CH 17

Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
17-1
CHAPTER 17
Investments
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the accounting for 3. Explain the equity method of
debt investments. accounting.
2. Explain the accounting for 4. Evaluate other major issues
equity investments. related to debt and equity
investments.
17-2
PREVIEW OF CHAPTER 17
Intermediate Accounting
IFRS 3rd Edition
Kieso ● Weygandt ● Warfield
17-3
LEARNING OBJECTIVE 1
Debt Investments Describe the accounting for
debt investments.
Two Types of Financial Assets

 Debt investments.
 Equity investments.
Motivations for investing:

 Earn a high rate of return.
 To secure certain operating or financing

arrangements with another company (equity
securities).
17-4 LO 1
Debt Investments
Classification and Measurement of Financial

Assets
Two criteria:
1. What is the company’s business model for managing its
financial assets?
2. What are the contractual cash flow characteristics of the

financial investment?
17-5 LO 1
Classification and Measurement of Financial
Assets
Summary of the classification and measurement of debt and

equity investments.
ILLUSTRATION 17.1
Classification and Measurement
17-6 LO 1
A Closer Look at Debt Investments
Debt investments are characterized by contractual payments

on specified dates of
 principal and
 interest on the principal amount outstanding.
Companies group debt investments into three categories:

1. Held-for-collection
2. Held-for-collection and selling
3. Trading
17-7 LO 1
A Closer Look at Debt Investments
Companies group debt investments into three categories:

1. Held-for-collection
2. Held-for-collection and selling
3. Trading ILLUSTRATION 17.2
Accounting for Debt Investments
by Category
17-8 LO 1
Debt Investment at Amortized Cost
Illustration: Robinson SA purchased €100,000 of 8 percent

bonds of Evermaster AG on January 1, 2019, at a discount,
paying €92,278. The bonds mature January 1, 2024 and yield
10 percent; interest is payable each July 1 and January 1.
Robinson records the investment as follows:
January 1, 2019
Debt Investments 92,278

Cash 92,278
17-9 LO 1
ILLUSTRATION 17.2
17-10 LO 1
ILLUSTRATION 17.2
Robinson records the receipt of the first semiannual interest

payment on July 1, 2019, as follows:
Cash 4,000
Debt Investments 614
Interest Revenue 4,614
17-11 LO 1
ILLUSTRATION 17.2
Robinson is on a calendar-year basis, it accrues interest and

amortizes the discount at December 31, 2019, as follows:
Interest Receivable 4,000

17-12 LO 1
Reporting of Bond Investment at Amortized Cost
ILLUSTRATION 17.3
17-13 LO 1
ILLUSTRATION 17.2
Assume that Robinson sells its investment on November 1,

2021, at 99¾ plus accrued interest. Robinson records this
discount amortization as follows:

Interest Revenue 522
(€783 x 4/6 = €522)
17-14 LO 1
Computation Gain on Sale of Bonds

ILLUSTRATION 17.4
Cash (€99,750 + €2,667) 102,417

Interest Revenue (4/6 x €4,000) 2,667
Gain on Sale of Investments 3,557
17-15 LO 1
Debt Investments—Held-for-Collection and
Selling (HFCS)
Debt investments held-for-collection and selling follow the

same accounting entries as debt investments held-for-
collection during the reporting period. That is, they are
recorded at amortized cost.
However, at each reporting date, companies

 Adjust the amortized cost to fair value.
 Any unrealized holding gain or loss is reported as part

of other comprehensive income rather than in the
profit and loss statement.
17-16 LO 1
Held-for-Collection and Selling (HFCS)
Illustration: Graff plc purchases £100,000, 10 percent, five-

year bonds on January 1, 2019, with interest payable on July 1
and January 1. The bonds sell for £108,111, which results in a
bond premium of £8,111 and an effective-interest rate of 8
percent. Graff records the purchase of the bonds as follows.
January 1, 2019
Cash 108,111
17-17 LO 1
ILLUSTRATION 17.6
Schedule of Interest
Revenue and Bond
Premium Amortization—
17-18 Effective-Interest Method
ILLUSTRATION 17.6
Illustration (Single Security): The entry to record interest revenue

on July 1, 2019, is as follows.
Cash 5,000
17-19 LO 1
Interest
Revenue for
2019 = $8,621
ILLUSTRATION 17.6
Illustration (Single Security): At December 31, 2019, Graff makes

the following entry to recognize interest revenue.
Interest Receivable 5,000

17-20 LO 1
ILLUSTRATION 17.6
Illustration (Single Security): To apply the fair value method to

these debt investments, assume that at December 31, 2019 the fair
value of the bonds is £105,000. Graff makes the following entry.
Unrealized Holding Gain or Loss—Equity 1,732

Fair Value Adjustment 1,732
17-21 LO 1
Illustration (Portfolio of Securities): Webb AG has two debt

securities classified as held-for-collection and selling. The following
illustration identifies the amortized cost, fair value, and the amount
of the unrealized gain or loss.
ILLUSTRATION 17.7
17-22 Computation of Fair Value Adjustment—HFCS (2019) LO 1
ILLUSTRATION 17.7
Prepare the adjusting entry Webb would make on December 31,

2019 to record the loss.

17-23 LO 1
Sale of HFCS Securities

If company sells bonds before maturity date:
 It must make entries to remove from the Debt Investments
account the amortized cost of bonds sold.
 Any realized gain or loss on sale is reported in the “Other

income and expense” section of the income statement.
17-24 LO 1
Illustration: Webb AG sold the Watson bonds (from Illustration 17.7)

on July 1, 2020, for £90,000, at which time it had an amortized cost
of £94,214.
ILLUSTRATION 17.8
Computation of Loss on Sale of Bonds
Cash 90,000
Loss on Sale of Investments 4,214
17-25 LO 1
Illustration: Webb reports this realized loss in the “Other income

and expense” section of the income statement. Assuming no other
purchases and sales of bonds in 2020, Herringshaw on December
31, 2020, prepares the information:
ILLUSTRATION 17.9
Computation of Fair Value Adjustment—HFCS (2020)
17-26 LO 1
Illustration: Webb records the following at December 31, 2020.

ILLUSTRATION 17.9

17-27 LO 1
ILLUSTRATION 17.10
Financial Statement Presentation Reporting of HFCS
Securities
17-28 LO 1
Debt Investments—Trading
Companies often hold debt investments with the intention

of selling them in a short period of time. These debt
investments are often referred to as trading investments.
Companies report trading securities

 at fair value,
 with unrealized holding gains and losses reported as

part of net income.
A holding gain or loss is the net change in the fair value of

a security from one period to another, exclusive of
dividend or interest revenue recognized but not received.
17-29 LO 1
Illustration: Assume that on December 31, 2019, Western Publishing

determined its trading securities portfolio to be as shown. At the date
of acquisition, Western Publishing recorded these trading securities
at cost in the account entitled Debt Investments. This is the first
valuation of this recently purchased portfolio. ILLUSTRATION 17.10
Computation of Fair Value
Adjustment—Trading Securities
Portfolio (2019)
17-30 LO 1
Illustration: At December 31, Western Publishing makes an adjusting

entry to the Fair Value Adjustment account, to record both the
increase in value and the unrealized holding gain.
ILLUSTRATION 17.10
17-31
Unrealized Holding Gain or Loss—Income 3,750
Fair Value Option
Companies have the option to report most financial assets at

fair value, with all gains and losses related to changes in fair
value reported in the income statement.
 Applied on an instrument-by-instrument basis.
 Generally available only at the time a company first

purchases the financial asset or incurs a financial liability.
 Company must measure this instrument at fair value until

the company no longer has ownership.
17-32 LO 1
Fair Value Option
Illustration: Hardy AG purchases bonds issued by the German

Central Bank. Hardy plans to hold the debt investment until it
matures in five years. At December 31, 2019, the amortized cost
of this investment is €100,000; its fair value at December 31,
2019, is €113,000. If Hardy chooses the fair value option to
account for this investment, it makes the following entry at
December 31, 2019.
Debt Investment (German bonds) 13,000

17-33 LO 1
Fair Value Option
In this situation,
 Hardy uses the Debt Investment account to record the

change in fair value at December 31.
 It does not use the Fair Value Adjustment account.
 The unrealized gain or loss is recorded as part of net

income even though it is managing the investment on a
held-for-collection basis.
 Hardy must continue to use the fair value method to record

this investment until it no longer has ownership of the
security.
17-34 LO 1
Equity Investments Describe the accounting for
equity investments.
Equity investment represents

 ownership interest, such as ordinary, preference, or other
capital shares.
 rights to acquire or dispose of ownership interests at an
agreed-upon or determinable price, such as in warrants
and rights.
Cost includes
 Purchase price of the security.
 Broker’s commissions and fees are recorded as expense.
17-35 LO 2
Equity Investments
The degree to which one corporation (investor) acquires an

interest in the common stock of another corporation (investee)
generally determines the accounting treatment for the
investment subsequent to acquisition.
ILLUSTRATION 17.12
Levels of Influence Determine Accounting Methods
17-36 LO 2
Equity Investments
ILLUSTRATION 17.13
Accounting and Reporting for Equity Investments by Category
17-37 LO 2
Equity Investments
Holdings of Less Than 20%

Under IFRS, the presumption is that equity investments are
held-for-trading.
General accounting and reporting rule:

 Investments valued at fair value.
 Record unrealized gains and losses in net income.
17-38 LO 2
Equity Investments
Holdings of Less Than 20%

IFRS allows companies to classify some equity investments
as non-trading.
General accounting and reporting rule:

 Investments valued at fair value.
 Record unrealized gains and losses in other

comprehensive income.
17-39 LO 2
Equity Investments—Trading (Income)
Illustration: November 3, 2019, Republic SA purchased

ordinary shares of three companies, each investment
representing less than a 20 percent interest. These shares are
held-for-trading.
Republic records these investments as follows:

17-40 LO 2
Equity
Investments —
Trading
Republic records these investments as follows:

Equity Investments 718,550
Cash 718,550
On December 6, 2019, Republic receives a cash dividend of

€4,200 on its investment in the ordinary shares of Nestlé.
Cash 4,200
Dividend Revenue 4,200
17-41 LO 2
At December 31, 2019, Republic’s equity investment portfolio has

the carrying value and fair value shown.
ILLUSTRATION 17.14
Computation of Fair Value Adjustment—
Equity Investment Portfolio (2019)
17-42 LO 2
ILLUSTRATION 17.14
On December 31, 2019, Republic prepares an adjusting entry to

record the decrease in fair value and to record the loss as follows.

17-43 LO 2
On January 23, 2020, Republic sold all of its Burberry ordinary

shares, receiving €287,220. ILLUSTRATION 17.15
Computation of Gain on Sale of Burberry Shares
Cash 287,220
17-44 LO 2
In addition, assume that on February 10, 2020, Republic purchased

€255,000 of Continental Trucking ordinary shares (20,000 shares
€12.75 per share), plus brokerage commissions of €1,850.
Republic’s equity investment portfolio as of December 31, 2020.
ILLUSTRATION 17.16
Computation of Fair
Value Adjustment—
Equity Investment
Portfolio (2020)
17-45
ILLUSTRATION 17.16
Republic records this adjustment on Dec. 31, 2020, as follows.

17-46 LO 2
Equity Investments—Non-Trading (OCI)
The accounting entries to record non-trading equity

investments are the same as for trading equity investments,
except for recording the unrealized holding gain or loss.
Companies report the unrealized holding gain or loss as other

comprehensive income.
17-47 LO 2
Illustration: On December 10, 2019, Republic SA purchased

1,000 ordinary shares of Hawthorne Company for €20.75 per
share (total cost €20,750). The investment represents less than a
20 percent interest. Hawthorne is a distributor for Republic
products in certain locales, the laws of which require a minimum
level of share ownership of a company in that region. The
investment in Hawthorne meets this regulatory requirement.
Republic accounts for this investment at fair value.
Equity Investments (Hawthorne) 20,750

Cash 20,750
17-48 LO 2
On December 27, 2019, Republic receives a cash dividend of

€450 on its investment in the ordinary shares of Hawthorne
Company. It records the cash dividend as follows.
Cash 450
Dividend Revenue 450
17-49 LO 2
At December 31, 2019, Republic’s investment in Hawthorne has

the carrying value and fair value shown. ILLUSTRATION 17.17
Computation of Fair Value Adjustment
Republic records this adjustment as follows.
Equity Investment (Hawthorne) 3,250

The Equity Investment account is used because the non-trading
classification is applied on investment by investment basis, rather than
on a portfolio basis.
17-50 LO 2
ILLUSTRATION 17.21
Financial Statement Presentation of Equity Investments at Fair Value (2019)
17-51 LO 2
On December 20, 2020, Republic sold all of its Hawthorne

Company ordinary shares receiving net proceeds of €22,500.
ILLUSTRATION 17.19
Adjustment to Carrying Value of Investment
Entry to adjust the carrying value of the non-trading investment.

Equity Investment (Hawthorne) 1,500
17-52 LO 2
On December 20, 2020, Republic sold all of its Hawthorne

Company ordinary shares receiving net proceeds of €22,500.
ILLUSTRATION 17.19
Adjustment to Carrying Value of Investment
Entry to the sale of the investment.
Cash 22,500
17-53 LO 2
Equity Investments Explain the equity method of
accounting.
Holdings Between 20% and 50%

An investment (direct or indirect) of 20 percent or more of the
voting shares of an investee should lead to a presumption that
in the absence of evidence to the contrary, an investor has the
ability to exercise significant influence over an investee.
In instances of “significant influence,” the investor must

account for the investment using the equity method.
17-54 LO 3
Holdings Between 20% and 50%
Equity Method
Record the investment at cost and subsequently adjust the
amount each period for changes in investee’s net assets.
 Investor’s proportionate share of the earnings (losses) of the
investee increases (decreases) the investment’s carrying
amount.
 Dividends received from the investee decrease the

investment’s carrying amount.
If investor’s share of investee’s losses exceeds the carrying amount

of the investment, the investor ordinarily should discontinue
applying the equity method and not recognize additional losses.
17-55 LO 3
ILLUSTRATION 17.20
Comparison of Fair Value Method and Equity Method
17-56 LO 3
Equity Investments
Holdings of More Than 50%

Controlling Interest - When one company acquires a voting
interest of more than 50 percent in another company.
 Investor is referred to as the parent.
 Investee is referred to as the subsidiary.
 Investment in the subsidiary is reported on the parent’s

books as a long-term investment.
 Parent generally prepares consolidated financial

statements.
17-57 LO 3
Other Reporting Issues Evaluate other major issues
related to debt and equity
investments.
Impairment of Value
A company should evaluate every debt investment accounted for
at amortized cost, at each reporting date, to determine if it has
suffered impairment—a loss in value such that the fair value of
the investment is below its carrying value.
If the company determines that an investment is impaired, it

writes down the amortized cost basis of the individual security to
reflect this loss in value.
The company accounts for the write-down as a realized loss, and

it includes the amount in net income.
17-58 LO 4
Impairment of Value
Impairment—Investment Measured at Amortized

Cost
Illustration: At December 31, 2018, Mayhew Ltd. has a debt
investment in Bao Group, purchased at par for ¥200,000 (amounts
in thousands). The investment has a term of four years, with
annual interest payments at 10 percent, paid at the end of each
year (the historical effective-interest rate is 10 percent). This debt
investment is classified as held-for-collection.
Using the following information record the loss on impairment.
17-59 LO 4
Investment Measured at Amortized Cost
ILLUSTRATION 17.22
Investment Cash Flows
ILLUSTRATION 17.23
Computation of
Impairment Loss
Loss on Impairment 12,680

Allowance for Impaired Debt Investments 12,680
17-60
Recovery of Impairment Loss
If subsequently the impairment loss decreases, some or all of

the previously recognized impairment loss shall be reversed
with a
 debit to the Allowance for Impaired Debt Investments

account and
 crediting Recovery of Impairment Loss.
Reversal of impairment losses shall not result in a carrying

amount of the investment that exceeds the amortized cost that
would have been reported had the impairment not been
recognized.
17-61 LO 4
Recovery of Impairment Loss
For example, assume that on March 31, 2020, Mayhew

determines that Bao’s credit risk has declined significantly.
Mayhew therefore decides to reverse the impairment by making
the following entry.

Recovery of Loss on Impairment 12,680
17-62 LO 4
Impairment of Value
Impairment—Debt Investments (HFCS)

Companies that have debt investments that are held-for-collection
and selling (HFCS) report the investment at fair value, and any
changes in fair value are reported in other comprehensive
income.
For these investments, companies use a different impairment

model.
17-63 LO 4
Illustration: Assume that Alexander AG purchases a HFCS debt

investment on July 1, 2019, for €1,000,000 (its face value). The
debt investment has an interest rate of 7 percent and a maturity
date of July 1, 2024. At December 31, 2019, the fair value of the
investment has declined to €960,000, due to an increase in
market interest rates. The entries to record this debt investment in
2019 are shown in Illustration 17.24.
17-64 LO 4
ILLUSTRATION 17.24
HFCS Impairment Entries
17-65 LO 4
At December 31, 2019, Alexander AG’s financial statements are

as shown in below.
ILLUSTRATION 17.25
Financial Statement Presentation
17-66 LO 4
What happens if the €40,000 decline is caused by
(1) a change of €10,000 due to market interest rate changes and
(2) an impairment of €30,000 due to credit risk?
In this case, the third entry in Illustration 17.24 changes because

the impairment loss of €30,000 is reported in the income statement,
not in other comprehensive income. The entries to record the
impairment and the change in fair value and related closing entry
are shown in Illustration 17.26.
17-67 LO 4
What happens if the €40,000 decline is caused by
(1) a change of €10,000 due to market interest rate changes and
(2) an impairment of €30,000 due to credit risk?
ILLUSTRATION 17.25
Impairment Entries—Increase in Credit Risk
17-68 LO 4
At December 31, 2019, Alexander’s financial statements are as

shown.
ILLUSTRATION 17.27
Financial Statement
Presentation
17-69 LO 4
If we assume Alexander sells its debt investments on January 1,

2020, for €960,000 (its fair value at that time), the entries are as
follows.
Cash 960,000
Loss on Sale of Debt Investment 10,000
Debt Investments 1,000,000

Accumulated Comprehensive Income 10,000
17-70 LO 4
What happens if Alexander decides to keep its debt investment

and later determines that its credit risk on this investment has
decreased by €15,000? In this case, it makes the following entry.

Recovery of Impairment Loss 15,000
17-71 LO 4
ILLUSTRATION 17.28
Impairment Model Summary
17-72 LO 4
Recycling Adjustments
Reporting Issues
Single-Period Example. To provide an example of the reporting of
investment securities and related gain or loss on held-for-
collection and selling (HFCS) investments, assume that on
January 1, 2019, Hinges plc had cash and share capital—ordinary
of £50,000. At that date, the company had no other asset, liability,
or equity balance. On January 2, Hinges purchased for cash
£50,000 of debt securities classified as HFCS. On June 30,
Hinges sold part of the HFCS security debt portfolio, realizing a
gain as shown in Illustration 17.29.
17-73 LO 4
Reporting Issues
On June 30, Hinges sold part of the HFCS security debt portfolio,
realizing a gain as shown. ILLUSTRATION 17.29
Computation of Realized Gain
Hinges did not purchase or sell any other securities during 2019. It
received £3,000 in interest during the year. At December 31, 2019,
the remaining portfolio is as shown ILLUSTRATION 17.30
Computation of Unrealized Gain
17-74 LO 4
ILLUSTRATION 17.31
ILLUSTRATION 17.32
17-75 LO 4
ILLUSTRATION 17.33
ILLUSTRATION 17.34
17-76 LO 4
Recycling Adjustments
Reporting Issues
Multi-Period Example. When a company sells securities during
the year, double-counting of the realized gains or losses in
comprehensive income can occur.
This double-counting results when a company reports unrealized

gains or losses in other comprehensive income in a prior period
and reports these gains or losses as part of net income in the
current period.
To ensure that gains and losses are not counted twice when a
sale occurs, a reclassification adjustment is necessary.
17-77 LO 4
Reporting Issues Multi-Period Example
To illustrate, assume that Open AG has the two HFCS debt

investments in its portfolio at the end of 2018 (its first year of
operations) shown.
ILLUSTRATION 17.35
HFCS Investment Portfolio (2018)
17-78 LO 4
ILLUSTRATION 17.35
The entry to record the unrealized holding gain in 2018 is as

follows.

17-79 LO 4
If Open reports net income in 2018 of €350,000, it presents a

statement of comprehensive income as shown.
ILLUSTRATION 17.36
Statement of Comprehensive Income (2018)
17-80 LO 4
The entry to transfer the unrealized holding gain—equity to

accumulated other comprehensive income is as follows.
December 31, 2018 (Closing Entry)

Accumulated Other Comprehensive Income 40,000
On August, 10, 2019, Open sells its Lehman Inc. bonds for
€105,000 and realizes a gain on the sale.
Cash 105,000
17-81 LO 4
This illustration shows the computation of the change in the Fair

Value Adjustment account (Woods Co. investment only).
ILLUSTRATION 17.37
HFCS Investment Portfolio (2019)
The entry to record the unrealized holding gain or loss in 2019 is:

17-82 LO 4
Assume that Open reports net income of €720,000 in 2019,

including the realized sale on the Lehman bonds, its statement of
comprehensive income is presented as shown.
ILLUSTRATION 17.38
Statement of Comprehensive Income (2019)
17-83 LO 4
At December 31, 2019, Open reports on its statement of financial

position debt investments of €155,000 (cost €120,000 plus a fair
value adjustment of €35,000) and accumulated other
comprehensive income in equity of €35,000 (€40,000 − €5,000).
The entry to transfer the unrealized holding loss—equity to
accumulated other comprehensive income is as follows.
December 31, 2019 (Closing Entry)

Accumulated Other Comprehensive Income 5,000
17-84 LO 4
This reclassification adjustment may be made in the income

statement, in accumulated other comprehensive income or in a
note to the financial statements. The IASB prefers to show the
reclassification amount in accumulated other comprehensive
income in the notes to the financial statements. For Open AG,
this presentation is as shown.
ILLUSTRATION 17.39
17-85
Transfers Between Categories
Transferring an investment from one classification to another
 should occur only when the business model for managing

the investment changes.
 IASB expects such changes to be rare.
 Companies account for transfers between classifications

prospectively, at the beginning of the accounting period after
the change in the business model.
17-86 LO 4
Illustration: British Sky Broadcasting Group plc (GBR) has a

portfolio of debt investments that are classified as trading; that is,
the debt investments are not held-for-collection but managed to
profit from interest rate changes. As a result, it accounts for these
investments at fair value. At December 31, 2018, British Sky has
the following balances related to these securities.
17-87 LO 4
Illustration: As part of its strategic planning process, completed in

the fourth quarter of 2018, British Sky management decides to
move from its prior strategy—which requires active management—
to a held-for-collection strategy for these debt investments. British
Sky makes the following entry to transfer these securities to the
held-for-collection classification.

17-88 LO 4
APPENDIX 17A Accounting for Derivative Instruments
Describe the uses of and accounting for derivatives.
Defining Derivatives
Financial instruments that derive their value from values of
other assets (e.g., ordinary shares, bonds, or commodities).
Three types of derivatives:
1. Financial forwards or financial futures.
2. Options.
3. Swaps.
17-89 LO 5
Who Uses Derivatives, and Why?

 Producers and Consumers
 Speculators and Arbitrageurs
17-90 LO 5
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.
17-91 LO 5
Derivative Financial Instrument (Speculation)

A call option gives the holder the right, but not the obligation, to buy
shares at a preset price.
Illustration: Assume that the company purchases a call option
contract on January 2, 2019, 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 shares at an option
price of €100 per share. The option expires on April 30, 2019. The
company purchases the call option for €400 and makes the following
entry.
Jan. 2, Call Option 400 Option

2019 Cash 400 Premium
17-92

The option premium consists of two amounts. ILLUSTRATION 17A.1
Option Premium
Formula
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, 2019, the intrinsic value is zero
because the market price equals the preset strike price.
17-93 LO 5

The option premium consists of two amounts. ILLUSTRATION 17A.1
Option Premium
Formula
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.
17-94 LO 5
Additional data available with respect to the call option:
On March 31, 2019, 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
€20,000
option contract of ____________. (€120,000 - €100,000)
17-95 LO 5
On March 31, 2019, it records the increase in the intrinsic value

of the option as follows.
Call Option 20,000

A market appraisal indicates that the time value of the option at

March 31, 2019, 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
17-96 LO 5
At March 31, 2019, the company reports the

 call option in its statement of financial position 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.
17-97 LO 5
On April 16, 2019, 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.

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
17-98 LO 5
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
17-99 LO 5
Summary effects of the call option contract

ILLUSTRATION 17A.2
on net income. Effect on Income Derivative
Financial Instrument
The company records the call option in the statement of financial

position on March 31, 2019. Furthermore, it reports the call option at
fair value, with any gains or losses reported in income.
17-100 LO 5
Differences between Traditional and Derivative

Financial Instruments
A derivative financial instrument has the following three basic
characteristics.
1. Instrument has (1) one or more underlyings and (2) an identified
payment provision.
2. Instrument requires little or no investment at the inception of the

contract.
3. Instrument requires or permits net settlement.
17-101 LO 5
Features of Traditional and Derivative Financial Instruments
ILLUSTRATION 17A.3
17-102 LO 5
Explain the accounting for hedges.
Derivatives Used for Hedging

Hedging: The use of derivatives to offset the negative impacts
of changes in interest rates or foreign currency exchange rates.
IFRS allows special accounting for two types of hedges—

 fair value and
 cash flow hedges.
17-103 LO 6
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.
17-104 LO 6
Illustration: On December 1, 2019, Hayward Tire Fabricators

holds an inventory of 1,000 tractor tires, with a cost of €200 per
tire. Hayward has been building an inventory of tractor tires in
anticipation of demand for these tires in the upcoming
spring planting season. Hayward records the inventory on its
statement of financial position at €200,000 (1,000 × €200), using
lower-of-FIFO-cost-or-net realizable value.
Until Hayward sells the tires, the company is exposed to the risk
that the value of the tire inventory will decline. Hayward wishes to
hedge its exposure to fair value declines for its tire inventory (the
inventory is pledged as collateral for one of its bank loans).
17-105 LO 6
Illustration: To hedge this risk, Hayward locks in the value of its

tire inventory on January 2, 2020, by purchasing a put option to
sell rubber at a fixed price. Hayward designates the option as a
fair value hedge of the tire inventory. This put option (which
expires in nine months) gives Hayward the option to sell 4,000
pounds of rubber at a price of €50 per pound, which is the current
spot price for rubber in the market. Since the exercise price
equals the current market price, no entry is necessary at
inception of the put option.
17-106 LO 6
Illustration: At March 31, 2020, the fair value of the inventory has
declined by 10 percent (€200,000 × 10% = €20,000 ) . Hayward
records the following entry for the tire inventory.

Allowance to Reduce Inventory to Fair Value 20,000
The following journal entry records the increase in value of the

put option to sell rubber, assuming that the spot price for
rubber declined by 10 percent.
Put Option 20,000

17-107 LO 6
ILLUSTRATION 17A.5
ILLUSTRATION 17A.6
17-108 LO 6
Cash Flow Hedge

Used to hedge exposures to cash flow risk, which results from
the variability in cash flows.
Reporting:
 Fair value on the statement of financial position.
 Gains or losses in equity, as part of other comprehensive

income.
17-109 LO 6
Illustration: In September 2019 Allied Can Ltd. anticipates

purchasing 1,000 metric tons of aluminum in January 2020.
Concerned that prices of aluminum will increase, Allied enters
into an aluminum futures contract. The aluminum futures contract
gives Allied the right and the obligation to purchase 1,000 metric
tons of aluminum for ¥1,550 per ton (amounts in thousands). This
contract price is good until the contract expires in January 2020.
The underlying for this derivative is the price of aluminum. Allied
enters into the futures contract on September 1, 2019. 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.
17-110 LO 6
Illustration: At December 31, 2019, 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

([¥1,575 - ¥1,550] x 1,000 tons)
Allied reports the futures contract in the statement of financial position as a

current asset and the gain as part of other comprehensive income.
17-111 LO 6
Illustration: In January 2020, 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
17-112 LO 6
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.
17-113 LO 6
Illustration: Assume that Allied processes the aluminum into

finished goods (cans). The total cost of the cans (including the
aluminum purchases in January 2020) is ¥1,700,000. Allied
sells the cans in July 2020 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
17-114 LO 6
Illustration: Since the effect of the anticipated transaction has

now affected earnings, Allied makes the following entry related
to the hedging transaction.
July 2020
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.
17-115 LO 6
Other Reporting Issues

Identify special reporting issues related to derivative financial instruments that cause
unique accounting problems.
Embedded Derivatives
A convertible bond is a hybrid instrument. Two parts:
1. a debt security, referred to as the host security, and
2. an option to convert the bond to shares of common stock, the
embedded derivative.
Accounted for as a single unit.
17-116 LO 7
Qualifying Hedge Criteria

Criteria that hedging transactions must meet before requiring
the special accounting for hedges.
1. Documentation, risk management, and designation.
2. Effectiveness of the hedging relationship.
3. Effect on reported earnings of changes in fair values or

cash flows.
17-117 LO 7
Summary of Derivative Accounting ILLUSTRATION 17A.8
17-118 LO 7
Comprehensive Hedge Accounting Example

Many companies popular type of derivative called a swap.
A swap is a transaction between two parties in which the
1. first party promises to make a payment to the second party.
2. Similarly, the second party promises to make a simultaneous

payment to the first party.
The most common type of swap is the interest rate swap. In this
type, one party makes payments based on a fixed or floating
rate, and the second party does just the opposite.
17-119 LO 7
Comprehensive Hedge Accounting Example

In most cases, large money-center banks bring together the two
parties. ILLUSTRATION 17A.9
Swap Transaction
17-120 LO 7
Fair Value Hedge

Illustration: Assume that Jones AG issues €1,000,000 of five-year,
8 percent bonds on January 2, 2019. Jones records this transaction
as follows.
Cash 1,000,000
Bonds Payable 1,000,000
To protect against the risk of loss, Jones hedges the risk of a

decline in interest rates by entering into a five-year interest rate
swap contract.
17-121 LO 7
Fair Value Hedge
Jones agrees to the following terms:
1. Jones will receive fixed payments at 8 percent (based on the
€1,000,000 amount).
2. Jones will pay variable rates, based on the market rate in
effect for the life of the swap contract. The variable rate at the
inception of the contract is 6.8 percent. ILLUSTRATION 17A.10
Interest Rate Swap
17-122 LO 7
Fair Value Hedge
Assuming that Jones enters into the swap on January 2, 2019 (the
same date as the issuance of the debt), the swap at this time has no
value. Therefore, no entry is necessary.
At the end of 2019, Jones makes the interest payment on the bonds.
It records this transaction as follows.
Interest Expense 80,000

Cash (8% × €1,000,000) 80,000
17-123 LO 7
Fair Value Hedge
At the end of 2019, market interest rates have declined
substantially. Therefore, the value of the swap contract increases.
Recall (see Illustration 17A.9) that in the swap, Jones receives a
fixed rate of 8 percent, or €80,000 (€1,000,000 × 8%), and pays a
variable rate (6.8%), or €68,000. Jones therefore receives €12,000
(€80,000 − €68,000) as a settlement payment on the swap contract
on the first interest payment date.
Jones records this transaction as follows.
Cash 12,000
Interest Expense 12,000
17-124 LO 7
Fair Value Hedge
In addition, a market appraisal indicates that the value of the interest
rate swap has increased €40,000. Jones records this increase in
value as follows.
Swap Contract 40,000

Because interest rates have declined, the company records a loss

and a related increase in its liability as follows.

Bonds Payable 40,000
17-125 LO 7
ILLUSTRATION 17A.11
ILLUSTRATION 17A.12
17-126 LO 7
APPENDIX 17B Fair Value Disclosures
Describe required fair value disclosures.
Disclosure of Fair Value Information: Financial

Instruments
Both
 cost and
 fair value
of all financial instruments must be reported in the notes to the

financial statements.
17-127 LO 8
Disclosure of Fair Value Information

Three broad levels related to the measurement of fair values.
 Level 1 is the most reliable measurement because fair value is

based on quoted prices in active markets for identical assets or
liabilities.
 Level 2 is less reliable; it is not based on quoted market prices
for identical assets and liabilities but instead may be based on
similar assets or liabilities.
 Level 3 is least reliable; it uses unobservable inputs that reflect
the company’s assumption as to the value of the financial
instrument.
17-128 LO 8

Companies must provide the following (with special emphasis
on Level 3 measurements):
1. Quantitative information about significant unobservable

inputs used for all Level 3 measurements.
2. A qualitative discussion about the sensitivity of recurring

Level 3 measurements to changes in the unobservable inputs
disclosed, including interrelationships between inputs.
3. A description of the company’s valuation process.
17-129 LO 8

Companies must provide the following (with special emphasis
on Level 3 measurements):
4. Any transfers between Levels 1 and 2 of the fair value

hierarchy.
5. Information about non-financial assets measured at fair value

at amounts that differ from the assets’ highest and best use.
6. The proper hierarchy classification for items that are not

recognized on the statement of financial position but are
disclosed in the notes to the financial statements.
17-130 LO 8
GLOBAL ACCOUNTING INSIGHTS
Compare the accounting for investments under IFRS and U.S. GAAP.
Until recently, when the IASB issued IFRS 9, the accounting and reporting for
investments under IFRS and U.S. GAAP were for the most part very similar.
While IFRS 9 introduces new investment classifications relative to U.S. GAAP,
both IFRS and U.S. GAAP have increased situations when investments are
accounted for at fair value, with gains and losses recorded in income.
17-131 LO 9
Relevant Facts
Following are the key similarities and differences between U.S. GAAP and
IFRS related to investments.
Similarities
• U.S. GAAP and IFRS use similar classifications for financial assets: cash,
loans and receivables, investments, and derivatives.
• Both IFRS and U.S. GAAP require that financial assets be sorted into
specific categories for measurement and classification purposes.
• Held-to-maturity (U.S. 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.
17-132 LO 9
Relevant Facts
Similarities
• Amortized cost or fair value is used depending upon the classification of the
financial instrument.
• The definitions of amortized cost and fair value are the same.
• Both U.S. 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.
• U.S. 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.
• Under both U.S. GAAP and IFRS, credit losses are recognized in income.
17-133
Relevant Facts
Differences
• While U.S. GAAP classifies debt investments as trading, available-for-sale,
and held-to-maturity, IFRS classifies debt investments as held-for-
collection, held-for-collection and selling (debt investments), and trading.
• U.S. GAAP requires that all changes in fair value for all equity securities be
reported as part of income. IFRS requires that changes in fair value for non-
trading equity securities be reported as part of other comprehensive
income.
17-134 LO 9
Relevant Facts
Differences
• U.S. GAAP measures impairments based on lifetime expected credit losses.
IFRS uses lifetime expected losses for financial assets that have
experienced a significant increase in credit risk since initial recognition
(otherwise, the credit loss allowance is based on 12-month expected credit
losses).
• U.S. GAAP generally does not permit the reversal of an impairment charge
related to held-to-maturity debt investments and equity investments. IFRS
allows reversals of impairments of held-for-collection investments.
• In the accounting for the fair value option, one difference is that U.S. GAAP
permits the fair value option for all financial assets; IFRS allows the fair
value option if doing so reduces an accounting mismatch.
17-135 LO 9
On the Horizon
At one time, both the FASB and IASB indicated that they believed that all
financial instruments should be reported at fair value and that changes in fair
value should be reported as part of net income. Through recent standards in
this area, the Boards continue to move toward that goal. U.S. GAAP and IFRS
are substantially converged, except for non-trading equity investments and the
measurement of credit losses.
17-136 LO 9
Copyright
Copyright © 2018 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
17-137

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Two Types of Financial Assets

Motivations for investing:

 To secure certain operating or financing

Classification and Measurement of Financial

2. What are the contractual cash flow characteristics of the

Summary of the classification and measurement of debt and

Debt investments are characterized by contractual payments

Companies group debt investments into three categories:

Companies group debt investments into three categories:

Illustration: Robinson SA purchased €100,000 of 8 percent

Debt Investments 92,278

Robinson records the receipt of the first semiannual interest

Robinson is on a calendar-year basis, it accrues interest and

Interest Receivable 4,000

Reporting of Bond Investment at Amortized Cost

Assume that Robinson sells its investment on November 1,

Debt Investments 522

Computation Gain on Sale of Bonds

Cash (€99,750 + €2,667) 102,417

Debt investments held-for-collection and selling follow the

However, at each reporting date, companies

 Any unrealized holding gain or loss is reported as part

Illustration: Graff plc purchases £100,000, 10 percent, five-

Illustration (Single Security): The entry to record interest revenue

Illustration (Single Security): At December 31, 2019, Graff makes

Interest Receivable 5,000

Illustration (Single Security): To apply the fair value method to

Unrealized Holding Gain or Loss—Equity 1,732

Illustration (Portfolio of Securities): Webb AG has two debt

Prepare the adjusting entry Webb would make on December 31,

Unrealized Holding Gain or Loss—Equity 9,537

Sale of HFCS Securities

 Any realized gain or loss on sale is reported in the “Other

Illustration: Webb AG sold the Watson bonds (from Illustration 17.7)

Illustration: Webb reports this realized loss in the “Other income

Illustration: Webb records the following at December 31, 2020.

Fair Value Adjustment 4,537

Companies often hold debt investments with the intention

Companies report trading securities

 with unrealized holding gains and losses reported as

A holding gain or loss is the net change in the fair value of

Illustration: Assume that on December 31, 2019, Western Publishing

Illustration: At December 31, Western Publishing makes an adjusting

Fair Value Adjustment 3,750

Companies have the option to report most financial assets at

 Generally available only at the time a company first

 Company must measure this instrument at fair value until

Illustration: Hardy AG purchases bonds issued by the German

Debt Investment (German bonds) 13,000

 Hardy uses the Debt Investment account to record the

 It does not use the Fair Value Adjustment account.

 The unrealized gain or loss is recorded as part of net

 Hardy must continue to use the fair value method to record

Equity investment represents

The degree to which one corporation (investor) acquires an

Holdings of Less Than 20%

General accounting and reporting rule:

 Record unrealized gains and losses in net income.

Holdings of Less Than 20%

General accounting and reporting rule:

 Record unrealized gains and losses in other

Illustration: November 3, 2019, Republic SA purchased