Intermediate Accounting Seventeenth Edition Kieso Weygandt Warfield Chapter

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Intermediate Accounting Seventeenth Edition Kieso ● Weygandt ● Warfield Chapter 17 Investments

Intermediate Accounting Seventeenth Edition Kieso ● Weygandt ● Warfield Chapter 17 Investments

Learning Objectives After studying this chapter, you should be able to: 1. Describe the

Learning Objectives After studying this chapter, you should be able to: 1. Describe the accounting for investments in debt securities. 2. Describe the accounting for investments in equity securities. 3. Explain the equity and consolidation methods of accounting. 4. Evaluate other major issues related to investments in debt and equity securities. Copyright © 2019 John Wiley & Sons, Inc. 2

Preview of Chapter 17 Investments in Debt Securities • • Debt investment classifications Held-to-maturity

Preview of Chapter 17 Investments in Debt Securities • • Debt investment classifications Held-to-maturity securities Available-for-sale securities Trading securities Copyright © 2019 John Wiley & Sons, Inc. 3

Preview of Chapter 17 Investments in Equity Securities • Holdings of less than 20%

Preview of Chapter 17 Investments in Equity Securities • Holdings of less than 20% • Holdings between 20% and 50% • Holdings of more than 50% Copyright © 2019 John Wiley & Sons, Inc. 4

Preview of Chapter 17 Investments Other Financial Reporting Issues • • • Fair value

Preview of Chapter 17 Investments Other Financial Reporting Issues • • • Fair value option Impairment of value Reclassification adjustments Transfers related to debt Securities Summary Copyright © 2019 John Wiley & Sons, Inc. 5

Learning Objective 1 Describe the Accounting for Investments in Debt Securities LO 1 Copyright

Learning Objective 1 Describe the Accounting for Investments in Debt Securities LO 1 Copyright © 2019 John Wiley & Sons, Inc. 6

Investment in Debt Securities Different motivations for investing: • To earn a high rate

Investment in Debt Securities Different motivations for investing: • To earn a high rate of return. • To secure certain operating or financing arrangements with another company. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 7

Investment in Debt Securities Summary of Investment Accounting Approaches Companies account for investments based

Investment in Debt Securities Summary of Investment Accounting Approaches Companies account for investments based on • the type of security (debt or equity) and • their intent with respect to the investment. Type of Security Debt Equity LO 1 Management Intent Valuation Approach No plans to sell Plan to sell Amortized cost Fair value Plan to sell Exercise some control Fair value Equity method Copyright © 2019 John Wiley & Sons, Inc. 8

Debt Investment Classifications Debt securities represent a creditor relationship: Type Accounting Category • U.

Debt Investment Classifications Debt securities represent a creditor relationship: Type Accounting Category • U. S. government securities • Held-to-maturity • Municipal securities • Available-for-sale • Corporate bonds • Trading • Convertible debt • Commercial paper LO 1 Copyright © 2019 John Wiley & Sons, Inc. 9

Debt Investment Classifications Accounting for Debt Securities by Category Valuation Held-tomaturity Amortized cost Unrealized

Debt Investment Classifications Accounting for Debt Securities by Category Valuation Held-tomaturity Amortized cost Unrealized Holding Gains or Losses Other Income Effects Not recognized Interest when earned; gains and losses from sale. Trading Fair value securities Recognized in net income Interest when earned; gains and losses from sale. Available- Fair value for-sale Recognized as other comprehensive income and as separate component of stockholders’ equity Interest when earned; gains and losses from sale. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 10

Investment in Debt Securities Held-to-Maturity Securities (Amortized Cost) Classify a debt security as held-to-maturity

Investment in Debt Securities Held-to-Maturity Securities (Amortized Cost) Classify a debt security as held-to-maturity only if it has both 1. the positive intent and 2. the ability to hold securities to maturity. Accounted for at amortized cost, not fair value. Amortize premium or discount using the effectiveinterest method unless the straight-line method yields a similar result. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 11

Held-to-Maturity Securities (Amortized Cost) Illustration: Robinson Company purchased $100, 000 of 8 percent bonds

Held-to-Maturity Securities (Amortized Cost) Illustration: Robinson Company purchased $100, 000 of 8 percent bonds of Bush Corporation on January 1, 2019, at a discount, paying $92, 278. The bonds mature January 1, 2024 and yield 10%; interest is payable each July 1 and January 1. Robinson records the investment as follows: January 1, 2019 Debt Investments Cash LO 1 92, 278 Copyright © 2019 John Wiley & Sons, Inc. 92, 278 12

Schedule of Interest Revenue and Bond Discount Amortization— Effective- Interest Method LO 1 Copyright

Schedule of Interest Revenue and Bond Discount Amortization— Effective- Interest Method LO 1 Copyright © 2019 John Wiley & Sons, Inc. 13

Amortized Cost – July 1, 2019 Robinson Company records the receipt of the first

Amortized Cost – July 1, 2019 Robinson Company records the receipt of the first semiannual interest payment on July 1, 2019, as follows: Cash Debt Investments Interest Revenue LO 1 Copyright © 2017 John Wiley & Sons, Inc. 4, 000 614 4, 614 34

Amortized Cost – December 31, 2019 Robinson is on a calendar-year basis, it accrues

Amortized Cost – December 31, 2019 Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2019, as follows: Interest Receivable Debt Investments Interest Revenue LO 1 Copyright © 2017 John Wiley & Sons, Inc. 4, 000 645 4, 645 34

Amortized Cost Reporting of Held-to-Maturity Securities LO 1 Copyright © 2019 John Wiley &

Amortized Cost Reporting of Held-to-Maturity Securities LO 1 Copyright © 2019 John Wiley & Sons, Inc. 16

Amortized Cost – November 1, 2023 Reporting of Held-to-Maturity Securities Robinson Company sells its

Amortized Cost – November 1, 2023 Reporting of Held-to-Maturity Securities Robinson Company sells its investment in Evermaster bonds on November 1, 2023, at 99¾ plus accrued interest. The discount amortization from July 1, 2023, to November 1, 2023, is $635 (4∕ 6 × $952). Robinson records this discount amortization as follows. Debt Investments Interest Revenue LO 1 Copyright © 2019 John Wiley & Sons, Inc. 635 17

Amortized Cost – November 1, 2023 Computation of Gain on Sale of Bonds Robinson

Amortized Cost – November 1, 2023 Computation of Gain on Sale of Bonds Robinson records the sale of the bonds as: Cash Interest Revenue Debt Investments Gain on Sale of Investments LO 1 102, 417 Copyright © 2019 John Wiley & Sons, Inc. 2, 667 99, 683 67 18

Available-for-Sale Securities (Fair Value Through Other Comprehensive Income Companies report available-for-sale securities at •

Available-for-Sale Securities (Fair Value Through Other Comprehensive Income Companies report available-for-sale securities at • fair value, with • unrealized holding gains and losses reported as other comprehensive income, a separate component of stockholder’s equity, until realized. Any discount or premium is amortized. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 19

Available-for-Sale Debt Securities Example: Single Security Graff Corporation purchases $100, 000, 10 percent, five-year

Available-for-Sale Debt Securities Example: Single Security Graff Corporation purchases $100, 000, 10 percent, five-year bonds on January 1, 2019, with interest payable on July 1 and January 1. The bonds sell for $108, 111, which results in a bond premium of $8, 111 and an effective interest rate of 8 percent. Graff records the purchase of the bonds on January 1, 2019, as follows. Debt Investments Cash LO 1 108, 111 Copyright © 2019 John Wiley & Sons, Inc. 108, 111 20

Schedule of Interest Revenue and Bond Premium Amortization— Effective-Interest Method LO 1 Copyright ©

Schedule of Interest Revenue and Bond Premium Amortization— Effective-Interest Method LO 1 Copyright © 2019 John Wiley & Sons, Inc. 21

Single Security – July 1, 2019 The entry to record interest revenue on July

Single Security – July 1, 2019 The entry to record interest revenue on July 1, 2019, is as follows. Cash Debt Investments Interest Revenue LO 1 Copyright © 2017 John Wiley & Sons, Inc. 5, 000 676 4, 324 34

Single Security – Dec. 31, 2019 The entry to record interest revenue on Dec.

Single Security – Dec. 31, 2019 The entry to record interest revenue on Dec. 31, 2019, is as follows. Interest Receivable Debt Investments Interest Revenue LO 1 Copyright © 2017 John Wiley & Sons, Inc. 5, 000 703 4, 297 34

Fair Value Adjustment – Dec. 31, 2019 To apply the fair value method to

Fair Value Adjustment – Dec. 31, 2019 To apply the fair value method to these debt securities, assume that at December 31, 2019 the fair value of the bonds is $105, 000. Graff makes the following entry. Unrealized Holding Gain or Loss—Equity Fair Value Adjustment LO 1 Copyright © 2017 John Wiley & Sons, Inc. 1, 732 34

Available-for-Sale Debt Securities Example: Portfolio of Securities Webb Corporation has two debt securities classified

Available-for-Sale Debt Securities Example: Portfolio of Securities Webb Corporation has two debt securities classified as availablefor-sale. The following illustration identifies the amortized cost, fair value, and the amount of the unrealized gain or loss. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 25

Portfolio of Securities Prepare the adjusting entry Webb would make on December 31, 2020

Portfolio of Securities Prepare the adjusting entry Webb would make on December 31, 2020 to record the loss. Unrealized Holding Gain or Loss—Equity Fair Value Adjustment LO 1 Copyright © 2017 John Wiley & Sons, Inc. 9, 537 34

Sale of Available-for-Sale Securities If company sells bonds before maturity date: • It must

Sale of Available-for-Sale Securities If company sells bonds before maturity date: • It must make entries to remove from the Debt Investments account the amortized cost of bonds sold. • Any realized gain or loss on sale is reported in the “Other” section of the income statement. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 27

Sale of Available-for-Sale Securities Illustration: Webb Corporation sold the Watson bonds on July 1,

Sale of Available-for-Sale Securities Illustration: Webb Corporation sold the Watson bonds on July 1, 2021, for $90, 000, at which time it had an amortized cost of $94, 214. Amortized cost (Watson bonds) Less: Selling price of bonds Loss on sale of bonds Cash Loss on Sale of Investments Debt Investments LO 1 $94, 214 90, 000 $ 4, 214 90, 000 4, 214 Copyright © 2019 John Wiley & Sons, Inc. 94, 214 28

Computation of Fair Value Adjustment —Available for-Sale (2021) Assuming no other purchases and sales

Computation of Fair Value Adjustment —Available for-Sale (2021) Assuming no other purchases and sales of bonds in 2021, Webb on December 31, 2021, prepares the information: LO 1 Copyright © 2019 John Wiley & Sons, Inc. 29

Fair Value Adjustment – Dec. 31, 2021 Webb records the following at December 31,

Fair Value Adjustment – Dec. 31, 2021 Webb records the following at December 31, 2021. Fair Value Adjustment 4, 537 Unrealized Holding Gain or Loss—Equity LO 1 Copyright © 2017 John Wiley & Sons, Inc. 4, 537 34

Available-for-Sale Debt Securities Financial Statement Presentation LO 1 Copyright © 2019 John Wiley &

Available-for-Sale Debt Securities Financial Statement Presentation LO 1 Copyright © 2019 John Wiley & Sons, Inc. 31

Investment in Debt Securities Trading Securities (Fair Value Through Net Income) Companies report trading

Investment in Debt Securities Trading Securities (Fair Value Through Net Income) Companies report trading securities at • fair value, with • unrealized holding gains and losses reported as part of net income. Any discount or premium is amortized. A holding gain or loss is the net change in fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 32

Trading Securities Debt Securities Illustration: On December 31, 2020, Western Publishing Corporation determined its

Trading Securities Debt Securities Illustration: On December 31, 2020, Western Publishing Corporation determined its trading securities portfolio to be as follows: LO 1 Copyright © 2019 John Wiley & Sons, Inc. 33

Trading Securities Computation of Fair Value Adjustment—Trading Securities Portfolio (2020) Illustration: At December 31,

Trading Securities Computation of Fair Value Adjustment—Trading Securities Portfolio (2020) Illustration: At December 31, Western Publishing makes an adjusting entry: Fair Value Adjustment 3, 750 Unrealized Holding Gain or Loss—Equity LO 1 Copyright © 2017 John Wiley & Sons, Inc. 3, 750 34

Trading Securities Illustration Debt Securities Hendricks Corporation purchased trading investment bonds for $50, 000

Trading Securities Illustration Debt Securities Hendricks Corporation purchased trading investment bonds for $50, 000 at par. At December 31, Hendricks received annual interest of $2, 000, and the fair value of the bonds was $47, 400. Instructions: a. Prepare the journal entry for the purchase of the investment. b. Prepare the journal entry for the interest received. c. Prepare the journal entry for the fair value adjustment. LO 1 Copyright © 2019 John Wiley & Sons, Inc. 35

Trading Debt Securities Journal Entry for Purchase of Investment Hendricks Corporation purchased trading investment

Trading Debt Securities Journal Entry for Purchase of Investment Hendricks Corporation purchased trading investment bonds for $50, 000 at par. At December 31, Hendricks received annual interest of $2, 000, and the fair value of the bonds was $47, 400. Prepare the journal entry for the purchase of the investment. Debt Investments Cash LO 1 50, 000 Copyright © 2019 John Wiley & Sons, Inc. 50, 000 36

Trading Debt Securities Journal Entry for Interest Received Hendricks Corporation purchased trading investment bonds

Trading Debt Securities Journal Entry for Interest Received Hendricks Corporation purchased trading investment bonds for $50, 000 at par. At December 31, Hendricks received annual interest of $2, 000, and the fair value of the bonds was $47, 400. Prepare the journal entry for the interest received. Cash Interest Revenue LO 1 2, 000 Copyright © 2019 John Wiley & Sons, Inc. 2, 000 37

Trading Debt Securities Journal Entry for Fair Value Adjustment Hendricks Corporation purchased trading investment

Trading Debt Securities Journal Entry for Fair Value Adjustment Hendricks Corporation purchased trading investment bonds for $50, 000 at par. At December 31, Hendricks received annual interest of $2, 000, and the fair value of the bonds was $47, 400. Prepare the journal entry for the fair value adjustment. Unrealized Holding Loss – Income Fair Value Adjustment LO 1 Copyright © 2019 John Wiley & Sons, Inc. 2, 600 38

Learning Objective 2 Describe the Accounting for Investments in Equity Securities LO 2 Copyright

Learning Objective 2 Describe the Accounting for Investments in Equity Securities LO 2 Copyright © 2019 John Wiley & Sons, Inc. 39

Investments in Equity Securities Represent ownership of capital stock. Cost includes: • price of

Investments in Equity Securities Represent ownership of capital stock. Cost includes: • price of the security, plus • broker’s 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. LO 2 Copyright © 2019 John Wiley & Sons, Inc. 40

Classification of Equity Investments LO 2 Copyright © 2019 John Wiley & Sons, Inc.

Classification of Equity Investments LO 2 Copyright © 2019 John Wiley & Sons, Inc. 41

Investments in Equity Securities Accounting and Reporting by Category Valuation Unrealized Holding Gains or

Investments in Equity Securities Accounting and Reporting by Category Valuation Unrealized Holding Gains or Losses Other Income Effects Holdings less than 20% Fair value* Recognized in net income Dividends declared; gains and losses from sale. Holdings between 20% and 50% Equity Not recognized Proportionate share of investee's net income. Holdings more than 50% Consolidation Not recognized Not applicable. *Companies report all equity investments at fair value and record unrealized gains and losses through net income. The only exception would be for practicability reasons for determining fair value. LO 2 Copyright © 2019 John Wiley & Sons, Inc. 42

Investments in Equity Securities Holding of Less Than 20% Accounting Subsequent to Acquisition Without

Investments in Equity Securities Holding of Less Than 20% Accounting Subsequent to Acquisition Without Readily Determinable Fair Value and report the investment using the fair value method. Readily Determinable Fair Value and report the investment using a practicability exception. * *Entities report equity investments at cost adjusted for changes in observable prices minus impairment. Entities recognize dividends when received and generally recognize gains or losses when selling the securities. LO 2 Copyright © 2019 John Wiley & Sons, Inc. 43

Holdings of Less Than 20% Upon acquisition, companies record equity securities at cost. Illustration:

Holdings of Less Than 20% Upon acquisition, companies record equity securities at cost. Illustration: On November 3, 2020, Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest. Northwest Industries, Inc. Campbell Soup Co. St. Regis Pulp Co. Total cost LO 2 Cost $259, 700 317, 500 141, 350 $718, 550 Copyright © 2019 John Wiley & Sons, Inc. 44

Holdings of Less Than 20% Dividends Received Illustration: On December 6, 2020, Republic receives

Holdings of Less Than 20% Dividends Received Illustration: On December 6, 2020, Republic receives a cash dividend of $4, 200 from Campbell Soup Co. Cash Dividend Revenue LO 2 Copyright © 2019 John Wiley & Sons, Inc. 4, 200 45

Holdings of Less Than 20% Portfolio Illustration: Republic’s available-for-sale equity security portfolio on December

Holdings of Less Than 20% Portfolio Illustration: Republic’s available-for-sale equity security portfolio on December 31, 2020: LO 2 Copyright © 2019 John Wiley & Sons, Inc. 46

Holdings of Less Than 20% Fair Value Adjustment Illustration: Prepare the entry Republic would

Holdings of Less Than 20% Fair Value Adjustment Illustration: Prepare the entry Republic would make on December 31, 2020, to record the net unrealized gains and losses. Unrealized Holding Loss – Income Fair Value Adjustment LO 2 Copyright © 2017 John Wiley & Sons, Inc. 35, 550 34

Holdings of Less Than 20% Computation of Gain on Sale of Stock Illustration: On

Holdings of Less Than 20% Computation of Gain on Sale of Stock Illustration: On January 23, 2021, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287, 220. Prepare the entry to record the sale. Net proceeds from sale Cost of Northwest shares Gain on sale of stock Cash Equity Investments Gain on Sale of Investments LO 2 Copyright © 2019 John Wiley & Sons, Inc. $287, 220 259, 700 $ 27, 520 287, 220 259, 700 27, 520 48

Fair Value Adjustment - 2021 Illustration: On February 10, 2021, Republic purchased 20, 000

Fair Value Adjustment - 2021 Illustration: On February 10, 2021, Republic purchased 20, 000 shares of Continental Trucking at a price of $12. 75 per share plus brokerage commissions of $1, 850 (total cost, $256, 850). LO 2 Copyright © 2019 John Wiley & Sons, Inc. 49

Fair Value Adjustment – 2021 Journal Entry Illustration: On Prepare the entry that Republic

Fair Value Adjustment – 2021 Journal Entry Illustration: On Prepare the entry that Republic would make at December 31, 2021, to adjust its portfolio to fair value. Fair Value Adjustment 99, 800 Unrealized Holding Gain or Loss—Income 99, 800 LO 2 Copyright © 2017 John Wiley & Sons, Inc. 34

Learning Objective 3 Explain the Equity and Consolidation Methods of Accounting LO 3 Copyright

Learning Objective 3 Explain the Equity and Consolidation Methods of Accounting LO 3 Copyright © 2019 John Wiley & Sons, Inc. 51

Investments in Equity Securities Holding Between 20% and 50% (Equity Method) An investment (direct

Investments in Equity Securities Holding Between 20% and 50% (Equity Method) An investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee. In instances of “significant influence, ” the investor must account for the investment using the equity method. LO 3 Copyright © 2019 John Wiley & Sons, Inc. 52

Holdings Between 20% and 50% Comparison of Equity Method to Fair Value Record the

Holdings Between 20% and 50% Comparison of Equity Method to Fair Value Record the investment at cost and subsequently adjust the amount each period for • the investor’s proportionate share of the earnings (losses) and • dividends received by the investor. If investor’s share of investee’s losses exceeds the carrying amount of the investment, the investor ordinarily should discontinue applying the equity method and not recognize additional losses. LO 3 Copyright © 2019 John Wiley & Sons, Inc. 53

Fair Value Method vs. Equity Method Copyright © 2019 John Wiley & Sons, Inc.

Fair Value Method vs. Equity Method Copyright © 2019 John Wiley & Sons, Inc. 54

Investments in Equity Securities Holding of More Than 50% (Consolidation) Controlling Interest - When

Investments in Equity Securities Holding of More Than 50% (Consolidation) Controlling Interest - When one corporation acquires a voting interest of more than 50 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 parent’s balance sheet as a long-term investment. • Parent generally prepares consolidated financial statements. LO 3 Copyright © 2019 John Wiley & Sons, Inc. 55

Learning Objective 4 Evaluate Other Major Issues Related to Investments in Debt and Equity

Learning Objective 4 Evaluate Other Major Issues Related to Investments in Debt and Equity Securities LO 4 Copyright © 2019 John Wiley & Sons, Inc. 56

Other Financial Reporting Issues Fair Value Option Companies have the option to report most

Other Financial Reporting Issues Fair Value Option Companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in income. • Applied on an instrument-by-instrument basis. • Generally available only at time a company first purchases financial asset or incurs a financial liability. • Company must measure this instrument at fair value until the company no longer has ownership. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 57

Fair Value Option Available-for-Sale Debt Securities Illustration: Hardy Company purchases stock in Fielder Company

Fair Value Option Available-for-Sale Debt Securities Illustration: Hardy Company purchases stock in Fielder Company during 2020 that it classifies as available-for-sale. At December 31, 2020, the cost of this security is $100, 000; its fair value at December 31, 2020, is $125, 000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2020. Equity Investments 25, 000 Unrealized Holding Gain or Loss—Income 25, 000 LO 4 Copyright © 2019 John Wiley & Sons, Inc. 58

Fair Value Option Equity Method Investments Illustration: Durham Company holds a 28 percent stake

Fair Value Option Equity Method Investments Illustration: Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2020 for $930, 000. At December 31, 2020, the fair value of the investment is $900, 000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this investment is as follows. Unrealized Holding Gain or Loss—Income Equity Investments LO 4 Copyright © 2019 John Wiley & Sons, Inc. 30, 000 59

Impairment of Value Receivables The rules for debt investments (debt securities and loans) reported

Impairment of Value Receivables The rules for debt investments (debt securities and loans) reported at amortized cost follow the same approach as discussed in Chapter 7. That is, companies should use the current expected credit loss model to record the impairment of debt investments similar to receivables. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 60

Impairment of Value Debt Investments: Held-to-Maturity Illustration: Strickler Company holds held-to-maturity bond securities with

Impairment of Value Debt Investments: Held-to-Maturity Illustration: Strickler Company holds held-to-maturity bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800, 000. In evaluating the securities, Strickler now determines that it is probable that it will not collect all amounts due. In this case, it reports a Loss on Impairment of $200, 000. Strickler includes this amount in income and records the impairment as follows. Allowance for Doubtful Accounts Debt Investments LO 4 Copyright © 2019 John Wiley & Sons, Inc. 200, 000 61

Impairment of Value Debt Investments: Available-for-Sale Companies that have debt investments that are classified

Impairment of Value Debt Investments: Available-for-Sale Companies that have debt investments that are classified as available-for-sale use a different impairment model. Under this model, if the fair value is greater than amortized cost, no expected credit loss is recognized. Impairment losses on debt investments that are available -for-sale are limited to the difference between fair value and amortized cost. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 62

Debt Investments: Available-for-Sale Illustration The following illustration provides an impairment analysis based on these

Debt Investments: Available-for-Sale Illustration The following illustration provides an impairment analysis based on these impairment guidelines for Alexander Company. Facts Amortized cost Fair value Expected credit loss recognized in net income Unrealized Holding Gain or (Loss)—Equity LO 4 Situation A Situation B Situation C $1, 000, 000 $1, 000 1, 100, 000 960, 000 860, 000 110, 000 -0 - 40, 000 110, 000 100, 000 -0 - 30, 000 Copyright © 2019 John Wiley & Sons, Inc. 63

Debt Investments: Available-for-Sale Situation A Alexander does not recognize an impairment loss because the

Debt Investments: Available-for-Sale Situation A Alexander does not recognize an impairment loss because the fair value of $1, 100, 000 is higher than the amortized cost of $1, 000. The entry Alexander makes is to record an unrealized holding gain of $100, 000 ($1, 100, 000 − $1, 000) in other comprehensive income. Fair Value Adjustment 100, 000 Unrealized Holding Gain or Loss—Equity 100, 000 Alexander does not recognize any impairment because the fair value of its security is above its amortized cost. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 64

Debt Investments: Available-for-Sale Situation B Alexander recognizes an impairment loss of $40, 000 ($1,

Debt Investments: Available-for-Sale Situation B Alexander recognizes an impairment loss of $40, 000 ($1, 000 − $960, 000) even though the expected credit loss is $110, 000. In other words, Alexander’s impairment loss is limited to the amount that fair value is less than amortized cost. Alexander makes the following entry to record this loss. Bad Debt Expense Allowance for Doubtful Accounts LO 4 Copyright © 2019 John Wiley & Sons, Inc. 40, 000 65

Debt Investments: Available-for-Sale Situation C Alexander recognizes an impairment loss of $110, 000 and

Debt Investments: Available-for-Sale Situation C Alexander recognizes an impairment loss of $110, 000 and an unrealized holding loss through other comprehensive income of $30, 000. In other words, Alexander separates the total loss of $140, 000 ($1, 000 − $860, 000) into the following two components. 1. The credit loss or the amount representing the decrease in cash flows expected to be collected of $110, 000. 2. The noncredit-related factors, such as changes in interest rates, market volatility, and liquidity concerns, of $30, 000. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 66

Debt Investments: Available-for-Sale Situation C Journal Entry Alexander makes the following entry. Bad Debt

Debt Investments: Available-for-Sale Situation C Journal Entry Alexander makes the following entry. Bad Debt Expense Unrealized Holding Gain or Loss—Equity Allowance for Doubtful Accounts Fair Value Adjustment LO 4 Copyright © 2019 John Wiley & Sons, Inc. 110, 000 30, 000 67

Impairment of Value Equity Investments Asset Measurement Basis Impairment Model Loans, receivables, and debt

Impairment of Value Equity Investments Asset Measurement Basis Impairment Model Loans, receivables, and debt securities measured at amortized cost. Expected losses recognized in net income. Debt securities measured at fair value with gains and losses recorded in other comprehensive income (available-for-sale). No expected credit losses recognized if fair value is greater than or equal to amortized cost. If fair value is less than amortized cost, the expected credit loss is recognized in net income. Credit losses are limited to the difference between fair value and amortized cost. Debt and equity securities measured at fair value with gains and losses recorded in net income. Impairment measured as the difference between the lower of amortized cost or fair value (debt securities) or lower of cost or fair value (equity securities). LO 4 Copyright © 2019 John Wiley & Sons, Inc. 68

Other Financial Reporting Issues Reclassification Adjustments As we indicated in Chapter 4, companies may

Other Financial Reporting Issues Reclassification Adjustments As we indicated in Chapter 4, companies may display the components of other comprehensive income in one of two ways: 1. in a combined statement of income and comprehensive income, or 2. in a separate statement of comprehensive income that begins with net income. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 69

Reclassification Adjustments Reporting Issues Single-Period Example: Assume that on January 1, 2020, Hinges Co.

Reclassification Adjustments Reporting Issues Single-Period Example: Assume that on January 1, 2020, Hinges Co. had cash and common stock of $50, 000. 13 At that date, the company had no other asset, liability, or equity balance. On January 2, Hinges purchased for cash $50, 000 of debt securities classified as available-for-sale. On June 30, Hinges sold part of the available-for-sale security debt portfolio, realizing a gain as shown in the following illustration. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 70

Reporting Issues Single-Period Example Computation of Realized Gain Fair value of securities sold Less:

Reporting Issues Single-Period Example Computation of Realized Gain Fair value of securities sold Less: Cost of securities sold Realized gain LO 4 Copyright © 2019 John Wiley & Sons, Inc. $22, 000 20, 000 $ 2, 000 71

Single-Period Example Computation of Unrealized Gain Hinges did not purchase or sell any other

Single-Period Example Computation of Unrealized Gain Hinges did not purchase or sell any other securities during 2020. It received $3, 000 in interest during the year. At December 31, 2020, the remaining portfolio is as shown as follows. Fair value of portfolio Less: Cost of portfolio Unrealized gain LO 4 Copyright © 2019 John Wiley & Sons, Inc. $34, 000 30, 000 $ 4, 000 72

Single-Period Example Income Statement The following illustration shows the company’s income statement for 2020.

Single-Period Example Income Statement The following illustration shows the company’s income statement for 2020. Hinges Co. Income Statement For the Year Ended December 31, 2020 Interest revenue Realized gains on investment in securities Net income LO 4 Copyright © 2019 John Wiley & Sons, Inc. $3, 000 2, 000 $5, 000 73

Single-Period Example Statement of Comprehensive Income Hinges Co. Statement of Comprehensive Income For the

Single-Period Example Statement of Comprehensive Income Hinges Co. Statement of Comprehensive Income For the Year Ended December 31, 2020 Net income (includes realized gain of $2, 000) Other comprehensive income: Unrealized holding gain Comprehensive income LO 4 Copyright © 2019 John Wiley & Sons, Inc. $5, 000 4, 000 $9, 000 74

Single-Period Example Statement of Stockholders’ Equity LO 4 Copyright © 2019 John Wiley &

Single-Period Example Statement of Stockholders’ Equity LO 4 Copyright © 2019 John Wiley & Sons, Inc. 75

Single-Period Example Comparative Balance Sheet LO 4 Copyright © 2019 John Wiley & Sons,

Single-Period Example Comparative Balance Sheet LO 4 Copyright © 2019 John Wiley & Sons, Inc. 76

Reporting Issues Multi-Period Example When a company sells securities during the year, doublecounting of

Reporting Issues Multi-Period Example When a company sells securities during the year, doublecounting of the realized gains or losses in comprehensive income can occur. This double-counting results when a company reports unrealized gains or losses in other comprehensive income in a prior period and reports these gains or losses as part of net income in the current period. To ensure that gains and losses are not counted twice when a sale occurs, a reclassification adjustment is necessary. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 77

Multi-Period Example Available-for-Sale Security Portfolio (2020) Assume Open Company has the following two available-forsale

Multi-Period Example Available-for-Sale Security Portfolio (2020) Assume Open Company has the following two available-forsale securities in its portfolio at the end of 2020 (its first year of operations). LO 4 Copyright © 2019 John Wiley & Sons, Inc. 78

Multi-Period Example Journal Entry December 31, 2020 Fair Value Adjustment 40, 000 Unrealized Holding

Multi-Period Example Journal Entry December 31, 2020 Fair Value Adjustment 40, 000 Unrealized Holding Gain or Loss—Equity 40, 000 LO 4 Copyright © 2017 John Wiley & Sons, Inc. 79

Multi-Period Example Statement of Comprehensive Income (2020) Open Company reports net income in 2020

Multi-Period Example Statement of Comprehensive Income (2020) Open Company reports net income in 2020 of $350, 000. Open Company Statement of Comprehensive Income For the Year Ended December 31, 2020 Net income Other comprehensive income: Unrealized holding gain Comprehensive income LO 4 Copyright © 2019 John Wiley & Sons, Inc. $350, 000 40, 000 $390, 000 80

Multi-Period Example Closing Entry December 31, 2020 At December 31, 2020, Open Company reports

Multi-Period Example Closing Entry December 31, 2020 At December 31, 2020, Open Company reports on its balance sheet debt investments of $240, 000 (cost $200, 000 plus fair value adjustment of $40, 000) and accumulated other comprehensive income in stockholders’ equity of $40, 000. The entry to transfer the unrealized holding gain—equity to accumulated other comprehensive income is as follows. Unrealized Holding Gain or Loss—Equity 40, 000 Accumulated Other Comprehensive Income 40, 000 LO 4 Copyright © 2017 John Wiley & Sons, Inc. 81

Multi-Period Example Sale of Lehman Inc. Bonds On August, 10, 2021, Open Company sells

Multi-Period Example Sale of Lehman Inc. Bonds On August, 10, 2021, Open Company sells its Lehman Inc. bonds for $105, 000 and realizes a gain on the sale of $25, 000 ($105, 000 − $80, 000). The journal entry to record this transaction is as follows. Cash Debt Investments Gain on Sale of Investments LO 4 Copyright © 2017 John Wiley & Sons, Inc. 105, 000 80, 000 25, 000 82

Multi-Period Example Available-for-Sale Security Portfolio (2021) At the end of 2021, this illustration shows

Multi-Period Example Available-for-Sale Security Portfolio (2021) At the end of 2021, this illustration shows the computation of the change in the Fair Value Adjustment account (based on only the Woods Co. investment as the Lehman bonds have been sold). LO 4 Copyright © 2019 John Wiley & Sons, Inc. 83

Multi-Period Example Journal Entry at December 31, 2021 Unrealized Holding Gain or Loss—Equity Fair

Multi-Period Example Journal Entry at December 31, 2021 Unrealized Holding Gain or Loss—Equity Fair Value Adjustment LO 4 Copyright © 2017 John Wiley & Sons, Inc. 5, 000 84

Multi-Period Example Statement of Comprehensive Income (2021) Open Company reports net income in 2021

Multi-Period Example Statement of Comprehensive Income (2021) Open Company reports net income in 2021 of $720, 000. Open Company Statement of Comprehensive Income For the Year Ended December 31, 2021 Net income (includes $24, 500 realized gain) Other comprehensive income Unrealized holding loss Comprehensive income LO 4 Copyright © 2019 John Wiley & Sons, Inc. $720, 000 (5, 000) $715, 000 85

Multi-Period Example Closing Entry December 31, 2021 At December 31, 2021, Open Company reports

Multi-Period Example Closing Entry December 31, 2021 At December 31, 2021, Open Company reports on its balance sheet debt investments of $155, 000 (cost $120, 000 plus a fair value adjustment of $35, 000) and accumulated other comprehensive income in stockholders’ equity of $35, 000 ($40, 000 − $5, 000). The entry to transfer the unrealized holding loss—equity to accumulated other comprehensive income is as follows. Accumulated Other Comprehensive Income Unrealized Holding Gain or Loss—Equity LO 4 Copyright © 2017 John Wiley & Sons, Inc. 5, 000 86

Multi-Period Example Note Disclosure of Reclassification Adjustments The FASB prefers to show the reclassification

Multi-Period Example Note Disclosure of Reclassification Adjustments The FASB prefers to show the reclassification amount in accumulated other comprehensive income in the notes to the financial statements. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 87

Other Financial Reporting Issues Transfers Related to Debt Securities Type of Transfer Measurement Basis

Other Financial Reporting Issues Transfers Related to Debt Securities Type of Transfer Measurement Basis Impact of Transfer on Stockholders' Equity* Transfer from trading to available-for-sale Security transferred at fair value at the date of transfer, which is the new cost basis of the security. The unrealized gain or loss at the date of transfer increases or decreases stockholders' equity. The unrealized gain or loss at the date of transfer is recognized in income. Transfer from available-for-sale to trading Security transferred at fair value at the date of transfer, which is the new cost basis of the security. The unrealized gain or loss at the date of transfer increases or decreases stockholders' equity. The unrealized gain or loss at the date of transfer is recognized in income. Transfer from held-tomaturity to availablefor-sale** Security transferred at fair value at the date of transfer. The separate component of stockholders' equity is increased or decreased by the unrealized gain or loss at the date of transfer. None. LO 4 Copyright © 2019 John Wiley & Sons, Inc. Impact of Transfer on Net Income* 88

Other Financial Reporting Issues Transfers Related to Debt Securities (continued) Type of Transfer Measurement

Other Financial Reporting Issues Transfers Related to Debt Securities (continued) Type of Transfer Measurement Basis Transfer from available-for-sale to held-to-maturity Security transferred at fair value at the date of transfer. Impact of Transfer on Stockholders' Equity* Impact of Transfer on Net Income* The unrealized gain or loss at the date of transfer carried as a separate component of stockholders' equity is amortized over the remaining life of the security. None. * Assumes that adjusting entries to report changes in fair value for the current period are not yet recorded. ** According to G A A P, these types of transfers should be rare. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 89

Summary of Reporting Treatment of Securities Classification* Valuation Approach and Balance Sheet Reporting Income

Summary of Reporting Treatment of Securities Classification* Valuation Approach and Balance Sheet Reporting Income Effects Debt Classifications Trading Fair value. Current assets. Interest is recognized as revenue. Available-for-sale Fair value. Current or noncurrent assets. Interest is recognized as revenue. Unrealized holding gains and losses are not recognized in income but in other comprehensive income. Held-to-maturity Amortized cost. Current or noncurrent assets. Interest is recognized as revenue. *Companies have the option to report financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. If a company chooses to use the fair option for some of its financial instruments, these assets or liabilities should be reported separately from other financial instruments that use a different valuation basis. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 90

Summary Classification Valuation Approach and Balance Sheet Reporting Income Effects Equity Classifications Holdings less

Summary Classification Valuation Approach and Balance Sheet Reporting Income Effects Equity Classifications Holdings less 20% Fair value. Current or noncurrent assets. Dividends are recognized as revenue. Unrealized gains and losses are included in income. Holdings between 20% and 50% Equity method. Investments originally recorded at cost with periodic adjustment for the investor's share of the investee's income or loss, and decreased by all dividends received from the investee, subsequent to the date of the investment. Revenue is recognized to the extent of the investee's income or loss. Holdings more than 50% Consolidation of financial statements. Parent and subsidiary company income or loss combined. Nonmarketable Cost. Dividends are recognized as revenue. LO 4 Copyright © 2019 John Wiley & Sons, Inc. 91

Learning Objective 5 Describe the Uses of and Accounting for Derivatives LO 5 Copyright

Learning Objective 5 Describe the Uses of and Accounting for Derivatives LO 5 Copyright © 2019 John Wiley & Sons, Inc. 92

Appendix 17 A: Accounting for Derivative Instruments Defining Derivatives Financial instruments that derive their

Appendix 17 A: Accounting for Derivative Instruments Defining Derivatives Financial instruments that derive their value from values of other assets (e. g. , stocks, bonds, or commodities). Three different types of derivatives: 1. Financial forwards or financial futures. 2. Options. 3. Swaps. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 93

Accounting for Derivative Instruments Who uses Derivatives, and Why? Producers and Consumers • Commodity

Accounting for Derivative Instruments Who uses Derivatives, and Why? Producers and Consumers • Commodity prices are volatile. • They depend on weather, crop production, and general economic conditions. • To plan effectively, it makes good sense to lock in specific future revenues or costs in order to run their businesses successfully. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 94

Who uses Derivatives, and Why? Speculators and Arbitrageurs • The speculator who may be

Who uses Derivatives, and Why? Speculators and Arbitrageurs • The speculator who may be in the market for only a few hours, will then sell the forward contract to another speculator or to a company. • Arbitrageurs attempt to exploit inefficiencies in markets. They seek to lock in profits by simultaneously entering into transactions in two or more markets. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 95

Basic Principles in Accounting for Derivative 1. Recognize derivatives in the financial statements as

Basic Principles in Accounting for Derivative 1. Recognize derivatives in the financial statements as assets and liabilities. 2. Report derivatives at fair value. 3. Recognize gains and losses resulting from speculation in derivatives immediately in income. 4. Report gains and losses resulting from hedge transactions differently, depending on the type of hedge. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 96

Example of Derivative Financial Instrument-Speculation Assume that a company purchases a call option contract

Example of Derivative Financial Instrument-Speculation Assume that a company purchases a call option contract from Baird Investment Co. on January 2, 2020, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1, 000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2020. The company purchases the call option for $400 and makes the following entry on January 2, 2020. Option Call Option 400 Premium 400 Cash LO 5 Copyright © 2019 John Wiley & Sons, Inc. 97

Example of Derivative Financial Instrument-Speculation Option Premium Formula – Intrinsic Value The option premium

Example of Derivative Financial Instrument-Speculation Option Premium Formula – Intrinsic Value The option premium consists of two amounts. Option Premium = Intrinsic Value + Time Value Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2020, the intrinsic value is zero because the market price equals the preset strike price. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 98

Example of Derivative Financial Instrument-Speculation Option Premium Formula – Time Value The option premium

Example of Derivative Financial Instrument-Speculation Option Premium Formula – Time Value The option premium consists of two amounts. Option Premium = Intrinsic Value + Time Value Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is $400. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 99

Derivative Instrument-Speculation Additional Data with Respect to Call Option Date Market Price of Laredo

Derivative Instrument-Speculation Additional Data with Respect to Call Option Date Market Price of Laredo Shares Time Value of Call Option March 31, 2020 $120 per share $100 April 16, 2020 115 per share 60 On March 31, 2020, the price of Laredo shares increases to $120 per share. The intrinsic value of the call option contract is now $20, 000. That is, the company can exercise the call option and purchase 1, 000 shares from Baird Investment for $100 per share. It can then sell the shares in the market for $120 per share. This gives the company a gain on the option contract of $20, 000 on the option contract. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 100

Derivative Instrument-Speculation Journal Entries March 31, 2020 On March 31, 2020, it records the

Derivative Instrument-Speculation Journal Entries March 31, 2020 On March 31, 2020, it records the increase in the intrinsic value of the option as follows. Call Option Unrealized Holding Gain or Loss—Income 20, 000 A market appraisal indicates that the time value of the option at March 31, 2020, is $100. The company records this change in value of the option as follows. Unrealized Holding Gain or Loss—Income Call Option ($400 − $100) LO 5 Copyright © 2019 John Wiley & Sons, Inc. 300 101

Derivative Instrument-Speculation At March 31, 2020, the company reports the • call option in

Derivative Instrument-Speculation At March 31, 2020, the company reports the • call option in its balance sheet at fair value of $20, 100. • unrealized holding gain which increases net income. • loss on the time value of the option which decreases net income. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 102

Derivative Instrument-Speculation Journal Entries April 16, 2020 On April 16, 2020, the company settles

Derivative Instrument-Speculation Journal Entries April 16, 2020 On April 16, 2020, the company settles the option before it expires. To properly record the settlement, it updates the value of the option for the decrease in the intrinsic value of $5, 000 ([$120 − $115]) × 1, 000) as follows. Unrealized Holding Gain or Loss—Income Call Option 5, 000 The decrease in the time value of the option of $40 ($100 − $60) is recorded as follows. Unrealized Holding Gain or Loss—Income Call Option LO 5 Copyright © 2019 John Wiley & Sons, Inc. 40 40 103

Derivative Instrument-Speculation Journal Entries April 16, 2020 (continued) At the time of settlement, the

Derivative Instrument-Speculation Journal Entries April 16, 2020 (continued) At the time of settlement, the call option’s carrying value is as follows: Call Option January 2, 2020 400 March 31, 2020 300 March 31, 2020 20, 000 April 16, 2020 5, 000 April 16, 2020 40 Balance, April 16, 2020 15, 060 Settlement of the option contract is recorded as follows. Cash Loss on Settlement of Call Option LO 5 Copyright © 2019 John Wiley & Sons, Inc. 15, 000 60 15, 060 104

Derivative Instrument-Speculation Effect on Income—Derivative Financial Instrument Date March 31, 2017 Transaction Net increase

Derivative Instrument-Speculation Effect on Income—Derivative Financial Instrument Date March 31, 2017 Transaction Net increase in value of call option ($20, 000 - $300) April 16, 2017 Decrease in value of call option ($5, 000 + $40) April 16, 2017 Settle call option Total net income Total Net income LO 5 Copyright © 2019 John Wiley & Sons, Income (Loss) Effect $19, 700 (5, 040) (60) $14, 600 105

Differences Between Traditional and Derivative Financial Instruments A derivative financial instrument has the following

Differences Between Traditional and Derivative Financial Instruments A derivative financial instrument has the following three basic characteristics. 1. The instrument has (1) one or more underlyings and (2) an identified payment provision. 2. The instrument requires little or no investment at the inception of the contract. 3. The instrument requires or permits net settlement. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 106

Features of Traditional and Derivative Financial Instruments Feature Traditional Financial Instrument (Trading Security) Derivative

Features of Traditional and Derivative Financial Instruments Feature Traditional Financial Instrument (Trading Security) Derivative Financial Instrument (Call Option) Payment provision Stock price times the number of shares. Change in stock price (underlying) times number of shares (notional amount). Initial investment Investor pays full cost. Initial investment is much less than full cost. Settlement Deliver stock to receive cash. Receive cash equivalent, based on changes in stock price times the number of shares. LO 5 Copyright © 2019 John Wiley & Sons, Inc. 107

Learning Objective 6 Explain the Accounting for Hedges LO 6 Copyright © 2019 John

Learning Objective 6 Explain the Accounting for Hedges LO 6 Copyright © 2019 John Wiley & Sons, Inc. 108

Derivatives Used for Hedging: The use of derivatives to offset the negative impacts of

Derivatives Used for Hedging: The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. FASB allows special accounting for two types of hedges— • fair value and • cash flow hedges. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 109

Derivatives Used for Hedging Fair Value Hedge A company uses a derivative to hedge

Derivatives Used for Hedging Fair Value Hedge A company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment. In a perfectly hedged position, the gain or loss on the fair value of the derivative equals and offsets that of the hedged asset or liability. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 110

Fair Value Hedge Illustration On December 31, 2020, Hayward Tire Fabricators, Inc. holds an

Fair Value Hedge Illustration On December 31, 2020, Hayward Tire Fabricators, Inc. holds an inventory of 1, 000 tractor tires, with a cost of $200 per tire. Hayward wishes to hedge its exposure to fair value declines for its tire inventory (the inventory is pledged as collateral for one of its bank loans). LO 6 Copyright © 2019 John Wiley & Sons, Inc. 111

Fair Value Hedge Illustration Facts To hedge this risk, Hayward locks in the value

Fair Value Hedge Illustration Facts To hedge this risk, Hayward locks in the value of its tire inventory on January 2, 2021, by purchasing a put option to sell rubber at a fixed price. Hayward designates the option as a fair value hedge of the tire inventory. This put option (which expires in two years) gives Hayward the option to sell 4, 000 pounds of rubber at a price of $50 per pound, which is the current spot price for rubber in the market. Since the exercise price equals the current market price, no entry is necessary at inception of the put option. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 112

Fair Value Hedge Journal Entries March 31, 2021 At March 31, 2021, the fair

Fair Value Hedge Journal Entries March 31, 2021 At March 31, 2021, the fair value of the inventory has declined by 10 percent. Hayward records the following. Unrealized Holding Gain or Loss—Income Allowance to Reduce Inventory to Fair Value 20, 000 The following journal entry records the increase in value of the put option to sell rubber, assuming that the spot price for rubber declined by 10 percent. Put Option Unrealized Holding Gain or Loss—Income LO 6 Copyright © 2019 John Wiley & Sons, Inc. 20, 000 113

Fair Value Hedge Balance Sheet Presentation Hayward reports the amounts related to the Inventory

Fair Value Hedge Balance Sheet Presentation Hayward reports the amounts related to the Inventory and the put option. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 114

Fair Value Hedge Income Statement Presentation Hayward reports the effects of the hedging transaction

Fair Value Hedge Income Statement Presentation Hayward reports the effects of the hedging transaction on income for the year ended December 31, 2021. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 115

Derivatives Used for Hedging Cash Flow Hedge Used to hedge exposures to cash flow

Derivatives Used for Hedging Cash Flow Hedge Used to hedge exposures to cash flow risk, which results from the variability in cash flows. Reporting: • Fair value on the balance sheet. • Gains or losses equity, as part of other comprehensive income. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 116

Cash Flow Hedge Illustration: In September 2020 Allied Can Co. anticipates purchasing 1, 000

Cash Flow Hedge Illustration: In September 2020 Allied Can Co. anticipates purchasing 1, 000 metric tons of aluminum in January 2021. 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 1, 000 metric tons of aluminum for $1, 550 per ton. This contract price is good until the contract expires in January 2021. The underlying for this derivative is the price of aluminum. Allied enters into the futures contract on September 1, 2020. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 117

Cash Flow Hedge Journal Entries At December 31, 2020, the price for January delivery

Cash Flow Hedge Journal Entries At December 31, 2020, the price for January delivery of aluminum increases to $1, 575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract. Futures Contract Unrealized Holding Gain or Loss—Equity ([$1, 575 − $1, 550] × 1, 000 tons) 25, 000 Allied reports the futures contract in the balance sheet as a current asset and the gain as part of other comprehensive income. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 118

Cash Flow Hedge Journal Entries January 2021 In January 2021, Allied purchases 1, 000

Cash Flow Hedge Journal Entries January 2021 In January 2021, Allied purchases 1, 000 metric tons of aluminum for $1, 575 and makes the following entry. Aluminum Inventory Cash ($1, 575 × 1, 000 tons) 1, 575, 000 At the same time, Allied makes final settlement on the futures contract. It records the following entry. Cash Futures Contract ($1, 575, 000 − $1, 550, 000) LO 6 Copyright © 2019 John Wiley & Sons, Inc. 25, 000 119

Cash Flow Hedge Effect of Hedge on Cash Flows There are no income effects

Cash Flow Hedge Effect of Hedge on Cash Flows There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 120

Cash Flow Hedge Journal Entries July 2021 Assume that Allied processes the aluminum into

Cash Flow Hedge Journal Entries July 2021 Assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2021) is $1, 700, 000. Allied sells the cans in July 2021 for $2, 000, and records this sale as follows. Cash Sales Revenue 2, 000 Cost of Goods Sold Inventory (cans) 1, 700, 000 LO 6 2, 000 1, 700, 000 Copyright © 2019 John Wiley & Sons, Inc. 121

Cash Flow Hedge Journal Entries July 2021 continued Since the effect of the anticipated

Cash Flow Hedge Journal Entries July 2021 continued Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction. Unrealized Holding Gain or Loss—Equity Cost of Goods Sold 25, 000 The gain on the futures contract, which Allied reported as part of other comprehensive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is $1, 550, 000. LO 6 Copyright © 2019 John Wiley & Sons, Inc. 122

Learning Objective 7 Identify Special Reporting Issues Related to Derivative Financial Instruments That Cause

Learning Objective 7 Identify Special Reporting Issues Related to Derivative Financial Instruments That Cause Unique Accounting Problems LO 7 Copyright © 2019 John Wiley & Sons, Inc. 123

Other Reporting Issues Embedded Derivatives Convertible bond is a hybrid instrument. Two parts: 1.

Other Reporting Issues Embedded Derivatives Convertible bond is a hybrid instrument. Two parts: 1. a debt security, referred to as the host security, and 2. an option to convert the bond to shares of common stock, the embedded derivative. To account for an embedded derivative, a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation. LO 7 Copyright © 2019 John Wiley & Sons, Inc. 124

Other Reporting Issues Qualifying Hedge Criteria that hedging transactions must meet before requiring the

Other Reporting Issues Qualifying Hedge Criteria that hedging transactions must meet before requiring the special accounting for hedges. 1. Documentation, risk management, and designation. 2. Effectiveness of the hedging relationship. 3. Effect on reported earnings of changes in fair values or cash flows. LO 7 Copyright © 2019 John Wiley & Sons, Inc. 125

Summary of Derivative Accounting Under GAAP Derivative Use Speculation Accounting for Derivative At fair

Summary of Derivative Accounting Under GAAP Derivative Use Speculation Accounting for Derivative At fair value with unrealized holding gains and losses recorded in income. Accounting for Hedged Item Not applicable Common Example Call or put option on an equity security. Hedging Fair value LO 7 At fair value with holding At fair value with Put option to hedge gains and losses recorded gains and losses an equity in income. recorded in income. investment. Copyright © 2019 John Wiley & Sons, Inc. 126

Summary of Derivative Accounting Under GAAP (continued) Derivative Use Cash flow LO 7 Accounting

Summary of Derivative Accounting Under GAAP (continued) Derivative Use Cash flow LO 7 Accounting for Derivative Accounting for Hedged Item Common Example At fair value with unrealized holding gains and losses from the hedge recorded in other comprehensive income, and reclassified in income when the hedged transaction's cash flows affect earnings. Use other generally accepted accounting principles for the hedged item. Use of a futures contract to hedge a forecasted purchase of inventory. Copyright © 2019 John Wiley & Sons, Inc. 127

Learning Objective 8 Describe Required Fair Value Disclosures LO 8 Copyright © 2019 John

Learning Objective 8 Describe Required Fair Value Disclosures LO 8 Copyright © 2019 John Wiley & Sons, Inc. 128

Appendix 17 B: Fair Value Disclosures FASB believes that fair value information is relevant

Appendix 17 B: Fair Value Disclosures FASB believes that fair value information is relevant for making effective business decisions. Others express concern about fair value measurements for two reasons: 1. the lack of reliability related to the fair value measurement in certain cases, and 2. the ability to manipulate fair value measurements. LO 8 Copyright © 2019 John Wiley & Sons, Inc. 129

Fair Value Disclosures Disclosure of Fair Value Information: Financial Instruments Both the cost and

Fair Value Disclosures Disclosure of Fair Value Information: Financial Instruments Both the cost and the fair value of all financial instruments are to be reported in the notes to the financial statements. FASB also decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. LO 8 Copyright © 2019 John Wiley & Sons, Inc. 130

Disclosure of Fair Value Information: Financial Instruments Two reasons for additional disclosure beyond the

Disclosure of Fair Value Information: Financial Instruments Two reasons for additional disclosure beyond the simple itemization of fair values are: 1. Differing levels of reliability exist in the measurement of fair value information. 2. Changes 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 8 Copyright © 2019 John Wiley & Sons, Inc. 131

Disclosure of Fair Value Information Levels of reliability fair value hierarchy. • Level 1

Disclosure of Fair Value Information Levels of reliability fair value hierarchy. • Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. • Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities. • Level 3 is least reliable; it uses unobservable inputs that reflect the company’s assumption as to the value of the financial instrument. LO 8 Copyright © 2019 John Wiley & Sons, Inc. 132

Disclosure of Fair Value Information Example of Fair Value Hierarchy LO 8 Copyright ©

Disclosure of Fair Value Information Example of Fair Value Hierarchy LO 8 Copyright © 2019 John Wiley & Sons, Inc. 133

Disclosure of Fair Value Information Reconciliation of Level 3 Inputs LO 8 Copyright ©

Disclosure of Fair Value Information Reconciliation of Level 3 Inputs LO 8 Copyright © 2019 John Wiley & Sons, Inc. 134

Disclosure of Fair Value Information Disclosure of Fair Value, with Impairment LO 8 Copyright

Disclosure of Fair Value Information Disclosure of Fair Value, with Impairment LO 8 Copyright © 2019 John Wiley & Sons, Inc. 135

Learning Objective 9 Compare the Accounting for Investments Under GAAP and IFRS LO 9

Learning Objective 9 Compare the Accounting for Investments Under GAAP and IFRS LO 9 Copyright © 2019 John Wiley & Sons, Inc. 136

IFRS Insights Relevant Facts - Similarities • GAAP and IFRS use similar classifications for

IFRS Insights Relevant Facts - Similarities • GAAP and IFRS use similar classifications for financial assets: cash, loans and receivables, investments, and derivatives. • Both IFRS and GAAP require that financial assets be sorted into specific categories for measurement and classification purposes. • Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. Gains and losses on some investments are reported in other comprehensive income. • Amortized cost or fair value is used depending upon the classification of the financial instrument. • The definition of amortized cost and fair value are the same. LO 9 Copyright © 2019 John Wiley & Sons, Inc. 137

IFRS Insights Relevant Facts – Similarities (continued) • Both GAAP and IFRS use the

IFRS Insights Relevant Facts – Similarities (continued) • Both GAAP and IFRS use the same test to determine whether the equity method of accounting should be used, that is, significant influence with a general guideline of over 20 percent ownership. • GAAP and IFRS are similar in the accounting for the fair value option. That is, the option to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income. LO 9 Copyright © 2019 John Wiley & Sons, Inc. 138

IFRS Insights Relevant Facts – Differences • While GAAP classifies debt investments as trading,

IFRS Insights Relevant Facts – Differences • While GAAP classifies debt investments as trading, available-for-sale, and held-to-maturity, IFRS classifies debt investments as held-forcollection (debt investments) and trading. • GAAP requires that all changes in fair value for all equity securities be reported as part of income. IFRS requires that changes in fair value for non-trading equity securities be reported as part of other comprehensive income. • While the measurement of impairments is similar under G AAP and IFRS, GAAP does not permit the reversal of an impairment charge related to held-to-maturity debt investments and equity investments. IFRS allows reversals of impairments of held-for-collection investments. LO 9 Copyright © 2019 John Wiley & Sons, Inc. 139

IFRS Insights Relevant Facts – Differences (continued) • While GAAP and IFRS are similar

IFRS Insights Relevant Facts – Differences (continued) • While GAAP and IFRS are similar in the accounting for the fair value option, one difference is that GAAP permits the fair value option for equity method investments; IFRS does not. LO 9 Copyright © 2019 John Wiley & Sons, Inc. 140

IFRS Insights On The Horizon At one time, both the FASB and IASB have

IFRS Insights On The Horizon At one time, both the FASB and IASB 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. Under the Boards’ recent standards in this area, GAAP and IFRS are substantially converged, except for non-trading equity investments. LO 9 Copyright © 2019 John Wiley & Sons, Inc. 141

Copyright © 2019 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation

Copyright © 2019 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright © 2019 John Wiley & Sons, Inc. 142