Intermediate Accounting

17-1

Prepared by Coby Harmon University of California, Santa Barbara

17 Investments

Intermediate Accounting 14th Edition

Kieso, Weygandt, and Warfield
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Learning Objectives
1. 2. 3. 4. 5. 6. Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. Understand the procedures for discount and premium amortization on bond investments. Identify the categories of equity securities and describe the accounting and reporting treatment for each category. Explain the equity method of accounting and compare it to the fair value method for equity securities. Describe the accounting for the fair value option. Discuss the accounting for impairments of debt and equity investments.

7.
8.
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Explain why companies report reclassification adjustments.
Describe the accounting for transfer of investment securities between categories.

Investments Investments in Debt Securities Held-to-maturity securities Available-for-sale securities Trading securities Investments in Equity Securities Holdings of less than 20% Holdings between 20% and 50% Holdings of more than 50% Other Reporting Issues Fair value option Impairment of value Reclassification adjustments Transfers between categories Fair value controversy Summary 17-4 .

To secure certain operating or financing arrangements with another company.Investment Accounting Approaches Different motivations for investing:   To earn a high rate of return. 17-5 .

Illustration 17-1 17-6 .Investment Accounting Approaches Companies account for investments based on   the type of security (debt or equity) and their intent with respect to the investment.

Investments in Debt Securities Debt securities (creditor relationship): Type  Accounting Category    U. government securities Municipal securities Corporate bonds Held-to-maturity Trading Available-for-sale     Convertible debt Commercial paper LO 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.S. 17-7 .

Investments in Debt Securities Accounting for Debt Securities by Category Illustration 17-2 17-8 LO 1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. .

LO 2 Understand the procedures for discount and premium amortization on bond investments. Amortize premium or discount using the effective-interest method unless the straight-line method yields a similar result. 17-9 . Accounted for at amortized cost.Held-to-Maturity Securities Classify a debt security as held-to-maturity only if it has both (1) the positive intent and (2) the ability to hold securities to maturity. not fair value.

278 92.000 of 8 percent bonds of Evermaster Corporation on January 1.278 17-10 LO 2 Understand the procedures for discount and premium amortization on bond investments.Held-to-Maturity Securities Illustration: Robinson Company purchased $100. 2011. . 2016 and yield 10%.278. paying $92. interest is payable each July 1 and January 1. The bonds mature January 1. 2011 Debt investments Cash 92. at a discount. Robinson records the investment as follows: January 1.

Held-to-Maturity Securities Schedule of Interest Revenue and Bond Discount Amortization— Effective-Interest Method Illustration 17-3 17-11 LO 2 .

Held-to-Maturity Securities
Illustration: Robinson Company records the receipt of the

first semiannual interest payment on July 1, 2011, as follows:
July 1, 2011 Cash Debt Investments Interest Revenue 4,000 614 4,614

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LO 2 Understand the procedures for discount and premium amortization on bond investments.

Held-to-Maturity Securities
Illustration: Robinson is on a calendar-year basis, it accrues

interest and amortizes the discount at December 31, 2011, as
follows: December 31, 2011

Interest Receivable
Debt Investments Interest Revenue

4,000
645 4,645

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LO 2 Understand the procedures for discount and premium amortization on bond investments.

Held-to-Maturity Securities
Reporting of Held-to-Maturity Securities
Illustration 17-4

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LO 2 Understand the procedures for discount and premium amortization on bond investments.

. 2015 Debt Investments Interest Revenue 635 635 $952 x 4/6 = $635 17-15 LO 2 Understand the procedures for discount and premium amortization on bond investments. at 99¾ plus accrued interest. Robinson records this discount amortization as follows: November 1. 2015.Held-to-Maturity Securities Illustration: Assume that Robinson Company sells its investment in Evermaster bonds on November 1.

Held-to-Maturity Securities Computation of gain on sale of bonds Illustration 17-5 Cash 102.000) Debt Investments Gain on Sale of Securities 17-16 2.417 Interest Revenue (4/6 x $4.667 99.683 67 LO 2 .

. 17-17 LO 2 Understand the procedures for discount and premium amortization on bond investments. Any discount or premium is amortized. with unrealized holding gains and losses reported as part of comprehensive income (equity).Available-for-Sale Securities Debt Securities Companies report available-for-sale securities at   fair value.

111 17-18 LO 2 Understand the procedures for discount and premium amortization on bond investments. five-year bonds on January 1. Debt Investments Cash 108. with interest payable on July 1 and January 1. The bonds sell for $108.111. . Graff records the purchase of the bonds on January 1.000.111 and an effective interest rate of 8 percent. as follows. which results in a bond premium of $8. 10 percent. 2011.Available-for-Sale Securities Debt Securities Illustration (Single Security): Graff Corporation purchases $100. 2011.111 108.

Available-for-Sale Securities Schedule of Interest Revenue and Bond Premium Amortization— Effective-Interest Method Debt Securities Illustration 17-6 17-19 LO 2 .

Available-for-Sale Securities Debt Securities Illustration (Single Security): The entry to record interest revenue on July 1. Cash Debt Investments 5. 2011. is as follows.324 17-20 LO 2 Understand the procedures for discount and premium amortization on bond investments. .000 676 Interest Revenue 4.

621 ($4.324 + $4. Graff makes the following entry to recognize interest revenue.000 703 Interest Revenue 4.Available-for-Sale Securities Debt Securities Illustration (Single Security): At December 31. Interest Receivable Debt Investments 5. 17-21 LO 2 Understand the procedures for discount and premium amortization on bond investments. . 2011.297).297 Graff reports revenue for 2009 of $8.

Available-for-Sale Securities Debt Securities Illustration (Single Security): To apply the fair value method to these debt securities.732 1.000 and that the carrying amount of the investments is $106. . Unrealized Holding Gain or Loss—Equity Fair Value Adjustment (AFS) 1. assume that at year-end the fair value of the bonds is $105.732.732 17-22 LO 2 Understand the procedures for discount and premium amortization on bond investments. Graff makes the following entry.

fair value.Available-for-Sale Securities Debt Securities Illustration (Portfolio of Securities): Webb Corporation has two debt securities classified as available-for-sale. and the amount of the unrealized gain or loss. . The following illustration identifies the amortized cost. Illustration 17-7 17-23 LO 2 Understand the procedures for discount and premium amortization on bond investments.

Unrealized Holding Gain or Loss—Equity Fair Value Adjustment (AFS) Webb reports the unrealized holding loss of $9.537 as other comprehensive income and a reduction of stockholders’ equity.537 9. 2012 to record the decrease in value and to record the loss as follows.537 17-24 LO 2 Understand the procedures for discount and premium amortization on bond investments. .Available-for-Sale Securities Debt Securities Illustration (Portfolio of Securities): Webb makes an adjusting entry to a valuation allowance on December 31. 9.

► ► Cost in Available-for-Sale Securities and Securities Fair Value Adjustment accounts.  Any realized gain or loss on sale is reported in the ―Other expenses and losses‖ section of the income statement. 17-25 . LO 2 Understand the procedures for discount and premium amortization on bond investments.Available-for-Sale Securities Sale of Available-for-Sale Securities If company sells bonds before maturity date:  Debt Securities Must make entry to remove the.

. 2013. Illustration 17-8 Cash Loss on Sale of Investments Debt Investments 17-26 90.000.000 4.214 94.Available-for-Sale Securities Debt Securities Illustration (Sale of Available-for-Sale Securities): Webb Corporation sold the Watson bonds (from Illustration 17-7) on July 1. at which time it had an amortized cost of $94. for $90.214 LO 2 Understand the procedures for discount and premium amortization on bond investments.214.

2013. . prepares the information: Illustration 17-9 17-27 LO 2 Understand the procedures for discount and premium amortization on bond investments. Assuming no other purchases and sales of bonds in 2013.Available-for-Sale Securities Debt Securities Illustration (Sale of Available-for-Sale Securities): Webb reports this realized loss in the ―Other expenses and losses‖ section of the income statement. Webb on December 31.

Illustration 17-9 Fair Value Adjustment (AFS) Unrealized Holding Gain or Loss—Equity 17-28 4.537 4. 2013.Available-for-Sale Securities Debt Securities Illustration (Sale of Available-for-Sale Securities): Webb records the following at December 31. .537 LO 2 Understand the procedures for discount and premium amortization on bond investments.

.Available-for-Sale Securities Financial Statement Presentation Debt Securities Illustration 17-10 17-29 LO 2 Understand the procedures for discount and premium amortization on bond investments.

Trading Securities Companies report trading securities at   Debt Securities fair value. Any discount or premium is amortized. 17-30 LO 2 Understand the procedures for discount and premium amortization on bond investments. with unrealized holding gains and losses reported as part of net income. .

Trading Securities Debt Securities Illustration: On December 31. 2012. Western Publishing Corporation determined its trading securities portfolio to be as follows: Illustration 17-11 17-31 LO 2 Understand the procedures for discount and premium amortization on bond investments. .

750 3.Trading Securities Debt Securities Illustration: At December 31. Western Publishing makes an adjusting entry: Illustration 17-11 Fair Value Adjustment (Trading) Unrealized Holding Gain or Loss—Income 17-32 3.750 LO 2 Understand the procedures for discount and premium amortization on bond investments. .

000. 17-33 LO 2 Understand the procedures for discount and premium amortization on bond investments. At December 31.000 at par. (c) Prepare the journal entry for the fair value adjustment. and the fair value of the bonds was $47.400. (b) Prepare the journal entry for the interest received. Hendricks received annual interest of $2. Instructions: (a) Prepare the journal entry for the purchase of the investment.Trading Securities Debt Securities BE17-4: (Trading Securities) Hendricks Corporation purchased trading investment bonds for $50. .

600 LO 2 Understand the procedures for discount and premium amortization on bond investments. (a) Debt investments Cash (b) Cash Interest revenue (c) Unrealized Holding Loss .000 2. .600 2.Income Fair Value Adjustment (Trading) 17-34 50.000 2.000 50. (b) the interest received. and (c) the fair value adjustment.Trading Securities Debt Securities BE17-4: Prepare the journal entries for (a) the purchase of the investment.000 2.

17-35 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. . Cost includes:   price of the security.Investments in Equity Securities Represent ownership of capital stock. 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. plus broker’s commissions and fees related to purchase.

50% ---------------.Investments in Equity Securities Ownership Percentages 0 ------------------20% ---------------. .100% No significant influence usually exists Investment valued using Fair Value Method Significant influence usually exists Investment valued using Equity Method Control usually exists Investment valued on parent’s books using Cost Method or Equity Method (investment eliminated in Consolidation) 17-36 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

.Investments in Equity Securities Accounting and Reporting for Equity Securities by Category Illustration 17-13 17-37 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

17-38 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. .Holdings of Less Than 20% Accounting Subsequent to Acquisition Market Price Available Value and report the investment using the fair value method. Market Price Unavailable Value and report the investment using the cost method.* * Securities are reported at cost. Dividends are recognized when received and gains or losses only recognized on sale of securities.

Illustration: On November 3. each investment representing less than a 20 percent interest. companies record available-for-sale securities at cost.Holdings of Less Than 20% Available-for-Sale Securities Upon acquisition. . 2012 Republic Corporation purchased common stock of three companies. 17-39 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

200 4.550 Cash 718. .200 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. Republic receives a cash dividend of $4.550 On December 6. as follows. Equity Investments 718. 2012. Cash Dividend revenue 17-40 4. 2012.200 from Campbell Soup Co.Holdings of Less Than 20% Available-for-Sale Securities Illustration: Republic records these investments on November 3.

.Holdings of Less Than 20% Available-for-Sale Securities Illustration: Republic’s available-for-sale equity security portfolio on December 31. 2012: Illustration 17-14 17-41 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

550 35.Holdings of Less Than 20% Available-for-Sale Securities Illustration: On December 31. . Republic records the net unrealized gains and losses related to changes in the fair value of available-for-sale equity securities in an Unrealized Holding Gain or Loss—Equity account. Unrealized Holding Gain or Loss—Equity Fair Value Adjustment (AFS) 35.550 17-42 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. 2012.

Holdings of Less Than 20% Available-for-Sale Securities Illustration: On January 23. Republic sold all of its Northwest Industries. Inc.520 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.220. . common stock receiving net proceeds of $287. 2013. Illustration 17-15 Cash Equity Investments Gain on Sale of Investments 17-43 287.220 259.700 27.

75 per share plus brokerage commissions of $1.Holdings of Less Than 20% Available-for-Sale Securities Illustration: On February 10.000 shares of Continental Trucking at a price of $12.850). Republic purchased 20. Illustration 17-16 17-44 LO 3 . $256. 2013.850 (total cost.

.Holdings of Less Than 20% Available-for-Sale Securities Illustration 17-16 Illustration: Fair Value Adjustment (AFS) Unrealized Holding Gain or Loss—Equity 17-45 99.800 99.800 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.

and the Oakwood common $193. preferred (3.500 shares) Oakwood Corp.000.000 133. the Horton shares were sold at a price of $54 per share. fair values were: Monty $106.000 shares of Patriot common stock were acquired at $54. 10. 2012. 31. its last reporting date.000.000 shares) Cost $ 215. 3. 17-46 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. In addition. The Dec. 2. common (1. 2012.50 per share on Nov.000 180.000 On Oct.Holdings of Less Than 20% P17-6: McElroy Company has the following portfolio of securities at September 30. .000 179.000 140. Inc.000.000 Fair Value $ 200. Patriot $132. Trading Securities Horton. Inc. 2012.000 shares) Monty. 2012. common (5.

2012 17-47 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category. purchase. Portfolio at September 30. and adjusting entries related to the trading securities in the last quarter of 2012.Holdings of Less Than 20% P17-6: Prepare the journal entries to record the sale. .

000 Equity investments (3. purchase.500 163.000 215. . 2012 (Horton): Cash (5.500 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.000 55.000 x $54) Equity investments Gain on sale of investments November 2. October 10. 2012 (Patriot): 270.000 x $54.50) Cash 17-48 163. and adjusting entries related to the trading securities in the last quarter of 2012.Holdings of Less Than 20% P17-6: Prepare the journal entries to record the sale.

2012 December 31.Holdings of Less Than 20% P17-6: Portfolio at December 31.500 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.500 36.Income Fair value adjustment (Trading) 17-49 36. 2012: Unrealized holding loss . .

17-50 LO 3 Identify the categories of equity securities and describe the accounting and reporting treatment for each category.  The unrealized holding loss would be deducted from the stockholders’ equity section rather than charged to the income statement. .Holdings of Less Than 20% P17-6: How would the entries change if the securities were classified as available-for-sale? The entries would be the same except that the  Unrealized Holding Gain or Loss—Equity account is used instead of Unrealized Holding Gain or Loss—Income.

Holdings Between 20% and 50% An investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary.‖ the investor must account for the investment using the equity method. 17-51 LO 4 Explain the equity method of accounting and compare it to the fair value method for equity securities. an investor has the ability to exercise significant influence over an investee. In instances of ―significant influence. .

17-52 . LO 4 Explain the equity method of accounting and compare it to the fair value method for equity securities. the investor ordinarily should discontinue applying the equity method.Holdings Between 20% and 50% Equity Method Record the investment at cost and subsequently adjust the amount each period for  the investor’s proportionate share of the earnings (losses) and dividends received by the investor.  If investor’s share of investee’s losses exceeds the carrying amount of the investment.

000.000. Instructions: Prepare the entries for Meredith to record the purchase and any additional entries related to this investment in Pirates Company in 2012.000 and paid dividends of $20. 2012. During the year. Pirates earned net income of $80. 17-53 LO 4 Explain the equity method of accounting and compare it to the fair value method for equity securities. Meredith Corporation purchased 25% of the common shares of Pirates Company for $200.Holdings Between 20% and 50% E17-17: (Equity Method) On January 1. .

000 LO 4 Explain the equity method of accounting and compare it to the fair value method for equity securities.Holdings Between 20% and 50% E17-17: Prepare the entries for Meredith to record the purchase and any additional entries related to this investment in Pirates Company in 2012.000 20.000 20.000 Cash Equity Investments 17-54 5.000 x 25%) 5. Equity Investments Cash Equity Investments Investment Revenue ($80.000 ($20.000 x 25%) 200. .000 200.

17-55 LO 4 Explain the equity method of accounting and compare it to the fair value method for equity securities.When one corporation acquires a voting interest of more than 50 percent in another corporation    Investor is referred to as the parent. Investment in the subsidiary is reported on the parent’s books as a long-term investment. .  Parent generally prepares consolidated financial statements.Holdings of More Than 50% Controlling Interest . Investee is referred to as the subsidiary.

Fair Value Option Companies have the option to report most financial instruments at fair value. . with all gains and losses related to changes in fair value reported in the income statement.   Applied on an instrument-by-instrument basis. 17-56 LO 5 Describe the accounting for the fair value option. Fair value option is 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.

is $125. 2012.000. it makes the following entry at December 31. If Hardy chooses the fair value option to account for the Fielder Company stock. 2012.000 Unrealized Holding Gain or Loss—Income 25. 2012.Fair Value Option Available-for-Sale Securities Illustration: Hardy Company purchases stock in Fielder Company during 2012 that it classifies as available-for-sale. its fair value at December 31. Equity Investments 25. the cost of this security is $100.000. At December 31.000 17-57 LO 5 Describe the accounting for the fair value option. .

000 17-58 LO 5 Describe the accounting for the fair value option. . The entry to record this investment is as follows. 2010. Durham elects to report the investment in Suppan using the fair value option. the fair value of the investment is $900. At December 31.000 30. Durham purchased the investment in 2010 for $930.000.000.Fair Value Option Equity Method Illustration: Durham Company holds a 28 percent stake in Suppan Inc. Unrealized Holding Gain or Loss—Income Equity Investments 30.

. 17-59 LO 6 Discuss the accounting for impairments of debt and equity investments.Impairment of Value Impairments of debt and equity securities are  losses in value that are determined to be other than temporary.  based on a fair value test. and  are charged to income.

000 as part of other comprehensive income. The fair value of these securities is $800.000 17-60 LO 6 Discuss the accounting for impairments of debt and equity investments. It records this impairment as follows.Impairment of Value Illustration: Strickler Company holds available-for-sale bond securities with a par value and amortized cost of $1 million. Loss on impairment Debt investments 200. Strickler now determines that it probably will not collect all amounts due. . Strickler has previously reported an unrealized loss on these securities of $200. In evaluating the securities.000 200.000.

. 17-61 LO 7 Explain why companies report reclassification adjustments. In that case. double counting results when the company reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current period or in previous periods.Reclassification Adjustments The reporting of changes in unrealized gains or losses in comprehensive income is straightforward unless a company sells securities during the year. To ensure that gains and losses are not counted twice when a sale occurs. a reclassification adjustment is necessary.

Illustration 17-19 17-62 LO 7 Explain why companies report reclassification adjustments. .Reclassification Adjustments Illustration: Open Company has the following two available-for-sale securities in its portfolio at the end of 2011 (its first year of operations).

Illustration 17-20 17-63 LO 7 Explain why companies report reclassification adjustments. it presents a statement of comprehensive income as follows. .000.Reclassification Adjustments Illustration: If Open Company reports net income in 2011 of $350.

Open Company sold the Lehman Inc.000). common stock for $105.000. Illustration 17-21 17-64 LO 7 Explain why companies report reclassification adjustments. the fair value of the Woods Co.000. .000 and realized a gain on the sale of $25. common stock increased an additional $20.000 ($105.Reclassification Adjustments Illustration: During 2012. to $155. At the end of 2012.000 – $80.

000 on the sale of the Lehman common stock. Illustration 17-22 17-65 LO 7 Explain why companies report reclassification adjustments. . Therefore.000.Reclassification Adjustments Illustration: In addition. Open realized a gain of $25. Comprehensive income includes both realized and unrealized components. Open recognizes a total holding gain (loss) in 2012 of $20. computed as follows.

Reclassification Adjustments Illustration: Open reports net income of $720. . Illustration 17-23 17-66 LO 7 Explain why companies report reclassification adjustments.000 in 2012. which includes the realized gain on sale of the Lehman securities.

17-67 LO 8 Describe the accounting for transfer of investment securities between categories. .Transfers Between Categories Illustration 17-30 * Assumes that adjusting entries to report changes in fair value for the current period are not yet recorded.

17-68 LO 8 .Transfers Between Categories Illustration 17-30 **According to GAAP. these types of transfers should be rare.

Fair Value Controversy  Measurement Based on Intent   Gains Trading Liabilities Not Fairly Valued 17-69 LO 8 Describe the accounting for transfer of investment securities between categories. .

APPENDIX

17A

ACCOUNTING FOR DIRIVATIVE INSTRUMENTS

Defining Derivatives
Financial instruments that derive their value from values of
other assets (e.g., stocks, bonds, or commodities). Three different types of derivatives:

1. Financial forwards or financial futures.
2. Options. 3. Swaps.

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APPENDIX

17A

ACCOUNTING FOR DIRIVATIVE INSTRUMENTS

Who Uses Derivatives, and Why?

Producers and Consumers
Speculators and Arbitrageurs

17-71

LO 9 Explain who uses derivative and why.

APPENDIX

17A

ACCOUNTING FOR DIRIVATIVE INSTRUMENTS

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.
17-72

LO 10 Understand the basic guidelines for accounting for derivatives.

The option expires on April 30. on January 2. 2012. The contract gives it the option to purchase 1. Call Option Cash 17-73 400 400 Option Premium LO 11 Describe the accounting for derivative financial instruments.000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. when Laredo shares are trading at $100 per share. The company purchases the call option for $400 and makes the following entry on January 2. 2012. . 2012.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Example of Derivative Financial Instrument-Speculation Illustration: Assume that a company purchases a call option contract from Baird Investment Co.

On January 2. 2012. . Illustration 17A-1 Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder. if exercising the option immediately. 17-74 LO 11 Describe the accounting for derivative financial instruments. the intrinsic value is zero because the market price equals the preset strike price.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Example of Derivative Financial Instrument-Speculation The option premium consists of two amounts.

How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. the time value for the option is $400. 17-75 LO 11 Describe the accounting for derivative financial instruments. As indicated.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Example of Derivative Financial Instrument-Speculation The option premium consists of two amounts. . Illustration 17A-1 Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero.

the price of Laredo shares increases to $120 per share.000 shares from Baird Investment for $100 per share. 2012.000) 17-76 LO 11 Describe the accounting for derivative financial instruments. ($120. This gives the company a gain $20. .$100.000 on the option contract of ____________. It can then sell the shares in the market for $120 per share.000.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Additional data available with respect to the call option: On March 31. the company can exercise the call option and purchase 1. That is. The intrinsic value of the call option contract is now $20.000 .

Call Option 20. The company records this change in value of the option as follows.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS On March 31.000 20. is $100. Unrealized Holding Gain or Loss—Income Call Option ($400 . it records the increase in the intrinsic value of the option as follows.$100) 17-77 300 300 LO 11 Describe the accounting for derivative financial instruments.000 Unrealized Holding Gain or Loss—Income A market appraisal indicates that the time value of the option at March 31. . 2012. 2012.

. 17-78 LO 11 Describe the accounting for derivative financial instruments. the company reports the    call option in its balance sheet at fair value of $20. 2012. loss on the time value of the option which decreases net income.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS At March 31. unrealized holding gain which increases net income.100.

2012.000 The decrease in the time value of the option of $40 ($100 .000) as follows.000 5. Unrealized Holding Gain or Loss—Income Call Option 17-79 40 40 LO 11 Describe the accounting for derivative financial instruments.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS On April 16. Unrealized Holding Gain or Loss—Income Call option 5. To properly record the settlement. it updates the value of the option for the decrease in the intrinsic value of $5.$60) is recorded as follows.$15]) x 1.000 ([$20 . the company settles the option before it expires. .

the call option’s carrying value is as follows.000 60 15. Settlement of the option contract is recorded as follows.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS At the time of the settlement. .060 LO 11 Describe the accounting for derivative financial instruments. Cash Loss on Settlement of Call Option Call Option 17-80 15.

17-81 LO 11 Describe the accounting for derivative financial instruments. 2012. the company records it in the balance sheet on March 31. It also reports the call option at fair value. . Illustration 17A-2 Because the call option meets the definition of an asset. with any gains or losses reported in income.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Summary effects of the call option contract on net income.

17-82 LO 11 Describe the accounting for derivative financial instruments. The instrument has (1) one or more underlyings and (2) an identified payment provision. 1. The instrument requires or permits net settlement. 3. 2. . The instrument requires little or no investment at the inception of the contract.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Differences between Traditional and Derivative Financial Instruments A derivative financial instrument has the following three basic characteristics.

APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Features of Traditional and Derivative Financial Instruments Illustration 17A-3 17-83 LO 11 Describe the accounting for derivative financial instruments. .

17-84 LO 11 Describe the accounting for derivative financial instruments. .APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Derivatives Used for Hedging Hedging: The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. FASB allows special accounting for two types of hedges—   fair value and cash flow hedges.

Companies commonly use several types of fair value hedges.   Interest rate swaps put options 17-85 LO 12 Explain how to account for a fair value hedge.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Fair Value Hedge A company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment. .

2012. Equity investments Cash 10.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: On April 1. It consequently classifies the Sonoma investment as availablefor-sale. Hayward Co. .000 10.000 17-86 LO 12 Explain how to account for a fair value hedge. Hayward does not intend to actively trade this investment. Hayward records this available-for-sale investment as follows. purchases 100 shares of Sonoma stock at a market price of $100 per share.

500 17-87 LO 12 Explain how to account for a fair value hedge. the value of the Sonoma shares increases to $125 per share during 2010.500 2. . 20120.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: Fortunately for Hayward. Hayward records the gain on this investment as follows. On December 31. Fair Value Adjustment (AFS) Unrealized Holding Gain or Loss—Equity 2.

. Illustration 17A-4 17-88 LO 12 Explain how to account for a fair value hedge.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Hayward reports the Sonoma investment in its balance sheet.

APPENDIX

17A

ACCOUNTING FOR DIRIVATIVE INSTRUMENTS

Hayward is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 shares of Sonoma stock. Illustration: Hayward enters into the put option contract on January 2, 2013, and designates the option as a fair value hedge of the Sonoma investment. This put option (which expires in two years) gives Hayward the option to sell Sonoma

shares at a price of $125. Since the exercise price equals the
current market price, no entry is necessary at inception of the put option.
17-89

LO 12 Explain how to account for a fair value hedge.

APPENDIX

17A

ACCOUNTING FOR DIRIVATIVE INSTRUMENTS

Illustration: At December 31, 2013, the price of the Sonoma

shares has declined to $120 per share. Hayward records the
following entry for the Sonoma investment. Unrealized Holding Gain or Loss—Income 500

Fair Value Adjustment (AFS)

500

17-90

LO 12 Explain how to account for a fair value hedge.

APPENDIX

17A

ACCOUNTING FOR DIRIVATIVE INSTRUMENTS

Illustration: The following journal entry records the increase

in value of the put option on Sonoma shares on December
31, 2013. Put Option 500

Unrealized Holding Gain or Loss—Income

500

17-91

LO 12 Explain how to account for a fair value hedge.

APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Balance Sheet Presentation of Fair Value Hedge Illustration 17A-5 Income Statement Presentation of Fair Value Hedge Illustration 17A-6 17-92 LO 12 Explain how to account for a fair value hedge. .

as part of other comprehensive income. which results from the variability in cash flows. Reporting:   Fair value on the balance sheet Gains or losses in equity.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Cash Flow Hedge Used to hedge exposures to cash flow risk. . 17-93 LO 13 Explain how to account for a cash flow hedge.

Therefore no entry is necessary.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: In September 2012 Allied Can Co. Allied enters into the futures contract on September 1. . 2012. As a result. Allied enters into an aluminum futures contract.000 metric tons of aluminum for $1. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price.550 per ton. 17-94 LO 13 Explain how to account for a cash flow hedge. The underlying for this derivative is the price of aluminum. This contract price is good until the contract expires in January 2013. anticipates purchasing 1. In this case.000 metric tons of aluminum in January 2013. the aluminum futures contract gives Allied the right and the obligation to purchase 1. With the two prices equal. the futures contract has no value.

. the price for January delivery of aluminum increases to $1.550] x 1.000 25.$1. 2012. 17-95 LO 13 Explain how to account for a cash flow hedge.000 Allied reports the futures contract in the balance sheet as a current asset and the gain as part of other comprehensive income.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: At December 31.000 tons) 25.575 .575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract. Futures Contract Unrealized Holding Gain or Loss—Equity ([$1.

575.550.000 tons) 1. .000 At the same time. Cash 25.575 and makes the following entry.000) 17-96 LO 13 Explain how to account for a cash flow hedge.000 .575 x 1.000 metric tons of aluminum for $1. Aluminum Inventory Cash ($1.000 Futures Contract ($1.$1.000 1.575.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: In January 2013.575. Allied purchases 1.000 25. Allied makes final settlement on the futures contract. It records the following entry.

. 17-97 LO 13 Explain how to account for a cash flow hedge.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS 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.

The total cost of the cans (including the aluminum purchases in January 2013) is $1.000 2.700. Cash Sales Revenue 2. and records this sale as follows.000.000.000.700.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: Assume that Allied processes the aluminum into finished goods (cans).000 17-98 LO 13 Explain how to account for a cash flow hedge.700.000.000 Cost of Goods Sold Inventory (Cans) 1.000. .000 1. Allied sells the cans in July 2013 for $2.

17-99 LO 13 Explain how to account for a cash flow hedge.000.550.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Illustration: Since the effect of the anticipated transaction has now affected earnings. Allied makes the following entry related to the hedging transaction.000 25. which Allied reported as part of other comprehensive income.000 The gain on the futures contract. . now reduces cost of goods sold. Unrealized Holding Gain or Loss—Equity Cost of Goods Sold 25. the cost of aluminum included in the overall cost of goods sold is $1. As a result.

. To account for an embedded derivative. a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation. and 2. an option to convert the bond to shares of common stock. LO 14 17-100 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. the embedded derivative. Two parts: 1. a debt security.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Other Reporting Issues Embedded Derivatives Convertible bond is a hybrid instrument. referred to as the host security.

. risk management. Documentation. LO 14 17-101 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. Effect on reported earnings of changes in fair values or cash flows. 1. 3. and designation.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Qualifying Hedge Criteria Criteria that hedging transactions must meet before requiring the special accounting for hedges. Effectiveness of the hedging relationship. 2.

.APPENDIX 17A ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Summary of Derivative Accounting under GAAP Illustration 17A-8 LO 14 17-102 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems.

17-103 LO 15 Describe the accounting for the variable-interest entitles. then consolidate in most cases. Voting-interest model—If a company owns more than 50 percent of another company. Risk-and-reward model—If a company is involved substantially in the economics of another company. . then consolidate. 2.APPENDIX 17B VARIABLE-INTEREST ENTITIES What About GAAP? Two models for consolidation: 1.

APPENDIX 17B VARIABLE-INTEREST ENTITIES Consolidation of Variable-Interest Entities A variable-interest entity (VIE) is an entity that has one of the following characteristics: 1. Stockholders lack decision-making rights. 3. 17-104 LO 15 Describe the accounting for the variable-interest entitles. 2. Insufficient equity investment at risk. Stockholders do not absorb the losses or receive the benefits of a normal stockholder. .

.APPENDIX 17B VARIABLE-INTEREST ENTITIES Illustration 17B-1 VIE Consolidation Model 17-105 LO 15 Describe the accounting for the variable-interest entitles.

17-106 LO 15 Describe the accounting for the variable-interest entitles. .APPENDIX 17B VARIABLE-INTEREST ENTITIES What Is Happening in Practice? One study of 509 companies with total market values over $500 million found that just 17 percent of the companies reviewed have a material impact.

and 2. 17-107 . the lack of reliability related to the fair value measurement in certain cases. Others express concern about fair value measurements for two reasons: 1.APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES FASB believes that fair value information is relevant for making effective business decisions. the ability to manipulate fair value measurements.

APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Disclosure of Fair Value Information: Financial Instruments—No Fair Value Option Both the cost and the fair value of all financial instruments are to be reported in the notes to the financial statements. 17-108 . FASB also decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement.

Differing levels of reliability exist in the measurement of fair value information. Changes in the fair value of financial instruments are reported differently in the financial statements. 17-109 . depending upon the type of financial instrument involved and whether the fair value option is employed. 2.APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Disclosure of Fair Value Information: Financial Instruments—No Fair Value Option Two reasons for additional disclosure beyond the simple itemization of fair values are: 1.

17-110 .  Level 3 is least reliable.  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.APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Levels of reliability fair value hierarchy.  Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. it uses unobservable inputs that reflect the company’s assumption as to the value of the financial instrument.

APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Example of Fair Value Hierarchy Illustration 17C-1 17-111 .

APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Reconciliation of Level 3 Inputs Illustration 17C-2 17-112 .

APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Disclosure of Fair Value Information: Financial Instruments—Fair Value Option Illustration 17C-3 Disclosure of Fair Value Option 17-113 .

APPENDIX 17C FAIR VALUE MEASUREMENTS AND DISCLOSURES Disclosure of Fair Values: Impaired Assets or Illustration 17C-4 Liabilities Disclosure of Fair Value with Impairment 17-114 .

IFRS uses held-for-collection (debt investments). Held-to-maturity (GAAP) and held-for-collection investments are accounted for at amortized cost. Gains and losses related to available-for-sale securities (GAAP) and non-trading equity investments (IFRS) are reported in other comprehensive income.RELEVANT FACTS  GAAP classifies investments as trading. and held-to-maturity (only for debt investments). and non-trading equity investment classifications. Both GAAP and IFRS use the same test to determine whether the equity method of accounting should be used. trading (both debt and equity investments). available-for-sale (both debt and equity investments). The accounting for trading investments is the same between GAAP and IFRS.   17-115 .

That is. under both systems. Under GAAP. However. which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting-interest approach. for consolidation to occur.RELEVANT FACTS  The basis for consolidation under IFRS is control. the investor company must generally own 50 percent of another company. the selection is irrevocable. GAAP and IFRS are similar in the accounting for the fair value option. a bipolar approach is used. One difference is that GAAP permits the fair value option for equity method investments.  17-116 . the option to use the fair value method must be made at initial recognition. and gains and losses are reported as part of income.

RELEVANT FACTS  While measurement of impairments is similar. GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. 17-117 . IFRS allows reversals of impairments of held-for-collection investments.

b. although IFRS allows recovery of impairment losses. IFRS and GAAP have a held-to-maturity investment classification. c. IFRS and GAAP apply the equity method to significant influence equity investments. IFRS and GAAP have a fair value option for financial instruments. 17-118 .IFRS SELF-TEST QUESTION All of the following are key similarities between GAAP and IFRS with respect to accounting for investments except: a. the accounting for impairment of investments is similar. d.

GAAP permits recovery of impairment losses.IFRS SELF-TEST QUESTION Which of the following statements is correct? a. IFRS and GAAP both have a trading investment classification. c. GAAP has a held-for-collection investment classification. b. non-trading equity investments are accounted for at amortized cost d. Under IFRS. 17-119 .

whether the financial asset is a debt investment. whether the financial asset is an equity investment. c. d. the company’s business model for managing its financial assets. b. All of the choices are IFRS requirements. 17-120 .IFRS SELF-TEST QUESTION IFRS requires companies to measure their financial assets at fair value based on: a.

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