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Chapter 12

Investments

QUESTIONS FOR REVIEW OF KEY TOPICS


Question 12-1
Investment securities are classified as held-to-maturity, available-for-sale, or trading
securities.

Question 12-2
Increases and decreases in the market value between the time a debt security is acquired and the
day it matures to a prearranged maturity value are ignored for securities classified as held-tomaturity. These changes arent important if sale before maturity isnt an alternative, which is the
case if an investor has the positive intent and ability to hold the securities to maturity.

Question 12-3
The fair value of an equity security is considered readily determinable if its selling price (or
bid-and-asked quotation) is currently available on a securities exchange. When its fair value is not
readily determinable, an investment is carried and reported at cost. Any dividends received are
recognized as investment revenue, and a gain or loss is reported only when actually realized through
the sale of the investment.

Question 12-4
For investments to be held for an unspecified period of time, fair value information is more
relevant than for investments to be held to maturity. Changes in fair values are less relevant if the
investment is to be held to maturity because sale at that fair value is not an option. The investor
receives the same contracted interest payments and principal at maturity, regardless of movements in
market values. However, when the investment is of unspecified length, changes in fair values
indicate managements success in deciding when to acquire the investment and when to sell it, as
well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term
securities.

Question 12-5
The way unrealized holding gains and losses are reported in the financial statements depends on
whether the investments are classified as securities available-for-sale or as trading securities.
Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not
included in the determination of income for the period. Rather, they are reported as a separate
component of shareholders equity, as part of Other comprehensive income.

Question 12-6

Comprehensive income is a more expansive view of the change in shareholders equity than
traditional net income. It encompasses all changes in equity from nonowner transactions. So, in
addition to net income, comprehensive income includes up to four other changes in equity: Net
unrealized holding gains (losses) on investments, Net unrecognized loss on pensions, Deferred gains
(losses) from derivatives, and Gains (losses) from foreign currency translation.
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Answers to Questions (continued)


Question 12-7
Unrealized holding gains or losses on trading securities are reported in the income statement as if
they actually had been realized. Trading securities are actively managed in a trading account with the
express intent of profiting from short-term market price changes. So, any gains and losses that result
from holding securities during market price changes are suitable measures of success or lack of
success in achieving that goal.
On the other hand, unrealized holding gains or losses on securities available-for-sale are not
reported in the income statement. By definition, these securities are not acquired for the purpose of
profiting from short-term market price changes, so gains and losses from holding these securities
while prices change are not considered relevant performance measures to be included in earnings.

Question 12-8
Apparently, the drop in the market price of the stock is an other-than-temporary impairment. So,
when the investment is written down to its fair value, the amount of the write-down should be treated
as if it were a realized loss, meaning the loss is included in income for the period. Subsequent to the
other-than-temporary write-down, the usual treatment of unrealized gains or losses should be
resumed. Therefore, later changes in fair value will be reported as a separate component of
shareholders equity, accumulated other comprehensive income.

Question 12-9
When acquired, debt and equity securities are assigned to one of the three reporting
classifications held-to-maturity, available-for-sale, or trading. The appropriateness of the
classification is reassessed at each reporting date. A reclassification should be accounted for as
though the security had been sold and immediately reacquired at its fair value. Any unrealized
holding gain or loss should be accounted for in a manner consistent with the classification into
which the security is being transferred. Specifically, when a security is transferred:
1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings
of the reclassification period.
2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded as
a separate component of shareholders equity, Other comprehensive income.
3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized
over the remaining time to maturity.

Question 12-10
Yes. Although a company is not required to report individual amounts for the three categories of
investments held-to-maturity, available-for-sale, or trading on the face of the balance sheet, that
information should be presented in the disclosure notes. The following also should be disclosed for
each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized
and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized
cost basis by major security type. In addition, information about maturities should be reported for
debt securities, by disclosing the fair value and cost for at least 4 maturity groupings: (a) within 1
year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.
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Answers to Questions (continued)


Question 12-11
The equity method is used when an investor cant control, but can significantly influence the
investee. If effective control is absent, the investor still might be able to exercise significant
influence over the operating and financial policies of the investee if the investor owns a large
percentage of the outstanding shares relative to other shareholders. By voting those shares as a
block, the investor often can sway decisions in the direction desired. We presume, in the absence of
evidence to the contrary, that the investor exercises significant influence over the investee when it
owns between 20% and 50% of the investee's voting shares.

Question 12-12
The equity method, like consolidation, views the investor and investee as a special type of single
entity. By the equity method, though, the investor doesnt include separate financial statement items
of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the
investor reports its equity interest in the investee as a single investment account. That single
investment account is periodically adjusted to reflect the effects of consolidation, without actually
consolidating financial statements.

Question 12-13
The investor should account for dividends from the investee as a reduction in the investment
account. Since investment revenue is recognized as the investee earns it, it would be inappropriate
to again recognize revenue when earnings are distributed as dividends. Rather, the dividend
distribution is considered to be a reduction of the investees net assets, indicating that the investors
ownership interest in those net assets declines proportionately.

Question 12-14
The equity method attempts to approximate the effects of accounting for the purchase of the
investee as a consolidation. Consolidated financial statements report acquired net assets at their fair
values. Both investment revenue and the investment would be reduced by the negative income
effect of the extra depreciation the higher fair value would cause. This would equal 40% x $12
million 10 years = $480,000 each year for ten years.

Question 12-15
The investment account was decreased by $40,000 (40% x $100,000). Cash increased the same
amount. There is no effect on the income statement.

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Answers to Questions (concluded)


Question 12-16
When it becomes necessary to change from the equity method to another method, no adjustment
is made to the carrying amount of the investment. The equity method is simply discontinued and the
new method is applied from then on. The investment account balance when the equity method is
discontinued would serve as the new cost basis for writing the investment up or down to market
value in the next set of financial statements.

Question 12-17
A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a
contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument
and (2) conveys to a second entity a right to receive cash or another financial instrument, or (d) a
contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially
unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments
on potentially favorable terms. Accounts payable, bank loans, and investments in securities are
examples.

Question 12-18
These instruments derive their values or contractually required cash flows from some other
security or index.

Question 12-19
Since this fund wont be used within the upcoming operating cycle, it is a noncurrent asset. It
should be reported as part of Investments and funds.

Question 12-20
Part of each premium payment the company makes is not used by the insurance company to pay
for life insurance coverage, but rather is invested on behalf of the insured company in a fixedincome investment. As a result, the periodic insurance premium should not be expensed in its
entirety; an appropriate portion should be recorded instead as a noncurrent asset cash surrender
value.

Question 12-21
When a creditors investment in a receivable becomes impaired, due to a troubled debt
restructuring or for any other reason, the receivable is re-measured based on the discounted present
value of currently expected cash flows at the loans original effective rate (regardless of the extent to
which expected cash receipts have been reduced). The extent of the impairment is the difference
between the carrying amount of the receivable (the present value of the receivables cash flows prior
to the restructuring) and the present value of the revised cash flows discounted at the loans original
effective rate. This difference is recorded as a loss at the time the receivable is reduced.

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BRIEF EXERCISES
Brief Exercise 12-1
(a)
Investment in bonds (face amount) .......................
Discount on bond investment (difference) ........
Cash (price of bonds).........................................

720,000

Cash (1.5% x $720,000) ........................................


Discount on bond investment (difference)............
Interest revenue (2% x $600,000) ..........................

10,800
1,200

120,000
600,000

(b)
12,000

Brief Exercise 12-2


Investment in Disney common shares ..........
Cash ([2,000 shares x $27] + $900) ..................

54,900

Cash ([2,000 shares x $29] $950) ......................


Gain on sale of investments .......................
Investment in Disney common shares .......

57,050

54,900

2,150
54,900

Brief Exercise 12-3


Securities available-for-sale are reported at fair value, and resulting holding gains
and losses are not included in the determination of income for the period. Rather, they
are reported as a separate component of shareholders equity, as part of Other
comprehensive income. The adjusting entry needed to increase the fair value
adjustment from $110,000 to $170,000 is:
Fair value adjustment ($670,000 610,000)......
Accumulated unrealized holding gains and losses

60,000
60,000

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Brief Exercise 12-4


These are securities available-for-sale and are reported at their fair value,
$4,000,000. We know this because securities held-to-maturity are debt securities an
investor has the positive intent and ability to hold to maturity. Actively traded
investments in debt or equity securities acquired principally for the purpose of selling
them in the near term are classified as trading securities. The FedEx shares have
been held for over a year. They are classified as available-for-sale since all
investments in debt and equity securities that dont fit the definitions of the other
reporting categories are classified this way. Of course, the equity method isnt
appropriate either because 40,000 shares of FedEx certainly dont constitute
significant influence. Investments in securities available-for-sale are reported at fair
value.

Brief Exercise 12-5


Unlike for securities available-for-sale, unrealized holding gains and losses for
trading securities are included in earnings. S&L reports its $2,000 holding loss in
2006 earnings. When the fair value rises by $7,000 in 2007, that amount is reported in
2007 earnings. S&Ls journal entries for these transactions would be:
2006
December 27
Investment in Coca Cola shares .........................................
Cash ...............................................................................

875,000

December 31
Unrealized holding loss ......................................................
Investment in Coca Cola shares ([$875,000 - $873,000)......

2,000

875,000

2,000

2007
January 3
Cash (selling price)................................................................
Gain on investments (to balance) ......................................
Investment in Coca Cola shares (account balance) .............

880,000
7,000
873,000

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Brief Exercise 12-6


Unlike for trading securities, unrealized holding gains and losses for securities
available-for-sale are not included in earnings. S&L reports its $2,000 holding loss in
2006 as Other comprehensive income, a negative component of shareholders equity,
not earnings. When the fair value rises to $880,000 in 2007, the amount is reported in
2007 earnings is the $5,000 gain realized by the sale of the securities. S&Ls journal
entries for these transactions would be:
2006
December 27
Investment in Coca Cola shares .........................................
Cash ...............................................................................

875,000

December 31
Unrealized holding loss (shareholders equity) .....................
Fair value adjustment ($875,000 - $873,000) ......................

2,000

875,000

2,000

2007
January 3
Cash (selling price)................................................................
Gain on investments (to balance) ......................................
Investment in Coca Cola shares (cost) .............................

880,000
5,000
875,000

Assuming no other transactions involving securities available-for-sale, the 2007


adjusting entry would be:
December 31
Fair value adjustment (balance) ...........................................
Unrealized holding loss (balance) ....................................

2,000
2,000

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Brief Exercise 12-7


An investor should account for dividends from an equity method investee as a
reduction in its investment account. Since investment revenue is recognized as the
investee earns it, it would be inappropriate to again recognize revenue when earnings
are distributed as dividends. Instead, the dividend distribution is considered to be a
reduction of the investees net assets, reflecting the fact that the investors ownership
interest in those net assets declined proportionately. Turners cash increased by $2
million (40% x $5 million). Its investment account declined by the same amount.
There is no effect on the income statement.

Brief Exercise 12-8


An investor should account for dividends from an investment not accounted for by
the equity method as investment revenue. Since Turner holds only 10% of ICA stock,
its assumed that it does not have significant influence over the company. Turners
cash increased by $500,000 (10% x $5 million). It also reports $500,000 as
investment revenue in the income statement.

Brief Exercise 12-9


With the equity method we attempt to approximate the effects of accounting for the
purchase of the investee as a consolidation. Consolidated financial statements report
acquired net assets at their fair values. Both investment revenue and the investment
would be reduced by the negative income effect of the extra depreciation the higher
fair value would cause. This would equal 30% x $50 million 15 years = $1 million
each year for fifteen years.

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Brief Exercise 12-10


Because the drop in the market price of stock is considered to be other-thantemporary, LED records the impairment as follows:
Impairment loss ($4.50 x $ 100,000 shares) ...........
Investment in Branch Pharmaceuticals ..........

450,000
450,000

The investment is written down to its fair value, and the amount of the write-down
should be treated as if it were a realized loss, meaning the loss is included in LEDs
earnings for the period. Following the other-than-temporary write-down, the usual
treatment of unrealized gains or losses should be resumed. Therefore, later changes in
fair value will be reported as Other comprehensive income or loss - a separate
component of shareholders equity.

Brief Exercise 12-11


The investment would be increased by $12 million. Financial statements would
be recast to reflect the equity method for each year reported for comparative
purposes. A disclosure note also should describe the change, justify the switch, and
indicate its effects on all financial statement items.
No. If Pioneer changes from the equity method, no adjustment is made to the
carrying amount of the investment. Instead, the equity method is simply
discontinued, and the new method is applied from then on. The balance in the
investment account when the equity method is discontinued would serve as the new
cost basis for writing the investment up or down to market value in the next set of
financial statements. There also would be no revision of prior years, but the change
should be described in a disclosure note.

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EXERCISES
Exercise 12-1
Requirement 1
Investment in bonds (face amount) .......................
Discount on bond investment (difference) ........
Cash (price of bonds).........................................
Requirement 2
Cash (3% x $240 million) ......................................
Discount on bond investment (difference)............
Interest revenue (4% x $200) ................................

($ in millions)

240
40
200
7.2
.8
8.0

Requirement 3
Tanner-UNF reports its investment in the December 31, 2006, balance sheet at
its amortized cost that is, its book value:
Investment in bonds ..........................................
Less: Discount on bond investment ($40 - .8 million)
Amortized cost...............................................

$240.0
39.2
$200.8

If sale before maturity isnt an alternative, increases and decreases in the


market value between the time a debt security is acquired and the day it matures
to a prearranged maturity value are relatively unimportant. For this reason, if
an investor has the positive intent and ability to hold the securities to
maturity, investments in debt securities are classified as held-to-maturity and
reported at amortized cost rather than fair value in the balance sheet.
Requirement 4
Cash (proceeds from sale) ......................................
Discount on bond investment (balance, determined above)
Loss on sale of investments (to balance) ..............
Investment in bonds (face amount) ...................

($ in millions)

190.0
39.2
10.8
240.0

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Exercise 12-2
November 1
($ in millions)

Cash ..............................................................
Investment revenue ....................................

2.4
2.4

December 1
Investment in Facsimile Enterprises bonds ....
Cash...........................................................

30
30

December 31
Investment in U.S. Treasury bills .................
Cash...........................................................

8.9
8.9

December 31
Investment revenue receivable - Convenience
bonds ($48 million x 10% x 2/12) ......................
Investment revenue receivable - Facsimile
Enterprises bonds ($30 million x 12% x 1/12) ....
Investment revenue ....................................

0.8
0.3
1.1

Note: Securities held-to-maturity are not adjusted to fair value.

Exercise 12-3
Investment in GM common shares ...............
Cash ([800 shares x $50] + $1,200) ..................

41,200

Cash ([800 shares x $53] $1,300) ......................


Loss on sale of investments ...........................
Investment in GM common shares ............

41,100
100

41,200

41,200

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Exercise 12-4
Requirement 1
($ in 000s)

Net unrealized holding gains and losses ................................


Fair value adjustment ($405 - 480) .......................................

75

Fair value adjustment ($480 - 450) ...........................................


Net unrealized holding gains and losses.............................

30

Fair value adjustment ($560 - 480) ...........................................


Net unrealized holding gains and losses.............................

80

Net unrealized holding gains and losses ................................


Fair value adjustment ($660 - 720) .......................................

60

75
30
80
60

Requirement 2
None. Accumulated net holding gains and losses for securities available-forsale are reported as a component of shareholders equity, and changes in the
balance are reported as Other comprehensive income or loss rather than as
part of earnings. This amount can be reported either (a) as an additional
section of the income statement, (b) as part of the statement of shareholders
equity, or (c) as a separate statement in a disclosure note.

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Exercise 12-5
Requirement 1
Securities held-to-maturity are debt securities an investor has the positive
intent and ability to hold to maturity. Actively traded investments in debt or
equity securities acquired principally for the purpose of selling them in the near
term are classified as trading securities. The IBM shares are neither. They are
classified as available-for-sale since all investments in debt and equity securities
that dont fit the definitions of the other reporting categories are classified this
way. Of course, the equity method isnt appropriate either because 10,000 shares
of IBM certainly dont constitute significant influence.
Investments in securities available-for-sale are reported at fair value, and holding
gains or losses are not included in the determination of income for the period.
Instead, they are reported as Other comprehensive income or loss. This amount
can be reported either (a) as an additional section of the income statement, (b) as
part of the statement of shareholders equity, or (c) as a separate statement in a
disclosure note. Accumulated net holding gains and losses for securities
available-for-sale are reported as a separate component of shareholders equity.
Requirement 2
December 31, 2006
Net unrealized holding gains and losses (10,000 shares x [$58 - 60])
Fair value adjustment ...........................................................

20,000
20,000

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Exercise 12-5 (concluded)


Requirement 3
December 31, 2007
($ in 000s)
Available-for-Sale Securities
IBM shares Dec. 31, 2007

Cost
$600

Fair Value
$610

Accumulated
Unrealized
Gain (Loss)
$10

Moving from a negative $20 (2006) to a positive $10 requires an increase of $30:
--------------------------------------------------------20
0
+10
+30 ----------------------------->

Fair value adjustment (10,000 shares x [$61 - 58]) ..........................


Net unrealized holding gains and losses (-$20 less $10) ...........

30,000
30,000

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Exercise 12-6
Requirement 1
2006
March 2
($ in millions)

Investment in Platinum Gauges, Inc. shares .............................


Cash ......................................................................................

31
31

April 12
Investment in Zenith bonds .......................................................
Cash ......................................................................................

20

July 18
Cash ..........................................................................................
Investment revenue ...............................................................

October 15
Cash ..........................................................................................
Investment revenue ...............................................................

October 16
Cash ..........................................................................................
Investment in Zenith bonds ...................................................
Gain on sale of investments...................................................
November 1
Investment in LTD preferred shares .........................................
Cash ......................................................................................

20

1
21
20
1
40
40

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Exercise 12-6 (continued)


December 31
($ in millions)

Available-for-Sale Securities
Platinum Gauges, Inc. shares
LTD preferred shares
Totals

Cost
$31
40
$71

Fair Value
$32*
37**
$69

Accumulated
Unrealized
Gain (Loss)
$1
(3)
$(2)

* $32 x 1 million shares


** $74 x 500,000 shares

Adjusting entry:
Net unrealized holding gains and losses ($71 69).....................
Fair value adjustment ($71 69)..............................................

2
2

2007
January 23
($ in millions)

Cash ([1 million shares x 1/2] x $32)...............................................


Gain on sale of investments (difference) ..................................
Investment in Platinum Gauges
shares ($31 million cost x 1/2) .................................................
March 1
Cash ($76 x 500,000 shares) ...........................................................
Loss on sale of investments (difference) ......................................
Investment in LTD preferred (cost) ........................................

16.0
.5
15.5

38
2
40

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Exercise 12-6 (concluded)


Requirement 2
2006 Income Statement
($ in millions)

Investment revenue (from July 18; Oct. 15)....................................


Gain on sale of investments (from Oct. 16) ..................................

$3
1

Other comprehensive income:*


Unrealized holding loss on investments**...........................

$2

* Assuming Construction Forms chooses to report Other comprehensive income as an


additional section of the income statement. Alternatively, it can report this (a) as part of the
statement of shareholders equity or (b) as a separate statement in a disclosure note.

Note: Unlike for trading securities, unrealized holding gains and losses are not
included in income for securities available-for-sale.

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Exercise 12-7
Requirement 1
Purchase

($ in millions)

Investment in Jackson Industry shares.......................................


Cash .....................................................................................

90
90

Net income

No entry
Dividends
Cash (5% x $60 million) ................................................................

Investment revenue ...............................................................

Adjusting entry

Fair value adjustment ($98 - 90 million) .......................................


Net unrealized holding gains and losses ................................

8
8

Requirement 2
Investment revenue .........................

$3 million

An unrealized holding gain is not included in income for securities availablefor-sale.

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Exercise 12-8
Requirement 1
2006
December 17
Investment in Grocers Supply preferred shares ................
Cash ...............................................................................

350,000

December 28
Cash ...................................................................................
Investment revenue ........................................................

2,000

December 31
Investment in Grocers Supply preferred shares .................
Unrealized holding gain ([$4 x 100,000 shares] - $350,000) ..

50,000

350,000

2,000

50,000

2007
January 5
Cash (selling price)................................................................
Loss on investments (to balance) ..........................................
Investment in Grocers Supply preferred
shares (account balance)................................................

395,000
5,000
400,000

Requirement 2
Balance Sheet
(short-term investment):
Trading securities ..................................................
Income Statement:
Investment revenue (dividends) .........................................
Unrealized holding gain (from adjusting entry) ....................

$400,000
$

2,000
50,000

Note: Unlike for securities available-for-sale, unrealized holding gains and losses for
trading securities are included in income.

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Exercise 12-9
1. Investments reported as current assets.
Security A
$ 910,000
Security B
100,000
Security C
780,000
Security E
490,000
Total
$2,280,000
2. Investments reported as noncurrent assets.
Security D
$ 915,000
Security F
615,000
$1,530,000

3. Unrealized gain (or loss) component of income before taxes.


Trading Securities:
Security

A
B

Totals

Cost

Fair value

$ 900,000
105,000
$1,005,000

$ 910,000
100,000
$1,010,000

Unrealized
gain (loss)
$10,000
(5,000)
$ 5,000

4. Unrealized gain (or loss) component of shareholders equity.


Securities Available-for-Sale:

Security
Totals

C
D

Cost

Fair value

$ 700,000
900,000
$1,600,000

$ 780,000
915,000
$1,695,000

Unrealized
gain (loss)
$80,000
15,000
$95,000

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Exercise 12-10
Requirement 1
($ in 000s)
Available-for-Sale Securities
IBM shares Dec. 31, 2006

Cost
$1,345

Fair Value
$1,175

Accumulated
Unrealized
Gain (Loss)
$(170)

Moving from a negative $145 (Jan.1) to a negative $170 requires a reduction of


$25:
--------------------------------------------------------170
-145
0
<---------------- - 25

Net unrealized holding gains and losses ...............................


Fair value adjustment ($1,175,000 - 1,200,000) ..................
Requirement 2
($ in 000s)
Available-for-Sale Securities
IBM shares Dec. 31, 2006

Cost
$1,345

Fair Value
$1,275

25,000
25,000

Accumulated
Unrealized
Gain (Loss)
$(70)

Moving from a negative $145 (Jan.1) to a negative $70 requires an increase of


$75:

-------------------------------------------------------------------------------------------145
-70
0
+75 ---------------------->

Fair value adjustment ($1,275,000 - 1,200,000) .........................


Net unrealized holding gains and losses.........................

75,000
75,000

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12-21

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Exercise 12-10 (concluded)


Requirement 3
($ in 000s)
Available-for-Sale Securities
IBM shares Dec. 31, 2006

Cost
$1,345

Fair Value
$1,375

Accumulated
Unrealized
Gain (Loss)
$30

Moving from a negative $145 (Jan.1) to a positive $30 requires an increase of


$175:
-------------------------------------------------------------------------------------------145
-70
0
+30
+175 -------------------------------------------------------->

Fair value adjustment ($1,375,000 - 1,200,000) .........................


Net unrealized holding gains and losses.........................

175,000
175,000

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Exercise 12-11
Requirement 1
The sale of the A Corporation shares decreased Harlons pretax earnings by $5
million. The purchase of the C Corporation shares had no effect on Harlons 2007
earnings. Here are the entries used to record those two transactions:
June 1, 2007
Cash
Loss on sale of investments (difference)
Investment in A Corporation shares (cost)
September 12, 2007
Investment in C Corporation shares
Cash

($ in millions)

15
5
20
15
15

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Exercise 12-11 (concluded)


Requirement 2
Harlons securities available-for-sale portfolio should be reported in its 2007
balance sheet at its fair value of $101 million:
December 31, 2007
($ in millions)
Cost, Dec. 31
Securities Available-for-Sale 2006 2007

A Corporation shares
B Corporation bonds
C Corporation shares
D Industries shares
Totals

$20
35
na
45
$100

na
$35
15
45
$95

Fair Value, Dec. 31


2006
2007

$14
35
na
46
$95

na
$ 37
14
50
$101

Moving from a negative $5 (2006) to a positive $6 requires an increase of $11:


---------------------------------------------------------5
0
+6
+11 ----------------------------->
Fair value adjustment ($5 credit to $6 debit)
11
Net unrealized holding gains and losses ($5 debit to $6 credit)

11

The adjustment has no effect on earnings. Unlike for trading securities, unrealized
holding gains and losses are not included in income for securities available-forsale.

Exercise 12-12
1. b
2. b

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Exercise 12-13
Requirement 1
Purchase

Investment in AMC common shares ..................................


Cash .............................................................................

480,000
480,000

Net income

No entry
Dividends
Cash (20% x 400,000 shares x $0.25) ........................................

20,000

Investment revenue .......................................................

20,000

Adjusting entry

Fair value adjustment ($505,000 - 480,000) ............................


Net unrealized holding gains and losses ........................

25,000
25,000

Requirement 2
Purchase

Investment in AMC common shares ..................................


Cash .............................................................................

480,000
480,000

Net income

Investment in AMC common shares (20% x $250,000) ........


Investment revenue .......................................................
Dividends
Cash (20% x 400,000 shares x $0.25) ........................................

Investment in AMC common shares .............................

50,000
50,000
20,000
20,000

Adjusting entry

No entry

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Exercise 12-14
Purchase

Investment in Nursery Supplies shares ..................................


Cash .................................................................................

($ in millions)

56
56

Net income

Investment in Nursery Supplies shares (30% x $40 million) .....


Investment revenue ...........................................................
Dividends
Cash (30% x 8 million shares x $1.25) .........................................

12
12
3

Investment in Nursery Supplies shares ..............................

Adjusting entry

No entry

Exercise 12-15
Requirement 1
($ in millions)

Investment in equity securities ($48 million 31 million) ..........


Retained earnings (investment revenue from the equity method).

17
17

Requirement 2
Financial statements would be recast to reflect the equity method for each year
reported for comparative purposes. A disclosure note also should describe the
change, justify the switch, and indicate its effects on all financial statement items.
Requirement 3
When a company changes from the equity method, no adjustment is made to the
carrying amount of the investment. Instead, the equity method is simply
discontinued, and the new method is applied from then on. The balance in the
investment account when the equity method is discontinued would serve as the new
cost basis for writing the investment up or down to market value in the next set of
financial statements. There also would be no revision of prior years, but the change
should be described in a disclosure note.

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Exercise 12-16
1. Error discovered before the books are adjusted or closed in 2006.
Investments ($100,000 80,000) ......................
Gain on sale of investments....................

20,000

20,000

2. Error not discovered until early 2007.


Investments ($100,000 80,000) ......................
Retained earnings ...................................

20,000

20,000

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Exercise 12-17
Purchase

($ in millions)

Investment in Carne Cosmetics shares ...............................


Cash ..............................................................................

68
68

Net income

Investment in Carne Cosmetics shares (25% x $40 million) ...


Investment revenue ........................................................
Dividends
Cash (4 million shares x $1) ....................................................

10
10
4

Investment in Carne Cosmetics shares............................

Depreciation Adjustment

Investment revenue ($8 million [calculation below] 8 years) .


Investment in Carne Cosmetics shares............................

1
1

Calculations:
Investee
Net Assets

Net Assets
Purchased

Difference
Attributed to:

Cost

$68

Fair value:

$224* x 25% = $56

Book value:

Goodwill:$12

$192 x 25% = $48

Undervaluation
of assets: $8

*[$192 + 32] = $224


Adjusting entry

No entry

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Exercise 12-18
Requirement 1
Purchase

($ in millions)

Investment in Lake Construction shares .............................


Cash ..............................................................................

300
300

Net income

Investment in Lake Construction shares (20% x $150 million)


Investment revenue ........................................................

30
30

Dividends
Cash (20% x $30 million) .......................................................

Investment in Lake Construction shares .........................

Adjustment for depreciation

Investment revenue ($10 million [calculation below] 10 years)


Investment in Lake Construction shares .........................

1
1

calculation:
Investee
Net Assets

Net Assets
Purchased

Cost
Fair value:

Book value:

Difference
Attributed to:

$300

Goodwill:

Undervaluation

$120

$900 x 20% = $180

$800 x 20% = $160

of buildings($10) and land ($10): $20

Requirement 2
a. Investment in Lake Construction shares
_________________________________________
($ in millions)

Cost
300
Share of income 30

Balance

6 Dividends
1 Depreciation adjustment
_________________
323
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Exercise 12-18 (concluded)

b. As investment revenue in the income statement.


$30 million (share of income) $1 million (depreciation adjustment) =
$29 million
c. Among investing activities in the statement of cash flows.
$300 million
[Cash dividends received ($6 million) also are reported - as part of operating activities.]

Exercise 12-19
1. b
2. b
3. b

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Exercise 12-20
1. c. According to SFAS 115, available-for-sale securities are investments in debt
securities that are not classified as held-to-maturity or trading securities and
in equity securities with readily determinable fair values that are not
classified as trading securities. They are measured at fair value in the
balance sheet.
2. b. Available-for-sale securities include (1) equity securities with readily
determinable fair values that are not classified as trading securities and (2)
debt securities that are not classified as held-to-maturity or trading securities.
Unrealized holding gains and losses are measured by the difference between
the amortized cost and fair value, excluded from earnings, and reported in
other comprehensive income. The balance is reported net of the tax effect
(ignored in this question). Thus, the difference at May 31, year 3 is $8,005
($643,500 fair value $635,495 amortized cost). This unrealized gain is
reported as a credit to accumulated other comprehensive income.
3. d. Debt securities that the company has the positive intent and ability to hold to
maturity are classified as held-to-maturity. Held-to-maturity securities are
reported at amortized cost. Under the provisions of SFAS 115, any
unrealized gains or losses are not recognized.

Exercise 12-21
Requirement 1
Insurance expense (difference) ..............................................
Cash surrender value of life insurance ($27,000 21,000)......
Cash (2006 premium).........................................................
Requirement 2
Cash (death benefit) .......................................................
Cash surrender value of life insurance (account balance)
Gain on life insurance settlement (to balance) ...........

64,000
6,000
70,000
4,000,000
27,000
3,973,000

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12-31

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Exercise 12-22
Requirement 1
Insurance expense (difference) ......................................
Cash surrender value of life insurance ($4,600 2,500).
Cash (premium) ........................................................

22,900
2,100
25,000

Requirement 2
Cash (death benefit) .......................................................
Cash surrender value of life insurance (account balance)
Gain on life insurance settlement (to balance) ...........

250,000
16,000
234,000

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12-33

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Exercise 12-23
ANALYSIS
Previous Value:

Accrued interest (10% x $12,000,000)


Principal
Carrying amount of the receivable

$ 1,200,000
12,000,000
$13,200,000

New Value:

Interest
$1 million
x 1.73554 *
Principal $11 million
x 0.82645 **
Present value of the receivable

=
=

$1,735,540
9,090,950
(10,826,490)
$ 2,373,510

Loss:
* present value of an ordinary annuity of $1: n=2, i=10%
** present value of $1: n=2, i=10%
JOURNAL ENTRIES

January 1, 2006
Loss on troubled debt restructuring (to balance) ...........
Accrued interest receivable (account balance) ............
Note receivable ($12,000,000 - 10,826,490) .................

2,373,510
1,200,000
1,173,510

December 31, 2006


Cash (required by new agreement)....................................
Note receivable (to balance)..........................................
Interest revenue (10% x $10,826,490) .........................

1,000,000
82,649

December 31, 2007


Cash (required by new agreement)....................................
Note receivable (to balance)..........................................
Interest revenue (10% x [$10,826,490 + 82,649]) ..........

1,000,000
90,861

Cash (required by new agreement)....................................


Note receivable (balance) .........................................

1,082,649

1,090,861*
11,000,000
11,000,000

* rounded to amortize the note to $11,000,000 (per schedule below)

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Exercise 12-23 (concluded)


Amortization Schedule Not required
Cash
Interest
by agreement

1
2

1,000,000
1,000,000

Effective
Increase in
Interest
Balance
10% x Outstanding Balance Discount Reduction
.10 (10,826,490) = 1,082,649
.10 (10,909,139) = 1,090,861*

2,000,000
* rounded

2,173,510

82,649
90,861

Outstanding
Balance

10,826,490
10,909,139
11,000,000

173,510

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Exercise 12-24
ANALYSIS
Previous Value:

Accrued interest (10% x $240,000)


Principal
Carrying amount of the receivable

$ 24,000
240,000
$264,000

New Value:

$11,555 + 11,555 + 11,555 + 240,000 = $274,665


$274,665 x 0.82645 * =
Loss:
* present value of $1: n=2, i=10%

(226,997)
$ 37,003

JOURNAL ENTRIES

January 1, 2006
Loss on troubled debt restructuring (to balance) ...........
Accrued interest receivable (10% x $240,000) ...........
Note receivable ($240,000 - $226,997)........................

37,003
24,000
13,003

December 31, 2006


Note receivable (to balance)..........................................
Interest revenue (10% x $226,997) .............................

22,700

December 31, 2007


Note receivable (to balance)..........................................
Interest revenue (10% x [$226,997 + 22,700]) ..............

24,968

Cash (required by new agreement)....................................


Note receivable (balance) .........................................

22,700

24,968*
274,665
274,665

* rounded to amortize the note to $274,665 (per schedule below)

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Exercise 12-24 (concluded)


Amortization Schedule Not required
Cash
Interest
by agreement

1
2

0
0

Effective
Interest
10% x Outstanding Balance
.10 (226,997) = 22,700
.10 (249,697) = 24,968*
47,668

Increase in
Outstanding
Balance
Balance
Discount Reduction

22,700
24,968

226,997
249,697
274,665

47,668

* rounded

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PROBLEMS
Problem 12-1
Requirement 1
Investment in bonds (face amount) .......................
Discount on bond investment (difference) ........
Cash (price of bonds).........................................

($ in millions)

80
14
66

Requirement 2
Cash (4% x $80 million) ........................................
Discount on bond investment (difference)............
Interest revenue (5% x $66) ..................................

3.20
.10

Requirement 3
Cash (4% x $80 million) ........................................
Discount on bond investment (difference)............
Interest revenue (5% x [$66 + 0.1]).......................

3.20
.11

3.30

3.31

Requirement 4
Fuzzy Monkey reports its investment in the December 31, 2006, balance sheet
at its amortized cost that is, its book value:
Investment in bonds .........................................................
Less: Discount on bond investment ($14 .1 .11 million)
Amortized cost..............................................................

$80.00
13.79
$66.21

Increases and decreases in the market value between the time a debt security
is acquired and the day it matures to a prearranged maturity value are relatively
unimportant if sale before maturity isnt an alternative. For this reason, if an
investor has the positive intent and ability to hold the securities to maturity,
investments in debt securities are classified as held-to-maturity and reported
at amortized cost rather than fair value in the balance sheet.

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Problem 12-2
Requirement 1
Investment in bonds (face amount) .......................
Discount on bond investment (difference) ........
Cash (price of bonds).........................................

($ in millions)

80
14
66

Requirement 2
Cash (4% x $80 million) ........................................
Discount on bond investment (difference)............
Interest revenue (5% x $66)...................................

3.20
.10

Requirement 3
Cash (4% x $80 million) ........................................
Discount on bond investment (difference)............
Interest revenue (5% x [$66 + 0.1]) .......................

3.20
.11

3.30

3.31

Requirement 4
Fuzzy Monkey reports its investment in the December 31, 2006, balance sheet
at its fair value, $70 million in this case. For investments in securities
available-for-sale, changes in market values, and thus market returns, provide
an indication of managements success in deciding when to acquire the
investment, when to sell it, whether to invest in fixed-rate or variable-rate
securities, and whether to invest in long-term or short-term securities.
To do this, we first need to determine the investments amortized cost (or book
value) at the end of the year:
Investment in bonds .........................................................
Less: Discount on bond investment ($14 .1 .11 million)
Amortized cost..............................................................

$80.00
13.79
$66.21

Then, to record it at fair value, we increase the investment by $70 66.21 =


$3.79 million:
Fair value adjustment ............................. ..........
Net unrealized holding gains and losses ($70 66.21)

3.79
3.79

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Problem 12-3
Requirement 1
2006
February 21
Investment in Distribution Transformers shares ........
Cash .......................................................................

400,000
400,000

March 18
Cash ...........................................................................
Investment revenue ................................................

8,000

September 1
Investment in American Instruments bonds ...............
Cash .......................................................................

900,000

October 20
Cash ...........................................................................
Investment in Distribution Transformers ..............
Gain on sale of investments....................................
November 1
Investment in M&D Corporation shares ....................
Cash .......................................................................

8,000

900,000
425,000
400,000
25,000
1,400,000
1,400,000

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Problem 12-3 (continued)


December 31
Adjusting entries:
Investment revenue receivable....................................
Investment revenue ($900,000 x 10% x 4/12) ..............

Available-for-Sale Securities
M & D Corporation shares
American Instruments bonds
Totals Dec. 31, 2006

Cost
$1,400,000
900,000
$2,300,000

30,000

Fair Value
$1,460,000
850,000
$2,310,000

30,000
Accumulated
Unrealized
Gain (Loss)
$60,000
(50,000)
$10,000*

Fair value adjustment (calculated above) ........................


10,000
Net unrealized holding gains and losses (change in accumulated balance)
10,000*
* The $10,000 credit balance in the Net unrealized holding gains and losses is reported as
Accumulated other comprehensive income, a component of Shareholders equity in the 2006
balance sheet. The $10,000 change in the accumulated balance is reported as 2006 Other
comprehensive income.

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Problem 12-3 (continued)


Requirement 2
Income statement:
Investment revenue ($8,000 + 30,000)
Gain on sale of investments

38,000
25,000

Other comprehensive income:


Net unrealized holding gain on investments*

10,000

Balance sheet:
Current Assets
Investment revenue receivable

30,000

Note: Unlike for trading securities, unrealized holding gains and losses are not
included in income for securities available-for-sale.

Securities available-for-sale
Plus: Fair value adjustment

$2,300,000
10,000 $2,310,000

Shareholders Equity
Accumulated other comprehensive income
Net unrealized holding gain (loss) ($60,000 - 50,000)

10,000

* Can be reported either (a) as an additional section of the income statement, (b) as part of the
statement of shareholders equity, or (c) as a separate statement in a disclosure note.

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Problem 12-3 (continued)


Requirement 3
2007
January 20
Cash ...........................................................................
Gain on sale of investments (to balance) ...................
Investment in M&D Corporation shares (cost) ........
March 1
Cash ...........................................................................
Investment revenue receivable................................
Investment revenue ................................................

1,485,000
85,000
1,400,000
45,000
30,000
15,000

August 12
Investment in Vast Communications shares ..............
Cash .......................................................................

650,000

September 1
Cash ...........................................................................
Investment revenue ................................................

45,000

650,000

45,000

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Problem 12-3 (continued)


December 31
Adjusting entries:
Investment revenue receivable....................................
Investment revenue ($900,000 x 10% x 4/12) ..............

Securities
Vast Communication shares
American Instruments bonds
Totals Dec. 31, 2007

Cost
$650,000
900,000
$1,550,000

30,000

Fair Value
$670,000
830,000
$1,500,000

30,000
Accumulated
Unrealized
Gain (Loss)
$20,000
(70,000)
$(50,000)*

Moving from a positive $10,000 (2006) to a negative $50,000 requires a decrease


of $60,000:
-------------------------------------------------------------------------------------------50,000
0
+10,000
<-------------------------------------------- $60,000

Net unrealized holding gains and losses (change in accumulated balance) 60,000*
Fair value adjustment (calculated above) ....................
60,000
* The $50,000 debit balance in the Net unrealized holding gains and losses is reported as
Accumulated other comprehensive income, a negative component of Shareholders equity in
the 2007 balance sheet. The $60,000 change in the accumulated balance is reported as 2007
Other comprehensive income.

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Problem 12-3 (continued)


Requirement 4
Income statement:
Investment revenue ($15,000 + 45,000 + 30,000)
Gain on sale of investments

90,000
85,000

Other comprehensive income:


Net unrealized holding loss on investments*

(60,000)

Balance sheet:
Current Assets
Investment revenue receivable

30,000

Note: Unlike for trading securities, unrealized holding gains and losses are not
included in income for securities available-for-sale.

Securities available-for-sale
Less: Fair value adjustment

$1,550,000
(50,000) $1,500,000

Shareholders Equity
Accumulated other comprehensive income
Net unrealized holding gain (loss) ($20,000 - 70,000)

$ (50,000)

* Can be reported either (a) as an additional section of the income statement, (b) as part of the
statement of shareholders equity, or (c) as a separate statement in a disclosure note.

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Problem 12-4
Requirement 1
2006

December 12
Investment in FF&G Corporation bonds ...................................
Cash .......................................................................................
December 13
Investment in Ferry common shares ..........................................
Cash .......................................................................................
December 15
Cash ...........................................................................................
Investment in FF&G Corporation bonds ................................
Gain on sale of investments ($12.1 12)...................................

($ in millions)

12
12
22
22
12.1
12.0
0.1

December 22
Investment in U.S. Treasury bills ..............................................
Investment in U.S. Treasury bonds ............................................
Cash .......................................................................................

56
65

December 23
Cash ...........................................................................................
Loss on sale of investments ($10 11) .........................................
Investment in Ferry common shares ($22 x 1/2) .......................

10
1

December 26
Cash (selling price)........................................................................
Gain on sale of investments ($57 56) .....................................
Investment in U.S. Treasury bills (balance) ..............................
December 27
Cash (selling price)........................................................................
Loss on sale of investments ($63 65) .........................................
Investment in U.S. Treasury bonds (balance) ...........................

121

11
57
1
56
63
2
65

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December 28
Cash ...........................................................................................
Investment revenue ................................................................

0.2
0.2

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Problem 12-4 (concluded)


December 31
($ in millions)

Adjusting entry:
Unrealized holding loss on investments ($10 million - [$22 million x 1/2])
Investment in Ferry common shares ......................................
Closing entry:
Income summary (to balance) .......................................................
Investment revenue ($5 + 0.2 million)............................................
Gain on sale of investments ($8 + 0.1 + 1 million) ..........................
Loss on sale of investments ($11 + 1 + 2 million) .......................
Unrealized holding loss on investments (adjusting entry) ...........

1.0
1.0
.7
5.2
9.1
14.0
1.0

Note: Unlike for securities available-for-sale, unrealized holding gains and losses are
included in income for trading securities.

Requirement 2
($ in millions)

Balance sheet (short-term investment):


Investment in Ferry common shares (balance after adjusting entry)
Income statement:
Investment revenue (closing entry)
Gain on sale of investments (closing entry)
Loss on sale of investments (closing entry)
Unrealized holding loss on investments (closing entry)

10.0
5.2
9.1
(14.0)
(1.0)

Requirement 3
2007
January 2
($ in millions)

Cash (selling price)........................................................................


Investment in Ferry common (balance after adjusting entry) .........
Gain on sale of investments (difference) ...................................
January 5
Investment in Warehouse Designs bonds ..................................
Cash .......................................................................................

10.2
10.0
.2
34
34

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Problem 12-5
($ in millions)

October 18
Investment in Millwork Ventures preferred shares ....................
Cash .......................................................................................
October 31
Cash ...........................................................................................
Investment revenue ................................................................

58
58

1.5
1.5

November 1
Investment in Holistic Entertainment bonds ...............................
Cash .......................................................................................

18

November 1
Cash ...........................................................................................
Loss on sale of investments ($28 30) .........................................
Investment in Kansas Abstractors bonds ...............................

28
2

December 1
Investment in Household Plastics bonds.....................................
Cash .......................................................................................

60

December 20
Investment in U.S. Treasury bonds ............................................
Cash .......................................................................................
December 21
Investment in NXS common shares ...........................................
Cash .......................................................................................
December 23
Cash ...........................................................................................
Investment in U.S. Treasury bonds ........................................
Gain on sale of investments ($5.7 5.6) ...................................

18

30

60

5.6
5.6

44
44
5.7
5.6
.1

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Problem 12-5 (continued)


($ in millions)

December 29
Cash ...........................................................................................
Investment revenue ..............................................................

December 31
Accrued interest:
Investment revenue receivable - Holistic
Entertainment ($18 million x 10% x 2/12)......................................
Investment revenue receivable - Household
Plastics ($60 million x 12% x 1/12)................................................
Investment revenue .............................................................

0.3

Revaluations:
Net unrealized holding loss on
investments ([2 million shares x $27.50] - $58 million) ....................
Fair value adjustment ..........................................................
Investment in NXS common shares ...........................................
Unrealized holding gain on
investments ([4 million shares x $11.50] - $44 million)..............

0.6
0.9

3
3
2
2

Note: Securities held-to-maturity are not adjusted to fair value.

Closing entry:
Unrealized holding gain on investments (NXS) ...........................
Investment revenue ($3.0 + 1.5 + .9)..............................................
Gain on sale of investments (U.S. Treasury bonds) .........................
Loss on sale of investments (Kansas Abstractors) ....................
Income summary (to balance) .................................................

2.0
5.4
.1
2.0
5.5

Note: Unlike for securities available-for-sale, unrealized holding gains and losses are
included in income for trading securities.

2007
January 7
Cash ...........................................................................................
Loss on sale of investments (to balance) .......................................
Investment in NXS common shares (after adjusting entry) ..........

43
3
46

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Problem 12-6
Requirement 1
Beale should report its securities available-for-sale in its December 31, 2007,
balance sheet at their fair value, $54 million.
Requirement 2
The journal entry needed to enable the investment to be reported at fair value is:
Fair value adjustment ($4 debit to $5 debit)
Net unrealized holding gains and losses ($4 credit to $5 credit)

($ in millions)

Requirement 3
The reclassification adjustment to 2007 other comprehensive income is $2 million.
Beales statement of comprehensive income can be provided as (a) an extension of
its income statement, (b) as part of its statement of shareholders equity, or (c) in a
disclosure note in a manner similar to this:
OTHER COMPREHENSIVE INCOME
($ in millions)

Unrealized holding gains (losses) on investments


$3
Reclassification adjustment of prior years unrealized
gain included in 2007 net income
(2)
Net unrealized holding gains (losses)
$1
Comprehensive income includes both net income and other comprehensive
income. Net income in 2007 includes the $3 million gain realized from selling the
Schwab shares. However, $2 million of that gain already has been reported in
comprehensive income as an unrealized holding gain in a prior year or years when
the shares value increased from $25 million to $27 million. To avoid doublecounting, Beale must compensate by reducing comprehensive income by the $2
million portion of the 2007 realized gain that already has been reported. Thats what
the reclassification adjustment does; it reduces this years comprehensive income by
the amount that was reported previously to keep it from being reported twice.

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Problem 12-7
Requirement 1
Purchase
Investment in Lavery Labeling shares ........................................
Cash ......................................................................................

($ in millions)

324
324

Net income
Investment in Lavery Labeling shares (30% x $160 million) .........
Investment revenue ................................................................

48

Dividends
Cash (10 million shares x $2) ..........................................................
Investment in Lavery Labeling shares ....................................

20

Depreciation adjustment
Investment revenue ([$80 million x 30%] 6 years) .....................
Investment in Lavery Labeling shares ....................................

48

20

Calculations:
Investee
Net Assets

Net Assets
Purchased

Cost
Fair value:
Book value:

Difference
Attributed to:

$324

Goodwill:

$60

Undervaluation
of depr. assets:

$24

$880* x 30% = $264


$800 x 30% = $240

*[$800 + 80] = $880


Adjusting entry
No entry

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Problem 12-7 (concluded)


Requirement 2
Purchase
Investment in Lavery Labeling shares ........................................
Cash ......................................................................................

($ in millions)

324
324

Net income
No entry
Dividends
Cash (10 million shares x $2) ..........................................................
Investment revenue ................................................................

20
20

Adjusting entry
Net unrealized holding loss on investments
([10 million shares x $31] $324 million) ..............................................

Fair value adjustment .............................................................

14
14

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Problem 12-8
Requirement 1
Purchase
Investment in Vancouver T&M shares .......................................
Cash ......................................................................................

($ in millions)

400.0
400.0

Net income
Investment in Vancouver T&M shares (40% x $140 million) ........
Investment revenue ................................................................

56.0

Dividends
Cash (40% x $30 million) ...............................................................
Investment in Vancouver T&M shares ...................................

12.0

Inventory adjustment
Investment revenue ($5 million x 40%: all sold in 2006) ...................
Investment in Vancouver T&M shares ...................................

2.0

Depreciation adjustment
Investment revenue ([$20 million x 40%] 16 years) ....................
Investment in Vancouver T&M shares ...................................

.5

56.0

12.0

2.0

.5

Calculations:
Investee
Net Assets

Net Assets
Purchased

Cost
Fair value:
inventory
plant facilities
Book value:

Difference
Attributed to:

$400
$800* x 40% = $320
(5) x 40%
(20) x 40%
$775

Goodwill:

Undervaluation
of inventory:
Undervaluation
of plant:

$80 [plug]

$2
$8

x 40% = $310

* $775 +5 +20

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Problem 12-8 (concluded)


Requirement 2
Investment Revenue

($ in millions)

56.0 Share of income


Inventory
Depreciation
Balance

2.0
.5
_________________
53.5

Requirement 3
Investment in Vancouver T&M shares
($ in millions)

Cost
400.0
Share of income 56.0

Balance

12.0 Dividends
2.0 Inventory
.5 Depreciation
_________________
441.5

Requirement 4
$400 million cash outflow from investing activities
$12 million cash inflow (dividends) among operating activities

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Problem 12-9
Requirement 1
Millers management should decide whether it has the ability to exercise significant
influence over operating and financial policies of the Marlon Company. Ability to
exercise significant influence is presumed for investments of 20 percent or more of
voting stock and presumed not to exist for investments of less than 20 percent, other
things being equal. Evidence to the contrary should be considered, including
participation on the board of directors, technological dependency, material
intercompany transactions, or interchange of managerial personnel.
Requirement 2
a. Income statement:
Investment revenue ($12 million x 1/6)

($ in millions)

$2.0

Patent amortization adjustment ($4 million* 10)

(.4)

*([$24 million] x 1/6])

$1.6
b. Balance sheet:
Investment in Marlon Company
($19 million + 2 million - 1 million - .4 million)

$19.6*

*Investment in Marlon Company

($ in millions)

Cost
Share of income

Balance

19.0
2.0

1.0 Dividends ($6 million x 1/6)


.4 Amortization adjustment
_________________
19.6

c. Statement of cash flows:


$19 million cash outflow from investing activities
$1 million cash inflow (dividends) among operating activities
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Problem 12-10
Item
__A_ 1. 35% of the nonvoting preferred stock
of American Aircraft Company
__M_ 2. Treasury bills to be held-to-maturity
__M_ 3. Two-year note receivable from affiliate
__N_ 4. Accounts receivable
__M_ 5. Treasury bond maturing in one week

Reporting Category
T.
M.
A.
E.
C.
N.

Trading securities
Securities held-to-maturity
Securities available-for-sale
Equity method
Consolidation
None of these

__T_ 6. Common stock held in trading account


for immediate resale.
__T_ 7. Bonds acquired to profit from short-term differences in price.
__E_ 8. 35% of the voting common stock of Computer Storage Devices Company.
__C_ 9. 90% of the voting common stock of Affiliated Peripherals, Inc.
__A_10. Corporate bonds of Primary Smelting Company to be sold if interest rates
fall 1/2%.
__A_11. 25% of the voting common stock of Smith Foundries Corporation: 51%
family-owned by Smith family; fair value determinable.
__E_ 12. 17% of the voting common stock of Shipping Barrels Corporation:
Investors CEO on the board of directors of Shipping Barrels Corporation.

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Problem 12-11
Requirement 1
($ in millions)

Land ...........................................................................................
Loss on debt restructuring ..........................................................
Note receivable ......................................................................
Accrued interest receivable ....................................................

16
6
20
2

Requirement 2
ANALYSIS

Previous Value:
Accrued interest (10% x $20,000,000)
Principal
Carrying amount of the receivable
New Value:
Interest
$1 million x 3.16987 *
Principal $15 million x 0.68301 **
Present value of the receivable
Loss:

$ 2,000,000
20,000,000
$22,000,000
=
=

$ 3,169,870
10,245,150
(13,415,020)
$ 8,584,980

* present value of an ordinary annuity of $1: n=4, i=10%


** present value of $1: n=4, i=10%
JOURNAL ENTRIES

January 1, 2006
Loss on troubled debt restructuring (to balance) ................
Accrued interest receivable (10% x $20,000,000) ............
Note receivable ($20,000,000 - $13,415,020) ...................
December 31, 2006
Cash (required by new agreement).........................................
Note receivable (to balance)...............................................
Interest revenue (10% x $13,415,020) ..............................

8,584,980
2,000,000
6,584,980
1,000,000
341,502
1,341,502

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December 31, 2007


Cash (required by new agreement).........................................
Note receivable (to balance)...............................................
Interest revenue (10% x $13,756,522) ..............................

1,000,000
375,652
1,375,652

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Problem 12-11 (continued)


December 31, 2008
Cash (required by new agreement).........................................
Note receivable (to balance)...............................................
Interest revenue (10% x $14,132,174) ..............................

1,000,000
413,217

December 31, 2009


Cash (required by new agreement).........................................
Note receivable (to balance)...............................................
Interest revenue (10% x $14,545,391) ..............................

1,000,000
454,609

1,413,217

1,454,609*

Cash (required by new agreement)......................................... 15,000,000


Note receivable (balance) ..............................................
15,000,000
* rounded to amortize the note to $15,000,000 (per schedule below)

Amortization Schedule Not required


Cash
Interest
by agreement

1
2
3
4

1,000,000
1,000,000
1,000,000
1,000,000
4,000,000

Effective
Interest
10% x Outstanding Balance
.10(13,415,020) = 1,341,502
.10(13,756,522) = 1,375,652
.10(14,132,174) = 1,413,217
.10(14,545,391) = 1,454,609*

5,584,980

Increase in
Balance
Discount Reduction

341,502
375,652
413,217
454,609
1,584,980

Outstanding
Balance

13,415,020
13,756,522
14,132,174
14,545,391
15,000,000

* rounded

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Problem 12-11 (continued)


Requirement 3
ANALYSIS

Previous Value:
Accrued interest (10% x $20,000,000)
Principal
Carrying amount of the receivable
New Value:
$27,775,000 x 0.68301 * =
Loss:

$ 2,000,000
20,000,000
$22,000,000
(18,970,603)
$ 3,029,397

* present value of $1: n=4, i=10%


JOURNAL ENTRIES

January 1, 2006
..
Loss on troubled debt restructuring (to balance) ...................
Accrued interest receivable (10% x $20,000,000) ............
Note receivable ($20,000,000 - 18,970,603) ......................

3,029,397
2,000,000
1,029,397

December 31, 2006


..
Note receivable (to balance)...............................................
Interest revenue (10% x $18,970,603) ..............................

1,897,060

December 31, 2007


..
Note receivable (to balance)...............................................
Interest revenue (10% x [$18,970,603 + 1,897,060])...........

2,086,766

December 31, 2008


..
Note receivable (to balance)...............................................
Interest revenue (10% x balance [see schedule]) ................

2,295,443

December 31, 2009


..
Note receivable (to balance)...............................................
Interest revenue (10% x balance [see schedule]) ................

2,525,128

1,897,060

2,086,766

2,295,443

2,525,128*

Cash (required by new agreement)......................................... 27,775,000


Note receivable (balance) ..............................................
27,775,000
* rounded to amortize the note to $27,775,000 (per schedule below)
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Problem 12-11 (concluded)


Amortization Schedule Not required
Cash
Interest
by agreement

1
2
3
4

0
0
0
0

Effective
Increase in
Interest
Balance
10% x Outstanding Balance Discount Reduction
.10 (18,970,603)
.10 (20,867,663)
.10 (22,954,429)
.10 (25,249,872)

= 1,897,060
= 2,086,766
= 2,295,443
= 2,525,128*
8,804,397

1,897,060
2,086,766
2,295,443
2,525,128
8,804,397

Outstanding
Balance

18,970,603
20,867,663
22,954,429
25,249,872
27,775,000

* rounded

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CASES
Real World Case 12-1
Requirement 1
December 31, 2004
($ in millions)
Securities available-for-sale
$90
Fair value adjustment ($42 + 25)
67
Investment (fair value)
$157
Requirement 2
($ in millions)
Securities Available-for-Sale
EarthLink shares

Cost
$90

Unrealized
Fair Value Gain (Loss)
$157

$ 67

Moving from a positive $61** (2003) to a positive $67 requires an increase of $6:

--------------------------------------------------------0
+ 61
+67*
+ 6 --------->
* $42 + 25 (tax)
** at year-end 2003, the gross (pre-tax) accumulated unrealized holding gains
were $38 + 23 = $61 million.
December 31, 2004
Fair value adjustment ($61 debit to $67 debit) ...................
Net unrealized holding gains and losses ($61 credit to $67 credit)

($ in millions)

6
6

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Case 12-1 (concluded)


Requirement 3
No, this does not imply that the securities involved had not previously been written up
above the original cost. Holding gains and losses from securities available-for-sale
are included in earnings when they are realized by selling the securities. When Sprint
sold the EarthLink securities, the fair value of the shares had apparently been written
up in previous years (securities primarily made up of EarthLink common stock had
produced unrealized holding gains). Those gains werent recognized in prior earnings
because they werent yet realized by selling the investment. Now, the gain is
recognized in 2004 when it is actually realized:
Cash (to balance) ...............................................................
Gain on sale of investments (given) ..............................
Investment in securities (determined below) ....................

($ in millions)

8.59

1.50
7.09

Calculation of cost:
$134.0 million
18.9 million
$7.09
1.0 million
$7.09 million

Cost at 2003 year-end


Shares at 2003 year-end
Average cost per share
Shares sold
Cost of shares sold

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Research Case 12-2


[Note:

This case encourages the student to reference actual annual reports.]

The footnote that describes an investment in securities available-for-sale may be


headed by any one of a variety of captions or subsumed within another disclosure
note. Likewise, the caption by which the investments are reported in the balance sheet
can be reported separately as one of several asset titles or included within another
asset caption.
They will be reported as current or noncurrent assets depending on the intent of
management regarding the timing of their eventual sale. Realized gains or losses are
reported in the income statement if any of these securities were sold during any year
reported.
Investments in securities available-for-sale are reported at fair value. Unrealized
holding gains and losses from retaining securities during periods of price change are
not included in the determination of income for the period. Rather, they are
accumulated and reported as accumulated other comprehensive income, a separate
component of shareholders equity. This means an unrealized holding gain would
increase shareholders equity and an unrealized holding loss would decrease
shareholders equity.
Because unrealized gains or losses cause changes in
shareholders equity, those changes are reported in the statement of shareholders
equity. [Some companies may not provide a statement of shareholders equity and
may provide a statement of retained earnings instead. Unrealized gains or losses have
no effect on retained earnings.] By definition, securities available-for-sale are not
acquired for the purpose of profiting from short-term market price changes, so gains
and losses from holding these securities while prices change are not considered
relevant performance measures to be included in earnings.
Cash outflows from acquiring these investments or inflows from selling them are
reported as investing activities in the companys comparative statements of cash
flows. Whether they are specifically identifiable depends on the degree of detail the
company uses in reporting its cash flows. Information on investing activities assists
investors and creditors by indicating the direction the company is directing its funds.
A disclosure note may provide information not available in the financial statements,
in part dependent on how much information the financial statements provide. Often
the footnote will indicate the cost of the securities.

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Integrating Case 12-3


SFAS 115, Accounting For Certain Investments in Debt and Equity Securities,
follows a mixed approach to transition to the new standard. It calls for either a
current approach or a prospective approach. Certain investments that previously were
reported at lower of cost or market were required by the new Standard to be reported
instead at their fair values. Fair values were not to be reported retrospectively, but
only from the effective date of the Standard forward. However, the cumulative
income effect of holding gains and losses created in years before the change are
reported by either a current approach or a prospective approach. For securities
classified as available-for-sale, unrealized holding gains and losses are reported as
part of Accumulated other comprehensive income within shareholders equity as of
the beginning of the year of adoption. Unrealized holding gains and losses for
securities classified as trading securities were reported in earnings of the year of
adoption as the cumulative effect of a change in accounting principle. Pro forma
effects are not reported.

Trueblood Accounting Case 12-4


A solution and extensive discussion materials accompany each case in the
Deloitte & Touche Trueblood Case Study Series. These are available to instructors at:
www.deloitte.com/more/DTF/cases_subj.htm.

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International Case 12-5


As stated in Renaults disclosure note, France, like the United States, uses the
equity method. However, unlike in the U.S., changes in the net assets of equity
method investees are not reported in net income. Instead, investment revenue consists
of dividends received.
Another difference relates to non-equity investments. These are valued at the
lower of cost or fair market value. In the U.S., they are classified as trading,
available-for-sale, or held-to-maturity. Trading and available-for-sale securities are
reported at fair value; held-to-maturity at amortized cost.

Research Case 12-6


Answers to the questions will, of course, vary because students will research
financial statements of different companies.
The responses should identify securities held that are classified as trading
securities, available-for-sale, or held-to-maturity. Although a company is not
required to report individual amounts for the three categories of investments heldto-maturity, available-for-sale, or trading on the face of the balance sheet, that
information should be presented in the disclosure notes. If securities available-forsale are held, there may be unrealized gains or losses reported in the shareholders
equity section of the balance sheet. Investments in securities available-for-sale are
reported at fair value, and holding gains or losses are not included in the
determination of income for the period. Instead, they are reported as a separate
component of shareholders equity.
Unlike for securities available-for-sale, unrealized holding gains and losses are
included in income for trading securities. There may also be gains or losses from the
sale of investments during the year. There also will likely be investment revenue
(dividends or interest) in the income statement.
The statement of cash flows will report acquisitions or disposals of investments as
investing activities. Investment revenue is an operating activity.

The McGraw-Hill Companies, Inc., 2007


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Real World Case 12-7


Requirement 1
The 2004 balance sheet reports the following two current and one
noncurrent asset categories ($ in millions):
2004

2003

CURRENT ASSETS:
Cash and cash equivalents

$2,878.8

$1,201.0

Short-term investments

$4,211.1

$2,972.0

$ 6,727.1

$7,941.2

NONCURRENT ASSETS:
Investments

In the summary of significant accounting policies (Note 2), Merck


describes its policy regarding investments classified as "cash
equivalents." It is consistent with the way most companies classify "cash
equivalents."
CASH AND CASH EQUIVALENTS -- Cash equivalents are comprised of
certain highly liquid investments with original maturities of less than three
months.

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Case 12-7 (continued)


Requirement 2
Merck (in the summary of significant accounting policies) describes its
policy regarding its available-for-sale securities in keeping with SFAS
115:
INVESTMENTS - Investments classified as available-for-sale are reported at
fair value, with unrealized gains or losses, to the extent not hedged, reported
net of tax and minority interests, in Accumulated other comprehensive
income. Investments in debt securities classified as held-to-maturity,
consistent with managements intent, are reported at cost. Impairment
losses are charged to Other (income) expense, net, for other-than-temporary
declines in fair value. The Company considers available evidence in
evaluating potential impairment of its investments, including the duration
and extent to which fair value is less than cost and the Companys ability
and intent to hold the investment.
Investments in securities available-for-sale are reported at fair
value. Unrealized holding gains and losses from retaining
securities during periods of price change are not included in the
determination of income for the period. Rather, they are
accumulated and reported as a separate component of
shareholders equity. This means an unrealized holding gain would
increase shareholders equity and an unrealized holding loss would
decrease shareholders equity. Because unrealized gains or losses
cause changes in shareholders equity, those changes are reported
in the statement of shareholders equity.
In the balance sheet, unrealized gains or losses may be reported
under that title, as "other" shareholders equity, or some different
caption.
Gross unrealized holding gains and losses of Merck are reflected as
adjustments to "accumulated other comprehensive income," net of
related income taxes. Realized gains or losses are reported in the
income statement if any of these securities were sold during any
year reported.

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Case 12-7 (continued)


Requirement 3
Investments accounted for using the equity method are described in the
note:
9. Joint Ventures and Other Equity Method Affiliates (in part)
In 2000, the Company and Schering-Plough Corporation (Schering-Plough)
entered into agreements to create separate equally-owned partnerships to develop
and market in the United States new prescription medicines in the cholesterolmanagement and respiratory therapeutic areas. The results from the
Companys interest in the Merck/ Schering-Plough partnership are recorded in
Equity income from affiliates and were income of $132.0 million in 2004 and
losses of $92.5 million and $147.4 million in 2003 and 2002, respectively.
In addition, Merck earns certain Partnership returns, which are recorded in
Equity income from affiliates. Such returns include a priority return provided for
in the Partnership Agreement, variable returns based, in part, upon sales of
certain former Astra USA, Inc. products, and a preferential return representing
Mercks share of undistributed AZLP GAAP earnings. These returns aggregated
$646.5 million, $391.5 million and $640.2 million in 2004, 2003 and 2002,
respectively. The decrease in 2003 is attributable to a reduction in the
preferential return, primarily resulting from the impact of generic competition for
Prilosec.
Investments in affiliates accounted for using the equity method, including
the above joint ventures, totaled $2.5 billion at December 31, 2004 and $2.2
billion at December 2003. These amounts are reported in Other assets. Dividends
and distributions received from these affiliates were $587.0 million in 2004,
$553.4 million in 2003 and $488.6 million in 2002.

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Intermediate Accounting, 4e

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Case 12-7 (concluded)


Requirement 4
Merck reported losses from these investments in 2004, 2003, and 2002
($ in millions):
Equity income from affiliates

(1,008.2 )

(474.2 )

(644.7 )

Unrealized holding gains and losses from available-for-sale


securities are not reported in the income statement.
Requirement 5
Cash outflows from acquiring these investments or inflows
from selling them are reported as investing activities in the
companys comparative statements of cash flows. Whether
they are specifically identifiable depends on the degree of
dissagregation the company uses in reporting its cash flows.
Information on investing activities assists investors and
creditors by indicating the direction the company is directing
its funds.

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Real World Case 12-8


Requirement 1
The note indicates Unrealized holding losses during 2004 in the amount of $1,846
million. This is not the amount Microsoft would include as a separate component of
shareholders equity. Actually, the balance sheet amount is the Accumulated net
unrealized holding gains. That is, over time, there have been, presumably, both
unrealized gains and losses. This is the net, accumulated amount. The 2004 amount
in the disclosure note is the 2004 addition to the accumulated amount.
Requirement 2
Reclassification adjustment for losses included in net income refers to unrealized
holding losses that occurred in periods prior to the period in which the securities are
sold. Holding gains and losses from securities available-for-sale are included in
earnings when they are realized by selling the securities. When Microsoft sold
securities in 2004, the entire decrease in the fair value of the shares since the
investment was acquired was included in earnings. The portion of that decline that
occurred prior to 2004, but wasnt recognized in prior earnings because it wasnt yet
realized by selling the investment, is what Microsoft refers to as its reclassification
adjustment.
Net income in 2004 includes the $973 million realized losses. However, $973 million
of that amount already has been reported in comprehensive income as unrealized
holding losses in periods when the price decline occurred. To avoid double-counting,
Microsoft compensates by increasing comprehensive income by the $973 million of
2004 realized losses that already have been reported. Thats what the reclassification
adjustment does; it adjusts this years comprehensive income by the amount that was
reported previously to keep it from being reported twice.
Requirement 3
In addition to net income, comprehensive income includes up to four other changes
in equity: Net unrealized holding gains (losses) on investments, Net unrecognized loss
on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign
currency translation.
Three of these Net gains (losses) on derivative instruments, Net unrealized holding
gains (losses) on investments, and Gains (losses) from foreign currency translation
are specifically mentioned in Microsofts disclosure note, so other refers to Net
unrecognized loss on pensions.

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Intermediate Accounting, 4e