Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter 12 Investments QUESTIONS FOR REVIEW OF KEY TOPICS Question 12-1 Investment securities are classified as “held-to-maturity,” “available-for-sale,” or “trading securities.” Question 12-2 Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are ignored for securities classified as “held-tomaturity.” These changes aren’t important if sale before maturity isn’t an alternative, which is the case if an investor has the “positive intent and ability” to hold the securities to maturity Question 12-3 The fair value of an equity security is considered “readily determinable” if its selling price (or bid-and-asked quotation) is currently available on a securities exchange When its fair value is not readily determinable, an investment is carried and reported at cost Any dividends received are recognized as investment revenue, and a gain or loss is reported only when actually realized through the sale of the investment Question 12-4 For investments to be held for an unspecified period of time, fair value information is more relevant than for investments to be held to maturity Changes in fair values are less relevant if the investment is to be held to maturity because sale at that fair value is not an option The investor receives the same contracted interest payments and principal at maturity, regardless of movements in market values However, when the investment is of unspecified length, changes in fair values indicate management’s success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities Question 12-5 The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as “securities available-for-sale” or as “trading securities.” Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period Rather, they are reported as a separate component of shareholders’ equity, as part of Other comprehensive income Question 12-6 Comprehensive income is a more expansive view of the change in shareholders’ equity than traditional net income It encompasses all changes in equity from nonowner transactions So, in addition to net income, comprehensive income includes up to four other changes in equity: Net unrealized holding gains (losses) on investments, Net unrecognized loss on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign currency translation © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 12-7 Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized Trading securities are actively managed in a trading account with the express intent of profiting from short-term market price changes So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings Question 12-8 Apparently, the drop in the market price of the stock is an other-than-temporary impairment So, when the investment is written down to its fair value, the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in income for the period Subsequent to the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed Therefore, later changes in fair value will be reported as a separate component of shareholders’ equity, accumulated other comprehensive income Question 12-9 When acquired, debt and equity securities are assigned to one of the three reporting classifications – held-to-maturity, available-for-sale, or trading The appropriateness of the classification is reassessed at each reporting date A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred Specifically, when a security is transferred: Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period Into the available-for-sale category, any unrealized holding gain or loss should be recorded as a separate component of shareholders’ equity, Other comprehensive income Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity Question 12-10 Yes Although a company is not required to report individual amounts for the three categories of investments – held-to-maturity, available-for-sale, or trading – on the face of the balance sheet, that information should be presented in the disclosure notes The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type In addition, information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least maturity groupings: (a) within year, (b) after year through years, (c) after years through 10 years, and (d) after 10 years © The McGraw-Hill Companies, Inc., 2007 12-2 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 12-11 The equity method is used when an investor can’t control, but can “significantly influence” the investee If effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders By voting those shares as a block, the investor often can sway decisions in the direction desired We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares Question 12-12 The equity method, like consolidation, views the investor and investee as a special type of single entity By the equity method, though, the investor doesn’t include separate financial statement items of the investee on an item-by-item basis as in consolidation Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements Question 12-13 The investor should account for dividends from the investee as a reduction in the investment account Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends Rather, the dividend distribution is considered to be a reduction of the investee’s net assets, indicating that the investor’s ownership interest in those net assets declines proportionately Question 12-14 The equity method attempts to approximate the effects of accounting for the purchase of the investee as a consolidation Consolidated financial statements report acquired net assets at their fair values Both investment revenue and the investment would be reduced by the negative income effect of the “extra depreciation” the higher fair value would cause This would equal 40% x $12 million ÷ 10 years = $480,000 each year for ten years Question 12-15 The investment account was decreased by $40,000 (40% x $100,000) Cash increased the same amount There is no effect on the income statement © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 12-16 When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment The equity method is simply discontinued and the new method is applied from then on The investment account balance when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements Question 12-17 A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms Accounts payable, bank loans, and investments in securities are examples Question 12-18 These instruments “derive” their values or contractually required cash flows from some other security or index Question 12-19 Since this fund won’t be used within the upcoming operating cycle, it is a noncurrent asset It should be reported as part of “Investments and funds.” Question 12-20 Part of each premium payment the company makes is not used by the insurance company to pay for life insurance coverage, but rather is “invested” on behalf of the insured company in a fixedincome investment As a result, the periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset – cash surrender value Question 12-21 When a creditor’s investment in a receivable becomes impaired, due to a troubled debt restructuring or for any other reason, the receivable is re-measured based on the discounted present value of currently expected cash flows at the loan’s original effective rate (regardless of the extent to which expected cash receipts have been reduced) The extent of the impairment is the difference between the carrying amount of the receivable (the present value of the receivable’s cash flows prior to the restructuring) and the present value of the revised cash flows discounted at the loan’s original effective rate This difference is recorded as a loss at the time the receivable is reduced © The McGraw-Hill Companies, Inc., 2007 12-4 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief Exercise 12-1 (a) Investment in bonds (face amount) Discount on bond investment (difference) Cash (price of bonds) 720,000 Cash (1.5% x $720,000) Discount on bond investment (difference) Interest revenue (2% x $600,000) 10,800 1,200 120,000 600,000 (b) 12,000 Brief Exercise 12-2 Investment in Disney common shares Cash ([2,000 shares x $27] + $900) 54,900 Cash ([2,000 shares x $29] – $950) Gain on sale of investments Investment in Disney common shares 57,050 54,900 2,150 54,900 Brief Exercise 12-3 Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period Rather, they are reported as a separate component of shareholders’ equity, as part of Other comprehensive income The adjusting entry needed to increase the fair value adjustment from $110,000 to $170,000 is: Fair value adjustment ($670,000 – 610,000) Accumulated unrealized holding gains and losses 60,000 60,000 © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 12-4 These are securities available-for-sale and are reported at their fair value, $4,000,000 We know this because securities “held-to-maturity” are debt securities an investor has the “positive intent and ability” to hold to maturity Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The FedEx shares have been held for over a year They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way Of course, the equity method isn’t appropriate either because 40,000 shares of FedEx certainly don’t constitute “significant influence.” Investments in securities available-for-sale are reported at fair value Brief Exercise 12-5 Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in earnings S&L reports its $2,000 holding loss in 2006 earnings When the fair value rises by $7,000 in 2007, that amount is reported in 2007 earnings S&L’s journal entries for these transactions would be: 2006 December 27 Investment in Coca Cola shares Cash 875,000 December 31 Unrealized holding loss Investment in Coca Cola shares ([$875,000 - $873,000) 2,000 875,000 2,000 2007 January Cash (selling price) Gain on investments (to balance) Investment in Coca Cola shares (account balance) 880,000 7,000 873,000 © The McGraw-Hill Companies, Inc., 2007 12-6 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 12-6 Unlike for trading securities, unrealized holding gains and losses for securities available-for-sale are not included in earnings S&L reports its $2,000 holding loss in 2006 as Other comprehensive income, a negative component of shareholders’ equity, not earnings When the fair value rises to $880,000 in 2007, the amount is reported in 2007 earnings is the $5,000 gain realized by the sale of the securities S&L’s journal entries for these transactions would be: 2006 December 27 Investment in Coca Cola shares Cash 875,000 December 31 Unrealized holding loss (shareholders’ equity) Fair value adjustment ($875,000 - $873,000) 2,000 875,000 2,000 2007 January Cash (selling price) Gain on investments (to balance) Investment in Coca Cola shares (cost) 880,000 5,000 875,000 Assuming no other transactions involving securities available-for-sale, the 2007 adjusting entry would be: December 31 Fair value adjustment (balance) Unrealized holding loss (balance) 2,000 2,000 © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 12-7 An investor should account for dividends from an equity method investee as a reduction in its investment account Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends Instead, the dividend distribution is considered to be a reduction of the investee’s net assets, reflecting the fact that the investor’s ownership interest in those net assets declined proportionately Turner’s cash increased by $2 million (40% x $5 million) Its investment account declined by the same amount There is no effect on the income statement Brief Exercise 12-8 An investor should account for dividends from an investment not accounted for by the equity method as investment revenue Since Turner holds only 10% of ICA stock, it’s assumed that it does not have significant influence over the company Turner’s cash increased by $500,000 (10% x $5 million) It also reports $500,000 as investment revenue in the income statement Brief Exercise 12-9 With the equity method we attempt to approximate the effects of accounting for the purchase of the investee as a consolidation Consolidated financial statements report acquired net assets at their fair values Both investment revenue and the investment would be reduced by the negative income effect of the “extra depreciation” the higher fair value would cause This would equal 30% x $50 million ÷ 15 years = $1 million each year for fifteen years © The McGraw-Hill Companies, Inc., 2007 12-8 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 12-10 Because the drop in the market price of stock is considered to be other-thantemporary, LED records the impairment as follows: Impairment loss ($4.50 x $ 100,000 shares) Investment in Branch Pharmaceuticals 450,000 450,000 The investment is written down to its fair value, and the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in LED’s earnings for the period Following the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed Therefore, later changes in fair value will be reported as Other comprehensive income or loss - a separate component of shareholders’ equity Brief Exercise 12-11 The investment would be increased by $12 million Financial statements would be recast to reflect the equity method for each year reported for comparative purposes A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items No If Pioneer changes from the equity method, no adjustment is made to the carrying amount of the investment Instead, the equity method is simply discontinued, and the new method is applied from then on The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements There also would be no revision of prior years, but the change should be described in a disclosure note © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com EXERCISES Exercise 12-1 Requirement Investment in bonds (face amount) Discount on bond investment (difference) Cash (price of bonds) Requirement Cash (3% x $240 million) Discount on bond investment (difference) Interest revenue (4% x $200) ($ in millions) 240 40 200 7.2 8.0 Requirement Tanner-UNF reports its investment in the December 31, 2006, balance sheet at its amortized cost – that is, its book value: Investment in bonds Less: Discount on bond investment ($40 - million) Amortized cost $240.0 39.2 $200.8 If sale before maturity isn’t an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet Requirement Cash (proceeds from sale) Discount on bond investment (balance, determined above) Loss on sale of investments (to balance) Investment in bonds (face amount) ($ in millions) 190.0 39.2 10.8 240.0 © The McGraw-Hill Companies, Inc., 2007 12-10 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 12-11 Requirement ($ in millions) Land Loss on debt restructuring Note receivable Accrued interest receivable 16 20 Requirement ANALYSIS Previous Value: Accrued interest (10% x $20,000,000) Principal Carrying amount of the receivable New Value: Interest $1 million x 3.16987 * Principal $15 million x 0.68301 ** Present value of the receivable Loss: $ 2,000,000 20,000,000 $22,000,000 = = $ 3,169,870 10,245,150 (13,415,020) $ 8,584,980 * present value of an ordinary annuity of $1: n=4, i=10% ** present value of $1: n=4, i=10% JOURNAL ENTRIES January 1, 2006 Loss on troubled debt restructuring (to balance) Accrued interest receivable (10% x $20,000,000) Note receivable ($20,000,000 - $13,415,020) December 31, 2006 Cash (required by new agreement) Note receivable (to balance) Interest revenue (10% x $13,415,020) 8,584,980 2,000,000 6,584,980 1,000,000 341,502 1,341,502 © The McGraw-Hill Companies, Inc., 2007 12-58 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com December 31, 2007 Cash (required by new agreement) Note receivable (to balance) Interest revenue (10% x $13,756,522) 1,000,000 375,652 1,375,652 © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-59 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 12-11 (continued) December 31, 2008 Cash (required by new agreement) Note receivable (to balance) Interest revenue (10% x $14,132,174) 1,000,000 413,217 December 31, 2009 Cash (required by new agreement) Note receivable (to balance) Interest revenue (10% x $14,545,391) 1,000,000 454,609 1,413,217 1,454,609* Cash (required by new agreement) 15,000,000 Note receivable (balance) 15,000,000 * rounded to amortize the note to $15,000,000 (per schedule below) Amortization Schedule – Not required Cash Interest by agreement 1,000,000 1,000,000 1,000,000 1,000,000 4,000,000 Effective Interest 10% x Outstanding Balance 10(13,415,020) = 1,341,502 10(13,756,522) = 1,375,652 10(14,132,174) = 1,413,217 10(14,545,391) = 1,454,609* 5,584,980 Increase in Balance Discount Reduction 341,502 375,652 413,217 454,609 1,584,980 Outstanding Balance 13,415,020 13,756,522 14,132,174 14,545,391 15,000,000 * rounded © The McGraw-Hill Companies, Inc., 2007 12-60 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 12-11 (continued) Requirement ANALYSIS Previous Value: Accrued interest (10% x $20,000,000) Principal Carrying amount of the receivable New Value: $27,775,000 x 0.68301 * = Loss: $ 2,000,000 20,000,000 $22,000,000 (18,970,603) $ 3,029,397 * present value of $1: n=4, i=10% JOURNAL ENTRIES January 1, 2006 Loss on troubled debt restructuring (to balance) Accrued interest receivable (10% x $20,000,000) Note receivable ($20,000,000 - 18,970,603) 3,029,397 2,000,000 1,029,397 December 31, 2006 Note receivable (to balance) Interest revenue (10% x $18,970,603) 1,897,060 December 31, 2007 Note receivable (to balance) Interest revenue (10% x [$18,970,603 + 1,897,060]) 2,086,766 December 31, 2008 Note receivable (to balance) Interest revenue (10% x balance [see schedule]) 2,295,443 December 31, 2009 Note receivable (to balance) Interest revenue (10% x balance [see schedule]) 2,525,128 1,897,060 2,086,766 2,295,443 2,525,128* Cash (required by new agreement) 27,775,000 Note receivable (balance) 27,775,000 * rounded to amortize the note to $27,775,000 (per schedule below) © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-61 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 12-11 (concluded) Amortization Schedule – Not required Cash Interest by agreement 0 0 Effective Increase in Interest Balance 10% x Outstanding Balance Discount Reduction 10 (18,970,603) 10 (20,867,663) 10 (22,954,429) 10 (25,249,872) = 1,897,060 = 2,086,766 = 2,295,443 = 2,525,128* 8,804,397 1,897,060 2,086,766 2,295,443 2,525,128 8,804,397 Outstanding Balance 18,970,603 20,867,663 22,954,429 25,249,872 27,775,000 * rounded © The McGraw-Hill Companies, Inc., 2007 12-62 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com CASES Real World Case 12-1 Requirement December 31, 2004 ($ in millions) Securities available-for-sale $90 Fair value adjustment ($42 + 25) 67 Investment (fair value) $157 Requirement ($ in millions) Securities Available-for-Sale EarthLink shares Cost $90 Unrealized Fair Value Gain (Loss) $157 $ 67 Moving from a positive $61** (2003) to a positive $67 requires an increase of $6: + 61 +67* + -> * $42 + 25 (tax) ** at year-end 2003, the gross (pre-tax) accumulated unrealized holding gains were $38 + 23 = $61 million December 31, 2004 Fair value adjustment ($61 debit to $67 debit) Net unrealized holding gains and losses ($61 credit to $67 credit) ($ in millions) 6 © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-63 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 12-1 (concluded) Requirement No, this does not imply that the securities involved had not previously been written up above the original cost Holding gains and losses from securities available-for-sale are included in earnings when they are realized by selling the securities When Sprint sold the EarthLink securities, the fair value of the shares had apparently been written up in previous years (securities “primarily made up of EarthLink common stock” had produced unrealized holding gains) Those gains weren’t recognized in prior earnings because they weren’t yet realized by selling the investment Now, the gain is recognized in 2004 when it is actually realized: Cash (to balance) Gain on sale of investments (given) Investment in securities (determined below) ($ in millions) 8.59 1.50 7.09 Calculation of cost: $134.0 million ÷ 18.9 million $7.09 1.0 million $7.09 million Cost at 2003 year-end Shares at 2003 year-end Average cost per share Shares sold Cost of shares sold © The McGraw-Hill Companies, Inc., 2007 12-64 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 12-2 [Note: This case encourages the student to reference actual annual reports.] The footnote that describes an investment in securities “available-for-sale” may be headed by any one of a variety of captions or subsumed within another disclosure note Likewise, the caption by which the investments are reported in the balance sheet can be reported separately as one of several asset titles or included within another asset caption They will be reported as current or noncurrent assets depending on the intent of management regarding the timing of their eventual sale Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported Investments in securities available-for-sale are reported at fair value Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period Rather, they are accumulated and reported as accumulated other comprehensive income, a separate component of shareholders’ equity This means an unrealized holding gain would increase shareholders’ equity and an unrealized holding loss would decrease shareholders’ equity Because unrealized gains or losses cause changes in shareholders’ equity, those changes are reported in the statement of shareholders’ equity [Some companies may not provide a statement of shareholders’ equity and may provide a statement of retained earnings instead Unrealized gains or losses have no effect on retained earnings.] By definition, securities available-for-sale are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings Cash outflows from acquiring these investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows Whether they are specifically identifiable depends on the degree of detail the company uses in reporting its cash flows Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds A disclosure note may provide information not available in the financial statements, in part dependent on how much information the financial statements provide Often the footnote will indicate the cost of the securities © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-65 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Integrating Case 12-3 SFAS 115, “Accounting For Certain Investments in Debt and Equity Securities,” follows a “mixed” approach to transition to the new standard It calls for either a current approach or a prospective approach Certain investments that previously were reported at lower of cost or market were required by the new Standard to be reported instead at their fair values Fair values were not to be reported retrospectively, but only from the effective date of the Standard forward However, the cumulative income effect of holding gains and losses created in years before the change are reported by either a current approach or a prospective approach For securities classified as “available-for-sale,” unrealized holding gains and losses are reported as part of Accumulated other comprehensive income within shareholders’ equity as of the beginning of the year of adoption Unrealized holding gains and losses for securities classified as “trading securities” were reported in earnings of the year of adoption as the cumulative effect of a change in accounting principle Pro forma effects are not reported Trueblood Accounting Case 12-4 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series These are available to instructors at: www.deloitte.com/more/DTF/cases_subj.htm © The McGraw-Hill Companies, Inc., 2007 12-66 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com International Case 12-5 As stated in Renault’s disclosure note, France, like the United States, uses the “equity method.” However, unlike in the U.S., changes in the net assets of equity method investees are not reported in net income Instead, investment revenue consists of dividends received Another difference relates to non-equity investments These are valued at the lower of cost or fair market value In the U.S., they are classified as trading, available-for-sale, or held-to-maturity Trading and available-for-sale securities are reported at fair value; held-to-maturity at amortized cost Research Case 12-6 Answers to the questions will, of course, vary because students will research financial statements of different companies The responses should identify securities held that are classified as trading securities, available-for-sale, or held-to-maturity Although a company is not required to report individual amounts for the three categories of investments – heldto-maturity, available-for-sale, or trading – on the face of the balance sheet, that information should be presented in the disclosure notes If securities available-forsale are held, there may be unrealized gains or losses reported in the shareholders’ equity section of the balance sheet Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period Instead, they are reported as a separate component of shareholders’ equity Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities There may also be gains or losses from the sale of investments during the year There also will likely be investment revenue (dividends or interest) in the income statement The statement of cash flows will report acquisitions or disposals of investments as investing activities Investment revenue is an operating activity © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-67 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 12-7 Requirement The 2004 balance sheet reports the following two current and one noncurrent asset categories ($ in millions): 2004 2003 CURRENT ASSETS: Cash and cash equivalents $2,878.8 $1,201.0 Short-term investments $4,211.1 $2,972.0 $ 6,727.1 $7,941.2 NONCURRENT ASSETS: Investments In the summary of significant accounting policies (Note 2), Merck describes its policy regarding investments classified as "cash equivalents." It is consistent with the way most companies classify "cash equivalents." CASH AND CASH EQUIVALENTS Cash equivalents are comprised of certain highly liquid investments with original maturities of less than three months © The McGraw-Hill Companies, Inc., 2007 12-68 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 12-7 (continued) Requirement Merck (in the summary of significant accounting policies) describes its policy regarding its available-for-sale securities in keeping with SFAS 115: INVESTMENTS - Investments classified as available-for-sale are reported at fair value, with unrealized gains or losses, to the extent not hedged, reported net of tax and minority interests, in Accumulated other comprehensive income Investments in debt securities classified as held-to-maturity, consistent with management’s intent, are reported at cost Impairment losses are charged to Other (income) expense, net, for other-than-temporary declines in fair value The Company considers available evidence in evaluating potential impairment of its investments, including the duration and extent to which fair value is less than cost and the Company’s ability and intent to hold the investment Investments in securities available-for-sale are reported at fair value Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period Rather, they are accumulated and reported as a separate component of shareholders’ equity This means an unrealized holding gain would increase shareholders’ equity and an unrealized holding loss would decrease shareholders’ equity Because unrealized gains or losses cause changes in shareholders’ equity, those changes are reported in the statement of shareholders’ equity In the balance sheet, unrealized gains or losses may be reported under that title, as "other" shareholders’ equity, or some different caption Gross unrealized holding gains and losses of Merck are reflected as adjustments to "accumulated other comprehensive income," net of related income taxes Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-69 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 12-7 (continued) Requirement Investments accounted for using the equity method are described in the note: Joint Ventures and Other Equity Method Affiliates (in part) In 2000, the Company and Schering-Plough Corporation (Schering-Plough) entered into agreements to create separate equally-owned partnerships to develop and market in the United States new prescription medicines in the cholesterolmanagement and respiratory therapeutic areas … The results from the Company’s interest in the Merck/ Schering-Plough partnership are recorded in Equity income from affiliates and were income of $132.0 million in 2004 and losses of $92.5 million and $147.4 million in 2003 and 2002, respectively In addition, Merck earns certain Partnership returns, which are recorded in Equity income from affiliates Such returns include a priority return provided for in the Partnership Agreement, variable returns based, in part, upon sales of certain former Astra USA, Inc products, and a preferential return representing Merck’s share of undistributed AZLP GAAP earnings These returns aggregated $646.5 million, $391.5 million and $640.2 million in 2004, 2003 and 2002, respectively The decrease in 2003 is attributable to a reduction in the preferential return, primarily resulting from the impact of generic competition for Prilosec Investments in affiliates accounted for using the equity method, including the above joint ventures, totaled $2.5 billion at December 31, 2004 and $2.2 billion at December 2003 These amounts are reported in Other assets Dividends and distributions received from these affiliates were $587.0 million in 2004, $553.4 million in 2003 and $488.6 million in 2002 © The McGraw-Hill Companies, Inc., 2007 12-70 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 12-7 (concluded) Requirement Merck reported losses from these investments in 2004, 2003, and 2002 ($ in millions): Equity income from affiliates (1,008.2 ) (474.2 ) (644.7 ) Unrealized holding gains and losses from available-for-sale securities are not reported in the income statement Requirement Cash outflows from acquiring these investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows Whether they are specifically identifiable depends on the degree of dissagregation the company uses in reporting its cash flows Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-71 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 12-8 Requirement The note indicates Unrealized holding losses during 2004 in the amount of $1,846 million This is not the amount Microsoft would include as a separate component of shareholders’ equity Actually, the balance sheet amount is the Accumulated net unrealized holding gains That is, over time, there have been, presumably, both unrealized gains and losses This is the net, accumulated amount The 2004 amount in the disclosure note is the 2004 addition to the accumulated amount Requirement Reclassification adjustment for losses included in net income refers to unrealized holding losses that occurred in periods prior to the period in which the securities are sold Holding gains and losses from securities available-for-sale are included in earnings when they are realized by selling the securities When Microsoft sold securities in 2004, the entire decrease in the fair value of the shares since the investment was acquired was included in earnings The portion of that decline that occurred prior to 2004, but wasn’t recognized in prior earnings because it wasn’t yet realized by selling the investment, is what Microsoft refers to as its reclassification adjustment Net income in 2004 includes the $973 million realized losses However, $973 million of that amount already has been reported in comprehensive income – as unrealized holding losses in periods when the price decline occurred To avoid double-counting, Microsoft compensates by increasing comprehensive income by the $973 million of 2004 realized losses that already have been reported That’s what the reclassification adjustment does; it adjusts this year’s comprehensive income by the amount that was reported previously to keep it from being reported twice Requirement In addition to net income, comprehensive income includes up to four other changes in equity: Net unrealized holding gains (losses) on investments, Net unrecognized loss on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign currency translation Three of these – Net gains (losses) on derivative instruments, Net unrealized holding gains (losses) on investments, and Gains (losses) from foreign currency translation – are specifically mentioned in Microsoft’s disclosure note, so “other” refers to Net unrecognized loss on pensions © The McGraw-Hill Companies, Inc., 2007 12-72 Intermediate Accounting, 4e ... (d) after 10 years © The McGraw-Hill Companies, Inc., 2007 12-2 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions... receivable is reduced © The McGraw-Hill Companies, Inc., 2007 12-4 Intermediate Accounting, 4e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief... losses 60,000 60,000 © The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol 1, Chapter 12 12-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise