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PART II: Corporate Accounting Concepts and Issues Lecture 19 Investments 1 Learning Learning Objectives Objectives 2 1. Describe the accounting for the fair value option. 2. Discuss the accounting for impairments of debt and equity investments. 3. Explain why companies report reclassification adjustments. 4. Describe the accounting for transfer of investment securities between categories. Investments Investments Other Reporting Issues Fair value option Impairment of value Reclassification adjustments Transfers between categories Fair value controversy Summary 3 Fair Fair Value Value Option Option Companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement.  Applied on an instrument-by-instrument basis.  Fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability.  Company must measure this instrument at fair value until the company no longer has ownership. 4 LO 1 Describe the accounting for the fair value option. Fair Fair Value Value Option Option Available-for-Sale Securities Illustration: Hardy Company purchases stock in Fielder Company during 2012 that it classifies as available-for-sale. At December 31, 2012, the cost of this security is $100,000; its fair value at December 31, 2012, is $125,000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2012. Equity Investments 25,000 Unrealized Holding Gain or Loss—Income 5 25,000 LO 1 Describe the accounting for the fair value option. Fair Fair Value Value Option Option Equity Method Illustration: Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2010 for $930,000. At December 31, 2010, the fair value of the investment is $900,000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this investment is as follows. Unrealized Holding Gain or Loss—Income Equity Investments 6 30,000 30,000 LO 1 Describe the accounting for the fair value option. Impairment Impairment of of Value Value Impairments of debt and equity securities are  losses in value that are determined to be other than temporary, 7  based on a fair value test, and  are charged to income. LO 2 Discuss the accounting for impairments of debt and equity investments. Impairment Impairment of of Value Value Illustration: Strickler Company holds available-for-sale bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800,000. Strickler has previously reported an unrealized loss on these securities of $200,000 as part of other comprehensive income. In evaluating the securities, Strickler now determines that it probably will not collect all amounts due. It records this impairment as follows. Loss on impairment Debt investments 8 200,000 200,000 LO 2 Discuss the accounting for impairments of debt and equity investments. Reclassification Reclassification Adjustments Adjustments The reporting of changes in unrealized gains or losses in comprehensive income is straightforward unless a company sells securities during the year. In that case, double counting results when the company reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current period or in previous periods. To ensure that gains and losses are not counted twice when a sale occurs, a reclassification adjustment is necessary. 9 LO 3 Explain why companies report reclassification adjustments. Reclassification Reclassification Adjustments Adjustments Illustration: Open Company has the following two available-for-sale securities in its portfolio at the end of 2011 (its first year of operations). Illustration 17-19 10 LO 3 Explain why companies report reclassification adjustments. Reclassification Reclassification Adjustments Adjustments Illustration: If Open Company reports net income in 2011 of $350,000, it presents a statement of comprehensive income as follows. 11 Illustration 17-20 LO 3 Explain why companies report reclassification adjustments. Reclassification Reclassification Adjustments Adjustments Illustration: During 2012, Open Company sold the Lehman Inc. common stock for $105,000 and realized a gain on the sale of $25,000 ($105,000 – $80,000). At the end of 2012, the fair value of the Woods Co. common stock increased an additional $20,000, to $155,000. Illustration 17-21 12 LO 3 Explain why companies report reclassification adjustments. Reclassification Reclassification Adjustments Adjustments Illustration: In addition, Open realized a gain of $25,000 on the sale of the Lehman common stock. Comprehensive income includes both realized and unrealized components. Therefore, Open recognizes a total holding gain (loss) in 2012 of $20,000, computed as follows. Illustration 17-22 13 LO 3 Explain why companies report reclassification adjustments. Reclassification Reclassification Adjustments Adjustments Illustration: Open reports net income of $720,000 in 2012, which includes the realized gain on sale of the Lehman securities. Illustration 17-23 14 LO 3 Explain why companies report reclassification adjustments. Transfers Transfers Between Between Categories Categories Illustration 17-30 * Assumes that adjusting entries to report changes in fair value for the current period are not yet recorded. 15 LO 4 Describe the accounting for transfer of investment securities between categories. Transfers Transfers Between Between Categories Categories Illustration 17-30 **According to GAAP, these types of transfers should be rare. 16 LO 8 Fair Fair Value Value Controversy Controversy 17  Measurement Based on Intent  Gains Trading  Liabilities Not Fairly Valued LO 4 Describe the accounting for transfer of investment securities between categories. ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Defining Derivatives Financial instruments that derive their value from values of other assets (e.g., stocks, bonds, or commodities). Three different types of derivatives: 1. Financial forwards or financial futures. 2. Options. 3. Swaps. 18 ACCOUNTING FOR DIRIVATIVE INSTRUMENTS Who Uses Derivatives, and Why? 19  Producers and Consumers  Speculators and Arbitrageurs LO 5 Explain who uses derivative and why. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Basic Principles in Accounting for Derivatives  Recognize derivatives in the financial statements as assets and liabilities.  Report derivatives at fair value.  Recognize gains and losses resulting from speculation in derivatives immediately in income.  Report gains and losses resulting from hedge transactions differently, depending on the type of hedge. 20 LO 6 Understand the basic guidelines for accounting for derivatives. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Example of Derivative Financial Instrument-Speculation Illustration: Assume that a company purchases a call option contract from Baird Investment Co. on January 2, 2012, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2012. The company purchases the call option for $400 and makes the following entry on January 2, 2012. Call Option Cash 21 400 400 Option Premium LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Example of Derivative Financial Instrument-Speculation The option premium consists of two amounts. Illustration 17A-1 Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2012, the intrinsic value is zero because the market price equals the preset strike price. 22 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Example of Derivative Financial Instrument-Speculation The option premium consists of two amounts. Illustration 17A-1 Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is $400. 23 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Additional data available with respect to the call option: On March 31, 2012, the price of Laredo shares increases to $120 per share. The intrinsic value of the call option contract is now $20,000. That is, the company can exercise the call option and purchase 1,000 shares from Baird Investment for $100 per share. It can then sell the shares in the market for $120 per share. This gives the company a gain $20,000 on the option contract of ____________. ($120,000 - $100,000) 24 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS On March 31, 2012, it records the increase in the intrinsic value of the option as follows. Call Option 20,000 Unrealized Holding Gain or Loss—Income 20,000 A market appraisal indicates that the time value of the option at March 31, 2012, is $100. The company records this change in value of the option as follows. Unrealized Holding Gain or Loss—Income Call Option ($400 - $100) 25 300 300 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS At March 31, 2012, the company reports the  call option in its balance sheet at fair value of $20,100.  unrealized holding gain which increases net income.  loss on the time value of the option which decreases net income. 26 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS On April 16, 2012, the company settles the option before it expires. To properly record the settlement, it updates the value of the option for the decrease in the intrinsic value of $5,000 ([$20 - $15]) x 1,000) as follows. Unrealized Holding Gain or Loss—Income 5,000 Call option 5,000 The decrease in the time value of the option of $40 ($100 - $60) is recorded as follows. Unrealized Holding Gain or Loss—Income Call Option 27 40 40 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS At the time of the settlement, the call option’s carrying value is as follows. Settlement of the option contract is recorded as follows. Cash 15,000 Loss on Settlement of Call Option Call Option 28 60 15,060 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Summary effects of the call option contract on net income. Illustration 17A-2 Because the call option meets the definition of an asset, the company records it in the balance sheet on March 31, 2012. It also reports the call option at fair value, with any gains or losses reported in income. 29 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Differences between Traditional and Derivative Financial Instruments A derivative financial instrument has the following three basic characteristics. 1. The instrument has (1) one or more underlyings and (2) an identified payment provision. 2. The instrument requires little or no investment at the inception of the contract. 3. The instrument requires or permits net settlement. 30 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Features of Traditional and Derivative Financial Instruments Illustration 17A-3 31 LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Derivatives Used for Hedging Hedging: The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. FASB allows special accounting for two types of hedges— 32  fair value and  cash flow hedges. LO 7 Describe the accounting for derivative financial instruments. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Fair Value Hedge A company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment. Companies commonly use several types of fair value hedges. 33  Interest rate swaps  put options LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: On April 1, 2012, Hayward Co. purchases 100 shares of Sonoma stock at a market price of $100 per share. Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as availablefor-sale. Hayward records this available-for-sale investment as follows. Equity investments Cash 34 10,000 10,000 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: Fortunately for Hayward, the value of the Sonoma shares increases to $125 per share during 2010. On December 31, 2012, Hayward records the gain on this investment as follows. Fair Value Adjustment (AFS) Unrealized Holding Gain or Loss—Equity 35 2,500 2,500 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Hayward reports the Sonoma investment in its balance sheet. Illustration 17A-4 36 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Hayward is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 shares of Sonoma stock. Illustration: Hayward enters into the put option contract on January 2, 2013, and designates the option as a fair value hedge of the Sonoma investment. This put option (which expires in two years) gives Hayward the option to sell Sonoma shares at a price of $125. Since the exercise price equals the current market price, no entry is necessary at inception of the put option. 37 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: At December 31, 2013, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment. Unrealized Holding Gain or Loss—Income Fair Value Adjustment (AFS) 38 500 500 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: The following journal entry records the increase in value of the put option on Sonoma shares on December 31, 2013. Put Option 500 Unrealized Holding Gain or Loss—Income 39 500 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Balance Sheet Presentation of Fair Value Hedge Income Statement Presentation of Fair Value Hedge 40 Illustration 17A-5 Illustration 17A-6 LO 8 Explain how to account for a fair value hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Cash Flow Hedge Used to hedge exposures to cash flow risk, which results from the variability in cash flows. Reporting:  Fair value on the balance sheet  Gains or losses in equity, as part of other comprehensive income. 41 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: In September 2012 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2013. As a result, Allied enters into an aluminum futures contract. In this case, the aluminum futures contract gives Allied the right and the obligation to purchase 1,000 metric tons of aluminum for $1,550 per ton. This contract price is good until the contract expires in January 2013. The underlying for this derivative is the price of aluminum. Allied enters into the futures contract on September 1, 2012. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary. 42 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: At December 31, 2012, the price for January delivery of aluminum increases to $1,575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract. Futures Contract 25,000 Unrealized Holding Gain or Loss—Equity 25,000 ([$1,575 - $1,550] x 1,000 tons) Allied reports the futures contract in the balance sheet as a current asset and the gain as part of other comprehensive income. 43 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: In January 2013, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry. Aluminum Inventory 1,575,000 Cash ($1,575 x 1,000 tons) 1,575,000 At the same time, Allied makes final settlement on the futures contract. It records the following entry. Cash 25,000 Futures Contract ($1,575,000 - $1,550,000) 44 25,000 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Effect of Hedge on Cash Flows Illustration 17A-7 There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory. 45 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: Assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2013) is $1,700,000. Allied sells the cans in July 2013 for $2,000,000, and records this sale as follows. Cash 2,000,000 Sales Revenue Cost of Goods Sold Inventory (Cans) 46 2,000,000 1,700,000 1,700,000 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Illustration: Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction. Unrealized Holding Gain or Loss—Equity Cost of Goods Sold 25,000 25,000 The gain on the futures contract, which Allied reported as part of other comprehensive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is $1,550,000. 47 LO 9 Explain how to account for a cash flow hedge. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Other Reporting Issues Embedded Derivatives Convertible bond is a hybrid instrument. Two parts: 1. a debt security, referred to as the host security, and 2. an option to convert the bond to shares of common stock, the embedded derivative. To account for an embedded derivative, a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation. 48 LO 10 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Qualifying Hedge Criteria Criteria that hedging transactions must meet before requiring the special accounting for hedges. 1. Documentation, risk management, and designation. 2. Effectiveness of the hedging relationship. 3. Effect on reported earnings of changes in fair values or cash flows. 49 LO 10 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. ACCOUNTING FOR DERIVATIVE INSTRUMENTS Summary of Derivative Accounting under GAAP Illustration 17A-8 50 LO 10 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. VARIABLE-INTEREST ENTITIES What About GAAP? Two models for consolidation: 1. Voting-interest model—If a company owns more than 50 percent of another company, then consolidate in most cases. 2. Risk-and-reward model—If a company is involved substantially in the economics of another company, then consolidate. 51 LO 11 Describe the accounting for the variable-interest entitles. VARIABLE-INTEREST ENTITIES Consolidation of Variable-Interest Entities A variable-interest entity (VIE) is an entity that has one of the following characteristics: 1. Insufficient equity investment at risk. 2. Stockholders lack decision-making rights. 3. Stockholders do not absorb the losses or receive the benefits of a normal stockholder. 52 LO 11 Describe the accounting for the variable-interest entitles. VARIABLE-INTEREST ENTITIES Illustration 17B-1 VIE Consolidation Model 53 LO 11 Describe the accounting for the variable-interest entitles. FAIR VALUE MEASUREMENTS AND DISCLOSURES FASB believes that fair value information is relevant for making effective business decisions. Others express concern about fair value measurements for two reasons: 1. the lack of reliability related to the fair value measurement in certain cases, and 2. the ability to manipulate fair value measurements. 54 FAIR VALUE MEASUREMENTS AND DISCLOSURES Disclosure of Fair Value Information: Financial Instruments—No Fair Value Option Both the cost and the fair value of all financial instruments are to be reported in the notes to the financial statements. FASB also decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. 55 FAIR VALUE MEASUREMENTS AND DISCLOSURES Disclosure of Fair Value Information: Financial Instruments—No Fair Value Option Two reasons for additional disclosure beyond the simple itemization of fair values are: 1. Differing levels of reliability exist in the measurement of fair value information. 2. Changes in the fair value of financial instruments are reported differently in the financial statements, depending upon the type of financial instrument involved and whether the fair value option is employed. 56 FAIR VALUE MEASUREMENTS AND DISCLOSURES Levels of reliability fair value hierarchy.  Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities.  Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities.  Level 3 is least reliable; it uses unobservable inputs that reflect the company’s assumption as to the value of the financial instrument. 57 RELEVANT FACTS 58  GAAP classifies investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (only for debt investments). IFRS uses held-for-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications.  The accounting for trading investments is the same between GAAP and IFRS. Held-to-maturity (GAAP) and held-for-collection investments are accounted for at amortized cost. Gains and losses related to available-for-sale securities (GAAP) and non-trading equity investments (IFRS) are reported in other comprehensive income.  Both GAAP and IFRS use the same test to determine whether the equity method of accounting should be used.