance sheet. In addition, changes in fair value (unrealized gains and losses) should be reported in income. Such reporting on trading securities provides more relevant information to existing and prospective stockholders. SECTION 2 I NVESTMENTS I N EQU ITY SECU R ITI ES Equity securities represent ownership interests such as common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants, rights, and call or put options. Companies do not treat convertible debt securities as equity securities. Nor do they treat as equity securities redeemable preferred stock (which must be redeemed for Objective3 common stock). The cost of equity securities includes the purchase price of the Identify the categories of equity security plus brokers commissions and other fees incidental to the purchase. securities and describe the acThe degree to which one corporation (investor) acquires an interest in the counting and reporting treatment common stock of another corporation (investee) generally determines the accountfor each category. ing treatment for the investment subsequent to acquisition. The classification of PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Holdings of Less Than 20% 867 such investments depends on the percentage of the investee voting stock that is held by the investor: 1. Holdings of less than 20 percent (fair value method)investor has passive interest. 2. Holdings between 20 percent and 50 percent (equity method)investor has significant influence. 3. Holdings of more than 50 percent (consolidated statements)investor has controlling interest. Illustration 17-12 lists these levels of interest or influence and the corresponding valuation and reporting method that companies must apply to the investment. Percentage of Ownership Level of Influence Valuation Method 0% 20% 50% 100% Little or None Fair Value Method ILLUSTRATION 17-12 Levels of Influence Determine Accounting Methods Significant Equity Method Control Consolidation The accounting and reporting for equity securities therefore depend on the level of influence and the type of security involved, as shown in Illustration 17-13. Unrealized Holding Gains or Losses Category Holdings less than 20% 1. Availablefor-sale Valuation Other Income Effects ILLUSTRATION 17-13 Accounting and Reporting for Equity Securities by Category Fair value Recognized in Other comprehensive income and as separate component of stockholders equity Recognized in net income Not recognized Dividends declared; gains and losses from sale. 2. Trading Fair value Dividends declared; gains and losses from sale. Proportionate share of investees net income. Not applicable. Holdings between 20% and 50% Holdings more than 50% Equity Consolidation Not recognized HOLDINGS OF LESS THAN 20% When an investor has an interest of less than 20 percent, it is presumed that the investor has little or no influence over the investee. In such cases, if market prices are available subsequent to acquisition, the company values and reports the investment using the fair value method.5 The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities. Because equity securities have no maturity date, companies cannot classify them as held-to-maturity. 5 If an equity investment is not publicly traded, a company values the investment and reports it at cost in periods subsequent to acquisition. This approach is often referred to as the cost method. Companies recognize dividends when received. They value the portfolio and report it at acquisition cost. Companies only recognize gains or losses after selling the securities. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 868 Chapter 17 Investments Available-for-Sale Securities Upon acquisition, companies record available-for-sale securities at cost.6 To illustrate, assume that on November 3, 2010 Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest. Cost Northwest Industries, Inc. Campbell Soup Co. St. Regis Pulp Co. Total cost $259,700 317,500 141,350 $718,550 Republic records these investments as follows. November 3, 2010 Available-for-Sale Securities Cash 718,550 718,550 On December 6, 2010, Republic receives a cash dividend of $4,200 on its investment in the common stock of Campbell Soup Co. It records the cash dividend as follows. December 6, 2010 Cash Dividend Revenue 4,200 4,200 All three of the investee companies reported net income for the year, but only Campbell Soup declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the common stock of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income earned by the investee is not a proper basis for recognizing income from the investment by the investor. Why? Because the increased net assets resulting from profitable operations may be permanently retained for use in the investees business. Therefore, the investor earns net income only when the investee declares cash dividends. At December 31, 2010, Republics available-for-sale equity security portfolio has the cost and fair value shown in Illustration 17-14. ILLUSTRATION 17-14 Computation of Securities Fair Value Adjustment Available-for-Sale Equity Security Portfolio (2010) AVAILABLE-FOR-SALE EQUITY SECURITY PORTFOLIO DECEMBER 31, 2010 Investments Northwest Industries, Inc. Campbell Soup Co. St. Regis Pulp Co. Total of portfolio Previous securities fair value adjustment balance Securities fair value adjustmentCr. Cost $259,700 317,500 141,350 $718,550 Fair Value $275,000 304,000 104,000 $683,000 Unrealized Gain (Loss) $ 15,300 (13,500) (37,350) (35,550) 0 $(35,550) 6 Companies should record equity securities acquired in exchange for noncash consideration (property or services) at (1) the fair value of the consideration given, or (2) the fair value of the security received, whichever is more clearly determinable. Accounting for numerous purchases of securities requires the preservation of information regarding the cost of individual purchases, as well as the dates of purchases and sales. If specific identification is not possible, companies may use an average cost for multiple purchases of the same class of security. The first-in, first-out method (FIFO) of assigning costs to investments at the time of sale is also acceptable and normally employed. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Holdings of Less Than 20% 869 For Republics available-for-sale equity securities portfolio, the gross unrealized gains are $15,300, and the gross unrealized losses are $50,850 ($13,500 $37,350), resulting in a net unrealized loss of $35,550. The fair value of the available-for-sale securities portfolio is below cost by $35,550. As with available-for-sale debt securities, Republic records the net unrealized gains and losses related to changes in the fair value of available-for-sale equity securities in an Unrealized Holding Gain or LossEquity account. Republic reports this amount as a part of other comprehensive income and as a component of other accumulated comprehensive income (reported in stockholders equity) until realized. In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss Equity account and crediting the Securities Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows. December 31, 2010 Unrealized Holding Gain or LossEquity Securities Fair Value Adjustment (Available-for-Sale) 35,550 35,550 On January 23, 2011, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287,220. Illustration 17-15 shows the computation of the realized gain on the sale. ILLUSTRATION 17-15 Computation of Gain on Sale of Stock Net proceeds from sale Cost of Northwest shares Gain on sale of stock $287,220 259,700 $ 27,520 Republic records the sale as follows. January 23, 2011 Cash Available-for-Sale Securities Gain on Sale of Stock 287,220 259,700 27,520 In addition, assume that on February 10, 2011, Republic purchased 20,000 shares of Continental Trucking at a market price of $12.75 per share plus brokerage commissions of $1,850 (total cost, $256,850). Illustration 17-16 lists Republics portfolio of available-for-sale securities, as of December 31, 2011. ILLUSTRATION 17-16 Computation of Securities Fair Value Adjustment Available-for-Sale Equity Security Portfolio (2011) AVAILABLE-FOR-SALE EQUITY SECURITY PORTFOLIO DECEMBER 31, 2011 Investments Continental Trucking Campbell Soup Co. St. Regis Pulp Co. Total of portfolio Previous securities fair value adjustment balanceCr. Securities fair value adjustmentDr. Cost $256,850 317,500 141,350 $715,700 Fair Value $278,350 362,550 139,050 $779,950 Unrealized Gain (Loss) $21,500 45,050 (2,300) 64,250 (35,550) $99,800 At December 31, 2011, the fair value of Republics available-for-sale equity securities portfolio exceeds cost by $64,250 (unrealized gain). The Securities Fair Value Adjustment account had a credit balance of $35,550 at December 31, 2011. To adjust its December 31, 2011, available-for-sale portfolio to fair value, the company debits the PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 870 Chapter 17 Investments Securities Fair Value Adjustment account for $99,800 ($35,550 records this adjustment as follows. December 31, 2011 Securities Fair Value Adjustment (Available-for-Sale) Unrealized Holding Gain or LossEquity 99,800 99,800 $64,250). Republic Trading Securities The accounting entries to record trading equity securities are the same as for availablefor-sale equity securities, except for recording the unrealized holding gain or loss. For trading equity securities, companies report the unrealized holding gain or loss as part of net income. Thus, the account titled Unrealized Holding Gain or LossIncome is used. HOLDINGS BETWEEN 20% AND 50% An investor corporation may hold an interest of less than 50 percent in an investee corporation and thus not possess legal control. However, as shown in our opening story about Coca-Cola, an investment in voting stock of less than 50 percent can still give Coke (the investor) the ability to exercise significant influence over the operating and financial policies of its bottlers. [5] Significant influence may be indicated in several ways. Examples include representation on the board of directors, participation in policymaking processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings. To achieve a reasonable degree of uniformity in application of the significant influence criterion, the profession concluded that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee.7 In instances of significant influence (generally an investment of 20 percent or more), the investor must account for the investment using the equity method. Equity Method Objective4 Explain the equity method of accounting and compare it to the fair value method for equity securities. Under the equity method, the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at the cost of the shares acquired but subsequently adjusts the amount each period for changes in the investees net assets. That is, the investors proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investments carrying amount. All dividends received by the investor from the investee also decrease the investments carrying amount. The equity method recognizes that investees earnings increase investees net assets, and that investees losses and dividends decrease these net assets. Cases in which an investment of 20 percent or more might not enable an investor to exercise significant influence include: (1) The investee opposes the investors acquisition of its stock. (2) The investor and investee sign an agreement under which the investor surrenders significant shareholder rights. (3) The investors ownership share does not result in significant influence because majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor. (4) The investor tries and fails to obtain representation on the investees board of directors. [6] 7 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Holdings between 20% and 50% 871 To illustrate the equity method and compare it with the fair value method, assume that Maxi Company purchases a 20 percent interest in Mini Company. To apply the fair value method in this example, assume that Maxi does not have the ability to exercise significant influence, and classifies the securities as available-for-sale. Where this example applies the equity method, assume that the 20 percent interest permits Maxi to exercise significant influence. Illustration 17-17 shows the entries. ILLUSTRATION 17-17 Comparison of Fair Value Method and Equity Method ENTRIES BY MAXI COMPANY Fair Value Method Equity Method On January 2, 2010, Maxi Company acquired 48,000 shares (20% of Mini Company common stock) at a cost of $10 a share. Available-for-Sale-Securities Cash 480,000 480,000 Investment in Mini Stock Cash 480,000 480,000 For the year 2010, Mini Company reported net income of $200,000; Maxi Companys share is 20%, or $40,000. No entry Investment in Mini Stock Revenue from Investment 40,000 40,000 At December 31, 2010, the 48,000 shares of Mini Company have a fair value (market price) of $12 a share, or $576,000. Securities Fair Value Adjustment (Available-for-Sale) Unrealized Holding Gain or LossEquity No entry 96,000 96,000 On January 28, 2011, Mini Company announced and paid a cash dividend of $100,000; Maxi Company received 20%, or $20,000. Cash Dividend Revenue 20,000 20,000 Cash Investment in Mini Stock 20,000 20,000 For the year 2011, Mini reported a net loss of $50,000; Maxi Companys share is 20%, or $10,000. No entry Loss on Investment Investment in Mini Stock 10,000 10,000 At December 31, 2011, the Mini Company 48,000 shares have a fair value (market price) of $11 a share, or $528,000. Unrealized Holding Gain or LossEquity Securities Fair Value Adjustment (Available-for-Sale) 48,000 No entry 48,000 Note that under the fair value method, Maxi reports as revenue only the cash dividends received from Mini. The earning of net income by Mini (the investee) is not considered a proper basis for recognition of income from the investment by Maxi (the investor). Why? Mini may permanently retain in the business any increased net assets resulting from its profitable operation. Therefore, Maxi only earns revenue when it receives dividends from Mini. Under the equity method, Maxi reports as revenue its share of the net income I NTERNATIONAL reported by Mini. Maxi records the cash dividends received from Mini as a de- I NSIGHT crease in the investment carrying value. As a result, Maxi records its share of the iGAAP permits companies to net income of Mini in the year when it is earned. With significant influence, Maxi measure significant-influence investcan ensure that Mini will pay dividends, if desired, on any net asset increases re- ments using the equity, cost, or fair sulting from net income. To wait until receiving a dividend ignores the fact that value methods. Maxi is better off if the investee has earned income. Using dividends as a basis for recognizing income poses an additional problem. For example, assume that the investee reports a net loss. However, the investor exerts influence to force a dividend payment from the investee. In this case, the investor reports income, even though the investee is experiencing a loss. In other words, using dividends as a basis for recognizing income fails to report properly the economics of the situation. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 872 Chapter 17 Investments For some companies, equity accounting can be a real pain to the bottom line. For example, Amazon.com, the pioneer of Internet retailing, at one time struggled to turn a profit. Furthermore, some of Amazons equity investments had resulted in Amazons earnings performance going from bad to worse. In a recent year, Amazon.com disclosed equity stakes in such companies as Altera International, Basis Technology, Drugstore.com, and Eziba.com. These equity investees reported losses that made Amazons already bad bottom line even worse, accounting for up to 22 percent of its reported loss in one year alone. Investee Losses Exceed Carrying Amount Underlying Concepts Revenue to be recognized should be earned and realized or realizable. A low level of ownership indicates that a company should defer the income from an investee until cash is received. If an investors share of the investees losses exceeds the carrying amount of the investment, should the investor recognize additional losses? Ordinarily, the investor should discontinue applying the equity method and not recognize additional losses. If the investors potential loss is not limited to the amount of its original investment (by guarantee of the investees obligations or other commitment to provide further financial support), or if imminent return to profitable operations by the investee appears to be assured, the investor should recognize additional losses. [7] HOLDINGS OF MORE THAN 50% When one corporation acquires a voting interest of more than 50 percent in another corporation, it is said to have a controlling interest. In such a relationship, the investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a longterm investment on the separate financial statements of the parent. When the parent treats the subsidiary as an investment, the parent generI NTERNATIONAL ally prepares consolidated financial statements. Consolidated financial stateI NSIGHT ments treat the parent and subsidiary corporations as a single economic entity. In contrast to U.S. firms, (Advanced accounting courses extensively discuss the subject of when and how financial statements of non-U.S. to prepare consolidated financial statements.) Whether or not consolidated companies often include both consolifinancial statements are prepared, the parent company generally accounts for dated (group) statements and parent the investment in the subsidiary using the equity method as explained in the company financial statements. previous section of this chapter. CONSOLIDATE THIS! Presently the rules for consolidation seem very straightforward: If a company owns more than 50 percent of another company, it generally should be consolidated. If it owns less than 50 percent, it is generally not consolidated. However the FASB recognizes the artificiality of the present test. Determination of who really has control often relies on factors other than stock ownership. In fact, specific guidelines force consolidation even though stock ownership is not above 50 percent in certain limited situations. For example, Enrons failure to consolidate three special purpose entities (SPEs) that it effectively controlled led to an overstatement of income of $569 million and overstatement of equity of $1.2 billion. In each of Enrons three SPEs, the GAAP guidelines would have led to consolidation. That is, the following factors indicate that consolidation should have occurred: the majority owner of the special purpose entity (SPE) made only a modest investment; the activities of the SPE primarily benefited Enron; and the substantive risks and rewards related to the assets or debt of the SPE rested directly or indirectly with Enron. The FASB has issued new guidelines related to SPEs, given all the reporting problems that have surfaced related to SPEs at Enron and other companies. We discuss these new rules in Appendix 17B. What do the numbers mean? PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Fair Value Option 873 FAIR VALUE OPTION As indicated in earlier chapters, companies have the option to report most finanObjective5 cial instruments at fair value, with all gains and losses related to changes in fair Describe the accounting for the value reported in the income statement. This option is applied on an instrumentfair value option. by-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. For example, assume that Abbott Laboratories purchased debt securities in 2010 that it classified as held-to-maturity. Abbott does not choose to report this security using the fair value option. In 2011, Abbott buys another held-to-maturity debt security. Abbott decides to report this security using the fair value option. Once it chooses the fair value option for the security bought in 2011, the decision is irrevocable (may not be changed). In addition, Abbott does not have the option to value the held-tomaturity security purchased in 2010 at fair value in 2011 or in subsequent periods. Many support the use of the fair value option as a step closer to total fair value reporting for financial instruments. They believe this treatment leads to an improvement in financial reporting. Others argue that the fair value option is confusing. A company can choose from period to period whether to use the fair value option for any new investment in a financial instrument. By permitting an instrument-by-instrument approach, companies are able to report some financial instruments at fair value but not others. To illustrate the accounting issues related to the fair value option, we discuss three different situations. Available-for-Sale Securities Available-for-sale securities are presently reported at fair value, and any unrealized gains and losses are recorded as part of other comprehensive income. Assume that Hardy Company purchases stock in Fielder Company during 2010 that it classifies as available-for-sale. At December 31, 2010, the cost of this security is $100,000; its fair value at December 31, 2010, is $125,000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2010. Investment in Fielder Stock Unrealized Holding Gain or LossIncome 25,000 25,000 In this situation, Hardy uses an account titled Investment in Fielder Stock to record the change in fair value at December 31. It does not use a Securities Fair Value Adjustment account because the accounting for a fair value option is on an investment-byinvestment basis rather than on a portfolio basis. Because Hardy selected the fair value option, the unrealized gain or loss is recorded as part of net income. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security. Equity Method of Accounting Companies may also use the fair value option for investments that otherwise follow the equity method of accounting. To illustrate, assume that Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2010 for $930,000. At December 31, 2010, the fair value of the investment is $900,000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this investment is as follows. Unrealized Holding Gain or LossIncome Investment in Suppan Stock 30,000 30,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 874 Chapter 17 Investments In contrast to equity method accounting, if the fair value option is chosen, Durham does not have to report its pro rata share of the income or loss from Suppan. In addition, any dividend payments are credited to Dividend Revenue and therefore do not reduce the Investment in Suppan Stock account. One major advantage of using the fair value option for this type of investment is that it addresses confusion about the equity method of accounting. In other words, what exactly does the one-line consolidation related to the equity method of accounting on the balance sheet tell investors? Many believe it does not provide information about liquidity or solvency, nor does it provide an indication of the worth of the company. Financial Liabilities One of the more controversial aspects of the fair value option relates to valuation of a companys own liabilities. Companies may apply the fair value option to their own debt instruments. As a result, changes in the fair value of the debt instrument are included as part of earnings in any given period. To illustrate, Edmonds Company has issued $500,000 of 6% bonds at face value on May 1, 2010. Edmonds chooses the fair value option for these bonds. At December 31, 2010, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent. The value of the debt securities falls because the bond is paying less than market rate for similar securities. Under the fair value option, Edmonds makes the following entry. Bonds Payable Unrealized Holding Gain or LossIncome 20,000 20,000 As the journal entry indicates, the value of the bonds declined. This decline leads to a reduction in the bond liability and a resulting unrealized holding gain, which is reported as part of net income. The value of Edmonds debt declined because interest rates increased. In addition, if the creditworthiness of Edmonds Company declines, the value of its debt also declines. That is, Edmonds issued debt at rates reflecting higher creditworthiness. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. If Edmonds is using the fair value option in this case, it records an unrealized holding gain due to its worsening credit position. Some question how Edmonds can record a gain when its creditworthiness is becoming worse. As one writer noted, It seems counter-intuitive. However, the FASB notes that the debtholders loss is the stockholders gain. That is, the stockholders claims on the assets of the company increase when the value of the debtholders declines. In addition, the worsening credit position may indicate that the assets of the company are declining in value as well. Thus, the company may be reporting losses on the asset side which will be offsetting gains on the liability side. SECTION 3 OTH ER R EPORTI NG ISSU ES We have identified the basic issues involved in accounting for investments in debt and equity securities. In addition, the following issues relate to both of these types of securities. 1. 2. 3. 4. Impairment of value. Reclassification adjustments. Transfers between categories. Fair value controversy. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Impairment of Value 875 IMPAIRMENT OF VALUE A company should evaluate every investment, at each reporting date, to deterObjective6 mine if it has suffered impairmenta loss in value that is other than temporary. Discuss the accounting for For example, if an investee experiences a bankruptcy or a significant liquidity criimpairments of debt and equity sis, the investor may suffer a permanent loss. If the decline is judged to be other investments. than temporary, a company writes down the cost basis of the individual security to a new cost basis. The company accounts for the write-down as a realized loss. Therefore, it includes the amount in net income. For debt securities, a company uses the impairment test to determine whether it is probable that the investor will be unable to collect all amounts due according to the contractual terms. For equity securities, the guideline is less precise. Any time realizable value is lower than the carrying amount of the investment, a company must consider an impairment. Factors involved include the length of time and the extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; and the intent and ability of the investor company to retain its investment to allow for any anticipated recovery in fair value. To illustrate an impairment, assume that Strickler Company holds available-forsale bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800,000. Strickler has previously reported an unrealized loss on these securities of $200,000 as part of other comprehensive income. In evaluating the securities, Strickler now determines that it probably will not collect all amounts due. In this case, it reports the unrealized loss of $200,000 as a loss on impairment of $200,000. Strickler includes this amount in income, with the bonds stated at their new cost basis. It records this impairment as follows. Loss on Impairment Available-for-Sale Securities 200,000 200,000 The new cost basis of the investment in debt securities is $800,000. Strickler includes subsequent increases and decreases in the fair value of impaired available-forsale securities as other comprehensive income.8 Companies base impairment for debt and equity securities on a fair value test. This test differs slightly from the impairment test for loans that we discuss in Appendix 7B. The FASB rejected the discounted cash flow alternative for securities because of the availability of market price information. An example of the criteria used by Caterpillar to assess impairment is provided in Illustration 17-18. Caterpillar, Inc. Notes to Financial Statements Note 1. Impairment of available-for-sale securities Available-for-sale securities are reviewed monthly to identify market values below cost of 20% or more. If a decline for a debt security is in excess of 20% for six months, the investment is evaluated to determine if the decline is due to general declines in the marketplace or if the investment has been impaired and should be written down to market value. . . . After the six-month period, debt securities with declines from cost in excess of 20% are evaluated monthly for impairment. For equity securities, if a decline from cost of 20% or more continues for a 12-month period, an other than temporary impairment is recognized without continued analysis. ILLUSTRATION 17-18 Disclosure of Impairment Assessment Criteria 8 Companies may not amortize any discount related to the debt securities after recording the impairment. The new cost basis of impaired held-to-maturity securities does not change unless additional impairment occurs. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 876 Chapter 17 Investments RECLASSIFICATION ADJUSTMENTS Objective7 Explain why companies report reclassification adjustments. As we indicated in Chapter 4, companies report changes in unrealized holding gains and losses related to available-for-sale securities as part of other comprehensive income. Companies may display the components of other comprehensive income in one of three ways: (1) in a combined statement of income and comprehensive income, (2) in a separate statement of comprehensive income that begins with net income, or (3) in a statement of stockholders equity. The reporting of changes in unrealized gains or losses in comprehensive income is straightforward unless a company sells securities during the year. In that case, double counting results when the company reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current period or in previous periods. To ensure that gains and losses are not counted twice when a sale occurs, a reclassification adjustment is necessary. To illustrate, assume that Open Company has the following two available-for-sale securities in its portfolio at the end of 2009 (its first year of operations). Unrealized Holding Gain (Loss) $25,000 15,000 40,000 0 $40,000 ILLUSTRATION 17-19 Available-for-Sale Security Portfolio (2009) Investments Lehman Inc. common stocks Woods Co. common stocks Total of portfolio Previous securities fair value adjustment balance Securities fair value adjustmentDr. Cost $ 80,000 120,000 $200,000 Fair Value $105,000 135,000 $240,000 If Open Company reports net income in 2009 of $350,000, it presents a statement of comprehensive income as follows. ILLUSTRATION 17-20 Statement of Comprehensive Income (2009) OPEN COMPANY STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED DECEMBER 31, 2009 Net income Other comprehensive income Holding gains arising during period Comprehensive income $350,000 40,000 $390,000 During 2010, Open Company sold the Lehman Inc. common stock for $105,000 and realized a gain on the sale of $25,000 ($105,000 $80,000). At the end of 2010, the fair value of the Woods Co. common stock increased an additional $20,000, to $155,000. Illustration 17-21 shows the computation of the change in the securities fair value adjustment account. ILLUSTRATION 17-21 Available-for-Sale Security Portfolio (2010) Unrealized Holding Gain (Loss) $35,000 (40,000) $ (5,000) Investments Woods Co. common stocks Previous securities fair value adjustment balanceDr. Securities fair value adjustmentCr. Cost $120,000 Fair Value $155,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Reclassification Adjustments 877 Illustration 17-21 indicates that Open should report an unrealized holding loss of $5,000 in comprehensive income in 2010. In addition, Open realized a gain of $25,000 on the sale of the Lehman common stock. Comprehensive income includes both realized and unrealized components. Therefore, Open recognizes a total holding gain (loss) in 2010 of $20,000, computed as follows. ILLUSTRATION 17-22 Computation of Total Holding Gain (Loss) Unrealized holding gain (loss) Realized holding gain Total holding gain recognized $ (5,000) 25,000 $20,000 Open reports net income of $720,000 in 2010, which includes the realized gain on sale of the Lehman securities. Illustration 17-23 shows a statement of comprehensive income for 2010, indicating how Open reported the components of holding gains (losses). ILLUSTRATION 17-23 Statement of Comprehensive Income (2010) $720,000 OPEN COMPANY STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED DECEMBER 31, 2010 Net income (includes $25,000 realized gain on Lehman shares) Other comprehensive income Total holding gains arising during period [$(5,000) $25,000] Less: Reclassification adjustment for gains included in net income Comprehensive income $20,000 25,000 (5,000) $715,000 In 2009, Open included the unrealized gain on the Lehman Co. common stock in comprehensive income. In 2010, Open sold the stock. It reported the realized gain in net income, which increased comprehensive income again. To avoid double counting this gain, Open makes a reclassification adjustment to eliminate the realized gain from the computation of comprehensive income in 2010. A company may display reclassification adjustments on the face of the financial statement in which it reports comprehensive income. Or it may disclose these reclassification adjustments in the notes to the financial statements. Comprehensive Example To illustrate the reporting of investment securities and related gain or loss on availablefor-sale securities, assume that on January 1, 2010, Hinges Co. had cash and common stock of $50,000.9 At that date the company had no other asset, liability, or equity balance. On January 2, Hinges purchased for cash $50,000 of equity securities classified as available-for-sale. On June 30, Hinges sold part of the available-for-sale security portfolio, realizing a gain as shown in Illustration 17-24. ILLUSTRATION 17-24 Computation of Realized Gain Fair value of securities sold Less: Cost of securities sold Realized gain $22,000 20,000 $ 2,000 9 We adapted this example from Dennis R. Beresford, L. Todd Johnson, and Cheri L. Reither, Is a Second Income Statement Needed? Journal of Accountancy (April 1996), p. 71. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 878 Chapter 17 Investments Hinges did not purchase or sell any other securities during 2010. It received $3,000 in dividends during the year. At December 31, 2010, the remaining portfolio is as shown in Illustration 17-25. ILLUSTRATION 17-25 Computation of Unrealized Gain Fair value of portfolio Less: Cost of portfolio Unrealized gain $34,000 30,000 $ 4,000 Illustration 17-26 shows the companys income statement for 2010. ILLUSTRATION 17-26 Income Statement HINGES CO. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Dividend revenue Realized gains on investment in securities Net income $3,000 2,000 $5,000 The company reports its change in the unrealized holding gain in a statement of comprehensive income as follows. ILLUSTRATION 17-27 Statement of Comprehensive Income HINGES CO. STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED DECEMBER 31, 2010 Net income Other comprehensive income: Holding gains arising during the period ($4,000 $2,000) Less: Reclassification adjustment for gains included in net income Comprehensive income $5,000 $6,000 2,000 4,000 $9,000 Its statement of stockholders equity appears in Illustration 17-28. ILLUSTRATION 17-28 Statement of Stockholders Equity HINGES CO. STATEMENT OF STOCKHOLDERS EQUITY FOR THE YEAR ENDED DECEMBER 31, 2010 Common Stock Beginning balance Add: Net income Other comprehensive income Ending balance $50,000 Retained Earnings $0 5,000 Accumulated Other Comprehensive Income $0 Total $50,000 5,000 4,000 $59,000 4,000 $50,000 $5,000 $4,000 The comparative balance sheet is shown on the next page in Illustration 17-29. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Transfers between Categories 879 ILLUSTRATION 17-29 Comparative Balance Sheet HINGES CO. COMPARATIVE BALANCE SHEET 1/1/10 Assets Cash Available-for-sale securities Total assets Stockholders equity Common stock Retained earnings Accumulated other comprehensive income Total stockholders equity $50,000 $50,000 $50,000 12/31/10 $25,000 34,000 $59,000 $50,000 5,000 4,000 $59,000 $50,000 This example indicates how an unrealized gain or loss on available-for-sale securities affects all the financial statements. Note that a company must disclose the components that comprise accumulated other comprehensive income. TRANSFERS BETWEEN CATEGORIES Companies account for transfers between any of the categories at fair value. Thus, if a company transfers available-for-sale securities to held-to-maturity investments, it records the new investment (held-to-maturity) at the date of transfer at fair value in the new category. Similarly, if it transfers held-to-maturity investments to available-for-sale investments, it records the new investments (available-for-sale) at fair value. This fair value rule assures that a company cannot omit recognition of fair value simply by transferring securities to the held-to-maturity category. Illustration 17-30 summarizes the accounting treatment for transfers. Impact of Transfer on Stockholders Equity* The unrealized gain or loss at the date of transfer increases or decreases stockholders equity. The unrealized gain or loss at the date of transfer increases or decreases stockholders equity. The separate component of stockholders equity is increased or decreased by the unrealized gain or loss at the date of transfer. The unrealized gain or loss at the date of transfer carried as a separate component of stockholders equity is amortized over the remaining life of the security. Impact of Transfer on Net Income* The unrealized gain or loss at the date of transfer is recognized in income. The unrealized gain or loss at the date of transfer is recognized in income. None Objective8 Describe the accounting for transfer of investment securities between categories. Type of Transfer Transfer from trading to available-forsale Transfer from available-forsale to trading Measurement Basis Security transferred at fair value at the date of transfer, which is the new cost basis of the security. Security transferred at fair value at the date of transfer, which is the new cost basis of the security. Security transferred at fair value at the date of transfer. ILLUSTRATION 17-30 Accounting for Transfers o co llege/k i es w Examples of the Entries for Recording Transfers Between Categories Transfer from held-to-maturity to availablefor-sale** Transfer from available-forsale to held-tomaturity Security transferred at fair value at the date of transfer. None *Assumes that adjusting entries to report changes in fair value for the current period are not yet recorded. **According to GAAP, these types of transfers should be rare. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / 880 Chapter 17 Investments FAIR VALUE CONTROVERSY The reporting of investment securities is controversial. Some believe that all securities should be reported at fair value; others believe they all should be stated at amortized cost. Others favor the present approach. In this section we look at some of the major unresolved issues. Measurement Based on Intent Companies classify debt securities as held-to-maturity, available-for-sale, or trading. As a result, companies can report three identical debt securities in three different ways in the financial statements. Some argue such treatment is confusing. Furthermore, the held-to-maturity category relies solely on intent, a subjective evaluation. What is not subjective is the fair value of the debt instrument. In other words, the three classifications are subjective, resulting in arbitrary classifications. Gains Trading Companies can classify certain debt securities as held-to-maturity and therefore report them at amortized cost. Companies can classify other debt and equity securities as available-for-sale and report them at fair value with the unrealized gain or loss reported as other comprehensive income. In either case, a company can become involved in gains trading (also referred to as cherry picking, snacking, or sell the best and keep the rest). In gains trading, companies sell their winners, reporting the gains in income, and hold on to the losers. Liabilities Not Fairly Valued Many argue that if companies report investment securities at fair value, they also should report liabilities at fair value. Why? By recognizing changes in value on only one side of the balance sheet (the asset side), a high degree of volatility can occur in the income and stockholders equity amounts. Further, financial institutions are involved in asset and liability management (not just asset management). Viewing only one side may lead managers to make uneconomic decisions as a result of the accounting. Fair ValuesFinal Comment Both the IASB and the FASB believe that fair value information for financial assets and financial liabilities provides more useful and relevant information than a costbased system. The Boards take this position because fair value reflects the current cash equivalent of the financial instrument rather that the cost of a past transaction. As a consequence, only fair value provides an understanding of the current worth of the investment. Companies must report fair values for some types of financial instruments. In addition, they have the option to record fair values for any of their financial instruments. How many companies will choose this fair value option? We are hopeful that many companies will select this option; we believe that the information provided by fair value reporting for financial instruments is useful and more understandable to financial statement users. SUMMARY OF REPORTING TREATMENT OF SECURITIES Illustration 17-31 summarizes the major debt and equity securities and their reporting treatment. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Summary of Reporting Treatment of Securities 881 ILLUSTRATION 17-31 Summary of Treatment of Major Debt and Equity Securities es o Category* Trading (debt and equity securities) Balance Sheet Investments shown at fair value. Current assets. Income Statement Interest and dividends are recognized as revenue. Unrealized holding gains and losses are included in net income. Interest and dividends are recognized as revenue. Unrealized holding gains and losses are not included in net income but in other comprehensive income. Interest is recognized as revenue. Revenue is recognized to the extent of the investees earnings or losses reported subsequent to the date of investment. co llege/k Available-for-sale (debt and equity securities) Held-to-maturity (debt securities) Equity method and/or consolidation (equity securities) Investments shown at amortized cost. Current or long-term assets. Investments originally are carried at cost, are periodically adjusted by the investors share of the investees earnings or losses, and are decreased by all dividends received from the investee. Classified as long-term. Discussion of Special Issues Related to Investments *Companies have the option to report financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. If a company chooses to use the fair option for some of its financial instruments, these assets or liabilities should be reported separately from other financial instruments that used a different valuation basis. To accomplish separate reporting, a company may either (a) report separate line items for the fair value and nonfair value amounts or (b) report the total fair value and nonfair value amounts in one line and parenthetically report the fair value amount in that line also.10 MORE DISCLOSURE, PLEASE As indicated in the last two sections, the level of disclosure for investment securities is extensive. How to account for investment securities is a particularly sensitive area, given the large amounts of equity investments involved. And presently companies report investments in equity securities at cost, equity, fair value, and full consolidation, depending on the circumstances. As a recent SEC study noted, there are so many different accounting treatments for investments that it raises the question of whether they are all needed. Presented below is an estimate of the percentage of companies on the major exchanges that have investments in the equity of other entities. Investments in the Equity of Other Companies Categorized by Accounting Treatment Presenting consolidated financial statements Reporting equity method investments Reporting cost method investments* Reporting available-for-sale investments Reporting trading investments Percent of Companies 91.1% 23.5 17.4 37.4 6.2 What do the numbers mean? *If the equity investments are not publicly traded, the company often accounts for the investment under the cost method. Changes in value are therefore not recognized unless there is impairment. As the table indicates, many companies have equity investments of some type. These investments can be substantial. For example, based on the table above, the total amount of equity-method investments appearing on company balance sheets is approximately $403 billion, and the amount shown in the income statements in any one year for all companies is approximately $38 billion. Source: Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers, United States Securities and Exchange CommissionOffice of Chief Accountant, Office of Economic Analyses, Division of Corporation Finance (June 2005), pp. 3639. You will want to read the CONVERGENCE CORNER on page 882 For discussion of how international convergence efforts relate to the accounting for investments. 10 Not surprisingly, the disclosure requirements for investments and other financial assets and liabilities are extensive. We provide an expanded discussion with examples of these disclosure requirements in Appendix 17C. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / Investments shown at fair value. Current or long-term assets. Unrealized holding gains and losses are a separate component of stockholders equity. i w CONVERGENCE CORNER INVESTMENTS The accounting for investment securities is discussed in IAS 27 (Consolidated and Separate Financial Statements), IAS 28 (Accounting for Investments in Associates), and IAS 39 (Financial Instruments: Recognition and Measurement). The accounting and reporting under iGAAP and U.S. GAAP are for the most part very similar, although the criteria used to determine the accounting is often different. R E L E VA N T FA C T S The accounting for trading, available-for-sale, and held-to-maturity securities is essentially the same between iGAAP and U.S. GAAP. ABOUT THE NUMBERS The following example illustrates the accounting for investment impairments under iGAAP. Belerus Company has an available-for-sale investment in the 8 percent, 10-year bonds of Wimbledon Company. The investment has a carrying value of 2,300,000 euros at December 31, 2010. Early in January 2011, Belerus learns that Wimbledon has lost a major customer. As a result, Belerus determines that this investment is impaired and now has a fair value of 1,500,000 euros. Belerus makes the following entry to record the impairment. Loss on Impairment (2,300,000 Available-for-Sale Investment 1,500,000) 800,000 800,000 Gains and losses related to available-for-sale securities are reported in other comprehensive income under U.S. GAAP. Under iGAAP, these gains and losses are reported directly in equity. Both iGAAP and U.S. GAAP use the same test to determine whether the equity method of accounting should be usedthat is, significant influence with a general guide of over 20 percent ownership. iGAAP uses the term associate investment rather than equity investment to describe its investment under the equity method. Early in 2012, Wimbledon secures several new customers, and its prospects have improved considerably. Belerus determines the fair value of its investment is now 2,000,000 euros and makes the following entry under iGAAP. Available-for-Sale Impairment (2,000,000 1,500,000) Recovery of Loss on Investment 500,000 500,000 Reclassifications of securities from one category to another generally follow the same accounting under the two GAAP systems. Reclassification in and out of trading securities is prohibited under iGAAP. It is not prohibited under U.S. GAAP, but this type of reclassification should be rare. Under U.S. GAAP, Belerus is prohibited from recording the recovery in value of the impaired investment. That is, once an investment is impaired, the impaired value becomes the new basis for the investment. Under iGAAP, both the investor and an associate company should follow the same accounting policies. As a result, in order to prepare financial information, adjustments are made to the associates policies to conform to the investors books. The basis for consolidation under iGAAP is control. Under U.S. GAAP, a bipolar approach is used, which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting-interest approach. However, under both systems, for consolidation to occur, the investor company must generally own 50 percent of another company. iGAAP and U.S. GAAP are similar in the accounting for the fair value option. That is, the selection to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses related to fair value changes are reported as part of income. The differences relate to disclosures and scope exceptions. U.S. GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. iGAAP follows the same approach for available-for-sale equity investments but permits reversal for available-for-sale debt securities and held-to-maturity securities. ON TH E HORIZON As indicated earlier, both the FASB and IASB have indicated that they believe that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. It seems likely as more companies choose the fair value option for financial instruments, we will eventually arrive at fair value measurement for all financial instruments. 882 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Summary of Learning Objectives 883 SUMMARY OF LEARNING OBJECTIVES 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. (1) Carry and report held-to-maturity debt securities at amor- KEY TERMS amortized cost, 859 available-for-sale securities, 858 consolidated financial statements, 872 controlling interest, 872 debt securities, 858 effective-interest method, 860 equity method, 870 equity securities, 866 exchange for noncash consideration, 868(n) fair value, 859 fair value method, 867 gains trading, 865, 880 held-to-maturity securities, 858 holding gain or loss, 865 impairment, 875 investee, 866 investor, 866 parent, 872 reclassification adjustment, 876 Securities Fair Value Adjustment account, 863 security, 858(n) significant influence, 870 subsidiary, 872 trading securities, 858 tized cost. (2) Value trading debt securities for reporting purposes at fair value, with unrealized holding gains or losses included in net income. (3) Value available-for-sale debt securities for reporting purposes at fair value, with unrealized holding gains or losses reported as other comprehensive income and as a separate component of stockholders equity. 2 Understand the procedures for discount and premium amortization on bond investments. Similar to bonds payable, companies should amortize discount or premium on bond investments using the effective-interest method. They apply the effective interest rate or yield to the beginning carrying value of the investment for each interest period in order to compute interest revenue. 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for the investment. Long-term investments by one corporation in the common stock of another can be classified according to the percentage of the voting stock of the investee held by the investor. 4 Explain the equity method of accounting and compare it to the fair value method for equity securities. Under the equity method the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at cost but subsequently adjusts the amount each period for changes in the net assets of the investee. That is, the investors proportionate share of the earnings (losses) of the investee periodially increases (decreases) the investments carrying amount. All dividends received by the investor from the investee decrease the investments carrying amount. Under the fair value method a company reports the equity investment at fair value each reporting period irrespective of the investees earnings or dividends paid to it. A company applies the equity method to investment holdings between 20 percent and 50 percent of ownership. It applies the fair value method to holdings below 20 percent. 5 Describe the accounting for the fair value option. Companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrumentby-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. 6 Discuss the accounting for impairments of debt and equity investments. Impairments of debt and equity securities are losses in value that are determined to be other than temporary, are based on a fair value test, and are charged to income. 7 Explain why companies report reclassification adjustments. A company needs a reclassification adjustment when it reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current or in previous periods. Companies should report unrealized holding gains or losses related to available-for-sale securities in other comprehensive income and the aggregate balance as accumulated comprehensive income on the balance sheet. 8 Describe the accounting for transfer of investment securities between categories. Transfers of securities between categories of investments should be accounted for at fair value, with unrealized holding gains or losses treated in accordance with the nature of the transfer. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 884 Chapter 17 Investments APPENDIX 17A ACCOUNTING FOR DERIVATIVE INSTRUMENTS Until the early 1970s, most financial managers worked in a cozy, if unthrilling, world. Since then, constant change caused by volatile markets, new technology, and deregulation has increased the risks to businesses. In response, the financial community developed products to manage these risks. These productscalled derivative financial instruments or simply, derivatives are useful for managing risk. Companies use the fair values or cash flows of these instruments to offset the changes in fair values or cash flows of the at-risk assets. The development of powerful computing and communication technology has aided the growth in derivative use. This technology provides new ways to analyze information about markets as well as the power to process high volumes of payments. DEFINING DERIVATIVES In order to understand derivatives, consider the following examples. Example 1Forward Contract. Assume that a company like Dell believes that the price of Googles stock will increase substantially in the next 3 months. Unfortunately, it does not have the cash resources to purchase the stock today. Dell therefore enters into a contract with a broker for delivery of 10,000 shares of Google stock in 3 months at the price of $110 per share. Dell has entered into a forward contract, a type of derivative. As a result of the contract, Dell has received the right to receive 10,000 shares of Google stock in 3 months. Further, it has an obligation to pay $110 per share at that time. What is the benefit of this derivative contract? Dell can buy Google stock today and take delivery in 3 months. If the price goes up, as it expects, Dell profits. If the price goes down, Dell loses. Example 2Option Contract. Now suppose that Dell needs 2 weeks to decide whether to purchase Google stock. It therefore enters into a different type of contract, one that gives it the right to purchase Google stock at its current price any time within the next 2 weeks. As part of the contract, the broker charges $3,000 for holding the contract open for 2 weeks at a set price. Dell has now entered into an option contract, another type of derivative. As a result of this contract, it has received the right, but not the obligation to purchase this stock. If the price of the Google stock increases in the next 2 weeks, Dell exercises its option. In this case, the cost of the stock is the price of the stock stated in the contract, plus the cost of the option contract. If the price does not increase, Dell does not exercise the contract, but still incurs the cost for the option. The forward contract and the option contract both involve a future delivery of stock. The value of the contract relies on the underlying assetthe Google stock. Thus, these financial instruments are known as derivatives because they derive their value from values of other assets (e.g., stocks, bonds, or commodities). Or, put another way, their value relates to a market-determined indicator (e.g., stock price, interest rates, or the Standard and Poors 500 stock composite index). In this appendix, we discuss the accounting for three different types of derivatives: 1. Financial forwards or financial futures. 2. Options. 3. Swaps. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 885 WHO USES DERIVATIVES, AND WHY? Whether to protect for changes in interest rates, the weather, stock prices, oil prices, or foreign currencies, derivative contracts help to smooth the fluctuations caused by various types of risks. A company that wants to ensure against certain types of business risks often uses derivative contracts to achieve this objective.11 Objective9 Explain who uses derivatives and why. Producers and Consumers To illustrate, assume that Heartland Ag is a large producer of potatoes for the consumer market. The present price for potatoes is excellent. Unfortunately, Heartland needs two months to harvest its potatoes and deliver them to the market. Because Heartland expects the price of potatoes to drop in the coming months, it signs a forward contract. It agrees to sell its potatoes today at the current market price for delivery in 2 months. Who would buy this contract? Suppose on the other side of the contract is McDonalds Corporation. McDonalds wants to have potatoes (for French fries) in 2 months and believes that prices will increase. McDonalds is therefore agreeable to accepting delivery in 2 months at current prices. It knows that it will need potatoes in 2 months, and that it can make an acceptable profit at this price level. In this situation, if the price of potatoes increases before delivery, Heartland loses and McDonalds wins. Conversely, if the price decreases, Heartland wins and McDonalds loses. However, the objective is not to gamble on the outcome. Regardless of which way the price moves, both Heartland and McDonalds have received a price at which they obtain an acceptable profit. In this case, although Heartland is a producer and McDonalds is a consumer, both companies are hedgers. They both hedge their positions to ensure an acceptable financial result. Commodity prices are volatile. They depend on weather, crop production, and general economic conditions. For the producer and the consumer to plan effectively, it makes good sense to lock in specific future revenues or costs in order to run their businesses successfully. Speculators and Arbitrageurs In some cases, instead of McDonalds taking a position in the forward contract, a speculator may purchase the contract from Heartland. The speculator bets that the price of potatoes will rise, thereby increasing the value of the forward contract. The speculator, who may be in the market for only a few hours, will then sell the forward contract to another speculator or to a company like McDonalds. Arbitrageurs also use derivatives. These market players attempt to exploit inefficiencies in markets. They seek to lock in profits by simultaneously entering into transactions in two or more markets. For example, an arbitrageur might trade in a futures contract. At the same time, the arbitrageur will also trade in the commodity underlying the futures contract, hoping to achieve small price gains on the difference between the two. Markets rely on speculators and arbitrageurs to keep the market liquid on a daily basis. In these illustrations, we explained why Heartland (the producer) and McDonalds (the consumer) would become involved in a derivative contract. Consider other types of situations that companies face. 1. Airlines, like Delta, Southwest, and United, are affected by changes in the price of jet fuel. 2. Financial institutions, such as Citigroup, Bankers Trust, and M&I Bank, are involved in borrowing and lending funds that are affected by changes in interest rates. 3. Multinational corporations, like Cisco Systems, Coca-Cola, and General Electric, are subject to changes in foreign exchange rates. 11 Derivatives are traded on many exchanges throughout the world. In addition, many derivative contracts (primarily interest rate swaps) are privately negotiated. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 886 Chapter 17 Investments In fact, most corporations are involved in some form of derivatives transactions. Companies give these reasons (in their annual reports) as to why they use derivatives: 1. ExxonMobil uses derivatives to hedge its exposure to fluctuations in interest rates, foreign currency exchange rates, and hydrocarbon prices. 2. Caterpillar uses derivatives to manage foreign currency exchange rates, interest rates, and commodity price exposure. 3. Johnson & Johnson uses derivatives to manage the impact of interest rate and foreign exchange rate changes on earnings and cash flows. Many corporations use derivatives extensively and successfully. However, derivatives can be dangerous. All parties involved must understand the risks and rewards associated with these contracts.12 BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVES Objective10 Understand the basic guidelines for accounting for derivatives. The FASB concluded that derivatives such as forwards and options are assets and liabilities. It also concluded that companies should report them in the balance sheet at fair value.13 The Board believes that fair value will provide statement users the best information about derivatives. Relying on some other basis of valuation for derivatives, such as historical cost, does not make sense. Why? Because many derivatives have a historical cost of zero. Furthermore, the markets for derivatives, and the assets upon which derivatives values rely, are well developed. As a result, the Board believes that companies can determine reliable fair value amounts for derivatives.14 On the income statement, a company should recognize any unrealized gain or loss in income, if it uses the derivative for speculation purposes. If using the derivative for hedging purposes, the accounting for any gain or loss depends on the type of hedge used. We discuss the accounting for hedged transactions later in the appendix. In summary, companies follow these guidelines in accounting for derivatives. 1. Recognize derivatives in the financial statements as assets and liabilities. 2. Report derivatives at fair value. 3. Recognize gains and losses resulting from speculation in derivatives immediately in income. 4. Report gains and losses resulting from hedge transactions differently, depending on the type of hedge. There are some well-publicized examples of companies that have suffered considerable losses using derivatives. For example, companies such as Fannie Mae (U.S.), Enron (U.S.), Showa Shell Sekiyu (Japan), Metallgesellschaft (Germany), Procter & Gamble (U.S.), and Air Products & Chemicals (U.S.) incurred significant losses from investments in derivative instruments. 13 12 GAAP covers accounting and reporting for all derivative instruments, whether financial or not. In this appendix we focus on derivative financial instruments because of their widespread use in practice. [8] As discussed in earlier chapters, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is therefore a market-based measure. The FASB has also developed a fair value hierarchy, which indicates the priority of valuation techniques to use to determine fair value. Level 1 fair value measures are based on observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 measures are based on inputs other than quoted prices included in Level 1 but that can be corroborated with observable data. Level 3 fair values are based on unobservable inputs (for example, a companys own data or assumptions). Thus, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. For Level 3 (the least reliable), much judgment is needed, based on the best information available, to arrive at a relevant and reliable fair value measurement. [9] 14 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 887 Example of Derivative Financial InstrumentSpeculation To illustrate the measurement and reporting of a derivative for speculative purposes, we examine a derivative whose value depends on the market price of Laredo Inc. common stock. A company can realize a gain from the increase in the value of the Laredo shares with the use of a derivative, such as a call option.15 A call option gives the holder the right, but not the obligation, to buy shares at a preset price. This price is often referred to as the strike price or the exercise price. For example, assume a company enters into a call option contract with Baird Investment Co., which gives it the option to purchase Laredo stock at $100 per share.16 If the price of Laredo stock increases above $100, the company can exercise this option and purchase the shares for $100 per share. If Laredos stock never increases above $100 per share, the call option is worthless. Accounting Entries. To illustrate the accounting for a call option, assume that the company purchases a call option contract on January 2, 2010, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2010. The company purchases the call option for $400 and makes the following entry. January 2, 2010 Call Option Cash 400 400 Objective11 Describe the accounting for derivative financial instruments. This payment is referred to as the option premium. It is generally much less than the cost of purchasing the shares directly. The option premium consists of two amounts: (1) intrinsic value and (2) time value. Illustration 17A-1 shows the formula to compute the option premium. ILLUSTRATION 17A-1 Option Premium Formula Option Premium Intrinsic Value Time Value Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2010, the intrinsic value is zero because the market price equals the preset strike price. Time value refers to the options value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is $400.17 15 Investors can use a different type of option contracta put optionto realize a gain if anticipating a decline in the Laredo stock value. A put option gives the holder the option to sell shares at a preset price. Thus, a put option increases in value when the underlying asset decreases in value. Baird Investment Co. is referred to as the counterparty. Counterparties frequently are investment bankers or other companies that hold inventories of financial instruments. 16 17 This cost is estimated using option-pricing models, such as the Black-Scholes model. The volatility of the underlying stock, the expected life of the option, the risk-free rate of interest, and expected dividends on the underlying stock during the option term affect the Black-Scholes fair value estimate. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 888 Chapter 17 Investments The following additional data are available with respect to the call option. Date March 31, 2010 April 16, 2010 Market Price of Laredo Shares $120 per share $115 per share Time Value of Call Option $100 $60 As indicated, on March 31, 2010, the price of Laredo shares increases to $120 per share. The intrinsic value of the call option contract is now $20,000. That is, the company can exercise the call option and purchase 1,000 shares from Baird Investment for $100 per share. It can then sell the shares in the market for $120 per share. This gives the company a gain of $20,000 ($120,000 $100,000) on the option contract.18 It records the increase in the intrinsic value of the option as follows. March 31, 2010 Call Option Unrealized Holding Gain or LossIncome 20,000 20,000 A market appraisal indicates that the time value of the option at March 31, 2010, is $100.19 The company records this change in value of the option as follows. March 31, 2010 Unrealized Holding Gain or LossIncome Call Option ($400 $100) 300 300 At March 31, 2010, the company reports the call option in its balance sheet at fair value of $20,100.20 The unrealized holding gain increases net income for the period. The loss on the time value of the option decreases net income. On April 16, 2010, the company settles the option before it expires. To properly record the settlement, it updates the value of the option for the decrease in the intrinsic value of $5,000 ([$20 $15]) 1,000) as follows. April 16, 2010 Unrealized Holding Gain or LossIncome Call Option 5,000 5,000 The decrease in the time value of the option of $40 ($100 April 16, 2010 Unrealized Holding Gain or LossIncome Call Option $60) is recorded as follows. 40 40 Thus, at the time of the settlement, the call options carrying value is as follows. Call Option January 2, 2010 March 31, 2010 Balance, April 16, 2010 400 20,000 15,060 March 31, 2010 April 16, 2010 April 16, 2010 300 5,000 40 18 In practice, investors generally do not have to actually buy and sell the Laredo shares to settle the option and realize the gain. This is referred to as the net settlement feature of option contracts. The decline in value reflects both the decreased likelihood that the Laredo shares will continue to increase in value over the option period and the shorter time to maturity of the option contract. As indicated earlier, the total value of the option at any point in time equals the intrinsic value plus the time value. 19 20 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 889 The company records the settlement of the option contract with Baird as follows. April 16, 2010 Cash Loss on Settlement of Call Option Call Option 15,000 60 15,060 Illustration 17A-2 summarizes the effects of the call option contract on net income. Date March 31, 2010 April 16, 2010 April 16, 2010 Transaction Net increase in value of call option ($20,000 $300) Decrease in value of call option ($5,000 $40) Settle call option Total net income Income (Loss) Effect $19,700 (5,040) (60) $14,600 ILLUSTRATION 17A-2 Effect on Income Derivative Financial Instrument The accounting summarized in Illustration 17A-2 is in accord with GAAP. That is, because the call option meets the definition of an asset, the company records it in the balance sheet on March 31, 2010. Furthermore, it reports the call option at fair value, with any gains or losses reported in income. Differences between Traditional and Derivative Financial Instruments How does a traditional financial instrument differ from a derivative one? A derivative financial instrument has the following three basic characteristics. [10] 1. The instrument has (1) one or more underlyings and (2) an identified payment provision. An underlying is a specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. The interaction of the underlying, with the face amount or the number of units specified in the derivative contract (the notional amounts), determines payment. For example, the value of the call option increased in value when the value of the Laredo stock increased. In this case, the underlying is the stock price. To arrive at the payment provision, multiply the change in the stock price by the number of shares (notional amount). 2. The instrument requires little or no investment at the inception of the contract. To illustrate, the company paid a small premium to purchase the call optionan amount much less than if purchasing the Laredo shares as a direct investment. 3. The instrument requires or permits net settlement. As indicated in the call option example, the company could realize a profit on the call option without taking possession of the shares. This net settlement feature reduces the transaction costs associated with derivatives. Illustration 17A-3 summarizes the differences between traditional and derivative financial instruments. Here, we use a trading security for the traditional financial instrument and a call option as an example of a derivative one. Traditional Financial Instrument (Trading Security) Stock price times the number of shares. Investor pays full cost. Deliver stock to receive cash. Derivative Financial Instrument (Call Option) Change in stock price (underlying) times number of shares (notional amount). Initial investment is much less than full cost. Receive cash equivalent, based on changes in stock price times the number of shares. Feature Payment provision ILLUSTRATION 17A-3 Features of Traditional and Derivative Financial Instruments Initial investment Settlement PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 890 Chapter 17 Investments DERIVATIVES USED FOR HEDGING Flexibility in use, and the low-cost features of derivatives relative to traditional financial instruments, explain the popularity of derivatives. An additional use for derivatives is in risk management. For example, companies such as Coca-Cola, ExxonMobil, and General Electric borrow and lend substantial amounts in credit markets. In doing so, they are exposed to significant interest rate risk. That is, they face substantial risk that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease. These same companies also have significant international operations. As such, they are also exposed to exchange rate riskthe risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses. Companies can use derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. This use of derivatives is referred to as hedging. GAAP established accounting and reporting standards for derivative financial instruments used in hedging activities. The FASB allows special accounting for two types of hedgesfair value and cash flow hedges.21 RISKY BUSINESS As shown in the graph below, use of derivatives has grown steadily in the past several years. In fact, over $450 trillion (in notional amounts) in derivative contracts were in play at the end of 2007. The primary players in the market for derivatives are large companies and various financial institutions, which continue to find new uses for derivatives for speculation and risk management. What do the numbers mean? Total Swaps and Equity Derivatives ($ in trillions) $500 400 300 200 100 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Financial engineers continue to develop new uses for derivatives, many times through the use of increasingly complex webs of transactions, spanning a number of markets. As new uses for derivatives appear, the financial system as a whole can be dramatically affected. As a result, some market-watchers are concerned about the risk that a crisis in one company or sector could bring the entire financial system to its knees. This concern was illustrated recently when both Fannie Mae and Freddie Mac (two federallychartered mortgage companies) indicated problems with their derivative accounting, and both of these companies had to restate their financial results for prior periods. This has led Congress to study whether the concentration of mortgages in these institutions is too high. With so many home buyers dependent on Fannie and Freddie, there is concern that these companies may be too loaded down with debt, which could negatively affect the home mortgage market. Source: Data from International Swaps and Derivatives Association Market Survey (2007). 21 GAAP also addresses the accounting for certain foreign currency hedging transactions. In general, these transactions are special cases of the two hedges we discuss here. [11] Understanding of foreign currency hedging transactions requires knowledge related to consolidation of multinational entities, which is beyond the scope of this textbook. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 891 Fair Value Hedge In a fair value hedge, a company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment. In a perfectly hedged position, the gain or loss on the fair value of the derivative equals and offsets that of the hedged asset or liability. Companies commonly use several types of fair value hedges. For example, companies use interest rate swaps to hedge the risk that changes in interest rates will impact the fair value of debt obligations. Or, they use put options to hedge the risk that an equity investment will decline in value. To illustrate a fair value hedge, assume that on April 1, 2010, Hayward Co. purchases 100 shares of Sonoma stock at a market price of $100 per share. Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as available-for-sale. Hayward records this available-for-sale investment as follows. April 1, 2010 Available-for-Sale Securities Cash 10,000 10,000 Objective12 Explain how to account for a fair value hedge. Hayward records available-for-sale securities at fair value on the balance sheet. It reports unrealized gains and losses in equity as part of other comprehensive income.22 Fortunately for Hayward, the value of the Sonoma shares increases to $125 per share during 2010. Hayward records the gain on this investment as follows. December 31, 2010 Security Fair Value Adjustment (Available-for-Sale) Unrealized Holding Gain or LossEquity 2,500 2,500 Illustration 17A-4 indicates how Hayward reports the Sonoma investment in its balance sheet. ILLUSTRATION 17A-4 Balance Sheet Presentation of Available-for-Sale Securities $12,500 HAYWARD CO. BALANCE SHEET (PARTIAL) DECEMBER 31, 2010 Assets Available-for-sale securities (at fair value) Stockholders Equity Accumulated other comprehensive income Unrealized holding gain $2,500 While Hayward benefits from an increase in the price of Sonoma shares, it is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 shares of Sonoma stock. Hayward enters into the put option contract on January 2, 2011, and designates the option as a fair value hedge of the Sonoma investment. This put option (which expires in two years) gives Hayward the option to sell Sonoma shares at a price of $125. Since the exercise price equals the current market price, no entry is necessary at inception of the put option.23 January 2, 2011 No entry required. A memorandum indicates the signing of the put option contract and its designation as a fair value hedge for the Sonoma investment. 22 We discussed the distinction between trading and available-for-sale investments in the chapter. To simplify the example, we assume no premium is paid for the option. 23 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 892 Chapter 17 Investments At December 31, 2011, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment. December 31, 2011 Unrealized Holding Gain or LossIncome Security Fair Value Adjustment (Available-for-Sale) 500 500 Note that upon designation of the hedge, the accounting for the available-for-sale security changes from regular GAAP. That is, Hayward records the unrealized holding loss in income, not in equity. If Hayward had not followed this accounting, a mismatch of gains and losses in the income statement would result. Thus, special accounting for the hedged item (in this case, an available-for-sale security) is necessary in a fair value hedge. The following journal entry records the increase in value of the put option on Sonoma shares. December 31, 2011 Put Option Unrealized Holding Gain or LossIncome 500 500 The decline in the price of Sonoma shares results in an increase in the fair value of the put option. That is, Hayward could realize a gain on the put option by purchasing 100 shares in the open market for $120 and then exercise the put option, selling the shares for $125. This results in a gain to Hayward of $500 (100 shares [$125 $120]).24 Illustration 17A-5 indicates how Hayward reports the amounts related to the Sonoma investment and the put option. ILLUSTRATION 17A-5 Balance Sheet Presentation of Fair Value Hedge Assets Available-for-sale securities (at fair value) Put option $12,000 500 HAYWARD CO. BALANCE SHEET (PARTIAL) DECEMBER 31, 2011 The increase in fair value on the option offsets or hedges the decline in value on Haywards available-for-sale security. By using fair value accounting for both financial instruments, the financial statements reflect the underlying substance of Haywards net exposure to the risks of holding Sonoma stock. By using fair value accounting for both these financial instruments, the balance sheet reports the amount that Hayward would receive on the investment and the put option contract if Hayward sold and settled them, respectively. Illustration 17A-6 illustrates the reporting of the effects of the hedging transaction on income for the year ended December 31, 2011. ILLUSTRATION 17A-6 Income Statement Presentation of Fair Value Hedge HAYWARD CO. INCOME STATEMENT (PARTIAL) FOR THE YEAR ENDED DECEMBER 31, 2011 Other Income Unrealized holding gainput option Unrealized holding lossavailable-for-sale securities $ 500 (500) 24 In practice, Hayward generally does not have to actually buy and sell the Sonoma shares to realize this gain. Rather, unless the counterparty wants to hold Hayward shares, Hayward can close out the contract by having the counterparty pay it $500 in cash. This is an example of the net settlement feature of derivatives. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 893 The income statement indicates that the gain on the put option offsets the loss on the available-for-sale securities.25 The reporting for these financial instruments, even when they reflect a hedging relationship, illustrates why the FASB argued that fair value accounting provides the most relevant information about financial instruments, including derivatives. Cash Flow Hedge Companies use cash flow hedges to hedge exposures to cash flow risk, which Objective13 results from the variability in cash flows. The FASB allows special accounting for Explain how to account for a cash cash flow hedges. Generally, companies measure and report derivatives at fair flow hedge. value on the balance sheet. They report gains and losses directly in net income. However, companies account for derivatives used in cash flow hedges at fair value on the balance sheet, but they record gains or losses in equity, as part of other comprehensive income. To illustrate, assume that in September 2010 Allied Can Co. anticipates purI NTERNATIONAL chasing 1,000 metric tons of aluminum in January 2011. Concerned that prices for I NSIGHT aluminum will increase in the next few months, Allied wants to hedge the risk Under iGAAP, companies record that it might pay higher prices for inventory in January 2011. As a result, Allied unrealized holding gains or losses on enters into an aluminum futures contract. cash flow hedges as adjustments to A futures contract gives the holder the right and the obligation to purchase an the value of the hedged item, not as asset at a preset price for a specified period of time.26 In this case, the aluminum fu- Other comprehensive income. tures contract gives Allied the right and the obligation to purchase 1,000 metric tons of aluminum for $1,550 per ton. This contract price is good until the contract expires in January 2011. The underlying for this derivative is the price of aluminum. If the price of aluminum rises above $1,550, the value of the futures contract to Allied increases. Why? Because Allied will be able to purchase the aluminum at the lower price of $1,550 per ton.27 Allied enters into the futures contract on September 1, 2010. Assume that the price to be paid today for inventory to be delivered in Januarythe spot priceequals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary. September 2010 No entry required. A memorandum indicates the signing of the futures contract. At December 31, 2010, the price for January delivery of aluminum increases to $1,575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract. December 31, 2010 Futures Contract Unrealized Holding Gain or LossEquity ([$1,575 $1,550] 1,000 tons) 25,000 25,000 Allied reports the futures contract in the balance sheet as a current asset. It reports the gain on the futures contract as part of other comprehensive income. Since Allied has not yet purchased and sold the inventory, this gain arises from an anticipated transaction. In this type of transaction, a company accumulates in equity gains or losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby affecting earnings. 25 Note that the fair value changes in the option contract will not offset increases in the value of the Hayward investment. Should the price of Sonoma stock increase above $125 per share, Hayward would have no incentive to exercise the put option. 26 A futures contract is a firm contractual agreement between a buyer and seller for a specified asset on a fixed date in the future. The contract also has a standard specification so both parties know exactly what is being traded. A forward is similar but is not traded on an exchange and does not have standardized conditions. As with the earlier call option example, the actual aluminum does not have to be exchanged. the Rather, parties to the futures contract settle by paying the cash difference between the futures price and the price of aluminum on each settlement date. 27 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 894 Chapter 17 Investments In January 2011, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry.28 January 2011 Aluminum Inventory Cash ($1,575 1,000 tons) 1,575,000 1,575,000 At the same time, Allied makes final settlement on the futures contract. It records the following entry. January 2011 Cash Futures Contract ($1,575,000 $1,550,000) 25,000 25,000 Through use of the futures contract derivative, Allied fixes the cost of its inventory. The $25,000 futures contract settlement offsets the amount paid to purchase the inventory at the prevailing market price of $1,575,000. The result: net cash outflow of $1,550 per metric ton, as desired. As Illustration 17A-7 shows, Allied has therefore effectively hedged the cash flow for the purchase of inventory. ILLUSTRATION 17A-7 Effect of Hedge on Cash Flows Anticipated Cash Flows Actual Cash Flows Actual cash paid Less: Cash received on futures contract Final cash paid $1,575,000 (25,000) $1,550,000 Wish to fix cash paid for inventory at $1,550,000 = There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory, affecting earnings through cost of goods sold. For example, assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2011) is $1,700,000. Allied sells the cans in July 2011 for $2,000,000, and records this sale as follows. July 2011 Cash Sales Revenue Cost of Goods Sold Inventory (Cans) 2,000,000 2,000,000 1,700,000 1,700,000 Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction. July 2011 Unrealized Holding Gain or LossEquity Cost of Goods Sold 25,000 25,000 The gain on the futures contract, which Allied reported as part of other comprehensive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is $1,550,000. The futures contract has worked as planned. Allied has managed the cash paid for aluminum inventory and the amount of cost of goods sold. 28 In practice, futures contracts are settled on a daily basis. For our purposes, we show only one settlement for the entire amount. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 895 OTHER REPORTING ISSUES The preceding examples illustrate the basic reporting issues related to the accounting for derivatives. Next, we discuss the following additional issues: 1. The accounting for embedded derivatives. 2. Qualifying hedge criteria. Objective14 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. Embedded Derivatives As we indicated at the beginning of this appendix, rapid innovation in the development of complex financial instruments drove efforts toward unifying and improving the accounting standards for derivatives. In recent years, this innovation has led to the development of hybrid securities. These securities have characteristics of both debt and equity. They often combine traditional and derivative financial instruments. For example, a convertible bond (discussed in Chapter 16) is a hybrid instrument. It consists of two parts: (1) a debt security, referred to as the host security, combined with (2) an option to convert the bond to shares of common stock, the embedded derivative. To provide consistency in accounting for similar derivatives, a company must account for embedded derivatives similarly to other derivatives. Therefore, to account for an embedded derivative, a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation.29 Thus, a company investing in a convertible bond must separate the stock option component of the instrument. It then accounts for the derivative (the stock option) at fair value and the host instrument (the debt) according to GAAP, as if there were no embedded derivative.30 Qualifying Hedge Criteria The FASB identified certain criteria that hedging transactions must meet before requiring the special accounting for hedges. The FASB designed these criteria to ensure the use of hedge accounting in a consistent manner across different hedge transactions. The general criteria relate to the following areas. I NTERNATIONAL I NSIGHT iGAAP qualifying hedge criteria are similar to those used in U.S. GAAP. 1. Documentation, risk management, and designation. At inception of the hedge, there must be formal documentation of the hedging relationship, the companys risk management objective, and the strategy for undertaking the hedge. Designation refers to identifying the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash flows attributable to the hedged risk. The FASB decided that documentation and designation are critical to the implementation of the special accounting for hedges. Without these requirements, companies might try to apply the hedge accounting provisions retroactively, only in response to negative changes in market conditions, to offset the negative impact of a transaction on the financial statements. Allowing special hedge accounting in such a setting could mask the speculative nature of the original transaction. 2. Effectiveness of the hedging relationship. At inception and on an ongoing basis, the hedging relationship should be highly effective in achieving offsetting changes in fair value or cash flows. Companies must assess effectiveness whenever preparing financial statements. 29 A company can also designate such a derivative as a hedging instrument. The company would apply the hedge accounting provisions outlined earlier in the chapter. The issuer of the convertible bonds would not bifurcate the option component of the convertible bonds payable. GAAP explicitly precludes embedded derivative accounting for an embedded derivative that is indexed to a companys own common stock. If the conversion feature was tied to another companys stock, then the derivative would be bifurcated. 30 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 896 Chapter 17 Investments The general guideline for effectiveness is that the fair values or cash flows of the hedging instrument (the derivative) and the hedged item exhibit a high degree of correlation. In practice, high effectiveness is assumed when the correlation is close to one (e.g., within plus or minus .10). In our earlier hedging examples (put option and the futures contract on aluminum inventory), the fair values and cash flows are perfectly correlated. That is, when the cash payment for the inventory purchase increased, it offset, dollar for dollar, the cash received on the futures contract. If the effectiveness criterion is not met, either at inception or because of changes following inception of the hedging relationship, the FASB no longer allows special hedge accounting. The company should then account for the derivative as a freestanding derivative.31 3. Effect on reported earnings of changes in fair values or cash flows. A change in the fair value of a hedged item or variation in the cash flow of a hedged forecasted transaction must have the potential to change the amount recognized in reported earnings.32 There is no need for special hedge accounting if a company accounts for both the hedging instrument and the hedged item at fair value under existing GAAP. In this case, earnings will properly reflect the offsetting gains and losses. For example, special accounting is not needed for a fair value hedge of a trading security, because a company accounts for both the investment and the derivative at fair value on the balance sheet with gains or losses reported in earnings. Thus, special hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP.33 Summary of Derivatives Accounting Illustration 17A-8 summarizes the accounting provisions for derivatives and hedging transactions. ILLUSTRATION 17A-8 Summary of Derivative Accounting under GAAP Accounting for Derivative At fair value with unrealized holding gains and losses recorded in income. At fair value with holding gains and losses recorded in income. At fair value with unrealized holding gains and losses from the hedge recorded in other comprehensive income, and reclassified in income when the hedged transactions cash flows affect earnings. Accounting for Hedged Item Not applicable Derivative Use Speculation Common Example Call or put option on an equity security. Hedging Fair value At fair value with gains and losses recorded in income. Use other generally accepted accounting principles for the hedged item. Put option to hedge an equity investment. Use of a futures contract to hedge a forecasted purchase of inventory. Cash flow 31 The accounting for the part of a derivative that is not effective in a hedge is at fair value, with gains and losses recorded in income. GAAP gives companies the option to measure most types of financial instrumentsfrom equity investments to debt issued by the companyat fair value. Changes in fair value are recognized in net income each reporting period. Thus, GAAP provides companies with the opportunity to hedge their financial instruments without the complexity inherent in applying hedge accounting provisions. For example, if the fair value option is used, bifurcation of an embedded derivative is not required. [12] An important criterion specific to cash flow hedges is that the forecasted transaction in a cash flow hedge is likely to occur. A company should support this probability (defined as significantly greater than the term more likely than not) by observable facts such as frequency of similar past transactions and its financial and operational ability to carry out the transaction. 32 33 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 897 As indicated, the general accounting for derivatives relies on fair values. GAAP also establishes special accounting guidance when companies use derivatives for hedging purposes. For example, when a company uses a put option to hedge price changes in an available-for-sale stock investment in a fair value hedge (see the Hayward example earlier), it records unrealized gains on the investment in earnings, which is not GAAP for available-for-sale securities without such a hedge. This special accounting is justified in order to accurately report the nature of the hedging relationship in the balance sheet (recording both the put option and the investment at fair value) and in the income statement (reporting offsetting gains and losses in the same period). Special accounting also is used for cash flow hedges. Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record unrealized holding gains or losses in other comprehensive income until selling or settling the hedged item. In a cash flow hedge, a company continues to record the hedged item at its historical cost. Disclosure requirements for derivatives are complex. Recent pronouncements on fair value information and financial instruments provide a helpful disclosure framework for reporting derivative instruments. Appendix 17C illustrates many of these disclosures, except for discussion of hedging issues. In general, companies that have derivatives are required to disclose the objectives for holding or issuing those instruments (speculation or hedging), the hedging context (fair value or cash flow), and the strategies for achieving risk-management objectives. COMPREHENSIVE HEDGE ACCOUNTING EXAMPLE To provide a comprehensive example of hedge accounting, we examine the use of an interest rate swap. First, lets consider how swaps work and why companies use them. Options and futures trade on organized securities exchanges. Because of this, options and futures have standardized terms. Although that standardization makes the trading easier, it limits the flexibility needed to tailor contracts to specific circumstances. In addition, most types of derivatives have relatively short time horizons, thereby excluding their use for reducing long-term risk exposure. As a result, many corporations instead turn to the swap, a very popular type of derivative. A swap is a transaction between two parties in which the first party promises to make a payment to the second party. Similarly, the second party promises to make a simultaneous payment to the first party. The most common type of swap is the interest rate swap. In this type, one party makes payments based on a fixed or floating rate, and the second party does just the opposite. In most cases, large money-center banks bring together the two parties. These banks handle the flow of payments between the parties, as shown in Illustration 17A-9. ILLUSTRATION 17A-9 Swap Transaction A pays B Party A B pays A Party B Facilitates Transaction PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 898 Chapter 17 Investments Fair Value Hedge To illustrate the use of a swap in a fair value hedge, assume that Jones Company issues $1,000,000 of five-year, 8 percent bonds on January 2, 2010. Jones records this transaction as follows. January 2, 2010 Cash Bonds Payable 1,000,000 1,000,000 Jones offered a fixed interest rate to appeal to investors. But Jones is concerned that if market interest rates decline, the fair value of the liability will increase. The company will then suffer an economic loss.34 To protect against the risk of loss, Jones hedges the risk of a decline in interest rates by entering into a five-year interest rate swap contract. Jones agrees to the following terms: 1. Jones will receive fixed payments at 8 percent (based on the $1,000,000 amount). 2. Jones will pay variable rates, based on the market rate in effect for the life of the swap contract. The variable rate at the inception of the contract is 6.8 percent. As Illustration 17A-10 shows, this swap allows Jones to change the interest on the bonds payable from a fixed rate to a variable rate. ILLUSTRATION 17A-10 Interest Rate Swap Swap Counterparty Jones pays variable rate of 6.8% Jones receives fixed rate of 8% Jones Company Jones pays fixed rate of 8% Bond Investors Swap Contract Bonds Payable The settlement dates for the swap correspond to the interest payment dates on the debt (December 31). On each interest payment (settlement) date, Jones and the counterparty compute the difference between current market interest rates and the fixed rate of 8 percent, and determine the value of the swap.35 If interest rates decline, the value of the swap contract to Jones increases (Jones has a gain), while at the same time Joness fixed-rate debt obligation increases (Jones has an economic loss). The swap is an effective risk-management tool in this setting. Its value relates to the same underlying (interest rates) that will affect the value of the fixed-rate bond payable. Thus, if the value of the swap goes up, it offsets the loss related to the debt obligation. Assuming that Jones enters into the swap on January 2, 2010 (the same date as the issuance of the debt), the swap at this time has no value. Therefore no entry is necessary. January 2, 2010 No entry required. A memorandum indicates the signing of the swap contract. At the end of 2010, Jones makes the interest payment on the bonds. It records this transaction as follows. December 31, 2010 Interest Expense Cash (8% $1,000,000) 34 80,000 80,000 This economic loss arises because Jones is locked into the 8 percent interest payments even if rates decline. The underlying for an interest rate swap is some index of market interest rates. The most commonly used index is the London Interbank Offer Rate, or LIBOR. In this example, we assume the LIBOR is 6.8 percent. 35 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Derivative Instruments 899 At the end of 2010, market interest rates have declined substantially. Therefore the value of the swap contract increases. Recall (see Illustration 17A-9) that in the swap, Jones receives a fixed rate of 8 percent, or $80,000 ($1,000,000 8%), and pays a variable rate (6.8%), or $68,000. Jones therefore receives $12,000 ($80,000 $68,000) as a settlement payment on the swap contract on the first interest payment date. Jones records this transaction as follows. December 31, 2010 Cash Interest Expense 12,000 12,000 In addition, a market appraisal indicates that the value of the interest rate swap has increased $40,000. Jones records this increase in value as follows.36 December 31, 2010 Swap Contract Unrealized Holding Gain or LossIncome 40,000 40,000 Jones reports this swap contract in the balance sheet. It reports the gain on the hedging transaction in the income statement. Because interest rates have declined, the company records a loss and a related increase in its liability as follows. December 31, 2010 Unrealized Holding Gain or LossIncome Bonds Payable 40,000 40,000 Jones reports the loss on the hedging activity in net income. It adjusts bonds payable in the balance sheet to fair value. Financial Statement Presentation of an Interest Rate Swap Illustration 17A-11 indicates how Jones reports the asset and liability related to this hedging transaction on the balance sheet. ILLUSTRATION 17A-11 Balance Sheet Presentation of Fair Value Hedge JONES COMPANY BALANCE SHEET (PARTIAL) DECEMBER 31, 2010 Current assets Swap contract Long-term liabilities Bonds payable $1,040,000 $40,000 The effect on Joness balance sheet is the addition of the swap asset and an increase in the carrying value of the bonds payable. Illustration 17A-12 indicates how Jones reports the effects of this swap transaction in the income statement. ILLUSTRATION 17A-12 Income Statement Presentation of Fair Value Hedge JONES COMPANY INCOME STATEMENT (PARTIAL) FOR THE YEAR ENDED DECEMBER 31, 2010 Interest expense ($80,000 Other income Unrealized holding gainswap contract Unrealized holding lossbonds payable Net gain (loss) $40,000 (40,000) $0 $12,000) $68,000 36 Theoretically, this fair value change reflects the present value of expected future differences in variable and fixed interest rates. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 900 Chapter 17 Investments On the income statement, Jones reports interest expense of $68,000. Jones has effectively changed the debts interest rate from fixed to variable. That is, by receiving a fixed rate and paying a variable rate on the swap, the company converts the fixed rate on the bond payable to variable. This results in an effective interest rate of 6.8 percent in 2010.37 Also, the gain on the swap offsets the loss related to the debt obligation. Therefore the net gain or loss on the hedging activity is zero. Illustration 17A-13 shows the overall impact of the swap transaction on the financial statements. ILLUSTRATION 17A-13 Impact on Financial Statements of Fair Value Hedge $40,000 Increase in gain and increase in swap asset $0 $40,000 Increase in loss and increase in bonds payable I NTERNATIONAL I NSIGHT International accounting for hedges (IAS 39 ) is similar to the provisions of U.S. GAAP. In summary, to account for fair value hedges (as illustrated in the Jones example) record the derivative at its fair value in the balance sheet, and record any gains and losses in income. Thus, the gain on the swap offsets or hedges the loss on the bond payable, due to the decline in interest rates. By adjusting the hedged item (the bond payable in the Jones case) to fair value, with the gain or loss recorded in earnings, the accounting for the Jones bond payable deviates from amortized cost. This special accounting is justified in order to report accurately the nature of the hedging relationship between the swap and the bond payable in the balance sheet (both the swap and the debt obligation are recorded at fair value) and in the income statement (offsetting gains and losses are reported in the same period).38 CONTROVERSY AND CONCLUDING REMARKS Companies need rules to properly measure and report derivatives in financial statements. However, some argue that reporting derivatives at fair value results in unrealized gains and losses that are difficult to interpret. Still, others raise concerns about the complexity and cost of implementing GAAP in this area. However, we believe that the long-term benefits of using fair value and reporting derivatives at fair value will far outweigh any short-term implementation costs. As the volume and complexity of derivatives and hedging transactions continue to grow, so does the risk that investors and creditors will be exposed to unexpected losses arising 37 Jones will apply similar accounting and measurement at future interest payment dates. Thus, if interest rates increase, Jones will continue to receive 8 percent on the swap (records a loss) but will also be locked into the fixed payments to the bondholders at an 8 percent rate (records a gain). An interest rate swap can also be used in a cash flow hedge. A common setting is the cash flow risk inherent in having variable rate debt as part of a companys debt structure. In this situation, the variable debt issuer can hedge the cash flow risk by entering into a swap contract to receive variable rate cash flows but pay fixed rate. The cash received on the swap contract will offset the variable cash flows to be paid on the debt obligation. 38 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Summary of Learning Objectives for Appendix 17A 901 from derivative transactions. Statement readers must have comprehensive information concerning many derivative financial instruments and the effects of hedging transactions using derivatives. SUMMARY OF LEARNING OBJECTIVES FOR APPENDIX 17A 9 Explain who uses derivatives and why. Any company or individual that wants to ensure against different types of business risks may use derivative contracts to achieve this objective. In general, these transactions involve some type of hedge. Speculators also use derivatives, attempting to find an enhanced return. Speculators are very important to the derivatives market because they keep it liquid on a daily basis. Arbitrageurs attempt to exploit inefficiencies in various derivative contracts. A company primarily uses derivatives for purposes of hedging its exposure to fluctuations in interest rates, foreign currency exchange rates, and commodity prices. 10 Understand the basic guidelines for accounting for derivatives. Companies should recognize derivatives in the financial statements as assets and liabilities, and report them at fair value. Companies should recognize gains and losses resulting from speculation immediately in income. They report gains and losses resulting from hedge transactions in different ways, depending on the type of hedge. 11 Describe the accounting for derivative financial instruments. Companies report derivative financial instruments in the balance sheet, and record them at fair value. Except for derivatives used in hedging, companies record realized and unrealized gains and losses on derivative financial instruments in income. 12 Explain how to account for a fair value hedge. A company records the derivative used in a qualifying fair value hedge at its fair value in the balance sheet, recording any gains and losses in income. In addition, the company also accounts for the item being hedged with the derivative at fair value. By adjusting the hedged item to fair value, with the gain or loss recorded in earnings, the accounting for the hedged item may deviate from GAAP in the absence of a hedge relationship. This special accounting is justified in order to report accurately the nature of the hedging relationship between the derivative hedging instruments and the hedged item. A company reports both in the balance sheet, reporting offsetting gains and losses in income in the same period. 13 Explain how to account for a cash flow hedge. Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record gains or losses in equity as part of other comprehensive income. Companies accumulate these gains or losses, and reclassify them in income when the hedged transactions cash flows affect earnings. Accounting is according to GAAP for the hedged item. KEY TERMS anticipated transaction, 893 arbitrageurs, 885 bifurcation, 895 call option, 887 cash flow hedge, 893 counterparty, 887(n) derivative financial instrument, derivative, 884 designation, 895 documentation, 895 embedded derivative, 895 fair value hedge, 891 forward contract, 884 futures contract, 893 hedging, 890 highly effective, 895 host security, 895 hybrid security, 895 interest rate swap, 897 intrinsic value, 887 net settlement, 888(n) notional amount, 887 option contract, 884 option premium, 887 put option, 887(n) risk management, 895 speculators, 885 spot price, 893 strike (exercise) price, 887 swap, 897 time value, 887 underlying, 889 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. A company should separate a derivative that is embed14 ded in a hybrid security from the host security, and account for it using the accounting for derivatives. This separation process is referred to as bifurcation. Special hedge accounting is allowed only for hedging relationships that meet certain criteria. The main criteria are: (1) There is formal documentation of the hedging relationship, the companys risk management objective, and the strategy for undertaking the hedge, and the company designates the derivative as either a cash flow or fair value hedge. (2) The company expects the hedging relationship to be highly effective in achieving offsetting PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 902 Chapter 17 Investments changes in fair value or cash flows. (3) Special hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP. APPENDIX 17B VARIABLE-INTEREST ENTITIES The FASB has issued an interpretation to address the concern that some companies are not reporting the risks and rewards of certain investments and other financial arrangements in their consolidated financial statements. [13] As one analyst noted, Enron showed the world the power of the idea that if investors cant see it, they cant ask you about itthe it being assets and liabilities. What exactly did Enron do? First, it created a number of entities whose purpose was to hide debt, avoid taxes, and enrich certain management personnel to the detriment of the company and its stockholders. In effect, these entities, called special purpose entities (SPEs), appeared to be separate entities for which Enron had a limited economic interest. For many of these arrangements, Enron actually had a substantial economic interest; the risks and rewards of ownership were not shifted to the entities but remained with Enron. In short, Enron was obligated to repay investors in these SPEs when they were unsuccessful. Once Enrons problems were discovered, it soon became apparent that many other companies had similar problems. Objective15 Describe the accounting for the variable-interest entitles. WHAT ABOUT GAAP? A reasonable question to ask with regard to SPEs is, Why didnt GAAP prevent companies from hiding SPE debt and other risks, by forcing companies to include these obligations in their consolidated financial statements? To understand why, we have to look at the basic rules of consolidation. The GAAP rules indicate that consolidated financial statements are usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in other companies. They further note that the usual condition for a controlling financial interest is ownership of a majority voting interest.39 In other words, if a company, like Intel, owns more than 50 percent of the voting stock of another company, Intel consolidates that company. GAAP also indicates that controlling financial interest may be achieved through arrangements that do not involve voting interests. However, applying these guidelines in practice is difficult. Whenever GAAP uses a clear line, like greater than 50 percent, companies sometimes exploit the criterion. For example, some companies set up joint ventures in which each party owns exactly 50 percent. In that case, neither party consolidates. Or like Coca-Cola in the opening story, a company may own less than 50 percent of the voting stock, but maintain effective control through board of director relationships, supply relationships, or through some other type of financial arrangement. So the FASB realized that changes had to be made to GAAP for consolidations, and it issued new guidelines. These guidelines define when a company should use factors other than voting interest to determine controlling financial interest. In this pronouncement, the FASB created a new risk-and-reward model to be used in situations where voting interests were unclear. The risk-and-reward model answers the basic questions of who stands to gain or lose the most from ownership in an SPE when ownership is uncertain. 39 Consolidation of Certain Special Purpose Entities,Proposed Interpretation (Norwalk, Conn.: FASB, June 28, 2002). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Variable-Interest Entities 903 In other words, we now have two models for consolidation: 1. Voting-interest modelIf a company owns more than 50 percent of another company, then consolidate in most cases. 2. Risk-and-reward modelIf a company is involved substantially in the economics of another company, then consolidate. Operationally, the voting-interest model is easy to apply: It sets a bright line ownership standard of more than 50 percent of the voting stock. However, if companies cannot determine control based on voting interest, they may use the risk-and-reward model. CONSOLIDATION OF VARIABLE-INTEREST ENTITIES To answer the question of who gains or loses when voting rights do not determine consolidation, the FASB developed the risk-and-reward model. In this model, the FASB introduced the notion of a variable-interest entity. A variable-interest entity (VIE) is an entity that has one of the following characteristics: 1. Insufficient equity investment at risk. Stockholders are assumed to have sufficient capital investment to support the entitys operations. If thinly capitalized, the entity is considered a VIE and is subject to the risk-and-reward model. 2. Stockholders lack decision-making rights. In some cases, stockholders do not have the influence to control the companys destiny. 3. Stockholders do not absorb the losses or receive the benefits of a normal stockholder. In some entities, stockholders are shielded from losses related to their primary risks, or their returns are capped or must be shared with other parties. Once the company determines that an entity is a variable-interest entity, it no longer can use the voting-interest model. The question that must then be asked is, What party is exposed to the majority of the risks and rewards associated with the VIE? This party is called the primary beneficiary and must consolidate the VIE. Illustration 17B-1 shows the decision model for the VIE consolidation model. ILLUSTRATION 17B-1 VIE Consolidation Model Question Answer Investors Do No It's Not a Not Absorb Losses VIE or Receive Gains? Yes Is Entity a VIE? Is Equity Inadequate? No Do Investors Lack Control? No Yes Yes It's a VIE Primary Beneficiary Test Is Entity a Primary Beneficiary? No Do Not Consolidate Yes Consolidate PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 904 Chapter 17 Investments Some Examples Lets look at a couple of examples to illustrate how this process works. Example 1 Assume that Citigroup sells notes receivable to another entity called RAKO. RAKOs assets are financed in two ways: Lenders provide 90 percent, and investors provide the remaining 10 percent as an equity investment. If Citigroup does not guarantee the debt, Citigroup has low or nonexistent risk. Therefore, Citigroup would not consolidate the assets and liabilities of RAKO. On the other hand, if Citigroup guarantees RAKOs debt, then RAKO is a VIE, and Citigroup is the primary beneficiary. In that case, Citigroup must consolidate. Example 2 San Diego Gas and Electric (SDGE) is required by law to buy power from small, local producers. In some cases, SDGE has contracts requiring it to purchase substantially all the power generated by these local companies over their lifetime. Because SDGE controls the outputs of the producers, they are VIEs. In this case, the risks and rewards related to ownership apply to SDGE. In other words, it is the primary beneficiary, and SDGE should include these producers in the consolidated financial statements. Note that the primary beneficiary may have the risks and rewards of ownership through use of a variety of instruments and financial arrangements, such as equity investments, loans to the VIE, leases, derivatives, and guarantees. Potential VIEs include the following: corporations, partnerships, limited liability companies, and majorityowned subsidiaries. ILLUSTRATION 17B-2 Impact of Rule Involving Risk-and-Reward Model Material impact 17% No disclosure 13% What Is Happening in Practice? For most companies, the new reporting related to VIEs will not materially affect their financial statements. As shown in Illustration 17B-2, one study of 509 companies with total market values over $500 million found that just 17 percent of the companies reviewed have a material impact. Of the material VIEs disclosed in the study, the most common types (42 percent) were related to joint-venture equity investments, followed by off-balance-sheet lease arrangements (22 percent). In some cases, companies are restructuring transactions to avoid consolidation. For example, Pep Boys, Choice Point, Inc., and Anadarko all appear to have restructured their lease transactions to avoid consolidation. On the other hand, companies like eBay, Kimberly-Clark, and Williams-Sonoma Inc. intend to or have consolidated their VIEs. In summary, companies are now required to consolidate certain investments and other financing arrangements that previously were reported off-balance-sheet. As a result, financial statements should be more complete in reporting the risks and rewards of these transactions. No material impact 51% Impact not yet determined 19% Source: Company Reports, Glass, Lewis, & Co. Research Report (November 6, 2003). KEY TERMS risk-and-reward model, 903 special purpose entity (SPE), 902 variable-interest entity (VIE), 903 voting-interest model, 903 SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17B 15 Describe the accounting for variable-interest entities. Special variable-interest accounting is used in situations where control cannot be determined based on voting rights. A company is required to consolidate a variable-interest entity if it is the primary beneficiary of the variable-interest entity. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Fair Value Measurements and Disclosures 905 APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES As indicated in the chapter, the FASB believes that fair value information is relevant for making effective business decisions. However, others express concern about fair value measurements for two reasons: (1) the lack of reliability related to the fair value measurement in certain cases, and (2) the ability to manipulate fair value measurements to achieve financial results inconsistent with the underlying economics of the situation. The Board recognizes these concerns and has attempted to develop a sound conceptual basis for measuring and reporting fair value information. In addition, it has placed emphasis on developing guidelines for reporting fair value information for financial instruments, because many of these instruments have relatively active markets for which valuations can be reliably determined. The purpose of this appendix is to explain the disclosure requirements for financial instruments related to fair value information. DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTSNO FAIR VALUE OPTION One requirement related to fair value disclosure is that both the cost and the fair value of all financial instruments be reported in the notes to the financial statements. [14] This enables readers of the financial statements to understand the fair value of the companys financial instruments and the potential gains and losses that might occur in the future as a result of these instruments. The Board also decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. Two reasons for additional disclosure beyond the simple itemization of fair values are: 1. Differing levels of reliability exist in the measurement of fair value information; it therefore is important to understand the varying risks involved in measurement. It is difficult to incorporate these levels of uncertainty into the financial statements. Disclosure provides a framework for addressing the qualitative aspects related to risk and measurement. 2. Changes in the fair value of financial instruments are reported differently in the financial statements, depending upon the type of financial instrument involved and whether the fair value option is employed. Note disclosure provides an opportunity to explain more precisely the impact that changes in the value of financial instruments have on financial results. In assessing the inputs, the Board recognizes that the reliability of the fair value measurement is of extreme importance. Many financial instruments are traded in active markets, and their valuation is not difficult. Other instruments are complex/illiquid, and their valuation is difficult. To highlight these levels of reliability in valuation, the FASB established a fair value hierarchy. As discussed in Chapter 2 (page 43), this hierarchy identifies three broad levels1, 2, and 3related to the measurement of fair values. Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities. Level 3 is least reliable; it uses unobservable inputs that reflect the companys assumption as to the value of the financial instrument. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 906 Chapter 17 Investments Illustration 17C-1 is an example of a fair value note disclosure for Sabathia Company. It includes both the fair value amounts and the reliability level. (A similar disclosure would be presented for liabilities.) ILLUSTRATION 17C-1 Example of Fair Value Hierarchy SABATHIA COMPANY NOTES TO THE FINANCIAL STATEMENTS ($ in 000s) Fair Value Measurements at Reporting Data Using Quoted Prices in Active Markets for Identical Assets (Level 1) $105 75 25 $205 Significant Other Observable Inputs (Level 2) $10 15 $25 $20 10 $30 Significant Unobservable Inputs (Level 3) Description Trading securities Available-for-sale securities Derivatives Venture capital investments Total Fair Value 12/31/10 $115 75 60 10 $260 For assets and liabilities measured at fair value and classified as Level 3, a reconciliation of Level 3 changes for the period is required. In addition, companies should report an analysis of how Level 3 changes in fair value affect total gains and losses and their impact on net income. Illustration 17C-2 is an example of this disclosure. ILLUSTRATION 17C-2 Reconciliation of Level 3 Inputs SABATHIA COMPANY NOTES TO THE FINANCIAL STATEMENTS ($ in 000s) Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Derivatives Beginning balance Total gains or losses (realized/unrealized) Included in earnings (or changes in net assets) Included in other comprehensive income Purchases, issuances, and settlements Transfers in and/or out of Level 3 Ending balance The amount of total gains or losses for the period included in earnings (or changes in net assets) attributable to the change in unrealized gains or losses relating to assets still held at the reporting date $14 11 4 (7) (2) $20 Venture Capital Investments $11 (3) 2 $10 Total $25 8 4 (5) (2) $30 $7 $2 $9 Gains and losses (realized and unrealized) included in earnings (or changes in net assets) for the period (above) are reported in trading revenues and in other revenues as follows. Trading Revenues Total gains or losses included in earnings (or changes in net assets) for the period (as shown in the table above) Change in unrealized gains or losses relating to assets still held at reporting date $11 $7 Other Revenues $(3) $2 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Fair Value Measurements and Disclosures 907 Sabathia Companys disclosure provides to the user of the financial statements an understanding of the following: 1. The carrying amount and the fair value of the companys financial instruments segregated by level of reliability. Thus the reader of the financial statements has a basis for judging what credence should be given to the fair value amounts. 2. For Level 3 financial instruments, a reconciliation of the balance from the beginning to the end of the period. This reconciliation enables the reader to understand the composition of the change. It is important because these calculations are most affected by subjective estimates and could be subject to manipulation. 3. The impact of changes in fair value on the net assets of the company from one period to the next. DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTSFAIR VALUE OPTION Some companies may choose to use the fair value option for some or all of their financial instruments. [15] In that case, companies have the option of incorporating the entire guidelines related to fair value measurement into one master schedule, or they can provide in a separate schedule information related solely to the fair value option. Illustration 17C-3 for Sheets Company includes only information related to the fair value option. It integrates the disclosure of the carrying amount in addition to the fair value disclosure. SHEETS COMPANY NOTES TO THE FINANCIAL STATEMENTS ($ in 000s) Fair Value Measurements at December 31, 2010 Using Quoted Prices in Active Markets for Identical Assets (Level 1) $105 75 0 25 0 (30) Changes in Fair Values for the 12-Month Period Ended December 31, 2010, for Items Measured at Fair Value Pursuant to Election of the Fair Value Option Total Changes in Fair Values Included in CurrentPeriod Earnings ILLUSTRATION 17C-3 Disclosure of Fair Value Option Description Trading securities Available-for-sale securities Loans Derivatives Private equity investments* Long-term debt Fair Value Measurements 12/31/10 $115 75 150 60 75 (60) Significant Other Observable Inputs (Level 2) $ 10 100 15 25 (10) Significant Unobservable Inputs (Level 3) Other Gains and Losses Interest Income on Loans Interest Expense on Long-Term Debt $ 50 20 50 (20) $ (3) (18) 13 $10 $7 (18) 9 $(4) *Represents investments that would otherwise be accounted for under the equity method of accounting. Loans are included in loans and lease receivables in the statement of financial position. As of December 31, 2010, approximately $160,000 of lease receivables are included in loans and lease receivables in the statement of financial position and are not eligible for the fair value option. Source: Adapted from FASB ASC 825-10-25 (Norwalk, Conn.: FASB, February 2007), Table 2, p. 47. DISCLOSURE OF FAIR VALUES: IMPAIRED ASSETS OR LIABILITIES In addition to financial instruments, companies often have assets or liabilities that are remeasured on a nonrecurring basis due to impairment. In this case the fair value hierarchy can highlight the reliability of the measurement, coupled with the related PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 908 Chapter 17 Investments gain or loss for the period. Illustration 17C-4 highlights this disclosure for McClung Company. ILLUSTRATION 17C-4 Disclosure of Fair Value, with Impairment McCLUNG COMPANY NOTES TO THE FINANCIAL STATEMENTS ($ in millions) Fair Value Measurements Using Quoted Prices in Active Markets for Identical Assets (Level 1) Description Long-lived assets held and used Goodwill Long-lived assets held for sale Year Ended 12/31/10 $75 30 26 Significant Other Observable Inputs (Level 2) $75 Significant Unobservable Inputs (Level 3) $30 26 Long-lived assets held and used with a carrying amount of $100 million were written down to their fair value of $75 million, resulting in an impairment charge of $25 million, which was included in earnings for the period. Goodwill with a carrying amount of $65 million was written down to its implied fair value of $30 million, resulting in an impairment charge of $35 million, which was included in earnings for the period. In accordance with the provisions of the Impairment or Disposal of Long-Lived Assets Subsections of FASB Codification Subtopic 360-10, long-lived assets held for sale with a carrying amount of $35 million were written down to their fair value of $26 million, less cost to sell of $6 million (or $20 million), resulting in a loss of $15 million, which was included in earnings for the period. FASB CODIFICATION FASB Codification References [1] FASB ASC 810-10-25. [Predecessor literature: Consolidation of Variable Interest Entities (revised)An Interpretation of ARB No. 51, Financial Accounting Standards Interpretation No. 46(R) (Norwalk, Conn.: FASB, December 2003.] [2] FASB ASC Glossary. [Predecessor literature: Accounting for Certain Investments in Debt and Equity Securities, Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB 1993), par. 137.] [3] FASB ASC 820-10-20. [Predecessor literature: Fair Value Measurement, Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] [4] FASB ASC 220. [Predecessor literature: Reporting Comprehensive Income, Statement of Financial Accounting Standards No. 130 (Norwalk, Conn.: FASB, 1997).] [5] FASB ASC 323-10-15. [Predecessor literature: The Equity Method of Accounting for Investments in Common Stock, Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 17.] [6] FASB ASC 323-10-15-10. [Predecessor literature: Criteria for Applying the Equity Method of Accounting for Investments in Common Stock, Interpretations of the Financial Accounting Standards Board No. 35 (Stamford, Conn.: FASB, 1981).] [7] FASB ASC 323-10-35. [Predecessor literature: The Equity Method of Accounting for Investments in Common Stock, Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 19(i).] [8] FASB ASC 815-10-05. [Predecessor literature: Accounting for Derivative Instruments and Hedging Activities, Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998).] [9] FASB ASC 820-10. [Predecessor literature: Fair Value Measurement, Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] [10] FASB ASC 815-10-05-4. [Predecessor literature: Accounting for Derivative Instruments and Hedging Activities, Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998), par. 249.] PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Questions 909 [11] FASB ASC 815-10-05-4. [Predecessor literature: Accounting for Derivative Instruments and Hedging Activities, Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998).] [12] FASB ASC 825-10-25-1. [Predecessor literature: The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115, Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).] [13] FASB ASC 810-10-05. [Predecessor literature: Consolidation of Variable Interest Entities (revised)An Interpretation of ARB No. 51, Financial Accounting Standards Interpretation No. 46(R) (FASB, Norwalk, Conn.: December 2003).] [14] FASB ASC 820-10. [Predecessor literature: Fair Value Measurement, Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] [15] FASB ASC 825-10-25-1. (Predecessor literature: The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115, Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).] Exercises Access the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. Provide Codification references for your responses. CE17-1 Access the glossary (Master Glossary) to answer the following. (a) (b) (c) (d) What What What What are trading securities? is the definition of holding gain or loss? is a cash flow hedge? is a fair value hedge? CE17-2 What guidance does the SEC give for disclosures regarding accounting policies used for derivatives? CE17-3 When would an investor discontinue applying the equity method in an investment? Are there any exceptions to this rule? CE17-4 For balance sheet purposes, can the fair value of a derivative in a loss position be netted against the fair value of a derivative in a gain position? An additional Codification case can be found in the Using Your Judgment section, on page 928. es o Be sure to check the companion website for a Review and Analysis Exercise, with solution. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter. co llege/k i w QUESTIONS 1. Distinguish between a debt security and an equity security. 2. What purpose does the variety in bond features (types and characteristics) serve? 7. At what amount should trading, available-for-sale, and held-to-maturity securities be reported on the balance sheet? 8. On July 1, 2010, Wheeler Company purchased $4,000,000 of Duggen Companys 8% bonds, due on July 1, 2017. The bonds, which pay interest semiannually on January 1 and July 1, were purchased for $3,500,000 to yield 10%. Determine the amount of interest revenue Wheeler should report on its income statement for year ended December 31, 2010. 3. What is the cost of a long-term investment in bonds? 4. Identify and explain the three types of classifications for investments in debt securities. 5. When should a debt security be classified as held-tomaturity? 6. Explain how trading securities are accounted for and reported. 9. If the bonds in question 8 are classified as available-forsale and they have a fair value at December 31, 2010, of PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / 910 Chapter 17 Investments $3,604,000, prepare the journal entry (if any) at December 31, 2010, to record this transaction. 23. Briefly discuss how a transfer of securities from the available-for-sale category to the trading category affects stockholders equity and income. 10. Indicate how unrealized holding gains and losses should be reported for investment securities classified as trading, available-for-sale, and held-to-maturity. 24. When is a debt security considered impaired? Explain how to account for the impairment of an available-for-sale debt security. 11. (a) Assuming no Securities Fair Value Adjustment (Available-for-Sale) account balance at the beginning of the year, prepare the adjusting entry at the end of the year if Laura Companys available-for-sale securities have a market value $60,000 below cost. (b) Assume the same information as part (a), except that Laura Company has a debit balance in its Securities Fair Value Adjustment (Availablefor-Sale) account of $10,000 at the beginning of the year. Prepare the adjusting entry at year-end. 25. What is the GAAP definition of fair value? 26. What is the fair value option? 27. Franklin Corp. has an investment that it has held for several years. When it purchased the investment, Franklin classified and accounted for it as available-for-sale. Can Franklin use the fair value option for this investment? Explain. 28. Where can authoritative iGAAP be found related to investments? 12. Identify and explain the different types of classifications for investment in equity securities. 29. Briefly describe some of the similarities and differences between U.S. GAAP and iGAAP with respect to the accounting for investments. 13. Why are held-to-maturity investments applicable only to debt securities? 14. Hayes Company sold 10,000 shares of Kenyon Co. common stock for $27.50 per share, incurring $1,770 in brokerage commissions. These securities were classified as trading and originally cost $260,000. Prepare the entry to record the sale of these securities. 30. Ramirez Company has an available-for-sale investment in the 6%, 20-year bonds of Soto Company. The investment was originally purchased for $1,200,000 in 2009. Early in 2010, Ramirez recorded an impairment of $300,000 on the Soto investment, due to Sotos financial distress. In 2011, Soto returned to profitability and the Soto investment was no longer impaired. What entry does Ramirez make in 2011 under (a) U.S. GAAP and (b) iGAAP? rivative financial instruments? nancial instrument and a derivative financial instrument? 15. Distinguish between the accounting treatment for availablefor-sale equity securities and trading equity securities. vestors financial interest is below the 50% level? vestee activities under the equity method. 16. What constitutes significant influence when an in- *31. What is meant by the term underlying as it relates to de17. Explain how the investment account is affected by in- *32. What are the main distinctions between a traditional fi18. When the equity method is applied, what disclosures *33. What is the purpose of a fair value hedge? should be made in the investors financial statements? *34. In what situation will the unrealized holding gain or loss 19. Hiram Co. uses the equity method to account for investon an available-for-sale security be reported in income? ments in common stock. What accounting should be made *35. Why might a company become involved in an interest rate for dividends received from these investments subsequent swap contract to receive fixed interest payments and pay to the date of investment? variable? 20. Raleigh Corp. has an investment with a carrying value *36. What is the purpose of a cash flow hedge? (equity method) on its books of $170,000 representing a 30% interest in Borg Company, which suffered a $620,000 *37. Where are gains and losses related to cash flow hedges involving anticipated transactions reported? loss this year. How should Raleigh Corp. handle its proportionate share of Borgs loss? *38. What are hybrid securities? Give an example of a hybrid security. 21. Where on the asset side of the balance sheet are trading securities, available-for-sale securities, and held-to-maturity *39. Explain the difference between the voting-interest model securities reported? Explain. and the risk-and-reward model used for consolidation. 22. Explain why reclassification adjustments are necessary. *40. What is a variable-interest entity? BRIEF EXERCISES 2 BE17-1 Garfield Company purchased, as a held-to-maturity investment, $80,000 of the 9%, 5-year bonds of Chester Corporation for $74,086, which provides an 11% return. Prepare Garfields journal entries for (a) the purchase of the investment, and (b) the receipt of annual interest and discount amortization. Assume effective-interest amortization is used. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 911 2 BE17-2 Use the information from BE17-1, but assume the bonds are purchased as an available-for-sale security. Prepare Garfields journal entries for (a) the purchase of the investment, (b) the receipt of annual interest and discount amortization, and (c) the year-end fair value adjustment. The bonds have a yearend fair value of $75,500. BE17-3 Carow Corporation purchased, as a held-to-maturity investment, $60,000 of the 8%, 5-year bonds of Harrison, Inc. for $65,118, which provides a 6% return. The bonds pay interest semiannually. Prepare Carows journal entries for (a) the purchase of the investment, and (b) the receipt of semiannual interest and premium amortization. Assume effective-interest amortization is used. BE17-4 Hendricks Corporation purchased trading investment bonds for $50,000 at par. At December 31, Hendricks received annual interest of $2,000, and the fair value of the bonds was $47,400. Prepare Hendricks journal entries for (a) the purchase of the investment, (b) the interest received, and (c) the fair value adjustment. BE17-5 Fairbanks Corporation purchased 400 shares of Sherman Inc. common stock as an available-forsale investment for $13,200. During the year, Sherman paid a cash dividend of $3.25 per share. At yearend, Sherman stock was selling for $34.50 per share. Prepare Fairbankss journal entries to record (a) the purchase of the investment, (b) the dividends received, and (c) the fair value adjustment. BE17-6 Use the information from BE17-5 but assume the stock was purchased as a trading security. Prepare Fairbankss journal entries to record (a) the purchase of the investment, (b) the dividends received, and (c) the fair value adjustment. BE17-7 Zoop Corporation purchased for $300,000 a 30% interest in Murphy, Inc. This investment enables Zoop to exert significant influence over Murphy. During the year Murphy earned net income of $180,000 and paid dividends of $60,000. Prepare Zoops journal entries related to this investment. BE17-8 Cleveland Company has a stock portfolio valued at $4,000. Its cost was $3,300. If the Securities Fair Value Adjustment (Available-for-Sale) account has a debit balance of $200, prepare the journal entry at year-end. BE17-9 The following information relates to Starbucks for 2007: net income $672.638 million; unrealized holding loss of $20.380 million related to available-for-sale securities during the year; accumulated other comprehensive income of $37.273 million on October 1, 2006. Assuming no other changes in accumulated other comprehensive income, determine (a) other comprehensive income for 2007, (b) comprehensive income for 2007, and (c) accumulated other comprehensive income at September 30, 2007. BE17-10 Hillsborough Co. has an available-for-sale investment in the bonds of Schuyler Corp. with a carrying (and fair) value of $70,000. Hillsborough determined that due to poor economic prospects for Schuyler, the bonds have decreased in value to $60,000. It is determined that this loss in value is otherthan-temporary. Prepare the journal entry, if any, to record the reduction in value. 2 2 3 3 4 3 7 6 EXERCISES 1 3 E17-1 (Investment Classifications) For the following investments identify whether they are: 1. 2. 3. Trading Securities Available-for-Sale Securities 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) 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. (f) Preferred stock was purchased for its constant dividend. The company is planning to hold the preferred stock for a long time. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 912 Chapter 17 Investments 2 E17-2 (Entries for Held-to-Maturity Securities) On January 1, 2010, Jennings Company purchased at par 10% bonds having a maturity value of $300,000. They are dated January 1, 2010, and mature January 1, 2015, with interest receivable December 31 of each year. The bonds are classified in the held-to-maturity category. Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare the journal entry to record the interest received for 2010. (c) Prepare the journal entry to record the interest received for 2011. 2 E17-3 (Entries for Held-to-Maturity Securities) On January 1, 2009, Roosevelt Company purchased 12% bonds, having a maturity value of $500,000, for $537,907.40. The bonds provide the bondholders with a 10% yield. They are dated January 1, 2009, and mature January 1, 2014, with interest receivable December 31 of each year. Roosevelt Company uses the effective-interest method to allocate unamortized discount or premium. The bonds are classified in the held-to-maturity category. Instructions (a) Prepare (b) Prepare (c) Prepare (d) Prepare the journal entry at the date of the bond purchase. a bond amortization schedule. the journal entry to record the interest received and the amortization for 2009. the journal entry to record the interest received and the amortization for 2010. 2 E17-4 (Entries for Available-for-Sale Securities) Assume the same information as in E17-3 except that the securities are classified as available-for-sale. The fair value of the bonds at December 31 of each yearend is as follows. 2009 2010 2011 $534,200 $515,000 $513,000 2012 2013 $517,000 $500,000 Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare the journal entries to record the interest received and recognition of fair value for 2009. (c) Prepare the journal entry to record the recognition of fair value for 2010. 2 E17-5 (Effective-Interest versus Straight-Line Bond Amortization) On January 1, 2010, Morgan Company acquires $300,000 of Nicklaus, Inc., 9% bonds at a price of $278,384. The interest is payable each December 31, and the bonds mature December 31, 2012. The investment will provide Morgan Company a 12% yield. The bonds are classified as held-to-maturity. Instructions (a) Prepare a 3-year schedule of interest revenue and bond discount amortization, applying the straight-line method. (Round to nearest dollar.) (b) Prepare a 3-year schedule of interest revenue and bond discount amortization, applying the effectiveinterest method. (Round to nearest cent.) (c) Prepare the journal entry for the interest receipt of December 31, 2011, and the discount amortization under the straight-line method. (d) Prepare the journal entry for the interest receipt of December 31, 2011, and the discount amortization under the effective-interest method. 3 E17-6 (Entries for Available-for-Sale and Trading Securities) The following information is available for Kinney Company at December 31, 2010, regarding its investments. Securities 3,000 shares of Petty Corporation Common Stock 1,000 shares of Dowe Incorporated Preferred Stock Cost $40,000 25,000 $65,000 Fair Value $46,000 22,000 $68,000 Instructions (a) Prepare the adjusting entry (if any) for 2010, assuming the securities are classified as trading. (b) Prepare the adjusting entry (if any) for 2010, assuming the securities are classified as availablefor-sale. (c) Discuss how the amounts reported in the financial statements are affected by the entries in (a) and (b). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 913 3 E17-7 (Trading Securities Entries) On December 21, 2010, Zurich Company provided you with the following information regarding its trading securities. December 31, 2010 Investments (Trading) Stargate Corp. stock Carolina Co. stock Vectorman Co. stock Total of portfolio Previous securities fair value adjustment balance Securities fair value adjustmentCr. Cost $20,000 10,000 20,000 $50,000 Fair Value $19,000 9,000 20,600 $48,600 Unrealized Gain (Loss) $(1,000) (1,000) 600 (1,400) 0 $(1,400) During 2011, Carolina Company stock was sold for $9,500. The fair value of the stock on December 31, 2011, was: Stargate Corp. stock$19,300; Vectorman Co. stock$20,500. Instructions (a) Prepare the adjusting journal entry needed on December 31, 2010. (b) Prepare the journal entry to record the sale of the Carolina Company stock during 2011. (c) Prepare the adjusting journal entry needed on December 31, 2011. 3 E17-8 (Available-for-Sale Securities Entries and Reporting) Player Corporation purchases equity securities costing $73,000 and classifies them as available-for-sale securities. At December 31, the fair value of the portfolio is $67,000. Instructions Prepare the adjusting entry to report the securities properly. Indicate the statement presentation of the accounts in your entry. 3 E17-9 (Available-for-Sale Securities Entries and Financial Statement Presentation) At December 31, 2010, the available-for-sale equity portfolio for Wenger, Inc. is as follows. Security A B C Total Cost $17,500 12,500 23,000 $53,000 Fair Value $15,000 14,000 25,500 $54,500 Unrealized Gain (Loss) ($2,500) 1,500 2,500 1,500 200 $1,300 Previous securities fair value adjustment balanceDr. Securities fair value adjustmentDr. On January 20, 2011, Wenger, Inc. sold security A for $15,300. The sale proceeds are net of brokerage fees. Instructions (a) Prepare the adjusting entry at December 31, 2010, to report the portfolio at fair value. (b) Show the balance sheet presentation of the investment related accounts at December 31, 2010. (Ignore notes presentation.) (c) Prepare the journal entry for the 2011 sale of security A. 7 E17-10 (Comprehensive Income Disclosure) Assume the same information as E17-9 and that Wenger, Inc. reports net income in 2010 of $120,000 and in 2011 of $140,000. Total holding gains (including any realized holding gain or loss) arising during 2011 total $30,000. Instructions (a) Prepare a statement of comprehensive income for 2010 starting with net income. (b) Prepare a statement of comprehensive income for 2011 starting with net income. 3 E17-11 (Equity Securities Entries) Capriati Corporation made the following cash purchases of securities during 2010, which is the first year in which Capriati invested in securities. 1. 2. 3. On January 15, purchased 9,000 shares of Gonzalez Companys common stock at $33.50 per share plus commission $1,980. On April 1, purchased 5,000 shares of Belmont Co.s common stock at $52.00 per share plus commission $3,370. On September 10, purchased 7,000 shares of Thep Co.s preferred stock at $26.50 per share plus commission $4,910. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 914 Chapter 17 Investments On May 20, 2010, Capriati sold 3,000 shares of Gonzalez Companys common stock at a market price of $35 per share less brokerage commissions, taxes, and fees of $2,850. The year-end fair values per share were: Gonzalez $30, Belmont $55, and Thep $28. In addition, the chief accountant of Capriati told you that Capriati Corporation plans to hold these securities for the long term but may sell them in order to earn profits from appreciation in prices. Instructions (a) Prepare the journal entries to record the above three security purchases. (b) Prepare the journal entry for the security sale on May 20. (c) Compute the unrealized gains or losses and prepare the adjusting entries for Capriati on December 31, 2010. 3 4 E17-12 (Journal Entries for Fair Value and Equity Methods) Presented below are two independent situations. Situation 1 Hatcher Cosmetics acquired 10% of the 200,000 shares of common stock of Ramirez Fashion at a total cost of $14 per share on March 18, 2010. On June 30, Ramirez declared and paid a $75,000 cash dividend. On December 31, Ramirez reported net income of $122,000 for the year. At December 31, the market price of Ramirez Fashion was $15 per share. The securities are classified as available-for-sale. Situation 2 Holmes, Inc. obtained significant influence over Nadal Corporation by buying 25% of Nadals 30,000 outstanding shares of common stock at a total cost of $9 per share on January 1, 2010. On June 15, Nadal declared and paid a cash dividend of $36,000. On December 31, Nadal reported a net income of $85,000 for the year. Instructions Prepare all necessary journal entries in 2010 for both situations. 4 E17-13 (Equity Method) Gator Co. invested $1,000,000 in Demo Co. for 25% of its outstanding stock. Demo Co. pays out 40% of net income in dividends each year. Instructions Use the information in the following T-account for the investment in Demo to answer the following questions. Investment in Demo Co. 1,000,000 130,000 52,000 (a) (b) (c) (d) 3 How much was Gator Co.s share of Demo Co.s net income for the year? How much was Gator Co.s share of Demo Co.s dividends for the year? What was Demo Co.s total net income for the year? What was Demo Co.s total dividends for the year? E17-14 (Equity InvestmentTrading) Feiner Co. had purchased 300 shares of Guttman Co. for $40 each this year and classified the investment as a trading security. Feiner Co. sold 100 shares of the stock for $43 each. At year end the price per share of the Guttman Co. stock had dropped to $35. Instructions Prepare the journal entries for these transactions and any year-end adjustments. 3 E17-15 (Equity InvestmentsTrading) Swanson Company has the following securities in its trading portfolio of securities on December 31, 2010. Investments (Trading) 1,500 shares of Parker, Inc., Common 5,000 shares of Beilman Corp., Common 400 shares of Duncan, Inc., Preferred Cost $ 71,500 180,000 60,000 $311,500 Fair Value $ 69,000 175,000 61,600 $305,600 All of the securities were purchased in 2010. In 2011, Swanson completed the following securities transactions. March 1 Sold the 1,500 shares of Parker, Inc., Common, @ $45 less fees of $1,200. April 1 Bought 700 shares of McDowell Corp., Common, @ $75 plus fees of $1,300. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 915 Swanson Companys portfolio of trading securities appeared as follows on December 31, 2011. Investments (Trading) 5,000 shares of Beilman Corp., Common 700 shares of McDowell Corp., Common 400 shares of Duncan, Inc., Preferred Cost $180,000 53,800 60,000 $293,800 Fair Value $175,000 50,400 58,000 $283,400 Instructions Prepare the general journal entries for Swanson Company for: (a) (b) (c) (d) 3 4 The The The The 2010 adjusting entry. sale of the Parker stock. purchase of the McDowell stock. 2011 adjusting entry for the trading portfolio. E17-16 (Fair Value and Equity Method Compared) Gregory Inc. acquired 20% of the outstanding common stock of Handerson Inc. on December 31, 2010. The purchase price was $1,250,000 for 50,000 shares. Handerson Inc. declared and paid an $0.80 per share cash dividend on June 30 and on December 31, 2011. Handerson reported net income of $730,000 for 2011. The fair value of Handersons stock was $27 per share at December 31, 2011. Instructions (a) Prepare the journal entries for Gregory Inc. for 2010 and 2011, assuming that Gregory cannot exercise significant influence over Handerson. The securities should be classified as availablefor-sale. (b) Prepare the journal entries for Gregory Inc. for 2010 and 2011, assuming that Gregory can exercise significant influence over Handerson. (c) At what amount is the investment in securities reported on the balance sheet under each of these methods at December 31, 2011? What is the total net income reported in 2011 under each of these methods? 4 E17-17 (Equity Method) On January 1, 2010, Meredith Corporation purchased 25% of the common shares of Pirates Company for $200,000. During the year, Pirates earned net income of $80,000 and paid dividends of $20,000. Instructions Prepare the entries for Meredith to record the purchase and any additional entries related to this investment in Pirates Company in 2010. 6 E17-18 (Impairment of Debt Securities) Cairo Corporation has municipal bonds classified as availablefor-sale at December 31, 2010. These bonds have a par value of $800,000, an amortized cost of $800,000, and a fair value of $740,000. The unrealized loss of $60,000 previously recognized as other comprehensive income and as a separate component of stockholders equity is now determined to be other than temporary. That is, the company believes that impairment accounting is now appropriate for these bonds. Instructions (a) Prepare the journal entry to recognize the impairment. (b) What is the new cost basis of the municipal bonds? Given that the maturity value of the bonds is $800,000, should Cairo Corporation amortize the difference between the carrying amount and the maturity value over the life of the bonds? (c) At December 31, 2011, the fair value of the municipal bonds is $760,000. Prepare the entry (if any) to record this information. 3 5 E17-19 (Fair Value Measurement) Presented below is information related to the purchases of common stock by Lilly Company during 2010. Cost (at purchase date) Investment in Arroyo Company stock Investment in Lee Corporation stock Investment in Woods Inc. stock Total $100,000 250,000 180,000 $530,000 Fair Value (at December 31) $ 80,000 300,000 190,000 $570,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 916 Chapter 17 Investments Instructions (a) What entry would Lilly make at December 31, 2010, to record the investment in Arroyo Company stock if it chooses to report this security using the fair value option? (b) What entry would Lilly make at December 31, 2010, to record the investment in Lee Corporation, assuming that Lilly wants to classify this security as available-for-sale? This security is the only available-for-sale security that Lilly presently owns. (c) What entry would Lilly make at December 31, 2010, to record the investment in Woods Inc., assuming that Lilly wants to classify this investment as a trading security? 3 5 E17-20 (Fair Value Measurement Issues) Assume the same information as in E17-19 for Lilly Company. In addition, assume that the investment in the Woods Inc. stock was sold during 2011 for $195,000. At December 31, 2011, the following information relates to its two remaining investments of common stock. Cost (at purchase date) Investment in Arroyo Company stock Investment in Lee Corporation stock Total $100,000 250,000 $350,000 Fair Value (at December 31) $140,000 310,000 $450,000 Net income before any security gains and losses for 2011 was $905,000. Instructions (a) Compute the amount of net income or net loss that Lilly should report for 2011, taking into consideration Lillys security transactions for 2011. (b) Prepare the journal entry to record unrealized gain or loss related to the investment in Arroyo Company stock at December 31, 2011. 2 3 5 E17-21 (Fair Value Option) Presented below is selected information related to the financial instruments of Dawson Company at December 31, 2010. This is Dawson Companys first year of operations. Carrying Amount Investment in debt securities (intent is to hold to maturity) Investment in Chen Company stock Bonds payable $ 40,000 800,000 220,000 Fair Value (at December 31) $ 41,000 910,000 195,000 Instructions (a) Dawson elects to use the fair value option whenever possible. Assuming that Dawsons net income is $100,000 in 2010 before reporting any securities gains or losses, determine Dawsons net income for 2010. (b) Record the journal entry, if any, necessary at December 31, 2010, to record the fair value option for the bonds payable. 11 *E17-22 (Derivative Transaction) On January 2, 2010, Jones Company purchases a call option for $300 on Merchant common stock. The call option gives Jones the option to buy 1,000 shares of Merchant at a strike price of $50 per share. The market price of a Merchant share is $50 on January 2, 2010 (the intrinsic value is therefore $0). On March 31, 2010, the market price for Merchant stock is $53 per share, and the time value of the option is $200. Instructions (a) Prepare the journal entry to record the purchase of the call option on January 2, 2010. (b) Prepare the journal entry(ies) to recognize the change in the fair value of the call option as of March 31, 2010. (c) What was the effect on net income of entering into the derivative transaction for the period January 2 to March 31, 2010? (Ignore tax effects.) 12 *E17-23 (Fair Value Hedge) On January 2, 2010, MacCloud Co. issued a 4-year, $100,000 note at 6% fixed interest, interest payable semiannually. MacCloud now wants to change the note to a variable-rate note. As a result, on January 2, 2010, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2010. Instructions (a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2010. (b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2010. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 917 13 *E17-24 (Cash Flow Hedge) On January 2, 2010, Parton Company issues a 5-year, $10,000,000 note at LIBOR, with interest paid annually. The variable rate is reset at the end of each year. The LIBOR rate for the first year is 5.8%. Parton Company decides it prefers fixed-rate financing and wants to lock in a rate of 6%. As a result, Parton enters into an interest rate swap to pay 6% fixed and receive LIBOR based on $10 million. The variable rate is reset to 6.6% on January 2, 2011. Instructions (a) Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2010. (b) Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2011. 12 *E17-25 (Fair Value Hedge) Sarazan Company issues a 4-year, 7.5% fixed-rate interest only, nonprepayable $1,000,000 note payable on December 31, 2010. It decides to change the interest rate from a fixed rate to variable rate and enters into a swap agreement with M&S Corp. The swap agreement specifies that Sarazan will receive a fixed rate at 7.5% and pay variable with settlement dates that match the interest payments on the debt. Assume that interest rates have declined during 2011 and that Sarazan received $13,000 as an adjustment to interest expense for the settlement at December 31, 2011. The loss related to the debt (due to interest rate changes) was $48,000. The value of the swap contract increased $48,000. Instructions (a) Prepare the journal entry to record the payment of interest expense on December 31, 2011. (b) Prepare the journal entry to record the receipt of the swap settlement on December 31, 2011. (c) Prepare the journal entry to record the change in the fair value of the swap contract on December 31, 2011. (d) Prepare the journal entry to record the change in the fair value of the debt on December 31, 2011. 11 *E17-26 (Call Option) On August 15, 2010. Outkast Co. invested idle cash by purchasing a call option on Counting Crows Inc. common shares for $360. The notional value of the call option is 400 shares, and the option price is $40. (Market price of an Outkast share is $40.) The option expires on January 31, 2011. The following data are available with respect to the call option. Date September 30, 2010 December 31, 2010 January 15, 2011 Market Price of Counting Crows Shares $48 per share $46 per share $47 per share Time Value of Call Option $180 65 30 Instructions Prepare the journal entries for Outkast for the following dates. (a) (b) (c) (d) 13 Investment in call option on Counting Crows shares on August 15, 2010. September 30, 2010Outkast prepares financial statements. December 31, 2010Outkast prepares financial statements. January 15, 2011Outkast settles the call option on the Counting Crows shares. *E17-27 (Cash Flow Hedge) Hart Golf Co. uses titanium in the production of its specialty drivers. Hart anticipates that it will need to purchase 200 ounces of titanium in October 2010, for clubs that will be shipped in the holiday shopping season. However, if the price of titanium increases, this will increase the cost to produce the clubs, which will result in lower profit margins. To hedge the risk of increased titanium prices, on May 1, 2010, Hart enters into a titanium futures contract and designates this futures contract as cash flow hedge of the anticipated titanium purchase. The notional amount of the contract is 200 ounces, and the terms of the contract give Hart the right and the obligation to purchase titanium at a price of $500 per ounce. The price will be good until the contract expires on November 30, 2010. Assume the following data with respect to the price of the call options and the titanium inventory purchase. Date May 1, 2010 June 30, 2010 September 30, 2011 Spot Price for November Delivery $500 per ounce 520 per ounce 525 per ounce PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 918 Chapter 17 Investments Instructions Present the journal entries for the following dates/transactions. May 1, 2010Inception of futures contract, no premium paid. June 30, 2010Hart prepares financial statements. September 30, 2010Hart prepares financial statements. October 5, 2010Hart purchases 200 ounces of titanium at $525 per ounce and settles the futures contract. (e) December 15, 2010Hart sells clubs containing titanium purchased in October 2010 for $250,000. The cost of the finished goods inventory is $140,000. (f) Indicate the amount(s) reported in the income statement related to the futures contract and the inventory transactions on December 31, 2010. (a) (b) (c) (d) es o llege/k i co See the books companion website, www.wiley.com/college/kieso, for a set of B Exercises. w 2 P17-1 (Debt Securities) Presented below is an amortization schedule related to Spangler Companys 5-year, $100,000 bond with a 7% interest rate and a 5% yield, purchased on December 31, 2008, for $108,660. Date 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13 Cash Received $7,000 7,000 7,000 7,000 7,000 Interest Revenue $5,433 5,354 5,272 5,186 5,095 Bond Premium Amortization $1,567 1,646 1,728 1,814 1,905 Carrying Amount of Bonds $108,660 107,093 105,447 103,719 101,905 100,000 The following schedule presents a comparison of the amortized cost and fair value of the bonds at year-end. 12/31/09 Amortized cost Fair value $107,093 $106,500 12/31/10 $105,447 $107,500 12/31/11 $103,719 $105,650 12/31/12 $101,905 $103,000 12/31/13 $100,000 $100,000 Instructions (a) Prepare the journal entry to record the purchase of these bonds on December 31, 2008, assuming the bonds are classified as held-to-maturity securities. (b) Prepare the journal entry(ies) related to the held-to-maturity bonds for 2009. (c) Prepare the journal entry(ies) related to the held-to-maturity bonds for 2011. (d) Prepare the journal entry(ies) to record the purchase of these bonds, assuming they are classified as available-for-sale. (e) Prepare the journal entry(ies) related to the available-for-sale bonds for 2009. (f) Prepare the journal entry(ies) related to the available-for-sale bonds for 2011. 2 P17-2 (Available-for-Sale Debt Securities) On January 1, 2010, Novotna Company purchased $400,000, 8% bonds of Aguirre Co. for $369,114. The bonds were purchased to yield 10% interest. Interest is payable semiannually on July 1 and January 1. The bonds mature on January 1, 2015. Novotna Company uses the effective-interest method to amortize discount or premium. On January 1, 2012, Novotna Company sold the bonds for $370,726 after receiving interest to meet its liquidity needs. Instructions (a) Prepare the journal entry to record the purchase of bonds on January 1. Assume that the bonds are classified as available-for-sale. (b) Prepare the amortization schedule for the bonds. (c) Prepare the journal entries to record the semiannual interest on July 1, 2010, and December 31, 2010. (d) If the fair value of Aguirre bonds is $372,726 on December 31, 2011, prepare the necessary adjusting entry. (Assume the securities fair value adjustment balance on January 1, 2011, is a debit of $3,375.) (e) Prepare the journal entry to record the sale of the bonds on January 1, 2012. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / PROBLEMS Problems 919 2 3 P17-3 (Available-for-Sale Investments) Cardinal Paz Corp. carries an account in its general ledger called Investments, which contained debits for investment purchases, and no credits, with the following descriptions. Feb. 1, 2010 April 1 July 1 Sharapova Company common stock, $100 par, 200 shares U.S. government bonds, 11%, due April 1, 2020, interest payable April 1 and October 1, 110 bonds of $1,000 par each McGrath Company 12% bonds, par $50,000, dated March 1, 2010 purchased at 104 plus accrued interest, interest payable annually on March 1, due March 1, 2030 $ 37,400 110,000 54,000 Instructions (Round all computations to the nearest dollar.) (a) Prepare entries necessary to classify the amounts into proper accounts, assuming that all the securities are classified as available-for-sale. (b) Prepare the entry to record the accrued interest and the amortization of premium on December 31, 2010 using the straight-line method. (c) The fair values of the securities on December 31, 2010, were: Sharapova Company common stock U.S. government bonds McGrath Company bonds $ 31,800 124,700 58,600 What entry or entries, if any, would you recommend be made? (d) The U.S. government bonds were sold on July 1, 2011, for $119,200 plus accrued interest. Give the proper entry. 2 P17-4 (Available-for-Sale Debt Securities) Presented below is information taken from a bond investment amortization schedule with related fair values provided. These bonds are classified as available-for-sale. 12/31/10 Amortized cost Fair value $491,150 $497,000 12/31/11 $519,442 $509,000 12/31/12 $550,000 $550,000 Instructions (a) Indicate whether the bonds were purchased at a discount or at a premium. (b) Prepare the adjusting entry to record the bonds at fair value at December 31, 2010. The Securities Fair Value Adjustment account has a debit balance of $1,000 prior to adjustment. (c) Prepare the adjusting entry to record the bonds at fair value at December 31, 2011. 3 P17-5 (Equity Securities Entries and Disclosures) Parnevik Company has the following securities in its investment portfolio on December 31, 2010 (all securities were purchased in 2010): (1) 3,000 shares of Anderson Co. common stock which cost $58,500, (2) 10,000 shares of Munter Ltd. common stock which cost $580,000, and (3) 6,000 shares of King Company preferred stock which cost $255,000. The Securities Fair Value Adjustment account shows a credit of $10,100 at the end of 2010. In 2011, Parnevik completed the following securities transactions. 1. 2. On January 15, sold 3,000 shares of Andersons common stock at $22 per share less fees of $2,150. On April 17, purchased 1,000 shares of Castles common stock at $33.50 per share plus fees of $1,980. On December 31, 2011, the market values per share of these securities were: Munter $61, King $40, and Castle $29. In addition, the accounting supervisor of Parnevik told you that, even though all these securities have readily determinable fair values, Parnevik will not actively trade these securities because the top management intends to hold them for more than one year. Instructions (a) Prepare the entry for the security sale on January 15, 2011. (b) Prepare the journal entry to record the security purchase on April 17, 2011. (c) Compute the unrealized gains or losses and prepare the adjusting entry for Parnevik on December 31, 2011. (d) How should the unrealized gains or losses be reported on Parneviks balance sheet? 3 P17-6 (Trading and Available-for-Sale Securities Entries) McElroy Company has the following portfolio of investment securities at September 30, 2010, its last reporting date. Trading Securities Horton, Inc. common (5,000 shares) Monty, Inc. preferred (3,500 shares) Oakwood Corp. common (1,000 shares) Cost $215,000 133,000 180,000 Fair Value $200,000 140,000 179,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 920 Chapter 17 Investments On October 10, 2010, the Horton shares were sold at a price of $54 per share. In addition, 3,000 shares of Patriot common stock were acquired at $54.50 per share on November 2, 2010. The December 31, 2010, fair values were: Monty $106,000, Patriot $132,000, and the Oakwood common $193,000. All the securities are classified as trading. Instructions (a) Prepare the journal entries to record the sale, purchase, and adjusting entries related to the trading securities in the last quarter of 2010. (b) How would the entries in part (a) change if the securities were classified as available-for-sale? 2 P17-7 (Available-for-Sale and Held-to-Maturity Debt Securities Entries) The following information relates to the debt securities investments of Wildcat Company. 1. 2. 3. 4. 5. 6. 7. On February 1, the company purchased 10% bonds of Gibbons Co. having a par value of $300,000 at 100 plus accrued interest. Interest is payable April 1 and October 1. On April 1, semiannual interest is received. On July 1, 9% bonds of Sampson, Inc. were purchased. These bonds with a par value of $200,000 were purchased at 100 plus accrued interest. Interest dates are June 1 and December 1. On September 1, bonds with a par value of $60,000, purchased on February 1, are sold at 99 plus accrued interest. On October 1, semiannual interest is received. On December 1, semiannual interest is received. On December 31, the fair value of the bonds purchased February 1 and July 1 are 95 and 93, respectively. Instructions (a) Prepare any journal entries you consider necessary, including year-end entries (December 31), assuming these are available-for-sale securities. (b) If Wildcat classified these as held-to-maturity securities, explain how the journal entries would differ from those in part (a). 3 4 5 P17-8 (Fair Value and Equity Methods) Brooks Corp. is a medium-sized corporation specializing in quarrying stone for building construction. The company has long dominated the market, at one time achieving a 70% market penetration. During prosperous years, the companys profits, coupled with a conservative dividend policy, resulted in funds available for outside investment. Over the years, Brooks has had a policy of investing idle cash in equity securities. In particular, Brooks has made periodic investments in the companys principal supplier, Norton Industries. Although the firm currently owns 12% of the outstanding common stock of Norton Industries, Brooks does not have significant influence over the operations of Norton Industries. Cheryl Thomas has recently joined Brooks as assistant controller, and her first assignment is to prepare the 2010 year-end adjusting entries for the accounts that are valued by the fair value rule for financial reporting purposes. Thomas has gathered the following information about Brookss pertinent accounts. 1. Brooks has trading securities related to Delaney Motors and Patrick Electric. During this fiscal year, Brooks purchased 100,000 shares of Delaney Motors for $1,400,000; these shares currently have a market value of $1,600,000. Brooks investment in Patrick Electric has not been profitable; the company acquired 50,000 shares of Patrick in April 2010 at $20 per share, a purchase that currently has a value of $720,000. Prior to 2010, Brooks invested $22,500,000 in Norton Industries and has not changed its holdings this year. This investment in Norton Industries was valued at $21,500,000 on December 31, 2009. Brooks 12% ownership of Norton Industries has a current market value of $22,225,000. 2. Instructions (a) Prepare the appropriate adjusting entries for Brooks as of December 31, 2010, to reflect the application of the fair value rule for both classes of securities described above. (b) For both classes of securities presented above, describe how the results of the valuation adjustments made in (a) would be reflected in the body of and notes to Brooks 2010 financial statements. (c) Prepare the entries for the Norton investment, assuming that Brooks owns 25% of Nortons shares. Norton reported income of $500,000 in 2010 and paid cash dividends of $100,000. 3 5 P17-9 (Financial Statement Presentation of Available-for-Sale Investments) Kennedy Company has the following portfolio of available-for-sale securities at December 31, 2010. Security Frank, Inc. Ellis Corp. Mendota Company Quantity 2,000 shares 5,000 shares 4,000 shares Percent Interest 8% 14% 2% Per Share Cost $11 23 31 Market $16 19 24 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Problems 921 Instructions (a) What should be reported on Kennedys December 31, 2010, balance sheet relative to these longterm available-for-sale securities? On December 31, 2011, Kennedys portfolio of available-for-sale securities consisted of the following common stocks. Percent Interest 14% 2% 1% Per Share Cost $23 31 25 Market $28 23 23 Security Ellis Corp. Mendota Company Mendota Company Quantity 5,000 shares 4,000 shares 2,000 shares At the end of year 2011, Kennedy Company changed its intent relative to its investment in Frank, Inc. and reclassified the shares to trading securities status when the shares were selling for $8 per share. (b) What should be reported on the face of Kennedys December 31, 2011, balance sheet relative to available-for-sale securities investments? What should be reported to reflect the transactions above in Kennedys 2011 income statement? (c) Assuming that comparative financial statements for 2010 and 2011 are presented, draft the footnote necessary for full disclosure of Kennedys transactions and position in equity securities. 3 5 P17-10 (Gain on Sale of Securities and Comprehensive Income) the following balance sheet. ACKER INC. BALANCE SHEET AS OF JANUARY 1, 2010 Assets Cash Available-for-sale securities Total $ 50,000 240,000 $290,000 On January 1, 2010, Acker Inc. had Equity Common stock Accumulated other comprehensive income Total $260,000 30,000 $290,000 The accumulated other comprehensive income related to unrealized holding gains on available-for-sale securities. The fair value of Acker Inc.s available-for-sale securities at December 31, 2010, was $190,000; its cost was $140,000. No securities were purchased during the year. Acker Inc.s income statement for 2010 was as follows. (Ignore income taxes.) ACKER INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Dividend revenue Gain on sale of available-for-sale securities Net income $ 5,000 30,000 $35,000 Instructions (Assume all transactions during the year were for cash.) (a) Prepare the journal entry to record the sale of the available-for-sale securities in 2010. (b) Prepare a statement of comprehensive income for 2010. (c) Prepare a balance sheet as of December 31, 2010. 3 P17-11 (Equity InvestmentsAvailable-for-Sale) Castleman Holdings, Inc. had the following availablefor-sale investment portfolio at January 1, 2010. Evers Company Rogers Company Chance Company Available-for-sale securities @ cost Securities fair value adjustmentAvailable-for-sale Available-for-sale securities @ fair value 1,000 shares @ $15 each 900 shares @ $20 each 500 shares @ $9 each $15,000 18,000 4,500 37,500 (7,500) $30,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 922 Chapter 17 Investments During 2010, the following transactions took place. 1. 2. 3. 4. On March 1, Rogers Company paid a $2 per share dividend. On April 30, Castleman Holdings, Inc. sold 300 shares of Chance Company for $11 per share. On May 15, Castleman Holdings, Inc. purchased 100 more shares of Evers Co. stock at $16 per share. At December 31, 2010, the stocks had the following price per share values: Evers $17, Rogers $19, and Chance $8. On February 1, Castleman Holdings, Inc. sold the remaining Chance shares for $8 per share. On March 1, Rogers Company paid a $2 per share dividend. On December 21, Evers Company declared a cash dividend of $3 per share to be paid in the next month. At December 31, 2011, the stocks had the following price per shares values: Evers $19 and Rogers $21. During 2011, the following transactions took place. 5. 6. 7. 8. Instructions (a) Prepare journal entries for each of the above transactions. (b) Prepare a partial balance sheet showing the Investments account at December 31, 2010 and 2011. 3 5 P17-12 (Available-for-Sale SecuritiesStatement Presentation) Fernandez Corp. invested its excess cash in available-for-sale securities during 2010. As of December 31, 2010, the portfolio of available-forsale securities consisted of the following common stocks. Security Lindsay Jones, Inc. Poley Corp. Arnold Aircraft Quantity 1,000 shares 2,000 shares 2,000 shares Cost $ 15,000 40,000 72,000 Totals $127,000 Fair Value $ 21,000 42,000 60,000 $123,000 Instructions (a) What should be reported on Fernandezs December 31, 2010, balance sheet relative to these securities? What should be reported on Fernandezs 2010 income statement? On December 31, 2011, Fernandezs portfolio of available-for-sale securities consisted of the following common stocks. Security Lindsay Jones, Inc. Lindsay Jones, Inc. Duff Company Arnold Aircraft Quantity 1,000 2,000 1,000 2,000 shares shares shares shares Cost $ 15,000 33,000 16,000 72,000 Totals $136,000 Fair Value $20,000 40,000 12,000 22,000 $94,000 During the year 2011, Fernandez Corp. sold 2,000 shares of Poley Corp. for $38,200 and purchased 2,000 more shares of Lindsay Jones, Inc. and 1,000 shares of Duff Company. (b) What should be reported on Fernandezs December 31, 2011, balance sheet? What should be reported on Fernandezs 2011 income statement? On December 31, 2012, Fernandezs portfolio of available-for-sale securities consisted of the following common stocks. Security Arnold Aircraft Duff Company Quantity 2,000 shares 500 shares Cost $72,000 8,000 Totals $80,000 Fair Value $82,000 6,000 $88,000 During the year 2012, Fernandez Corp. sold 3,000 shares of Lindsay Jones, Inc. for $39,900 and 500 shares of Duff Company at a loss of $2,700. (c) What should be reported on the face of Fernandezs December 31, 2012, balance sheet? What should be reported on Fernandezs 2012 income statement? (d) What would be reported in a statement of comprehensive income at (1) December 31, 2010, and (2) December 31, 2011? 11 *P17-13 (Derivative Financial Instrument) The treasurer of Miller Co. has read on the Internet that the stock price of Wade Inc. is about to take off. In order to profit from this potential development, Miller Co. purchased a call option on Wade common shares on July 7, 2010, for $240. The call option is for 200 shares PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Problems 923 (notional value), and the strike price is $70. (The market price of a share of Wade stock on that date is $70.) The option expires on January 31, 2011. The following data are available with respect to the call option. Date September 30, 2010 December 31, 2010 January 4, 2011 Market Price of Wade Shares $77 per share 75 per share 76 per share Time Value of Call Option $180 65 30 Instructions Prepare the journal entries for Miller Co. for the following dates. (a) (b) (c) (d) 11 July 7, 2010Investment in call option on Wade shares. September 30, 2010Miller prepares financial statements. December 31, 2010Miller prepares financial statements. January 4, 2011Miller settles the call option on the Wade shares. *P17-14 (Derivative Financial Instrument) Johnstone Co. purchased a put option on Ewing common shares on July 7, 2010, for $240. The put option is for 200 shares, and the strike price is $70. (The market price of a share of Ewing stock on that date is $70.) The option expires on January 31, 2011. The following data are available with respect to the put option. Date September 30, 2010 December 31, 2010 January 31, 2011 Market Price of Ewing Shares $77 per share 75 per share 78 per share Time Value of Put Option $125 50 0 Instructions Prepare the journal entries for Johnstone Co. for the following dates. (a) (b) (c) (d) 11 July 7, 2010Investment in put option on Ewing shares. September 30, 2010Johnstone prepares financial statements. December 31, 2010Johnstone prepares financial statements. January 31, 2011Put option expires. *P17-15 (Free-Standing Derivative) Warren Co. purchased a put option on Echo common shares on January 7, 2010, for $360. The put option is for 400 shares, and the strike price is $85 (which equals the price of an Echo share on the purchase date). The option expires on July 31, 2010. The following data are available with respect to the put option. Date March 31, 2010 June 30, 2010 July 6, 2010 Market Price of Echo Shares $80 per share 82 per share 77 per share Time Value of Put Option $200 90 25 Instructions Prepare the journal entries for Warren Co. for the following dates. (a) (b) (c) (d) 12 January 7, 2010Investment in put option on Echo shares. March 31, 2010Warren prepares financial statements. June 30, 2010Warren prepares financial statements. July 6, 2010Warren settles the put option on the Echo shares. *P17-16 (Fair Value Hedge Interest Rate Swap) On December 31, 2010, Mercantile Corp. had a $10,000,000, 8% fixed-rate note outstanding, payable in 2 years. It decides to enter into a 2-year swap with Chicago First Bank to convert the fixed-rate debt to variable-rate debt. The terms of the swap indicate that Mercantile will receive interest at a fixed rate of 8.0% and will pay a variable rate equal to the 6-month LIBOR rate, based on the $10,000,000 amount. The LIBOR rate on December 31, 2010, is 7%. The LIBOR rate will be reset every 6 months and will be used to determine the variable rate to be paid for the following 6-month period. Mercantile Corp. designates the swap as a fair value hedge. Assume that the hedging relationship meets all the conditions necessary for hedge accounting. The 6-month LIBOR rate and the swap and debt fair values are as follows. Date December 31, 2010 June 30, 2011 December 31, 2011 6-Month LIBOR Rate 7.0% 7.5% 6.0% Swap Fair Value (200,000) 60,000 Debt Fair Value $10,000,000 9,800,000 10,060,000 Instructions (a) Present the journal entries to record the following transactions. (1) The entry, if any, to record the swap on December 31, 2010. (2) The entry to record the semiannual debt interest payment on June 30, 2011. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 924 Chapter 17 Investments (3) The entry to record the settlement of the semiannual swap amount receivables at 8%, less amount payable at LIBOR, 7%. (4) The entry to record the change in the fair value of the debt on June 30, 2011. (5) The entry to record the change in the fair value of the swap at June 30, 2011. (b) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2010. (c) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on June 30, 2011. (d) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2011. 13 *P17-17 (Cash Flow Hedge) LEW Jewelry Co. uses gold in the manufacture of its products. LEW anticipates that it will need to purchase 500 ounces of gold in October 2010, for jewelry that will be shipped for the holiday shopping season. However, if the price of gold increases, LEWs cost to produce its jewelry will increase, which would reduce its profit margins. To hedge the risk of increased gold prices, on April 1, 2010, LEW enters into a gold futures contract and designates this futures contract as a cash flow hedge of the anticipated gold purchase. The notional amount of the contract is 500 ounces, and the terms of the contract give LEW the right and the obligation to purchase gold at a price of $300 per ounce. The price will be good until the contract expires on October 31, 2010. Assume the following data with respect to the price of the call options and the gold inventory purchase. Date April 1, 2010 June 30, 2010 September 30, 2010 Spot Price for October Delivery $300 per ounce 310 per ounce 315 per ounce Instructions Prepare the journal entries for the following transactions. April 1, 2010Inception of the futures contract, no premium paid. June 30, 2010LEW Co. prepares financial statements. September 30, 2010LEW Co. prepares financial statements. October 10, 2010LEW Co. purchases 500 ounces of gold at $315 per ounce and settles the futures contract. (e) December 20, 2010LEW sells jewelry containing gold purchased in October 2010 for $350,000. The cost of the finished goods inventory is $200,000. (f) Indicate the amount(s) reported on the balance sheet and income statement related to the futures contract on June 30, 2010. (g) Indicate the amount(s) reported in the income statement related to the futures contract and the inventory transactions on December 31, 2010. (a) (b) (c) (d) 12 *P17-18 (Fair Value Hedge) On November 3, 2010, Sprinkle Co. invested $200,000 in 4,000 shares of the common stock of Pratt Co. Sprinkle classified this investment as available-for-sale. Sprinkle Co. is considering making a more significant investment in Pratt Co. at some point in the future but has decided to wait and see how the stock does over the next several quarters. To hedge against potential declines in the value of Pratt stock during this period, Sprinkle also purchased a put option on the Pratt stock. Sprinkle paid an option premium of $600 for the put option, which gives Sprinkle the option to sell 4,000 Pratt shares at a strike price of $50 per share. The option expires on July 31, 2011. The following data are available with respect to the values of the Pratt stock and the put option. Date December 31, 2010 March 31, 2011 June 30, 2011 Market Price of Pratt Shares $50 per share 45 per share 43 per share Time Value of Put Option $375 175 40 Instructions (a) Prepare the journal entries for Sprinkle Co. for the following dates. (1) November 3, 2010Investment in Pratt stock and the put option on Pratt shares. (2) December 31, 2011Sprinkle Co. prepares financial statements. (3) March 31, 2011Sprinkle prepares financial statements. (4) June 30, 2011Sprinkle prepares financial statements. (5) July 1, 2011Sprinkle settles the put option and sells the Pratt shares for $43 per share. (b) Indicate the amount(s) reported on the balance sheet and income statement related to the Pratt investment and the put option on December 31, 2010. (c) Indicate the amount(s) reported on the balance sheet and income statement related to the Pratt investment and the put option on June 30, 2011. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Concepts for Analysis 925 CONCEPTS FOR ANALYSIS CA17-1 (Issues Raised about Investment Securities) You have just started work for Warren Co. as part of the controllers group involved in current financial reporting problems. Jane Henshaw, controller for Warren, is interested in your accounting background because the company has experienced a series of financial reporting surprises over the last few years. Recently, the controller has learned from the companys auditors that there is authoritative literature that may apply to its investment in securities. She assumes that you are familiar with this pronouncement and asks how the following situations should be reported in the financial statements. Situation 1 Trading securities in the current assets section have a fair value that is $4,200 lower than cost. Situation 2 A trading security whose fair value is currently less than cost is transferred to the available-for-sale category. Situation 3 An available-for-sale security whose fair value is currently less than cost is classified as noncurrent but is to be reclassified as current. Situation 4 A companys portfolio of available-for-sale securities consists of the common stock of one company. At the end of the prior year the fair value of the security was 50% of original cost, and this reduction in market value was reported as an other than temporary impairment. However, at the end of the current year the fair value of the security had appreciated to twice the original cost. Situation 5 The company has purchased some convertible debentures that it plans to hold for less than a year. The fair value of the convertible debentures is $7,700 below its cost. Instructions What is the effect upon carrying value and earnings for each of the situations above? Assume that these situations are unrelated. CA17-2 (Equity Securities) Lexington Co. has the following available-for-sale securities outstanding on December 31, 2010 (its first year of operations). Cost Greenspan Corp. Stock Summerset Company Stock Tinkers Company Stock $20,000 9,500 20,000 $49,500 Fair Value $19,000 8,800 20,600 $48,400 During 2011 Summerset Company stock was sold for $9,200, the difference between the $9,200 and the fair value of $8,800 being recorded as a Gain on Sale of Securities. The market price of the stock on December 31, 2011, was: Greenspan Corp. stock $19,900; Tinkers Company stock $20,500. Instructions (a) What justification is there for valuing available-for-sale securities at fair value and reporting the unrealized gain or loss as part of stockholders equity? (b) How should Lexington Company apply this rule on December 31, 2010? Explain. (c) Did Lexington Company properly account for the sale of the Summerset Company stock? Explain. (d) Are there any additional entries necessary for Lexington Company at December 31, 2011, to reflect the facts on the financial statements in accordance with generally accepted accounting principles? Explain. (AICPA adapted) CA17-3 (Financial Statement Effect of Equity Securities) Presented below are three unrelated situations involving equity securities. Situation 1 An equity security, whose market value is currently less than cost, is classified as available-for-sale but is to be reclassified as trading. Situation 2 A noncurrent portfolio with an aggregate market value in excess of cost includes one particular security whose market value has declined to less than one-half of the original cost. The decline in value is considered to be other than temporary. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 926 Chapter 17 Investments Situation 3 The portfolio of trading securities has a cost in excess of fair value of $13,500. The available-for-sale portfolio has a fair value in excess of cost of $28,600. Instructions What is the effect upon carrying value and earnings for each of the situations above? CA17-4 (Equity Securities) The Financial Accounting Standards Board issued accounting guidance to clarify accounting methods and procedures with respect to certain debt and all equity securities. An important part of the statement concerns the distinction between held-to-maturity, available-for-sale, and trading securities. Instructions (a) Why does a company maintain an investment portfolio of held-to-maturity, available-for-sale, and trading securities? (b) What factors should be considered in determining whether investments in securities should be classified as held-to-maturity, available-for-sale, and trading? How do these factors affect the accounting treatment for unrealized losses? CA17-5 (Investment Accounted for under the Equity Method) On July 1, 2011, Fontaine Company purchased for cash 40% of the outstanding capital stock of Knoblett Company. Both Fontaine Company and Knoblett Company have a December 31 year-end. Knoblett Company, whose common stock is actively traded in the over-the-counter market, reported its total net income for the year to Fontaine Company and also paid cash dividends on November 15, 2011, to Fontaine Company and its other stockholders. Instructions How should Fontaine Company report the above facts in its December 31, 2011, balance sheet and its income statement for the year then ended? Discuss the rationale for your answer. (AICPA adapted) CA17-6 (Equity Investment) On July 1, 2010, Selig Company purchased for cash 40% of the outstanding capital stock of Spoor Corporation. Both Selig and Spoor have a December 31 year-end. Spoor Corporation, whose common stock is actively traded on the American Stock Exchange, paid a cash dividend on November 15, 2010, to Selig Company and its other stockholders. It also reported its total net income for the year of $920,000 to Selig Company. Instructions Prepare a one-page memorandum of instructions on how Selig Company should report the above facts in its December 31, 2010, balance sheet and its 2010 income statement. In your memo, identify and describe the method of valuation you recommend. Provide rationale where you can. Address your memo to the chief accountant at Selig Company. CA17-7 (Fair Value) Addison Manufacturing holds a large portfolio of debt and equity securities as an investment. The fair value of the portfolio is greater than its original cost, even though some securities have decreased in value. Sam Beresford, the financial vice president, and Angie Nielson, the controller, are near year-end in the process of classifying for the first time this securities portfolio in accordance with GAAP. Beresford wants to classify those securities that have increased in value during the period as trading securities in order to increase net income this year. He wants to classify all the securities that have decreased in value as available-for-sale (the equity securities) and as held-to-maturity (the debt securities). Nielson disagrees. She wants to classify those securities that have decreased in value as trading securities and those that have increased in value as available-for-sale (equity) and held-to-maturity (debt). She contends that the company is having a good earnings year and that recognizing the losses will help to smooth the income this year. As a result, the company will have built-in gains for future periods when the company may not be as profitable. Instructions Answer the following questions. (a) Will classifying the portfolio as each proposes actually have the effect on earnings that each says it will? (b) Is there anything unethical in what each of them proposes? Who are the stakeholders affected by their proposals? (c) Assume that Beresford and Nielson properly classify the entire portfolio into trading, availablefor-sale, and held-to-maturity categories. But then each proposes to sell just before year-end the securities with gains or with losses, as the case may be, to accomplish their effect on earnings. Is this unethical? PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Using Your Judgment 927 USING YOUR JUDGMENT FI NANCIAL REPORTI NG Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B or can be accessed at the books companion website, www.wiley.com/college/kieso. Instructions llege/k i o es Refer to P&Gs financial statements and the accompanying notes to answer the following questions. (a) What investments does P&G report in 2007, and where are these investments reported in its financial statements? (b) How are P&Gs investments valued? How does P&G determine fair value? (c) How does P&G use derivative financial instruments? co w co llege/k i es o PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile ile y. c o m / y. c o m / Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the books companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) Based on the information contained in these financial statements, determine each of the following for each company. (1) Cash used in (for) investing activities during 2007 (from the statement of cash flows). (2) Cash used for acquisitions and investments in unconsolidated affiliates (or principally bottling companies) during 2007. (3) Total investment in unconsolidated affiliates (or investments and other assets) at the end of 2007. (4) What conclusions concerning the management of investments can be drawn from these data? (b) (1) Briefly identify from Coca-Colas December 31, 2007, balance sheet the investments it reported as being accounted for under the equity method. (2) What is the amount of investments that Coca-Cola reported in its 2007 balance sheet as cost method investments, and what is the nature of these investments? (c) In its Note number 9 on Financial Instruments, what total amounts did Coca-Cola report at December 31, 2007, as: (1) trading securities, (2) available-for-sale securities, and (3) held-tomaturity securities? w Financial Statement Analysis Case Union Planters Union Planters is a Tennessee bank holding company (that is, a corporation that owns banks). (Union Planters is now part of Regions Bank.) Union Planters manages $32 billion in assets, the largest of which is its loan portfolio of $19 billion. In addition to its loan portfolio, however, like other banks it has significant debt investments. The nature of these investments varies from short-term in nature to long-term in nature. As a consequence, consistent with the requirements of accounting rules, Union Planters reports its investments in two different categoriestrading and available-for-sale. The following facts were found in a recent Union Planters annual report. Amortized Cost $ 275 8,209 Gross Unrealized Gains $108 Gross Unrealized Losses $15 Fair Value $ 275 8,302 224 (9) (all dollars in millions) Trading account assets Securities available for sale Net income Net securities gains (losses) 928 Chapter 17 Investments Instructions (a) Why do you suppose Union Planters purchases investments, rather than simply making loans? Why does it purchase investments that vary in nature both in terms of their maturities and in type (debt versus stock)? (b) How must Union Planters account for its investments in each of the two categories? (c) In what ways does classifying investments into two different categories assist investors in evaluating the profitability of a company like Union Planters? (d) Suppose that the management of Union Planters was not happy with its net income for the year. What step could it have taken with its investment portfolio that would have definitely increased reported profit? How much could it have increased reported profit? Why do you suppose it chose not to do this? BRI DGE TO TH E PROFESSION Professional Research: FASB Codification Your client, Cascade Company, is planning to invest some of its excess cash in 5-year revenue bonds issued by the county and in the stock of one of its suppliers, Teton Co. Tetons shares trade on the overthe-counter market. Cascade plans to classify these investments as available-for-sale. They would like you to conduct some research on the accounting for these investments. Instructions Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses. (a) Since the Teton shares do not trade on one of the large stock markets, Cascade argues that the fair value of this investment is not readily available. According to the authoritative literature, when is the fair value of a security readily determinable? (b) How is an impairment of a security accounted for? (c) To avoid volatility in their financial statements due to fair value adjustments, Cascade debated whether the bond investment could be classified as held-to-maturity; Cascade is pretty sure it will hold the bonds for 5 years. How close to maturity could Cascade sell an investment and still classify it as held-to-maturity? (d) What disclosures must be made for any sale or transfer from securities classified as held-to-maturity? Professional Simulation Go to the books companion website, at www.wiley.com.college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for investments. KWW_Professional _Simulation Investments Time Remaining 3 hours 20 minutes copy paste calculator sheet standards help ? spliter done llege/k i es o co Remember to check the books companion website to find additional resources for this chapter. w PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark

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York University - ADMS - 101
CHAPTER18R EVEN U E R ECOGN ITIONLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7Apply the revenue recognition principle. Describe accounting issues for revenue recognition at point of sale. Apply the percentage-of
York University - ADMS - 101
CHAPTER19ACCOU NTI NG FOR I NCOME TAXESLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9 10Identify differences between pretax financial income and taxable income. Describe a temporary difference that results in
York University - ADMS - 101
CHAPTER20ACCOU NTI NG FOR PE NSIONS AN D POSTRETIREMENT BENEFITSLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Distinguish between accounting for the employers pension plan and accounting for the pension fund.
York University - ADMS - 101
CHAPTER21ACCOU NTI NG FOR LEASESLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Explain the nature, economic substance, and advantages of lease transactions. Describe the accounting criteria and procedures for
York University - ADMS - 101
CHAPTER22ACCOU NTI NG C HANG E S AN D ER ROR ANALYSISLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Identify the types of accounting changes. Describe the accounting for changes in accounting principles. Under
York University - ADMS - 101
CHAPTER23STATEMENT OF CASH FLOWSLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Describe the purpose of the statement of cash flows. Identify the major classifications of cash flows. Differentiate between net i
York University - ADMS - 101
CHAPTER24FU LL D ISC LOSU R E I N FI NANC IAL R EPORTI NGLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8Review the full disclosure principle and describe implementation problems. Explain the use of notes in fina
York University - ADMS - 101
I N D EXA. C. Nielsen Company, 657n.16 AASB (Australian Accounting Standards Board), 1360 Abbott Laboratories, 183, 873874 Abdel-khalik, A. Rashad, 1129n.19 Abnormal shortages, 456 Abrams, J., 993n.1 Absences, compensated, 648650 Accelerated Cost Recover
Temasek Polytechnic - EE - 33500
A/D, QuantizationWord Length n-bits 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Number of Quantizer Levels M=2^n 2 4 8 16 32 64 128 256 512 1024 2048 4096 8192 16384 32768 65536 Bandwidth n2B 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 Dynamic Range 20*log(M)
Temasek Polytechnic - EE - 33500
3mu=0.52mu=1mu=1.510 0 1 2 3 4 5 6 7-1-2-3
Temasek Polytechnic - EE - 3320
Complex Numbers in Communications Engineeringj = i = 1e = cos j sin Eulers Formula: Proof: Substitute complex arguments into a real-valued Taylor Series expansion (why?):cos( ) = 1 j22! mj+44! j66! mj+ . j sin( ) = j e j = 1 j 33! 3! +55
Temasek Polytechnic - EE - 3320
Temasek Polytechnic - EE - 3320
Temasek Polytechnic - EE - 3320
Temasek Polytechnic - EE - 3320
Temasek Polytechnic - EE - 3320
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Determining the periodicity of the sum of periodic signalsLet x(t) = x1(t) + x2(t) + xN(t) where xj(t) is a periodic signal with fundamental period Tj seconds, j = 1,2N. To determine whether x(t) is periodic, form the ratios T1 / Tj, j=2,N. If every one
Temasek Polytechnic - EE - 3320
Temasek Polytechnic - EE - 3320
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~Fourier Series,"~i.Fourier Series for Common SignalsName~1t;WaveformCoCk, k '1= 0CommentstI t t~1. Square wave Xo 0 -T. 0 -Xc -T. t -J .2Xo 7Tk Ck = 0, k even2. Xo Sawtooth . Xo 2 t . Xo J27Tk!J"] i cot'el-To 3. TriangUlar wave - T
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University of Technology, Sydney - EE - 3350
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University of Technology, Sydney - EE - 3350
University of Technology, Sydney - EE - 3350
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Art Inst. San Diego - WEB - digital il
ADOBE ILLUSTRATOR CS4 CLASSROOm In A BOOkInstructor NotesAdobe Illustrator CS4 Classroom in a Book for Windows and Mac OS 2009 Adobe Systems Incorporated and its licensors. All rights reserved. If this guide is distributed with software that includes
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