Prepared by Coby Harmon University of California, Santa Barbara



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Identify the three categories of debt 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 and for impairments of debt and equity investments.
  • Describe the reporting of reclassification adjustments and the accounting for transfers between categories.
  • LEARNING OBJECTIVES
  • 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.
  • Investments
  • 17
  • 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.
  • LO 6
  • Reclassifications and Transfers
  • Illustration: Open Company has the following two available-for-sale securities in its portfolio at the end of 2013 (its first year of operations).
  • Illustration 17-19
  • Reclassification Adjustments
  • LO 6
  • Illustration: If Open Company reports net income in 2013 of $350,000, it presents a statement of comprehensive income as follows.
  • Illustration 17-20
  • Reclassification Adjustments
  • LO 6
  • Illustration: During 2014, 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 2014, the fair value of the Woods Co. common stock increased an additional $20,000, to $155,000.
  • Illustration 17-21
  • Reclassification Adjustments
  • LO 6
  • Illustration: If we assume that Open Company reports net income of $720,000 in 2014, including the realized loss on the Lehman stock, its income statement is presented as shown in Illustration 17-22.
  • Illustration 17-22
  • Reclassification Adjustments
  • LO 6
  • Illustration 17-30
  • * Assumes that adjusting entries to report changes in fair value for the current period are not yet recorded.
  • Reclassifications and Transfers
  • Transfers Between Categories
  • LO 6
  • Transfers Between Categories
  • Illustration 17-30
  • **According to GAAP, these types of transfers should be rare.
  • LO 6
  • Defining Derivatives
  • Financial instruments that derive their value from values of other assets (e.g., stocks, bonds, or commodities).
  • Three different types of derivatives:
    • Financial forwards or financial futures.
    • Options.
    • Swaps.
  • APPENDIX 17A
  • LO 7 Describe the uses of and accounting for derivatives.
  • Who Uses Derivatives, and Why?
    • Producers and Consumers
    • Commodity prices are volatile.
    • They depend on weather, crop production, and general economic conditions.
    • To plan effectively, it makes good sense to lock in specific future revenues or costs in order to run their businesses successfully.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Who Uses Derivatives, and Why?
    • Speculators and Arbitrageurs
    • 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.
    • Arbitrageurs attempt to exploit inefficiencies in markets. They seek to lock in profits by simultaneously entering into transactions in two or more markets.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Basic Principles in Accounting for Derivatives
    • Recognize derivatives in the financial statements as assets and liabilities.
    • Report derivatives at fair value.
    • Recognize gains and losses resulting from speculation in derivatives immediately in income.
    • Report gains and losses resulting from hedge transactions differently, depending on the type of hedge.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Example of Derivative Financial Instrument-Speculation
  • Illustration: Assume that a company purchases a call option contract from Baird Investment Co. on January 2, 2014, 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, 2014. The company purchases the call option for $400 and makes the following entry on January 2, 2014.
  • Call Option 400
  • Cash 400
  • Option Premium
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Example of Derivative Financial Instrument-Speculation
  • The option premium consists of two amounts.
  • Illustration 17A-1
  • 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, 2012, the intrinsic value is zero because the market price equals the preset strike price.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Example of Derivative Financial Instrument-Speculation
  • The option premium consists of two amounts.
  • Illustration 17A-1
  • Time value refers to the option’s 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.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Additional data available with respect to the call option:
  • On March 31, 2014, 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 on the option contract of ____________.
  • $20,000
  • ($120,000 - $100,000)
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • On March 31, 2014, it records the increase in the intrinsic value of the option as follows.
  • Call Option 20,000
  • Unrealized Holding Gain or Loss—Income 20,000
  • A market appraisal indicates that the time value of the option at March 31, 2014, is $100. The company records this change in value of the option as follows.
  • Unrealized Holding Gain or Loss—Income 300
  • Call Option ($400 - $100) 300
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • At March 31, 2012, the company reports the
    • call option in its balance sheet at fair value of $20,100.
    • unrealized holding gain which increases net income.
    • loss on the time value of the option which decreases net income.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • On April 16, 2014, 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]) x 1,000) as follows.
  • Unrealized Holding Gain or Loss—Income 5,000
  • Call option 5,000
  • The decrease in the time value of the option of $40 ($100 - $60) is recorded as follows.
  • Unrealized Holding Gain or Loss—Income 40
  • Call Option 40
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • At the time of the settlement, the call option’s carrying value is as follows.
  • Settlement of the option contract is recorded as follows.
  • Cash 15,000
  • Loss on Settlement of Call Option 60
  • Call Option 15,060
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Summary effects of the call option contract on net income.
  • Illustration 17A-2
  • Because the call option meets the definition of an asset, the company records it in the balance sheet on March 31, 2014. It also reports the call option at fair value, with any gains or losses reported in income.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • A derivative financial instrument has the following three basic characteristics.
    • The instrument has (1) one or more underlyings and (2) an identified payment provision.
    • The instrument requires little or no investment at the inception of the contract.
    • The instrument requires or permits net settlement.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Features of Traditional and Derivative Financial Instruments
  • Illustration 17A-3
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 7
  • Derivatives Used for Hedging
  • Hedging: The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates.
  • FASB allows special accounting for two types of hedges—
    • fair value and
    • cash flow hedges.
  • LO 8 Explain how to account for a fair value hedge.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • 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.
  • Companies commonly use several types of fair value hedges.
    • Interest rate swaps
    • put options
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Illustration: On April 1, 2014, 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.
  • Equity investments 10,000
  • Cash 10,000
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Illustration: Fortunately for Hayward, the value of the Sonoma shares increases to $125 per share during 2012. On December 31, 2015, Hayward records the gain on this investment as follows.
  • Fair Value Adjustment (AFS) 2,500
  • Unrealized Holding Gain or Loss—Equity 2,500
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Hayward reports the Sonoma investment in its balance sheet.
  • Illustration 17A-4
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Hayward 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.
  • Illustration: Hayward enters into the put option contract on January 2, 2015, 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.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Illustration: At December 31, 2015, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment.
  • Unrealized Holding Gain or Loss—Income 500
  • Fair Value Adjustment (AFS) 500
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Illustration: The following journal entry records the increase in value of the put option on Sonoma shares on December 31, 2015.
  • Put Option 500
  • Unrealized Holding Gain or Loss—Income 500
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 8
  • Illustration 17A-5
  • Income Statement Presentation of Fair Value Hedge
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • Illustration 17A-6
  • LO 8
  • Cash Flow Hedge
  • Used to hedge exposures to cash flow risk, which results from the variability in cash flows.
  • Reporting:
    • Fair value on the balance sheet
    • Gains or losses in equity, as part of other comprehensive income.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9 Explain how to account for a cash flow hedge.
  • Illustration: In September 2014 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2015. As a result, Allied enters into an aluminum futures contract. In this case, the aluminum futures 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 2015. The underlying for this derivative is the price of aluminum.
  • Allied enters into the futures contract on September 1, 2014. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9
  • Illustration: At December 31, 2014, 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.
  • Futures Contract 25,000
  • Unrealized Holding Gain or Loss—Equity 25,000
  • ([$1,575 - $1,550] x 1,000 tons)
  • Allied reports the futures contract in the balance sheet as a current asset and the gain as part of other comprehensive income.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9
  • Illustration: In January 2013, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry.
  • Aluminum Inventory 1,575,000
  • Cash ($1,575 x 1,000 tons) 1,575,000
  • At the same time, Allied makes final settlement on the futures contract. It records the following entry.
  • Cash 25,000
  • Futures Contract ($1,575,000 - $1,550,000) 25,000
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9
  • Effect of Hedge on Cash Flows
  • Illustration 17A-7
  • 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.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9
  • Illustration: Assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2015) is $1,700,000. Allied sells the cans in July 2015 for $2,000,000, and records this sale as follows.
  • Cash 2,000,000
  • Sales Revenue 2,000,000
  • Cost of Goods Sold 1,700,000
  • Inventory (Cans) 1,700,000
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9
  • Illustration: Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction.
  • Unrealized Holding Gain or Loss—Equity 25,000
  • Cost of Goods Sold 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.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 9
  • Other Reporting Issues
  • Embedded Derivatives
  • Convertible bond is a hybrid instrument. Two parts:
    • a debt security, referred to as the host security, and
    • an option to convert the bond to shares of common stock, the embedded derivative.
  • 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.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 10 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems.
  • Qualifying Hedge Criteria
  • Criteria that hedging transactions must meet before requiring the special accounting for hedges.
    • Documentation, risk management, and designation.
    • Effectiveness of the hedging relationship.
    • Effect on reported earnings of changes in fair values or cash flows.
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 10
  • Summary of Derivative Accounting under GAAP
  • Illustration 17A-8
  • APPENDIX 17A
  • ACCOUNTING FOR DIRIVATIVE INSTRUMENTS
  • LO 10
  • What About GAAP?
  • Two models for consolidation:
    • Voting-interest model—If a company owns more than 50 percent of another company, then consolidate in most cases.
    • Risk-and-reward model—If a company is involved substantially in the economics of another company, then consolidate.
  • APPENDIX 17B
  • VARIABLE-INTEREST ENTITIES
  • LO 11 Describe the accounting for variable-interest entities.
  • Consolidation of Variable-Interest Entities
  • A variable-interest entity (VIE) is an entity that has one of the following characteristics:
    • Insufficient equity investment at risk.
    • Stockholders lack decision-making rights.
    • Stockholders do not absorb the losses or receive the benefits of a normal stockholder.
  • APPENDIX 17B
  • VARIABLE-INTEREST ENTITIES
  • LO 11
  • VIE Consolidation Model
  • Illustration 17B-1
  • APPENDIX 17B
  • VARIABLE-INTEREST ENTITIES
  • LO 11
  • What Is Happening in Practice?
  • 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.
  • APPENDIX 17B
  • VARIABLE-INTEREST ENTITIES
  • LO 11
  • FASB believes that fair value information is relevant for making effective business decisions. Others express concern about fair value measurements for two reasons:
    • the lack of reliability related to the fair value measurement in certain cases, and
    • the ability to manipulate fair value measurements.
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • LO 12 Describe required fair value disclosures.
  • Both the cost and the fair value of all financial instruments are to be reported in the notes to the financial statements.
  • FASB 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.
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • LO 12
  • Disclosure of Fair Value Information: Financial Instruments—No Fair Value Option
  • Two reasons for additional disclosure beyond the simple itemization of fair values are:
    • Differing levels of reliability exist in the measurement of fair value information.
    • 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.
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • LO 12
  • Levels of reliability fair value hierarchy.
    • 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 company’s assumption as to the value of the financial instrument.
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • LO 12
  • Illustration 17C-1
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • LO 12
  • Reconciliation of Level 3 Inputs
  • Illustration 17C-2
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • Disclosure of Fair Values: Impaired Assets or Liabilities
  • Illustration 17C-4
  • Disclosure of Fair Value with Impairment
  • APPENDIX 17C
  • FAIR VALUE DISCLOSURES
  • LO 13 Compare the accounting for investments under GAAP and IFRS.
  • RELEVANT FACTS - Similarities
    • GAAP and IFRS use similar classifications for trading investments.
    • The accounting for trading investments is the same between GAAP and IFRS. Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. Gains and losses on some investments are reported in other comprehensive income.
    • Both GAAP and IFRS use the same test to determine whether the equity method of accounting should be used, that is, significant influence with a general guideline of over 20 percent ownership.
  • LO 13
  • RELEVANT FACTS - Similarities
    • GAAP and IFRS are similar in the accounting for the fair value option. That is, the option to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income. One difference is that GAAP permits the fair value option for equity method investments.
    • The measurement of impairments is similar under GAAP and IFRS.
  • RELEVANT FACTS - Differences
    • While GAAP classifies investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (only for debt investments), IFRS uses held-for-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications.
    • The basis for consolidation under IFRS is control. Under 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.
  • LO 13
  • RELEVANT FACTS - Differences
    • While the measurement of impairments is similar under GAAP and IFRS, GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. IFRS allows reversals of impairments of held-for-collection investments.
    • While GAAP and IFRS are similar in the accounting for the fair value option, one difference is that GAAP permits the fair value option for equity method investments; IFRS does not.
  • LO 13
  • ON THE HORIZON
  • At one time, 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. However, the recently issued IFRS indicates that the IASB believes that certain debt investments should not be reported at fair value. The IASB’s decision to issue new rules on investments, prior to the FASB’s completion of its deliberations on financial instrument accounting, could create obstacles for the Boards in converging the accounting in this area.
  • LO 13
  • All of the following are key similarities between GAAP and IFRS with respect to accounting for investments except:
    • IFRS and GAAP have a held-to-maturity investment classification.
    • IFRS and GAAP apply the equity method to significant influence equity investments.
    • IFRS and GAAP have a fair value option for financial instruments.
    • the accounting for impairment of investments is similar, although IFRS allows recovery of impairment losses.
  • IFRS SELF-TEST QUESTION
  • LO 13
  • Which of the following statements is correct?
    • GAAP has a held-for-collection investment classification.
    • GAAP permits recovery of impairment losses.
    • Under IFRS, non-trading equity investments are accounted for at amortized cost
    • IFRS and GAAP both have a trading investment classification.
  • IFRS SELF-TEST QUESTION
  • LO 13
  • IFRS requires companies to measure their financial assets at fair value based on:
    • the company’s business model for managing its financial assets.
    • whether the financial asset is a debt investment.
    • whether the financial asset is an equity investment.
    • All of the choices are IFRS requirements.
  • IFRS SELF-TEST QUESTION
  • LO 13

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