CHAPTER 17 Investments ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions 1 Debt securities 1, 2, 3, 13 Brief Exercises Exercises Problems Concepts for Analysis 1 1, 6 1, 2, 7 (a) Heldtomaturity 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 Availableforsale 1, 6 1, 6 4, 5 (a) Availableforsale 7, 10, 11, 12, 15, 21 5, 8 1, 6, 8, 9, 11, 3, 5, 6, 8, 9, 1, 2, 3 12, 16, 10, 11, 12 19, 20, 21 (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 10 19, 20, 21 18 1, 3 6, 8, 10, 18 9, 10, 12 2, 3, 4 21 8, 9, 10 5, 8, 9, 10, 11, 12 *9 Derivatives 28, 29, 30, 31, 32, 33, 34, 35 22, 23, 24, 25, 26, 27 13, 14, 15, 16, 17, 18 *10 Variable interest entities 36, 37 *11 Fair value disclosures 31 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 171 *This material is dealt with in an Appendix to the chapter 172 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Brief Exercises Exercises Problems Identify the three categories of debt securities and describe the accounting and reporting treatment for each category 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 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 Explain the equity method of accounting and compare it to the fair value method for equity securities 12, 13, 16, 17 Describe the accounting for the fair value option and for impairments of debt and equity investments. 10 18, 19, 20, 21 8, 10, 12 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 variableinterest entities *12 Describe required fair value disclosures Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 173 ASSIGNMENT CHARACTERISTICS TABLE Item Description Level of Difficulty Time (minutes) E171 Investment classifications Simple 5–10 E172 Entries for heldtomaturity securities Simple 10–15 E173 Entries for heldtomaturity securities Simple 15–20 E174 Entries for availableforsale securities Simple 10–15 E175 Effectiveinterest versus straightline bond amortization Simple 20–30 E176 Entries for availableforsale and trading securities Simple 10–15 E177 Trading securities entries Simple 10–15 E178 Availableforsale securities entries and reporting Simple 5–10 E179 Availableforsale securities entries and financial statement presentation Simple 10–15 E1710 Comprehensive income disclosure Moderate 20–25 E1711 Equity securities entries Simple 20–25 E1712 Journal entries for fair value and equity methods Simple 15–20 E1713 Equity method Moderate 10–15 E1714 Equity investment—trading Moderate 10–15 E1715 Equity investments—trading Moderate 15–20 E1716 Fair value and equity method compared Simple 15–20 E1717 Equity method Simple 10–15 E1718 Impairment of debt securities Moderate 15–20 E1719 Fair Value measurement Moderate 15–20 E1720 Fair Value measurement issues Moderate 15–20 E1721 Fair value option Moderate 15–20 *E1722 Derivative transaction Moderate 15–20 *E1723 Fair value hedge Moderate 20–25 *E1724 Cash flow hedge Moderate 20–25 *E1725 Fair value hedge Moderate 15–20 *E1726 Call option Moderate 20–25 *E1727 Cash flow hedge Moderate 25–30 P171 Debt securities Moderate 30–40 P172 Availableforsale debt securities Moderate 30–40 P173 Availableforsale investments Moderate 25–30 P174 Availableforsale debt investments Moderate 25–35 P175 Equity securities entries and disclosures Moderate 25–35 P176 Trading and availableforsale securities entries Simple 25–35 P177 Availableforsale and heldtomaturity debt securities entries Moderate 25–35 P178 Fair value and equity methods Moderate 20–30 174 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) P179 Financial statement presentation of availableforsale investments Moderate 20–30 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 175 ASSIGNMENT CHARACTERISTICS TABLE (Continued) Description Level of Difficulty Time (minutes) P1710 Gain on sale of securities and comprehensive income Moderate 20–30 P1711 Equity investments—availableforsale Complex 35–45 P1712 Availableforsale securities—statement presentation Moderate 20–30 *P1713 Derivative financial instrument Moderate 20–25 *P1714 Derivative financial instrument Moderate 20–25 *P1715 Freestanding derivative Moderate 20–25 *P1716 Fair value hedge interest rate swap Moderate 30–40 *P1717 Cash flow hedge Moderate 25–35 *P1718 Fair value hedge Moderate 25–35 CA171 Issues raised about investment securities Moderate 25–30 CA172 Equity securities Moderate 25–30 CA173 Financial statement effect of equity securities Simple 20–30 CA174 Investment accounted for under the equity method Moderate 20–25 CA175 Equity investment Moderate 25–35 CA176 Fair value Moderate 25–35 Item 176 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) LEARNING OBJECTIVES Identify the three categories of debt securities and describe the accounting and reporting treatment for each category Understand the procedures for discount and premium amortization on bond investments Identify the categories of equity securities and describe the accounting and reporting treatment for each category Explain the equity method of accounting and compare it to the fair value method for equity securities. Describe the accounting for the fair value option and for impairments of debt and equity investments. 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 variableinterest 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 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 177 CHAPTER REVIEW 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 longterm 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 (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 Debt securities are grouped into the following three separate categories: a Heldtomaturity: 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 shortterm price differences c Availableforsale: Debt securities not classified as heldtomaturity or trading securities HeldtoMaturity Debt Securities (L.O. 2) Heldtomaturity debt securities are accounted for at amortized cost, not fair value. Amortization on Bond Investments The effectiveinterest method is required to amortize premium or discount unless some other method—such as the straightline method—yields a similar result. The effective interest method is applied to bond investments in a fashion similar to that described for bonds payable. The effectiveinterest 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 AvailableforSale Debt Securities Availableforsale 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 availableforsale 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 178 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Adjustment (AvailableforSale)” is used instead of debiting or crediting the Availablefor Sale Securities account to enable the company to maintain a record of its amortized cost 7 When an availableforsale 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 availablefor sale securities or trading securities 12 When acquired, availableforsale 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 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 179 value are recorded in an Unrealized Holding Gain or LossEquity 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 (availableforsale) 13 The accounting entries to record trading equity securities are the same as for available forsale 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 policymaking 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 investment’s carrying amount is periodically increased (decreased) by the investor’s 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 investor’s share of the investee’s losses exceeds the carrying amount of the investment, the investor should discontinue applying the equity method and not recognize additional losses (unless the investor’s 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) Workowski’s share is $91,000 ($350,000 × 26%) Equity Investments Investment Income 91,000 91,000 1710 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 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 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 optionpricing model and is the option’s 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 Loss—Income (4) To record a decrease in the time value of the option: Dr. Unrealized Holding Gain or Loss—Income 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 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1719 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 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 fairvalues 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. 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 are used to hedge the risk that an equity investment will decline in value 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 availableforsale 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 Loss—Income Financial statement disclosure of fair value hedges a. On the balance sheet, both the investment security and the put option are reported at fair value 1720 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 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 A cash flow hedge is used to hedge cash flow risk and is reported on the balance sheet at fair value Any gains or losses on the hedge are recorded in equity as part of other comprehensive income A futures contract gives the holder the right and obligation to purchase an asset at a preset price for a specified period of time A spot price is the price to be paid today for an asset to be delivered sometime in the future 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 Loss—Equity 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 Loss—Equity Cr. Cost of Goods Sold *J (L.O. 10) Other Reporting Issues Embedded derivatives a Bifurcation is the separation of the hybrid security from the host security Qualifying hedge criteria a Documentation, risk management, and designation Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1721 b c Effectiveness of the hedging relationship Effect on reported earnings of changes in fair values or cash flows TEACHING TIP Use Illustration 176 to provide a summary of derivatives accounting *K (L.O. 11) Appendix 17B. VariableInterest Entities A variableinterest entity (VIE) has one of the following characteristics a Insufficient equity investment at risk b Stockholders lack decisionmaking rights c Stockholders do not absorb the losses or receive the benefits of a normal stockholder VIE models for consolidation a Votinginterest model. If a company owns more than 50% of another company’s voting stock, it must consolidate b Riskandreward model. If a company is involved substantially in the economics of another company, it must consolidate TEACHING TIP Use Illustration 177 to discuss when to consolidate a variableinterest 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 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 Reasons for additional disclosure beyond itemizing fair values: 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 1722 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Additional disclosures a The carrying amount and the fair value of the company’s 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 company’s 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 (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 (“Financial Instruments”). Similarities 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 Heldtomaturity (GAAP) and heldforcollection (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 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1723 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, availableforsale (both debt and equity investments), and heldtomaturity (only for debt investments), IFRS uses heldforcollection (debt investments), trading (both debt and equity investments), and nontrading equity investment classifications b The basis for consolidation under IFRS is control Under GAAP, a bipolar approach is used, which is a riskandreward model (often referred to as a variableentity approach, discussed in Appendix 17B) and a votinginterest 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 availableforsale debt and equity investments. IFRS allows reversals of impairments of heldfor collection 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 1724 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 171 ACCOUNTING FOR DEBT SECURITIES BY CATEGORY Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1725 ILLUSTRATION 172 ACCOUNTING FOR HELDTOMATURITY SECURITIES 1726 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 173 ACCOUNTING AND REPORTING FOR EQUITY SECURITIES BY CATEGORY Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1727 1728 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 174 ACCOUNTING FOR TRANSFERS BETWEEN INVESTMENT CATEGORIES Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1729 ILLUSTRATION 175 SUMMARY OF REPORTING OF MAJOR DEBT AND EQUITY SECURITIES 1730 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 176 SUMMARY OF DERIVATIVE ACCOUNTING UNDER GAAP Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1731 ILLUSTRATION 177 CONSOLIDATE A VARIABLEINTEREST EQUITY 1732 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1733 ... Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) LEARNING OBJECTIVES Identify the three categories of debt securities and describe the accounting and ... Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 177 CHAPTER REVIEW The problems of accounting for investments involve... Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) TEACHING TIP Illustration 173 indicates how the levels of ownership determine valuation and accounting