ACC 499 Investments in Common Stock Week 3 Discussion

INVESTMENTS AND LONG-TERM

RECEIVABLES

Investing for the Future

Companies often invest in the debt and equity securities of other companies for a vari- ety of reasons, including obtaining additional income. For example, Apple Inc. gener- ates approximately 42% of its operating cash flows for the year in its first fiscal quarter, but it needs cash throughout the year. Because its operating cash inflows do not coincide with its operating cash outflows, Apple must manage its cash to meet its short-term obligations, while investing excess cash to earn a return. It does this by investing its excess cash in marketable debt and equity securities and selling these marketable securities when it needs cash. At the end of its 2015 fiscal year, Apple had over $184 billion of such investments that allowed it to earn additional income in the form of interest or dividends, as well as profits from the potential price appreci- ation of the securities. By contrast, at the end of fiscal 2015, Starbucks held $81.3 million in short-term and $312.5 million in long-term investment securities.

In addition to obtaining additional income, a company may invest in another company to improve its competitive position. By purchasing shares of a supplier, cus- tomer, or other valuable business, the investing company is able to exert significant influence over that company’s activities. The return from such an investment comes in the form of increased profits and growth. For example, Starbucks has investments that give it significant influence over several international companies that are li- censed to operate Starbucks’s retail stores. In addition, Starbucks recently acquired Teavana to capitalize on the fast-growing, and profitable, tea market. Finally, Star- bucks has also strategically invested in a joint venture with PepsiCo called the North America Coffee Partnership, which produces and distributes Frappuccino�

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13 L E A R N I N G O B J E C T I V E S

After reading this chapter you will

be able to:

LO 13.1 Explain the classification and valuation of investments.

LO 13.2 Account for investments in debt securities classified as held-to- maturity, including amortization of bond premiums and discounts.

LO 13.3 Account for investments in debt and equity securities classified as trading.

LO 13.4 Account for investments in debt securities classified as available- for-sale.

LO 13.5 Understand transfers between categories and impairment of debt and equity securities.

LO 13.6 Account for intercompany investments using the equity method.

LO 13.7 Understand disclosures of investments.

LO 13.8 Account for additional types of investments, including long-term receivables.

LO 13.9 (Appendix 13.1) Account for derivative financial instruments.

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beverages and other espresso drinks to grocery stores and

other outlets. At the end of its 2015 fiscal year, Starbucks

had $306.4 million of such strategic investments.

A major challenge of accounting for investments relates

to the use of fair value measurements. In order to provide rele-

vant information, a company that does not have control or sig-

nificant influence over the investee generally reports the

investment at fair value because it provides the most relevant

information about the value of the investments to financial

statement users. Because the value of investment securities

can change dramatically in a short period of time, accounting

information that reflects fair value allows financial statement

users to better evaluate a company’s investment strategies, as

well as its financial flexibility and liquidity. However, the

changes in fair value introduce uncertainty which could pro-

duce less predictable earnings. In addition, the representa-

tional faithfulness of fair value estimates may diminish when

securities markets become illiquid. Addressing these issues is

critical if accounting wishes to convey the most useful informa-

tion to investors, creditors, and other lenders.

Companies invest excess cash in financial instruments for numerous reasons that range from earning interest, dividends, or capital gains to developing a strategic relationship.1 In this chapter, we focus on investments in debt and equity securities. A debt security represents a creditor relationship with another company. Thus, investments in debt securities include:

• U.S. treasury securities • municipal and corporate bonds • convertible debt • commercial paper • preferred stock that has certain debt-like features

An equity security represents an ownership interest in another company. Thus, invest- ments in equity securities include:

• common stock • preferred stock • stock options, rights, and warrants • put and call options

When a company invests in debt securities and equity securities that have a readily determinable fair value, they are classified as investments on the balance sheet. If the investment is in a relatively small proportion of another company’s equity securities, it is measured at fair value. If the investment is in a debt security, it is measured at either fair value or amortized cost, depending on the company’s intent to hold or sell the securities. The entire group of securities is often referred to as a portfolio of marketable securities (or investment securities).2 However, if a company owns a relatively large proportion of the outstanding equity shares of another company, different methods of accounting apply. If the investment allows the company to significantly influence the investee’s

1 The FASB defines a financial instrument as cash, evidence of an ownership interest in an entity, or a contract that both (1) imposes on one entity a contractual obligation either to deliver cash or another financial instrument to a second entity or to exchange other financial instruments on potentially unfavorable terms with the second entity and (2) conveys to that second entity a contractual right either to receive cash or another financial instrument from the first entity or to exchange other financial instruments on poten- tially favorable terms with the first entity. (FASB ASC Master Glossary)

2 Marketable securities are securities that have readily determinable fair values. A fair value is considered readily determinable if a sales price is currently available on a securities exchange (e.g., the New York Stock Exchange) or in an over-the-counter market for which prices are publicly reported. Nonmarketable securities are those that are not publicly traded. GAAP does not require that nonmarketable securities be reported at fair value. Consequently, most companies report them at historical cost, often referred to as the cost method.

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decisions, the company will use the equity method. If the investment is sufficient for the investor to control the investee, consolidation accounting applies. This chapter focuses on the accounting for a wide variety of investments in the marketable debt and equity securities of other companies.3

In addition, companies commonly include other items in the investments category on the balance sheet, such as long-term receivables, the cash surrender value of life insur- ance policies, and sinking funds. The recording and reporting for these types of invest- ments are also discussed in this chapter.

HOW ARE INVESTMENTS CLASSIFIED AND REPORTED? When a company’s investment is not sufficiently large enough to allow it to control or exert significant influence over the other company, the investment is considered a minority passive investment. Generally, an investment is considered passive when a company owns less than 20% of the voting common stock of the investee. At acquisition, a company classi- fies each passive investment in debt and equity securities into one of three categories:

1. Held-to-Maturity Securities. Investments in held-to-maturity securities are debt securities for which the company has the positive intent and ability to hold until maturity, which is not the same as the absence of an intent to sell.4 Any sales of these securities prior to their maturity should be rare and should be due to a change in cir- cumstances, such as the tax status of the investment, the credit quality of the issuer, or other isolated, nonrecurring, and unusual events for the company. A company does not classify a security as being held-to-maturity if it intends to hold the security for an indefinite period. Therefore, the classification is not appropriate if the security might be sold for reasons such as a change in market interest rates or a need for liquid funds.5

2. Trading Securities. All equity securities and investments in debt securities that are purchased and held principally to sell in the near term are classified as trading securities.6 Trading generally involves active and frequent buying and selling, and the securities are held with the intent to profit on short-term changes in price. Financial institutions such as banks, insurers, and security brokers and dealers gener- ally hold sizable portfolios of trading securities. For example, Citibank reported almost $286 billion of trading assets at December 31, 2013. It is much less common for companies that are not financial institutions to hold trading portfolios; neverthe- less, for 2015, Starbucks reported $65.8 million of investments classified as trading securities, primarily equity mutual funds and equity exchange-traded funds.

3. Available-for-Sale Securities. Investments classified as available-for-sale securities are debt securities that are not classified as held-to-maturity or trading. Available- for-sale securities are investments the company intends to hold for an indefinite pe- riod. Such securities could be held for a long period of time or could be sold if the price of the security becomes attractive or the company needs the funds from the sale. For example, at the end of 2015, Starbucks reported $15.5 million of short- term available-for-sale investments and $312.5 million of long-term available for sale investments.

3 In January 2016, the FASB issued Accounting Standards Update 2016-01: Recognition and Measurement of Financial Assets and Liabilities (FASB ASC 825-10: Financial Instruments — Overall) which is effective for fiscal years beginning after December 15, 2017. This chapter presents GAAP with regard to financial instruments as amended by this Update.

LEARNING OBJECT IVE 13.1 Explain the classification and valuation of investments.

4 FASB ASC 320-10-25: Investments—Debt and Equity Securities: Overall: Recognition. 5 Sales of held-to-maturity debt securities are considered to be at maturity if (1) the security is sold near enough to its maturity that

interest rate risk is substantially eliminated or (2) the sale occurs after the company has collected a substantial portion (e.g., 85%) of the principal.

6 If an investment in an equity security does not have a readily determinable fair value, it may be measured at cost less impairment, plus or minus any observable price changes of an identical or similar investment of the same issuer. Any change in the basis of these equity investments will be reported in current earnings.

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All equity securities with readily determinable fair values must be categorized as trading securities and reported at fair value. The accounting for debt securities differs based on management intent. While these three classifications provide information about managers’ intent regarding their debt investments, they may be criticized as creating the potential for inconsistency in the application of GAAP. For example, companies holding identical debt securities could account for those securities using three different methods. Therefore, allowing classification of investments in debt securities based on management intent may create a lack of comparability among these debt investments both for an indi- vidual company as well as among companies.

A company reports its held-to-maturity securities at amortized cost. Because holders of these securities have the intent and ability to hold the securities until maturity, any changes in fair value prior to the maturity date are not a primary concern in predicting the level and riskiness of cash flows. Therefore, U.S. GAAP allows the use of amortized cost measurement for held-to-maturity securities because it is a faithful representation of the amount invested.

A company reports its investments in trading securities at fair value on the balance sheet with any changes in fair value reported on the income statement as part of net income. Investments classified as available-for-sale are also reported at fair value on the balance sheet; however, any changes in fair value are reported as other comprehensive income and shown in accumulated other comprehensive income in the shareholders’ eq- uity section of the balance sheet. As Chapter 4 describes, fair value is the amount that would be received if a security is sold in an orderly transaction between market partici- pants.7 For marketable investment securities, fair value is generally determined as the number of units of the security times the quoted selling price. Fair value provides a rele- vant measure of these investments because it provides users with more timely measures of the future cash flows that could be realized from the securities (as compared to the ac- quisition or historical cost of those securities). This information helps users evaluate the performance of a company’s investment strategies. It also provides an indication of the fi- nancial flexibility, or solvency, of companies, particularly for financial institutions that have a large portion of their assets in such securities. Using fair values to measure trading and available-for-sale securities results in “unrealized holding gains and losses,” which are the changes in fair value from one period to another. (discussed later in the chapter).

In addition to passive investments, a company may invest in the debt or equity secur- ities of other corporations to establish long-term relationships with suppliers or to obtain significant influence over the companies’ activities. Significant influence generally occurs when the investor owns between 20% and 50% of the voting common stock of the investee. These types of investments are considered minority active investments (or eq- uity method investments). When the investor has significant influence over the investee, the equity method is used to account for the investment, as we discuss later in the chapter.

Consolidation occurs when the investor controls the investee through an investment in equity securities. Legal control occurs when the investor owns more than 50% of the voting common stock of the investee. However, control can also be defined as the power to direct the use of the assets of the investee in essentially the same way as the company can use its own assets. Therefore, a company may possess effective control at a lower ownership level than legal control.8 When the investor controls the investee, the investment is considered a majority active investment. GAAP requires the majority investor to issue consolidated fi- nancial statements, which are the combined financial statements of both companies.9

Exhibit 13.1 provides an overview of the various categories and methods for record- ing and reporting investments in securities. 7 FASB ASC Glossary. 8 The 20% and 50% levels of ownership are guidelines in determining whether significant influence or control exists. A company

may own less than 20% of the voting common stock of the investee and still be considered to have significant influence. Similarly, a company owning less than 50% of the voting common stock may have effective control. The determination of whether significant influence or control exists depends on the full set of circumstances and requires the exercise of professional judgment.

9 Although the underlying concepts of consolidation accounting are briefly discussed in a later section, the preparation of consoli- dated financial statements is covered in advanced accounting texts.

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Fair Value Option As noted in earlier chapters, GAAP allows companies to report most financial instruments at fair value, with unrealized gains and losses recognized in income in the period in which they occur. This fair value option is generally a choice made when a company first purchases a financial asset or incurs a financial liability and must be applied on an instrument-by- instrument basis. The choice as to whether or not to use the fair value option is an irrevocable decision. With regard to financial assets, the effect of the application of the fair value option is to measure the financial assets at fair value on the balance sheet with unrealized gains and losses recognized in net income, consistent with the treatment of trading securities.

In addition, the fair value option allows companies to report certain financial liabilities at fair value, which may provide a more relevant view of the company’s exposure to interest rate risk.10 For example, financial institutions manage their interest rate risk by coordinating their holdings of financial assets and liabilities, effectively creating a hedge against such risk. Therefore, the fair value option allows companies to avoid the earnings volatility that may exist if only one side of their portfolio of financial instruments were reported at fair value.

GOT IT? 13-1 Why do companies purchase securities of other corporations? 13-2 Provide brief definitions for the following terms: (a) debt security, (b) equity security,

and (c) fair value. 13-3 What are the three categories of minority passive investments in debt and equity secur-

ities? Describe the criteria used to classify the investments into these three categories. 13-4 How are each of the three categories of minority passive investments reported on the

balance sheet? 13-5 Identify the accounting methods a company uses for investments of 20% or more in the

voting common stock of the investee.

13.1Accounting for Investments Accounting Methods for Investments

Balance Sheet Income Statement Unrealized Holding Gains

and Losses

Equity Securities 1. No significant influence:

Trading Fair value Dividends, realized gains/losses Net income 2. Significant influence Equity method Proportion of investee’s income Not recognized; disclosed in footnotes 3. Control Consolidation Proportion of investee’s income Not recognized

Debt Securities 1. Trading Fair value Interest, realized gains/losses Net income 2. Available-for-sale Fair value Interest, realized gains/losses Other comprehensive income 3. Held-to-maturity Amortized cost Interest, realized gains/losses Not recognized; disclosed in footnotes

10 The FASB does not require liabilities to be reported at fair value because of the difficulty of determining which liabilities should be reported at fair value and obtaining a reliable value for those liabilities that do not trade in an established market. In addition, not all companies manage risk in the same way. Therefore, the benefits of using fair value for liabilities of these companies may not be worth the additional cost.

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How Are Investments Classified and Reported? 13-5

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HOW ARE INVESTMENTS IN HELD-TO- MATURITY SECURITIES MEASURED AND REPORTED? When a company has the positive ability and intent to hold a debt security to maturity, it can be reported as a held-to-maturity security. The accounting for investments in held- to-maturity debt securities is as follows:

• The investment is initially recorded at cost. • The investment is subsequently reported at amortized cost on the ending balance

sheet(s).11

• Unrealized holding gains and losses are not recognized on the balance sheet or the income statement but are disclosed in the notes to the financial statements.

• Interest income is recognized in net income as it is earned, along with any realized gains and losses on sales (but these should be rare given the held-to- maturity classification).

Recording Initial Cost Investments in debt securities are initially recorded at cost. Cost is determined as the price paid to acquire the debt securities, which can be measured as the principal amount, or face value, of the debt plus any premium or minus any discount at acquisition.12 As discussed more completely in Chapter 14, debt securities, such as bonds, that carry a stated interest rate above the prevailing market interest rate for securities with a similar amount of risk sell at an amount above their face value. This is termed selling at a pre- mium. This premium results in reported interest income being less than the cash received for interest. Debt securities carrying a stated interest rate below the prevailing market rate for securities with a similar amount of risk sell at an amount below their face value. This is termed selling at a discount. The discount results in reported interest income being greater than the cash received for interest.

Example Drinkwitz Company invests in bonds that it intends to hold to maturity. The bonds have a face value of $100,000 and mature on December 31, 2020. Drinkwitz pays $99,000 on January 1, 2018. Interest is payable semiannually on June 30 and December 31. Drinkwitz records this purchase on January 1, 2018, as follows:

Investment in Held-to-Maturity Debt Securities 99,000 Cash 99,000

Note that Drinkwitz includes the $1,000 discount ($100,000 face value 2 $99,000 cost) directly in the investment account.13 �

Recognition of Interest Income and Amortization of Bond Premiums and Discounts Investments in held-to-maturity debt securities that are purchased at a premium (dis- count) result in a market, or effective, interest rate that is below (above) the stated rate. When a company receives the interest on these investments, the cash receipt is based on the stated rate of interest. However, the amount of interest income recognized each

LEARNING OBJECT IVE 13.2 Account for investments in debt securities classified as held-to-maturity, including amortization of bond premiums and discounts.

11 Amortized cost is the remaining amount (e.g., carrying value) of the investment after any premium or discount has been amortized each period and interest revenue is recognized.

12 Other costs, such as brokerage fees, necessary for the acquisition are also included in the cost of the securities. However, these amounts would then be allocated among each security purchased to determine its cost. For simplicity, we do not discuss this procedure.

13 Companies may record any premiums or discounts in a separate valuation account. However, this is not common practice in accounting for investments. Therefore, these journal entries are not shown.

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accounting period is based on the effective (or market) interest rate determined at the time of acquisition. Interest income is computed as follows:

Interest Income5Effective Interest Rate3Book Value of the Investment at Beginning of Period3Time

Consequently, a portion of any premium or discount is amortized over the remaining life of the bonds. This amortization is equal to the difference between the amount of interest income and the cash receipt. This process is known as the effective interest method (or interest method) of amortization.

An alternative procedure to record interest income and account for premiums and discounts is the straight-line method, in which the discount or premium is amortized to interest income in equal amounts each period during the life of the debt security. GAAP requires use of the effective interest method, unless the use of the straight-line method does not result in a material difference in the amount of interest income recognized in any year. These methods are discussed in greater detail in Chapter 14.

Example: Accounting for Premiums Colburn Company invests in bonds that will be held to maturity. The bonds have a face value of $100,000, and Colburn pays $102,458.71 on January 1, 2018, resulting in a premium of $2,458.71 ($102,458.71 2 $100,000). The bonds carry a stated interest rate of 13% payable semiannually on June 30 and December 31. The bonds mature on December 31, 2020, and have an effective interest rate of 12%. Colburn records the acquisition on January 1, 2018, as follows:

Investment in Held-to-Maturity Debt Securities 102,458.71 Cash 102,458.71

Example 13.1 shows the schedule for computing interest income, the premium amor- tization, and the carrying value under the effective interest method for these investments.

Using the effective interest method, Colburn records the first interest receipt on June 30, 2018, for the investment purchased at a premium, as follows:

Cash 6,500.00 Investment in Held-to-Maturity Debt Securities 352.48 Interest Income 6,147.52

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E 13.1Investment Interest Income and Premium Amortization Schedule: Effective

Interest Method

Date Cash

(Debit)a

Interest Income (Credit)b

Investment in Debt Securities

(Credit)c

Carrying Value of Investment in

Debt Securitiesd

1/1/18 $102,458.71 6/30/18 $6,500.00 $6,147.52 $352.48 102,106.23 12/31/18 6,500.00 6,126.37 373.63 101,732.60 6/30/19 6,500.00 6,103.96 396.04 101,336.56 12/31/19 6,500.00 6,080.19 419.81 100,916.75 6/30/20 6,500.00 6,055.01 444.99 100,471.76 12/31/20 6,500.00 6,028.24e 471.76 100,000.00 a $100,000 (face value) 3 0.13 (stated rate of interest) 3 6/12 months. b Previous Investment Carrying Value 3 0.12 (effective interest rate) 3 6/12 months. c Amount from a – Amount from b. d Previous Investment Carrying Value 2 Amount from c. e Difference of $0.07 due to rounding.

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Note that Colburn credits the premium amortization directly to the investment account. Over the remaining life, Colburn records a similar entry every 6 months, using the amounts in the amortization schedule from Example 13.1.

By contrast, if Colburn uses the straight-line method, it would amortize the $2,458.71 premium over the 6 remaining semiannual periods ($2,458:714 6 5 $409:79) and make the following entry every 6 months:

Cash 6,500.00 Investment in Held-to-Maturity Debt Securities 409.79 Interest Income 6,090.21

Example: Accounting for Discounts Colburn Company invests in bonds that will be held to maturity. The bonds have a face value of $100,000, and Colburn pays $97,616.71 on January 1, 2018, resulting in a discount of $2,383.29 ($100,000 2 $97,616.71). The bonds carry a stated interest rate of 13% payable semiannually on June 30 and December 31. The bonds mature on December 31, 2020, and have an effective interest rate of 14%. Colburn records the acquisition on January 1, 2018, as follows:

Investment in Held-to-Maturity Debt Securities 97,616.71 Cash 97,616.71

Example 13.2 illustrates the schedule for computing interest income, the discount amortization, and the carrying value under the effective method for these bonds.

Colburn records the first interest receipt on June 30, 2018, using the effective interest method for the investment purchased at a discount, as follows:

Cash 6,500.00 Investment in Held-to-Maturity Debt Securities 333.17

Interest Income 6,833.17

Note that Colburn debits the discount amortization directly to the investment account.

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13.2 Investment Interest Income and Discount Amortization Schedule: Effective Interest Method

Date Cash

(Debit)a

Interest Income (Credit)b

Investment in Debt Securities

(Debit)c

Carrying Value of Investment in Debt

Securitiesd

1/1/18 $ 97,616.71 6/30/18 $6,500.00 $6,833.17 $333.17 97,949.88 12/31/18 6,500.00 6,856.49 356.49 98,306.37 6/30/19 6,500.00 6,881.45 381.45 98,687.82 12/31/19 6,500.00 6,908.15 408.15 99,095.97 6/30/20 6,500.00 6,936.72 436.72 99,532.69 12/31/20 6,500.00 6,967.31e 467.31 100,000.00 a $100,000 (face value) 3 0.13 (stated rate of interest) 3 6/12 months. b Previous Investment Carrying Value 3 0.14 (effective interest rate) 3 6/12 months. c Amount from b 2 Amount from a. d Previous Investment Carrying Value 1 Amount from c. e Difference of $0.02 due to rounding.

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If Colburn uses the straight-line method, it would amortize the $2,383.29 discount over the 6 remaining semiannual periods ($2,383:29 4 6 5 $397:22) and make the following entry every 6 months:

Cash 6,500.00 Investment in Held-to-Maturity Debt Securities 397.22

Interest Income 6,897.22 �

Amortization for Bonds Acquired between Interest Dates Investments in held-to-maturity debt securities may be acquired between interest dates. When a company purchases debt securities between interest payment dates, it normally pays both the purchase price and the interest accrued on the debt securities from the most recent interest payment date to the date of purchase. The interest amount received is typically debited to Interest Income. On the next interest payment date, the company receives interest for the entire period and records interest income as usual.14

Example Tallen Company purchased 9% bonds with a face value of $200,000 at par plus accrued interest on March 1, 2018. Interest on these bonds is payable June 30 and December 31, and the bonds mature December 31, 2020 (34 months after the date of purchase). Tallen records the acquisition on March 1, 2018, as follows:

Investment in Held-to-Maturity Debt Securities 200,000 Interest Income ($200,000 3 0.09 3 2/12) 3,000

Cash 203,000

If the investment was purchased at a premium or discount, it would be amortized over the remaining life of the debt securities as shown in the previous section.

Tallen records the first interest receipt on June 30, 2018, as follows:

Cash ($200,000 3 0.09 3 6/12) 9,000 Interest Income 9,000

Note that the actual amount of interest income recognized in Tallen’s income statement for the 6 months ending June 30, 2015, is $6,000 ($9,000 2 $3,000), which represents interest earned for the 4 months it owned the investment. �

Sale of a Held-to-Maturity Investment Prior to Maturity Selling an investment in held-to-maturity securities before the maturity date should be rare because the sale may violate the reason for their classification. However, circum- stances may arise (e.g., a significant deterioration of the issuer’s creditworthiness, a tax law change that eliminates the tax exempt status of the debt security, or other iso- lated, nonrecurring or unusual events) which would cause a company to sell a held-to- maturity debt security prior to its maturity. When such a sale occurs, a company first accrues any interest income and amortizes any premium or discount on the investment from the last interest date to the sale date. This procedure is necessary to record the correct amount of interest income and to determine the carrying value of the invest- ment on the date of the sale. The carrying value of the investment is then subtracted from the sales price (excluding any accrued interest) to determine the gain or loss that is recorded. In addition, any interest earned since the last interest date is collected from the purchaser.

Example On March 31, 2019, Colburn Company sells $100,000, 13% bonds classified as held-to-maturity for $102,000 plus accrued interest. The bonds were purchased on January 1, 2018, for $97,616.71 and have a maturity date of December 31, 2020.

14 This procedure reduces the record keeping for the first interest receipt and is discussed more completely in Chapter 14.

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The effective interest rate at the time the bonds were purchased was 14%. Colburn amor- tizes the bond discount by the effective interest method (see Example 13.2) and reports the investment’s carrying value at January 1, 2019, as $98,306.37. Colburn records the following entries on March 31, 2019:

Investment in Held-to-Maturity Debt Securities [($98,306.37 3 0.14 3 3/12) 2 ($100,000 3 0.13 3 3/12)]

190.72

Interest Income 190.72

Cash ($102,000 1 $3,250) 105,250.00 Interest Income ($100,000 3 0.13 3 3/12) 3,250.00 Investment in Held-to-Maturity Debt Securities

($98,306.37 from Example 13.2 1 $190.72) 98,497.09 Gain on Sale of Debt Securities 3,502.91

The first journal entry amortizes the discount up to the date of sale, which increases the investment’s carrying value to $98,497:09 ($98,306:37 1 $190:72). In the second jour- nal entry, Colburn collects the sales price plus the $3,250 interest earned in the 3 months since the last interest payment date and eliminates the current carrying value of the investment account. Colburn computes the gain on the sale by comparing the carrying value of the investment account on the sale date ($98,497.09) with the $102,000 selling price of the investment. Colburn reports this gain as part of income from continuing operations. �

If held-to-maturity debt securities are sold in response to other circumstances (e.g., change in market interest rates, the need for liquidity), the company’s intent to hold the other debt securities to maturity may be called into question or “tainted.” If this occurs, the company may be forced to reclassify other held-to-maturity securities to either the trading or available-for-sale categories. The transfer of securities between investment categories is discussed in a later section.

GOT IT? 13-6 Briefly summarize the accounting for an investment in debt securities held to maturity. 13-7 When are investments in debt securities held to maturity purchased at a premium?

How does the amortization of a premium under the effective interest method affect interest income?

13-8 When are investments in debt securities held to maturity purchased at a discount? How does the amortization of a discount under the effective interest method affect interest income?

13-9 Briefly describe the two methods available to determine interest income and account for premiums and discounts on investments in bonds held to maturity.

HOW ARE INVESTMENTS IN TRADING SECURITIES MEASURED AND REPORTED? All investments in equity securities and investments in debt securities that are actively bought and sold with the intention to profit on short-term changes in price are classified as trading securities. The accounting for trading securities applies the most complete fair value measurement approach, as follows:

• The investment is initially recorded at cost (which equals fair value on the date of purchase).

• The investment is subsequently reported at fair value on the balance sheet.

LEARNING OBJECT IVE 13.3 Account for investments in debt and equity securities classified as trading.

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• Unrealized holding gains and losses resulting from changes in the fair value of the securities are included in net income each period.

• Interest and dividend income, as well as realized gains and losses on sales, are included in net income each period.

The accounting for trading securities is illustrated in the following sections using the information for Kent Company shown in Example 13.3.

Recording the Initial Cost of Trading Securities A company records the purchase of investments in trading securities at the acquisition price of the securities.

Example The total cost of the trading securities purchased by Kent is $68,000 [(100 shares 3 $50) 1 (300 shares 3 $80) 1 (200 shares 3 $120) 1 $15,000]. Kent records the purchase as follows:

Investment in Trading Securities 68,000 Cash 68,000 �

Recording Interest and Dividend Income Interest income related to investments in debt securities is recorded as it is earned during the period. Because companies only receive cash related to interest periodically (e.g., semiannually), interest income should be accrued as time passes (using either the effec- tive or straight-line method). In contrast, companies are not obligated to pay dividends on equity securities. Therefore, dividend income is recorded when dividends are declared by the company’s board of directors.

Example On May 31, 2018, and every month Kent holds the investment in Delta Com- pany bonds, Kent will accrue one month of interest as follows:

Interest Receivable 125 Interest Income ($15,000 3 0.10 3 1/12) 125

If Kent had purchased the Delta Company bonds at a premium or discount, it would compute the interest income using the effective interest (or straight-line) method and amortize a portion of the premium or discount, as discussed earlier.

On October 31, 2018, Kent receives the semiannual interest payment and records it as follows:

Cash 750 Interest Receivable 750

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13.3Investment in Trading Securities • On May 1, 2018, Kent Company purchases the following securities:

Able Company common stock 100 shares at $50 per share Baker Company common stock 300 shares at $80 per share Charlie Company preferred stock 200 shares at $120 per share Delta Company 10% bonds Face value of $15,000, acquired at par. Interest

is paid on April 30 and October 31 each year.

• Kent intends to actively buy and sell the debt investments to profit on short-term price changes. Therefore, Kent appropriately classifies the debt securities as an investment in trading securities.

• Kent received $3,000 of dividends during 2018 related to the common stock investments.

How Are Investments in Trading Securities Measured and Reported? 13-11

NOT FOR SALE

Kent records the $3,000 of dividends it received related to its investments in the stock of Able, Baker, and Charlie as follows:

Cash 3,000 Dividend Income 3,000

If Able, Baker, or Charlie had declared dividends at year-end but Kent had not yet received them, it would debit Dividends Receivable instead of Cash. �

Recognition of Unrealized Holding Gains and Losses On its balance sheet, a company reports any investments in trading securities at fair value. An increase in the fair value of investment securities is an unrealized holding gain, while a decrease in the fair value of investment securities is an unrealized holding loss. The gain or loss is unrealized because the securities have not been sold. For invest- ments in trading securities, a company reports its unrealized gains and losses as part of net income. Notice that for investments in trading securities, a company reports both its realized and unrealized gains and losses in its net income.

For investments in trading securities, the Unrealized Holding Gain/Loss account is a temporary account that is closed to Retained Earnings during the closing process. A debit balance in the account represents a net unrealized loss. A credit balance in the account represents a net unrealized gain.

Example On December 31, 2018, the fair value of Kent’s investment in trading secur- ities is $71,000 as follows:

Security Cost 12/31/18 Fair Value

Cumulative Change in Fair Value

100 shares of Able Company common stock $ 5,000 $ 6,000 $1,000 300 shares of Baker Company common stock 24,000 23,500 (500) 200 shares of Charlie Company preferred stock 24,000 26,000 2,000 $15,000 face value of Delta Company bonds 15,000 15,500 500

Totals $68,000 $71,000 $3,000

Kent records the $3,000 net increase in the value of the securities, an unrealized holding gain, as follows:

Investment in Trading Securities 3,000 Unrealized Holding Gain/Loss—Trading Securities 3,000

On its December 31, 2018, balance sheet, Kent reports the investment as an asset at the $71,000 fair value of the securities.15 Because trading securities are frequently bought and sold, the investment will be reported as a current asset, and the Unrealized Holding Gain/Loss is included in net income of the current period.16 The disclosure of invest- ments in trading securities is shown later in the chapter.

To illustrate subsequent increases or decreases in fair value, suppose that on December 31, 2019, the fair value of the investment in trading securities held by Kent is $66,000 as follows:

Security 12/31/18 Fair Value

12/31/19 Fair Value

Change in Fair Value

100 shares of Able Company common stock $ 6,000 $ 6,100 $ 100 300 shares of Baker Company common stock 23,500 22,700 (800) 200 shares of Charlie Company preferred stock 26,000 23,200 (2,800) $15,000 face value of Delta Company bonds 15,500 14,000 (1,500)

Totals $71,000 $66,000 $(5,000)

15 Alternatively, a company may choose to record any changes in fair value in a valuation account, Allowance for Change in Value of Investment. We illustrate the use of a valuation account in the discussion of investments in available-for-sale securities.

16 The fair value method is not allowed for federal tax purposes. Therefore, the inclusion of unrealized gains/losses in net income and its exclusion from taxable income creates a temporary difference which leads to the recognition of deferred income taxes, as discussed in Chapter 18.

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Kent determines the amount of the year-end adjustment by comparing the fair value of the investments at the end of the period with the fair value of the investments at the beginning of the period. Therefore, Kent records a $5,000 unrealized holding loss as follows:

Unrealized Holding Gain/Loss—Trading Securities 5,000 Investment in Trading Securities 5,000

On its December 31, 2019, balance sheet, Kent reports the investment in trading secur- ities as an asset at the $66,000 fair value of the securities.17 It reports the $5,000 unreal- ized holding loss in its 2019 income statement. �

Realized Gains and Losses on Sales of Trading Securities A company reports realized gains and losses on sales of investments in trading securities in net income. The realized gain or loss is measured as the difference between the selling price and the fair value of the security on the previous balance sheet.

Example On March 1, 2020, Kent sold the 100 shares of Able Company common stock for $6,000. The fair value at the previous balance sheet was $6,100. Kent recog- nizes a loss of $100 ($6,000 selling price 2 $6,100 fair value at the previous balance sheet) as follows:

Cash 6,000 Loss on Sale of Trading Securities 100

Investment in Trading Securities 6,100

At the end of 2020, Kent reports the fair values of the securities it still owns. On December 31, 2020, the total fair value of the remaining securities is $62,300 as follows:

Security 12/31/19 Fair Value

12/31/20 Fair Value

Cumulative Change in Fair Value

300 shares of Baker Company common stock $22,700 $23,500 $ 800 200 shares of Charlie Company preferred stock 23,200 24,100 900 $15,000 face value of Delta Company bonds 14,000 14,700 700

Totals $59,900 $62,300 $2,400

Kent records the increase in value (unrealized holding gain) as follows:

Investment in Trading Securities 2,400 Unrealized Holding Gain/Loss—Trading

Securities 2,400

Kent reports the $100 realized loss on the sale of its investment in the Able Company common stock and the $2,400 unrealized holding gain (on the Baker, Charlie, and Delta securities) in its 2020 net income. �

GOT IT? 13-10 Briefly summarize the accounting for an investment in trading securities. 13-11 Briefly describe how to determine and record any subsequent increases or decreases

in the fair value of an investment in trading securities. 13-12 Briefly describe how to determine and record the gain or loss on the sale of an invest-

ment in trading securities.

17 A company preparing interim (quarterly) financial statements would use the same accounting procedures each quarter.

How Are Investments in Trading Securities Measured and Reported? 13-13

NOT FOR SALE

HOW ARE INVESTMENTS IN AVAILABLE-FOR- SALE SECURITIES MEASURED AND REPORTED? Investments in debt securities that are not classified as held-to-maturity or trading are classified as available-for-sale. The accounting for investments in available-for-sale secur- ities is as follows:

• The investment is initially recorded at cost (which equals fair value on the acquisition date).

• The investment is subsequently reported at fair value on the balance sheet. • Unrealized holding gains and losses resulting from changes in the fair value of

the securities are reported as a component of other comprehensive income each period. The cumulative unrealized holding gains and losses are reported in the accumulated other comprehensive income section of shareholders’ equity.

• Interest income is included in net income each period. • When a security is sold, realized gains and losses are included in net income, and any

unrealized holding gains or losses must be reclassified from accumulated other com- prehensive income into net income.

The accounting for available-for-sale securities is illustrated in the following sections using the information for Morgan Company shown in Example 13.4.

Recording the Initial Cost of Available-for-Sale Securities A company records the purchase of investments in available-for-sale securities at the acquisition price of the securities, which can be measured as the principal amount of the debt plus any premium or minus any discount at acquisition. The concept, computation, and recognition of the initial cost of investments in available-for-sale securities is identical to that required for investments in held-to-maturity securities.

Example Using the information in Example 13.4, Morgan records the purchase as follows:

Investment in Available-for-Sale Securities 195,000 Cash 195,000

Note that similar to the accounting for investments in held-to-maturity securities, the $5,000 discount is included directly in the investment account. �

Recording Interest and Dividend Income Interest income related to investments in debt securities accrues continuously over time. Similar to the accounting for investments in held-to-maturity securities, any interest income is computed using the effective interest (or straight-line) method.

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13.4 Investment in Available-for-Sale Securities

• On January 1, 2018, Morgan Company purchases bonds for $195,000. • The bonds have a face value of $200,000 • The bonds pay interest semiannually on June 30 and December 31 at a stated interest

rate of 10% • The bonds mature on December 31, 2027 (10 years) • Morgan does not intend to hold the debt securities to maturity nor does it intend to

actively buy and sell them. Therefore, Morgan appropriately classifies the securities as available-for-sale investments.

• Morgan uses the straight-line method of amortization.

LEARNING OBJECT IVE 13.4 Account for investments in debt securities classified as available-for-sale.

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Example On June 30, 2018, Morgan records the first semiannual interest receipt (using the straight-line method) for the investment as follows:

Cash ($200,000 3 0.10 3 6/12) 10,000 Investment in Available for Sale Securities ($5,000 4 20) 250

Interest Income 10,250

Note that Morgan records the discount amortization directly to the investment account. A similar entry would be made periodically over the remaining time that Morgan holds the investment.

�

Recognition of Unrealized Holding Gains and Losses On its balance sheet, a company reports any investments in available-for-sale securi- ties at fair value through the use of a valuation account named Allowance for Change in Fair Value of Investments. This allowance account is an adjunct/contra account to the investment account. A debit balance in the allowance account represents an increase in fair value above the amortized cost of the investment (an unrealized holding gain). A credit balance in the allowance account represents a decrease in fair value below the amortized cost of the investment (an unrealized holding loss). The use of an allowance account allows the company to report the investment at fair value while maintaining a record of the amortized cost of the investment.

The company reports any unrealized holding gains and losses in other com- prehensive income for the period. For available-for-sale securities, a credit change in the Unrealized Holding Gain/Loss account represents the net unrealized holding gains on the securities for the period, while a debit change in this account represents the net unrealized holding losses on the securities for the period. A credit balance in the account represents the cumulative net unrealized holding gains and is reported as a positive element in the accumulated other comprehensive income section of sharehold- ers’ equity. A debit balance in the account represents the cumulative net unrealized holding losses and is reported as a negative element in the accumulated other compre- hensive income section of shareholders’ equity. In summary, for available-for-sale securities, a company reports the realized gains and losses in net income but reports unrealized gains and losses in other comprehensive income.

Example On December 31, 2018, the amortized cost of Morgan’s investment in avail- able-for-sale securities was $195,500 ($195,000 acquisition cost 1 $500 amortization of discount). The fair value of the investment at that date was determined to be $199,000. Morgan records the $3,500 difference between the amortized cost and the fair value of the investment, an unrealized holding gain, as follows:

Allowance for Change in Fair Value of Investments 3,500 Unrealized Holding Gain/Loss—Available-for-Sale Securities 3,500

On its December 31, 2018, balance sheet, Morgan reports the investment as an asset at the $199,000 fair value of the securities. If Morgan holds multiple available- for-sale investments and some are determined to be current and some noncurrent, the asset account is separated between the current and noncurrent components, as shown later in the chapter. The use of an allowance account to record the changes in the fair values of the securities allows a company to retain information about the amortized cost of each security that will be used to compute the realized gain or loss on the sale of a security.18

18 Alternatively, a company may choose to record any changes in the fair value directly in the investment account, similar to what was shown for trading securities. However, this method makes it more difficult to determine information needed for transactions in subsequent periods; therefore, we do not use this method for investments in available-for-sale securities.

How Are Investments in Available-for-Sale Securities Measured and Reported? 13-15

NOT FOR SALE

Morgan reports the $3.500 increase in fair value as an unrealized holding gain in its other comprehensive income for 2018. Because this is the first year that Morgan owns marketable securities, the balance in the Unrealized Holding Gain/Loss account equals the unrealized holding gain/loss for the year. Therefore, it also reports the $3,500 credit balance in the Unrealized Holding Gain/Loss account as an addition to Accumulated Other Comprehensive Income in the shareholders’ equity section of its balance sheet.19

This disclosure is shown later in the chapter. To illustrate subsequent increases or decreases in fair value, suppose that on

December 31, 2019, the fair value of Morgan’s investment in available-for-sale securities is $198,000. The amortized cost of this investment on 12/31/19 is $196,000 ($195,500 book value at 12/31/18 1 $500 amortization for 2019). Note that Morgan continues to amortize the discount based on the investment’s original acquisi- tion cost.

Once a company has established an allowance account, it determines the amount of the period-end adjustment by first computing the required amount in the allowance account as the difference between the fair value and the amortized cost of the investment. At December 31, 2019, the required amount of Morgan’s allowance account is a $2,000 debit balance ($198,000 fair value 2 $196,000 amortized cost). Next, the amount of the period-end adjustment is computed by comparing the required amount in the allowance account with the previous balance in the account. For Morgan, the previous balance at December 31, 2018, was a $3,500 debit balance. Therefore, Morgan credits the allowance account for $1,500 at the end of 2019 to record the decline in fair value, an unrealized holding loss, as follows:

Unrealized Holding Gain/Loss—Available-for-Sale Securities 1,500 Allowance for Change in Fair Value of Investments 1,500

On its December 31, 2019, balance sheet, Morgan reports the investment as an asset at the $198,000 fair value of the securities ($196,000 amortized cost 1 $2,000 allowance). It reports the $1,500 decrease in fair value as an unrealized holding loss in its other comprehensive income for 2019. It also reports the $2,000 credit balance in the Unrealized Holding Gain/Loss account as an addition to accumulated other com- prehensive income in the shareholders’ equity section of its balance sheet. �

Realized Gains and Losses on Sales of Available-for-Sale Securities A company reports realized gains and losses on sales of investments in available-for-sale securities in net income. The realized gain or loss is measured as the selling price minus the amortized cost of a debt security. Because the security is no longer in the portfolio of available-for-sale securities, the related balances in the Allowance for Change in Fair Value of Investment and Unrealized Holding Gain/Loss accounts reported at the previ- ous balance sheet date for the security sold must be “reversed” by making a reclassifica- tion adjustment. This reclassification adjustment serves two purposes. First, it eliminates the allowance account that is associated with the investment that was sold. Second, it adjusts other comprehensive income for the previous amount of unrealized gain or loss which is now being realized.

Example On March 31, 2020, Morgan sold its investment in available-for-sale secur- ities for $197,000. The amortized cost of the securities at March 31, 2020, was $196,125 ($196,000 amortized cost at 12/31/19 1 $125 amortization during 2020). Morgan records the sale and the reclassification adjustment on March 31, 2020, in two journal entries as follows:

19 The amounts included in other comprehensive income for the year and accumulated other comprehensive income are reported net of tax. For simplicity, we do not include the tax effects in this discussion.

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Cash 197,000 Investment in Available-for-Sale Securities 196,125 Gain on Sale of Available-for-Sale Securities 875

Unrealized Holding Gain/Loss—Available-for-Sale Securities 2,000 Allowance for Change in Fair Value of Investment 2,000

The first journal entry records the sale and the realized gain of $875 ($197,000 selling price 2 $196,125 amortized cost) in 2020. The second journal entry reverses (elimi- nates) the $2,000 unrealized gain that had accumulated from January 1, 2018 (the date the company purchased the securities), until December 31, 2019 (the most recent balance sheet date). This unrealized gain had previously been reported in other com- prehensive income, and this reclassification adjustment avoids a double-counting of this gain in Morgan’s comprehensive income.20 The net effect on comprehensive income for the period in which the gain is realized is a $1,125 loss (an $875 realized gain in net income minus a $2,000 elimination of the previous amount of the unreal- ized gain in other comprehensive income). �

Summary and Conceptual Discussion Exhibit 13.2 summarizes the accounting issues we have discussed for the three categories of investments in securities.

As you complete the audit of Blanket Insurance Company, an interesting item comes to your attention. One of the staff accountants on the job noted that at the end of each quarter, the company sold a portion of its investments classified as available- for-sale. With each sale, Blanket was able to recognize a gain and increase income so that it would be able to just meet analyst forecasts. As the audit manager, you began to look into this finding and an interesting pattern emerged. For the last 5 years, if the company’s income appeared to fall short of the analysts’ expectations, Blanket would sell available-for-sale

investments that had increased in value and recognize a gain that would allow Blanket to meet the analysts’ forecasts. Because the company has a significant investment port- folio, you overlooked the strategic timing of these sales of appreciated securities in previous years. In discussions with Blanket’s management, the CEO noted that this practice was part of the company’s financial reporting strategy. Also, the CEO argued that the recognition of these gains and losses was entirely within GAAP. What is your reaction to the CEO’s comments?

13.2Summary of Accounting for Marketable Investments

Classification Initially

Record at:

Report on Balance Sheet at:

Recognize Unrealized Holding Gains/Losses in:

Recognize Interest and/or Dividend

Income in:

Recognize Realized Gains/

Losses in:

Held-to-maturity Cost Amortized cost No recognition Net income Net income* Trading Cost Fair value Net income Net income Net income Available-for-sale Cost Fair value Other comprehensive income Net income Net income

*Sales of held-to-maturity securities should be rare.

20 A sale of an investment in securities at a loss would be recorded in the same way. The company would record the sale and real- ized loss in the first journal entry and would eliminate any cumulative unrealized gain or loss and allowance on that security.

How Are Investments in Available-for-Sale Securities Measured and Reported? 13-17

NOT FOR SALE

Three items are of particular interest. First, a company measures and reports investments in trading and available-for-sale securities for which the investor has no significant influence at fair value. The FASB believes that the use of fair value for fi- nancial instruments that are part of a trading or available-for-sale portfolio provides relevant information that reflects the underlying economics of a company’s invest- ments. In addition, for these types of investments, fair value provides more useful in- formation for financial statement users in evaluating the performance of a company’s investment strategies as well as understanding and analyzing a company’s risk. How- ever, for some investments, the FASB believes the use of fair value may not be as rele- vant because a company’s business strategy is to realize the value of its investment through collection of contractual cash flows (principal and interest).21 Therefore, U.S. GAAP permits the use of amortized cost for investments expected to be held to maturity. The FASB made this exception to the use of fair value restrictive. A company that wishes to use amortized cost must establish, for each investment in a debt security, the positive intent and ability to hold the security until maturity to be able to classify the investment as held-to-maturity. Thus, the accounting for market- able securities at both fair value and historical cost is an example of a mixed-attribute measurement model.

Second, FASB requires all investments in equity securities to be classified as trading securities. Equity securities cannot be classified as held-to-maturity because they do not have specified maturity dates. Further, the FASB believes that reporting equity invest- ments at fair value with changes in the fair value presented in net income is the most rel- evant measurement attribute for equity investments. This conclusion is based largely on the fact that the primary way companies ultimately realize the value of equity invest- ments is by selling the investment.

Finally, one of the major differences between the accounting for investments in trad- ing and available-for-sale securities is the treatment of unrealized holding gains and losses. Because trading securities are actively managed, the FASB concluded that income measurement for those securities is more relevant if it includes the results of changes in fair value—the unrealized holding gains and losses. Therefore, a company’s net income includes the results of economic events that occur in the period and provides a better measure of the company’s return on investment. However, partly in response to the political pressure from banks and other financial institutions, the FASB concluded that including unrealized holding gains and losses in income for available-for-sale securities could create volatility in a company’s reported net income. Such volatility may not repre- sent the way that the company manages its business and the impact of economic events of the period. Therefore, unrealized holding gains and losses on available-for-sale secur- ities are not included in net income but instead are reported as a component of other comprehensive income.

By allowing unrealized holding gains and losses on investments in available-for- sale investments to temporarily bypass the income statement until they are realized, current accounting standards provide a company with the ability to manage its earn- ings through a practice known as gains trading. This practice involves selectively sell- ing investments that have risen in value so that a company can include the gains in income, while not selling investments that have declined in value and thereby avoid recognizing the losses. Thus, companies are able to “manage” the amount of net income they report by selecting which securities to sell. Note, however, that this prac- tice does not permit companies to manage comprehensive income because the reclassi- fication adjustment corrects comprehensive income for the amount of gain or loss that

21 For additional discussion, see the Basis of Conclusions in FASB Accounting Standards Update (ASU) 2016-01.

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had been unrealized in prior periods. Astute analysts and financial statement users should compare realized gains and losses in net income against reclassification adjust- ments in comprehensive income to try to detect whether a company is engaging in gains trading.

GOT IT? 13-13 Briefly summarize the accounting for an investment in available-for-sale securities. 13-14 Briefly describe how to determine and record any subsequent increases or decreases

in the fair value of an investment in available-for-sale securities. 13-15 Briefly describe how to determine and record the gain or loss on the sale of an invest-

ment in available-for-sale securities.

HOW DO WE ACCOUNT FOR TRANSFERS AND IMPAIRMENTS? Two additional issues arise in accounting for investments—one involves transfers between investment categories and the second involves impairments of investments.22

Transfers of Investments between Categories At each reporting date, a company should assess the appropriateness of the classification of its investments in debt securities. If the classification previously used is no longer appropri- ate, the investment should be reclassified and transferred into the appropriate category. The transfer of a security between investment categories is accounted for at fair value at the time of the transfer. In the journal entry to record the transfer, the fair value is used as the “new” carrying value of the investment, and the “old” carrying value is elimi- nated. However, the accounting for any related unrealized gain or loss depends on the type of transfer.

• A transfer from the trading category into any other category—No accounting for the unrealized holding gain or loss is needed because it has already been recognized in net income.

• A transfer into the trading category from any other category—The previous unreal- ized holding gain or loss is recognized immediately in net income and eliminated from accumulated other comprehensive income.

• A transfer into the available-for-sale category from the held-to-maturity category— The difference between the held-to-maturity security’s amortized cost and the fair value at the time of transfer gives rise to an unrealized holding gain or loss, which is included in other comprehensive income.

• A transfer of a debt security into the held-to-maturity category from the avail- able-for-sale category—The unrealized holding gain or loss on the date of trans- fer will continue to be reported as a separate component of accumulated other comprehensive income and also represents a premium or discount that is

LEARNING OBJECT IVE 13.5 Understand transfers between categories and impairment of debt and equity securities.

22 When a company adopts Accounting Standards Update 2016-01: Recognition and Measurement of Financial Assets and Liabilities, it should apply the guidance by making a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption.

How Do We Account for Transfers and Impairments? 13-19

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amortized over the remaining life of the security consistent with the effective interest method.

Note that transfers into or out of the trading category should be rare, as should transfers from the held-to-maturity category.

Example: Transfer into Trading from Available-for-Sale In early 2019, Haigh Company purchased bonds it classified as available-for-sale invest- ments. The bonds have a face value of $5,000 and were purchased at par. On December 31, 2019, the bonds had a fair value of $6,100, resulting in an unrealized gain presented in other comprehensive income of $1,100. In 2020, when the bonds had a fair value of $6,300, Haigh transfers the bonds into the trading category. Haigh records the transfer as follows:

Investment in Trading Securities 6,300 Investment in Available-for-Sale Securities 5,000 Gain on Transfer of Securities 1,300

Unrealized Holding Gain/Loss—Available-for-Sale Securities 1,100 Allowance for Change in Fair Value of Investments 1,100

In the first journal entry, the investment is transferred to the trading securities account at its fair value ($6,300) and the amortized cost of the securities ($5,000) is removed from the available-for-sale securities account. The difference results in a realized gain of $1,300, which is included in net income for 2020. In the second journal entry, Haigh eliminates the unrealized holding gain of $1,100 that was reported in accumulated other comprehensive income at December 31, 2019, as well as the related allowance account. This reclassification amount is included in other comprehensive income for the period. Note that the net effect of this transfer increases comprehensive income in 2020 by $200 ($1,300 gain on transfer 2 $1,100 elimination of the unrealized holding gain in other comprehensive income). The net amount of gain in comprehensive income reflects the change in the fair value of these securities during the period ($6,300 at the end of the pe- riod 2 $6,100 at the beginning of the period), adjusted by amortization of the premium or discount ($0 because the bonds were purchased at par). �

Example: Transfer into Available-for-Sale from Held-to-Maturity Devon Company has bonds it classified as an investment in held-to-maturity securities. The bonds have a face value of $10,000, and the company purchased them at par. When the fair value of the bonds is $9,500, Devon transfers the bonds into the available-for- sale category. Because an investment in available-for-sale securities is recorded at cost with an allowance account to adjust the carrying value to fair value (with a correspond- ing adjustment to the Unrealized Holding Gain/Loss account), Devon records the transfer as follows:

Investment in Available-for-Sale Securities 10,000 Investment in Held-to-Maturity Securities 10,000

Unrealized Holding Gain/Loss—Available-for-Sale Securities 500 Allowance for Change in Fair Value of Investments 500

If Devon purchased bonds being held to maturity at a premium or discount, it would record the investment in available-for-sale securities at the amortized cost, and it would compute the adjustment to the allowance and unrealized holding gain/loss accounts by comparing the fair value to the amortized cost. Note that, because the trans- fer casts doubt on whether Devon can faithfully represent other securities as held-to- maturity, Devon may be required to reclassify all of its held-to-maturity securities to available-for-sale. �

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Example: Transfer into Held-to-Maturity from Available-for-Sale Assume the same facts for Devon Company, except that it currently classifies the bonds as available-for-sale and transfers them into the held-to-maturity category. The bonds had a fair value of $9,700 on the previous balance sheet date. In this case, Devon records the investment in held-to-maturity securities at the current fair value of $9,500 and eliminates the previous $300 ($9,700 2 $10,000) holding loss reported in the allowance account and in accumulated other comprehensive income. It creates a new shareholders’ equity account, Unrealized Holding Gain/Loss—Held-to-Maturity Securities for the $500 unrealized holding loss on the date of transfer. Devon records the transfer as follows:

Investment in Held-to-Maturity Securities 9,500 Unrealized Holding Gain/Loss—Held-to-Maturity Securities 500

Investment in Available-for-Sale Securities 10,000

Allowance for Change in Fair Value of Investments 300 Unrealized Holding Gain/Loss—Available-for-Sale Securities 300

In later periods, Devon amortizes the $500 discount in the Investment in Held-to- Maturity Securities account using the effective interest method over the remaining life of the bonds. The $500 unrealized holding loss is also amortized as an adjustment to inter- est income, using the effective interest method over the remaining life of the bonds, and this amount offsets the amortization of the discount. �

Impairments At each reporting date, a company should evaluate its investment in held-to-maturity and available-for-sale debt securities to determine if an impairment exists. This evalua- tion involves three steps:23

• Step 1. Determine whether the investment is impaired. An investment is considered impaired when its fair value is less than its cost. The company assesses impairment for each individual security.

• Step 2. Evaluate whether the impairment is other than temporary. The company must evaluate whether it will be able to recover the cost of the investment. A debt security’s impairment is other-than-temporary if the company: (a) has decided to sell the security, or (b) considers it more likely than not that it will be required to sell the security before the recovery of its amortized cost basis. In making its other-than-temporary impairment assessment, a company should consider all information relevant to the collectibility of the security such as the remaining payment terms of the security, prepayment speeds, the financial condition of the issuer, expected defaults, and the value of any underlying collateral.24

• Step 3. If the impairment is other than temporary, recognize a loss equal to the differ- ence between the cost of the investment and its fair value. The company includes the amount of the write-down in net income and the fair value becomes the new carrying value of the investment. Under U.S. GAAP, this loss cannot be restored for any subsequent increases in fair value.

23 FASB ASC 320-10-35: Investments—Debt Securities: Overall: Subsequent Measurement. 24 The SEC has also been involved in the issue of how the “other than temporary” criterion is to be applied by publicly traded com-

panies. It suggests that a company should consider the length of time a security has been impaired and the amount by which the fair value is less than cost; the financial condition and near-term prospects of the investee; and the intent and ability of the com- pany to retain its investment for long enough to allow for any anticipated recovery in fair value.

How Do We Account for Transfers and Impairments? 13-21

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Example Tracey Company has a bond investment categorized as held-to-maturity, which has a carrying value of $21,500 and a fair value of $6,500. If it considers the decline in value to be other than temporary, Tracey records the decline of $15,000 ($21,500 2 $6,500) as follows:

Impairment Loss 15,000 Investment in Held-to-Maturity Securities 15,000

The $6,500 fair value becomes the new carrying value of the security, and Tracey com- putes interest income using the effective interest method based on the new effective interest rate computed. �

A similar procedure is followed for an investment in a debt security classified as avail- able-for-sale which has a decline in value that is considered to be other than temporary. Because a company is already reporting the security at fair value by using an allowance account, it establishes the fair value as the new cost basis. It eliminates the allowance and unrealized holding gain/loss accounts and records the loss from the write-down as an impairment loss. Any subsequent changes in fair value (that are considered to be tempo- rary) are recognized as unrealized holding gains and losses in other comprehensive income.

GOT IT? 13-16 Briefly describe how to record the transfer of an investment in a debt security from (a)

the held-to-maturity category to the available-for-sale category and (b) the available- for-sale category to the held-to-maturity category.

LOOKING AHEAD

The FASB is considering an impairment model based on current expected credit losses (CECL). Under this approach, a company should recognize current expected credit losses for any investments measured at amortized cost. Under the CECL model, a company would evaluate financial assets with similar characteristics on a collective (pool) basis. An estimate of expected credit losses is then developed after considering all available information relevant to assessing the collectability of contractual cash flows. This information would include qualitative and quantitative factors relating to the environment in which the company operates and factors specific to the borrow. The estimate of expected credit losses should consider all contractual cash flows over the life of the financial asset, including expected prepayments and should always reflect the risk of loss, even if that risk is remote.

In addition, for any investment in debt securities classified as available-for-sale, an allowance approach would be used for recognizing credit losses. Such an approach would allow a company to recognize reversals of credit losses. The measurement of the expected credit losses for these securities will be limited to the difference between fair value and amortized cost.

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HOW DO YOU ACCOUNT FOR MINORITY ACTIVE INVESTMENTS? When an investor company owns a sufficiently large percentage of common stock of another company, it is able to exert significant influence over the financial and operat- ing policies of the investee company. For example, the investor could influence the investee’s dividend policy in response to its own cash needs, the desire to raise its income, or tax considerations. In addition, the investor may use its influence to create favorable operating relationships with the investee. Significant influence is determined by factors such as:

• representation on the board of directors • participation in policy-making processes • material intercompany transactions • interchange of managerial personnel • technological dependency

In the absence of evidence to the contrary, an investment of 20% or more in the out- standing common stock of the investee leads to the presumption of significant influ- ence and the use of the equity method.25

The equity method recognizes that a material economic relationship exists between the investor and the investee. Because of this relationship, accounting for an investment as a trading security, which recognizes income when dividends are declared, is not appropriate because the investor could influence the amount and timing of the investee’s dividend payments and therefore the amount of income it recognizes. The result would be that the earnings of the investee that were generated under the investor’s influence may not be faithfully represented in the investor’s financial statements. Therefore, the equity method of accounting is used to account for investments in which significant influence exists. The equity method requires the investor to recognize as income (or loss) each period its proportionate share of the net income (or loss) of the investee. For example, Starbucks reported income related to its equity method investees of $191 million for 2015.26 The objective of the equity method is to reflect the economic substance of the investor’s underly- ing claim on the net income and net assets of the investee rather than the legal form of two separate entities. The use of the equity method more closely fits the requirements of accrual accounting because the investor’s share in investee income is reported by the investor during the period in which it is earned rather than when cash is received. The equity method, therefore, supplies more relevant information for decision makers.

When determining how to account for an investment, it’s important to understand how much the investment allows the company to control or influence decisions. In the absence of evidence to the contrary, an investment of 20% or more in the outstanding common stock of the investee leads to the presumption of significant influ- ence and the use of the equity method.

A N

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LEARNING OBJECT IVE 13.6 Account for intercompany investments using the equity method.

25 If an investor has significant influence but holds less than a 20% investment, the investor should use the equity method. On the other hand, there are situations in which an investor holds 20% or more of the outstanding common stock of the investee and does not have the ability to exercise significant influence over the investee. In these cases, the investor would not use the equity method. (FASB ASC 320-10-15: Investments—Equity Method and Joint Ventures: Overall: Scope and Scope Exceptions.)

26 Starbucks reports $249.9 million of income from equity method investees on the income statement. However, as disclosed in Note 6, Equity and Cost Investments (Appendix A), this amount includes $58.9 million of gross profit from transactions with the investees. Therefore, the net amount of income from equity method investees is $191 million.

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Accounting Procedures To apply the equity method, an investor:

• Initially records the investment at its acquisition cost. • Subsequently records income and an increase in the carrying value of the investment

account when income is reported by the investee. The amount of income recorded is based on the investor’s percentage of ownership in the investee.

• Records dividends received (or receivable) as reductions in the carrying value of the investment account when they are paid (or declared) by the investee.

In addition, the investor must make certain adjustments to its investment income. The most frequent are to:

• Record the proportionate share of the investee’s equity adjustments for other com- prehensive income as increases or decreases to the investment account with corre- sponding adjustments in equity.

• Depreciate the proportionate share of any difference between the fair values and book val- ues of the investee’s depreciable assets that is implied by the acquisition price being greater than the book value of the investee. In the event the investor cannot determine the fair value of the specific investee assets, the entire excess of the acquisition price of the invest- ment over the proportionate book value is treated as goodwill and is not amortized.27

In summary, the investor accounts for the investment and income under the equity method as follows:

Investment 5 Acquisition Cost 1 Investor’s Share of Investee Income 2 Dividends Received

where

Investor’s Share of Investee Income 5 ðInvestee’s Net Income 3 Ownership %) 2 Adjustments

and

Dividends Received 5 Total Dividends Paid by Investee 3 Ownership %

Example: Equity Method Panther Company purchases 4,200 shares of Salsa Company’s outstanding common stock on January 1, 2016. On that date, Salsa had 16,800 shares outstanding; therefore, Panther’s investment is 25% and significant influence is presumed to exist. Panther paid $125,000 for the shares and, on the date of acquisition, obtains the following informa- tion concerning Salsa:

Balance Sheet Book Value Fair Value

Depreciable assets (remaining life, 10 years) $400,000 $450,000 Other non-depreciable assets (e.g., land) 190,000 246,000 Total $590,000 $696,000

Liabilities $200,000 $220,000 Common stock 250,000 Retained earnings 140,000 Total $590,000

There were no intercompany transactions during the year. Salsa paid a $20,000 dividend on August 27, 2016, and reported net income for 2016 of $81,000. Panther records these events as follows:

To record the original investment on January 1, 2016:

Investment in Stock: Salsa Company 125,000 Cash 125,000

27 In addition, the investor recognizes deferred income taxes for any difference between income reported under the equity method for financial reporting purposes and dividend income reported for income tax purposes. Deferred taxes are discussed in Chapter 18.

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To record the receipt of dividends on August 27, 2016:

Cash 5,000 Investment in Stock: Salsa Company (0.25 3 $20,000) 5,000

The effect of this transaction is simply to exchange one asset (Investment in Stock: Salsa Company) for another (Cash).

To record Panther’s 25% share in the year’s net income on December 31, 2016:

Investment in Stock: Salsa Company 20,250 Investment Income (0.25 3 $81,000) 20,250

Note that Panther increases the investment account by its share of the total net income.

To depreciate the increase in the recorded value of depreciable assets:

Investment Income 1,250 Investment in Stock: Salsa Company ($12,500 4 10) 1,250

The depreciable assets have a fair value that exceeds book value by $50,000 ð$450,000 2 $400,000Þ and the remaining useful life of the assets is 10 years. Because it owns 25% of Salsa’s shares, it therefore owns 25% of this increase in asset value, so Panther depreciates $12,500 (0:25 3 $50,000) of the additional depreciable asset value over the remaining useful life of the assets. This results in additional depreciation of $1,250 ($12,500 4 10 years), which Panther records directly as a deduction from the investment income and the investment on December 31, 2016.

The investment must also be reviewed for impairment as we discuss later in the chapter.28

Panther computes the carrying value of its Investment in Stock: Salsa Company account by adding the reported income for the year and deducting the dividends and depreciation expense. The carrying value of the investment is computed as follows:

Investment in Salsa Company

Acquisition price January 1, 2016 $125,000 Add: Share of 2016 reported income 20,250

$145,250 Less: Dividends received August 27, 2016 $5,000

Depreciation of excess fair value of assets ($12,500 4 10) 1,250 (6,250)

Carrying value $139,000

This investment is reported in the long-term investment’s section of Panther’s December 31, 2016, balance sheet.

The total amount of investee income that Panther reports on its income statement for 2016 is $19,000. This amount is computed as follows:

Income from Investment

Share of 2016 income $20,250 Less: Depreciation of excess fair value of acquired assets (1,250) Net Investment income $19,000 �

28 According to FASB ASC 323-10-35: (Investments—Equity Method and Joint Ventures: Overall: Subsequent Measurement), any implied goodwill at the purchase of equity investments is not reviewed for impairment.

How Do You Account for Minority Active Investments? 13-25

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INTERNATIONAL DIMENSION

ACCOUNTING FOR INVESTMENTS

Several key differences in the accounting for investments exist between U.S. GAAP and IFRS as follows:

• Classification and Measurement: IFRS has three classification categories for debt and equity investments: amortized cost, fair value through other comprehensive income (FVOCI), and fair value through profit and loss (FVPL). Unlike U.S. GAAP where all equity securities are classified as trading and the classification of an investment in debt securities is based on management intent, IFRS classify investments in marketable debt securities based on the company’s business model for managing financial assets and the characteristics of the contractual cash flows of the financial asset. If the objective of the business model is (a) to hold the asset and collect the contractual cash flows and (b) the cash flows represent solely payments of principal and interest (SPPI), the debt investment is initally recognized at fair value and subsequently measured at amortized cost. If the objective of the business model is achieved by collecting contractual cash flows (consisting of SPPI) and selling financial assets, the debt investment is measured at fair value through other comprehensive income. If the debt security does not meet the business model or cash flow characteristics conditions, it is classified as fair value through profit and loss. All equity investments are classified as FVPL and are initially measured at fair value with any change recorded through profit or loss. A company may make an irrevocable election at initial recognition to classify equity investments that it does not hold for trading as FVOCI.

• Fair Value Option: In both U.S. GAAP and IFRS, at initial recognition com- panies are given a fair value option to choose whether to record the changes in value of any financial asset or liability on the balance sheet and in net income. However, IFRS only allow this fair value option if reporting changes in fair value though profit and loss would eliminate a measurement or recognition inconsistency (sometimes called an “accounting mismatch”) that would arise from measured assets and liabilities on different measurement bases.

• Impairments: For investments classified as amortized cost or FVOCI, IFRS require an expected loss impairment model in which expected credit losses are measured through a loss allowance at an amount equal to either (a) the 12-month expected credit losses or (b) full lifetime expected credit losses. In addition, IFRS allow for the reversal of these impairment losses with the amount of the reversal recognized in income. No such reversals are allowed under U.S. GAAP.

The application of the equity method is generally the same under IFRS and U.S. GAAP. However, several items should be noted:

• One major terminology difference is that IFRS use the term associate to refer to what would be referred to as an equity method investee under U.S. GAAP.

• IFRS do not address whether an investor’s interest that is represented by something other than an equity instrument but that is similar in substance to an equity instrument (e.g., in-substance common stock) gives rise to signifi- cant influence over the investee. U.S. GAAP contains more detailed guidance on such non-equity interests.

• IFRS define joint venture arrangements and account for joint ventures by either the equity method or proportionate consolidation. Under proportionate consolidation, companies would report consolidated financial statements including their proportionate share of the joint venture. Under U.S. GAAP, proportionate consolidation is generally not permitted.

Source: IAS 28, 31, IFRS 9 (See Appendix C at the end of this book.)

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Special Issues When a company applies the equity method, it may encounter issues such as impair- ments of the equity investment or changes in the level of ownership of the investee.

Impairment: Other Than Temporary The investor must recognize “other than tem- porary” declines in the value of investments accounted for under the equity method. Evidence of these declines may be provided by the bankruptcy of the investee, by lengthy declines in the fair value of the stock, or by a number of years of operating losses. These events bring into question the ability of the investee to sustain income sufficient to justify the carrying value of the investment. When a decline is considered to be other than temporary, the investor debits a loss account and credits the investment account for the difference between the carrying value of the investment and the fair value. If the fair value of the investment later increases, the investor does not recognize the recovery in value.

Change to Equity Method When an investor currently accounting for an equity investment as a trading security acquires enough additional common shares during a year to obtain significant influence over the investee, the investor is required to adopt the equity method of accounting. When the equity method is adopted, the investor restates its investment in the investee by debiting the investment account and credit- ing Retained Earnings for its previous percentage of investee income (minus divi- dends) for the period from the original date of acquisition to the date that significant influence was obtained. This is a retrospective adjustment.29 Thereafter, the equity method is applied in the usual manner based on the current percentage ownership.

Example On January 2, 2018, Short Company purchased as its only investment 15% of the outstanding common stock of Jones Corporation for $150,000, which it classified as a trading security. At that time, Jones’s book value of net assets was $1,000,000. At the end of 2018, Jones reported net income of $300,000 and paid dividends of $60,000. Because the market value of Jones’s shares at the end of 2018 was $186,000, Short wrote up the carrying value of the investment to fair value. On January 2, 2019, to exert significant influence on Jones, Short purchased an additional 25% of its out- standing common stock for $310,000.

The journal entries that Short recorded in 2018 and 2019 related to this informa- tion are shown in the upper portion of Example 13.5.

While most of these entries have been previously discussed, the last three entries for 2019 in which Short accounts for its previous 15% ownership under the equity method deserve an explanation. First, Short applies the equity method retrospectively by recognizing $45,000 ($300,000 3 0:15) of the 2018 net income of Jones as an increase in its Investment account and in Retained Earnings. Second, it also reduces its Investment account and Retained Earnings by $9,000 for its share of the 2018 dividends of Jones. (Note that Retained Earnings was adjusted directly for the share of net income and dividends because these are from the prior year.) Finally, Short reverses its December 31, 2018, adjustment to increase the carrying value of the investment. (Note that Short must debit Retained Earnings because the unrealized holding gain was recognized in income in the prior year) Because the purchase price of the shares was equal to their underlying book value, no additional depreciation was recorded.

The lower portion of Example 13.5 explains the rationale behind the adjustments. Note that the book value of the net assets of Jones was $1,240,000 on January 2, 2019. By increasing the $150,000 initial investment for the $45,000 share of 2018 net income and decreasing it for the $9,000 share of the 2018 dividends, the book value of the Investment account is $186,000, or 15% of the $1,240,000 net assets of Jones on

29 Retrospective adjustments are discussed in more detail in Chapter 22.

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January 2, 2019. Increasing the $186,000 for the $310,000 (25%) additional investment results in an Investment account balance of $496,000, or 40% of the net assets. From this point on, Short will apply the equity method using the 40% ownership interest. �

Change from Equity Method Sometimes an investor using the equity method sells a portion of the investment so that its portion of ownership falls below 20%, or the inves- tor may lose significant influence over the investee. Under these conditions, the use of the equity method is no longer appropriate, and the investor no longer accrues its share of investee income. However, previously recorded income remains as a part of the book value of the investment account. The investor then accounts for the investment as a trad- ing security.30

Consolidated Financial Statements When an investor using the equity method acquires control over the investee’s operations, the entity concept is enhanced by

EX A

M PL

E

13.5 Journal Entries to Illustrate a Change to the Equity Method Trading Security Change to Equity Method

1/2/18 Investment in Trading Securities

150,000 1/2/19 Investment in Stock: Jones Corporation

310,000

Cash 150,000 Cash 310,000

12/31/18 Cash 9,000a 1/2/19 Investment in Stock: Jones Corporation

186,000 Dividend Income 9,000

Investment in Trading Securities

186,000

12/31/18 Investment in Trading Securities

36,000 1/2/19 Investment in Stock: 45,000b

Unrealized Holding Gain/Loss: Trading Securities

36,000 Jones Corporation

Retained Earnings 45,000

1/2/19 Retained Earnings 9,000 Investment in Stock: 9,000

Jones Corporation

1/2/19 Retained Earnings 36,000 Investment in Trading Securities

36,000

Comparison of Book Values

Jones Corporation Net Assets

Investment in Jones

Book value, 1/2/18 $1,000,000 $150,000 1 Net income for 2018 300,000 45,000 – Dividends for 2018 (60,000) (9,000) Book value, 1/2/19 $1,240,000 $186,000 (15%)c

Additional investment (25%) 310,000 (25%) Book value, 1/2/19 (40%) $496,000 (40%)

a $60,000 3 0.15 b $300,000 3 0.15 c $186,000 4 $1,240,000

30 The investment may also be accounted for under the cost method as described in FASB ASC 325-20: Investments—Other: Cost Method Investments.

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preparing financial statements for the combined set of companies. However, the two (or more) companies continue to maintain separate accounting records. During the year, the investor accounts for its investment in the investee by the equity method, as previ- ously discussed. At the end of the year, the two sets of financial statements of the inves- tor and investee are combined (and the investment account is eliminated) and reported in one consolidated set of financial statements.

The logic of consolidation accounting is to present financial statements for a single economic entity, even though there are separate legal entities. The two guiding princi- ples for the preparation of consolidated financial statements are:

• The entity cannot make a profit by selling to itself. That is, intercompany sales and profits must be eliminated from the consolidated financial statements.

• The entity cannot own or owe itself. That is, intercompany receivables and payables must be eliminated from the consolidated financial statements.

Discussion of the preparation of consolidated financial statements is included in advanced accounting textbooks.

GOT IT? 13-17 Discuss the rationale behind the use of the equity method for an investment in com-

mon stock. 13-18 Briefly describe the accounting for an investment in common stock under the equity

method. 13-19 Discuss the appropriate accounting treatment to use when (a) an investor acquires

enough additional common stock during a year to change from accounting for the invest- ment as a trading security to using the equity method and (b) an investor using the equity method sells enough common stock so that its portion of ownership falls below 20%.

13-20 How does IFRS categorize minority passive investments? Describe how this clas- sification is determined.

13-21 Describe the accounting treatment under IFRS of investments accounted for at fair value.

13-22 How would the reversal of an impairment loss on an available-for-sale equity security be treated under IFRS? How does this compare with the treatment under U.S. GAAP?

13-23 Morgan Inc. and Parker Company are considering entering into a joint venture arrangement. Under IFRS, what accounting alternatives are available to Morgan and Parker with respect to this joint venture? How does this compare with the options under U.S. GAAP?

HOW ARE INVESTMENTS DISCLOSED IN THE FINANCIAL STATEMENTS? For minority passive investments, a company is required to make the following major disclosures for each major type of security:

• Trading Securities. A company should disclose: � aggregate fair value � change in the net unrealized holding gain or loss that is included in each income

statement • Available-for-Sale Securities. For each balance sheet date, a public company should

disclose: � aggregate fair value � gross unrealized holding gains and losses � amortized cost

LEARNING OBJECT IVE 13.7 Understand disclosures of investments.

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For each income statement period, a company should disclose: � proceeds from sales and the gross realized gains and losses on those sales � basis on which cost was determined (e.g., the average cost method) � gross gains and gross losses included in net income from transfers of securities

from this category into the trading category � change in the net unrealized holding gain or loss included as a separate compo-

nent of other comprehensive income • Held-to-Maturity Securities. For each balance sheet date, a public company should

disclose � aggregate fair value � gross unrecognized holding gains and losses � amortized cost � the related realized or unrealized gain or loss and the circumstances leading to

the decision to sell or transfer the security

As noted in Chapter 4, the FASB has established a three-tiered hierarchy that distin- guishes among different inputs used to determine fair value. Although the relevance of fair values is obvious, the FASB did recognize that the representational faithfulness of Level 2 and Level 3 inputs may be questioned. To allow financial statement users to assess the valuation techniques and inputs used to develop fair value measurements as well as the effect on net income or other comprehensive income, several additional dis- closures related to fair value are required. In addition to the fair value measurement of the investment, companies must also disclose:

• level within the fair value hierarchy of the fair value measurement • for fair value measurements using significant unobservable inputs (Level 3), a recon-

ciliation of the beginning and ending balances • description of the valuation technique used for Level 2 or Level 3 fair value

measurements

Investments in trading securities are always classified as current assets on a company’s classified balance sheet. Investments in available-for-sale securities are classified as cur- rent or noncurrent assets depending on whether or not they will mature or be sold within one year or the operating cycle, whichever is longer. Investments in held-to- maturity securities are classified as noncurrent assets unless they mature within the next year.31

Cash flows from purchases, sales, and maturities of available-for-sale securities and held-to-maturity securities are classified as cash flows from investing activities. The gross amounts of inflows and outflows are reported for each category. Even though interest received on debt securities is related to an investing activity, U.S. GAAP requires any cash received for interest to be included in the operating section of the statement of cash flows. Cash flows from purchases, sales, and maturities of trading securities are generally classified as cash flows from operating activities if trading in these securities is a normal part of operations. However, for companies that do not routinely invest in trading securities, the related cash flows can be classified as cash flows from investing activities.

For minority active (or equity method) investments, a company should make the following major disclosures:

• name of each investee and the percentage of ownership of its common stock • investor’s accounting policies with respect to equity method investments • aggregate value of each investment based on the quoted market price (if available)

Real Report 13.1 shows the disclosures of Apple in its 2015 annual report.

31 FASB ASC 320-10-45: Investments—Debt and Equity Securities: Overall: Other Presentation Matters.

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DISCLOSURE OF INVESTMENTS 13.1

Notes to Consolidated Financial Statements (in part):

Note 1: Summary of Significant Accounting Policies (in part)

Financial Instruments (in part)

Cash Equivalents and Marketable Securities

The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the designations at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. Marketable equity securities, including mutual funds, are classified as either short-term or long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity securities are carried at fair value, with unrealized gains and losses, net of taxes, reported as a component of Accumulated Other Comporehensive Income (“AOCI”) in shareholders’ equity, with the exception of unrealized losses believed to be other-than-temporary which are reported in earnings in the current period. The cost of securities sold is based upon the specific identification method.

Note 2: Financial Instruments (in part)

Cash, Cash Equivalents and Marketable Securities (in part)

The following tables show the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short- or long-term marketable securities as of September 26, 2015 and September 27, 2014 (in millions):

2015

Adjusted Cost

Unrealized Gains

Unrealized Losses

Fair Value

Cash and Cash

Equivalents

Short-Term Marketable Securities

Long-Term Marketable Securities

Cash $ 11,389 $ 0 $ 0 $ 11,389 $11,389 $ 0 $ 0 Level 1:

Money market funds 1,798 0 0 1,798 1,798 0 0 Mutual funds 1,772 0 (144) 1,628 0 1,628 0

Subtotal 3,570 0 (144) 3,426 1,798 1,628 0 Level 2:

U.S. Treasury securities 34,902 181 (1) 35,082 0 3,498 31,584 U.S. agency securities 5,864 14 0 5,878 841 767 4,270 Non-U.S. government

securities 6,356 45 (167) 6,234 43 135 6,066 Certificates of deposit and

time deposits 4,347 0 0 4,347 2,065 1,405 877 Commercial paper 6,016 0 0 6,016 4,981 1,035 0 Corporate securities 116,908 242 (985) 116,165 3 11,948 104,214 Municipal securities 947 5 0 952 0 48 904 Mortgage- and asset-backed

securities 16,121 87 (31) 16,177 0 17 16,160 Subtotal 191,461 574 (1,184) 190,851 7,933 18,853 164,065

Total $206,420 $574 $(1,328) $205,666 $21,120 $20,841 $164,065

Apple Inc.

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2014

Adjusted Cost

Unrealized Gains

Unrealized Losses

Fair Value

Cash and Cash

Equivalents

Short-Term Marketable Securities

Long-Term Marketable Securities

Cash $ 10,232 $ 0 $ 0 $ 10,232 $10,232 $ 0 $ 0 Level 1:

Money market funds 1,546 0 0 1,546 1,546 0 0 Mutual funds 2,531 1 (132) 2,400 0 2,400 0

Subtotal 4,077 1 (132) 3,946 1,546 2,400 0 Level 2:

U.S. Treasury securities 23,140 15 (9) 23,146 12 607 22,527 U.S. agency securities 7,373 3 (11) 7,365 652 157 6,556 Non-U.S. government

securities 6,925 69 (69) 6,925 0 204 6,721 Certificates of deposit and

time deposits 3,832 0 0 3,832 1,230 1,233 1,369 Commercial paper 475 0 0 475 166 309 0 Corporate securities 85,431 296 (241) 85,486 6 6,298 79,182 Municipal securities 940 8 0 948 0 0 948 Mortgage- and asset-backed

securities 12,907 26 (49) 12,844 0 25 12,859 Subtotal 141,023 417 (379) 141,061 2,066 8,833 130,162

Total $155,332 $418 $(511) $155,239 $13,844 $11,233 $130,162

The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management. The maturities of the Company’s long-term marketable securities generally range from one to five years.

As of September 26, 2015, the Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature and did not consider any of its investments other-than-temporarily impaired. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than- temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s cost basis.

Questions: 1. What was the pretax amount of the gross unrealized holding gain and gross unrealized

holding loss on available-for-sale securities that Apple included in other comprehensive income for 2015?

2. How much did Apple include in accumulated other comprehensive income (pretax) at the end of its 2015 fiscal year for available-for-sale securities?

3. How much gain or loss related to marketable securities did Starbucks include on its income statement for 2015? Were any impairment losses recognized?

Suggested answers to these questions are

found at the end of the chapter.

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GOT IT? 13-24 Show the balance sheet disclosures of an investment in available-for-sale securities

that a company classifies as current and has a fair value in excess of cost.

WHAT IS THE ACCOUNTING FOR OTHER TYPES OF INVESTMENTS? In addition to investments in debt and equity securities of other companies, other items are often classified on a company’s balance sheet under the investments category. These include long-term receivables, the cash surrender value of life insurance, and investments in funds.

Long-Term Notes Receivable Companies may acquire long-term notes receivable as a result of lending cash to another entity. However, except for financial institutions, long-term notes receivable are acquired primarily as a result of an exchange for property, goods, or services.

When a company receives a note in exchange for property, goods, or services, it should presume that the stipulated interest rate on the note is fair unless:

• no interest rate is stated • the stated interest rate is clearly unreasonable • the face value of the note is materially different from the cash sales price of the prop-

erty, goods, or services, or from the fair value of the note on the transaction date

In any of these situations, the note receivable is recorded at the fair value of the property, goods, or services or the fair value of the note, whichever is more clearly determinable. If neither of these values can be determined, the note is recorded at its present value by using the borrower’s incremental interest rate. The effective interest method is used to record the periodic interest income. Recording the note at its fair value (present value) and using the effective interest method results in the correct asset valuation and in the proper timing of income recognition.

Example: Exchange of Equipment for Note Receivable Joyce Company accepts a $10,000, non-interest-bearing, 5-year note on January 1, 2016, in exchange for used equipment it sold to Marsden Company. Because Joyce cannot deter- mine the fair value of the equipment or the note, it uses Marsden’s incremental borrowing rate, which is 12%, to determine a present value of $5,674:27 ($10,000 3 0:567427 from Present Value of 1 Table in the TVM Module) for the note. The equipment had originally cost Joyce $8,000 and had a book value of $5,000 on the date of sale. Joyce records the following journal entries for the exchange and the first two interest receipts:

January 1, 2016 Notes Receivable 10,000.00 Accumulated Depreciation 3,000.00

Discount on Notes Receivable ($10,000 2 $5,674.27) 4,325.73 Equipment 8,000.00 Gain on Sale of Equipment 674.27

December 31, 2016 Discount on Notes Receivable 680.91

Interest income [($10,000 2 $4,325.73) 3 0.12] 680.91

December 31, 2017 Discount on Notes Receivable 762.62

Interest income {[$10,000 2 ($4,325.73 2 $680.91)] 3 0.12} 762.62

LEARNING OBJECT IVE 13.8 Account for additional types of investments, including long-term receivables.

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At the date of exchange, Joyce records the difference between the present value and face value of the note in a Discount on Notes Receivable account. This account is a con- tra-account and is subtracted from the Notes Receivable account to report the carrying (book) value of the note in the investments section on Joyce’s balance sheet. Joyce com- putes the $674.27 gain by comparing the book value ($5,000) of the equipment with the present value ($5,674.27) of the note.32 At the end of each year, Joyce records inter- est income using the effective interest method. By the maturity date, it will have amor- tized the entire discount to Interest Income, and the carrying value will equal the face value of the note. �

Loan Fees and Loan Origination Costs Lending activities precede the payment of funds and generally include efforts to identify and attract potential borrowers and to originate a loan or loan commitment. The nonrefundable fees charged to borrowers for these activities are called loan origination fees (or commitment fees). Generally, any loan origination or commitment fees are deferred and recognized over the life of the loan as an increase in the interest income related to the note receivable.33 Likewise, any direct loan origination costs are deferred and recognized over the life of the loan as a decrease in the interest income. In either case, a new, effective interest rate is computed for the loan.

Impairment of a Loan A loan (note receivable) is impaired if it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.34 Impairment occurs when there is a delay or reduction in the payment of the principal or interest. The creditor, often a financial institution, applies its normal loan review procedures in making this determination. A loan is not impaired even if there is a delay in making interest or principal payments provided the creditor expects to collect all amounts due, including interest accrued during the period of delay. When a loan is deemed to be impaired, the creditor computes the present value of the expected future cash flows of the impaired loan using the effective interest rate on the loan. The effective interest rate is the original (contractual) interest rate on the loan (adjusted for any loan fees, discount, or premium). The creditor recognizes the amount by which the present value is less than the recorded investment in the loan by increasing Bad Debt Expense and Allowance for Doubtful Notes. Alternatively, the creditor may measure the impairment based on the loan’s market price, or the fair value of the collat- eral, net of the costs of selling the loan or the collateral, if it expects repayment of the loan to be provided solely by the underlying collateral.

Once the creditor has written down the loan, it computes the interest income each period by multiplying the carrying value of the loan by the effective interest rate. It rec- ognizes the interest income as a reduction of the allowance account.35 If there are addi- tional changes in the amount or timing of an impaired loan’s expected cash flows, or if actual cash flows are different than expected cash flows, the creditor recalculates the amount of the impairment. It recognizes the difference, whether an increase or decrease, as an adjustment to Bad Debt Expense and the Allowance account.

32 If the exchange takes place in the middle of the year, Joyce must make a depreciation adjusting entry to bring the book value of the equipment up to date. If Joyce receives cash in addition to the note, it computes the gain by comparing the book value of the equipment with the sum of the cash received plus the present value of the note.

33 FASB ASC 310-20-25: and 35 Receivables, Nonrefundable Fees and Other Costs: Recognition and Subsequent Measurement. 34 FASB ASC 310-10-35: Receivables: Overall: Subsequent Measurement. 35 This method is the conceptually preferred method for recognizing income. Alternatively, the entire change in the present value

(the bad debt expense and the interest revenue) can be recognized as a single amount and reported as an increase or decrease in bad debt expense. However, because the two alternatives were inconsistent with the accounting for impaired loans required by bank and thrift regulators, FASB ASC 310-10-35 allows the use of any method of income recognition, such as cash basis or cost recovery, even though the current value of the impaired loan may be less than the present value of the expected cash flows discounted at the loan’s effective interest rate. Thus, the FASB allows a reduction of comparability in order to reduce implementa- tion costs for companies. Because illustrations of all the methods are beyond the scope of the book, we use the conceptually pre- ferred effective interest method.

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Example: Impairment of Loan Snook Company has a $100,000 note receivable from Ullman Company that it is carry- ing at face value. The original loan agreement specifies that interest of 8% is payable each December 31 and the principal is to be paid on December 31, 2021. Ullman paid the interest due on December 31, 2016, but informed Snook at that time that it probably would miss the next 2 years’ interest payments because of its financial difficulties. After that, it expects to resume the $8,000 annual interest payments, but the principal pay- ment would be made one year late with interest paid for that additional year. The differ- ent cash flows are shown in Example 13.6.

On December 31, 2016, Snook computes the present value of the impaired loan as shown below. Note that Snook discounts the principal for 6 years, the period from December 31, 2016, to December 31, 2022, but discounts the interest for only 4 years, deferred 2 years, because Ullman will not pay interest for 2 years.

Present Value of Principal 5 $100,000 3 present value of a single sum for 6 years at 8% (from Time Value of Money Module)

5 $100,000 3 0.630170 5 $63,017.00

Present Value of Interest 5 $8,000 3 present value of an annuity for 4 years at 8% deferred 2 years (from Time Value of Money Module)

5 $8,000 3 3.312127 3 0.857339 5 $22,716.93

Value of the Impaired Loan 5 $63,017.00 1 $22,716.93 5 $85,733.93

At December 31, 2016, Snook recognizes the impairment of $14,266.07 ($100,000 carrying value 2 $85,733.93 present value) as follows:

Bad Debt Expense 14,266.07 Allowance for Doubtful Notes 14,266.07

The carrying value of the debt after recording the impairment is $85,733:93 ð$100,000 2 $14,266:07Þ. At December 31, 2017, Snook recognizes interest income of $6,858:71 ð8% 3 $85,733:93Þ as follows:

Allowance for Doubtful Notes 6,858.71 Interest Income 6,858.71

EX A

M PL

E

13.6Expected Cash Flows Related to Impairment

Old Payments Present value at 8% = $100,000

2016 2017 2018 2019 December 31

2020 2021 2022

$8,000 $8,000 $8,000 $8,000 $8,000

$8,000 $100,000

$8,000 $100,000

New Payments Present value at 8% = $85,733.93

$8,000 $0 $0 $8,000 $8,000 $8,000

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The carrying value of the debt is now $92,592:64 ($85,733:93 1 $6,858:71). At December 31, 2018, Snook recognizes interest income of $7,407:41 (8% 3 $92,592:64). This eliminates the balance in the Allowance for Doubtful Notes account, and the carry- ing value of the receivable is now $100,000. Snook will recognize interest income of $8,000 each year for 2019 through 2022 as the cash payment is received. Snook will eliminate the $100,000 carrying value on December 31, 2022, when it receives the prin- cipal payment. If Snook’s expectations of future cash flows decrease (increase) before December 31, 2018, it would debit (credit) Bad Debt Expense and credit (debit) the Allowance account for the decrease (increase) in the present value. In either situation, the company would recognize interest income each year. �

Cash Surrender Value of Life Insurance Because a company is dependent on the skill and expertise of its officers, it will frequently purchase insurance policies on their lives. The reason for this is that the company will be at least partly compensated for the loss of executive skill in the event of an unexpected death.

Many insurance policies allow a portion of accumulated premiums to build up as a savings plan. If the policy is canceled, this savings plan or cash surrender value of the policy is returned to the company buying the life insurance policy. When a company is guaranteed a return equal to the amount of the cash surrender value of the policy, part of each annual premium represents an investment which is included as a long-term investment on the balance sheet. The company records the portion of the yearly pre- mium that does not increase the cash surrender value of the policy as insurance expense. Additionally, some life insurance policies pay dividends. The company holding such a policy treats any dividends received as a reduction of insurance expense.

Example At the beginning of the year, Mele Corporation pays an annual insurance premium of $5,500 to cover the lives of its officers. It records the payment as follows:

Prepaid Insurance 5,500 Cash 5,500

According to the terms of the insurance contract, the cash surrender value of the policies increases from $7,200 to $8,300 during that year. The adjusting entry at the end of the year to increase the cash surrender value is as follows:

Insurance Expense 4,400 Cash Surrender Value of Life Insurance ($8,300 2 $7,200) 1,100

Prepaid Insurance 5,500

Upon the death of any of the insured officers, Mele would collect the face amount of the insurance policy and credit the Cash Surrender Value account to close out the balance in the account related to this policy. The difference between the proceeds and the cash sur- render value is normally reported as an ordinary gain, because collecting insurance pro- ceeds is a usual operating procedure. For income tax purposes, the premiums are not tax deductible and the gain is not taxable. �

Investments in Funds Companies may place assets in special funds for specific purposes, and some of these assets then are restricted from use in normal operations because of indenture or other contractual arrangements. Special funds may be current, if they are expected to be used within one year, or they may be long term. The most common long-term funds are as follows:

• funds used to accumulate cash to retire long-term liabilities (sinking funds) • funds used to retire preferred stock (stock redemption funds) • funds used to purchase long-term assets (plant expansion funds)

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A company reports its long-term funds as investments on its balance sheet. It is important to understand the distinction between a fund and an appropriation, or restriction, of retained earnings. A fund actually sets aside cash and other assets to accomplish specific objectives. In contrast, an appropriation of retained earnings discloses legal or contractual restrictions limiting the use of cash for payment of dividends or share repurchases (as we dis- cuss in Chapter 16). An appropriation does not set aside any cash.

Accounting for long-term funds requires separate accounts, and the funds may be placed in trust with a separate legal entity. In essence, the fund is accounted for as an indi- vidual set of books. This company makes journal entries to these accounts to record its:

• initial and/or periodic cash contributions to the sinking fund • investments in various securities to earn dividends and interest • expenses to administer the fund • unrealized increases and decreases in value • sale of the securities to acquire cash to retire the bonds.

The company reports any revenues, expenses, gains, and losses in the usual manner on its income statement.

APPENDIX 13.1: DERIVATIVE FINANCIAL INSTRUMENTS Companies have always held or issued financial instruments. However, derivatives of those financial instruments create interesting accounting issues. Companies often use derivatives to reduce the risk of adverse changes in interest rates, commodity prices, and foreign currency exchange rates. Some companies also use derivatives to take risk or speculate on future movements of economic factors, such as interest rates, commodity prices, or foreign currencies. It is important for financial statements to show the effects of that risk management and risk-taking. Here, we discuss recording and reporting issues as they relate to selected derivative transactions.

A financial instrument is cash, evidence of an ownership interest in an entity, or a contract that both:

• imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity or to exchange other financial instruments on poten- tially unfavorable terms with the second entity

• conveys to that second entity a contractual right to receive cash or another financial instrument from the first entity or to exchange other financial instruments on poten- tially favorable terms with the first entity36

Thus, financial instruments include cash, accounts and notes receivable, accounts and notes payable, and investments in debt and equity securities, as well as bonds payable and common stock.

A derivative financial instrument (or simply derivative) derives its value from an underlying asset, market price, interest rate, foreign exchange rate, or index. Derivatives include futures, forwards, swaps, and option contracts. Derivative contracts can be very complex, and they involve the following concepts:37

• A derivative’s cash flows or fair value must fluctuate and vary based on the changes in the fair value of one or more underlying variables.

• The contract must be based on one or more notional (defined later) amounts or pay- ment provisions or both. The underlying and notional amounts determine the amount of the settlement.

• Many contracts require no initial net investment. • The contract may be readily settled by a net cash payment.

LEARNING OBJECT IVE 13.9 Account for derivative financial instruments.

36 FASB ASC Glossary. 37 FASB ASC 815-10: Derivatives and Hedging: Overall.

Appendix 13.1: Derivative Financial Instruments 13-37

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A recent study indicated that more than $639 trillion of derivative contracts (notional amount) are outstanding worldwide. Derivative contracts have been in the news in recent years and include situations in which Procter & Gamble sustained significant losses, Bankers Trust has been sued by numerous clients, Barings Bank in London was bankrupted, Orange County, California, lost millions of dollars, and Fannie Mae restated its results by $9 billion.

A hedge is a means of protecting against a financial loss by mitigating exposure to changes in values of underlying assets, liabilities, or future cash flows. A derivative may help mitigate exposure to a risk if, for example, the value of the derivative increases when the value of the hedged item decreases. Alternately, a derivative can help mitigate a risk exposure if cash flows received from the derivative contract offset cash flows paid out of the hedged item. For a derivative to be considered a hedge, it must be “highly effective” in offsetting a substantial amount of risk exposure associated with changes in fair values or cash flows of the hedged item. The three types of hedges are:

• fair value hedges • cash flow hedges • hedges of foreign currency exposures of net investments in foreign operations

GAAP requires a different accounting treatment for each type of hedge. Accounting for derivatives can be very complex. To explain the basic issues, we show the accounting for a fair value hedge using an interest-rate swap and discuss the accounting issues for a cash flow hedge.38 In our examples, we use simplifying assumptions (such as a flat yield curve) so that you can understand the basic accounting issues and avoid many real-world complexities regarding valuation.

An interest-rate swap is an agreement in which two companies agree to exchange the interest payments on debt over a specified period. The interest payments are based on a principal amount that often is referred to as a notional amount because the swap does not involve an actual exchange of principal at either inception or maturity. A company might use an interest-rate swap if, for example, it held a variable rate note receivable (where the interest rate on the note changed periodically with an index) but wanted to lock in the interest income it would earn on that note. In that situation, the company could engage in an interest-rate swap arrangement in which the company receives a fixed rate of interest and pays a variable rate. In such a hedge, the counterparty to the interest-rate swap is a company (often a financial institution) that receives a variable rate of interest and pays a fixed rate.

Although we discuss investments in this chapter, we focus on accounting for a deriv- ative of a financial instrument that is a liability because they are more common for nonfi- nancial companies. However, a derivative can result in either an asset or a liability being recognized by either party, as market conditions change. The other company involved in the original transaction, a bank in our example, has a financial instrument that is an asset.

Fair Value Hedge A fair value hedge protects against the risk from changes in value caused by fixed terms, rates, or prices. For example, a company with an outstanding financial debt obligation that has a fixed interest rate faces interest rate risk because if interest rates fall, the fair value of the debt will increase (making it more costly for the company if it decides to retire the debt before maturity). To mitigate this fair value risk, the company enters into an interest-rate swap to receive a fixed rate of interest and pay a variable rate. If interest rates fall, the value of the debt obligation increases, but the fair value of the interest-rate swap (asset) increases, offsetting (hedging) the fair value of the debt obligation. If interest rates rise, it will pay a higher rate on the swap than the fixed rate, so the fair value of the swap will decline (become a liability), hedging the decline in the fair value of the debt obligation (liability). Another example would be a company that purchases a commodity, such as oil. If the

38 Hedges of foreign currency exposures are beyond the scope of this book.

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company wishes to hedge the fair value of the oil, it can agree to a fixed price futures con- tract to sell the oil at a specified future date. If, for example, the market price of oil decreases, the fair value of the oil the company owns will fall, but the value of the future contract fixing the future selling price will rise, hedging the fair value of the oil. If the market price for oil rises, the fair value of the company’s oil increases, but the fair value of the futures contract falls. Again the fair value of the oil has been hedged. In each case, the com- pany has converted a fixed-rate contract (for interest or oil) into a variable-rate contract.

For a fair value hedge, GAAP requires a company to recognize in its current net income:

• any gain or loss from a change in the fair value of the derivative (fair value hedge) • any gain or loss from the change in the fair value of the financial instrument or other

item being hedged, along with any interest income or expense

As a result, the company reports both the derivative and the financial instrument on its bal- ance sheet at their respective fair values. Note that GAAP requires the use of the fair value method in the valuation of derivatives and the related hedged financial instruments.

Example: Interest-Rate Swap That Is a Fair Value Hedge Laki Company has had a $1 million, 6% fixed-rate bank loan (the financial instrument) from MidAmerica Bank outstanding for several years. On January 1, 2016, when the $1 million loan (debt) has 5 years remaining, Laki contracts with Jordan Investment Bank (a swaps dealer) for a 5-year interest-rate swap (the derivative) with a $1 million notional amount. Laki agrees to receive from Jordan a fixed interest rate of 6% and to pay Jordan an interest rate each year that is variable. The variable rate is the LIBOR (London Interbank Offer Rate) interest rate at the beginning of each year. In other words, Laki has converted (“swapped”) its fixed interest rate debt into the variable LIBOR interest rate debt. If the LIBOR interest rate debt is 5.3% at January 1, 2016, the company has converted 6% debt into 5.3% debt for that year. This type is called a “matched” swap because the notional amount is the same as the actual loan amount and the fixed interest rate on the derivative is equal to the fixed interest rate paid on the loan. Therefore, the derivative is an effective hedge of the risk of interest rate changes. Example 13.7 summarizes the facts for the loan and swap involving Laki, MidAmerica Bank, and Jordan Investment Bank.

EX A

M PL

E

13.7Fair Value Hedge: Interest-Rate Swap BEFORE SWAP

Financial Instrument: $1 Million Loan

MidAmerica Bank Laki Company

Note Receivable of $1 million

Financial Pay Fixed (6%) Interest Rate Instrument:

Financial Pay Fixed (6%) Interest Rate Instrument:

Note Payable of $1 million

AFTER SWAP

Financial Instrument: $1 Million Loan, and Derivative: Matched Interest-Rate Swap with $1 Million Notional Amount

MidAmerica Bank Laki Company

Note Receivable of $1 million

Note Payable of $1 million

Jordan Investment Bank

Interest-Rate Swap ($1 million notional amount)

Derivative: Interest-Rate Swap ($1 million notional amount)Pay LIBOR (Variable)

Interest Rate

Receive Fixed (6%) Interest Rate

Appendix 13.1: Derivative Financial Instruments 13-39

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Laki recorded the following journal entry for the financial instrument (the original loan):

Cash 1,000,000 Notes Payable 1,000,000

Laki accounts for the derivative (the fair value hedge) in 2016 and 2017, as follows:

Interest Payment on Loan: December 31, 2016 Laki pays MidAmerica the fixed rate of 6% on the $1 million loan and records this as interest expense, as follows:

Interest Expense 60,000 Cash 60,000

Interest-Rate Swap Payment: December 31, 2016 Because the LIBOR rate that was set at January 1, 2016, is 5.3%, there is a net payment (settlement) between Laki and Jordan. Because Laki owes to Jordan the 5.3% LIBOR rate and receives from Jordan the fixed 6% rate, it receives from Jordan the net 0.7% on the notional amount of $1 million, or $7,000. Laki records the cash received as a decrease to interest expense, as follows:

Cash 7,000 Interest Expense 7,000

Thus, Laki records a total interest expense of $53,000 ($60,000 2 $7,000) in 2016, which is the equivalent of the variable rate of 5.3% on the $1 million loan.

Fair Values and Gains and Losses: December 31, 2016 The fair value method uses market values to recognize the value of derivatives if they are available, such as for futures contracts traded on exchanges. However, many derivatives are forward contracts that are custom-designed for the two entities, and market values are not readily available for such distinctive contracts, as in this example. In these cases, discounted cash flows are used to value the derivative.

Laki determines the gain or loss for 2016 on the derivative (fair value hedge) by computing the net present value of the future cash flows over the remaining life of the derivative. It is based on the difference between the fixed interest rate contracted in the derivative and the current market fixed interest rate applied to the notional amount for the remaining life of the swap. Note that this rate is typically different than the LIBOR rate that is a short-term variable rate and has no inherent fair value because it can be obtained at any time. Thus, there are three interest rates:

• fixed interest rate (6%) on the loan and the derivative • variable LIBOR interest rate at the beginning of the year that is used to determine

the swap payment at the end of the year (5.3% for 2016, and we assume it changes to 6.8% for 2017)

• fixed market rate of interest at the end of the year for the remaining life of the loan or derivative (We assume this rate to be 7% for a 4-year loan or derivative at December 31, 2016, and we assume it changes to 5.5% for a 3-year loan or derivative at December 31, 2017.)

If the fixed market rate of interest for the 4-year remaining life of the derivative is 7% (compared to the LIBOR rate of 6.8% that is set at January 1, 2017), the difference in the fixed interest rates at the end of 2016 is 1% (6% fixed rate 2 7% 4-year market rate). The $33,872 value of the derivative is $10,000 per year (the difference of 1% multiplied by the notional amount of $1,000,000) discounted at the current fixed market rate of 7% for the remaining 4 years, as follows:

Present value of derivative 5 $10,000 3 3.387211 (n 5 4, i 5 0.07) 5 $33,872

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A swap derivative liability and loss exist because the 7% current market rate is higher than the 6% fixed interest rate that Laki receives on the derivative. Laki records the liability and loss as follows:

Loss in Value of Derivative 33,872 Liability from Interest-Rate Swap 33,872

Because interest rates have changed, the value of Laki’s debt (financial instrument) has also changed. The increase in interest rates decreases the value of the debt. The current value of the debt is computed based on the 7% market rate as follows:

Present value of principal 5 $1,000,000 3 0.762895 (n 5 4, i 5 0.07) 5 $762,895

Present value of interest 5 $60,000 3 3.387211 (n 5 4, i 5 0.07) 5 $203,233

Total present value of debt 5 $762,895 1 $203,233 5 $966,128

Laki recognizes the $33,872 ($1,000,000 2 $966,128) decrease in the value of the debt and the related gain as follows:

Notes Payable 33,872 Gain in Value of Debt 33,872

Laki reports both the $33,872 gain in the value of the debt and the $33,872 loss in value of the derivative in the other items section of its 2016 income statement. There is no net effect because it is an effective hedge. Laki reports the $33,872 derivative liability and the $966,128 ($1,000,000 2 $33,872) value of the note payable on its December 31, 2016, balance sheet. Therefore, its total liability in regard to this debt is $1,000,000.

Interest Payment on Loan: December 31, 2017 Laki pays MidAmerica the fixed rate of 6% on the $1 million loan and records this as interest expense, as follows:

Interest Expense 60,000 Cash 60,000

Interest-Rate Swap Payment: December 31, 2017 Assume that at the beginning of 2017 the LIBOR interest rate is 6.8%. Because Laki pays Jordan the LIBOR 6.8% rate and receives from Jordan the fixed 6% rate, it pays to Jordan the net 0.8% on the notional amount of $1 million, or $8,000. Laki records the payment as an increase in interest expense, as follows:

Interest Expense 8,000 Cash 8,000

Thus, Laki records a total interest expense of $68,000 ($60,000 1 $8,000) in 2017, which is the equivalent of the variable rate of 6.8% on the $1 million loan.

Fair Values and Gains and Losses: December 31, 2017 Laki again determines the gain or loss for 2017 on the derivative (fair value hedge) by computing the net present value of the future cash flows over the remaining life of the derivative. It is again based on the difference between the fixed interest rate contracted in the derivative and the current market fixed interest rate, applied to the notional amount for the remaining life of the swap. Assume that at December 31, 2017, the 3-year fixed interest rate is 5.5%. Thus, the difference in fixed interest rates at the end of 2017 is 0.5% (6% fixed rate 2 5.5% 3-year market rate). The $13,490 value of the deriv- ative is $5,000 per year (the difference of 0.5% multiplied by the notional amount of

Appendix 13.1: Derivative Financial Instruments 13-41

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$1,000,000) discounted at the current market rate of 5.5% for the remaining 3 years, computed as follows:

Present value of derivative 5 $5,000 3 2.697933 (n 5 3, i 5 0.055) 5 $13,490

A swap derivative asset and gain exist because the current 5.5% market rate is lower than the 6% fixed interest rate that Laki receives on the derivative. So Laki has moved from a $33,872 liability at the end of 2016 to a $13,490 asset position at the end of 2017, and has a $47,362 ($33,872 1 $13,490) gain which it records as follows:

Liability from Interest-Rate Swap 33,872 Asset from Interest-Rate Swap 13,490

Gain in Value of Derivative 47,362

Again, because interest rates have changed, the value of Laki’s debt (financial instru- ment) has also changed. The decrease in interest rates increases the value of the debt. The current value of the debt is computed based on the 5.5% current market rate as follows:

Present value of principal 5 $1,000,000 3 0.851614 (n 5 3, i 5 0.055) 5 $851,614

Present value of interest 5 $60,000 3 2.697933 (n 5 3, i 5 0.055) 5 $161,876

Total present value of debt 5 $851,614 1 $161,876 5 $1,013,490

Laki recognizes the $47,362 ($1,013,490 current value 2 $966,128 previous value) increase and the related loss as follows:

Loss in Value of Debt 47,362 Notes Payable 47,362

Laki reports the $47,362 gain in value of the derivative and the $47,362 loss in value of the debt in the other items section of its 2017 income statement. There is no net effect for this effective hedge. It reports the $13,490 derivative asset as a long-term investment and the $1,013,490 ($966,128 1 $47,362) value of the note payable on its December 31, 2017, balance sheet. Note that Laki’s net liability in regard to the debt is still $1,000,000. Laki would account for the loan and the derivative (fair value hedge) in a similar manner for the years 2018 through 2021.

In summary, Laki has converted a fixed interest rate bank loan into a variable inter- est rate loan with this interest-rate swap. Laki pays a variable net interest rate on this loan and reports the amount each year as interest expense on its income statement. Laki reports the derivative asset or liability and the related financial instrument (note payable) on its balance sheet at their respective fair values. There is no effect from the change in the fair value of this derivative on the income statement because the change in the fair value of the derivative is offset by the change in the fair value of the financial instrument (i.e., an effective hedge of the fixed rate debt). Note that when a hedge is not perfect or is ineffective (e.g., the notional amount is not equal to the actual principal amount), then a net amount is reported on the income statement. The financial reporting reflects Laki’s interest rate risk management strategy. Laki discloses the characteristics of its financial instrument and derivative in the notes to its financial statements. �

Cash Flow Hedge A cash flow hedge protects against the risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain. A cash flow hedge is a hedge of an expected transaction that will probably occur in the future, but the amount of the

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transaction has not been fixed. This contrasts with a fair value hedge that protects against the risk from changes in value caused by fixed terms, rates, or prices related to existing assets or liabilities.

For example, a company with a variable rate debt that enters into an interest-rate swap to receive a variable rate of interest and pay a fixed rate protects itself against paying a higher rate of interest if interest rates increase. Of course, it will pay a higher rate than the variable rate if interest rates fall. The company has hedged the future cash flows for interest payments because it converted a variable-rate contract into a fixed-rate contract.

For a cash flow hedge, GAAP requires a company to recognize in its current other comprehensive income any gain or loss from a change in the fair value of the derivative (cash flow hedge). The company reports the derivative at its fair value and the related accumulated other comprehensive income in its shareholders’ equity on its ending bal- ance sheet. The company does not recognize in its financial statements any change in value of the financial instrument being hedged because the derivative is intended to hedge the future cash flows associated with that financial instrument rather than the fair value of the instrument itself. When the hedged expected transaction occurs, the com- pany transfers the accumulated other comprehensive income to its current net income.

Example: Interest-Rate Swap That Is a Cash Flow Hedge Assume the same facts as for the fair value hedge, except that Laki has a 5.3% (for 2016) variable rate $1 million loan (debt) with MidAmerica Bank that is based on the LIBOR rate. It enters into an interest-rate swap with Jordan Investment Bank in which it will receive a variable (5.3% for 2016) interest rate and pay a 6% fixed rate. Because this hedge protects against the risk caused by variable interest rates, it is a cash flow hedge. Example 13.8 summarizes the facts for the loan and swap involving Laki, MidAmerica Bank, and Jordan.

Laki reports this swap at its fair (present) value on the balance sheet and reports any change in the fair value for the period in other comprehensive income. It reports the total change in fair value as accumulated other comprehensive income in the

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13.8Cash Flow Hedge: Interest-Rate Swap

Derivative: Receive LIBOR (Variable) Interest Rate

Pay Fixed (6%) Interest Rate

BEFORE SWAP

Financial Instrument: $1 Million Loan

MidAmerica Bank Laki Company

Note Receivable of $1 million

Financial Instrument:

Pay LIBOR (Variable) Interest Rate

Financial Instrument:

Pay LIBOR (Variable) Interest Rate, Reset Annually

Note Payable of $1 million

AFTER SWAP

Financial Instrument: $1 Million Loan, and Derivative: Matched Interest-Rate Swap with $1 Million Notional Amount

MidAmerica Bank Laki Company

Note Receivable of $1 million

Note Payable of $1 million

Jordan Investment Bank

Interest-Rate Swap of $1 million (notional amount)

Interest-Rate Swap of $1 million (notional amount)

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shareholders’ equity section of its balance sheet. This type of interest-rate swap does not hedge the liability. Instead, it hedges the future interest payments. Thus, as Laki makes each interest payment, a hedged expected transaction occurs and Laki must transfer an amount from the accumulated other comprehensive income to its net income, based on the change in the present value. In this case, Laki must compute the present value of each interest payment separately. Because each payment occurs at a different point on the yield curve, Laki would use a different interest rate to determine its present value. These procedures are beyond the scope of this book. �

GOT IT? 13-25 Describe the steps necessary for a company to determine the value at which to record

a non-interest-bearing note receivable exchanged for property, goods, or services. 13-26 If a company receives a note in exchange for property, goods, or services, when and

for what calculations is the borrower’s incremental rate used? 13-27 Why is the cash surrender value of a life insurance policy on which the company is

the beneficiary carried as an investment? How does the company determine the increase in this amount and the amount of insurance expense determined each year?

13-28 What is a fund? Distinguish between a fund and an appropriation of retained earnings. 13-29 What is a hedge? Describe the differences between a fair value and a cash flow hedge. 13-30 Explain the accounting differences between a fair value hedge and a cash flow hedge.

REVIEW CENTER

At the beginning of the chapter, we discussed how companies make investments in other companies for reasons ranging from obtaining additional income to improving their competitive position. We also identified several objectives you would accomplish after reading the chapter. The objectives are listed below and followed by a brief summary of the key points.

KEY TAKEAWAYS • Minority passive investments in the financial instruments (debt and equity securities)

of other companies in which the investor does not have significant influence or con- trol are classified as: � Held-to-maturity debt securities—investments in debt securities for which the

company has the positive intent and ability to hold to maturity � Trading securities—all investments in equity securities with a readily determinable

fair value and investments in debt securities that are purchased and held princi- pally for the purpose of selling them in the near term

� Available-for-sale securities—investments in debt securities that are not classified as held-to-maturity or trading securities

• While all minority passive investments are initially recorded at cost with dividend income, interest income, and realized gains and losses recorded on the income state- ment, the subsequent valuation of these securities and the recognition of unrealized gains and losses depend on their classification.

• Minority active investments, ownership of between 20% and 50% of a company’s vot- ing stock, give the investor significant influence over the investee and are accounted for under the equity method.

LEARNING OBJECT IVE 13.1 Explain the classification and valuation of investments.

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• When an investor controls the investee, the investment is considered a majority active investment and consolidation is appropriate.

• GAAP also gives companies the option to report financial instruments at fair value, with unrealized gains and losses recognized in income.

KEY TERMS available-for-sale securities, p. 13-3 consolidation, p. 13-4 debt security, p. 13-2 equity security, p. 13-2 held-to-maturity securities, p. 13-3 majority active investment, p. 13-4

marketable securities (investment securities), p. 13-2

minority active investments (equity method investments), p. 13-4

minority passive investment, p. 13-3 trading securities, p. 13-3

KEY TAKEAWAYS • Investments in held-to-maturity debt securities are initially recorded at cost and sub-

sequently reported at amortized cost, with any premium or discount amortized over the remaining life of the security.

• Unrealized holding gains and losses are not recognized. • Interest income, as well as realized gains and losses on sales (if any), are included in

net income of the current period.

KEY TERM effective interest method (interest method) p. 13-7

KEY CALCULATION Interest Income5Effective Interest Rate3Book Value of the Investment at Beginning of Period3Time

KEY TAKEAWAYS • Investments in debt and equity trading securities are initially recorded at cost and

subsequently reported at fair value. • Unrealized holding gains and losses, which result from increases or decreases in the

fair value of the securities, are included in net income of the period. • Interest and dividend income, as well as realized gains and losses on sales, are

included in net income of the current period.

KEY TERMS unrealized holding loss, p. 13-12 unrealized holding gain, p. 13-12

KEY TAKEAWAYS • Investments in available-for-sale debt securities are initially recorded at cost and sub-

sequently reported at fair value. • Unrealized holding gains and losses are reported as a component of other compre-

hensive income of the period. The cumulative net unrealized holding gains or losses are reported in the accumulated other comprehensive income section of sharehold- ers’ equity on the balance sheet.

• Realized gains and losses are included in net income for the current period and, when the security is sold, any unrealized holding gains or losses must be reclassified from accumulated other comprehensive income into net income.

• Interest income is included in net income of the current period.

KEY CALCULATION Realized Gain or Loss on Debt Security 5 Selling Price 2 Amortized Cost

LEARNING OBJECT IVE 13.2 Account for investments in debt securities classified as held-to-maturity, including amortization of bond premiums and discounts.

LEARNING OBJECT IVE 13.3 Account for investments in debt and equity securities classified as trading.

LEARNING OBJECT IVE 13.4 Account for investments in debt securities classified as available-for-sale.

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KEY TAKEAWAYS • The transfer of a security between categories is accounted for at the fair value at the

time of the transfer. • Depending on the classification of the security transferred, the unrealized gain or loss

is either eliminated or established. • An impairment occurs when there is an other than temporary decline below the

amortized cost of a debt security classified as available-for-sale or held-to-maturity. The company writes down the amortized cost of the security to the fair value and includes the amount of the write-down in net income as a realized loss.

KEY TERMS impairment, p. 13-21 other than temporary, p. 13-21

KEY TAKEAWAYS • An investor company uses the equity method when it is able to exercise significant

influence over the operating and financial policies of an investee. Significant influence is presumed if the investor owns between 20% and 50% of the investee’s outstanding common stock.

• Under the equity method: � The initial investment is recorded at cost, is increased by the investor’s propor-

tionate share of the investee’s reported income, and is reduced by the investor’s proportionate share of any dividends declared.

� The investor depreciates its proportionate share of any difference between the fair value and the book value of the investee’s depreciable assets by reducing the investment account.

� If a company changes its accounting for investments to the equity method, a ret- rospective restatement (adjustment) is made to adjust the accounts to the balance they would have shown if the equity method had always been used.

� If the equity method is no longer appropriate (e.g., the investor’s ownership per- centage falls below 20%), the company will normally account for the investment as a trading security.

KEY TERM equity method, p. 13-23

KEY CALCULATIONS Investment 5 Acquisition Cost 1 Investor’s Share of Investee Income 2 Dividends Received

where

Investor’s Share of Investee Income 5 (Investee’s Net Income 3 Ownership %) 2 Adjustments

and

Dividends Received 5 Total Dividends Paid by Investee 3 Ownership %

KEY TAKEAWAYS • For trading securities, a company must disclose the aggregate fair value of the secur-

ities and the change in the net unrealized holding gain or loss that is included in each income statement.

• For available-for-sale securities, a company must disclose, for each balance sheet date, the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, and amortized cost by major security types. For each income statement period, the company must disclose (1) the proceeds from the sales and the gross realized gains and losses on those sales as well as the basis on which cost was determined, (2) the gross gains and gross losses included in net income from transfers of securities from this

LEARNING OBJECT IVE 13.5 Understand transfers between categories and impairment of debt and equity securities.

LEARNING OBJECT IVE 13.6 Account for intercompany investments using the equity method.

LEARNING OBJECT IVE 13.7 Understand disclosures of investments.

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category into the trading category, and (3) the change in the net unrealized holding gain or loss included as a separate component of other comprehensive income.

• For held-to-maturity securities, a company must disclose for each balance sheet date the aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost by major security types. For any sales or transfers from this cate- gory, the disclosures must include the amortized cost, the related realized or unrealized gain or loss, and the circumstances leading to the decision to sell or transfer security.

KEY TAKEAWAYS • Long-term receivables are classified as investments and recorded at the fair value of

the property, goods, or services, or the fair value of the note, whichever is more clearly determinable.

• A loan is impaired if it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.

• Other items classified as investments include the cash surrender value of life insurance and investments in funds.

KEY TERMS cash surrender value, p. 13-36 loan origination fees (commitment fees),

p. 13-34

plant expansion funds, p. 13-36 sinking funds, p. 13-36 stock redemption funds, p. 13-36

KEY TAKEAWAYS • A derivative derives its value from an underlying financial instrument. • A hedge is a means of protecting against a financial loss. � A fair value hedge protects against the risk from changes in value caused by fixed

terms, rates, or prices. A company recognizes in its current net income any gain or loss from a change in the fair value of the derivative (fair value hedge) and any gain or loss from the change in the fair value of the financial instrument being hedged, along with any interest income or expense. As a result, the company reports both the derivative and the financial instrument on its balance sheet at their respective fair values.

� A cash flow hedge protects against the risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain. A cash flow hedge is a hedge of an expected transaction that will probably occur in the future, but the amount of the transaction has not been fixed. A company recognizes in its current other comprehensive income any gain or loss from a change in the fair value of the derivative (cash flow hedge). The company reports the derivative at its fair value and the related accumulated other comprehensive income in its shareholders’ equity on its ending balance sheet.

KEY TERMS derivative, p. 13-37 derivative financial instrument, p. 13-37 financial instrument, p. 13-37

hedge, p. 13-38 interest-rate swap, p. 13-38 notional, p. 13-38

ANSWERS TO REAL REPORT QUESTIONS

Real Report 13.1 Answers Apple Inc.—Disclosure of Investments 1. Other comprehensive income for 2015 included any change in the unrealized gains

and losses from securities that are classified as available-for-sale. The total pretax unrealized gains and losses for Apple for 2015 and 2014 are shown below.

LEARNING OBJECT IVE 13.8 Account for additional types of investments, including long-term receivables.

LEARNING OBJECT IVE 13.9 (Appendix 13.1) Account for derivative financial instruments.

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Apple’s other comprehensive income for 2015 would report a pretax unrealized gain of $156 million and a pretax unrealized loss of $817 million. Therefore, the net unrealized loss would be $661 million.

2. Accumulated other comprehensive income would include the cumulative unrealized gains and losses for the available-for-sale securities. At the end of 2015, Apple has a cumulative pretax gross unrealized loss of $754 million ($574 million gross unreal- ized gain minus $1,328 million gross unrealized loss).

3. On its income statement for 2015, Apple did not appear to report any gains/losses from the sale of marketable securities classified as available-for-sale as none were dis- closed in the annual report. In addition, Apple reported no impairment loss on these securities after considering factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer, and Apple’s intent to sell, or whether it is more likely than not that it will be required to sell, the investment before the recovery of its cost basis.

(in millions) 2015 2014 Net Change

Gross Unrealized Gain $ 574 $ 418 $ 156 Gross Unrealized Loss (1,328) (511) (817) Net Unrealized Loss $(661)

MULTIPLE-CHOICE (AICPA ADAPTED)

Select the best answer for each of the following.

M13-1 On January 1, 2016, Weaver Company purchased as held-to-maturity debt securities $500,000 face value of Park Corporation’s 8% bonds for $456,200. The bonds were purchased to yield 10% interest and pay interest annually. The bonds mature on January 1, 2021. Weaver uses the effec- tive interest method of amortization. What amount should Weaver report on its December 31, 2016, balance sheet as an investment in held- to-maturity debt securities?

a. $450,580 c. $461,820 b. $456,200 d. $466,200

M13-2 On its December 31, 2015, balance sheet, Fay Company reported investments, classified as trad- ing securities, at a market value of $183,000. There was no change during 2016 in the compo- sition of Fay’s portfolio of marketable equity securities. Pertinent data are as follows:

Security Cost Market Value at 12/31/15

Market Value at 12/31/16

A $ 60,000 $ 62,000 $ 63,000 B 45,000 42,000 40,000 C 80,000 79,000 78,500 Totals $185,000 $183,000 $181,500

What amount of loss on these securities should be included in Fay’s income statement for the year ended December 31, 2016?

a. $0 c. $2,000 b. $1,500 d. $3,500

M13-3 During 2018, Anthony Company purchased secur- ities as a long-term investment and classified them as trading. Pertinent data are as follows:

Security Cost Market Value at

12/31/18

A $ 20,000 $ 18,000 B 40,000 30,000 C 90,000 93,000 Totals $150,000 $141,000

The net holding gain or loss included in Anthony’s income statement for the year should be:

a. $0 c. $9,000 loss b. $3,000 gain d. $12,000 loss

M13-4 On July 1, 2016, Aldrich Company purchased as an available-for-sale security $200,000 face value, 9% U.S. Treasury notes for $194,000. The notes mature July 1, 2017, and pay interest semiannu- ally on January 1 and July 1. The notes were sold on December 1, 2016, for $199,000. Aldrich nor- mally uses straight-line amortization on all of its

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notes. In its income statement for the year ended December 31, 2016, what amount should Aldrich report as a gain on the sale of the available-for-sale security?

a. $2,500 c. $5,000 b. $3,500 d. $6,000

M13-5 In 2018, Cromwell Corporation purchased bonds of Oliver Company at par for $300,000 and classi- fied the investment as available-for-sale. In 2019, the market value declined to $200,000. In 2020, the market value of the Fleming stock rose to $230,000, and the stock was sold. How much should Cromwell record as a realized gain or loss in its determination of net income for 2020?

a. $0 c. $70,000 loss b. $30,000 gain d. $100,000 loss

M13-6 When the market value of a company’s portfolio of available-for-sale securities is lower than its cost, the difference should be:

a. accounted for as a valuation allowance deducted from the asset to which it relates

b. accounted for as an addition in the share- holders’ equity section of the balance sheet

c. accounted for as a liability d. disclosed and described in a note to the

financial statements but not accounted for

M13-7 A security in a portfolio of available-for-sale secur- ities is transferred to the trading category. The security should be transferred between the corre- sponding portfolios at:

a. book value at date of transfer if higher than the fair value at date of transfer

b. fair value at date of transfer, regardless of its cost

c. cost, regardless of the fair value at date of transfer

d. lower of its cost or fair value at date of transfer

M13-8 On January 2, 2016, Portela Inc. bought 30% of the outstanding common stock of Bracero Corpo- ration for $258,000 cash. Portela accounts for this investment by the equity method. At the date of acquisition of the stock, Bracero’s property, plant, and equipment had a fair value in excess of its book value of $150,000. Bracero’s property, plant, and equipment has a remaining life of 10 years. Bracero’s net income for the year ended December 31, 2016, was $180,000. During 2016, Bracero declared and paid cash dividends of $20,000. On December 31, 2016, Portela should have carried its investment in Bracero in the amount of:

a. $258,000 c. $306,000 b. $301,500 d. $312,000

M13-9 Cash dividends declared out of current earnings were distributed to an investor. How will the investor’s investment account be affected by those dividends under each of the following accounting methods?

Trading Security Equity Method

a. Decrease No effect b. No effect Decrease c. Decrease Decrease d. No effect No effect

M13-10 On January 1, 2016, Parke Company accepted a $36,000, non-interest-bearing, 3-year note from a major customer in exchange for used equipment. The equipment had originally cost Parke $200,000 and had a book value of $20,000 on the date of the sale. At the 12% imputed interest rate for this type of loan, the present value of the note is $25,500 at January 1, 2016. Parke uses the effective interest rate. What is the carrying value of the note receivable on Parke’s December 31, 2016, balance sheet?

a. $28,560 c. $32,500 b. $29,000 d. $36,000

REVIEW EXERCISES

RE13-1 On January 1, 2018, Gatrong Corporation purchased 12%, 5-year Fleming Corporation bonds with a face value of $200,000. It expects to hold these bonds until maturity. The bonds pay interest semiannually on June 30 and December 31. Gatrong paid $215,443, a price that yields a 10% effective annual interest rate. Prepare the journal entry of Gatrong to record the purchase of the bonds.

RE13-2 Refer to the information in RE13-1. Prepare the journal entry on June 30 for Gatrong to record the first interest receipt, using the effective interest method. Round to the nearest dollar.

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RE13-3 On July 1, 2018, Wolfpack Corporation purchased securities which it intends to buy and sell frequently. These securities consisted of (a) Todd Corporation 10%, 5-year bonds with a face value of $20,000 which were pur- chased for $18,500 and (b) 300 shares of Cornett Company common stock which were purchased at $40 per share. Prepare the July 1 journal entry to record the purchase of these trading securities.

RE13-4 Refer to the information in RE13-3. Assume that on December 31, 2018, Wolfpack received interest on the Todd Corporation bonds as well as a $3 dividend per share interest on the Cornett Company stock. Wolpack uses the straight-line method to amortize premiums and discounts. Prepare the December 31 journal entries to record the receipt of the interest and the receipt of the dividends.

RE13-5 Refer to the information in RE13-3. Assume that on December 31, 2018, the investment in Todd Corporation bonds has a market value of $22,300, and the investment in Cornett Company stock has a market value of $10,500. Prepare the year-end journal entry to record the unrealized gain or loss.

RE13-6 Refer to the information in RE13-3. Assume that on February 1, 2019, Wolfpack sold its investment in Cornett stock for $10,000. Prepare the journal entries of Wolfpack to record the sale.

RE13-7 On April 30, 2018, Aggie Corporation purchased Smith Corporation 10%, 5-year bonds with a face value of $12,000 at par plus four months of accrued interest. Prepare the April 30 journal entry to record the purchase of these available-for-sale securities.

RE13-8 Refer to the information in RE13-7. Assume that on June 30, Aggie received interest on the Smith Corporation bonds. Prepare the June 30 journal entries to record the receipt of the interest.

RE13-9 Refer to the information in RE13-7. Assume that on December 31, 2018, the investment in Smith Corporation bonds has a market value of $12,300. Prepare the year-end journal entry to record the unrealized gain or loss.

RE13-10 Refer to the information in RE13-7. Assume that on February 1, 2019, Aggie sold its investment in Smith Cor- poration for $12,500. Prepare the journal entries of Aggie Corporation to record the sale and adjustment of the unrealized gain or loss.

RE13-11 On February 1, 2019, Razorback Corporation decides to transfer its available-for-sale securities to the trading cat- egory. These securities had been purchased for $9,400 early in 2018 and had a fair value of $11,700 on December 31, 2018. On February 1, 2019, the securities have a fair value of $12,500. Prepare the journal entries to record the transfer.

RE13-12 On September 30, Franz Corporation notices a decline in value of its investment in held-to-maturity bonds that it believes to be other than temporary. On that date, the carrying value of the bonds is $38,500 and the fair value is $22,980. Prepare the journal entry to record the impairment.

RE13-13 On January 1, 2016, Tiger Company purchased 6,720 shares of Eagle Corporation’s common stock when Eagle had 22,400 shares outstanding. On that date, the following information pertained to Eagle:

Balance Sheet

Book Value Fair Value

Depreciable assets (remaining life, 8 years) $600,000 $620,000 Other non-depreciable assets 290,000 300,000 Total $890,000 $920,000 Liabilities $300,000 $330,000 Shareholders’ equity 590,000 Total $890,000

During 2016, Eagle earned net income of $120,000 and paid total dividends of $48,000. Prepare the journal entries of Tiger related to its share of Eagle’s net income and dividends in 2016.

RE13-14 On January 1, Kilgore Inc. accepts a $20,000 non-interest-bearing, 5-year note from Dieland Company for equipment. Neither the fair value of the note nor the equipment is determinable. Kilgore had originally pur- chased the equipment for $18,000, and the equipment has a book value of $14,000 on January 1. Kilgore knows Dieland’s incremental borrowing rate of 9%. Prepare the journal entry for Kilgore to record the sale of the equipment on January 1.

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RE13-15 Moontake Corporation holds a $250,000 note receivable from Golden Company. Based on present value compu- tations, it now appears that the Golden note is impaired and that Golden will only be able to pay back 87% of the principal at maturity. Prepare the journal entry for Moontake to record the impairment.

RE13-16 At the beginning of the year, Commodore Company paid its $12,000 annual insurance premium for life insurance on its officers. The cash surrender value of the life insurance policies increased during the year from $8,500 to $10,000. Prepare the journal entries of Commodore to record the annual payment at the beginning of the year and the adjustment needed at the end of the year to recognize the change in surrender value.

EXERCISES

E13-1 Classification of Investments The following investments occurred in 2018 for Mole Company. a. Mole purchased 5% of the common stock on Brandon Company, a business which has a history of paying large

quarterly dividends. Mole wishes to hold the securities for the forseeable future in order to receive these divi- dends.

b. Mole purchased a bond that will mature in 10 years. Mole purchased this bond because it expects that over the next 6 months, interest rates will fall, causing the bond price to increase. At that time, Mole plans to sell the bonds to earn a profit.

c. Mole purchased $100,000 of Wilson Company’s convertible bonds. Mole has no intention of converting the bonds or selling the debt in the near future.

d. Mole purchased 30% of the common stock in a supplier in an effort to have more input into the quality of the raw materials it receives.

e. Mole purchased bonds for Collier Company with a face value of $100,000 for $95,000. The bonds pay interest of 8% semiannually. Mole has the ability and intent to hold the bonds to maturity and collect the principal and interest.

Required: 1. Classify each investment as either held-to-maturity, trading, available-for-sale, or an equity method investment. 2. Next Level Discuss the basis upon which the classification of each investment is based. 3. Next Level How would each of these investments be classified under IFRS?

E13-2 Held-to-Maturity Securities and Amortization of a Discount On January 1, 2018, Kelly Corporation acquired bonds with a face value of $500,000 for $483,841.79, a price that yields a 10% effective annual interest rate. The bonds carry a 9% stated rate of interest, pay interest semiannually on June 30 and December 31, are due December 31, 2021, and are being held to maturity.

Required: Prepare journal entries to record the purchase of the bonds and the first two interest receipts using the: 1. straight-line method of amortization 2. effective interest method of amortization

E13-3 Purchase of Bonds between Interest Dates On March 31, 2018, Brodie Corporation acquired bonds with a par value of $400,000 for $425,800. The bonds are due December 31, 2023, carry a 12% annual interest rate, pay in- terest on June 30 and December 31, and are being held to maturity. The accrued interest is included in the acquisi- tion price of the bonds. Brodie uses straight-line amortization.

Required: 1. Prepare journal entries for Brodie to record the purchase of the bonds and the first two interest receipts. 2. Next Level If Brodie failed to separately record the interest at acquisition, explain the errors that would occur

in the company’s financial statements (no calculations are required).

E13-4 Purchase, Discount Amortization, and Sale of Bond Investment On November 1, 2017, Reid Corporation acquired bonds with a face value of $700,000 for $673,618.61. The bonds carry a stated rate of interest of 10%, were purchased to yield 11%, pay interest semiannually on April 30 and October 31, were purchased to be held to maturity, and are due October 31, 2021. On November 1, 2018, in contemplation of a major acquisition, the bonds were sold for $700,000. Reid is on a fiscal year accounting period ending October 31 and uses the effective interest method.

(continued)

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Required: Prepare journal entries to record the purchase of the bonds, the interest receipts on April 30, 2018, and October 31, 2018, and the sale of the bonds.

E13-5 Investment Discount Amortization Schedule On January 1, 2018, Rodgers Company purchased $200,000 face value, 10%, 3-year bonds for $190,165.35, a price that yields a 12% effective annual interest rate. The bonds pay interest semiannually on June 30 and December 31.

Required: 1. Record the purchase of the bonds. 2. Prepare an investment interest income and discount amortization schedule using the effective interest method. 3. Record the receipts of interest on June 30, 2018, and June 30, 2020.

E13-6 Investment Premium Amortization Schedule On January 1, 2018, Lynch Company acquired 13% bonds with a face value of $50,000. The bonds pay interest on June 30 and December 31 and mature on December 31, 2020. Lynch paid $51,229.35, a price that yields a 12% effective annual interest rate.

Required: 1. Record the purchase of the bonds. 2. Prepare an investment interest income and premium amortization schedule using the effective interest method. 3. Record the receipts of interest on June 30, 2018, and December 31, 2020.

E13-7 Purchase, Premium Amortization, and Sale of Bond Investment Glover Corporation purchased bonds with a face value of $300,000 for $307,493.34 on January 1, 2018. The bonds carry a face rate of interest of 12%, pay interest semiannually on June 30 and December 31, were purchased to be held to maturity, are due December 31, 2020, and were purchased to yield 11%. On January 1, 2019, in contemplation of a major acquisition, the bonds were sold for $300,000. Glover uses the effective interest method.

Required: 1. Prepare journal entries to record the purchase of the bonds, the first two interest receipts, and the sale of the

bonds. 2. Next Level Discuss the considerations involved when held-to-maturity debt securities are sold prior to their

maturity date.

E13-8 Trading Securities Midwest Bank invests in trading securities. At the beginning of December 2018, the bank held no trading securities. During December of 2018, it entered into the following trading securities transactions:

Dec. 10 Purchased 500 shares of Carroll Company common stock for $76 per share. 21 Purchased 800 shares of Dynamo Company common stock for $34 per share.

At the end of December, the Carroll Company common stock had a quoted market price of $79 per share, and the Dynamo Company common stock had a quoted market price of $33 per share.

Required: 1. Prepare journal entries to record the preceding information. 2. What is the unrealized holding gain or loss, and where is it reported in the 2018 financial statements? 3. Show how the bank reports the trading securities on its December 31, 2018, balance sheet. 4. Next Level If Midwest uses IFRS, how would the accounting be different from U.S. GAAP?

E13-9 Trading Securities Southeast Bank invests in trading securities and prepares quarterly financial statements. At the beginning of the fourth quarter of 2018, the bank held as trading securities 200 shares of Eglan Company common stock that originally cost $5,500. At that time, these securities had a fair value of $5,200. During the fourth quarter, the bank engaged in the following trading securities transactions:

Oct. 26 Purchased 300 shares of Farrell Company common stock for $35 per share. Nov. 26 Sold 200 shares of Eglan common stock for $25 per share. Dec. 10 Purchased 400 shares of Gray Company common stock for $41 per share.

On December 31, 2018, the quoted market prices of the shares were as follows: Eglan Company, $52 per share; Farrell Company, $38 per share; and Gray Company, $40 per share.

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Required: 1. Prepare journal entries to record the preceding information for the fourth quarter. 2. Show what the bank reports on its fourth quarter 2018 income statement for these trading securities. 3. Show how the bank reports these trading securities on its balance sheet at the end of the fourth quarter of 2018. 4. Next Level What justification does the FASB give for its treatment of unrealized holding gains and losses for

trading securities?

E13-10 Available-for-Sale Securities On December 31, 2018, Marsh Company held Xenon Company bonds in its port- folio of available-for-sale securities. The bonds have a par value of $15,000, carry a 10% annual interest rate, mature in 2025, and had originally been purchased at par. The market value of the bonds at December 31, 2018 was $13,000. The December 31, 2018, balance sheet showed the following:

Assets

Investment in available-for-sale securities $15,000 Less: Allowance for change in value of investment (2,000)

$13,000 Shareholders’ Equity

Unrealized holding gain/loss $ (2,000)

On January 1, 2019, Marsh acquired bonds of Yellow Company with a par value of $16,000 for $16,200. The Yel- low Company bonds carry an annual interest rate of 12% and mature on December 31, 2023. Additionally, Marsh acquired Zebra Company bonds with a face value of 18,000 for $17,600. The Zebra Company bonds carry an 8% annual interest rate and mature on December 31, 2028. At the end of 2019, the respective market values of the bonds were: Xenon, $14,000; Yellow, $17,000; and Zebra, $20,000. Marsh classifies all of the debt securities as available-for-sale as it does not intend to hold them to maturity nor does it intend to actively buy and sell them. Assume that Marsh uses the straight-line method to amortize any discounts or premiums.

Required: 1. Prepare the journal entries necessary to record the purchase of the investments on January 1, 2019, the annual

interest payments on December 31, 2019, and the adjusting entry needed on December 31, 2019. 2. What would Marsh disclose on its December 31, 2019, balance sheet related to these investments?

E13-11 Available-for-Sale Securities At the beginning of 2018, Ace Company had the following portfolio of investments in available-for-sale debt securities (all of which were acquired at par value):

Security Cost 1/1/2018 Fair Value

A $20,000 $25,000 B 30,000 29,000 Totals $50,000 $54,000

During 2018, the following transactions occurred:

May 3 Purchased C debt securities at their par value for $50,000. July 1 Sold all of the A securities for $25,000 plus interest of $1,000. Dec. 31 Received interest of $7,600 on the B and C securities. Additionally the following information was available:

Security 12/31/18 Fair Value

B $29,000 C 52,500

Required: 1. Prepare journal entries to record the preceding information. 2. What is the balance in the Unrealized Holding Gain/Loss account on December 31, 2018? 3. Next Level What justification does the FASB give for its treatment of unrealized holding gains and losses for

available-for-sale securities?

E13-12 Available-for-Sale Securities At the end of 2018, Terry Company prepared the following schedule of investments in available-for-sale debt securities (all of which were acquired at par value):

(continued)

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Company Amortized Cost

12/31/18 Fair Value

Cumulative Change in Fair Value

Morgan Company $35,000 $34,200 $ (800) Nance Company 50,000 53,100 3,100 Totals $85,000 $87,300 $2,300

During 2019, the following transactions occurred:

July 1 Purchased Oscar Company debt securities with a par value of 100,000 for $98,000. The securities carry an annual interest rate of 10%, mature on December 31, 2021, and pay interest seminannually on July 1 and December 31. Terry uses the straight-line method to amortize any discounts or premiums.

Oct. 11 Sold all of the Morgan Company securities for $33,000 plus interest of $1,300. Dec. 31 Received interest of $6,000 on the Nance Company and Oscar Company debt securities, and the following year-

end total market values were available: Nance Company debt securities, $55,000; Oscar Company debt securities, $96,000.

Required: 1. Prepare journal entries to record the preceding information. 2. Show how the preceding items are reported on Terry’s December 31, 2019, balance sheet. Assume all invest-

ments are noncurrent. 3. Next Level If Terry uses IFRS, how would the accounting for investments be different from U.S. GAAP?

E13-13 Transfer Between Categories On December 31, 2015, Leslie Company held an investment in bonds of Kaufmann Company which it categorized as being held to maturity. At that time, the 8%, $100,000 face value bonds had a carrying value of $107,023.56 and were being amortized using the effective interest method based on a market rate of 7%. Interest on these bonds is paid annually each December 31.

On December 31, 2016, after recording the interest earned, Leslie decided to reclassify the Kaufmann bonds to its available-for-sale category in anticipation of a major restructuring. At that time, the ending quoted market price for the bonds was $105,000.

Required: Prepare the journal entries on December 31, 2016, to record the interest earned and the reclassification.

E13-14 Impairment On June 1, 2016, Hansen Company purchased ten $1,000 Francisco Company bonds at par and classified them as held-to-maturity. In 2017, Francisco experienced financial difficulties and Hansen reduced the carrying value of each bond by 40%. In 2018, Francisco improved its financial condition, and Hansen believed that each bond was now worth $900 based on current market yields.

Required: 1. Prepare the journal entries for Hansen to record the above events under U.S. GAAP. 2. How would your answers change if the company uses IFRS?

E13-15 Equity Method Miller Corporation acquired 30% of the outstanding common stock of Crowell Corporation for $160,000 on January 1, 2018, and obtained significant influence. The purchase price of the shares was equal to their book value. During 2018, the following information is available for Crowell:

Mar. 31 Declared and paid a cash dividend of $50,000. June 30 Reported semiannual earnings of $120,000 for the first half of 2018. Sept. 30 Declared and paid a cash dividend of $50,000. Dec. 31 Reported semiannual earnings of $140,000 for the second half of 2018.

Required: 1. Prepare journal entries for Miller to reflect the preceding information. 2. What is the balance in Miller’s investment account on December 31, 2018? Show your computations.

E13-16 Equity Method On January 1, 2018, Field Company acquired 40% of North Company by purchasing 8,000 shares for $144,000 and obtained significant influence. On the date of acquisition, Field calculated that its share of the excess of the fair value over the book value of North’s depreciable assets was $15,000 and that the purchased good- will was $12,000. At the end of 2018, North reported net income of $45,000 and paid dividends of $0.70 per share. Field depreciates its depreciable assets over a 12-year remaining life.

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Required: 1. Prepare all the journal entries of Field to record the preceding information for 2018. 2. Next Level What is the conceptual justification for the use of the equity method?

E13-17 Equity Method On January 1, 2018, Jones Company acquires a 30% interest in Fink Company by purchasing 3,000 of its 10,000 common shares for $16 per share and obtains significant influence. On the date of acquisition, the net assets of Fink were as shown here:

Book Value Fair Value

Non-depreciable assets (for example, land) $ 15,000 $ 25,000 Depreciable assets (10-year remaining life) 90,000 115,000

$105,000 $140,000 Liabilities $ 10,000 $ 15,000

During 2018, Fink earned income of $22,000 and paid dividends of $6,000.

Required: Prepare all journal entries on Jones’s books to record the acquisition, dividends, and income from the investment in Fink. Show supporting calculations.

E13-18 Notes Receivable On January 1, 2016, Crouser Company sold land to Chad Company, accepting a 2-year, $150,000, non-interest-bearing note due January 1, 2018. The fair value of the land was $123,966.90 on the date of sale. The company purchased the land for $120,000 on January 1, 2010.

Required: Prepare all the journal entries on Crouser’s books for January 1, 2016, through January 1, 2018, in regard to the Chad note.

E13-19 Notes Receivable On January 1, 2016, Worthylake Company sold used machinery to Brown Company, accepting a $25,000, non-interest-bearing note maturing on January 1, 2018. Worthylake carried the machinery on its books at a cost of $22,000 and a current book value of $15,000. Neither the fair value of the machinery nor the note was determinable at the time of sale; however, Brown’s incremental borrowing rate was 12%.

Required: Prepare the journal entries on Worthylake’s books to record: 1. sale of the machinery 2. related adjusting entries on December 31, 2016, and 2017 3. payment of the note by Brown on January 1, 2018

E13-20 Note Receivable in Installments On January 1, 2016, Tabor Company sold land with a book value of $50,000 to Wilson Company, accepting a $60,000 note, payable in three $20,000 annual installments beginning December 31, 2016. The note carried no stated interest rate and the fair values of the land and the note were not determina- ble. An appropriate interest rate for this note is 12%.

Required: Prepare the journal entries on Tabor’s books to record (1) the sale and (2) the annual interest income and receipt of each $20,000 installment.

E13-21 Notes Receivable and Income On January 1, 2016, Pitt Company sold a patent to Chatham Inc. which had a car- rying value on Pitt’s books of $10,000. Chatham gave Pitt a $60,000, non-interest-bearing note payable in five equal annual installments of $12,000 with the first payment due and paid on January 1, 2017. There was no estab- lished price for the patent, and the note has no ready market value. The prevailing rate of interest for a note of this type at January 1, 2016, is 12%.

Required: 1. Prepare a schedule showing the income or loss before income taxes that Pitt should record for the years ended

December 31, 2016 and 2017. Show supporting computations in good form. 2. Next Level If Pitt inadvertently failed to discount the note and instead recorded it at its gross value, what

would be the effect on income or loss before income taxes for the year ended December 31, 2016?

E13-22 Loan Impairment Perry National Bank has a note receivable of $200,000 from Mogren Company that it is carry- ing at face value and is due on December 31, 2020. Interest on the note is payable at 9% each December 31.

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Mogren paid the interest due on December 31, 2016, but informed the bank that it would probably miss the next 2 years’ interest payments because of its financial difficulties. After that, it expected to resume its annual interest payments, but it would make the principal payment one year late, with interest paid for that additional year at the time of the principal payment.

Required: 1. Compute the value of the impaired loan on December 31, 2016. 2. Prepare the journal entries from 2016 to 2021 for the bank to record the above events.

E13-23 Loan Impairment Oaks National Bank has a note receivable of $500,000 from Haldane Company that it is carry- ing at face value, and it is due on December 31, 2022. Interest on the note is payable at 6% each December 31. Haldane paid the interest due on December 31, 2016, but informed the bank that it would probably miss the next 3 years’ interest payments because of its financial difficulties. After that, it expected to resume its annual interest payments, but it would make the principal payment 2 years late, with interest paid for the additional years. On Janu- ary 1, 2019, the bank received new information and now expected Haldane to pay the interest for 2019 through 2024 on December 31 of each year.

Required: 1. Compute the value of the impaired loan on December 31, 2016. 2. Prepare the journal entries from 2016 to 2024 for the bank to record the above loan impairment events.

E13-24 Cash Surrender Value of Life Insurance Westford Corporation purchases life insurance policies on its officers, and these policies all carry a cash surrender value clause. At the beginning of 2016, Westford paid $13,300 in life insurance premiums for one year. During 2016, the cash surrender value of the policies increased from $98,450 to $103,900. At the beginning of 2017, Westford’s vice president died in an automobile accident. The policy carried on this officer paid $50,000, and the cash surrender value of the policy was $6,480.

Required: Prepare journal entries to record the preceding information on Westford’s books.

E13-25 Sinking Funds Entries The following information is available concerning Nunan Corporation’s sinking fund:

2016 Jan. 1 Established a sinking fund to retire an outstanding bond issue by contributing $425,000. Feb. 3 Purchased securities for $400,000. July 30 Sold securities originally costing $48,000 for $45,000. Dec. 31 Collected dividends and interest on the remaining securities in the amount of $49,000; the securities had a

market value of $355,000 at this time. 2017 Dec. 31 Collected dividends and interest on the remaining securities in the amount of $40,000.

31 Paid sinking fund expenses of $4,500. 31 Sold the remaining securities in the fund for $360,000. 31 Retired an outstanding bond issue of $500,000 with the cash from the fund and transferred the remaining

fund balance back to the Cash account.

Required: Prepare journal entries to record the preceding transactions for Nunan.

E13-26 (Appendix 13.1) Derivatives Anglar Company has a $3 million, 7% bank loan from Castle Rock Bank. On January 1, 2016, when the $3 million loan has 3 years remaining, Anglar contracts with Susan Investment Bank to enter into a 3-year interest-rate swap with a $3 million notional amount. Anglar agrees to receive from Susan a fixed interest rate of 7% and to pay Susan an interest amount each year that is variable based on the LIBOR interest rate at the beginning of the year. The interest payments are made at year-end. The applicable interest rate on the swap is reset each year after the annual interest payment is made. The LIBOR interest rate is 6.6% at the beginning of 2016. The 3-year fixed interest rate is 8% at December 31, 2016.

Required: 1. Prepare the journal entries of Anglar for the bank loan and derivative for 2016. Round answers to the nearest

dollar. 2. Prepare the appropriate disclosures in Anglar’s financial statements for 2016.

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PROBLEMS

P13-1 Premium Amortization on Bond Investment and Partial Sale of the Investment Using the Effective Inter- est Method On January 1, 2018, Hyde Corporation purchased bonds with a face value of $300,000 for $308,373.53. The bonds are due June 30, 2021, carry a 13% stated interest rate, and were purchased to yield 12%. Interest is payable semiannually on June 30 and December 31. On March 31, 2019, in contemplation of a major acquisition, the company sold one-half the bonds for $159,500 including accrued interest; the remainder were held until maturity.

Required: Prepare the journal entries to record the purchase of the bonds, each interest payment, the partial sale of the invest- ment on March 31, 2019, and the retirement of the bond issue on June 30, 2021.

P13-2 Bond Investment Discount Amortization Schedule Tudor Company acquired $500,000 of Carr Corporation bonds for $487,706.69 on January 1, 2018. The bonds carry an 11% stated interest rate, pay interest semiannually on January 1 and July 1, were issued to yield 12%, and are due January 1, 2021.

Required: 1. Prepare an investment interest income and discount amortization schedule using the:

a. straight-line method b. effective interest method

2. Prepare the July 1, 2020, journal entries to record the interest income under both methods.

P13-3 Discount Amortization on Bonds Purchased Between Interest Dates On October 1, 2018, Jenkins Corpora- tion bought bonds with a face value of $200,000 for $199,175, which included accrued interest. The bonds are due December 31, 2020, and carry a face rate of interest of 10.5%. Interest on the bonds is payable semiannually on June 30 and December 31. Jenkins uses the straight-line method to amortize the discount.

Required: 1. Prepare journal entries to record the purchase of the bonds, each interest receipt, and the retirement of the

issue on December 31, 2020. 2. Next Level If Jenkins failed to separately record the interest at acquisition, explain the errors that would occur

in the company’s financial statements (no calculations are required).

P13-4 Bond Investment Premium Amortization Schedule Mercer Corporation acquired $400,000 of Park Com- pany’s bonds on June 30, 2018, for $409,991.12. The bonds carry a 12% stated interest rate and pay interest semi- annually on June 30 and December 31. The appropriate market interest rate is 11%, and the bonds are due June 30, 2021.

Required: 1. Prepare an investment interest income and premium amortization schedule, using the:

a. straight-line method b. effective interest method

2. Prepare journal entries to record the December 31, 2018, and December 31, 2020, interest receipts using both methods.

P13-5 Discount Amortization on Bond Investment and Partial Sale of Investment Using Effective Interest Method On January 1, 2018, Mark Corporation purchased bonds with a face value of $500,000 for $475,413.60. The bonds are due December 31, 2020, carry a 10% stated rate, and were purchased to yield 12%. Interest is pay- able semiannually on June 30 and December 31. On January 1, 2020, in contemplation of a major acquisition, one-fourth of the bonds were sold for $127,000. The remainder were held until maturity.

Required: Prepare journal entries to record the purchase of the bonds, each interest payment, the partial sale of the investment on January 1, 2020, and the retirement of the bond issue on December 31, 2020.

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P13-6 Trading Securities The investment manager of 4th National Bank invests some of the bank’s financial resources in trading securities. During the last quarter of 2018, the following transactions occurred in regard to these trading securities:

Nov. 5 Purchased 200 shares of Morgan Company common stock at $86 per share. 19 Purchased 300 shares of Parker Company preferred stock at $63 per share. 29 Sold 100 shares of Morgan Company common stock at $89 per share.

Dec. 15 Purchased 400 shares of Tathem Company common stock at $37 per share. 17 Sold 100 shares of Parker Company preferred stock at $62 per share.

On December 31, 2018, the market values of the shares were as follows: Morgan, $87 per share; Parker, $61 per share; and Tathem, $37.25 per share. The bank held no trading securities at the beginning of the last quarter of 2018.

Required: 1. Prepare journal entries to record the preceding information. 2. Show what the bank reports on its fourth quarter 2018 income statement for these trading securities. 3. Show how the bank reports these trading securities on its December 31, 2018, balance sheet.

P13-7 Trading Securities 8th State Bank prepares interim financial statements and follows an investment strategy of investing in trading securities. At the beginning of the third quarter of 2018, the bank held the following portfolio of trading securities:

Security Cost June 30, 2018

Fair Value

100 shares of Gordan Company common stock $ 2,900 $ 2,800 600 shares of Olivia Company common stock 12,000 12,600 Totals $14,900 $15,400

During the third quarter of 2018, the bank entered into the following trading securities transactions:

July 2 Received dividends of $1.50 per share on the Gordan Company common stock. 14 Sold 600 shares of Olivia Company common stock for $20 per share.

Aug. 9 Purchased 300 shares of Porter Company common stock for $36 per share. 24 Sold 100 shares of Gordan Company common stock for $30 per share.

Sept. 17 Purchased 500 shares of Union Company common stock for $22 per share.

On September 30, 2018, the Porter Company common stock had a quoted market price of $36.50 per share and the Union Company common stock had a quoted market price of $21 per share.

Required: 1. Prepare journal entries to record the preceding information. 2. Show what the bank reports on its third quarter 2018 income statement for these trading securities. 3. Show how the bank reports these trading securities on its September 30, 2018, balance sheet.

P13-8 Investments in Equity Securities Noonan Corporation prepares quarterly financial statements and invests its excess funds in marketable securities. At the end of 2018, Noonan’s portfolio of trading investments consisted of the following equity securities:

Security Number of

Shares Cost per Share

Fair Value per Share

Keene Company 500 $60 $60 Sachs Inc. 800 43 44 Bacon Company 400 70 72

During the first half of 2019, Noonan engaged in the following investment transactions:

Jan. 6 Sold one-half of the Sachs shares for $45 per share. Feb. 3 Purchased 700 shares of Jackson Corporation common stock for $45 per share. Mar. 31 Dividends of $2,500 were received on the investments, and the following information is available on market

prices:

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Security Fair Value per Share

Keene Company $59 Sachs Inc. 45 Bacon Company 70 Jackson Corporation 43

Apr. 14 Purchased 300 shares of Quinn Company preferred stock for $52 per share. May 11 Sold the remainder of the Sachs shares for $42 per share. June 30 Dividends of $2,800 were received on investments, and the following information is available:

Security Fair Value per Share

Keene Company $62 Bacon Company 69 Jackson Corporation 46 Quinn Company 50

Required: 1. Record Noonan’s investment transactions for January 6 through June 30, 2019. 2. Show the items of income or loss from investment transactions that Noonan reports for each of the first and

second quarters of 2019. 3. Show how the preceding items are reported on the first and second quarter 2019 ending balance sheets, assum-

ing that management expects to dispose of the Keene and Sachs securities within the next year.

P13-9 Investments in Trading Securities Manson Incorporated reported investments in trading securities of $60,495 as a current asset on its December 31, 2018, balance sheet. An analysis of Manson’s investments on December 31, 2018, reveals the following:

Equity Security Cost Fair Value

400 shares of Turben Company, common $14,275 $13,590 500 shares of Cook Corp. common stock 12,650 13,175 700 shares of Hill Corp. common stock 17,450 18,180 200 shares of Web Engines, preferred stock 19,100 15,550 Totals $63,475 $60,495

During 2019, the following transactions related to Manson’s investments occurred:

Jan. 6 Received a $265 dividend on the Turben Company common stock. Mar. 31 Received the semiannual dividend of $500 on the Web Engines preferred stock. The

following information is available concerning Manson’s investments:

Equity Security Fair Value

Turben Company $13,470 Cook Corp. 13,765 Hill Corp. 18,940 Web Engines 15,500

June 30 Received a $375 dividend on the Cook Corp. common stock and a $700 dividend on the Hill Corp. common stock. The information is available concerning Manson’s investments:

Equity Security Fair Value

Turben Company $13,300 Cook Corp. 14,125 Hill Corp. 19,300 Web Engines 15,400

July 6 Sold the Turben Company common stock for $13,750. Sept. 29 Received the semiannual dividend of $500 on the Web Engines preferred stock. The following information is

available concerning Manson’s investments: (continued)

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Equity Security Fair Value

Cook Corp. $14,230 Hill Corp. 19,500 Web Engines 15,900

Nov. 2 Sold the Hill Corp. common stock for $19,780. Dec. 30 Received a $375 dividend on the Cook Corp. common stock. The following information is available:

Equity Security Fair Value

Cook Corp. $14,280 Web Engines 16,400

Required: 1. Assuming Manson prepares quarterly financial statements, prepare journal entries to record the preceding infor-

mation. 2. Show the items of income or loss from investment transactions that Manson reports for each quarter of 2019. 3. Show how Manson’s investments are reported on the balance sheet on March 31, 2019; June 30, 2019;

September 30, 2019; and December 31, 2019.

P13-10 Available-for-Sale Securities Holly Company invests its excess cash in marketable securities. At the beginning of 2019, it had the following portfolio of investments in available-for-sale debt securities:

Security Par Value Amortized

Cost 12/31/18 Fair Value

Igor Company 5% bonds, maturing on Dec. 31, 2028 $10,000 $ 8,400 $ 9,400 Ozone Company 6% bonds, maturing on Dec. 31, 2023 $20,000 23,100 21,700 Totals $31,500 $31,100

During 2019, the following transactions occurred:

Mar. 31 Purchased Union Company 8% bonds with a face value of $10,000 for $10,000 plus accrued interest; interest is payable on the bonds each June 30 and December 31.

Mar. 31 Sold the Ozone Company investment for $22,000 plus accrued interest. June 30 Received the semiannual interest on the Union Company bonds. Dec. 31 Received the annual interest on the Igor Company bonds and the semiannual interest on the Union Company

bonds.

The December 31 closing market prices were as follows: Igor Company bonds, $9,000; and Union Company 8% bonds, $10,100. Holly uses the straight-line method to amortize any discounts or premiums.

Required: 1. Prepare journal entries to record the preceding information. 2. Show what is reported on Holly’s 2019 income statement. 3. Assuming the investment in Igor Company bonds is considered to be a current asset and the investment in

Union Company bonds is considered to be a noncurrent asset, show how all the items are reported on Holly’s December 31, 2019, balance sheet.

4. What is Holly’s unrealized holding gain or loss on available-for-sale securities in 2019?

P13-11 Investment in Available-for-Sale Bonds The following information relates to Starr Company’s investment in available-for-sale bonds for 2018:

Jan. 1 Purchased $30,000 face value of Bradford Company 8% bonds for $29,100. The market rate of interest is 10%, and interest on the bonds is payable each June 30 and December 31.

1 Purchased $40,000 face value of Morris Company 10% bonds for $40,400. The market rate of interest is 9.8%, and interest on the bonds is payable each June 30 and December 31.

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June 30 Collected the interest and the following information is available:

Security Fair Value

Bradford Company 8% $29,160 Morris Company 10% 40,800

July 1 Purchased $25,000 face value of Whipple Corporation 11% bonds for $23,000. The market rate of interest is 12%, and interest on the bonds is payable each June 30 and December 31.

Nov. 30 Sold the Whipple bonds for $22,750 plus accrued interest. Dec. 31 Starr collected the interest, sold the Morris bonds for $40,800, and the following information is also

available:

Security Fair Value

Bradford Company 8% bonds $28,800

Required: 1. Prepare journal entries to record the previous information for 2018. Use the effective interest method and

round all amounts to the nearest dollar. Assume that Starr prepares semiannual financial statements. 2. Show the items of income or loss from investment transactions that Starr reports for each 2018 semiannual

income statement. 3. Show how the investment items are reported on each of the 2018 semiannual balance sheets, assuming that

management expects to dispose of all investments within one year of purchase.

P13-12 Investments in Available-for-Sale Bonds During 2018, Dana Company decided to begin investing its idle cash in marketable securities. The information contained below relates to Dana’s 2018 marketable security transactions:

Apr. 1 Purchased $20,000 face value of Solomon Inc. 12% bonds at par plus accrued interest; interest on the bonds is payable each June 30 and December 31.

June 30 Received the semiannual interest on the Solomon bonds and a $0.25 per share dividend on the Blair common stock.

Nov. 1 Purchased $30,000 face value of Edwards Company 11% bonds at par plus accrued interest; interest on the bonds is payable each June 1 and December 1.

Dec. 1 Received the interest on the Edwards bonds and sold the bonds for $30,300. 31 Received the interest on the Solomon bonds. At year-end, the market price of the Solomon bonds was

$20,200.

Required: 1. Record Dana’s investment transactions for 2018. 2. Show the items of income or loss on temporary investments Dana reports on its 2018 income statement. 3. Show the carrying value of Dana’s investment account on its December 31, 2018, balance sheet.

P13-13 Investments, Petty Cash, Bank Reconciliation During the first quarter of 2018, Payne Corporation entered into the following transactions:

Jan. 1 Acquired 150 shares of Block Corporation common stock for $20 per share, 200 shares of Bridle Corporation common stock for $30 per share, and 100 shares of Alpha Corporation common stock for $25 per share. These are the only shares the company owns and all are classified as trading securities.

Feb. 1 Purchased 12% Atom Company bonds with a face value of $20,000 at par, plus accrued interest. Interest on the bonds is payable February 28 and August 31 each year, and the bonds are due August 31, 2019. Also purchased 10% Bradford Company bonds with a face value of $12,000 at par, plus accrued interest. Interest on the bonds is payable March 31 and September 30, and the bonds are due September 30, 2022. These are the only bonds the company owns and all are classified as available-for-sale securities.

(continued)

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Feb. 1 Established a petty cash fund for incidental expenditures at $500. 28 Received the semiannual interest on the Atom Company bonds. 28 A count of cash on hand indicated that $125.50 remained in the petty cash fund. A sorting of petty cash

vouchers disclosed that $110.00 was spent for postage, $170.65 was spent for office supplies, $45.00 was spent for transportation, and $43.50 was spent for miscellaneous items. The fund was replenished.

Mar. 31 Received first quarter dividends of $1,500 and the semiannual interest on the Bradford Company bonds. 31 The fair value of Payne’s trading securities is $10,200 and the fair value of its available-for-sale securities is

$32,400. 31 A count of cash on hand indicated that $230.50 remained in the petty cash fund. A sorting of petty cash

vouchers disclosed that $140.00 was spent for postage, $75.30 was spent for office supplies, and $54.20 was spent for miscellaneous items. The fund was replenished.

The bank statement and the accounting records of Payne for the month of March 2018 indicated that the cash collected from the dividends and the Bradford Company bond interest was deposited on March 31 but did not appear on the March bank statement. There were no other deposits in transit. The bank statement showed a balance on March 31 of $13,459.75, which included collection of a $1,500 note and $100 of interest by the bank for Payne. Also listed was a $20 bank service charge and a $75.60 NSF check returned by the bank. The cash balance per the accounting records on March 31 was $11,689.95, which included checks totaling $2,365.40 that had not yet cleared the bank.

Required: 1. Prepare journal entries to record the preceding transactions of Payne for the first quarter of 2018. 2. Prepare a bank reconciliation for Payne for March 31, 2018. 3. Prepare any journal entries necessary to adjust Payne’s books on March 31, 2018.

P13-14 Comparison of Fair Value and Equity Methods On January 1, 2018, Snow Corporation purchased 20% of the 200,000 outstanding shares of common stock of Garvey Company for $4.00 per share as a long-term investment. The purchase price of the shares was equal to their book value. The following information is available about Garvey for 2018 and 2019:

End of 2018 Reported net income $80,000 Cash dividends declared and paid $30,000 Market value of shares $3.80 per share

End of 2019 Reported net income $90,000 Cash dividends declared and paid $35,000 Market value of shares $4.25 per share

Required: 1. Prepare journal entries to record this information, assuming:

a. Snow accounts for the investment as a trading security. b. Snow uses the equity method.

2. Assume 10,000 of the Garvey shares are sold on January 4, 2020, by Snow for $4.30 per share. Prepare the journal entry for this sale, assuming: a. Snow accounts for the investment as a trading security. b. Snow uses the equity method.

P13-15 Application of Equity Method On January 1, 2016, Doe Company purchased 3,000 of the 10,000 common shares outstanding of Ray Company for $15 per share and obtained significant influence. Doe amortizes its patents over 10 years. Ray’s December 31, 2015, condensed balance sheet is shown here:

Current assets $ 10,000 Liabilities $ 50,000 Fixed assets (net) 100,000 Common stock, no par 30,000 Patents (net) 40,000 Retained earnings 70,000

$150,000 $150,000

Doe was unable to determine the fair value of Ray’s identifiable net assets shown on the preceding balance sheet. It did, however, determine that Ray uses the straight-line method (no residual value) to depreciate its fixed assets and to amortize its patents over 20 years and 10 years, respectively. At the end of 2016, Ray disclosed the following con- densed income statement and retained earnings statement for 2016:

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Revenues $100,000 Beginning retained earnings $ 70,000 Expenses (68,000) Add: Net income 32,000 Net income $ 32,000 $102,000

Less: Cash dividends (20,000) Ending retained earnings $ 82,000

Required: Prepare all the 2016 journal entries that Doe should make related to this investment. Show and label all supporting calculations.

P13-16 Recording Investments Under the Equity Method Harper Corporation acquired 80,000 of the 200,000 out- standing shares of Moore Corporation on April 1, 2016, for $400,000 and obtained significant influence. The fol- lowing information concerning Moore is available on the date of acquisition:

Book Value Fair Value

Depreciable assets (remaining life, 15 years) $ 600,000 $ 700,000 Other assets 500,000 450,000 Total $1,100,000 $1,150,000 Liabilities $ 300,000 $ 320,000 Common stock 250,000 Retained earnings 550,000 Total $1,100,000

Subsequently, Moore paid a cash dividend of $40,000 on August 31, 2016, and reported net income of $155,000 on December 31, 2016.

Required: 1. Prepare journal entries for Harper to record the preceding information. 2. What is the balance in Harper’s investment account on December 31, 2016? Show all computations. 3. Prepare Harper’s net cash flow from operating activities section of its 2016 statement of cash flows under the indi-

rect method, assuming Harper reported $200,000 of net income. Ignore income taxes.

P13-17 Equity Method and Subsequent Sale On January 1, 2016, Easton Corporation acquired 30% of the outstanding common shares of Feeley Corporation for $140,000, purchased 25% of the outstanding common shares of Holmes Company for $82,500, and obtained significant influence in both situations. On this date, the financial statements of Feeley and Holmes disclosed the following information:

Feeley Holmes

Current assets $190,000 $140,000 Long-term assets 370,000 180,000

$560,000 $320,000 Liabilities $120,000 $ 90,000 Common stock (no par) 200,000 150,000 Retained earnings 240,000 80,000

$560,000 $320,000

During 2016, Feeley reported a loss of $70,000 and paid dividends of $40,000; Holmes reported income of $45,000 and paid dividends of $28,000. On January 1, 2017, Easton sold all the Holmes shares for $90,000. Assume Easton records both investments under the equity method and considers that any difference between each purchase price and the respective book value of the net assets acquired is goodwill.

Required: Prepare journal entries to record (1) the purchase of the Feeley and Holmes shares, (2) the recognition of invest- ment income, (3) the receipt of investee dividends, and (4) the sale of the Holmes shares.

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P13-18 Change to Equity Method On January 1, 2018, Lion Company paid $600,000 for 10,000 shares of Wolf Com- pany’s voting common stock, which was a 10% interest in Wolf. Lion does not have the ability to exercise significant influence over the operating and financial policies of Wolf. Lion received dividends of $1.00 per share from Wolf on October 2, 2018. Wolf reported net income of $400,000 for the year ended December 31, 2018, and the ending market price of its shares was $63.

On July 2, 2019, Lion paid $1,950,000 for 30,000 additional shares of Wolf’s voting common stock, which represents a 30% investment in Wolf. The fair values of all of Wolf’s assets, net of liabilities, were equal to their book values of $6,500,000. As a result of this transaction, Lion has the ability to exercise significant influence over the operating and financial policies of Wolf. Lion received dividends of $1.00 per share from Wolf on April 2, 2019, and $1.35 per share on October 1, 2019. Wolf reported net income of $500,000 for the year ended December 31, 2019, and $200,000 for the 6 months ended December 31, 2019.

Required: 1. For Lion, show the dividend income for 2018, as well as the December 31, 2018, unrealized holding gain or

loss for the trading securities and carrying value of the investment account. 2. Assuming that Lion issues comparative financial statements for 2018 and 2019, show the investment income

for 2018 and 2019, as well as the December 31, 2018 and 2019 carrying value of the investment account.

P13-19 Notes Receivable On January 1, 2016, Somerville Corporation sold a used truck to Cornelius Company and accepted a $28,000 non-interest-bearing note due January 1, 2019. Somerville carried the truck on its books at a cost of $30,000 and a current book value of $23,000. Neither the fair value of the truck nor the note was available at the time of the sale; however, Cornelius’s incremental borrowing rate was 12%.

Required: 1. Prepare the journal entries on Somerville’s books to record:

a. sale of the truck b. related adjusting entries on December 31, 2016, 2017, and 2018 c. collection of the note on January 1, 2019

2. Prepare the notes receivable portion of Somerville’s December 31, 2016, 2017, and 2018 balance sheets.

P13-20 Notes Receivable On January 1, 2016, Lisa Company sold machinery with a book value of $118,000 to Mark Company. Mark signed a $180,000 non-interest-bearing note, payable in three $60,000 annual installments on December 31, 2016, 2017, and 2018. The fair value of the machinery was $149,211.12 on the date of sale. The machinery had been purchased by Lisa at a cost of $160,000.

Required: 1. Prepare all the journal entries on Lisa’s books for January 1, 2016, through December 31, 2018. 2. Prepare the notes receivable portion of Lisa’s balance sheet on December 31, 2016 and 2017.

P13-21 Comprehensive Notes Receivable On January 1, 2016, Seaver Company sold land with a book value of $23,000 to Bench Company. Bench paid $15,000 down and signed a $15,000 non-interest-bearing note, payable in two $7,500 annual installments on December 31, 2016, and 2017. Neither the fair value of the land nor of the note is determinable. Bench’s incremental borrowing rate is 12%. Later in the year, on July 1, 2016, Seaver sold a building to Hane Company, accepting a 2-year, $100,000 non-interest-bearing note due July 1, 2018. The fair value of the building was $82,644.60 on the date of the sale. The building had been purchased at a cost of $90,000 on January 1, 2011, and had a book value of $67,500 on December 31, 2015. It was being depreciated on a straight-line basis (no residual value) over a 20-year life.

Required: 1. Prepare all the journal entries on Seaver’s books for January 1, 2016, through December 31, 2017, in regard

to the Bench note. 2. Prepare all the journal entries on Seaver’s books for July 1, 2016, through July 1, 2018, in regard to the Hane

note. 3. Prepare the notes receivable portion of Seaver’s balance sheet on December 31, 2016 and 2017.

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P13-22 Cash Surrender Value of Life Insurance On January 1, 2015, Kehoe Corporation insured the lives of its presi- dent, vice president, controller, and treasurer for $100,000 each. The annual premium on each policy is $4,200, payable on January 1 of each year, and the cash surrender values for the policies increase by 4% of the annual premi- ums paid. Premium payments were made on the scheduled date by Kehoe through 2017, and the following divi- dends were received at the end of the year on each policy: 2015, $450; 2016, $575; 2017, $550. On February 1, 2018, the treasurer died and Kehoe collected the face value of his policy plus 11 months’ premium.

Required: Prepare journal entries to record the preceding information for the years 2015 through 2018. Round calculations to the nearest dollar.

P13-23 (Appendix 13.1) Derivatives Danburg Company has a $5 million, 9% bank loan outstanding with its local bank. On January 1, 2016, when the loan has 4 years remaining, Danburg contracts with Bradford Investment Bank to enter into a 4-year interest-rate swap with a $5 million notional amount. Danburg agrees to receive from Bradford a fixed interest rate of 9% and to pay Bradford an interest amount each year that is variable based on the LIBOR interest rate at the beginning of the year. The interest payments are made at year-end. The applicable interest rate on the swap is reset each year after the annual interest payment is made. The LIBOR interest rate is 8.6% and 9.5% at the beginning of 2016 and 2017, respectively. The 3-year fixed interest rate is 10% at December 31, 2016, and the 2-year rate is 8% at December 31, 2017.

Required: 1. Prepare the journal entries of Danburg for the bank loan and derivative for 2016 and 2017. Round calculations

to the nearest dollar. 2. Prepare the appropriate disclosures in Danburg’s financial statements for 2016 and 2017.

CASES

C O M M U N I C A T I O N

C13-1 Realized and Unrealized Losses: Minority Passive Investments An important part of the accounting for minority passive investments is the distinction between investments categorized as trading, available-for- sale, or held-to-maturity.

Required: 1. When a company has excess cash, what types

of securities may it invest in? 2. Explain why a company invests in debt and

equity securities. 3. Explain how the distinction between the three

categories is made. 4. Discuss the distinction between realized and

holding gains and losses on investments in debt and equity securities.

5. Explain how a company discloses realized and holding gains and losses on investments in eq- uity securities on its financial statements.

C13-2 Investments in Securities Cane Company has two portfolios of investments in marketable debt securities. It classifies one as trading securities and the other as available-for- sale securities. Cane does not have the ability to

exercise significant influence over any of the com- panies in either portfolio. It sold some securities from each portfolio during the year. Cane reclassi- fied one of the securities in the available-for-sale category to the trading category when its fair value was less than its amortized cost. At the beginning and end of the year, the aggregate cost of each portfolio exceeded its aggregate market value by different amounts.

Required: 1. Explain how Cane measures and reports the

income statement effects of the securities sold during the year from each portfolio.

2. Explain how Cane accounts for the reclassified security.

3. Explain how Cane reports the effects of changes in the fair value of investments in each portfolio on its balance sheet as of the end of the year and on its income statement for the year. Do not discuss the securities sold.

4. Explain gains trading. Can Cane use gains trading on either portfolio? Does gains trad- ing raise ethical issues?

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C13-3 Equity Method The most common method of accounting for unconsolidated subsidiaries is the equity method.

Required: Answer the following questions with respect to the equity method. 1. Under what circumstances does a company

apply the equity method?

2. At what amount does a company record the initial investment and what events subsequent to the initial investment (if any) change this amount?

3. How does a company recognize investment earnings under the equity method, and how does it determine the amount?

C R E A T I V E A N D C R I T I C A L T H I N K I N G

C13-4 Investments in Stocks and Bonds Victoria Company has investments in marketable securities classified as trading and available-for-sale. At the beginning of the year, the aggregate market value of each portfolio exceeded its amortized cost. During the year, Victoria sold some securities from each portfolio. At the end of the year, the aggre- gate amortized cost of each portfolio exceeded its market value.

Victoria also has investments in bonds classified as held-to-maturity, all of which were purchased for face value. During the year, some of these bonds held by Victoria were called prior to their maturity by the bond issuer. Three months before the end of the year, additional similar bonds were purchased for face value plus 2 months’ accrued interest.

Required: 1. Explain how Victoria accounts for:

a. sale of securities from each portfolio b. each equity securities portfolio at year-end

2. Explain how Victoria accounts for the disposi- tion prior to their maturity of the long-term bonds called by their issuer.

3. Explain how Victoria reports the purchase of the additional similar bonds at the date of the acquisition.

C13-5 Available-for-Sale Securities The following are four unrelated situations involv- ing investments in available-for-sale securities:

Situation I A portfolio of available-for-sale debt securities with an aggregate fair value in excess of amortized cost includes one particular security whose fair value has declined to less than one-half of its amortized cost. The decline in value is considered to be other than temporary.

Situation II The portfolio of available-for-sale debt securities includes securities that have an amortized cost in excess of fair value of $500. The remainder of the

portfolio has a net fair value in excess of amortized cost of $1,000.

Situation III An available-for-sale debt security, whose fair value is currently less than its amortized cost, is reclassi- fied as a trading security.

Situation IV A company’s portfolio of available-for-sale secur- ities consists of the bonds of one company. At the end of the prior year, the fair value of the security was 95% of amortized cost, and the effect was properly reflected in an allowance account. How- ever, at the end of the current year, the fair value of the debt security had appreciated to 102% of the amortized cost.

Required: Explain the effect on classification, carrying value, and earnings for each of the preceding situations.

C13-6 Change in Percent Ownership For the past 5 years, Herbert has maintained an investment (properly accounted for and reported upon) in Broome amounting to a 10% interest in the voting common stock of Broome. The purchase price was $700,000 and the underlying net equity in Broome at the date of purchase was $620,000. On January 2 of the current year, Herbert purchased an additional 15% of the voting common stock of Broome for $1,200,000; the underlying net equity of additional investment at January 2 was $1,000,000. Broome has been profitable and has paid dividends annually since Herbert’s initial acquisition.

Required: Discuss how this increase in ownership affects the accounting for and reporting upon the investment in Broome. Include in your discussion adjustments, if any, to the amount shown prior to the increase in investment to bring the amount into conformity with GAAP. Also include how the company would report in current and subsequent periods.

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C13-7 Ethics and Investments You are an accountant for Davanzo Company. The president of the company calls you into her office and says, “I want to ask you about two issues. First, we need to sell one of our investments to raise $1 million because I think I have found a better invest- ment. We could sell the bonds of Company X, which are currently worth $1 million even though they have an amortized cost basis of $950,000. But I don’t want to sell them because I like the steady stream of cash flow we get related to interest. Or we could sell the bonds in that dog, Company Z. These bonds are also worth $1 million, but they cost us $1.2 million. I hate to admit we made such a big mistake, and if they can somehow avoid bank- ruptcy, we may actually recover our investment. And then there’s that loss. I don’t want to report that. Second, I am going to use the $1 million to buy about 20% of the shares of Company M, but I seem to remember that there is some accounting rule that might affect how much we buy. I was also wondering about buying some of Company M’s convertible preferred stock so we can convert that into a large ownership position in the future. Let me know what you think.” You are aware that Company M is a new company that is not yet listed on the stock market, has been making losses, and is expected to continue making losses for a few more years.

Required: From financial reporting and ethical perspectives, discuss the issues raised by this situation.

C13-8 Analyzing Starbucks’s Investments Disclo- sures Obtain Starbucks’s 2015 annual report either using the “Investor Relations” portion of its web- site (do a web search for Starbucks investor

relations) or go to http://www.sec.gov and click “Search for company filings” under “Filings and Forms (EDGAR).”

Required: 1. What amount did Starbucks report as the fair

value of available-for-sale securities? Trading securities? What level inputs were used to determine these fair values?

2. How much did Starbucks report as an unreal- ized holding gain/loss for 2015 for each class of marketable security? Where were these amounts reported?

3. Explain why Starbucks has cost method investments.

4. What amount did Starbucks report as equity method investments for its 2015 fiscal year? Are any assets and liabilities of equity method investees reflected on Starbucks’s financial statements?

C13-9 Analyzing Nestl�e’s Disclosure of Investments Obtain Nestl�e’s 2013 annual report using the “Investor Relations” portion of its website (do a web search for Nestl�e investor relations).

Required: 1. What is the value of Nestl�e’s financial assets at

December 31, 2013? 2. What was the carrying value of Nestl�e’s finan-

cial assets classified as fair value through net income (FVNI)? Describe the accounting for these assets.

3. What was the carrying value of Nestl�e’s finan- cial assets classified as available-for-sale? Describe the accounting for these assets.

4. What are associates? How much has Nestl�e invested in these associates, and how does it account for this investment group?

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USING CODIFICATION

C13-10 Researching GAAP Situation Middleton Company has operated a successful retail business for many years that has gener- ated significant amounts of excess cash. Middleton invests this excess cash in equity and debt securities and has appropriately classi- fied all of its investments as either available- for-sale or held-to-maturity. As Middleton pre- pares its financial statements for the current fis- cal year, its auditors have questioned whether

any of the investments are other than tempo- rarily impaired. Middleton had never consid- ered this issue before and needs guidance as to how to test these securities for impairment.

Directions 1. Research the related generally accepted

accounting principles and prepare a short memo to Middleton that provides guid- ance as to how available-for-sale and held-to-maturity investment securities should be evaluated for impairment.

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