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CHAPTER 17

Investments
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics

Questions

1. Debt securities.

Brief
Exercises Exercises

1, 2, 3, 13

Problems

Concepts
for Analysis

1, 6

1, 2, 7

(a) Held-to-maturity.

4, 5, 7, 8,
10, 13, 21

1, 3

1, 2, 3, 5

(b) Trading.

4, 6, 7, 8,
10, 21

(c)

4, 7, 8, 9,
10, 11, 21

2, 9

1, 4

1, 2, 3, 4, 7

2. Bond amortization.

8, 9

1, 2, 3

2, 3, 4, 5

1, 2, 3, 7

3. Equity securities.

1, 12, 16

Available-for-sale.

1, 6
1, 6

4, 5

(a) Available-for-sale.

7, 10, 11,
12, 15, 21

5, 8

1, 6, 8, 9, 11, 3, 5, 6, 8, 9,
12, 16,
10, 11, 12
19, 20, 21

1, 2, 3

(b) Trading.

6, 7, 8, 10,
12, 14, 15,
21

1, 6, 7,
14, 15

6, 8

1, 3

(c)

12, 16, 17,


18, 19, 20

1, 12, 13,
16, 17

4, 5

Equity method.

4. Fair value option.

25, 26, 27

5. Impairments.

24

6. Transfers between
categories.

22, 23

7. Reporting investments.

22

8. Disclosures of investments.

21

10

19, 20, 21

18

3
1, 3

6, 8, 10, 18

9, 10, 12

2, 3, 4

8, 9, 10

5, 8, 9, 10,
11, 12

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*9. Derivatives.

28, 29, 30, 31,


32, 33, 34, 35

*10. Variable interest entities.

36, 37

*11. Fair value disclosures.

31

22, 23, 24,


25, 26, 27

13, 14, 15,


16, 17, 18

*This material is dealt with in an Appendix to the chapter.

17-2

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ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)


Learning Objectives

Brief
Exercises

Exercises

Problems

1.

Identify the three categories of debt securities


and describe the accounting and reporting
treatment for each category.

2.

Understand the procedures for discount and


premium amortization on bond investments.

1, 2, 3, 4

2, 3, 4, 5, 21

1, 2, 3, 4, 7

3.

Identify the categories of equity securities and


describe the accounting and reporting
treatment for each category.

5, 6, 8

1, 6, 7, 8, 9,
11, 12, 14,
15, 16, 19,
20, 21

3, 5, 6, 8, 9,
10, 11, 12

4.

Explain the equity method of accounting and


compare it to the fair value method for equity
securities.

12, 13,
16, 17

5.

Describe the accounting for the fair value


option and for impairments of debt and equity
investments.

10

18, 19, 20, 21

8, 10, 12

6.

Describe the reporting of reclassification


adjustments and the accounting for transfers
between categories.

10

*7.

Describe the uses of and accounting for


derivatives.

*8.

Explain how to account for a fair value hedge.

23, 25

16, 18

*9.

Explain how to account for a cash flow hedge.

24, 27

17

*10.

Identify special reporting issues related to


derivative financial instruments that cause
unique accounting problems.

*11.

Describe the accounting for variable-interest


entities.

*12.

Describe required fair value disclosures.

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17-3

ASSIGNMENT CHARACTERISTICS TABLE


Item

Description

Level of
Difficulty

Time
(minutes)

E17-1

Investment classifications.

Simple

510

E17-2

Entries for held-to-maturity securities.

Simple

1015

E17-3

Entries for held-to-maturity securities.

Simple

1520

E17-4

Entries for available-for-sale securities.

Simple

1015

E17-5

Effective-interest versus straight-line bond amortization.

Simple

2030

E17-6

Entries for available-for-sale and trading securities.

Simple

1015

E17-7

Trading securities entries.

Simple

1015

E17-8

Available-for-sale securities entries and reporting.

Simple

510

E17-9

Available-for-sale securities entries and financial statement


presentation.

Simple

1015

E17-10

Comprehensive income disclosure.

Moderate

2025

E17-11

Equity securities entries.

Simple

2025

E17-12

Journal entries for fair value and equity methods.

Simple

1520

E17-13

Equity method.

Moderate

1015

E17-14

Equity investmenttrading.

Moderate

1015

E17-15

Equity investmentstrading.

Moderate

1520

E17-16

Fair value and equity method compared.

Simple

1520

E17-17

Equity method.

Simple

1015

E17-18

Impairment of debt securities.

Moderate

1520

E17-19

Fair Value measurement.

Moderate

1520

E17-20

Fair Value measurement issues.

Moderate

1520

E17-21

Fair value option.

Moderate

1520

*E17-22

Derivative transaction.

Moderate

1520

*E17-23

Fair value hedge.

Moderate

2025

*E17-24

Cash flow hedge.

Moderate

2025

*E17-25

Fair value hedge.

Moderate

1520

*E17-26

Call option.

Moderate

2025

*E17-27

Cash flow hedge.

Moderate

2530

P17-1

Debt securities.

Moderate

3040

P17-2

Available-for-sale debt securities.

Moderate

3040

P17-3

Available-for-sale investments.

Moderate

2530

17-4

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P17-4

Available-for-sale debt investments.

Moderate

2535

P17-5

Equity securities entries and disclosures.

Moderate

2535

P17-6

Trading and available-for-sale securities entries.

Simple

2535

P17-7

Available-for-sale and held-to-maturity debt securities entries.

Moderate

2535

P17-8

Fair value and equity methods.

Moderate

2030

P17-9

Financial statement presentation of available-for-sale


investments.

Moderate

2030

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17-5

ASSIGNMENT CHARACTERISTICS TABLE (Continued)


Description

Level of
Difficulty

Time
(minutes)

P17-10

Gain on sale of securities and comprehensive income.

Moderate

2030

P17-11

Equity investmentsavailable-for-sale.

Complex

3545

P17-12

Available-for-sale securitiesstatement presentation.

Moderate

2030

*P17-13

Derivative financial instrument.

Moderate

2025

*P17-14

Derivative financial instrument.

Moderate

2025

*P17-15

Free-standing derivative.

Moderate

2025

*P17-16

Fair value hedge interest rate swap.

Moderate

3040

*P17-17

Cash flow hedge.

Moderate

2535

*P17-18

Fair value hedge.

Moderate

2535

CA17-1

Issues raised about investment securities.

Moderate

2530

CA17-2

Equity securities.

Moderate

2530

CA17-3

Financial statement effect of equity securities.

Simple

2030

CA17-4

Investment accounted for under the equity method.

Moderate

2025

CA17-5

Equity investment.

Moderate

2535

CA17-6

Fair value.

Moderate

2535

Item

17-6

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LEARNING OBJECTIVES
1. Identify the three categories of debt securities and describe the accounting and
reporting treatment for each category.
2. Understand the procedures for discount and premium amortization on bond
investments.
3. Identify the categories of equity securities and describe the accounting and reporting
treatment for each category.
4. Explain the equity method of accounting and compare it to the fair value method for
equity securities.
5. Describe the accounting for the fair value option and for impairments of debt and equity
investments.
6. Describe the reporting of reclassification adjustments and the accounting for transfers
between categories.
*7. Describe the uses of and accounting for derivatives.
*8. Explain how to account for a fair value hedge.
*9. Explain how to account for a cash flow hedge.
*10. Identify special reporting issues related to derivative financial instruments that cause
unique accounting problems.
*11. Describe the accounting for variable-interest entities.
*12. Describe required fair value disclosures.
*13. Compare the accounting for investments under GAAP and IFRS.
*This material is covered in an Appendix to the chapter.

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17-7

CHAPTER REVIEW
1. The problems of accounting for investments involve measurement, recognition, and
disclosure. Investments are generally classified as either debt securities or equity
securities and may be either temporary or long-term investments. The first section
presents accounting for debt securities; the second section covers accounting for equity
securities; and the remainder of the chapter presents the equity method of accounting,
disclosure requirements, impairments, and accounting for the transfer of investment
securities between categories.
Debt Securities
2. (L.O. 1)Debt securities are instruments representing a creditor relationship with an
enterprise. Debt securities include U.S. government securities, municipal securities,
corporate bonds, convertible debt, commercial paper, and all securitized debt instruments.
3. Debt securities are grouped into the following three separate categories:
a. Held-to-maturity:Debt securities that the enterprise has the positive intent and ability
to hold to maturity.
b. Trading:Debt securities bought and held primarily for sale in the near term to generate
income on short-term price differences.
c. Available-for-sale:Debt securities not classified as held-to-maturity or trading securities.
Held-to-Maturity Debt Securities
4. (L.O. 2) Held-to-maturity debt securities are accounted for at amortized cost, not fair value.
Amortization on Bond Investments
5. The effective-interest method is required to amortize premium or discount unless some
other methodsuch as the straight-line methodyields a similar result. The effectiveinterest method is applied to bond investments in a fashion similar to that described for
bonds payable. The effective-interest rate or yield is computed at the time of investment
and is applied to its beginning carrying amount (book value) for each interest period to
compute interest revenue. The investment carrying amount is increased by the amortized
discount or decreased by the amortized premium in each period.
Available-for-Sale Debt Securities
6. Available-for-sale debt securities are reported at fair value. After a company recognizes
interest revenue and bond investment amortization, it adjusts the carrying value of the
debt securities to fair value. The unrealized gains and losses related to changes in the fair
value of available-for-sale debt securities are recorded in an unrealized holding gain or
loss account. This account is reported as other comprehensive income and as a separate
component of stockholders equity until realized. A valuation account called Fair Value
17-8

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Adjustment (Available-for-Sale) is used instead of debiting or crediting the Available-forSale Securities account to enable the company to maintain a record of its amortized cost.
7. When an available-for-sale debt security is sold, the realized gain or loss is reported in the
Other Revenues and Gains section or the Other Expenses and Losses section of the
income statement. The unamortized cost of the bond investment is removed from the
investment account.
Trading Debt Securities
8. Trading debt securities are reported 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 the next period, exclusive of dividend or interest revenue
recognized but not received. A valuation account called Fair Value Adjustment (Trading)
is used instead of debiting or crediting the Trading Securities account.
Equity Securities
9. (L.O. 3)Equity securities are described as securities representing ownership interest
such as common, preferred, or other capital stock. They also include rights to acquire or
dispose of ownership interests at an agreed upon or determinable price such as warrants,
rights, and call options or put options. The cost of equity securities includes the purchase
price of the security plus brokers commissions and other fees incidental to the purchase.
10. The degree to which one corporation (investor) acquires an interest in the voting stock of
another corporation (investee) generally determines the accounting treatment for the
investment subsequent to acquisition. Investments by one corporation in the voting stock
of another and the accounting method to be used can be classified according to the
percentage of the voting stock of the investee held by the investor:
____Holdings

Valuation

a. Less than 20%

Fair value method

b. Between 20% and 50%

Equity method

c. More than 50%

Consolidated statements

Fair Value Method Equity Securities


11. When an investor has an interest of less than 20%, it is presumed that the investor has
little or no influence over the investee. If market prices are available, the investment is
valued and reported subsequent to acquisition using the fair value method. The fair value
method requires that companies classify equity securities at acquisition as available-forsale securities or trading securities.
12. When acquired, available-for-sale equity securities are recorded at cost. When cash
dividends are declared by the investee, the investor recognizes the dividends as
Investment Income. The net unrealized gains and losses related to changes in the fair
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17-9

value are recorded in an Unrealized Holding Gain or Loss-Equity account that is reported
as a part of other comprehensive income and as a separate component of stockholders
equity until realized. The offsetting portion of recognizing an unrealized gain or loss is
debited or credited to the valuation account, Fair Value Adjustment (available-for-sale).
13. The accounting entries to record trading equity securities are the same as for availablefor-sale equity securities except for reporting the unrealized holding gain or loss. For trading
equity securities, the unrealized holding gain or loss is reported as part of net income.
Equity Method
14. (L.O. 4)When an investor has a holding interest of between 20% and 50% in an investee
corporation, the investor is generally deemed to exercise significant influence over
operating and financial policies of the investee. Other factors to consider in determining
whether an investor can exercise significant influence over an investee include
representation on the board of directors, participation in policy-making processes,
material company transactions, interchange of managerial personnel, or technological
dependency. In instances of significant influence, the investor is required to account for
the investment using the equity method.
15. Under the equity method, the investments carrying amount is periodically increased
(decreased) by the investors proportionate share of the earnings (losses) of the investee
and decreased by dividends received by the investor from the investee. The investor must
recognize the amount of ordinary and extraordinary income in as separate components in
the same manner as reported by the investee.
16. Under the equity method, if an investors share of the investees losses exceeds the
carrying amount of the investment, the investor should discontinue applying the equity
method and not recognize additional losses (unless the investors loss is not limited or if
return to profitability appears to be assured).
17. The following transactions illustrate the journal entries for an investment accounted for
under the equity method.
a. On January 2, 2014, Workowski Corporation purchased 55,000 shares (26%) of Wendy
Company at a cost of $8 per share.
Equity Investments ($8 55,000).......................
Cash..............................................................

440,000

440,000

b. At the end of 2014, Wendy Company reported net income of $350,000 (all ordinary).
Workowskis share is $91,000 ($350,000 26%).
Equity Investments.............................................
Investment Income........................................

17-10

91,000

91,000

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c. Wendy Company reported a $215,000 net loss (all ordinary) for 2014. Workowskis
share is $55,900 ($215,000 26%).
Investment Loss..................................................
Equity Investments........................................

55,900

55,900

d. In early 2015, Wendy Company paid a $75,000 dividend. Workowskis share is


$19,500 ($75,000 26%).
Cash...................................................................
Equity Investments........................................

19,500

19,500

Consolidated Financial Statements


18. When one corporation (the parent) acquires a voting interest of more than 50% in another
corporation (the subsidiary), the investor corporation is deemed to have a controlling
interest. When the parent treats the subsidiary as an investment, consolidated financial
statements are generally prepared. The subject of when and how to prepare consolidated
financial statements is discussed extensively in advanced accounting.
Fair Value Option
19. (L.O. 5)Companies have the option to report most financial assets and liabilities at fair
value, with gains and losses reported in net income. The fair value option is only available
at the acquisition date or date incurred, and applies on a security-by-security basis. When
the fair value option in selected, it must be used for the life of the instrument.
20. When the fair value option is used for
a. Available-for-sale securities, gains and losses related to changes in fair value are
reported in net income (rather than as part of comprehensive income).
b. Equity method investments, the investor does not report it share of the investee
income or loss, rather, changes in the fair value of the investment are reported in net
income. Likewise, the receipt of dividends is recorded as dividend revenue rather than
as a reduction of the investment account.
c. Financial liabilities, a company revalues its own liabilities, with gains and losses
reported in net income. That is, when the market price of a companys bonds declines,
the company will reduce the liability and record a gain in the income statement.
Impaired Investments
21. Each accounting period, every investment must be evaluated to determine if it has
suffered a loss in value that is other than temporary (an impairment). If an investment is
deemed impaired, the cost basis of the individual security is written down to a new cost
basis. The amount of the writedown is accounted for as a realized loss and included in
net income.

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17-11

Reclassification Adjustments
22. (L.O. 6) The reporting of changes in unrealized gains or losses in comprehensive income
is straightforward unless securities are sold during the year. When this occurs, a
reclassification adjustment is necessary to ensure that gains and losses are not
counted twice. The adjustment is shown either on the face of the statement in which
comprehensive income is reported, or disclosed in the notes.
Transfers Between Categories
23. Transfers between any of the investment categories are accounted for at fair value. The
text gives an illustration of measurement basis and how stockholders equity and net
income are impacted upon a transfer between investment categories.
Accounting for Derivative Instruments
*24. (L.O. 7)Derivatives are a product that has been developed to manage the risks due to
changes in market prices. Derivatives include such instruments as interest-rate swaps
and options, current futures and options, stock-index futures and options, caps, floors,
commodity futures, swaptions, leaps, and collateralized mortgage obligations. They are
called derivatives because their value is derived from values of other assets (for example
stock, bonds, or commodities) or is related to a market-determined indicator (for example,
interest rates or the Standard and Poors stock composite index).
*25. Any individual or company that wants to insure against different types of business risks
often can use derivative contracts to achieve this objective. Producers and consumers
both find derivatives useful so they can hedge their positions to ensure an acceptable
financial result. A speculator is betting that the change in the derivative value will go
a certain way and therefore makes the purchase with the purpose of gaining earnings
based on his prediction. An arbitrageur purchases and sells derivatives in an attempt to
exploit inefficiencies in various derivative markets.
Basic Principles in Accounting for Derivatives
*26. Derivatives are recognized in the financial statements as assets and liabilities and are
reported in the balance sheet at fair value. On the income statement, any unrealized gain
or loss should be recognized in income if the derivative is used for speculation purposes.
If the derivative is used for hedging purposes, the accounting for any gain or loss depends
on the type of hedge used.
*27. When distinguishing between the differences of traditional and derivative financial
instruments, a derivative financial instrument has the following three basic characteristics:
a. The instrument has (1) one or more underlyings and (2) an identified payment provision
(an underlying is a specified interest rate, security price, commodity price, index of
prices or rates, or other market-related variable).
b. The instrument requires little or no investment at the inception of the contract.
c. The instrument requires or permits net settlement (for example, a profit can be realized
without an actual purchase and sale of the underlying item).
17-12

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Derivatives Used for Hedging Fair Value Hedge


*28. (L.O. 8)In a fair value hedge, a derivative is used to hedge (offset) the exposure to
changes in the fair value of a recognized asset or liability or of an unrecognized
commitment. In accounting for fair value hedges, the derivative should be presented at its
fair value on the balance sheet with any gains and losses recorded in income.
Derivatives Used for HedgingC ash Flow Hedge
*29. Cash flow hedges are used to hedge exposures to cash flow risk, which is exposure to
the variability in cash flows. In accounting for cash flow hedges, the derivative should be
presented at fair value on the balance sheet, but gains or losses are recorded in equity as
a part of other comprehensive income.
Other Reporting Issues
*30. (L.O. 10)Hybrid securities have characteristics of both debt and equity and often are
a combination of traditional and derivative financial instruments. In some cases, a host
security is combined with an embedded derivative. When this occurs, the embedded
derivative should be separated from the host security and accounted for using the
accounting for derivatives. This separation process is referred to as bifurcation.
*31. For special accounting of hedges to occur, certain criteria must first be met. The general
criteria relate to the following areas:
a. Documentation, risk management, and designation.
b. Effectiveness of the hedging relationship.
c. Effect on reported earnings of changes in fair values or cash flows.
Variable-Interest Entities
*32. (L.O. 11)In order to prevent companies like Enron from hiding debt and risk in special
purpose entities, the FASB created a risk-and-reward model to be used in situations
where voting interests are unclear. A variable-interest entity (VIE) is an entity that has
(1) insufficient equity investment at risk, (2) stockholders lack decision-making rights, or
(3) stockholders do not absorb the losses or receive the benefits of a normal stockholder.
A company is required to consolidate a VIE if it is the primary beneficiary of the VIE.
Fair Value Disclosures
*33. (L.O. 12) Fair Value Disclosures.
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.

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17-13

*34.

Reasons for additional disclosure beyond itemizing fair values include: differing levels
of reliability existing in the measurement of fair value information, and changes in the
fair value of financial instruments that are reported differently in the financial
statements, depending on the type of financial instrument involved and whether the fair
value option is employed.

*35.

Additional disclosures required include:


a. The carrying amount and the fair value of the companys financial instruments
segregated by level of reliability.
b. A reconciliation of the balance from the beginning of the period.
c. The impact of changes in fair value on the net assets of the company from one
period to the next.
d. Quantitative information about significant unobservable inputs used for all Level 3
measurements.
e. A qualitative discussion about the sensitivity of recurring Level 3 measurements to
changes in the unobservable inputs disclosed, including interrelationships between
inputs.
f. A description of the companys valuation process.
g. Any transfers between Levels 1 and 2 of the fair value hierarchy.
h. Information about nonfinancial assets measured at fair value at amounts that differ
from the assets highest and best use.
i. The proper hierarchy classification for items that are not recognized on the balance
sheet but are disclosed in the notes to the financial statements.

17-14

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LECTURE OUTLINE
The material in this chapter can be covered in three class periods. Students will have some
difficulty with the classifications of debt securities into trading, available-for-sale, and held-tomaturity. The same issues will develop with equity securities as they are classified as trading or
available-for-sale (assuming ownership interest is less than 20%). Illustrations 17-1, 17-3, and
17-5 can be used to clarify the issues. When discussing investments in debt securities, it is
often useful to contrast the entries made for debt securities with the entries made for debt
obligations on the issuers book (see Chapter 14). Illustration 17-2 provides an example of
entries made for investments and issuances of debt securities.
A. (L.O. 1)Accounting for Investments in Debt Securities.
1.

Debt securities represent a creditor relationship with another entity.

2. Debt securities include U.S. government securities, municipal securities, corporate bonds,
convertible debt, and commercial paper.
3. Trade accounts receivable and loans receivable are not debt securities because they
do not meet the definition of a security.
4. Investments in debt securities are classified into three separate categories:

5.

a.

Held-to-maturity.Debt securities that the company has the positive intent and
ability to hold to maturity.

b.

Trading.Debt securities bought and held primarily for sale in the near term to
generate income on short-term price differences.

c.

Available-for-sale.Debt securities not classified as held-to-maturity or trading


securities.

Accounting and reporting for debt securities.


TEACHING TIP

Illustration 17-1 indicates the accounting for debt securities by category and provides an
overview for subsequent discussion.
6. (L.O. 2)Held-to-maturity securities are accounted for at amortized cost, not fair value.
Rationale:If management intends to hold certain investment securities to maturity and
has no plans to sell them, fair values (selling prices) are not relevant for measuring and
evaluating the cash flows associated with these activities.
a.

The effective-interest method is applied to bond investments in a fashion similar to


bonds payable.

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17-15

b.

The investment carrying amount is increased (decreased) by the amortized discount


(premium) in each period.
TEACHING TIP

Illustration 17-2 indicates the accounting for held-to-maturity securities.


7. Available-for-sale debt securities are reported at fair value.
a.

The unrealized holding gains and losses related to changes in fair value of
available-for-sale debt securities are recognized as other comprehensive income
and reported as a separate component of stockholders equity.

b.

At each reporting date, available-for-sale debt securities are reported at fair value
with an adjustment to an Unrealized Holding Gain or LossEquity account.

c.

A Fair Value Adjustment (available-for-sale) account is used to record the


difference between fair value and amortized cost.

d.

When sold, a realized gain/loss is recognized in an amount equal to the difference


between amortized cost and the selling price.

8. Trading debt securities are reported at fair value.


a.

The unrealized holding gain or loss is reported as part of income.

b.

A Fair Value Adjustment (trading) account is used to record the difference


between fair value and cost.

c.

When securities are actively traded, the FASB believes that changes in fair value
(unrealized gains/losses) should be reported in income to provide information that
is more relevant to existing and prospective stockholders.

B. (L.O. 3)Investments in Equity Securities.


1. Equity securities represent ownership interests such as common, preferred, or other
capital stock.
2. The cost of equity securities includes the purchase price of the security plus brokers
commissions and other fees incidental to the purchase.
3. Investments by one corporation in the voting stock of another can be classified according to
the percentage of ownership.

17-16

a.

Holdings of less than 20% (fair value method).

b.

Holdings between 20% and 50% (equity method).

c.

Holdings of more than 50% (consolidated statements).

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TEACHING TIP

Illustration 17-3 indicates how the levels of ownership determine valuation and accounting
methods.
4.

Holdings of less than 20%.If market prices are available, the investment is valued and
reported subsequent to acquisition using the fair value method.
a.

Available-for-sale securities.As with available-for-sale debt securities, the net


unrealized gains or losses are recorded in an Unrealized Holding Gain or Loss
Equity account that is recognized as other comprehensive income and is reported
as a separate component of stockholders equity until realized.

b.

Trading equity securities. The unrealized holding gains or losses are reported as
part of net income in an Unrealized Holding Gain or LossIncome account.

5. (L.O. 4)Holdings Between 20% and 50%.Use the equity method. The investment
account is increased (decreased) by the investors share of the earnings (losses) of the
investee and decreased by all dividends received.
a.

The investor should discontinue applying the equity method and not recognize
additional losses if its share of the investees losses exceeds the carrying amount
of the investment.

6. Holdings over 50%.When one corporation (the parent) acquires a voting interest of
more than 50% in another corporation (the subsidiary), the parent generally prepares
consolidated financial statements.
C. (L.O. 5)Fair Value Option
1. Companies may use the fair value option to account for most financial assets and
liabilities. The fair value option is generally available only at the time a company first
purchases the financial asset or incurs a financial liability. All gains and losses related
to changes in fair value are reported in the income statement.
2. If a company chooses to use the fair value option, it must measure this instrument at
fair value until the company no longer has ownership.
D. Impairment of Value
1. If a decline is judged to be other than temporary, the cost basis of the individual
security is written down to a new cost basis. The amount of the writedown is accounted
for as a realized loss.
a.

For debt securities, a company uses an impairment test to determine whether it is


probable that the investor will be unable to collect all amounts due according to
the contractual terms.

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17-17

b.

For equity securities, the guideline is less precise. Any time realizable value is
lower than the carrying amount of the investment, an impairment must be
considered.

E. (L.O. 6)Reclassification Adjustments.


1.

Reclassification adjustments to reclassify are made to prevent double counting


when realized gains or losses are reported as part of net income and as part of
other comprehensive income in the current period or previous periods.

2.

The adjustment may be shown on the face of the financial statement in which
comprehensive income is reported, or

3.

It may be disclosed in the notes to the financial statements.

F. Transfers Between Categories.


1.

Transfers between any of the categories are accounted for at fair value.

2.

The fair value rule assures that a company cannot escape recognition of fair
value by simply transferring securities to the held-to-maturity category.
TEACHING TIP

Illustration 17-4 provides a summary table of accounting for transfers.


TEACHING TIP

Illustration 17-5 provides a summary chart of the reporting requirements for major debt and
equity securities.
*G.(L. O. 7) Accounting for Derivative Investments.
1. Understanding Derivatives.
a.

Forward Contracts. Results in the buyer receiving a right and an obligation to


purchase in the future.

b.

Open Contracts. Results in the buyer receiving a right, but not an obligation to
purchase in the future.

2. Who Uses Derivatives, and Why?

17-18

a.

Producers and consumers.

b.

Speculators and arbitrageurs.

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3. Accounting for Derivatives.


a.

Recognized as assets and liabilities in the financial statements.

b.

Reported at fair value.

c.

Gains and losses from speculation in derivatives are recognized in income


immediately.

d.

Gains and losses from hedge transactions are reported in accordance with the
type of hedge.

4. Accounting for Derivative Financial Instruments Held for Speculation.


a.

A call option gives the holder the right, but not the obligation, to buy shares at
a preset price (strike price or exercise price).

b.

Accounting entries:
(1) To record the purchase price (option premium) of a call option:
Dr. Call Option
Cr. Cash
(2) Option premium = Intrinsic value + Time value = The payment
a.

Intrinsic value = Market price Preset strike price

b.

Time value is estimated using an option-pricing model and is the options


value over and above its intrinsic value. It reflects the possibility the market
price will increase above the strike price.

(3) To record an increase in the intrinsic value of an option:


Dr. Call Option
Cr. Unrealized Holding Gain or LossIncome
(4) To record a decrease in the time value of the option:
Dr. Unrealized Holding Gain or LossIncome
Cr. Call Option
c.

Financial statement reporting.


(1) A call option is reported as an asset at fair value.
(2) Any gains or losses are reported in income.

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17-19

5. Derivative instruments have three basic characteristics.


a.

The instrument has (1) one or more underlyings and (2) an identified payment
provision.

b.

The instrument requires little or no investment at the inception of the contract.

c.

The instrument requires or permits net settlement.

6. Hedging.
a.

Hedging is the use of derivatives to reduce interest rate risk and exchange rate risk.
(1) Interest rate risk is risk that changes in interest rates will negatively affect
the fair-values or cash flow of interest sensitive assets and liabilities.
(2) Exchange rate risk is the risk of foreign exchange rates negatively affecting
profits.

*H. (L. O. 8) Fair Value Hedge.


1. A fair value hedge is a derivative used to hedge (offset) the exposure to changes in the
fair value of a recognized asset or liability, or of an unrecognized commitment is a fair
value hedge.
a.

Interest rate swaps are used to hedge the risk that changes in interest rates will
have on fair value of debt obligations.

b.

Put options areused to hedge the risk that an equity investment will decline
in value.

2. Journal entries to account for a put option.


a.

To record a purchase, assuming no premium is paid: A memo entry only.

b.

Once the hedge is designated, accounting for any unrealized gain or loss on
available-for-sale securities is recorded in income, not in equity.

c.

To record an increase in the value of the put option:


Dr. Put Option
Cr. Unrealized Holding Gain or LossIncome

3. Financial statement disclosure of fair value hedges.


a.

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On the balance sheet, both the investment security and the put option are reported
at fair value.

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b.

On the income statement,any unrealized gain or loss on the investment security


and the put option are reported under Other Income or Other Expense.

*I. (L.O. 9)Cash Flow Hedge.


1. A cash flow hedge is used to hedge cash flow risk and is reported on the balance sheet
at fair value.
2. Any gains or losses on the hedge are recorded in equity as part of other
comprehensive income.
3. A futures contractgives the holder the right and obligation to purchase an asset at a
preset price for a specified period of time.
4. A spot price is the price to be paid today for an asset to be delivered sometime in the
future.
5. Journal entries to record cash flow hedging:
a.

To record the signing of a futures contract (assuming spot price and contract price
are equal): Memo entry.

b.

To record an increase in value of futures contract due to an increase in the spot


price.
Dr. Futures Contract
Cr. Unrealized Holding Gain or LossEquity

c.

To record the settlement of a futures contract (assuming spot price exceeded


contract price):
Dr. Cash
Cr. Futures Contract

d.

To record the disposition of an unrealized loss when goods are sold:


Dr. Unrealized Holding Gain or LossEquity
Cr. Cost of Goods Sold

*J. (L.O. 10)Other Reporting Issues.


1. Embedded derivatives.
a.

Bifurcation is the separation of the hybrid security from the host security.

2. Qualifying hedge criteria.


a.

Documentation, risk management, and designation.

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17-21

b.
c.

Effectiveness of the hedging relationship.


Effect on reported earnings of changes in fair values or cash flows.
TEACHING TIP

Use Illustration 17-6 to provide a summary of derivatives accounting.


*K. (L.O. 11)Appendix 17B.Variable-Interest Entities.
1. A variable-interest entity (VIE) has one of the following characteristics.
a.

Insufficient equity investment at risk.

b.

Stockholders lack decision-making rights.

c.

Stockholders do not absorb the losses or receive the benefits of a normal stockholder.

2. VIE models for consolidation.


a.

Voting-interest model. If a company owns more than 50% of another companys


voting stock, it must consolidate.

b.

Risk-and-reward model. If a company is involved substantially in the economics of


another company, it must consolidate.
TEACHING TIP

Use Illustration 17-7 to discuss when to consolidate a variable-interest entity.


c.

The primary beneficiary is the party exposed to the majority of the risks and
rewards associated with a VIE.

*L. (L.O. 12) Fair Value Disclosures.


1.

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.

2.

Reasons for additional disclosure beyond itemizing fair values:

17-22

a.

Differing levels of reliability exist in the measurement of fair value information.

b.

Changes in the fair value of financial instruments are reported differently in the
financial statements, depending on the type of financial instrument involved and
whether the fair value option is employed.

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17-23

3.

Additional disclosures
a.

The carrying amount and the fair value of the companys financial instruments
segregated by level of reliability.

b.

A reconciliation of the balance from the beginning of the period.

c.

The impact of changes in fair value on the net assets of the company from one
period to the next.

d.

Quantitative information about significant unobservable inputs used for all Level 3
measurements.

e.

A qualitative discussion about the sensitivity of recurring Level 3 measurements to


changes in the unobservable inputs disclosed, including interrelationships
between inputs.

f.

A description of the companys valuation process.

g.

Any transfers between Levels 1 and 2 of the fair value hierarchy.

h.

Information about nonfinancial assets measured at fair value at amounts that differ
from the assets highest and best use.

i.

The proper hierarchy classification for items that are not recognized on the
balance sheet but are disclosed in the notes to the financial statements.

*M. IFRS Insights


1.

(L.O. 13) The accounting for investments is discussed in IAS 27 (Consolidated and
Separate Financial Statements), IAS 28 (Accounting for Investments in Associates),
IAS 39 (Financial Instruments: Recognition and Measurement), and IFRS 9
(Financial Instruments).

2.

Similarities

17-24

a.

GAAP and IFRS use similar classifications and differences between GAAP and
IFRS related to investments.

b.

The accounting for trading investments is the same between GAAP and IFRS.
Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted
for at amortized cost. Gains and losses on some investments are reported in other
comprehensive income.

c.

Both GAAP and IFRS use the same test to determine whether the equity method
of accounting should be used, that is, significant influence with a general guideline
of over 20 percent ownership.

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3.

d.

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.

e.

The measurement of impairments is similar under GAAP and IFRS.

Differences
a.

While 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.

b.

The basis for consolidation under IFRS is control. Under GAAP, a bipolar
approach is used, which is a risk-and-reward model (often referred to as a
variable-entity approach, discussed in Appendix 17B) and a voting-interest
approach. However, under both systems, for consolidation to occur, the investor
company must generally own 50 percent of another company.

c.

While the measurement of impairments is similar under GAAP and IFRS, GAAP
does not permit the reversal of an impairment charge related to available-for-sale
debt and equity investments. IFRS allows reversals of impairments of held-forcollection investments.

d.

While GAAP and IFRS are similar in the accounting for the fair value option, one
difference is that GAAP permits the fair value option for equity method
investments; IFRS does not.

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17-25

ILLUSTRATION 17-1
ACCOUNTING FOR DEBT SECURITIES BY CATEGORY

17-26

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17-27

ILLUSTRATION 17-2
ACCOUNTING FOR HELD-TO-MATURITY SECURITIES

17-28

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ILLUSTRATION 17-3
ACCOUNTING AND REPORTING FOR EQUITY
SECURITIES BY CATEGORY

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17-29

17-30

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ILLUSTRATION 17-4
ACCOUNTING FOR TRANSFERS BETWEEN INVESTMENT
CATEGORIES

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17-31

17-32

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ILLUSTRATION 17-5
SUMMARY OF REPORTING OF MAJOR DEBT
AND EQUITY SECURITIES

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17-33

ILLUSTRATION 17-6
SUMMARY OF DERIVATIVE ACCOUNTING UNDER GAAP

17-34

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ILLUSTRATION 17-7
CONSOLIDATE A VARIABLE-INTEREST EQUITY

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17-35

17-36

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