Chap012.doc

Chapter 12 - Investments

Investment securities are classified as “held-to-maturity,” “trading,” or “available-for-sale” securities.

Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are ignored for a security classified as “held-to-maturity.” These changes aren’t important if sale

before maturity isn’t an alternative, which is the case if an investor has the “positive intent and ability” to hold the security to maturity.

GAAP distinguishes between three levels of inputs to fair value determination, with level 1 being readily observable fair values (for example, from a securities exchange), level 2 inputs are other observable amounts (for example, quoted values

for similar items, or important inputs like interest rates), and level 3 inputs are unobservable, like the company’s own assumptions. GAAP requires disclosure of the amount of fair values based on each of these three classes of inputs.

For investments to be held for an unspecified period of time, fair value information is more relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because

sale at that fair value is not an option. The investor receives the same contracted interest payments for the period held to maturity and the stated principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in fair values indicate management’s success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.

The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as “securities available-for-sale” or as “trading securities.” Securities available-for-sale are

reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders’ equity, as part of other comprehensive income (OCI). (Available-for-sale securities for which the investor has chosen the fair value option are reclassified as trading securities.)

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Chapter 12 Investments

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 12-1

Question 12-2

Question 12-3

Question 12-4

Question 12-5


Answers to Questions (continued)Comprehensive income is a more expansive view of the change in

shareholders’ equity than traditional net income. It encompasses all changes in equity from non-owner transactions. The non-income part of comprehensive

income is called “Other comprehensive income.” Other comprehensive income includes net unrealized holding gains (losses) on AFS investments, and also the non-credit-loss component of other-than-temporary impairments of HTM investments.

Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from

short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal.

On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are less relevant performance measures to be included in earnings.

When acquired, debt and equity securities are assigned to one of the three reporting classifications – held-to-maturity, trading, or

available-for-sale. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred:

1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period.

2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded in Other Comprehensive Income, which will then increase Accumulated Other Comprehensive Income in shareholders’ equity.

3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity. This would be the case for Western Die-Casting’s investment in the LGB Heating Equipment bonds.

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Question 12-6

Question 12-7

Question 12-8


Yes. Although a company is not required to report individual amounts for the three categories of investments – held-to-maturity, available-for-sale, or trading – on the face of the balance sheet, that information should be presented in the disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type. Information about the level of the fair value hierarchy upon which fair values are based should be provided, and more disclosure is necessary with respect to amounts based on level 3 of the fair value hierarchy. In addition, information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least 4 maturity groupings: (a) within 1 year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.

When a company elects the fair value option for held-to-maturity or available-for-sale investments, it simply reclassifies those investments as trading securities and accounts for them in that fashion.

U.S. GAAP allows companies complete discretion in electing the fair value option when an investment is made. The only constraint is that the election is irrevocable. IFRS only allows companies to elect the fair value option in specific

circumstances, e.g., when electing the fair value option for an asset or liability allows a company to avoid the “accounting mismatch” that occurs when some parts of a fair value risk-hedging arrangement are accounted for at fair value and others are not.

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Answers to Questions (continued)

Question 12-9

Question 12-10

According to U.S. GAAP, the fair value of an equity security is considered readily determinable only if its selling price is currently available on particular securities exchanges or over-the-counter markets. If the fair value of an equity security is not readily determinable, U.S. GAAP uses the cost method. Under IFRS, equity investments typically are measured at fair value, even if they are not listed on an exchange or over-the-counter market. Under IAS No. 39, the cost method only is used if fair value cannot be measured reliably, which occurs when the range of reasonable fair value estimates is significant and the probability of various estimates within the range cannot be reasonably estimated. Under IFRS No. 9, the cost method is prohibited, although cost can sometimes be used as an estimate of fair value. Therefore, in general, use of the cost method is less prevalent under IFRS than under U.S. GAAP.

Question 12-11

Question 12-12


The equity method is used when an investor can’t control but can “significantly influence” the investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.

The equity method, like consolidation, views the investor and investee as a special type of single entity. By the equity method, though, the investor doesn’t

include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.

The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized as the investee

earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investee’s net assets, indicating that the investor’s ownership interest in those net assets declines proportionately.

Question 12-16The equity method attempts to approximate the effects of accounting for the purchase of the

investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values as of the date the investor acquired the investee. The accounting in the consolidated financial statements subsequent to the acquisition date is based on those fair values. So, if Finest had consolidated its acquisition of Penner, Penner’s depreciable assets would have been put on Finest’s balance sheet in their respective asset accounts at their fair value on the date of acquisition and then depreciated over 10 years. Under the equity method, Finest’s investment in Penner is shown in a single investment account. Therefore, for the equity method to approximate consolidation, it would reduce both investment revenue (as if depreciation expense were being recognized) and the investment (as if the book value of the asset were being reduced) by the negative income effect of the “extra depreciation” the higher fair value would cause. This would equal 40% x $12 million ÷ 10 years = $480,000 each year for ten years.

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Answers to Questions (continued)

Question 12-13

Question 12-14

Question 12-15


Answers to Questions (continued)The investment account was decreased by $40,000 (40% x $100,000). Cash

increased by the same amount. There is no effect on the income statement.When it becomes necessary to change from the equity method to another

method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then

on. The investment account balance when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value in the next set of financial statements.

IFRS require that accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Also, IFRS allow investors to account for a joint venture using

either the equity method or “proportionate consolidation,” whereby the investor combines its proportionate share of the investee’s accounts with its own accounts on an item-by-item basis. U.S. GAAP generally requires that the equity method be used to account for joint ventures.

When a company elects the fair value option for a significant-influence investment, that investment is not reclassified as a trading security. Rather, the investment still appears in the balance sheet as a significant-influence investment,

but the amount that is accounted for at fair value is indicated in the balance sheet either parenthetically on a single line that includes the total amount of significant-influence investment or on a separate line. As with trading securities, unrealized gains and losses are included in earnings in the period in which they occur.

A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to

receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.

These instruments “derive” their values or contractually required cash flows from some other security or index.

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Question 12-17

Question 12-18

Question 12-19

Question 12-20

Question 12-21

Question 12-22


Answers to Questions (continued)Since this money won’t be used within the upcoming operating cycle, it is a

noncurrent asset. It should be reported as part of Investments .Part of each premium payment the company makes is not used by the

insurance company to pay for life insurance coverage, but rather is “invested” on behalf of the insured company in a fixed-income investment. As a result, the

periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset – cash surrender value.

If the investor intends to sell the investment, or thinks it will be more likely than not that it will be required to sell the investment prior to recovering the impairment, the investor is required to recognize the entire impairment loss in the

income statement as an OTT impairment, writing down the investment to fair value in the balance sheet.

Otherwise, the investor considers whether credit losses exist. If there are no credit losses, no impairment loss is recognized. On the other hand, if there are some credit losses, then the investment is written down to fair value in the balance sheet. However, only the credit loss component is recognized in net income. Any non-credit losses are recognized in OCI. In the income statement, the entire impairment loss is shown, and then the amount of non-credit loss is subtracted, leaving only the credit loss reducing net income.

If the OTT impairment relates to an equity investment, the entire amount of impairment is recognized in net income. Any previously recorded unrealized losses are reclassified out of AOCI.

If the OTT impairment relates to a debt investment, the accounting is more complicated. First, if the investor intends to sell the investment, or thinks it will be more likely than not that it will be required to sell the investment prior to recovering the impairment, it is required to recognize the entire impairment loss in the income statement as an OTT impairment, writing down the investment to fair value in the balance sheet.

Otherwise, the investor considers whether credit losses exist. If there are no credit losses, no impairment loss is recognized. On the other hand, if there are some credit losses, then the investment is written down to fair value in the balance sheet. However, only the credit loss component is recognized in net income. Any non-credit losses are recognized in OCI. In the income statement, the entire impairment loss is shown, and then the amount of non-credit loss is subtracted, leaving only the credit loss reducing net income.

Given that the decline in shares relates to a new law banning a primary approach used by the company, it likely would be treated as an other-than-temporary impairment. So, when the investment is written down to its fair value, the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in income for the period. This could require a reclassification adjustment if any unrealized losses were included previously in OCI, just as if the investment was being sold. Subsequent to the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as a separate component of shareholders’ equity, accumulated other comprehensive income.

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Question 12-23

Question 12-24

Question 12-25

Question 12-26

Answers to Questions (concluded)

Question 12-27


U.S. GAAP and IFRS differ somewhat. Under IFRS, OTT impairments only are recognized on debt that is classified as HTM to the extent that credit losses exist, so there is no non-credit-loss component of OTT impairments under IFRS.

OTT impairments are recognized on debt classified as AFS in their entirety, with no distinction made between credit losses and non-credit losses. Also, under IFRS, OTT impairments can be recovered in earnings for debt investments, but not for equity investments.

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Question 12-28


BRIEF EXERCISES (a)

Investment in bonds (face amount)........................ 720,000Discount on bond investment (difference)......... 120,000Cash (price of bonds).......................................... 600,000

(b)Cash (1.5% x $720,000).......................................... 10,800Discount on bond investment (difference)............ 1,200

Interest revenue (2% x $600,000)....................... 12,000

Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in earnings. S&L reports its $2,000 holding loss in 2011 earnings. When the fair value rises by $7,000 in 2012, that amount is reported in 2012 earnings ($5000 as a realized gain, and $2000 as the reversal of the unrealized loss that was recognized in 2011). S&L’s journal entries for these transactions would be:

2011

December 27Investment in Coca Cola shares .......................................... 875,000

Cash.................................................................................. 875,000

December 31Net unrealized holding gains and losses—I/S..................... 2,000

Fair value adjustment ($875,000 – 873,000)........................ 2,000

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Brief Exercise 12-1

Brief Exercise 12-2


Brief Exercise 12-2 (concluded)

2012

January 3Cash (selling price).................................................................. 880,000

Gain on investments (to balance)....................................... 5,000Investment in Coca Cola shares (account balance).............. 875,000

Assuming no other trading securities, the 2012 adjusting entry to remove the fair value adjustment associated with the sold securities would be:

December 31Fair value adjustment (account balance).................................. 2,000

Net unrealized holding gains and losses—I/S (to balance) 2,000

Unlike for trading securities, unrealized holding gains and losses for securities available-for-sale are not included

in earnings. S&L reports its $2,000 holding loss in 2011 as Other comprehensive income in the statement of comprehensive income. When the fair value rises to $880,000 in 2012, the amount is reported in 2012 earnings is the $5,000 gain realized by the sale of the securities. S&L’s journal entries for these transactions would be:

2011


Cash.................................................................................. 875,000

December 31Net unrealized holding gains and losses–OCI..................... 2,000

Fair value adjustment ($875,000 – 873,000)........................ 2,000

2012

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Brief Exercise 12-3



Gain on investments (to balance)....................................... 5,000Investment in Coca Cola shares (cost).............................. 875,000

Assuming no other transactions involving securities available-for-sale, the 2012 adjusting entry to remove the fair value adjustment associated with the sold securities would be:


Net unrealized holding gains and losses–OCI................. 2,000

Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of net income for the period. Rather, they are reported as “other comprehensive income” in the statement of comprehensive income. The accumulated balance of net holding gains and losses is reported as a separate component of shareholders’ equity, as part of accumulated other comprehensive income. The adjusting entry needed to increase the fair value adjustment from $110,000 to $170,000 is:

Fair value adjustment ($670,000 – 610,000)........... 60,000Net unrealized holding gains and losses–OCI. 60,000

These are securities available-for-sale and are reported at their fair value, $4,000,000. We know this because

securities “held-to-maturity” are debt securities that an investor has the “positive intent and ability” to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The FedEx shares have been held for over a year. They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn’t appropriate either because 40,000 shares of FedEx certainly don’t constitute “significant influence.” Investments in securities available-for-sale are reported at fair value.

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Brief Exercise 12-4

Brief Exercise 12-5


Because S&L elected the fair value option, it would classify this investment as a trading security and account for

it in that fashion. Therefore, S&L reports its $2,000 holding loss in 2011 earnings. When the fair value rises by $7,000 in 2012, that amount is reported in 2012 earnings ($5000 as a realized gain, and $2000 as the reversal of the unrealized loss that was recognized in 2011). S&L’s journal entries for these transactions would be:

2011


Cash.................................................................................. 875,000


Fair value adjustment ($875,000 – 873,000)................... 2,000

2012


Gain on investments (to balance)....................................... 5,000Investment in Coca Cola shares (account balance).............. 875,000



Net unrealized holding gains and losses—I/S (to balance) 2,000

An investor should account for dividends from an investment not accounted for by the equity method as

investment revenue. Since Turner holds only 10% of ICA stock, it’s assumed that it does not have significant influence over the company. Turner’s cash increased by $500,000 (10% x $5 million). It also reports $500,000 as investment revenue in the income statement.

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Brief Exercise 12-6

Brief Exercise 12-7


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

With the equity method we attempt to approximate the effects of accounting for the purchase of the investee as a

consolidation. Consolidated financial statements report acquired net assets at their fair values. Both investment revenue and the investment would be reduced by the negative income effect of the “extra depreciation” the higher fair value would cause. This would equal 30% x $50 million ÷ 15 years = $1 million each year for fifteen years.

Under proportionate consolidation, Park would have included its portion of Wallis’s depreciable assets in the Park depreciable asset accounts on its consolidated balance sheet. Those depreciable asset accounts would be reduced by the “extra depreciation” the higher fair value would cause. This would equal 50% x $50 million ÷ 15 years = $1.67 million each year for fifteen years.

The investment would be increased by $12 million. Financial statements would be recast to reflect the equity

method for each year reported for comparative purposes. A disclosure note also

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Brief Exercise 12-8

Brief Exercise 12-9

Brief Exercise 12-10



should describe the change, justify the switch, and indicate its effects on all financial statement items.

The answer would not be the same if Pioneer changes from the equity method. Rather, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.

Given Turner’s election of the fair value option, it would account for this investment similar to a trading security, while still preserving its classification as a

significant-influence investment and showing it as a non-current asset in the balance sheet.

2011

January 2Investment in ICA Company ..............................................10,000,000

Cash.................................................................................. 10,000,000

December 30Cash (40% x $500,000) ........................................................... 200,000

Investment revenue ......................................................... 200,000

December 31Fair value adjustment ($11.5M – 10M)................................... 1,500,000

Net unrealized holding gains and losses—I/S (may also labeled “Investment revenue”)........................ 1,500,000

Note: A different approach to reach the same outcome would be for Turner to use equity-method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Turner would recognize 40% of ICA’s $750,000 income ($300,000) as investment income, it would not recognize investment income associated with ICA’s dividend, and it would end up with an Investment account containing $10,100,000 ($10,000,000 + $300,000 – 200,000). Turner then would need to make a fair value adjustment of $1,400,000 ($11,500,000 – 10,100,000) to its ICA investment. So the total amount of income recognized would be $1,700,000 ($300,000 investment income +

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$1,400,000 unrealized gain). Note that this alternative produces the same total amount of investment income as is produced above, $1,700,000 ($200,000 investment revenue + $1,500,000 unrealized gain).

Because the drop in the market price of stock is considered to be other-than-temporary, LED records the

impairment of $450,000 ($4.50 x 100,000 shares) and reclassifies previously recognized unrealized losses of $100,000 ($1.00 x 100,000 shares) as follows:

Other-than-temporary impairment loss – I/S..... 450,000AFS Investment (Branch) ............................... 450,000

Fair value adjustment.......................................... 100,000 Net unrealized holding gains and losses – OCI 100,000

In the income statement, the entire $450,000 will be shown as an OTT impairment loss. A $100,000 reclassification adjustment will increase OCI (because the $100,000 decreased OCI and therefore AOCI in a prior period, it must be backed out of OCI and AOCI in the current period). Therefore, the net effect on comprehensive income during the current period will be $350,000.

12-14




LED believes it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is not relevant. LED must recognize the entire OTT impairment in earnings, reducing the carrying value of the LED bonds by crediting a discount on bond investment account. LED records the impairment of $450,000 and reclassifies previously recognized unrealized losses of $100,000 as follows:

Other-than-temporary impairment loss – I/S..... 450,000Discount on bond investment ......................... 450,000


In the income statement, the entire $450,000 will be shown as an OTT impairment loss. A $100,000 reclassification adjustment will increase OCI (because the $100,000 decreased OCI and therefore AOCI in a prior period, it must be backed out of OCI and AOCI in the current period). Therefore, the net effect on comprehensive income during the current period will be $350,000.

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LED does not intend to sell the investment, and it does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is relevant. LED must recognize the $200,000 credit loss component of the OTT impairment in earnings, and the $250,000 non-credit-loss component in OCI. LED records the impairment of $450,000 and reclassifies previously recognized unrealized losses of $100,000 as follows:

Other-than-temporary impairment loss – I/S..... 200,000Discount on bond investment.......................... 200,000

OTT impairment loss– OCI................................ 250,000 Fair value adjustment...................................... 250,000


LED still would have to include the entire $450,000 in the income statement before backing out the $250,000 to leave a $200,000 reduction of earnings. The $100,000 reclassification adjustment will increase OCI (because the $100,000 decreased OCI and therefore AOCI in a prior period, it must be backed out of OCI and AOCI in the current period). Therefore, the net effect on comprehensive income will be $350,000 during the current period ($200,000 from net income, $150,000 from OCI).

12-16


Wickum would have recorded a journal entry previously that recognized the OTT impairment in earnings and reduced the investment account:

Other-than-temporary impairment loss – I/S...... 500,000Discount on debt investment .......................... 500,000

Upon recovery of $300,000 of fair value, Wickum would reverse the impairment by that amount:

Discount on debt investment............................... 300,000 Recovery of other-than-temporary impairment loss – I/S 300,000

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EXERCISES Requirement 1 ($ in millions)

Investment in bonds (face amount)........................ 240.0Discount on bond investment (difference)......... 40.0Cash (price of bonds).......................................... 200.0

Requirement 2 Cash (3% x $240 million)........................................ 7.2Discount on bond investment (difference)............ .8

Interest revenue (4% x $200)............................. 8.0

Requirement 3 Tanner-UNF reports its investment in the December 31, 2011, balance sheet at its amortized cost – that is, its book value:

Investment in bonds............................................ $240.0Less: Discount on bond investment ($40 – .8 million) 39 .2

Amortized cost................................................ $200.8

If sale before maturity isn’t an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet.

Requirement 4 ($ in millions)Cash (proceeds from sale)....................................... 190.0Discount on bond investment (balance, determined above) 39.2Loss on sale of investments (to balance)............... 10.8

Investment in bonds (face amount).................... 240.0

November 1 ($ in millions)

Cash................................................................. 2.4Investment revenue..................................... 2.4

December 1 Investment in Facsimile Enterprises bonds..... 30

Cash............................................................. 30

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Exercise 12-1

Exercise 12-2


December 31 Investment in U.S. Treasury bills ................... 8.9

Cash............................................................. 8.9

December 31 Investment revenue receivable–Convenience bonds ($48 million x 10% x 2/12)........................ 0.8Investment revenue receivable–Facsimile Enterprises bonds ($30 million x 12% x 1/12)..... 0.3

Investment revenue ................................... 1.1

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

Investment in GM common shares 41,200Cash ([800 shares x $50] + $1,200)................................41,200

Cash ([800 shares x $53] – $1,300)....................... 41,100Loss on sale of investments............................ 100

Investment in GM common shares ............. 41,200

Requirement 1

2011

December 17Investment in Grocers’ Supply preferred shares ................. 350,000

Cash.................................................................................. 350,000

December 28Cash...................................................................................... 2,000

Investment revenue.......................................................... 2,000

December 31Fair value adjustment........................................................... 50,000

Net unrealized holding gains and losses—I/S ([$4 x 100,000 shares] – $350,000)......................................... 50,000

2012

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Exercise 12-3

Exercise 12-4



Gain on investments (to balance)....................................... 45,000Investment in Grocers’ Supply preferred shares (account balance)................................................. 350,000



Fair value adjustment (account balance).............................. 50,000

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Exercise 12-4 (concluded)

Requirement 2 Balance Sheet

(short-term investment):Trading securities.................................................... $400,000

Income Statement:Investment revenue (dividends)........................................... $ 2,000Net unrealized holding gains and losses (from adjusting entry) 50,000

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

Requirement 1 .

Net unrealized holding gains and losses–OCI 25,000Fair value adjustment ($45,000 – 20,000) 25,000

Requirement 2

None. Accumulated net holding gains and losses for securities available-for-sale are reported as a component of shareholders’ equity (in accumulated other comprehensive income), and changes in the balance are reported as other comprehensive income or loss in the statement of comprehensive income rather than as part of earnings. This statement can be reported either (a) as an extension of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note.

Requirement 1

Securities “held-to-maturity” are debt securities that an investor has the “positive intent and ability” to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The IBM shares are neither. They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn’t appropriate either because 10,000 shares of IBM certainly don’t constitute “significant influence.”

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Exercise 12-5

Exercise 12-6


Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as other comprehensive income or loss in the statement of comprehensive income. This statement can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note. Accumulated net holding gains and losses for securities available-for-sale are reported as a separate component of shareholders’ equity in the balance sheet.

Requirement 2

December 31, 2011Net unrealized holding gains and losses–OCI

(10,000 shares x [$58 – 60]) ......................................................... 20,000 Fair value adjustment............................................................ 20,000

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Requirement 3

December 31, 2012Accumulated

($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2012 $600 $610 $10

Moving from a negative $20 (2011) to a positive $10 (2012) requires an increase of $30:

---------------------------------------------------------20 0 +10

+30 ----------------------------->

Fair value adjustment 10,000 shares x [$61 – 58])............................ 30,000Net unrealized holding gains and losses–OCI (-$20 less $10). . . 30,000

Requirement 1

2011

12-23

Fair Value Adjustment

Balance needed in fair value adjustment $10Existing balance in fair value adjustment: ($20)

Increase (decrease) needed in fair value adjustment: $30

Exercise 12-7


March 2($ in millions)

Investment in Platinum Gauges, Inc. shares ............................... 31Cash......................................................................................... 31

April 12Investment in Zenith bonds......................................................... 20

Cash......................................................................................... 20

July 18Cash............................................................................................. 2

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

October 15Cash............................................................................................. 1


October 16 Cash............................................................................................. 21

Investment in Zenith bonds..................................................... 20Gain on sale of investments..................................................... 1

November 1Investment in LTD preferred shares ........................................... 40

Cash......................................................................................... 40

12-24


Exercise 12-7(continued)

December 31Accumulated

($ in millions) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) Platinum Gauges, Inc. shares $31 $32* $1LTD preferred shares 40 37** (3 ) Totals $71 $69 $(2)

* $32 x 1 million shares ** $74 x 500,000 shares

Adjusting entry: Net unrealized holding gains and losses–OCI ($71 – 69)............. 2

Fair value adjustment ($71 – 69)............................................... 2

2012

January 23($ in millions)

Cash ([1 million shares x 1/2] x $32)................................................ 16.0Gain on sale of investments (difference).................................... 0.5Investment in Platinum Gauges shares ($31 million cost x 1/2)................................................... 15.5

March 1Cash ($76 x 500,000 shares)............................................................. 38Loss on sale of investments (difference)........................................ 2

Investment in LTD preferred (cost).......................................... 40Note: As part of the process of recording the normal, period-end fair value adjusting entry at 12/31/2012, Construction would debit Fair value adjustment and credit Net unrealized gains and losses—OCI for the $2.5 million associated with the sold investments to remove their effects from the financial statements. (Construction sold only half the Platinum investments so only half of the Platinum fair value adjustment should be removed. The 2.5 amount comes from 3.0 LTD - 0.5 Platinum.)

12-25



Requirement 2 2011 Income Statement

($ in millions)Investment revenue (from July 18; Oct. 15)..................................... $3Gain on sale of investments (from Oct. 16).................................... 1

Other comprehensive income:*Net unrealized holding gains and losses on investments**. . $2

** Assuming Construction Forms chooses to report Other comprehensive income as an additional section of the income statement. Alternatively, it can report this (a) as part of the statement of shareholders’ equity or (b) as a separate statement in a disclosure note.

Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Rather, they are included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.

Requirement 1

Purchase ($ in millions)Investment in Jackson Industry shares........................................ 90

Cash ........................................................................................ 90

Net incomeNo entry

DividendsCash (5% x $60 million).................................................................. 3


Adjusting entryFair value adjustment ($98 – 90 million)......................................... 8

Net unrealized holding gains and losses–OCI......................... 8

12-26

Exercise 12-8


Requirement 2

Investment revenue.......................... $3 million

Note: An unrealized holding gain is not included in income for securities available-for-sale. Rather, it is included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.

1. Investments reported as current assets.

Security A $ 910,000Security B 100,000Security C 780,000Security E 490,000 Total $2,280,000

2. Investments reported as noncurrent assets.Security D $ 915,000Security F 615,000

$1,530,000

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

Trading Securities:Cost Fair value Unrealized

gain (loss)Security A $ 900,000 $ 910,000 $10,000

B 105,000 100,000 (5,000 ) Totals $1,005,000 $1,010,000 $ 5,000

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

Securities Available-for-Sale:

Cost Fair value Unrealized gain (loss)

12-27

Exercise 12-9


Security C $ 700,000 $ 780,000 $80,000D 900,000 915,000 15,000

Totals $1,600,000 $1,695,000 $95,000

Requirement 1

Accumulated ($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2011 $1,345 $1,175 $(170)

Moving from a negative $145 (Jan.1) to a negative $170 requires a reduction of $25:

---------------------------------------------------------170 -145 0

<---------------- – 25

Net unrealized holding gains and losses–OCI........................ 25,000Fair value adjustment ($1,175,000 – 1,200,000)................... 25,000

12-28

Exercise 12-10


Balance needed in fair value adjustment ($170)Existing balance in fair value adjustment: ($145)

Increase (decrease) needed in fair value adjustment: ($ 25)


Exercise 12-10 (continued)

Requirement 2 Accumulated

($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2011 $1,345 $1,275 $(70)

Moving from a negative $145 (Jan.1) to a negative $70 requires an increase of $75:

--------------------------------------------------------------------------------------------145 -70 0

+75 ---------------------->

Fair value adjustment ($1,275,000 – 1,200,000) ........................ 75,000Net unrealized holding gains and losses–OCI................. 75,000

12-29


Balance needed in fair value adjustment ($ 70)Existing balance in fair value adjustment: ($145)

Increase (decrease) needed in fair value adjustment: $ 75



Requirement 3 Accumulated

($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2011 $1,345 $1,375 $30

Moving from a negative $145 (Jan.1) to a positive $30 requires an increase of $175:

--------------------------------------------------------------------------------------------145 -70 0 +30

+175 -------------------------------------------------------->

Fair value adjustment ($1,375,000 – 1,200,000) ........................ 175,000Net unrealized holding gains and losses–OCI................. 175,000

Requirement 1

The sale of the A Corporation shares decreased Harlon’s pretax earnings by $5 million. The purchase of the C Corporation shares had no effect on Harlon’s 2012 earnings (because the shares are classified as available-for-sale investments, any unrealized gains or losses occurring after purchase during 2012 would not affect 2012 earnings). Here are the entries used to record those two transactions:

June 1, 2012 ($ in millions)Cash 15 Loss on sale of investments (difference) 5

Investment in A Corporation shares (cost) 20

September 12, 2012

12-30


Balance needed in fair value adjustment $ 30Existing balance in fair value adjustment: ($145)


Exercise 12-11


Investment in C Corporation shares 15Cash 15

12-31



Requirement 2

Harlon’s securities available-for-sale portfolio should be reported in its 2012 balance sheet at its fair value of $101 million:

December 31, 2012

($ in millions) Cost, Dec. 31 Fair Value, Dec. 31 Securities Available-for-Sale 2011 2012 2011 2012

A Corporation shares $20 na $14 naB Corporation bonds 35 $35 35 $ 37C Corporation shares na 15 na 14D Industries shares 45 45 46 50 Totals $100 $95 $95 $101

In 2011, Harlon would have had a net unrealized loss of $5 (cost of $100 – fair value of $95). Moving from a negative $5 (2011) to a positive $6 requires an increase of $11:

----------------------------------------------------------5 0 +6

+11 ----------------------------->

Fair value adjustment ($5 credit to $6 debit) 11Net unrealized holding gains and losses–OCI 11

The adjustment has no effect on earnings. Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Rather, they are included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.

12-32

Fair Value Adjustment Allowance

Balance needed in fair value adjustment $ 6Existing balance in fair value adjustment: (5)



Requirement 1

The investment would be accounted for as an available-for-sale investment:

PurchaseInvestment in AMC common shares.................................... 480,000

Cash ............................................................................... 480,000

Net incomeNo entry

DividendsCash (20% x 400,000 shares x $0.25)......................................... 20,000

Investment revenue......................................................... 20,000

Adjusting entryFair value adjustment ($505,000 – 480,000)............................ 25,000

Net unrealized holding gains and losses–OCI................ 25,000

Requirement 2

The investment would be accounted for using the equity method:

PurchaseInvestment in AMC common shares.................................... 480,000

Cash ............................................................................... 480,000

Net incomeInvestment in AMC common shares (20% x $250,000) ......... 50,000

Investment revenue......................................................... 50,000

DividendsCash (20% x 400,000 shares x $0.25)......................................... 20,000

Investment in AMC common shares.............................. 20,000

Adjusting entryNo entry

12-33

Exercise 12-12

Exercise 12-13


Purchase ($ in millions)Investment in Nursery Supplies shares.................................... 56

Cash .................................................................................... 56

Net incomeInvestment in Nursery Supplies shares (30% x $40 million) ...... 12

Investment revenue.............................................................. 12

DividendsCash (30% x 8 million shares x $1.25)........................................... 3

Investment in Nursery Supplies shares................................ 3

Adjusting entryNo entry

Requirement 1 ($ in millions)

Investment in equity securities ($48 million – 31 million)........... 17Retained earnings (investment revenue from the equity method). 17

Requirement 2 Financial statements would be recast to reflect the equity method for each year

reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items.

Requirement 3 When a company changes from the equity method, no adjustment is made to the

carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.

12-34

Exercise 12-14


Requirement 1: Error discovered before the books are adjusted or closed in 2011.

The journal entry the company made is:

Cash............................................................. 100,000Investments.............................................. 100,000

The journal entry the company should have made is:

Cash............................................................. 100,000Investments.............................................. 80,000Gain on sale of investments ($100,000 – 80,000) 20,000

Therefore, to get from what was done to what should have been done, the following entry is needed:

Investments ($100,000 – 80,000)..................... 20,000Gain on sale of investments.................... 20,000

Requirement 2: Error not discovered until early 2012.

12-35

Exercise 12-15


Investments ($100,000 – 80,000)..................... 20,000Retained earnings.................................... 20,000

Purchase ($ in millions)Investment in Carne Cosmetics shares................................ 68

Cash ................................................................................. 68

Net incomeInvestment in Carne Cosmetics shares (25% x $40 million) ... 10

Investment revenue.......................................................... 10

DividendsCash (4 million shares x $1)...................................................... 4

Investment in Carne Cosmetics shares............................ 4

Depreciation Adjustment

Investment revenue ($8 million [calculation below‡] ÷ 8 years).. 1Investment in Carne Cosmetics shares............................ 1

‡Calculations:Investee Net Assets Difference

Net Assets Purchased Attributed to:

Cost $68

Goodwill:$12

Fair value: $224* x 25% = $56

UndervaluationBook value: $192 x 25% = $48 of assets: $8

*[$192 + 32] = $224

Adjusting entryNo entry to adjust for changes in fair value as this investment is accounted for under the equity method.

Requirement 1

12-36

Exercise 12-16

Exercise 12-17


Purchase ($ in millions)Investment in Lake Construction shares.............................. 300

Cash ................................................................................. 300

Net incomeInvestment in Lake Construction shares (20% x $150 million) 30

Investment revenue.......................................................... 30

DividendsCash (20% x $30 million)......................................................... 6

Investment in Lake Construction shares.......................... 6

Adjustment for depreciation

Investment revenue ($10 million [calculation below‡] ÷ 10 years) 1Investment in Lake Construction shares.......................... 1

‡ calculation:Investee Net Assets Difference


Cost $300

Goodwill: $120 Fair value: $900 x 20% = $180

Undervaluation

Book value: $800 x 20% = $160 of buildings ($10) and land ($10): $20

Requirement 2 a. Investment in Lake Construction shares__________________________________________

($ in millions)Cost 300Share of income 30

6 Dividends1 Depreciation adjustment

_________________Balance 323

12-37



b. As investment revenue in the income statement.

$30 million (share of income) – $1 million (depreciation adjustment) = $29 million

c. Among investing activities in the statement of cash flows.

$300 million [Cash dividends received ($6 million) also are reported - as part of operating activities. If Cameron reports cash flows using the indirect method, the operations section of its statement of cash flows would include an adjustment of ($23 million) to get from the net income figure that includes $29 million of revenue to a cash flow number that should only include $6 million of cash flow.]

Requirement 1

Investee Net Assets DifferenceNet Assets Purchased Attributed to:

Cost $750

Goodwill: $300 Fair value: $900 x 50% = $450

Undervaluation

Book value: $800 x 50% = $400 of buildings ($25) and land ($25): $50

a. January 1, 2011 effect on Buildings

12-38

Exercise 12-18

First we need to identify the amount of difference between book value and fair value associated with goodwill, buildings and land:

Because half of the fair value of Lake’s individual net assets are buildings, and Lake would be consolidated with Cameron, Cameron’s Buildings account would increase by 1/2 x $450 = $225 million.


b. January 1, 2011 effect on Land

c. January 1, 2011 effect on Goodwill

d. January 1, 2011 effect on Equity method investments

Requirement 2 a. December 31, 2011 effect on Buildings

b. December 31, 2011 effect on Land

c. December 31, 2011 effect on Goodwill

d. December 31, 2011 effect on Equity method investments

12-39

Because half of the fair value of Lake’s individual net assets is land, and Lake would be consolidated with Cameron, Cameron’s Land account would increase by 1/2 x $450 = $225 million.

Because Lake would be consolidated with Cameron, Cameron’s Goodwill account would increase by $300 million.

Because Lake would be consolidated with Cameron, there would be no effect of this investment on Cameron’s Equity method investment account.


Because half of the fair value of Lake’s individual net assets are buildings, and Lake would be consolidated with Cameron, Cameron’s Buildings account would increase by 1/2 x $450 = $225 million. Cameron would depreciate those buildings over their remaining 10 year life, so Lake would recognize $22.5 million of depreciation expense per year ($225 million ÷ 10 years). Therefore, at December 31, 2011, the buildings associated with the Lake investment would have a carrying value of $202.5 million ($225 million cost - $22.5 million accumulated depreciation).

Land is not amortized, so its carrying value would not change from its value on January 1, 2011.

Goodwill is not amortized, so its carrying value would not change from its value on January 1, 2011.

Because Lake would be consolidated with Cameron, there would be no effect of this investment on Cameron’s Equity method investment account at December 31, 2011.


Requirement 3

Requirement 1

Electing the fair value option for held-to-maturity securities simply requires reclassifying those securities as trading securities. Therefore, this investment would be classified as a trading security on Tanner-UNF’s balance sheet.

Requirement 2 ($ in millions)Investment in bonds (face amount)........................ 240

Discount on bond investment (difference)......... 40Cash (price of bonds).......................................... 200

Requirement 3 Cash (3% x $240 million)........................................ 7.2Discount on bond investment (difference)............ .8

Interest revenue (4% x $200).................................. 8.0

Requirement 4

The carrying value of the bonds is $240 – ($40 – $0.8) = $200.8. Therefore, to adjust to fair value of $210, Tanner-UNF would need the following journal entry:

Fair value adjustment.......................................... 9.2Net unrealized holding gains and losses—I/S ($210 – 200.8) 9.2

Requirement 5

Tanner-UNF reports its investment in the December 31, 2011, balance sheet at fair value of $210 million.


12-40

The effect of the investment on Cameron’s December 31, 2011 retained earnings would not differ between the equity method and proportionate consolidation treatments. Under the equity method, Cameron would recognize investment revenue based on its share of Lake’s net income, while under proportionate consolidation, Cameron would include its share of Lake’s revenue and expenses on those lines of the consolidated income statement. Regardless, the same total amount would be included in Cameron’s net income and closed to Cameron’s retained earnings.

Exercise 12-19


Cash (proceeds from sale)....................................... 190.0Loss on sale of investments (to balance)............... 10.8Discount on bond investment (account balance)... . 39.2

Investment in bonds (account balance)............... 240.0

Assuming no other trading securities, the 2012 adjusting entry would be:Net unrealized holding gains and losses—I/S..... 9.2 Fair value adjustment (account balance) ............ 9.2

Requirement 1

Electing the fair value option for available-for-sale securities simply requires reclassifying those securities as trading securities. Therefore, this investment would be classified as a trading security on Sanborn’s balance sheet.

Requirement 2

Purchase ($ in millions)Investment in Jackson Industry shares........................................ 90

Cash ........................................................................................ 90

Net incomeNo entry

DividendsCash (5% x $60 million).................................................................. 3


Adjusting entryFair value adjustment ($98 – 90 million)......................................... 8

Net unrealized holding gains and losses—I/S......................... 8

12-41

Exercise 12-20


Requirement 3

Investment revenue (dividends)........................................... $ 3,000Net unrealized holding gains and losses (from adjusting entry) 8,000 Total effect on 2011 net income before taxes 11,000

Requirement 1

Electing the fair value option for significant-influence investments requires use of the same basic accounting approach that is used for trading securities. However, the investments will still be classified as significant-influence investments and shown either on the same line of the balance sheet as equity-method investments (but with the amount at fair value indicated parenthetically) or on a separate line of the balance sheet.

Requirement 2

Purchase ($ in millions)Investment in Nursery Supplies shares.................................... 56

Cash .................................................................................... 56

Net incomeNo entry.

DividendsCash (30% x 8 million shares x $1.25)........................................... 3

Investment revenue.............................................................. 3

Adjusting entry.......................................................................................Net unrealized holding gains and losses—I/S ($56 – 52 million) 4

Fair value adjustment........................................................... 4

12-42

Exercise 12-21


Note: A different approach to reach the same outcome would be for Florists to use equity-method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Florists would recognize 30% of Nursery’s $40 million of income ($12 million) as investment income, it would not recognize investment income associated with Nursery’s dividend, and would end up with an Investment account containing $65 ($56 million + $12 million – $3 million). The company would need to make a fair value adjustment of $13 million ($65 million – 52 million). So the total amount of loss recognized would be $1 million ($12 million investment income – $13 million unrealized loss). Note that this alternative produces the same total amount of investment loss as is produced above: $1 million ($3 million investment revenue – $4 million unrealized loss).

Requirement 1

Insurance expense (difference)............................................... 64,000Cash surrender value of life insurance ($27,000 – 21,000)...... 6,000

Cash (2011 premium).......................................................... 70,000

Requirement 2 Cash (death benefit)......................................................... 4,000,000

Cash surrender value of life insurance (account balance) 27,000Gain on life insurance settlement (to balance)............ 3,973,000

Requirement 1

Insurance expense (difference)....................................... 22,900Cash surrender value of life insurance ($4,600 – 2,500).. 2,100

Cash (premium).......................................................... 25,000

Requirement 2

Cash (death benefit)......................................................... 250,000Cash surrender value of life insurance (account balance) 16,000Gain on life insurance settlement (to balance)............ 234,000

Requirement 1

12-43

Exercise 12-22

Exercise 12-23

Exercise 12-24


Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is not relevant. Bloom must recognize the entire OTT impairment in earnings as follows:


On the income statement, the entire $400,000 will be shown as an OTT impairment loss.

Requirement 2

Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is relevant. Bloom must recognize the $250,000 of credit losses as an OTT impairment in earnings, and the other $150,000 as a reduction of OCI, as follows:


OTT impairment loss – OCI .............................. 150,000Fair value adjustment – Non-credit loss.......... 150,000

On the income statement, the entire $400,000 will be shown as an OTT impairment loss, then the amount of non-credit loss is subtracted to leave only the credit loss reducing earnings:

OTT impairment on HTM investments Total OTT impairment loss........................ ($400,000) Less portion recognized in OCI................. $150,000 Net OTT impairment recognized in earnings ($250,000)

12-44



Requirement 3

Bloom does not plan to sell the investment, and does not believe it is more likely than not that Bloom will have to sell the investment before fair value recovers, but the entire impairment consists of non-credit losses, so Bloom does not record any OTT impairment.

Requirement 1: Assuming Bloom has not previously recorded a $100,000 loss

Scenario 1: Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is not relevant. Bloom must recognize the entire OTT impairment in earnings. Bloom makes the following entry:


On the income statement, the entire $400,000 will be shown as an OTT impairment loss. There is no effect on OCI, and a $400,000 effect on comprehensive income.

Scenario 2: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is relevant. Bloom must recognize the $250,000 of credit losses as an OTT impairment in earnings, and the other $150,000 as a reduction of OCI. Bloom makes the following entry:

Other-than-temporary impairment loss– I/S...... 250,000Discount on bond investment.......................... 250,000

Net unrealized holding gains and losses—OCI. . 150,000Fair value adjustment...................................... 150,000

On the income statement, the entire $400,000 will be shown as an OTT impairment loss, then the amount of non-credit loss is subtracted to leave only the credit loss reducing earnings:

OTT impairment on AFS investments Total OTT impairment loss........................ ($400,000)

12-45

Exercise 12-25


Less portion recognized in OCI................. $150,000 Net OTT impairment recognized in earnings ($250,000)

So, net income will be decreased by $250,000, OCI by $150,000, and comprehensive income by $400,000.

12-46


Exercise 12-25 (continued)

Scenario 3: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, but the entire impairment consists of non-credit losses, so Bloom does not record any OTT impairment.

Requirement 2: Assuming Bloom has previously recorded a $100,000 loss

Scenario 1: Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is not relevant. Bloom must recognize the entire OTT impairment in earnings. Bloom makes the following entry:


Assuming a previously recorded $100,000 unrealized loss, Bloom must also reclassify that loss out of OCI and the fair value adjustment. In 2010 Bloom would have made the following entry:

Net unrealized holding gains and losses—OCI. 100,000Fair value adjustment...................................... 100,000

So to reclassify that unrealized loss, Bloom would reverse that entry.

Fair value adjustment.......................................... 100,000Net unrealized holding gains and losses—OCI 100,000

On the income statement, the entire $400,000 will be shown as an OTT impairment loss. OCI will be increased by the $100,000 reclassification, such that the net effect on comprehensive income is $300,000.

Scenario 2: Bloom does not plan to sell the investment, and does not believe it is more likely

than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is relevant. Bloom must recognize the $250,000 of credit losses as an OTT impairment in earnings, and the other $150,000 as a reduction of OCI. Bloom makes the following entry:

12-47



Other-than-temporary impairment loss.............. 250,000Discount on bond investment.......................... 250,000


Assuming a previously recorded $100,000 unrealized loss, Bloom must also reclassify that loss out of OCI and the fair value adjustment:

Fair value adjustment.......................................... 100,000Net unrealized holding gains and losses--OCI 100,000

Note that, when combined with the other journal entries, the net effect is that net income is decreased by $250,000, OCI is decreased by $50,000 ($150,000 – 100,000), and comprehensive income therefore is decreased by $300,000. That makes sense, because $100,000 of decrease in OCI and comprehensive income occurred in 2010, when the $100,000 unrealized loss was recognized.

Scenario 3: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, but the entire impairment consists of non-credit losses, so Bloom does not record any OTT impairment.

December 31, 2011:

Kettle must record an unrealized loss of $10,000 to account for the fact that the fair value of Icalc’s shares has fallen from the original cost of $50,000 to $40,000.

Net unrealized holding gains and losses–OCI........................ 10,000Fair value adjustment ($50,000 – 40,000)............................ 10,000

This adjustment has no effect on net income, but it reduces OCI and comprehensive income by $10,000.

December 31, 2012:

Kettle now must record an OTT impairment. To reduce the investment from its original cost of $50,000 to $25,000, Kettle makes the following entry:

12-48

Exercise 12-26


Other-than-temporary impairment loss ($50,000 – 25,000) 25,000Investment in Icalc.......................................... 25,000

Kettle also must reclassify the 2011 unrealized loss out of OCI and remove the fair value adjustment, making the following entry that reverses the 2011 entry:


On the income statement, the $25,000 will be shown as an OTT impairment loss. OCI will be increased by the $10,000 reclassification, such that the net effect on comprehensive income is $15,000.

December 31, 2013:

Subsequent to recording the OTT impairment, Kettle continues to treat the investment as AFS, but with an amortized cost of $25,000. Given an increase in fair value to $30,000 during 2013, Kettle records a $5,000 unrealized gain, with no effect on net income but an increase of $5,000 to OCI and comprehensive income:


Requirement 1

HTM investment, December 31, 2011Under IFRS, only credit losses are recognized as OTT impairments with respect to

HTM investments. Therefore, Flower would make the following journal entry to reduce the carrying value of the investment from its amortized cost of €1,000,000 to the present value of expected future cash flows (computed at the discount rate that applied when the investment was purchased) of €750,000:

Other-than-temporary impairment loss............... 250,000Investment in James bonds.............................. 250,000

Requirement 2

HTM investment, December 31, 2012Under IFRS, OTT impairments associated with debt investments can be recovered.

Therefore, Flower would record a reversal of OTT impairment to increase the carrying

12-49

Exercise 12-27


value of the James investment from €750,000 to €800,000 (the present value of expected future cash flows as of December 31, 2012, computed at the discount rate that applied when the investment was purchased):

Investment in James bonds................................. 50,000 Recovery of other-than-temporary impairment loss 50,000

Requirement 3

AFS debt investment, December 31, 2011Under IFRS, the entire difference between amortized cost and fair value is shown

as an OTT impairment with respect to an AFS investment. Therefore, Flower would make the following journal entry to reduce the carrying value of the investment from its amortized cost of €1,000,000 to fair value of €600,000:

Other-than-temporary impairment loss............... 400,000Investment in James bonds.............................. 400,000

12-50



Requirement 4: AFS debt investment, December 31, 2012

Under IFRS, OTT impairments associated with debt investments can be recovered. Therefore, Flower would record a reversal of OTT impairment to increase the carrying value of the James investment from €600,000 to its fair value of €875,000:

Investment in James bonds................................. 275,000 Recovery of other-than-temporary impairment loss 275,000

Requirement 5: AFS equity investment, December 31, 2012

Under IFRS, OTT impairments associated with equity investments cannot be recovered. Therefore, Flower would just view the increase in fair value as an unrealized gain, adjusting the carrying value of the investment and OCI to reflect the increase in fair value from €600,000 to €875,000:


Requirement 2

The specific citation that specifies the circumstances and conditions under which it is appropriate to account for investments as Held-to-Maturity is FASB ACS 320–10–25–4: “Investments—Debt and Equity Securities—Overall—Recognition—Circumstances Not Consistent with Held-to-Maturity Classification.”

Requirement 3

FASB ACS 320–10–25–4 reads as follows:

“An entity shall not classify a debt security as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. Consequently, a debt security shall not, for example, be classified as held-to-maturity if the entity anticipates that the security would be available to be sold in response to any of the following circumstances:

a. Changes in market interest rates and related changes in the security's prepayment risk

12-51

Exercise 5-28


b. Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims)

c. Changes in the availability of and the yield on alternative investments

d. Changes in funding sources and terms

e. Changes in foreign currency risk.”

The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:

1. Unrealized holding gains for trading securities should be included in earnings: FASB ACS 320–10–35–1a: “Investments—Debt and Equity Securities—Overall—Subsequent Measurement—General.”

2. Under the equity method, the investor accounts for its share of the earnings or losses of the investee in the periods they are reported by the investee in its financial statements: FASB ACS 323–10–35–4: “Investments—Equity Method and Joint Ventures—Overall—Subsequent Measurement—General.”

3. Transfers of securities between categories shall be accounted for at fair value: FASB ACS 320–10–35–10: “Investments—Debt and Equity Securities—Overall—Subsequent Measurement—General.”

4. Disclosures for available-for-sale securities should include total losses for securities that have net losses included in accumulated other comprehensive income: FASB ACS 320–10–50–2: “Investments—Debt and Equity Securities—Overall—Disclosure—Securities Classified as Available for Sale.”

12-52

Exercise 5-29


CPA / CMA REVIEW QUESTIONS

1. d. Sales price (2,000 shares x $14) $28,000Less: Brokerage commission (1,400)Net Proceeds $26,600Less: Cost of investment (31,500)Realized loss on trading security $(4,900)

If these securities had been categorized as available-for-sale, the total loss of $4,900 would have been recognized in net income. The prior year's unrealized holding loss would not have been included (recognized) in earnings (net income), but rather would have been reported as an element of other comprehensive income. A reclassification adjustment for the unrealized holding loss ($2,000) would also be included in other comprehensive income to remove it from the balance sheet and report it in income.

Note: The question asks for realized loss. This is defined as the net cash proceeds from sale minus the original cost of the investment. That realized loss was recognized over two accounting periods: Year 4 (unrealized loss) and Year 5 (realized, due to sale). Be careful when answering these questions: watch for the difference between loss realized and loss recognized.

12-53

CPA Exam Questions


CPA Review Questions (continued)

2. a. Marketable equity securities (equity securities with readily determinable fair values) are categorized as either trading securities (which are classified as current assets) or available-for-sale securities (which are classified as current or noncurrent assets), as appropriate. Because Lark’s investments are long-term, they are categorized as available-for-sale securities.

Available-for-sale securities are reported at fair value with unrealized holding gains and losses reported in other comprehensive income and included in the balance of accumulated other comprehensive income reported in equity. The unrealized holding gain included in other comprehensive income for 2011 would be $60,000 ($240,000 current fair value vs. $180,000 prior period fair value). The net unrealized holding gain, included in the accumulated other comprehensive income as of December 31, 2011 is $40,000 ($60,000 current period unrealized holding gain less $20,000 prior period unrealized holding loss). Alternative calculation shown below.

Net unrealized holding gains at December 31, 2011: Fair value at December 31, 2011 $240,000 Cost (200,000 ) Net unrealized holding gain $ 40,000

3. d. $116,250.

LT investments in marketable equity securities at fair value $ 96,450Plus: Net unrealized holding gains and losses on

long-term marketable equity securities 19,800Cost of LT investments in marketable equity securities $116,250

Unrealized holding gains and losses on the non-current portfolio of investments in marketable equity securities (categorized as available-for-sale securities) are reported in other comprehensive income and included in the balance of accumulated other comprehensive income reported in stockholders' equity.

12-54


CPA Review Questions (continued)

4. d. Since the decline in value occurred in 2010, the available-for-sale security was reduced to fair value with a related unrealized holding loss reported in other comprehensive income in 2010. In 2011, the asset continues to be carried at the same net value but the unrealized holding loss in accumulated other comprehensive income is removed and recognized as a loss in the determination of net income since the decline is considered to be permanent. The recognition of the loss (write-down to fair value) establishes a new cost basis which will not be changed for subsequent recoveries in fair value. However, subsequent unrealized holding gains and losses will be reported in other comprehensive income.

5. d. Neither a change in fair value of investee's common stock nor cash dividends from investee affect the investor's reported investment income (equity in earnings of investee) under the equity method. Under the equity method, cash dividends would be charged against (reduce) the investment account and have no effect on income. A change in the fair value of the investee's common stock would not be recorded under the equity method unless the change were judged a permanent and substantial decline, and then the decline would be charged to a loss account rather than investment income. These rules do not apply to investments accounted for under the equity method.

6. c. The entries should have been:

Investment in affiliate (40% x 20,000) 8,000Equity in earnings of affiliate 8,000

Cash (40% x $5,000) 2,000Investment in affiliate 2,000

By erroneously recognizing the $2,000 dividend as revenue, retained earnings are overstated. The dividends should have been booked as a reduction of the investment; thus the investment is overstated.

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CPA Review Questions (concluded)

7. b. Under the equity method, the investor should reflect adjustments which would be made in consolidation, based on the investor's percentage ownership, if such adjustment (eliminations) can be recorded between investment income and the investment account. The fair value of the FIFO inventory in excess of the carrying value would reduce net income of the investee, therefore, the investor would charge investment income and credit the investment account to reflect the decrease in income. The fair value of the land in excess of its carrying value would not affect income as it is not a depreciable asset. No adjustment would be made relative to the land.

8. a. $435,000. The equity method of accounting for investments in common stock should be used if the investor has significant influence over the operating and financial policies of the investee. Well Company's significant influence is demonstrated by its officers being a majority of the investees' board of directors.

Original cost of investment $400,000Add: Share of income subsequent to acquisition 10% x $500,000 50,000Less: Dividend of investee 10% x $150,000 (15,000)

$435,000

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1. c. According to GAAP, available-for-sale securities are investments in debt securities that are not classified as held-to-maturity or trading securities and in equity securities with readily determinable fair values that are not classified as trading securities. They are measured at fair value in the balance sheet.

2. b. Available-for-sale securities include (1) equity securities with readily determinable fair values that are not classified as trading securities and (2) debt securities that are not classified as held-to-maturity or trading securities. Unrealized holding gains and losses are measured by the difference between the amortized cost and fair value, excluded from earnings, and reported in other comprehensive income. The balance is reported net of the tax effect (ignored in this question). Thus, the difference at May 31, year 3 is $8,005 ($643,500 fair value – $635,495 amortized cost). This unrealized gain is reported as a credit to accumulated other comprehensive income.

3. d. Debt securities that the company has the positive intent and ability to hold to maturity are classified as held-to-maturity. Held-to-maturity securities are reported at amortized cost. Any unrealized gains or losses are not recognized.

12-57

CMA Exam Questions


PROBLEMS Requirement 1 ($ in millions)

Investment in bonds (face amount)........................ 80Discount on bond investment (difference)......... 14Cash (price of bonds).......................................... 66

Requirement 2 Cash (4% x $80 million).......................................... 3.20Discount on bond investment (difference)............ .10

Interest revenue (5% x $66).................................... 3.30


Interest revenue (5% x [$66 + 0.1])........................ 3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2011, balance sheet at its amortized cost – that is, its book value:

Investment in bonds............................................................ $80.00Less: Discount on bond investment ($14 –.1 –.11 million) 13 .79

Amortized cost................................................................ $66.21

Increases and decreases in the fair value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant if sale before maturity isn’t an alternative. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet.

12-58

Problem 12-1


Problem 12-1 (concluded)

Requirement 5

Fuzzy Monkey’s 2011 statement of cash flows would be affected as follows:

Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – $6.61 = ($0.21) to get from net income to cash from operations.)

Investing cash flows: Cash outflow from purchasing investments of $66.







Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2011, balance sheet at its fair value, $70 million in this case. For investments in trading securities, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.

To do this, we first need to determine the investment’s amortized cost (or book value) at the end of the year:

12-59

Problem 12-2



Amortized cost................................................................ $66.21

Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million:

Fair value adjustment......................................... 3.79Net unrealized holding gains and losses—I/S ($70 – 66.21) 3.79

Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2011 income statement.

12-60



Requirement 5


Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 and an unrealized holding gain of $3.79 included in net income, totaling $10.4, so would have to include an adjustment of $6.4 – $10.4 = ($4.0) to get from net income to cash from operations.)

Fuzzy Monkey would also be likely to treat the cash outflow from purchasing trading securities of $66 as an operating cash flow.







Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2011, balance sheet at its fair value, $70 million in this case. For investments in securities available-for-sale, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.

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Problem 12-3


To do this, we first need to determine the investment’s amortized cost (or book value) at the end of the year:


Amortized cost................................................................ $66.21

Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million:

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

Because these are available-for-sale securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2011 other comprehensive income, and serve to increase the accumulated other comprehensive income shown in shareholders’ equity.

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Requirement 5


Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – $6.61 = ($0.21) to get from net income to cash from operations.)

Investing cash flows: Cash outflow from purchasing investments of $66.

Note: Because Fuzzy Monkey elected the fair value option, these investments will be reclassified as trading securities and accounted

for under that approach. Therefore, the answers to Requirements 1-5 are the same as those to Problem 12-2.

Requirement 1 ($ in millions)Investment in bonds (face amount)........................ 80

Discount on bond investment (difference)......... 14Cash (price of bonds).......................................... 66





12-63

Problem 12-4


Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2011, balance sheet at its fair value, $70 million in this case. For investments in trading securities, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.

To determine the journal entry that Fuzzy Monkey must make, we first need to determine the investment’s amortized cost (or book value) at the end of the year:


Amortized cost................................................................ $66.21

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Problem 12-4 (concluded)Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million:

Fair value adjustment......................................... 3.79Net unrealized holding gains and losses—I/S ($70 – 66.21) 3.79

Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2011 income statement.

Requirement 5


Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have included in net income interest revenue of $3.30 + $3.31 = $6.61 and an unrealized holding gain of $3.79, totaling $10.4, so would have to include an adjustment of $6.4 – $10.4 = ($4.0) to get from net income to the correct operating cash flow.)

Fuzzy Monkey would also be likely to treat the cash outflow from purchasing trading securities of $66 as an operating cash flow. However, if Fuzzy Monkey anticipate holding these investments for a sufficiently long period, it could classify this cash outflow as an investing cash flow.

Requirement 6

The answers to requirements 1-5 would not differ if the investment qualified for treatment as a held-to-maturity investment, because Fuzzy Monkey’s choice of the fair value option still requires reclassification of the investment as trading securities.

Requirement 1

2011February 21

Investment in Distribution Transformers shares ......... 400,000Cash.......................................................................... 400,000

12-65

Problem 12-5


March 18Cash.............................................................................. 8,000

Investment revenue.................................................. 8,000

September 1Investment in American Instruments bonds ................ 900,000

Cash.......................................................................... 900,000

October 20Cash.............................................................................. 425,000

Investment in Distribution Transformers ............... 400,000Gain on sale of investments..................................... 25,000

November 1Investment in M&D Corporation shares ..................... 1,400,000

Cash.......................................................................... 1,400,000

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Problem 12-5 (continued)

December 31Adjusting entries:

Investment revenue receivable..................................... 30,000Investment revenue ($900,000 x 10% x 4/12)............... 30,000

AccumulatedUnrealized

Available-for-Sale Securities Cost Fair Value Gain (Loss) M & D Corporation shares $1,400,000 $1,460,000 $60,000American Instruments bonds 900,000 850,000 (50,000 ) Totals – Dec. 31, 2011 $2,300,000 $2,310,000 $10,000*

Fair value adjustment (calculated above)......................... 10,000Net unrealized holding gains and losses–OCI......... 10,000*

* The $10,000 credit balance in the net unrealized holding gain is reported as 2011 Other comprehensive income in the statement of comprehensive income. It serves to increase Accumulated other comprehensive income, a component of Shareholders’ equity in the 2011 balance sheet.

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Requirement 2 Income statement:

Investment revenue ($8,000 + 30,000) $ 38,000Gain on sale of investments 25,000

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

Statement of comprehensive income*:Net unrealized holding gains and losses on investments $ 10,000

Balance sheet:Current AssetsInvestment revenue receivable $ 30,000

Securities available-for-sale $2,300,000Plus: Fair value adjustment 10,000 $2,310,000

Shareholders’ EquityAccumulated other comprehensive income

Net unrealized holding gain (loss) ($60,000 – 50,000) $ 10,000

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

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Requirement 3

2012January 20

Cash.............................................................................. 1,485,000Gain on sale of investments (to balance).................... 85,000Investment in M&D Corporation shares (cost)......... 1,400,000

March 1Cash.............................................................................. 45,000

Investment revenue receivable................................. 30,000Investment revenue.................................................. 15,000

August 12Investment in Vast Communications shares ............... 650,000

Cash.......................................................................... 650,000

September 1Cash.............................................................................. 45,000

Investment revenue.................................................. 45,000

12-69



December 31Adjusting entries:Investment revenue receivable..................................... 30,000

Investment revenue ($900,000 x 10% x 4/12)............... 30,000

AccumulatedUnrealized

Securities Cost Fair Value Gain (Loss) Vast Communication shares $650,000 $670,000 $20,000American Instruments bonds 900,000 830,000 (70,000 ) Totals – Dec. 31, 2012 $1,550,000 $1,500,000 $(50,000)*

Moving from a positive $10,000 (2011) to a negative $50,000 requires a decrease of $60,000:

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

Net unrealized holding gains and losses—OCI........... 60,000* Fair value adjustment (calculated above)................... 60,000

* The $60,000 debit balance in the net unrealized holding gains and losses is reported as 2012 Other comprehensive income in the statement of comprehensive income. It serves to decrease Accumulated other comprehensive income, a component of Shareholders’ equity in the 2012 balance sheet, from the $10,000 credit balance it showed on the 2011 balance sheet to the $50,000 debit balance it shows in the 2012 balance sheet.

12-70


Balance needed in fair value adjustment ($50)Existing balance in fair value adjustment: $10

Increase (decrease) needed in fair value adjustment: ($60)



Requirement 4 Income statement:

Investment revenue ($15,000 + 45,000 + 30,000) $ 90,000Gain on sale of investments 85,000

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

Statement of comprehensive income*:Net unrealized holding gains and losses on investments $ (60,000)

Balance sheet:Current AssetsInvestment revenue receivable $ 30,000

Securities available-for-sale $1,550,000Less: Fair value adjustment (50,000 ) $1,500,000

Shareholders’ EquityAccumulated other comprehensive income

Net unrealized holding gain (loss) ($20,000 – 70,000) $ (50,000)

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

Requirement 1

2011December 12 ($ in millions)

Investment in FF&G Corporation bonds ..................................... 12Cash.......................................................................................... 12

December 13Investment in Ferry common shares ............................................ 22

Cash.......................................................................................... 22

12-71

Problem 12-6


December 15Cash.............................................................................................. 12.1

Investment in FF&G Corporation bonds ................................. 12.0Gain on sale of investments ($12.1 – 12).................................... 0.1

December 22Investment in U.S. Treasury bills ................................................ 56Investment in U.S. Treasury bonds .............................................. 65

Cash.......................................................................................... 121

December 23Cash.............................................................................................. 10 Loss on sale of investments ($10 – 11)........................................... 1

Investment in Ferry common shares ($22 x 1/2)......................... 11

December 26Cash (selling price).......................................................................... 57

Gain on sale of investments ($57 – 56)....................................... 1Investment in U.S. Treasury bills (account balance).................... 56

December 27Cash (selling price).......................................................................... 63 Loss on sale of investments ($63 – 65)........................................... 2

Investment in U.S. Treasury bonds (account balance)................. 65

12-72



December 28Cash.............................................................................................. 0.2

Investment revenue................................................................... 0.2

December 31($ in millions)

Adjusting entry:Net unrealized holding gains and losses—I/S

($10 million – [$22 million x 1/2])................................................... 1.0Fair value adjustment................................................................ 1.0

Closing entry:Income summary (to balance)......................................................... .7Investment revenue ($5 + 0.2 million).............................................. 5.2Gain on sale of investments ($8 + 0.1 + 1 million)........................... 9.1

Loss on sale of investments ($11 + 1 + 2 million)........................ 14.0Net unrealized holding gains and losses—I/S (adjusting entry)... 1.0

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


Balance sheet (short-term investment):Trading Securities............................... 11Less: Fair value adjustment................. (1 ) Total..................................................... 10

Income statement:Investment revenue (closing entry) 5.2Gain on sale of investments (closing entry) 9.1Loss on sale of investments (closing entry) (14.0)Net unrealized holding gains and losses on investments (closing entry) (1.0)

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Requirement 3

2012January 2

($ in millions)Cash (selling price).......................................................................... 10.2Loss on sale of investments (to balance) ........................................ 0.8

Investment in Ferry common (account balance)........................... 11.0

Assuming no other transactions involving trading securities, the 2012 adjusting entry to remove the fair value adjustment associated with the sold securities would be:

December 31Fair value adjustment (account balance)...................................... 1.0

Net unrealized holding gains and losses—I/S.......................... 1.0

January 5Investment in Warehouse Designs bonds .................................... 34

Cash.......................................................................................... 34

2011($ in millions)

October 18Investment in Millwork Ventures preferred shares ..................... 58

Cash.......................................................................................... 58

October 31Cash.............................................................................................. 1.5


November 1Investment in Holistic Entertainment bonds................................. 18

Cash.......................................................................................... 18

12-74

Problem 12-7


November 1Cash.............................................................................................. 28 Loss on sale of investments ($28 – 30)........................................... 2

Investment in Kansas Abstractors bonds ................................. 30

December 1Investment in Household Plastics bonds...................................... 60

Cash.......................................................................................... 60

December 20Investment in U.S. Treasury bonds .............................................. 5.6

Cash.......................................................................................... 5.6

December 21Investment in NXS common shares ............................................ 44

Cash.......................................................................................... 44

December 23Cash.............................................................................................. 5.7

Investment in U.S. Treasury bonds .......................................... 5.6Gain on sale of investments ($5.7 – 5.6)..................................... .1

12-75


Problem 12-7 (continued)($ in millions)

December 29Cash.............................................................................................. 3

Investment revenue................................................................ 3

December 31Accrued interest:Investment revenue receivable - Holistic Entertainment ($18 million x 10% x 2/12)....................................... 0.3Investment revenue receivable - Household Plastics ($60 million x 12% x 1/12).................................................. 0.6

Investment revenue ............................................................... 0.9

Revaluations:Net unrealized holding gains and losses—OCI ([2 million shares of Millwork Ventures x $27.50] – $58 million).......... 3

Fair value adjustment ............................................................ 3

Fair value adjustment ................................................................... 2Net unrealized holding gains and losses—I/S

([4 million shares of NXS x $11.50] – $44 million)........................ 2

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

Closing entry:Net unrealized holding gains and losses—I/S (NXS).................... 2.0Investment revenue ($3.0 + 1.5 + .9)............................................... 5.4Gain on sale of investments (U.S. Treasury bonds).......................... .1

Loss on sale of investments (Kansas Abstractors)...................... 2.0Income summary (to balance)................................................... 5.5

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

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2012January 7

Cash.............................................................................................. 43 Loss on sale of investments (to balance)......................................... 1

Investment in NXS common shares (account balance)................ 44

Assuming no other transactions involving trading securities, the 2012 adjusting entry to remove the fair value adjustment associated with the sold securities would be:

December 31Net unrealized holding gains and losses—I/S.............................. 2.0

Fair value adjustment (account balance).................................. 2.0

Requirement 1

Beale should report its securities available-for-sale in its December 31, 2012, balance sheet at their fair value, $54 million.

Requirement 2

The journal entry needed to enable the investment to be reported at fair value is:

($ in millions)Fair value adjustment ($4 debit to $5 debit) 1

Net unrealized holding gains and losses–OCI ($4 credit to $5 credit) 1

Requirement 3

As of December 31, 2011, the cost of the Schwab Pharmaceuticals investment was $25 million and its fair value was $27 million. Therefore, in the year-end 2011 adjustment process, Beale must have made whatever adjustment was necessary to produce a debit balance of $2 in the fair value adjustment valuation allowance for Schwab Pharmaceuticals and a credit balance of that amount in accumulated other comprehensive income. Because the Schwab Pharmaceuticals investment was sold during 2012, the reclassification adjustment would have to remove that amount in 2012. Beale’s statement of comprehensive income can be provided as (a) an extension of its income statement, (b) as part of its statement of shareholders’ equity, or (c) in a disclosure note in a manner similar to this:

12-77

Problem 12-8


STATEMENT OF COMPREHENSIVE INCOME($ in millions)Net income.............................................. $xxxOther comprehensive income:

Unrealized holding gains (losses) on investments $ 3Reclassification adjustment of prior years’ unrealized gain included in 2012 net income (2 )

Net unrealized holding gains (losses) 1Comprehensive income $xxx

12-78



Comprehensive income includes both net income and other comprehensive income. Net income in 2012 includes the $3 million gain realized from selling the Schwab shares. However, $2 million of that gain already has been reported in comprehensive income – as an unrealized holding gain in a prior year or years when the shares’ value increased from $25 million to $27 million. To avoid double-counting, Beale must compensate by reducing comprehensive income by the $2 million portion of the 2012 realized gain that already has been reported. That’s what the reclassification adjustment does; it reduces this year’s comprehensive income by the amount that was reported previously to keep it from being reported twice. For there to be a total increase in AOCI of $1 million (from $4 million to $5 million), and the reclassification serving to reduce AOCI by $2 million, $3 million of unrealized holding gains must have occurred during 2012.

Requirement 1

Purchase ($ in millions)Investment in Lavery Labeling shares.......................................... 324

Cash ......................................................................................... 324

Net incomeInvestment in Lavery Labeling shares (30% x $160 million) .......... 48

Investment revenue................................................................... 48

DividendsCash (10 million shares x $2)............................................................. 20

Investment in Lavery Labeling shares...................................... 20

Depreciation adjustment

Investment revenue ([$80 million x 30%] ÷ 6 years) ‡...................... 4Investment in Lavery Labeling shares...................................... 4

12-79

Problem 12-9


‡Calculations:


Cost $324

Goodwill: $60

Fair value: $880* x 30% =$264

UndervaluationBook value: $800 x 30% =$240 of depr. assets: $24

*[$800 + 80] = $880

Adjusting entryNo entry to recognize changes in the fair value of the Lavery investment, as Runyan is accounting for its investment under the equity method.

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Requirement 2


Cash ......................................................................................... 324

Net incomeNo entry



Adjusting entryNet unrealized holding gains and losses–OCI ([10 million shares x $31] – $324 million)................................................. 14

Fair value adjustment................................................................ 14

Requirement 1


Cash ......................................................................................... 324

Net incomeNo entry



Adjusting entryNet unrealized holding gains and losses—I/S ([10 million shares x $31] – $324 million).................................................. 14


12-81

Problem 12-10


Requirement 2

Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2011 net income. Therefore, total effect on net income would be $20 million – 14 million, or $6 million.

Requirement 1 (note: requirement 1 has the same answer as does P 12-10)


Cash ......................................................................................... 324

Net incomeNo entry



Adjusting entryNet unrealized holding gains and losses—I/S ([10 million shares x $31] – $324 million)................................................. 14


Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2011 net income. Therefore, total effect on net income would be $20 of dividend – $14 of unrealized holding loss, or $6. The investment would be shown in the balance sheet at its fair value of $310.

12-82

Problem 12-11



Requirement 2


Cash ......................................................................................... 324

Net incomeInvestment in Lavery Labeling shares (30% x $160 million) .......... 48



Investment in Lavery Labeling shares...................................... 20


Investment revenue ([$80 million x 30%] ÷ 6 years) ‡....................... 4Investment in Lavery Labeling shares...................................... 4

‡Calculations:


Cost $324

Goodwill: $60

Fair value: $880* x 30% =$264

UndervaluationBook value: $800 x 30% =$240 of depr. assets: $24

*[$800 + 80] = $880

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Note: After the preceding journal entries are recorded, the balance in the Lavery Labeling investment account would be:

Investment in Lavery Labeling shares__________________________________________

($ in millions)Cost 324Share of income 48

20 Dividends4 Depreciation adjustment

_________________Balance 348

At December 31, 2011, the fair value of that investment is $310 (= 10 million shares x $31/share), implying need for the following adjusting entry to adjust the carrying value of the investment to fair value:

Net unrealized holding gains and losses—I/S ([10 million shares x $31] – $348 million)................................................. 38


Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2011 net income. Therefore, total effect on net income would be $48 million for Runyan’s share of Lavery income minus $4 million of depreciation adjustment and minus the $38 million unrealized holding loss, yielding a total of $6 of income. The investment would be shown in the balance sheet at its fair value of $310 million.

Note that the income effect and the carrying value in the balance sheet are the same in requirements 1 and 2.

Requirement 1

Purchase ($ in millions)Investment in Vancouver T&M shares......................................... 400.0

Cash ......................................................................................... 400.0

12-84

Problem 12-12


Net incomeInvestment in Vancouver T&M shares (40% x $140 million) ......... 56.0


DividendsCash (40% x $30 million).................................................................. 12.0

Investment in Vancouver T&M shares..................................... 12.0

Inventory adjustmentInvestment revenue ($5 million x 40%: all sold in 2011).................... 2.0

Investment in Vancouver T&M shares..................................... 2.0


Investment revenue ([$20 million x 40%] ÷ 16 years) ‡..................... .5Investment in Vancouver T&M shares..................................... .5

‡Calculations:Investee Net Assets Difference


Cost $400

Goodwill: $80 [plug]

Fair value: $800* x 40% =$320

inventory (5) x 40% Undervaluationof inventory: $2

plant facilities (20 ) x 40% Undervaluationof plant: $8

Book value: $775 x 40% = $310

* $775 +5 +20

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Requirement 2

Investment Revenue ($ in millions)

56.0 Share of incomeInventory 2.0Depreciation .5

_________________Balance 53 .5

Requirement 3

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

Cost 400.0Share of income 56.0

12.0 Dividends2.0 Inventory.5 Depreciation

_________________Balance 441 .5

Requirement 4 $400 million cash outflow from investing activities $12 million cash inflow (dividends) among operating activities (Note: if Northwest uses the indirect method to report its operating cash flows, it would need an adjustment of ($41.5) to get from the $53.5 included as investment revenue in net income to the $12 of cash actually received in dividends and needing to be shown in cash from operations.)

Requirement 1

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Problem 12-13


Miller’s management should decide whether it has the ability to exercise significant influence over operating and financial policies of the Marlon Company. Ability to exercise significant influence is presumed for investments of 20 percent or more of voting stock and presumed not to exist for investments of less than 20 percent, other things being equal. Evidence to the contrary should be considered, including participation on the board of directors, technological dependency, material intercompany transactions, or interchange of managerial personnel.

Requirement 2

a. Income statement: ($ in millions)

Investment revenue ($12 million x 1/6) $2.0

Patent amortization adjustment ($4 million* ÷ 10) ( .4) *([$24 million] x 1/6])

$1 .6

b. Balance sheet:Investment in Marlon Company ($19 million + 2 million – 1 million – 0.4 million) $19 .6*

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*Investment in Marlon Company ($ in millions)

Cost 19.0Share of income 2.0

1.0 Dividends ($6 million x 1/6).4 Amortization adjustment

_________________Balance 19 .6

c. Statement of cash flows: $19 million cash outflow from investing activities $1 million cash inflow (dividends) among operating activities (Note: if Marlon uses the indirect method to report its operating cash flows, it would need an adjustment of ($0.6) to get from the $1.6 included as investment revenue in net income to the $1 of cash actually received in dividends and needing to be shown in cash from operations.)

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Item Reporting Category

__A_ 1. 35% of the nonvoting preferred stock T. Trading securities of American Aircraft Company M. Securities held-to-maturity

__M_ 2. Treasury bills to be held-to-maturity A. Securities available-for-sale __M_ 3. Two-year note receivable from affiliate E. Equity method __N_ 4. Accounts receivable C. Consolidation__M_ 5. Treasury bond maturing in one week N. None of these

__T_ 6. Common stock held in trading account for immediate resale.

__T_ 7. Bonds acquired to profit from short-term differences in price.__E_ 8. 35% of the voting common stock of Computer Storage Devices Company.__C_ 9. 90% of the voting common stock of Affiliated Peripherals, Inc.__A_10. Corporate bonds of Primary Smelting Company to be sold if interest rates

fall 1/2%.__A_11. 25% of the voting common stock of Smith Foundries Corporation: 51%

family-owned by Smith family; fair value determinable.__E_12. 17% of the voting common stock of Shipping Barrels Corporation:

Investor’s CEO on the board of directors of Shipping Barrels Corporation.

Requirement 1

Bond Fair Value at 1/1/2011:Interest [($150,000 x 6%) / 2] x 14.21240 * = $ 63,956Principal $150,000 x 0.50257 ** = 75,386 Present value of the receivable $139,342

* present value of an ordinary annuity of $1: n=20, i=3.5% (=7% ÷ 2) (from Table 4)** present value of $1: n=20, i=3.5% (=7% ÷ 2) (from Table 2)

January 1, 2011Investment in bonds (face amount)........................ 150,000

Discount on bond investment (difference)......... 10,658Cash (price of bonds).......................................... 139,342

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Problem 12-14

Problem 12-15


Requirement 2



June 30, 2011Cash [(150,000 x 6%) / 2]........................................ 4,500Discount on bond investment (difference)............ 377

Interest revenue [($150,000 – 10,658) x 7%] / 2 . . 4,877

December 31, 2011Cash (6% / 2 x $150,000)........................................ 4,500Discount on bond investment (difference)............ 390

Interest revenue [{$150,000 – ($10,658 – 377)} x 7%] / 2 4,890

Note: For held-to-maturity investments, there are no adjustments to fair value.

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Requirement 3



June 30, 2011Cash ($150,000 x 6%) / 2 ....................................... 4,500Discount on bond investment (difference)............ 377

Interest revenue [($150,000 – 10,658) x 7%] / 2 . 4,877

Bond Fair Value at June 30, 2011:Interest [($150,000 x 6%) / 2] x 13.13394 * = $ 59,103Principal $150,000 x 0.47464 ** = 71,196 Present value of the receivable $130,299

*present value of an ordinary annuity of $1: n=19, i=4% (=8% ÷ 2) (from Table 4)**present value of $1: n=19, i=4% (=8% ÷ 2) (from Table 2)

January 1 initial cost $139,342 Increase from discount amortization 377June 30 amortized initial cost $139,719

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value.

June 30 amortized initial cost $139,719June 30 fair value 130,299

Fair value adjustment needed $ 9,420

Net unrealized holding gains and losses—I/S ............................ 9,420 Fair value adjustment........................................................... 9,420

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December 31, 2011Cash ($150,000 x 6%) / 2....................................... 4,500Discount on bond investment (difference)............ 390

Interest revenue [{$150,000 – ($10,658 – 377)} x 7%] / 2 4,890

Bond Fair Value at December 31, 2011:Interest [($150,000 x 6%) / 2] x 12.15999 * = $ 54,720Principal $150,000 x 0.45280 ** = 67,920 Present value of the receivable $122,640

* present value of an ordinary annuity of $1: n=18, i=4.5% (=9% ÷ 2) (from Table 4)** present value of $1: n=18, i=4.5% (=9% ÷ 2) (from Table 2)

June 30 amortized initial cost $139,719 Increase from discount amortization 390Dec. 31 amortized initial cost $140,109

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value.

Dec. 31 amortized initial cost $140,109 Dec. 31 fair value 122,640Fair value adjustment balance needed: debit/(credit) $ 17,469

Less: Current fair value adjustment debit/(credit) (9,420 ) Change in fair value adjustment needed $ 8,049

Net unrealized holding gains and losses—I/S ............................ 8,049 Fair value adjustment........................................................... 8,049

Bee Company Investment

2011: Stewart does not plan to sell the Bee investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is relevant. Stewart must recognize the $240,000 of credit losses as an OTT impairment in earnings, and the other $260,000 as a reduction of OCI, as follows:

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Problem 12-16


Other-than-temporary impairment loss – I/S...... 240,000Discount on bond investment.......................... 240,000

OTT impairment loss – OCI .............................. 260,000Fair value adjustment – Non-credit loss.......... 260,000

2012: Stewart ignores the change in Bee’s fair value during 2012, as the Bee investment is accounted for as an HTM investment and fair value changes are not relevant unless viewed as OTT impairments. GAAP does not allow recovery of prior OTT impairments when fair value increases. Over the remaining life of the bonds, Stewart would amortize the bonds as if they had a $240,000 discount. Stewart also would amortize the $260,000 of “Fair value adjustment – Non-credit loss” in AOCI over the remaining life of the bonds by crediting that account and debiting “Fair value adjustment – non-credit loss” for a portion each period, thus gradually decreasing the amount shown in AOCI and increasing the carrying amount of the bonds.

Oliver Corporation Investment

2011: Stewart accounts for the Oliver investment as a trading security, so OTT impairment accounting is not relevant. Stewart simply continues to recognize in earnings any unrealized gains and losses associated with fair value changes. Given that the bonds already have a negative fair value adjustment of $200,000, and need a negative fair value adjustment of $300,000 to adjust from amortized cost of $2,500,000 to fair value of $2,200,000, Stewart must recognize additional unrealized losses of $100,000 for 2011.

Net unrealized holding gains and losses—I/S......... 100,000Fair value adjustment........................................... 100,000

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2012: Fair value increased to $2,700,000 during 2012, so Stewart needs to have a positive fair value adjustment of $200,000 on the balance sheet to adjust from amortized cost of $2,500,000 to fair value of $2,700,000. Therefore, Stewart must recognize an unrealized gain $500,000 for 2012, moving the fair value adjustment from a negative $300,000 to a positive $200,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for a TS investment.

Fair value adjustment......................................... 500,000Net unrealized holding gains and losses—I/S 500,000

Jones, Inc Investment

2011: Stewart does not plan to sell the Jones investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and non-credit losses is relevant. Stewart must recognize the $225,000 of credit losses as an OTT impairment in earnings, and the other $575,000 as a reduction of OCI, as follows:

Other-than-temporary impairment loss – I/S..... 225,000Investment in Jones bonds............................... 225,000


Stewart also must reclassify the previously recognized $400,000 unrealized loss out of OCI and the fair value adjustment:


Note that Stewart could net the latter two journal entries together to be:


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However, Stewart still would need to show on the face of the income statement the total OTT impairment of $800,000 less the $575,000 in OCI, yielding a $225,000 reduction in earnings.

2012: Stewart continues to treat the Jones investment as AFS. Therefore, Stewart would show an unrealized gain associated with an increase of fair value from $2,700,000 to $2,900,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for an AFS investment. The amount of credit loss and non-credit loss is not relevant to this subsequent accounting.


Helms Corp. Investment

2011: Because the Helms Corp. investment is equity, Stewart bases the OTT impairment on the entire difference between amortized cost and fair value.

Other-than-temporary impairment loss............... 400,000Investment in Helms equity............................. 400,000

Stewart also must reclassify the previously recognized $120,000 unrealized gain out of OCI and the fair value adjustment:


2012: Stewart continues to treat the Helms investment as AFS. Therefore, Stewart would show an unrealized gain associated with an increase of fair value from $600,000 to $700,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for an AFS investment.


Bee Company Investment

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Problem 12-17


2011: Under IFRS only the credit loss component is relevant for debt impairments. Therefore, Stewart recognizes the $240,000 of credit losses as an OTT impairment in earnings, as follows:

Other-than-temporary impairment loss.............. 240,000Discount on bond investment.......................... 240,000

2012: IFRS allows recovery of OTT impairments on debt investments. Therefore, Stewart would record a reversal of OTT impairment in earnings to increase the carrying value of the Bee investment to the level indicated by a $140,000 credit loss.

Discount on bond investment.............................. 100,000 Recovery of other-than-temporary impairment loss—I/S 100,000

Oliver Corporation Investment

2011: Stewart accounts for the Oliver investment as a trading security, which under IFRS would be called “Fair value through profit and loss”, so OTT impairment accounting is not relevant. Stewart simply continues to recognize in earnings any unrealized gains and losses associated with fair value changes. Given that the bonds already have a negative fair value adjustment of $200,000, and need a negative fair value adjustment of $300,000 to adjust from amortized cost of $2,500,000 to fair value of $2,200,000, Stewart must recognize additional unrealized losses of $100,000 for 2011.

Net unrealized holding gains and losses—I/S......... 100,000Fair value adjustment........................................... 100,000

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2012: Fair value increased to $2,700,000 during 2012, so Stewart needs to have a positive fair value adjustment of $200,000 on the balance sheet to adjust from amortized cost of $2,500,000 to fair value of $2,700,000. Therefore, Stewart must recognize an unrealized gain $500,000 for 2012, moving the fair value adjustment from a negative $300,000 to a positive $200,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for a “Fair value through profit and loss” investment.

Fair value adjustment......................................... 500,000Net unrealized holding gains and losses—I/S 500,000

Jones, Inc Investment

2011: Given that this debt investment is AFS, IFRS bases the OTT impairment on fair value rather than on credit losses. Therefore, Stewart recognizes the entire $800,000 difference between amortized cost and fair value as an OTT impairment in earnings, as follows:

Other-than-temporary impairment loss.............. 800,000Investment in Jones bonds............................... 800,000

Stewart also must reclassify the previously recognized $400,000 unrealized loss out of OCI and the fair value adjustment:


2012: IFRS allows recovery of OTT impairments on debt investments. Therefore, Stewart would record a reversal of OTT impairment in earnings to increase the carrying value of the Jones investment to the fair value of $2,900,000.

Investment in Jones bonds.................................. 200,000 Recovery of other-than-temporary impairment loss—I/S 200,000

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Helms Corp. Investment

2011: Because the Helms Corp. investment is classified as AFS, Stewart bases the OTT impairment on the entire difference between amortized cost and fair value.

Other-than-temporary impairment loss............... 400,000Investment in Helms equity............................. 400,000

Stewart also must reclassify the previously recognized $120,000 unrealized gain out of OCI and the fair value adjustment:


2012: IFRS does not allow recovery of OTT impairments for equity investment. However, Stewart continues to treat the Helms investment as AFS, so Stewart would show an unrealized gain associated with an increase of fair value from $600,000 to $700,000. This is not a recovery of the OTT impairment, but just normal ongoing accounting for an AFS investment.


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CASES

Real World Case 12-1

Requirement 1 Fair Value Adjustment, AFS Investments

210 ($225 loss – 15 gain on 12/27/08)

change over first half of 2009 220____________

$138 gain – 128 loss on 6/27/09 10

Requirement 2

Intel needs to record unrealized holding gains and losses associated with its AFS investments during the first half of 2009:

Fair value adjustment, AFS investment.................. 223Net unrealized holding gains and losses—OCI 223

Requirement 3 Fair Value Adjustment, AFS Investments

210 $225 loss – 15 gain on 12/27/08

unrealized gains 2233 to balance

____________$138 gain – 128 loss on 6/27/09 10

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Case 12-1 (concluded)What could account for the unaccounted-for credit of $3? The most likely explanation is that there are reclassification adjustments for AFS investments that have been sold or for which OTT impairments have been recognized. If Intel had previously recognized an unrealized gain for some investments, it would have increased the fair value adjustment when it included that gain in OCI. If Intel sold or impaired those investments during the first half of 2009, a reclassification entry would reduce (credit) the fair value adjustment and OCI to remove those effects.

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

The footnote that describes an investment in securities “available-for-sale” may be headed by any one of a variety of captions or subsumed within another disclosure note. Likewise, the caption by which the investments are reported in the balance sheet can be reported separately as one of several asset titles or included within another asset caption.

Investments in securities available-for-sale will be reported as current or noncurrent assets depending on the intent of management regarding the timing of their eventual sale. Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported.

Investments in securities available-for-sale are reported at fair value. Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period. Rather, they are accumulated and reported as accumulated other comprehensive income, a separate component of shareholders’ equity. This means an unrealized holding gain would increase shareholders’ equity and an unrealized holding loss would decrease shareholders’ equity. Because unrealized gains or losses cause changes in shareholders’ equity, those changes are reported in the statement of shareholders’ equity. [Some companies may not provide a statement of shareholders’ equity and may provide a statement of retained earnings instead. Unrealized gains or losses have no effect on retained earnings.] By definition, securities available-for-sale are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings.

Cash outflows from acquiring these investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows unless trading securities are included in the operating activities section. Whether they

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Research Case 12-2


are specifically identifiable depends on the degree of detail the company uses in reporting its cash flows. Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds.

A disclosure note may provide information not available in the financial statements, in part dependent on how much information the financial statements provide. Often the footnote will indicate the cost of the securities.

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Trueblood Accounting Case 12-3

A solution and extensive discussion materials accompany each case in the Deloitte & Touche

Trueblood Case Study Series. These are available to instructors at:

www.deloitte.com/more/DTF/cases_subj.htm

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http://www.deloitte.com/view/en_US/us/index.htm


International Case 12-4

Requirement 1

Satisfied by going to http://www.iasplus.com/standard/ias28.htm.

Requirement 2

Renault’s decision appears appropriate, as the company has significant influence, but not control. Significant influence is indicated by a greater-than-20% equity stake and seats on the Nissan board. Lack of control is indicated by Renault not owning a majority of voting rights or board seats and not having full rights to use assets or the obligations with respect to liabilities.

Requirement 3

It is not surprising that Renault makes adjustments that take into account the fair value of Nissan’s assets and liabilities at the time Renault invested in Nissan. For example, if the fair value of Nissan’s fixed assets was greater than the book value of those assets on the date of Renault’s purchase, Renault would need to recognize additional depreciation over the life of those assets when applying the equity method. This is consistent with IFRS and also with U.S. GAAP.

Requirement 4

Renault’s harmonization adjustments are required by IFRS, which requires that, “if the associate uses accounting policies that differ from those of the investor, the associate's financial statements should be adjusted to reflect the investor's accounting policies for the purpose of applying the equity method.” [IAS 28.27]. U.S. GAAP has no such requirement.

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International Case 12-5

http://www.iasplus.com/standard/ias28.htm


Note 13, “Investments in joint ventures,” describes Vodafone’s accounting for their participation in joint ventures. Per Note 2, “A joint venture is a contractual arrangement whereby the Group and other parties undertake an economic activity that is subject to joint control; that is, when the strategic financial and operating policy decisions relating to the activities require the unanimous consent of the parties sharing control. The Group reports its interests in jointly controlled entities using proportionate consolidation. The Group’s share of the assets, liabilities, income, expenses and cash flows of jointly controlled entities are combined with the equivalent items in the results on a line-by-line basis.”

Note 14, “Investments in associated undertakings”, describes Vodafone’s accounting for their significant-influence investments. Per Note 2, “An associate is an entity over which the Group has significant influence and that is neither a subsidiary nor an interest in a joint venture. Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. The results and assets and liabilities of associates are incorporated in the consolidated financial statements using the equity method of accounting. Under the equity method, investments in associates are carried in the consolidated balance sheet at cost as adjusted for post-acquisition changes in the Group’s share of the net assets of the associate, less any impairment in the value of the investment. Losses of an associate in excess of the Group’s interest in that associate are not recognised. Additional losses are provided for, and a liability is recognised, only to the extent that the Group has incurred legal or constructive obligations or made payments on behalf of the associate. Any excess of the cost of acquisition over the Group’s share of the net fair value of the identifiable assets, liabilities and contingent liabilities of the associate recognised at the date of acquisition is recognised as goodwill. The goodwill is included within the carrying amount of the investment.”

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Research Case 12-6Answers to the questions will, of course, vary because students will research

financial statements of different companies. The responses should identify securities held that are classified as trading

securities, available-for-sale, or held-to-maturity. Although a company is not required to report individual amounts for the three categories of investments – held-to-maturity, available-for-sale, or trading – on the face of the balance sheet, that information should be presented in the disclosure notes. If securities available-for-sale are held, there may be unrealized gains or losses reported in the shareholders’ equity section of the balance sheet. Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as a separate component of shareholders’ equity.

Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities. There may also be gains or losses from the sale of investments during the year. There also will likely be investment revenue (dividends or interest) in the income statement.

The statement of cash flows will report acquisitions or disposals of investments as investing activities. Investment revenue is an operating activity.

Requirement 1

The 2008 balance sheet reports the following two current and one noncurrent asset categories ($ in millions):

2008 2007CURRENT ASSETS:

Cash and cash equivalents $4,368.3 $5,336.1

Short-term investments 1118.1 $2,894.7

NONCURRENT ASSETS: Investments $ 6,491.3 $7,159.2

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In the summary of significant accounting policies (Note 2), Merck describes its policy regarding investments classified as "cash equivalents." It is consistent with the way most companies classify "cash equivalents."

CASH AND CASH EQUIVALENTS -- Cash equivalents are comprised of certain highly liquid investments with original maturities of less than three months.

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Case 12-7 (continued)

Requirement 2

Merck (in the summary of significant accounting policies) describes its policy regarding its available-for-sale securities:

INVESTMENTS - … For declines in fair value that are considered other-than-temporary, impairment losses are charged to Other (income) expense, net. Declines in fair value that are considered temporary, to the extent not hedged, are reported net of tax in Accumulated other comprehensive income (“AOCI”). The Company considers available evidence in evaluating potential impairment of its investments, including the duration and extent to which fair value is less than cost and the Company’s ability and intent to hold the investment. Realized gains and losses are included in Other (income) expense, net.

Given that unrealized gains and losses are reported in AOCI, Merck must be classifying these investments as available-for-sale.

Requirement 3 Investments accounted for using the equity method are described in note 8. The company has ongoing joint ventures and other equity-method investments with Merck/Schering-Plough, AstraZeneca LP, and several others.

Requirement 4

As indicated in the income statement and in note 8, equity income recognized by Merck during 2008 was $2,560.8.

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Case 12-7 (concluded)

Requirement 5

Operating section: Cash inflows from dividends are shown in operations on the statement of cash flows, and equal $4,289.6 million for 2008. Cash flows from interest income are included in net income, and given that Merck prepares an indirect-method statement of cash flows that starts the operations section with net income, interest income is included in operations via that number.

Investing section: Cash outflows from acquiring investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows. Whether they are specifically identifiable depends on the degree of disaggregation the company uses in reporting its cash flows. Merck shows 2008 cash spent on “purchases of securities and other investments” of ($11,967.3) million, and cash received from “proceeds from sales of securities and other investments” of $11,065.8 million. The company also lists a distribution from AstraZeneca LP of $1,899.3.Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds.

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Requirement 1 The note indicates Unrealized holding losses during 2009 in the amount of ($263) million. This amount is included in other comprehensive income. It is not the amount Microsoft would include as a separate component of shareholders’ equity -- that amount is Accumulated other comprehensive income. The 2009 amount in the disclosure note is the 2009 addition to the accumulated amount, not the accumulated amount.

Requirement 2 Reclassification adjustment for losses (gains) included in net income refers to unrealized holding gains and losses that occurred in periods prior to the period in which the securities are sold. Holding gains and losses from securities available-for-sale are included in earnings when they are realized by selling the securities. When Microsoft sold securities in 2009, the entire increase in the fair value of the shares since the investment was acquired was included in earnings. The portion of that increase that occurred prior to 2009, but wasn’t recognized in prior earnings because it wasn’t yet realized by selling the investment, is what Microsoft refers to as its reclassification adjustment.

Net income in 2009 includes the $263 million of realized losses on an after tax basis (or $263 + $142 = $405 of realized losses on a before-tax basis). However, that $263 gain already has been reported in comprehensive income – as unrealized holding gains that were included in other comprehensive income in periods when price increases occurred. To avoid double-counting when those same gains are realized and included in comprehensive income via net income when the securities are actually sold, Microsoft compensates by decreasing other comprehensive income by the $263 million in that period. The basic idea is that the company only gets to report the gain in comprehensive income one time, so if the company includes it later in income, it must offset that by reducing other comprehensive income by the same amount. That’s what the reclassification adjustment does; it adjusts this year’s other comprehensive income by the amount that was reported previously to keep it from being reported twice.

From “Recognition and Presentation of Other-Than-Temporary Impairments,” FASB Staff Position (FSP) No. 115-2 and 124-2 (Norwalk, Conn.: FASB April 9, 2009), pp. 17-19,

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Research Case 12-9


1. Need to reduce net income for the full difference between amortized cost and fair value for debt investments, rather than only for credit losses, because that better suits the nee4ds of investors: “Messrs. Linsmeier and Siegel …believe that to the extent there is an other-than-temporary impairment, it should be measured as the entire difference between the fair value and the carrying value of the impaired item with that change fully reflected in net income as an unrealized loss.

a. Messrs. Linsmeier and Siegel believe that investors generally have opined that their preference is for the fair value of financial instruments to be reflected in net income. … Messrs. Linsmeier and Siegel believe that the primary purpose of financial reporting is to serve investors; therefore, if a bifurcation of the full fair value change into credit and noncredit components is needed to facilitate bank regulators in their regulatory capital decisions, that bifurcation should be provided on the face of the income statement with both components recognized in earnings consistent with investors’ preferences.

b. Messrs. Linsmeier and Siegel also object to bifurcating (dividing) the impairment loss into credit and noncredit components because they do not believe the expected loss approach (as prescribed in this FSP) can isolate the credit loss from other losses.”

2. Likely that there will be fewer OTT impairments given the new recognition criteria: “Second, Messrs. Linsmeier and Siegel object to the change in the trigger for the nonrecognition of the full impairment loss in net income. The previous GAAP requirements permitted nonrecognition of the full impairment loss when an entity could assert its intent and ability to hold the instrument to recovery of its amortized cost basis. Instead, this FSP permits nonrecognition of the noncredit portion of the full impairment loss in net income if the entity can assert that it does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery to its amortized cost basis. While Messrs. Linsmeier and Siegel understand that the

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Case 12-9 (concluded)

primary objective of this change is to make the held-to-recovery concept more operational, they also recognize that a likely result of this change is a reduction in the amount of impairment losses recognized in net income. A 1991 U.S. Treasury report cited delayed recognition of impairment losses as having an exacerbating effect on the length and ultimate cost of the savings and loan crisis. There also are potential parallels to the experience in Japan when delays in recognition of losses resulted in the so-called lost decade in the 1990s. Similarly, Messrs Linsmeier and Siegel are concerned that to the extent the proposed FSP results in delayed recognition of impairment losses in net income, there also may be a negative effect on investor confidence.”

3. Lack of convergence with the IASB: Finally, Messrs. Linsmeier and Siegel believe that there potentially may be other standard-setting issues that need to be addressed within the current other-than-temporary impairment model. However, they would prefer to address those concerns in the joint medium term project with the International Accounting Standards Board (IASB). Messrs. Linsmeier and Siegel believe that there is a high risk that the unilateral change to the recognition and presentation of other-than-temporary impairments could create the opportunity for an “accounting arbitrage” with pressure for FASB and IASB standards to converge to the standard perceived most lenient. In addition, when one standard setter enacts changes on its own, there is a failure to achieve convergence of accounting standards, which continues the challenges faced by investors in comparing global financial institutions reporting under two different accounting models.

Note: This dissent offers interesting opportunities for classroom discussion. Points that might come up include:

1. Political pressures on the FASB (banks were pushing hard for flexibility in recognizing OTT impairments and relegating non-credit-losses to OCI, and Congress pushed as well).

2. Potential effects of unilateral standard setting on progress towards convergence. 3. The fact that even very good accountants don’t always agree on which

accounting approach is most correct.

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British Airways Case

Requirement 1 Per note 2, BA treats “other current interest-bearing deposits” as held-to-maturity so long as it has the intent and ability to hold the investments to maturity. BA carries these investments at amortized cost, amortizing any premium or discount using the effective interest method, and recognizing gains and losses when the assets are derecognized (in other words, sold) or when impairments are recognized. This is consistent with U.S. GAAP. Per note 25, BA has £979 million of those investments as of March 31, 2009.

Requirement 2 Per note 2, BA treats “available-for-sale assets” at fair value, with gains or losses recognized as a separate component of equity (in other words, in AOCI) until the assets are derecognized (in other words, sold) or when impairments are recognized, at which time the cumulative gain or loss previously reported in equity is included in income (in other words, reclassified). This is consistent with U.S. GAAP. Per note 21, BA has £65 million of those investments as of March 31, 2009.

Requirement 3 Per note 20, BA uses the equity method, which is consistent with U.S. GAAP accounting for “significant influence” investments.

Requirement 4 BA’s approach is consistent with U.S. GAAP. Per note 20, even though BA owns less than 20% of Iberia shares, it indicates that “the Group has the ability to exercise significant influence over the investment due to the Group’s voting power (both through its equity holding and its representation on key decision-making committees) and the nature of its commercial relationships with Iberia.”

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British Airways Case (concluded)

Requirement 5 The impairment recognition that BA would use for HTM investments might differ from U.S. GAAP, as under IFRS BA would always recognize only credit losses for HTM investments and would allow recovery of prior impairments to be reflected in earnings, whereas under U.S. GAAP non-credit losses would be recognized in OCI under some circumstances and no recoveries would be allowed. The impairment recognition that BA would use for AFS investments also might differ from U.S. GAAP, as BA would always recognize the entire difference between amortized cost and fair value as an impairment under IFRS, while it would recognize only credit losses under some circumstances for debt investments under U.S. GAAP, and recoveries of AFS debt investments would be allowed under IFRS but not U.S. GAAP.

Requirement 6 Per note 21, BA’s investment in Flybe appears to be in equity, as BA describes the investment as 15%. The impairment wrote down the investment to fair value, as it would for an AFS equity investment under U.S. GAAP. Also, BA indicates that the impairment in 2009 was due to “a further decline in fair value, associated with lower rate of forecast revenue and earnings growth than previously expected.” Recognizing impairments due to such a “significant and prolonged decline in fair value” (starting in 2008) is consistent with U.S. GAAP (the rules for impairment recognition are ill-defined under both IFRS and U.S. GAAP).

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Chap012.doc