KiesoIA_15e_PPR_Ch17(1)

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Prepared byPrepared by

Coby HarmonCoby Harmon

University of California, Santa BarbaraUniversity of California, Santa Barbara

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Prepared byPrepared by

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University of California, Santa BarbaraUniversity of California, Santa Barbara!estmont Collee!estmont Collee

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Prepared by

Coby Harmon

University of California, Santa Barbara

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PREVIEW OF CHAPTER PREVIEW OF CHAPTER

Intermediate Accounting

15th Edition

Kieso Weygandt Warfield

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. $/plain t0e euity met0od of accountin

and compare it to t0e fair value met0od

for euity securities.

2. 'escribe t0e accountin for t0e fair value

option and for impairments of debt and

euity investments.

3. 'escribe t0e reportin of reclassification

ad4ustments and t0e accountin for

transfers bet5een cateories.

After studying this chapter, you should be able to:

6$A%"I") (B$C#I8$S6$A%"I") (B$C#I8$S

6$A%"I") (B$C#I8$S6$A%"I") (B$C#I8$S

1. Identify t0e t0ree cateories of debt

securities and describe t0e accountin

and reportin treatment for eac0 cateory.

+. Understand t0e procedures for discount

and premium amorti9ation on bond

investments.

. Identify t0e cateories of euity securities

and describe t0e accountin and

reportin treatment for eac0 cateory.

InvestmentsInvestments

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'ifferent motivations for investin:

To earn a high rate of return.

To secure certain operating or financing arrangements

with another company.

Investment in 'ebt Securities

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Companies account for investments based on

the type of security (debt or equity) and

their intent with respect to the investment.

Illustration 17-1Summary of Investment

Accounting Approaches


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'ebt securities represent a creditor relationship

!.S. governmentsecurities

"unicipal securities

#orporate bonds

#onvertible debt

#ommercial paper

Type

Held-to-maturity #radin

Available-for-sale

Accounting #ategory


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'ebt Investment Classifications


I66US#%A#I(" 17-+ Accounting for $ebtSecurities by #ategory

Amorti9ed cost is the acquisition cost ad%usted for the amorti&ation of

discount or premium' if appropriate.

LO 1

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euity investments.





6$A%"I") (B$C#I8$S6$A%"I") (B$C#I8$S6$A%"I") (B$C#I8$S6$A%"I") (B$C#I8$S






investments.





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#lassify a debt security as 0eld-to-maturity only if it has bot0

) the positive intent and

) the ability to hold securities to maturity.

Accounted for at amorti&ed cost' not fair value.

LO 2


Held-to-&aturity Securities

Amorti&e premium or discount

using the effective-interest

met0od unless the straight*line

method yields a similar result.

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Illustration: +*Smith #ompany purchased ,--'--- of percentbonds of /ush #orporation on 0anuary ' -1' at a discount'

paying ,2'3. The bonds mature 0anuary ' - and yield

-45 interest is payable each 0uly and 0anuary . +*Smith

records the investment as follows

anuary 1, +=1

$ebt Investments 2'3

#ash 2'3


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Illustration 17-

Schedule ofInterest

6evenue and /ond

$iscount

Amorti&ation7

8ffective*Interest"ethod


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Illustration 17-

Illustration: +*Smith #ompany records the receipt of the first

semiannual interest payment on 0uly ' -1' as follows

#ash 9'---$ebt Investments :9

Interest 6evenue 9':9

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Illustration 17-

Illustration: +*Smith is on a calendar*year basis' it accrues

interest and amorti&es the discount at $ecember 1' -1' as

follows

Interest 6eceivable 9'---

$ebt Investments :9;

Interest 6evenue 9':9;


LO 2

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%eportin of Held-to-&aturity SecuritiesIllustration 17-

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Illustration 17-

Illustration: Assume +*Smith

sells its

investment in

/ush bonds on<ovember '

-3' at 22=

plus accrued

interest. +*Smithrecords discount

amorti&ation as

follows

$ebt Investments :1;

Interest 6evenue :1;

Calculation of amorti9ation > ?<2+ / @3 > ?32

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LO 2

#omputation of >ain on Sale of /onds

#ash -'93Interest 6evenue (9?: @ ,9'---) '::3

$ebt Investments 22':1

>ain on Sale of Securities :3

Illustration 17-2

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#ompanies report available*for*sale securities at

fair value' with

unreali&ed holding gains and losses reported as other

comprehensive income' a separate component of

stockholders equity' until reali&ed.

Any discount or premium is amorti&ed.


Available-for-Sale Securities

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Illustration Sinle Security: >raffeo #orporation purchases,--'---' - percent' five*year bonds on 0anuary ' -1' with

interest payable on 0uly and 0anuary . The bonds sell for

,-'' which results in a bond premium of ,' and an

effective interest rate of percent. >raffeo records the purchase ofthe bonds on 0anuary ' -1' as follows.

$ebt Investments -'

#ash -'

Available-for-Sale Securities 'ebtSecurities

LO 2

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Illustration 17-3

Schedule of

Interest

6evenue and /ond

Bremium

Amorti&ation7

8ffective*Interest"ethod


LO 2

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Illustration 17-3

Illustration Sinle Security: The entry to record interest

revenue on 0uly ' -1' is as follows.

#ash ;'---$ebt Investments :3:

Interest 6evenue 9'19

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Illustration 17-3

Illustration Sinle Security: At $ecember 1' -1' >raffeo

makes the following entry to recogni&e interest revenue.

Interest 6eceivable ;'---$ebt Investments 3-1

Interest 6evenue 9'23

Interest

6evenue for

-1 C ?;,3+1

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Illustration Sinle Security: To apply the fair value method to

these debt securities' assume that at $ecember 1' -1 the fair

value of the bonds is ,-;'---. >raffeo makes the following entry.

!nreali&ed Dolding >ain or Eoss78quity '31

Fair Galue Ad%ustment (AFS) '31


Illustration 17-3

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Illustration Portfolio of Securities: Derringshaw #orporationhas two debt securities classified as available*for*sale. The

following illustration identifies the amorti&ed cost' fair value' and the

amount of the unreali&ed gain or loss.

Illustration 17-7


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Brepare the ad%usting entry Derringshaw would make on $ecember

1' -9 to record the loss.

!nreali&ed Dolding >ain or Eoss78quity 2';13

Fair Galue Ad%ustment (AFS) 2';13


Illustration 17-7

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Sale of Available-for-Sale Securities

If company sells bonds before maturity date

It must make entries to remove from the $ebt Investments

account the amorti&ed cost of bonds sold.

Any reali&ed gain or loss on sale is reported in the Hther

e@penses and lossesJ section of the income statement.


LO 2

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Illustration Sale of Available-for-Sale Securities: Derringshaw#orporation sold the Katson bonds (from Illustration 3*3) on 0uly

' -;' for ,2-'---' at which time it had an amorti&ed cost of

,29'9.

#ash 2-'---

Eoss on Sale of Investments 9'9

$ebt Investments 29'9

Illustration 17-;


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Illustration Sale of Available-for-Sale Securities: Derringshawreports this reali&ed loss in the Hther e@penses and lossesJ

section of the income statement. Assuming no other purchases and

sales of bonds in -;' Derringshaw on $ecember 1' -;'

prepares the informationIllustration 17-<


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Illustration Sale of Available-for-Sale Securities: Derringshawrecords the following at $ecember 1' -;.

Fair Galue Ad%ustment (AFS) 9';13

!nreali&ed Dolding >ain or Eoss78quity 9';13

Illustration 17-<


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*inancial Statement Presentation Illustration 17-1=6eporting of Available*for*Sale Securities


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#ompanies report tradin securities at

fair value' with

unreali&ed holding gains and losses reported as part of

net income.

Any discount or premium is amorti&ed.

A 0oldin ain or loss is the net change in the fair value ofa security from one period to another' e@clusive of

dividend or interest revenue recogni&ed but not

received.


#radin Securities

'ebtSecurities

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Illustration: n $ecember 1' -9' Loopmans Bublishing#orporation determined its trading securities portfolio to be as

follows

#radin Securities 'ebtSecurities

Illustration 17-11#omputation of Fair Galue

Ad%ustment7TradingSecurities Bortfolio (-9)

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Illustration At $ecember 1' Loopmans Bublishing makes anad%usting entry

Fair Galue Ad%ustment (Trading) 1'3;-

!nreali&ed Dolding >ain or Eoss7Income 1'3;-

Illustration 17-11


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Illustration: #radin Securities Dendricks #orporationpurchased trading investment bonds for ,;-'--- at par. At

$ecember 1' Dendricks received annual interest of ,'---' and

the fair value of the bonds was ,93'9--.

Instructions:

a) Brepare the %ournal entry for the purchase of the

investment.

b) Brepare the %ournal entry for the interest received.

c) Brepare the %ournal entry for the fair value ad%ustment.


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the fair value of the bonds was ,93'9--. Prepare t0e 4ournal

entry for t0e purc0ase of t0e investment.


$ebt investments ;-'---

#ash ;-'---

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entry for t0e interest received.


#ash '---

Interest 6evenue '---

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entry for t0e fair value ad4ustment.


!nreali&ed Dolding Eoss M Income ':--

Fair Galue Ad%ustment (Trading) ':--

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euity investments.











investments.





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Investments in $uity Securities

6epresent ownership of capital stock.

#ost includes

price of the security' plus

brokers commissions and fees related to purchase.

The degree to which one corporation (investor ) acquires an

interest in the common stock of another corporation (investee)

generally determines the accounting treatment for the

investment subsequent to acquisition.

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- ******************-4 **************** ;-4 **************** --4

<o significant

influenceusually e@ists

Significant

influenceusually e@ists

#ontrol usually

e@ists

Investmentvalued using

*air 8alue &et0od

Investmentvalued using

$uity&et0od

Investment valued onparents books using #ost

"ethod or 8quity "ethod (investment eliminated inConsolidation)

(5ners0ip Percentaes(5ners0ip Percentaes


LO 3

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Illustration 17-1 Accounting and 6eporting for 8quity Securities by #ategory

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Accounting Subsequent to Acquisition

"arket Brice

Available

Galue and report the

investment using the

fair value met0od.

"arket Brice

!navailable

Galue and report the

investment using the

cost met0od.N

N Securities are reported at cost. $ividends are recogni&ed whenreceived and gains or losses only recogni&ed on sale of securities.


Holdin of 6ess #0an +=

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Holdins of 6ess #0an +=

Available-for-Sale Securities!pon acquisition' companies record available*for*sale securities at

cost.

Illustration: n <ovember 1' -9' 6epublic #orporation

purchased common stock of three companies' each investment

representing less than a - percent interest.

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Illustration: 6epublic records these investments on <ovember 1'as follows.


8quity Investments 3';;-

#ash 3';;-

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Illustration: n $ecember :' -9' 6epublic receives a cashdividend of ,9'-- from #ampbell Soup #o.


#ash 9'--

$ividend revenue 9'--

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Illustration: 6epublics available*for*sale equity security portfolioon $ecember 1' -9

Illustration 17-1


LO 3

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!nreali&ed Dolding >ain or Eoss78quity 1;';;-

Fair Galue Ad%ustment (AFS) 1;';;-

Available-for-Sale SecuritiesIllustration 17-1

Illustration: Brepare the entry 6epublic would make on $ecember 1'

-9' to record the net unreali&ed gains and losses.

LO 3

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Illustration: n 0anuary 1' -;' 6epublic sold all of its<orthwest Industries' Inc. common stock receiving net proceeds

of ,3'-. Brepare the entry to record the sale.

#ash 3'-8quity Investments

;2'3--

>ain on Sale of Investments

3';-

Illustration 17-12


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euity investments.











investments.





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An investment (direct or indirect) of - percent or more of the

voting stock of an investee should lead to a presumption that in

the absence of evidence to the contrary' an investor has the

ability to e@ercise sinificant influence over an investee.

In instances of Hsignificant influence'J the investor must account

for the investment using the euity met0od.


Holdin Bet5een += and 2=

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Holdins Bet5een += and 2=

$uity &et0od6ecord the investment at cost and subsequently ad%ust the

amount each period for

the investors proportionate share of the earnings (losses)and

dividends received by the investor.

If investors share of investees losses e@ceeds the carrying amount of theinvestment' the investor ordinarily should discontinue applying the equitymethod and not recogni&e additional losses.

LO 4

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Holdins Bet5een += and 2=

LO 4Illustration 17-17#omparison of Fair Galue "ethod and 8quity "ethod Advance slide in presentationmode to reveal 4ournal entries.

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Controllin Interest * Khen one corporation acquires a voting

interest of more than ;- percent in another corporation

Investor corporation is referred to as the parent. Investee corporation is referred to as the subsidiary.

Investment in the subsidiary is reported on the parents

balance sheet as a long*term investment.

Barent generally prepares consolidated financial

statements.

LO 4


Holdin of &ore #0an 2=

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euity investments.











investments.





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#ompanies have the option to report most financial

instruments at fair value' with all gains and losses related to

changes in fair value reported in the income statement.

Applied on an instrument*by*instrument basis.

>enerally available only at the time a company first

purchases the financial asset or incurs a financial liability.

#ompany must measure this instrument at fair value until

the company no longer has ownership.

LO 5

Additional &easurement Issues

*air 8alue (ption

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Illustration: "c#ollum #ompany purchases stock in Fielder

#ompany during -9 that it classifies as available*for*sale. At

$ecember 1' -9' the cost of this security is ,--'---5 its fair

value at $ecember 1' -9' is ,;'---. If "c#ollum chooses

the fair value option to account for the Fielder #ompany stock' it

makes the following entry at $ecember 1' -9.


8quity Investments ;'---

!nreali&ed Dolding >ain or Eoss7Income ;'---

*air 8alue (ption

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*air 8alue (ption

Illustration: Sullivan #ompany holds a percent stake in

Suppan Inc. Sullivan purchased the investment in -9 for

,21-'---. At $ecember 1' -9' the fair value of the investment

is ,2--'---. Sullivan elects to report the investment in Suppan

using the fair value option. The entry to record this investment is

as follows.

$uity &et0od Investments

!nreali&ed Dolding >ain or Eoss7Income 1-'---

8quity Investments 1-'---

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A company should evaluate every investment' at each

reporting date' to determine if it has suffered impairment.

Impairments represent a loss in value that is other than temporary.

reali&ed loss that is included in net income.

#ompanies base impairment for debt and equity securitieson a fair value test.

Additional &easurement Issues

Impairment of 8alue

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Impairment of 8alue

Illustration: Strickler #ompany holds available*for*sale bondsecurities with a par value and amorti&ed cost of , million. The

fair value of these securities is ,--'---. Strickler has previously

reported an unreali&ed loss on these securities of ,--'--- as

part of other comprehensive income. In evaluating the securities'Strickler now determines that it probably will not collect all

amounts due. It records this impairment as follows.

Eoss on impairment --'---

$ebt investments --'---

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euity investments.











investments.





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% l ifi ti d # f

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The reporting of changes in unreali&ed gains or losses in

comprehensive income is straightforward unless a company sells

securities during the year.

In that case' double counting results when the company reports

reali&ed gains or losses as part of net income but also shows the

amounts as part of other comprehensive income in the current

period or in previous periods.

To ensure that gains and losses are not counted twice when a sale

occurs' a reclassification ad4ustment is necessary.

LO 6

%eclassifications and #ransfers

%eclassification Ad4ustments

% l ifi ti Ad4 t t

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Illustration: pen #ompany has the following two available*for*sale

securities in its portfolio at the end of -1 (its first year of

operations).

Illustration 17-1<


LO 6

% l ifi ti Ad4 t t

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17-3;

Illustration: If pen #ompany reports net income in -1 of

,1;-'---' it presents a statement of comprehensive income as

follows.Illustration 17-+=


LO 6

% l ifi ti Ad4 t t

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17-3<

Illustration: $uring -9' pen #ompany sold the Eehman Inc.

common stock for ,-;'--- and reali&ed a gain on the sale of

,;'--- (,-;'--- M ,-'---). At the end of -9' the fair value of

the Koods #o. common stock increased an additional ,-'---' to

,;;'---.

Illustration 17-+1


LO 6

% l ifi ti Ad4 t t

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17-7=

Illustration: In addition' pen reali&ed a gain of ,;'--- on the sale

of the Eehman common stock. #omprehensive income includes both

reali&ed and unreali&ed components. Therefore' pen recogni&es a

total holding gain (loss) in -9 of ,-'---' computed as follows.

Illustration 17-++


LO 6

% l ifi ti Ad4 t t

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Illustration: pen reports net income of ,3-'--- in -9' which

includes the reali&ed gain on sale of the Eehman securities.

Illustration 17-+


LO 6

% l ifi ti d # f

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17-7+

Illustration 17-=

N Assumes that ad%usting entries to report changes in fair value for the current period are not yetrecorded.

%eclassifications and #ransfers

#ransfers Bet5een Cateories

LO 6

# f B t C t i

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#ransfers Bet5een Cateories

Illustration 17-=

NNAccording to >AAB' these types of transfers should be rare.

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'efinin 'erivativesFinancial instruments that derive t0eir value from values of

other assets (e.g.' stocks' bonds' or commodities).

Three different types of derivatives

. Financial forwards or financial futures.

. ptions.

1. Swaps.

APP$"'IDAPP$"'ID 17A ACC(U"#I") *(% 'I%I8A#I8$ I"S#%U&$"#S

LO 7 escribe the uses of and accounting for deri!ati!es"

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17-72

!0o Uses 'erivatives, and !0yEProducers and Consumers

#ommodity prices are volatile.

They depend on weather' crop production' and generaleconomic conditions.

To plan effectively' it makes good sense to lock in specific future

revenues or costs in order to run their businesses successfully.


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!0o Uses 'erivatives, and !0yESpeculators and Arbitraeurs

The speculator who may be in the market for only a few hours'

will then sell the forward contract to another speculator or to acompany.

Arbitraeurs attempt to e@ploit inefficiencies in markets. They

seek to lock in profits by simultaneously entering into transactions

in two or more markets.


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Basic Principles in Accountin for 'erivatives 6ecogni&e derivatives in the financial statements as

assets and liabilities.

6eport derivatives at fair value.

6ecogni&e gains and losses resulting from speculation

in derivatives immediately in income.

6eport gains and losses resulting from hedge

transactions differently' depending on the type of hedge.


LO 7

1 A

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17-7;

$/ample of 'erivative *inancial Instrument-SpeculationIllustration: Assume that a company purchases a call option

contract from /aird Investment #o. on 0anuary ' -9' when

Earedo shares are trading at ,-- per share. The contract gives it

the option to purchase '--- shares (referred to as the notionalamount) of Earedo stock at an option price of ,-- per share. The

option e@pires on April 1-' -9. The company purchases the call

option for ,9-- and makes the following entry on 0anuary ' -9.

#all ption 9--

#ash 9--

(ption

Premium


LO 7

17A

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17-7<

$/ample of 'erivative *inancial Instrument-SpeculationThe option premium consists of two amounts.

Illustration 17A-1

Intrinsic value is the difference between the market price and the preset

strike price at any point in time. It represents the amount reali&ed by theoption holder' if e@ercising the option immediately. n 0anuary ' -' the

intrinsic value is &ero because the market price equals the preset strike

price.


LO 7

17A

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17-;=

$/ample of 'erivative *inancial Instrument-SpeculationThe option premium consists of two amounts.

Illustration 17A-1

#ime value refers to the options value over and above its intrinsic value.

Time value reflects the possibility that the option has a fair value greaterthan &ero. DowO /ecause there is some e@pectation that the price of

Earedo shares will increase above the strike price during the option term. As

indicated' the time value for the option is ,9--.


LO 7

17A

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17-;1

Additional data available with respect to the call option

n &arc0 1, +=1' the price of Earedo shares increases to ,- per

share. The intrinsic value of the call option contract is now ,-'---.

That is' the company can e@ercise the call option and purchase '---

shares from /aird Investment for ,-- per share. It can then sell the

shares in the market for ,- per share. This gives the company a gain

on the option contract of PPPPPPPPPPPP.?+=,===?+=,===(,-'--- * ,--'---)


LO 7

17A CC( ) ( S S

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17-;+

n &arc0 1, +=1' it records the increase in the intrinsic value of the

option as follows.

#all ption -'---

!nreali&ed Dolding >ain or Eoss7Income -'---

A market appraisal indicates that the time value of the option at &arc0

1, +=1' is ,--. The company records this change in value of the

option as follows.

!nreali&ed Dolding >ain or Eoss7Income 1--

#all ption (,9-- * ,--) 1--


LO 7

17A ACC(U"#I") *(% 'I%I8A#I8$ I"S#%U&$"#S

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17-;

At &arc0 1, +=1+' the company reports the

call option in its balance sheet at fair value of ,-'--.

unreali&ed holding gain which increases net income.

loss on the time value of the option which decreases netincome.


LO 7

17A ACC(U"#I") *(% 'I%I8A#I8$ I"S#%U&$"#S

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17-;

n April 13, +=1' the company settles the option before it e@pires.

To properly record the settlement' it updates the value of the option

for the decrease in the intrinsic value of ,;'--- (Q,- * ,;R) @ '---)

as follows.

!nreali&ed Dolding >ain or Eoss7Income ;'---

#all option ;'---

The decrease in the time value of the option of ,9- (,-- * ,:-) is

recorded as follows.

!nreali&ed Dolding >ain or Eoss7Income 9-

#all ption 9-


LO 7

17A ACC(U"#I") *(% 'I%I8A#I8$ I"S#%U&$"#S

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17-;2

At the time of the settlement' the call options carrying value is as

follows.

Settlement of the option contract is recorded as follows.

#ash ;'---

Eoss on Settlement of #all ption :-

#all ption ;'-:-


LO 7

17A ACC(U"#I") *(% 'I%I8A#I8$ I"S#%U&$"#S

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17-;3

Summary effects of the call option contract on net income.

Illustration 17A-+

/ecause the call option meets the definition of an asset' the companyrecords it in the balance sheet on "arch 1' -9. It also reports the

call option at fair value' with any gains or losses reported in income.


LO 7

APP$"'ID 17A ACC(U"#I") *(% 'I%I8A#I8$ I"S#%U&$"#S

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'ifferences bet5een #raditional and 'erivative*inancial Instruments

A derivative financial instrument has the following three basic

characteristics.

. The instrument has () one or more underlyings and () an

identified payment provision.

. The instrument requires little or no investment at the inception

of the contract.

1. The instrument requires or permits net settlement.


LO 7


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Features of Traditional and $erivative

Financial InstrumentsIllustration 17A-


LO 7


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17-;<

'erivatives Used for HedinHedin: The use of derivatives to offset the negative

impacts of changes in interest rates or foreign currency

e@change rates.

FAS/ allows special accounting for two types of hedges7

fair value and

cash flow hedges.

LO # $%plain ho& to account for a fair !alue hedge"



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17-<=

*air 8alue Hede A company uses a derivative to hedge (offset) the e@posure to

changes in the fair value of a recogni&ed asset or liability or of

an unrecogni&ed commitment.

#ompanies commonly use several types of fair value hedges.

Interest rate swaps

put options


LO #


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17-<1

Illustration: n April 1, +=1' Dayward #o. purchases --shares of Sonoma stock at a market price of ,-- per share.

Dayward does not intend to actively trade this investment. It

consequently classifies the Sonoma investment as available*for*

sale. Dayward records this available*for*sale investment asfollows.

8quity investments -'---

#ash -'---


LO #


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17-<+

Illustration: Fortunately for Dayward' the value of the Sonomashares increases to ,; per share during -. n $ecember

1' -;' Dayward records the gain on this investment as follows.

Fair Galue Ad%ustment (AFS) ';--!nreali&ed Dolding >ain or Eoss78quity ';--


LO #


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17-<

Dayward reports the Sonoma investment in its balance sheet.

Illustration 17A-


LO #


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17-<

Dayward is e@posed to the risk that the price of the Sonoma stock willdecline. To hedge this risk' Dayward locks in its gain on the Sonoma

investment by purchasing a put option on -- shares of Sonoma

stock.

Illustration: Dayward enters into the put option contract on 0anuary' -;' and designates the option as a fair value hedge of the

Sonoma investment. This put option (which e@pires in two years)

gives Dayward the option to sell Sonoma shares at a price of ,;.

Since the e@ercise price equals the current market price' no entry isnecessary at inception of the put option.


LO #


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17-<2

Illustration: At 'ecember 1, +=12' the price of the Sonomashares has declined to ,- per share. Dayward records the

following entry for the Sonoma investment.

!nreali&ed Dolding >ain or Eoss7Income ;--Fair Galue Ad%ustment (AFS) ;--


LO #


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17-<3

Illustration: The following %ournal entry records the increase invalue of the put option on Sonoma shares on 'ecember 1,

+=12.

But ption ;--!nreali&ed Dolding >ain or Eoss7Income ;--


LO #


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17-<7

/alance Sheet Bresentation of Fair Galue DedgeIllustration 17A-2

Income Statement Bresentation of Fair Galue Dedge


Illustration 17A-3

LO #


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17-<;

Cas0 *lo5 Hede!sed to hedge e@posures to cas0 flo5 risF' which results from

the variability in cash flows.

6eporting Fair value on the balance sheet

>ains or losses in equity' as part of other comprehensive

income.


LO ' $%plain ho& to account for a cash flo& hedge"


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17-<<

Illustration: In September -9 Allied #an #o. anticipates

purchasing '--- metric tons of aluminum in 0anuary -;. As a

result' Allied enters into an aluminum futures contract. In this case'

the aluminum futures contract gives Allied the right and the

obligation to purchase '--- metric tons of aluminum for ,';;- per

ton. This contract price is good until the contract e@pires in 0anuary

-;. The underlying for this derivative is the price of aluminum.

Allied enters into the futures contract on September ' -9.

Assume that the price to be paid today for inventory to be delivered

in 0anuary7the spot price7equals the contract price. Kith the two

prices equal' the futures contract has no value. Therefore no entry

is necessary.


LO '


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17-1==

Illustration: At 'ecember 1, +=1' the price for 0anuary delivery

of aluminum increases to ,';3; per metric ton. Allied makes the

following entry to record the increase in the value of the futures

contract.

Futures #ontract ;'---

!nreali&ed Dolding >ain or Eoss78quity ;'---

(Q,';3; * ,';;-R @ '--- tons)

Allied reports the futures contract in the balance sheet as a current assetand the gain as part of other comprehensive income.


LO '


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17-1=1

Illustration: In anuary +=1' Allied purchases '--- metric tons of

aluminum for ,';3; and makes the following entry.

Aluminum Inventory ';3;'---

#ash (,';3; @ '--- tons) ';3;'---

At the same time' Allied makes final settlement on the futures

contract. It records the following entry.

#ash ;'---

Futures #ontract (,';3;'--- * ,';;-'---) ;'---


LO '


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17-1=+

8ffect of Dedge on #ash FlowsIllustration 17A-7

There are no income effects at this point. Allied accumulates in equity the gainon the futures contract as part of other comprehensive income until the periodwhen it sells the inventory.

APP$"'IDAPP$"'ID 17A

LO '


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17-1=

Illustration: Assume that Allied processes the aluminum into

finished goods (cans). The total cost of the cans (including the

aluminum purchases in 0anuary -;) is ,'3--'---. Allied sells

the cans in uly +=12 for ,'---'---' and records this sale as

follows.

#ash '---'---

Sales 6evenue '---'---

#ost of >oods Sold '3--'---Inventory (#ans) '3--'---


LO '


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17-1=

Illustration: Since the effect of the anticipated transaction has

now affected earnings' Allied makes the following entry related to

the hedging transaction.

!nreali&ed Dolding >ain or Eoss78quity ;'---

#ost of >oods Sold ;'---

The gain on the futures contract' which Allied reported as part of othercomprehensive income' now reduces cost of goods sold. As a result' the cost ofaluminum included in the overall cost of goods sold is ,';;-'---.


LO '


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17-1=2

(t0er %eportin Issues$mbedded 'erivatives

#onvertible bond is a 0ybrid instrument. Two parts

. a debt security' referred to as the 0ost security' and. an option to convert the bond to shares of common stock' the

embedded derivative.

To account for an embedded derivative' a company s0ould

separate it from t0e 0ost security and then account for it usingthe accounting for derivatives. This separation process is referred

to as bifurcation.


LO 1( )dentify special reporting issues related to deri!ati!e financial

instru*ents that cause uni+ue accounting proble*s"


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17-1=3

Gualifyin Hede Criteria#riteria that hedging transactions must meet before requiring

the special accounting for hedges.

. $ocumentation' risk management' and designation.

. 8ffectiveness of the hedging relationship.

1. 8ffect on reported earnings of changes in fair values or cash

flows.


LO 1(


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17-1=7

Summary of $erivative Accounting under >AABIllustration 17A-;


LO 1(

APP$"'IDAPP$"'ID 17B 8A%IAB6$-I"#$%$S# $"#I#I$S

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17-1=;

!0at About )AAPETwo models for consolidation

1. 8otin-interest model7If a company owns more than

;- percent of another company' then consolidate in

most cases.

+. %isF-and-re5ard model7If a company is involved

substantially in the economics of another company'

then consolidate.

APP$"'ID

LO 11 escribe the accounting for !ariableinterest entities"


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17-1=<

Consolidation of 8ariable-Interest $ntities A variable-interest entity 8I$ is an entity that has one of

the following characteristics

. Insufficient equity investment at risk.

. Stockholders lack decision*making rights.

1. Stockholders do not absorb the losses or receive the

benefits of a normal stockholder.

LO 11


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17-11=

GI8

#onsolidation

"odel

Illustration 17B-1

LO 11


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17-111

!0at Is Happenin in PracticeEne study of ;-2 companies with

total market values over ,;-- million

found that %ust 3 percent of the

companies reviewed have a material

impact.

LO 11

APP$"'IDAPP$"'ID 17C *AI% 8A6U$ 'ISC6(SU%$S

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17-11+

FAS/ believes that fair value information is relevant for making

effective business decisions. thers e@press concern about

fair value measurements for two reasons

. the lack of reliability related to the fair value measurement in

certain cases' and

. the ability to manipulate fair value measurements.

LO 12 escribe re+uired fair !alue disclosures"


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17-11

'isclosure of *air 8alue Information: *inancial

Instruments"o *air 8alue (ption

/oth the cost and the fair value of all financial instruments are to

be reported in the notes to the financial statements.

FAS/ also decided that companies should disclose information

that enables users to determine the e@tent of usage of fair value

and the inputs used to implement fair value measurement.

LO 12


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17-11

'isclosure of *air 8alue Information: *inancial

Instruments"o *air 8alue (ption

Two reasons for additional disclosure beyond the simple

itemi&ation of fair values are

. $iffering levels of reliability e@ist in the measurement of fair

value information.

. #hanges in the fair value of financial instruments are

reported differently in the financial statements' depending

upon the type of financial instrument involved and whether

the fair value option is employed.

LO 12


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17-112

6evels of reliability fair value hierarchy.

6evel 1 is the most reliable measurement because fair value

is based on quoted prices in active markets for identical

assets or liabilities.

6evel + is less reliable5 it is not based on quoted market

prices for identical assets and liabilities but instead may be

based on similar assets or liabilities.

6evel is least reliable5 it uses unobservable inputs that

reflect the companys assumption as to the value of the

financial instrument.

LO 12


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17-113

8@ample of Fair Galue DierarchyIllustration 17C-1

LO 12


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17-117

6econciliation

of Eevel 1

Inputs

Illustration 17C-+


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17-11;

'isclosure of *air 8alues: Impaired Assets or

6iabilities Illustration 17C-

$isclosure of

Fair Galue withImpairment

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17-11<

LO 13 -o*pare the accounting for in!est*ents under .AA/ and )0"

%$6$8A"# *AC#S - Similarities

>AAB and IF6S use similar classifications for trading investments.

The accounting for trading investments is the same between >AAB and

IF6S. Deld*to*maturity (>AAB) and held*for*collection (IF6S)

investments are accounted for at amorti&ed cost. >ains and losses on

some investments are reported in other comprehensive income.

/oth >AAB and IF6S use the same test to determine whether the equity

method of accounting should be used' that is' significant influence with a

general guideline of over - percent ownership.

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17-1+= LO 13

%$6$8A"# *AC#S - Similarities

>AAB and IF6S are similar in the accounting for the fair value option.

That is' the option to use the fair value method must be made at initial

recognition' the selection is irrevocable' and gains and losses are

reported as part of income. ne difference is that >AAB permits the fair

value option for equity method investments. The measurement of impairments is similar under >AAB and IF6S.

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17-1+1

%$6$8A"# *AC#S - 'ifferences

Khile >AAB classifies investments as trading' available*for*sale (both

debt and equity investments)' and held*to*maturity (only for debt

investments)' IF6S uses held*for*collection (debt investments)' trading

(both debt and equity investments)' and non*trading equity investment

classifications. The basis for consolidation under IF6S is control. !nder >AAB' a bipolar

approach is used' which is a risk*and*reward model (often referred to as

a variable*entity approach) and a voting*interest approach. Dowever'

under both systems' for consolidation to occur' the investor company

must generally own ;- percent of another company.

LO 13

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17-1++

%$6$8A"# *AC#S - 'ifferences

Khile the measurement of impairments is similar under >AAB and IF6S'

>AAB does not permit the reversal of an impairment charge related to

available*for*sale debt and equity investments. IF6S allows reversals of

impairments of held*for*collection investments.

Khile >AAB and IF6S are similar in the accounting for the fair value

option' one difference is that >AAB permits the fair value option for

equity method investments5 IF6S does not.

LO 13

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17-1+

(" #H$ H(%I("

At one time' both the FAS/ and IAS/ have indicated that they believe that all

financial instruments should be reported at fair value and that changes in fair

value should be reported as part of net income. Dowever' the recently issued

IF6S indicates that the IAS/ believes that certain debt investments should not

be reported at fair value. The IAS/s decision to issue new rules oninvestments' prior to the FAS/s completion of its deliberations on financial

instrument accounting' could create obstacles for the /oards in converging the

accounting in this area.

LO 13

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17-1+

All of the following are key similarities between >AAB and IF6S with

respect to accounting for investments e@cept

a. IF6S and >AAB have a held*to*maturity investment

classification.

b. IF6S and >AAB apply the equity method to significant influence

equity investments.

c. IF6S and >AAB have a fair value option for financial

instruments.

d. the accounting for impairment of investments is similar'

although IF6S allows recovery of impairment losses.

I*%S S$6*-#$S# GU$S#I("

LO 13

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17-1+2

Khich of the following statements is correctO

a. >AAB has a held*for*collection investment classification.

b. >AAB permits recovery of impairment losses.

c. !nder IF6S' non*trading equity investments are accounted for

at amorti&ed cost

d. IF6S and >AAB both have a trading investment classification.

I*%S S$6*-#$S# GU$S#I("

LO 13

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17-1+3

IF6S requires companies to measure their financial assets at fair

value based on

a. the companys business model for managing its financial

assets.

b. whether the financial asset is a debt investment.

c. whether the financial asset is an equity investment.

d. All of the choices are IF6S requirements.

I*%S S$6*-#$S# GU$S#I("

LO 13

Copyri0t

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#opyright -1 0ohn Kiley Sons' Inc. All rights reserved.

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Section 3 of the 23: !nited States #opyright Act without the

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distribution or resale. The Bublisher assumes no responsibility for

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KiesoIA_15e_PPR_Ch17(1)