University of California, Santa Barbara

University of California, Santa Barbara
Prepared by Coby Harmon University of California, Santa Barbara Westmont College

Investments CHAPTER 17 LEARNING OBJECTIVES
After studying this chapter, you should be able to: Describe the accounting for debt investments. Explain the accounting for equity investments. Explain the equity method of accounting. Evaluate other major issues related to debt and equity investments.

Intermediate Accounting Kieso ● Weygandt ● Warfield
PREVIEW OF CHAPTER 17 Intermediate Accounting IFRS 3rd Edition Kieso ● Weygandt ● Warfield

Debt Investments Two Types of Financial Assets
LEARNING OBJECTIVE 1 Describe the accounting for debt investments. Debt Investments Two Types of Financial Assets Debt investments. Equity investments. Motivations for investing: Earn a high rate of return. To secure certain operating or financing arrangements with another company (equity securities). LO 1

Debt Investments Classification and Measurement of Financial Assets
Two criteria: What is the company’s business model for managing its financial assets? What are the contractual cash flow characteristics of the financial investment? LO 1

Classification and Measurement of Financial Assets
Summary of the classification and measurement of debt and equity investments. ILLUSTRATION 17.1 Classification and Measurement LO 1

A Closer Look at Debt Investments
Debt investments are characterized by contractual payments on specified dates of principal and interest on the principal amount outstanding. Companies group debt investments into three categories: Held-for-collection Held-for-collection and selling Trading LO 1

A Closer Look at Debt Investments
Companies group debt investments into three categories: Held-for-collection Held-for-collection and selling Trading ILLUSTRATION 17.2 Accounting for Debt Investments by Category LO 1

Debt Investment at Amortized Cost
Illustration: Robinson SA purchased €100,000 of 8 percent bonds of Evermaster AG on January 1, 2019, at a discount, paying €92,278. The bonds mature January 1, 2024 and yield 10 percent; interest is payable each July 1 and January 1. Robinson records the investment as follows: January 1, 2019 Debt Investments 92,278 Cash 92,278 LO 1

ILLUSTRATION 17.2 LO 1

ILLUSTRATION 17.2 Robinson records the receipt of the first semiannual interest payment on July 1, 2019, as follows: Cash 4,000 Debt Investments 614 Interest Revenue 4,614 LO 1

ILLUSTRATION 17.2 Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2019, as follows: Interest Receivable 4,000 Debt Investments 645 Interest Revenue 4,645 LO 1

Reporting of Bond Investment at Amortized Cost ILLUSTRATION 17.3 LO 1

ILLUSTRATION 17.2 Assume that Robinson sells its investment on November 1, 2021, at 99¾ plus accrued interest. Robinson records this discount amortization as follows: Debt Investments 522 Interest Revenue 522 (€783 x 4/6 = €522) LO 1

Computation Gain on Sale of Bonds ILLUSTRATION 17.4 Cash (€99,750 + €2,667) 102,417 Interest Revenue (4/6 x €4,000) 2,667 Debt Investments 96,193 Gain on Sale of Investments 3,557 LO 1

Debt Investments—Held-for-Collection and Selling (HFCS)
Debt investments held-for-collection and selling follow the same accounting entries as debt investments held-for-collection during the reporting period. That is, they are recorded at amortized cost. However, at each reporting date, companies Adjust the amortized cost to fair value. Any unrealized holding gain or loss is reported as part of other comprehensive income rather than in the profit and loss statement. LO 1

Held-for-Collection and Selling (HFCS)
Illustration: Graff plc purchases £100,000, 10 percent, five-year bonds on January 1, 2019, with interest payable on July 1 and January 1. The bonds sell for £108,111, which results in a bond premium of £8,111 and an effective-interest rate of 8 percent. Graff records the purchase of the bonds as follows. January 1, 2019 Debt Investments 108,111 Cash 108,111 LO 1

ILLUSTRATION 17.6 Schedule of Interest Revenue and Bond Premium Amortization— Effective-Interest Method

ILLUSTRATION 17.6 Illustration (Single Security): The entry to record interest revenue on July 1, 2019, is as follows. Cash 5,000 Debt Investments 676 Interest Revenue 4,324 LO 1

Interest Revenue for 2019 = $8,621
Held-for-Collection and Selling (HFCS) Interest Revenue for 2019 = $8,621 ILLUSTRATION 17.6 Illustration (Single Security): At December 31, 2019, Graff makes the following entry to recognize interest revenue. Interest Receivable 5,000 Debt Investments 703 Interest Revenue 4,297 LO 1

ILLUSTRATION 17.6 Illustration (Single Security): To apply the fair value method to these debt investments, assume that at December 31, 2019 the fair value of the bonds is £105,000. Graff makes the following entry. Unrealized Holding Gain or Loss—Equity 1,732 Fair Value Adjustment 1,732 LO 1

Illustration (Portfolio of Securities): Webb AG has two debt securities classified as held-for-collection and selling. The following illustration identifies the amortized cost, fair value, and the amount of the unrealized gain or loss. ILLUSTRATION 17.7 Computation of Fair Value Adjustment—HFCS (2019) LO 1

ILLUSTRATION 17.7 Prepare the adjusting entry Webb would make on December 31, 2019 to record the loss. Unrealized Holding Gain or Loss—Equity 9,537 Fair Value Adjustment 9,537 LO 1

Sale of HFCS Securities If company sells bonds before maturity date: It must make entries to remove from the Debt Investments account the amortized cost of bonds sold. Any realized gain or loss on sale is reported in the “Other income and expense” section of the income statement. LO 1

Sale of HFCS Securities
Illustration: Webb AG sold the Watson bonds (from Illustration 17.7) on July 1, 2020, for £90,000, at which time it had an amortized cost of £94,214. ILLUSTRATION 17.8 Computation of Loss on Sale of Bonds Cash 90,000 Loss on Sale of Investments 4,214 Debt Investments 94,214 LO 1

Illustration: Webb reports this realized loss in the “Other income and expense” section of the income statement. Assuming no other purchases and sales of bonds in 2020, Herringshaw on December 31, 2020, prepares the information: ILLUSTRATION 17.9 Computation of Fair Value Adjustment—HFCS (2020) LO 1

Illustration: Webb records the following at December 31, 2020. ILLUSTRATION 17.9 Fair Value Adjustment 4,537 Unrealized Holding Gain or Loss—Equity 4,537 LO 1

Financial Statement Presentation ILLUSTRATION 17.10 Reporting of HFCS Securities LO 1

Debt Investments—Trading
Companies often hold debt investments with the intention of selling them in a short period of time. These debt investments are often referred to as trading investments. Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. LO 1

Illustration: Assume that on December 31, 2019, Western Publishing determined its trading securities portfolio to be as shown. At the date of acquisition, Western Publishing recorded these trading securities at cost in the account entitled Debt Investments. This is the first valuation of this recently purchased portfolio. ILLUSTRATION 17.10 Computation of Fair Value Adjustment—Trading Securities Portfolio (2019) LO 1

Illustration: At December 31, Western Publishing makes an adjusting entry to the Fair Value Adjustment account, to record both the increase in value and the unrealized holding gain. ILLUSTRATION 17.10 Fair Value Adjustment 3,750 Unrealized Holding Gain or Loss—Income 3,750

Fair Value Option Companies have the option to report most financial assets 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. 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. LO 1

Fair Value Option Illustration: Hardy AG purchases bonds issued by the German Central Bank. Hardy plans to hold the debt investment until it matures in five years. At December 31, 2019, the amortized cost of this investment is €100,000; its fair value at December 31, 2019, is €113,000. If Hardy chooses the fair value option to account for this investment, it makes the following entry at December 31, 2019. Debt Investment (German bonds) 13,000 Unrealized Holding Gain or Loss—Income 13,000 LO 1

Fair Value Option In this situation,
Hardy uses the Debt Investment account to record the change in fair value at December 31. It does not use the Fair Value Adjustment account. The unrealized gain or loss is recorded as part of net income even though it is managing the investment on a held-for-collection basis. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security. LO 1

Equity Investments Equity investment represents
LEARNING OBJECTIVE 2 Describe the accounting for equity investments. Equity Investments Equity investment represents ownership interest, such as ordinary, preference, or other capital shares. rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants and rights. Cost includes Purchase price of the security. Broker’s commissions and fees are recorded as expense. LO 2

Equity Investments The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for the investment subsequent to acquisition. ILLUSTRATION 17.12 Levels of Influence Determine Accounting Methods LO 2

Equity Investments LO 2 ILLUSTRATION 17.13
Accounting and Reporting for Equity Investments by Category LO 2

Equity Investments Holdings of Less Than 20%
Under IFRS, the presumption is that equity investments are held-for-trading. General accounting and reporting rule: Investments valued at fair value. Record unrealized gains and losses in net income. LO 2

Equity Investments Holdings of Less Than 20%
IFRS allows companies to classify some equity investments as non-trading. General accounting and reporting rule: Investments valued at fair value. Record unrealized gains and losses in other comprehensive income. LO 2

Equity Investments—Trading (Income)
Illustration: November 3, 2019, Republic SA purchased ordinary shares of three companies, each investment representing less than a 20 percent interest. These shares are held-for-trading. Republic records these investments as follows: LO 2

Equity Investments —Trading
Republic records these investments as follows: Equity Investments 718,550 Cash 718,550 On December 6, 2019, Republic receives a cash dividend of €4,200 on its investment in the ordinary shares of Nestlé. Cash 4,200 Dividend Revenue 4,200 LO 2

At December 31, 2019, Republic’s equity investment portfolio has the carrying value and fair value shown. ILLUSTRATION 17.14 Computation of Fair Value Adjustment— Equity Investment Portfolio (2019) LO 2

Unrealized Holding Gain or Loss—Income 35,550
ILLUSTRATION 17.14 On December 31, 2019, Republic prepares an adjusting entry to record the decrease in fair value and to record the loss as follows. Unrealized Holding Gain or Loss—Income 35,550 Fair Value Adjustment 35,550 LO 2

On January 23, 2020, Republic sold all of its Burberry ordinary shares, receiving €287,220. ILLUSTRATION 17.15 Computation of Gain on Sale of Burberry Shares Cash 287,220 Equity Investments 259,700 Gain on Sale of Investments 27,520 LO 2

In addition, assume that on February 10, 2020, Republic purchased €255,000 of Continental Trucking ordinary shares (20,000 shares €12.75 per share), plus brokerage commissions of €1,850. Republic’s equity investment portfolio as of December 31, 2020. ILLUSTRATION 17.16 Computation of Fair Value Adjustment— Equity Investment Portfolio (2020)

Republic records this adjustment on Dec. 31, 2020, as follows.
ILLUSTRATION 17.16 Republic records this adjustment on Dec. 31, 2020, as follows. Fair Value Adjustment 101,650 Unrealized Holding Gain or Loss—Income 101,650 LO 2

Equity Investments—Non-Trading (OCI)
The accounting entries to record non-trading equity investments are the same as for trading equity investments, except for recording the unrealized holding gain or loss. Companies report the unrealized holding gain or loss as other comprehensive income. LO 2

Illustration: On December 10, 2019, Republic SA purchased 1,000 ordinary shares of Hawthorne Company for €20.75 per share (total cost €20,750). The investment represents less than a 20 percent interest. Hawthorne is a distributor for Republic products in certain locales, the laws of which require a minimum level of share ownership of a company in that region. The investment in Hawthorne meets this regulatory requirement. Republic accounts for this investment at fair value. Equity Investments (Hawthorne) 20,750 Cash 20,750 LO 2

On December 27, 2019, Republic receives a cash dividend of €450 on its investment in the ordinary shares of Hawthorne Company. It records the cash dividend as follows. Cash 450 Dividend Revenue 450 LO 2

At December 31, 2019, Republic’s investment in Hawthorne has the carrying value and fair value shown. ILLUSTRATION 17.17 Computation of Fair Value Adjustment Republic records this adjustment as follows. Equity Investment (Hawthorne) 3,250 Unrealized Holding Gain or Loss—Equity 3,250 The Equity Investment account is used because the non-trading classification is applied on investment by investment basis, rather than on a portfolio basis. LO 2

ILLUSTRATION 17.21 Financial Statement Presentation of Equity Investments at Fair Value (2019) LO 2

On December 20, 2020, Republic sold all of its Hawthorne Company ordinary shares receiving net proceeds of €22,500. ILLUSTRATION 17.19 Adjustment to Carrying Value of Investment Entry to adjust the carrying value of the non-trading investment. Unrealized Holding Gain or Loss—Equity 1,500 Equity Investment (Hawthorne) 1,500 LO 2

On December 20, 2020, Republic sold all of its Hawthorne Company ordinary shares receiving net proceeds of €22,500. ILLUSTRATION 17.19 Adjustment to Carrying Value of Investment Entry to the sale of the investment. Cash 22,500 Equity Investments 22,500 LO 2

Equity Investments Holdings Between 20% and 50%
LEARNING OBJECTIVE 3 Explain the equity method of accounting. Equity Investments Holdings Between 20% and 50% An investment (direct or indirect) of 20 percent or more of the voting shares of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee. In instances of “significant influence,” the investor must account for the investment using the equity method. LO 3

Holdings Between 20% and 50%
Equity Method Record the investment at cost and subsequently adjust the amount each period for changes in investee’s net assets. Investor’s proportionate share of the earnings (losses) of the investee increases (decreases) the investment’s carrying amount. Dividends received from the investee decrease the investment’s carrying amount. If investor’s share of investee’s losses exceeds the carrying amount of the investment, the investor ordinarily should discontinue applying the equity method and not recognize additional losses. LO 3

ILLUSTRATION 17.20 Comparison of Fair Value Method and Equity Method LO 3

Equity Investments Holdings of More Than 50%
Controlling Interest - When one company acquires a voting interest of more than 50 percent in another company. Investor is referred to as the parent. Investee is referred to as the subsidiary. Investment in the subsidiary is reported on the parent’s books as a long-term investment. Parent generally prepares consolidated financial statements. LO 3

Other Reporting Issues
LEARNING OBJECTIVE 4 Evaluate other major issues related to debt and equity investments. Other Reporting Issues Impairment of Value A company should evaluate every debt investment accounted for at amortized cost, at each reporting date, to determine if it has suffered impairment—a loss in value such that the fair value of the investment is below its carrying value. If the company determines that an investment is impaired, it writes down the amortized cost basis of the individual security to reflect this loss in value. The company accounts for the write-down as a realized loss, and it includes the amount in net income. LO 4

Impairment of Value Impairment—Investment Measured at Amortized Cost
Illustration: At December 31, 2018, Mayhew Ltd. has a debt investment in Bao Group, purchased at par for ¥200,000 (amounts in thousands). The investment has a term of four years, with annual interest payments at 10 percent, paid at the end of each year (the historical effective-interest rate is 10 percent). This debt investment is classified as held-for-collection. Using the following information record the loss on impairment. LO 4

Investment Measured at Amortized Cost
ILLUSTRATION 17.22 Investment Cash Flows ILLUSTRATION 17.23 Computation of Impairment Loss Loss on Impairment 12,680 Allowance for Impaired Debt Investments 12,680

Recovery of Impairment Loss
If subsequently the impairment loss decreases, some or all of the previously recognized impairment loss shall be reversed with a debit to the Allowance for Impaired Debt Investments account and crediting Recovery of Impairment Loss. Reversal of impairment losses shall not result in a carrying amount of the investment that exceeds the amortized cost that would have been reported had the impairment not been recognized. LO 4

Recovery of Impairment Loss
For example, assume that on March 31, 2020, Mayhew determines that Bao’s credit risk has declined significantly. Mayhew therefore decides to reverse the impairment by making the following entry. Allowance for Impaired Debt Investments 12,680 Recovery of Loss on Impairment 12,680 LO 4

Impairment of Value Impairment—Debt Investments (HFCS)
Companies that have debt investments that are held-for-collection and selling (HFCS) report the investment at fair value, and any changes in fair value are reported in other comprehensive income. For these investments, companies use a different impairment model. LO 4

Impairment—Debt Investments (HFCS)
Illustration: Assume that Alexander AG purchases a HFCS debt investment on July 1, 2019, for €1,000,000 (its face value). The debt investment has an interest rate of 7 percent and a maturity date of July 1, At December 31, 2019, the fair value of the investment has declined to €960,000, due to an increase in market interest rates. The entries to record this debt investment in are shown in Illustration LO 4

ILLUSTRATION 17.24 HFCS Impairment Entries LO 4

At December 31, 2019, Alexander AG’s financial statements are as shown in below. ILLUSTRATION 17.25 Financial Statement Presentation LO 4

What happens if the €40,000 decline is caused by a change of €10,000 due to market interest rate changes and an impairment of €30,000 due to credit risk? In this case, the third entry in Illustration changes because the impairment loss of €30,000 is reported in the income statement, not in other comprehensive income. The entries to record the impairment and the change in fair value and related closing entry are shown in Illustration LO 4

What happens if the €40,000 decline is caused by a change of €10,000 due to market interest rate changes and an impairment of €30,000 due to credit risk? ILLUSTRATION 17.25 Impairment Entries—Increase in Credit Risk LO 4

At December 31, 2019, Alexander’s financial statements are as shown. ILLUSTRATION 17.27 Financial Statement Presentation LO 4

If we assume Alexander sells its debt investments on January 1, 2020, for €960,000 (its fair value at that time), the entries are as follows. Cash 960,000 Loss on Sale of Debt Investment 10,000 Allowance for Impaired Debt Investments 30,000 Debt Investments 1,000,000 Fair Value Adjustment 10,000 Accumulated Comprehensive Income 10,000 LO 4

What happens if Alexander decides to keep its debt investment and later determines that its credit risk on this investment has decreased by €15,000? In this case, it makes the following entry. Allowance for Impaired Debt Investments 15,000 Recovery of Impairment Loss 15,000 LO 4

ILLUSTRATION 17.28 Impairment Model Summary LO 4

Recycling Adjustments
Reporting Issues Single-Period Example. To provide an example of the reporting of investment securities and related gain or loss on held-for-collection and selling (HFCS) investments, assume that on January 1, 2019, Hinges plc had cash and share capital—ordinary of £50,000. At that date, the company had no other asset, liability, or equity balance. On January 2, Hinges purchased for cash £50,000 of debt securities classified as HFCS. On June 30, Hinges sold part of the HFCS security debt portfolio, realizing a gain as shown in Illustration LO 4

Reporting Issues On June 30, Hinges sold part of the HFCS security debt portfolio, realizing a gain as shown. ILLUSTRATION 17.29 Computation of Realized Gain Hinges did not purchase or sell any other securities during It received £3,000 in interest during the year. At December 31, 2019, the remaining portfolio is as shown ILLUSTRATION 17.30 Computation of Unrealized Gain LO 4

ILLUSTRATION 17.31 ILLUSTRATION 17.32 LO 4

ILLUSTRATION 17.33 ILLUSTRATION 17.34 LO 4

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

Reporting Issues Multi-Period Example
To illustrate, assume that Open AG has the two HFCS debt investments in its portfolio at the end of (its first year of operations) shown. ILLUSTRATION 17.35 HFCS Investment Portfolio (2018) LO 4

ILLUSTRATION 17.35 The entry to record the unrealized holding gain in 2018 is as follows. Fair Value Adjustment 40,000 Unrealized Holding Gain or Loss—Equity 40,000 LO 4

If Open reports net income in 2018 of €350,000, it presents a statement of comprehensive income as shown. ILLUSTRATION 17.36 Statement of Comprehensive Income (2018) LO 4

December 31, 2018 (Closing Entry)
Reporting Issues Multi-Period Example The entry to transfer the unrealized holding gain—equity to accumulated other comprehensive income is as follows. December 31, 2018 (Closing Entry) Unrealized Holding Gain or Loss—Equity 40,000 Accumulated Other Comprehensive Income 40,000 On August, 10, 2019, Open sells its Lehman Inc. bonds for €105,000 and realizes a gain on the sale. Cash 105,000 Debt Investments 80,000 Gain on Sale of Investments 25,000 LO 4

This illustration shows the computation of the change in the Fair Value Adjustment account (Woods Co. investment only). ILLUSTRATION 17.37 HFCS Investment Portfolio (2019) The entry to record the unrealized holding gain or loss in 2019 is: Unrealized Holding Gain or Loss—Equity 5,000 Fair Value Adjustment 5,000 LO 4

Assume that Open reports net income of €720,000 in 2019, including the realized sale on the Lehman bonds, its statement of comprehensive income is presented as shown. ILLUSTRATION 17.38 Statement of Comprehensive Income (2019) LO 4

December 31, 2019 (Closing Entry)
Reporting Issues Multi-Period Example At December 31, 2019, Open reports on its statement of financial position debt investments of €155,000 (cost €120,000 plus a fair value adjustment of €35,000) and accumulated other comprehensive income in equity of €35,000 (€40,000 − €5,000). The entry to transfer the unrealized holding loss—equity to accumulated other comprehensive income is as follows. December 31, 2019 (Closing Entry) Accumulated Other Comprehensive Income 5,000 Unrealized Holding Gain or Loss—Equity 5,000 LO 4

This reclassification adjustment may be made in the income statement, in accumulated other comprehensive income or in a note to the financial statements. The IASB prefers to show the reclassification amount in accumulated other comprehensive income in the notes to the financial statements. For Open AG, this presentation is as shown. ILLUSTRATION 17.39

Transfers Between Categories
Transferring an investment from one classification to another should occur only when the business model for managing the investment changes. IASB expects such changes to be rare. Companies account for transfers between classifications prospectively, at the beginning of the accounting period after the change in the business model. LO 4

Illustration: British Sky Broadcasting Group plc (GBR) has a portfolio of debt investments that are classified as trading; that is, the debt investments are not held-for-collection but managed to profit from interest rate changes. As a result, it accounts for these investments at fair value. At December 31, 2018, British Sky has the following balances related to these securities. LO 4

Illustration: As part of its strategic planning process, completed in the fourth quarter of 2018, British Sky management decides to move from its prior strategy—which requires active management—to a held-for-collection strategy for these debt investments. British Sky makes the following entry to transfer these securities to the held-for-collection classification. Debt Investments 125,000 Fair Value Adjustment 125,000 LO 4

Defining Derivatives Accounting for Derivative Instruments
APPENDIX 17A Accounting for Derivative Instruments LEARNING OBJECTIVE 5 Describe the uses of and accounting for derivatives. Defining Derivatives Financial instruments that derive their value from values of other assets (e.g., ordinary shares, bonds, or commodities). Three types of derivatives: Financial forwards or financial futures. Options. Swaps. LO 5

Who Uses Derivatives, and Why?
APPENDIX 17A Accounting for Derivative Instruments Who Uses Derivatives, and Why? Producers and Consumers Speculators and Arbitrageurs LO 5

Basic Principles in Accounting for Derivatives
APPENDIX 17A 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. LO 5

Derivative Financial Instrument (Speculation)
APPENDIX 17A Accounting for Derivative Instruments Derivative Financial Instrument (Speculation) A call option gives the holder the right, but not the obligation, to buy shares at a preset price. Illustration: Assume that the company purchases a call option contract on January 2, 2019, 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 shares at an option price of €100 per share. The option expires on April 30, The company purchases the call option for €400 and makes the following entry. Call Option 400 Cash 400 Jan. 2, 2019 Option Premium

APPENDIX 17A Accounting for Derivative Instruments Derivative Financial Instrument (Speculation) The option premium consists of two amounts. ILLUSTRATION 17A.1 Option Premium Formula 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, 2019, the intrinsic value is zero because the market price equals the preset strike price. LO 5

APPENDIX 17A Accounting for Derivative Instruments Derivative Financial Instrument (Speculation) The option premium consists of two amounts. ILLUSTRATION 17A.1 Option Premium Formula Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is €400. LO 5

Accounting for Derivative Instruments
APPENDIX 17A Accounting for Derivative Instruments Additional data available with respect to the call option: On March 31, 2019, the price of Laredo shares increases to €120 per share. The intrinsic value of the call option contract is now €20,000. That is, the company can exercise the call option and purchase 1,000 shares from Baird Investment for €100 per share. It can then sell the shares in the market for €120 per share. This gives the company a gain on the option contract of ____________. €20,000 (€120,000 - €100,000) LO 5

APPENDIX 17A Accounting for Derivative Instruments On March 31, 2019, 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, 2019, is €100. The company records this change in value of the option as follows. Unrealized Holding Gain or Loss—Income 300 Call Option (€400 - €100) 300 LO 5

APPENDIX 17A Accounting for Derivative Instruments At March 31, 2019, the company reports the call option in its statement of financial position at fair value of €20,100. unrealized holding gain which increases net income. loss on the time value of the option which decreases net income. LO 5

APPENDIX 17A Accounting for Derivative Instruments On April 16, 2019, 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 40 Call Option 40 LO 5

APPENDIX 17A 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 60 Call Option 15,060 LO 5

APPENDIX 17A Accounting for Derivative Instruments Summary effects of the call option contract on net income. ILLUSTRATION 17A.2 Effect on Income Derivative Financial Instrument The company records the call option in the statement of financial position on March 31, Furthermore, it reports the call option at fair value, with any gains or losses reported in income. LO 5

Differences between Traditional and Derivative Financial Instruments
APPENDIX 17A Accounting for Derivative Instruments Differences between Traditional and Derivative Financial Instruments A derivative financial instrument has the following three basic characteristics. Instrument has (1) one or more underlyings and (2) an identified payment provision. Instrument requires little or no investment at the inception of the contract. Instrument requires or permits net settlement. LO 5

APPENDIX 17A Accounting for Derivative Instruments Features of Traditional and Derivative Financial Instruments ILLUSTRATION 17A.3 LO 5

Derivatives Used for Hedging
APPENDIX 17A Accounting for Derivative Instruments LEARNING OBJECTIVE 6 Explain the accounting for hedges. Derivatives Used for Hedging Hedging: The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. IFRS allows special accounting for two types of hedges— fair value and cash flow hedges. LO 6

Fair Value Hedge Accounting for Derivative Instruments APPENDIX 17A
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. LO 6

APPENDIX 17A Accounting for Derivative Instruments Illustration: On December 1, 2019, Hayward Tire Fabricators holds an inventory of 1,000 tractor tires, with a cost of €200 per tire. Hayward has been building an inventory of tractor tires in anticipation of demand for these tires in the upcoming spring planting season. Hayward records the inventory on its statement of financial position at €200,000 (1,000 × €200), using lower-of-FIFO-cost-or-net realizable value. Until Hayward sells the tires, the company is exposed to the risk that the value of the tire inventory will decline. Hayward wishes to hedge its exposure to fair value declines for its tire inventory (the inventory is pledged as collateral for one of its bank loans). LO 6

APPENDIX 17A Accounting for Derivative Instruments Illustration: To hedge this risk, Hayward locks in the value of its tire inventory on January 2, 2020, by purchasing a put option to sell rubber at a fixed price. Hayward designates the option as a fair value hedge of the tire inventory. This put option (which expires in nine months) gives Hayward the option to sell 4,000 pounds of rubber at a price of €50 per pound, which is the current spot price for rubber in the market. Since the exercise price equals the current market price, no entry is necessary at inception of the put option. LO 6

APPENDIX 17A Accounting for Derivative Instruments Illustration: At March 31, 2020, the fair value of the inventory has declined by 10 percent (€200,000 × 10% = €20,000 ) . Hayward records the following entry for the tire inventory. Unrealized Holding Gain or Loss—Income 20,000 Allowance to Reduce Inventory to Fair Value 20,000 The following journal entry records the increase in value of the put option to sell rubber, assuming that the spot price for rubber declined by 10 percent. Put Option 20,000 Unrealized Holding Gain or Loss—Income 20,000 LO 6

APPENDIX 17A Accounting for Derivative Instruments ILLUSTRATION 17A.5 ILLUSTRATION 17A.6 LO 6

Cash Flow Hedge Accounting for Derivative Instruments APPENDIX 17A
Used to hedge exposures to cash flow risk, which results from the variability in cash flows. Reporting: Fair value on the statement of financial position. Gains or losses in equity, as part of other comprehensive income. LO 6

APPENDIX 17A Accounting for Derivative Instruments Illustration: In September 2019 Allied Can Ltd. anticipates purchasing 1,000 metric tons of aluminum in January Concerned that prices of aluminum will increase, Allied enters into an aluminum futures contract. The aluminum futures contract gives Allied the right and the obligation to purchase 1,000 metric tons of aluminum for ¥1,550 per ton (amounts in thousands). This contract price is good until the contract expires in January The underlying for this derivative is the price of aluminum. Allied enters into the futures contract on September 1, Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary. LO 6

APPENDIX 17A Accounting for Derivative Instruments Illustration: At December 31, 2019, 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 statement of financial position as a current asset and the gain as part of other comprehensive income. LO 6

APPENDIX 17A Accounting for Derivative Instruments Illustration: In January 2020, 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) 25,000 LO 6

APPENDIX 17A 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. LO 6

APPENDIX 17A 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 2020) is ¥1,700,000. Allied sells the cans in July 2020 for ¥2,000,000, and records this sale as follows. Cash 2,000,000 Sales Revenue 2,000,000 Cost of Goods Sold 1,700,000 Inventory (Cans) 1,700,000 LO 6

APPENDIX 17A 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. July 2020 Unrealized Holding Gain or Loss—Equity 25,000 Cost of Goods Sold 25,000 The gain on the futures contract, which Allied reported as part of other comprehensive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is ¥1,550,000. LO 6

Other Reporting Issues
APPENDIX 17A Accounting for Derivative Instruments Other Reporting Issues LEARNING OBJECTIVE 7 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. Embedded Derivatives A convertible bond is a hybrid instrument. Two parts: a debt security, referred to as the host security, and an option to convert the bond to shares of common stock, the embedded derivative. Accounted for as a single unit. LO 7

Qualifying Hedge Criteria
APPENDIX 17A Accounting for Derivative Instruments Qualifying Hedge Criteria Criteria that hedging transactions must meet before requiring the special accounting for hedges. Documentation, risk management, and designation. Effectiveness of the hedging relationship. Effect on reported earnings of changes in fair values or cash flows. LO 7

Summary of Derivative Accounting
APPENDIX 17A Accounting for Derivative Instruments Summary of Derivative Accounting ILLUSTRATION 17A.8 LO 7

Comprehensive Hedge Accounting Example
APPENDIX 17A Accounting for Derivative Instruments Comprehensive Hedge Accounting Example Many companies popular type of derivative called a swap. A swap is a transaction between two parties in which the first party promises to make a payment to the second party. Similarly, the second party promises to make a simultaneous payment to the first party. The most common type of swap is the interest rate swap. In this type, one party makes payments based on a fixed or floating rate, and the second party does just the opposite. LO 7

Comprehensive Hedge Accounting Example
APPENDIX 17A Accounting for Derivative Instruments Comprehensive Hedge Accounting Example In most cases, large money-center banks bring together the two parties. ILLUSTRATION 17A.9 Swap Transaction LO 7

Fair Value Hedge Accounting for Derivative Instruments APPENDIX 17A
Illustration: Assume that Jones AG issues €1,000,000 of five-year, 8 percent bonds on January 2, Jones records this transaction as follows. Cash 1,000,000 Bonds Payable 1,000,000 To protect against the risk of loss, Jones hedges the risk of a decline in interest rates by entering into a five-year interest rate swap contract. LO 7

Fair Value Hedge Jones agrees to the following terms:
Jones will receive fixed payments at 8 percent (based on the €1,000,000 amount). Jones will pay variable rates, based on the market rate in effect for the life of the swap contract. The variable rate at the inception of the contract is 6.8 percent. ILLUSTRATION 17A.10 Interest Rate Swap LO 7

Fair Value Hedge Assuming that Jones enters into the swap on January 2, 2019 (the same date as the issuance of the debt), the swap at this time has no value. Therefore, no entry is necessary. At the end of 2019, Jones makes the interest payment on the bonds. It records this transaction as follows. Interest Expense 80,000 Cash (8% × €1,000,000) 80,000 LO 7

Fair Value Hedge At the end of 2019, market interest rates have declined substantially. Therefore, the value of the swap contract increases. Recall (see Illustration 17A.9) that in the swap, Jones receives a fixed rate of 8 percent, or €80,000 (€1,000,000 × 8%), and pays a variable rate (6.8%), or €68,000. Jones therefore receives €12,000 (€80,000 − €68,000) as a settlement payment on the swap contract on the first interest payment date. Jones records this transaction as follows. Cash 12,000 Interest Expense 12,000 LO 7

Fair Value Hedge In addition, a market appraisal indicates that the value of the interest rate swap has increased €40,000. Jones records this increase in value as follows. Swap Contract 40,000 Unrealized Holding Gain or Loss—Income 40,000 Because interest rates have declined, the company records a loss and a related increase in its liability as follows. Unrealized Holding Gain or Loss—Income 40,000 Bonds Payable 40,000 LO 7

ILLUSTRATION 17A.11 ILLUSTRATION 17A.12 LO 7

Fair Value Disclosures
APPENDIX 17B Fair Value Disclosures LEARNING OBJECTIVE 8 Describe required fair value disclosures. Disclosure of Fair Value Information: Financial Instruments Both cost and fair value of all financial instruments must be reported in the notes to the financial statements. LO 8

APPENDIX 17B Fair Value Disclosures Disclosure of Fair Value Information Three broad levels related to the measurement of fair values. Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities. Level 3 is least reliable; it uses unobservable inputs that reflect the company’s assumption as to the value of the financial instrument. LO 8

APPENDIX 17B Fair Value Disclosures Disclosure of Fair Value Information Companies must provide the following (with special emphasis on Level 3 measurements): Quantitative information about significant unobservable inputs used for all Level 3 measurements. A qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed, including interrelationships between inputs. A description of the company’s valuation process. LO 8

APPENDIX 17B Fair Value Disclosures Disclosure of Fair Value Information Companies must provide the following (with special emphasis on Level 3 measurements): Any transfers between Levels 1 and 2 of the fair value hierarchy. Information about non-financial assets measured at fair value at amounts that differ from the assets’ highest and best use. The proper hierarchy classification for items that are not recognized on the statement of financial position but are disclosed in the notes to the financial statements. LO 8

GLOBAL ACCOUNTING INSIGHTS
LEARNING OBJECTIVE 9 Compare the accounting for investments under IFRS and U.S. GAAP. Until recently, when the IASB issued IFRS 9, the accounting and reporting for investments under IFRS and U.S. GAAP were for the most part very similar. While IFRS 9 introduces new investment classifications relative to U.S. GAAP, both IFRS and U.S. GAAP have increased situations when investments are accounted for at fair value, with gains and losses recorded in income. LO 9

Relevant Facts Following are the key similarities and differences between U.S. GAAP and IFRS related to investments. Similarities U.S. GAAP and IFRS use similar classifications for financial assets: cash, loans and receivables, investments, and derivatives. Both IFRS and U.S. GAAP require that financial assets be sorted into specific categories for measurement and classification purposes. Held-to-maturity (U.S. GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. Gains and losses on some investments are reported in other comprehensive income. LO 9

Relevant Facts Similarities Amortized cost or fair value is used depending upon the classification of the financial instrument. The definitions of amortized cost and fair value are the same. Both U.S. GAAP and IFRS use the same test to determine whether the equity method of accounting should be used, that is, significant influence with a general guideline of over 20 percent ownership. U.S. GAAP and IFRS are similar in the accounting for the fair value option. That is, the option to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income. Under both U.S. GAAP and IFRS, credit losses are recognized in income.

Relevant Facts Differences While U.S. GAAP classifies debt investments as trading, available-for-sale, and held-to-maturity, IFRS classifies debt investments as held-for-collection, held-for-collection and selling (debt investments), and trading. U.S. GAAP requires that all changes in fair value for all equity securities be reported as part of income. IFRS requires that changes in fair value for non-trading equity securities be reported as part of other comprehensive income. LO 9

Relevant Facts Differences U.S. GAAP measures impairments based on lifetime expected credit losses. IFRS uses lifetime expected losses for financial assets that have experienced a significant increase in credit risk since initial recognition (otherwise, the credit loss allowance is based on 12-month expected credit losses). U.S. GAAP generally does not permit the reversal of an impairment charge related to held-to-maturity debt investments and equity investments. IFRS allows reversals of impairments of held-for-collection investments. In the accounting for the fair value option, one difference is that U.S. GAAP permits the fair value option for all financial assets; IFRS allows the fair value option if doing so reduces an accounting mismatch. LO 9

On the Horizon At one time, both the FASB and IASB indicated that they believed that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. Through recent standards in this area, the Boards continue to move toward that goal. U.S. GAAP and IFRS are substantially converged, except for non- trading equity investments and the measurement of credit losses. LO 9

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