Chapter 18

Intermediate Accounting II

Otto Chang

Professor of Accounting

Investment

• In debt securities:– Trading: fair value method– Available for sale: fair value method– Held to maturity: cost method

• In equity securities– Less than 20%: Fair value method– Between 20% to 50%: equity method– Greater than 50%: consolidation method

Held-to-Maturity Debt Securities

• At acquisition: recorded at fair value or present value (face amount adjusted for discount or premium)

• During the year: use effective interest method to amortize discount or premium, adjust investment by the amount amortized.

• Unrealized holding gain or loss is never recognized

Available-for-Sale Debt Securities

• At acquisition: recorded at present valueAvailable-for-sale securities xxx Cash xxx

• Interest received: amortize discount/premium Cash xxxAvailable-for-Sale Securities xxx Interest Revenue xxx

• At year-end: adjusted to fair valueUnrealized Holding Gain or Loss-Equity xxx Securities Fair Value Adjustment xxx • Unrealizable holding gain or loss is other

comprehensive income/stockholder’s equity

Trading Debt Securities

• At acquisition: recorded at fair value or present value

• During the year: discount or premium is not amortized due to the short-term nature

• At year-end, unrealized holding gain and loss is included in income

Unrealized Holding Gain or Loss-Income xxx

Securities Value Adjustment-Trading xxx

Investment in Equity Securities: Holding of Less Than 20%

• At acquisition: recorded at cost acquired, classify as trading or available-for-sale

• Dividend received:Cash xxx Dividend Revenue xxx

• At year-end: adjust to fair valueUnrealized Holding Gain or Loss* xxx Securities Value Adjustment xxx

* Income or Equity depends on type of securities

Equity Method: Holding Between 20% to 50%

• At acquisition:Investment in XYZ Stock xxx Cash xxx

• Recording proportionate share of investee’s income, losses, or extraordinary items

Investment in XYZ Stock xxx Revenues from Investment xxx

• Dividend received:Cash xxx

Investment in XYZ Stock xxx

Equity Method: More Details

• When the purchase price of the stock exceeds the investor’s proportionate share of investee’s book value of net assets, a purchase premium was paid for goodwill or unrecorded assets, annual amortization of this purchase premium is required:

Revenues from Investment xxx

Investment in XYZ stock xxx

Reclassification Adjustment for Gains Included in Income

• When available-for-sale securities are sold, Gains and losses are realized based on the difference between sales proceeds and its original acquisition cost. To avoid double counting, an equal amount of the unrealized holding gain or loss accumulated in the comprehensive income/stockholder’s equity is eliminated

Transfer Between Categories

• Transfer between any two categories are accounted for at fair value.

• From trading (cost $70,000, FV= $85,000) to available-for-sale or held to maturity: unrealized gain or loss recognized at transfer and included in income.Available-for-Sale Securities 85,000

Unrealized Holding Gain-Income 15,000

Trading Securities 70,000

Transfer Between Categories

• From available-for-sale (cost=$80,000, FV=$75,000) or held-to-maturity to trading: unrealized gain or loss recognized at transfer & included in incomeTrading Securities 75,000

Unrealized Holding Loss-Income 5,000

Available-for-sale Securities 80,000

Transfer Between Categories

• From held-to-maturity (cost=$80,000, FV=$90,000) to available-for-sale: unrealized holding gain or loss recognized at transfer and included in other comprehensive income/stockholder equity.Securities Fair Value Adjustment 10,000

Available-for-sale Securities 80,000

Unrealized Holding Gain 10,000

Held-to-maturity Securities 80,000

Transfer Between Categories

• From available-for-sale (cost=$100,000; FV=$104,000) to held-to-maturity (remaining life 10 years): unrealized holding gain or loss recognized at transfer and included in other comprehensive income.

Securities Fair Value Adjustment 4,000Held-to-maturity Securities 100,000 Unrealized Holding Gain-Equity 4,000 Available-for-sale Securities 100,000

Annual Amortization:Unrealized Holding Gain-Equity 400 Securities Fair Value Adjustment 400

Investment in Stock Rights

• At acquisition: base allocation requiredInvestment in Stock Rights xxx Investment in Stock xxx

• If the rights are sold separately:Cash xxx Investment in Stock Rights xxx Gain from sale of Stock Rights xxx

• If the rights are exercised:Investment in Stock xxx Investment in Stock rights xxx Cash xxx

Investment in Stock Rights

• If stock rights are expired:Loss on Expiration of Stock Rights xxx

Investment in Stock Rights xxx

Investment in Life Insurance with Cash Surrender Value

• Payment of periodic insurance premiumInsurance Expenses xxxCash Surrender Value xxx Cash xxx

• Upon receipt of death benefit at death:Cash xxx Cash Surrender Value xxx Insurance expenses xxx (unexpired) Gain on Life Insurance xxx

Accounting for Derivatives

• Example of derivatives– Financial forwards of futures– Options– Swaps

• Who uses derivatives?– Producers and consumers– Speculators and arbitrageours

Why Use Derivatives?

• For speculation and arbitrage profit: taking advantage of price difference in different markets

• Hedging against risk in:– Changes in prices of commodity– Changes in interest rate– Changes in foreign exchange rate

Basic Principles

• Derivatives should be recognized in the financial statements as assets and liabilities

• Derivatives should be reported at fair value.

• Gains and losses from speculation should be recognized immediately in income

• Gains and losses from hedging are reported differently depending on the type of hedge

Accounting for a Call Option-Speculation

• On 1/2/00 when X shares are $100/share, You paid $400 to purchase a call option which allows you to buy1,000 X shares at $100/share on 4/30/00.

Option premium = intrinsic value + time value $400 = $0 + $400 • 1/2/00 Journal entry:

Call Option 400 Cash 400

Call Option Example--continued

• 3/31/00 X shares are traded at $120/shareCall Option 20,000 Unrealized Holding Gain/Loss-Income 20,000

• 3/31/00 Time value of the option is $100Unrealized Holding Gain/Loss-Income 300 Call option ($400 - $100) 300

• 4/1/00 the call option is settled for $20,000Cash 20,000Loss on Settlement of Call Option 100 Call Option 20,100

Fair Value Hedge: Interest Rate Swap Example

• 1/2/00 you issued $1,000,000 of 5-year, 8% fixed rate bonds. You are concerned that interest rate might goes down and you are still locked into the 8% rate. So on the same date, you enter into a swap contract:– You will receive fixed payment at 8% based on

the $1,000,000 on 12/31 of next 5 years– You will pay variable amount based on the

effective variable rate on 12/31 of next 5 years

Journal Entries-Interest Rate Swap

• On 1/2/01 when the contract is signedNo entry required

• On 12/31/01 the variable rate is 6.8%Interest Expense 80,000 Cash (8% x $1000,000) 80,000To record paying cash interest to bondholdersCash 12,000 (80,000 - 68,000) Interest Expense 12,000To record settlement of swap contract

Interest Rate Swap Example-continued

• In addition, the value of the swap contract has increased by $40,000 on 12/31/01Swap Contract 40,000

Unrealized Holding Gain/Loss-Income $40,000

• Because interest rate is going down, the fair value of bond payable increases by $40,000Unrealized Holding Gain/Loss-Income 40,000

Bonds Payable 40,000

Presentation on Financial Statement

• Balance sheet on 12/31/02Current AssetsCurrent Assets: Long-term Liabilities:

Swap Contract $40,000 B/P $1,040,000

• Income Statement for the year of 2001Interest Expense $68,000

Unrealized Holding Gain-Swap Contract $40,000

Unrealized Holding Loss-B/P ($40,000)

Net Gain or loss $0

Cash Flow Hedging from Forecasted Transactions

• On 9/1/00, you expect to buy 1000 tons of materials in 1/1/01. To protect possible price increase, you enter a future contract to give you the right and obligation to purchase the material at $1,550/ton, the market price of the materials on that day

• On 9/1/00 when the contract is signed:No entry required (the value of the contract is $0)

Cash Flow Hedge Example--continued

• On 12/31/00, price increase to $1,575/tonFuture Contract (1,575-1,550)x1,000 25,000 Unrealized Holding Gain/Loss-Equity 25,000

• On 1/1/01 purchased materials at $1,575/tonMaterial Inventory 1,575,000 Cash ($1,575x1,000) 1,575,000To record cash purchase of the materialsCash 25,000 Future Contract 25,000To record settlement of the future contract

Cash Flow Hedge Example --continued

• On 7/1/01, when the finished goods made of the materials were sold for $2,000,000 with total cost of goods sold at $1,700,000. Cash 2,000,000 Sales Revenue 2,000,000Cost of Goods Sold 1,700,000 Finished Good Inventory 1,700,000Unrealized Holding Gain/Loss-Equity 25,000 Cost of Goods Sold 25,000

Qualifying Hedge Criteria

• The special accounting for Hedging can only be applied when:– Designation and documentation of risk

management formally done– Effectiveness of the hedging relationship is

clear evident– There must be an effect on reported earnings of

changes in fair value or cash flows

Disclosure Requirements

• The fair value and carrying value of financial instrument

• The objective of holding the instrument(speculation or hedging), the strategy for achieving risk management

• Separate disclosure (no aggregation)

• Market risk of derivatives