CH 17 Investments

Chapter
17-1
CHAPTER 17
INVESTMENTS
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
17-2
Learning
Learning Objectives
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.
6. Discuss the accounting for impairments of debt and equity investments.
7. Explain why companies report reclassification adjustments.
8. Describe the accounting for transfer of investment securities between
categories.
Chapter
17-3
Investments
Investments
Investments in Investments in Other Reporting

Debt Securities Equity Securities Issues
Held-to-maturity Holdings of less than Impairment of value

securities 20%
Reclassification
Available-for-sale Holdings between 20% adjustments
securities and 50%
Transfers between
Trading securities Holdings of more than categories
50%
Fair value
Fair value option controversy
Summary
Chapter
17-4
Investment
Investment Accounting
Accounting Approaches
Approaches
Different motivations for investing:

To earn a high rate of return.
To secure certain operating or financing

arrangements with another company.
Chapter
17-5
Investment
Investment Accounting
Accounting Approaches
Approaches
Companies account for investments based on

 the type of security (debt or equity) and
 their intent with respect to the investment.
Illustration 17-1
Chapter
17-6
Investments
Investments in
in Debt
Debt Securities
Securities
Debt securities (creditor relationship):
Type Accounting
Category
U.S. government
securities Held-to-maturity
Municipal securities Trading
Corporate bonds Available-for-sale
Convertible debt
Commercial paper
Chapter LO 1 Identify the three categories of debt securities and describe

17-7
the accounting and reporting treatment for each category.
Investments
Investments in
in Debt
Debt Securities
Securities
Accounting for Debt Securities by Category

Illustration 17-2
Chapter LO 1 Identify the three categories of debt securities and describe

17-8
the accounting and reporting treatment for each category.
Held-to-Maturity
Held-to-Maturity Securities
Securities
Classify a debt security as held-to-maturity only

if it has both
(1) the positive intent and
(2) the ability to hold securities to maturity.
Accounted for at amortized cost, not fair value.
Amortize premium or discount using the effective-

interest method unless the straight-line method yields
a similar result.
Chapter LO 2 Understand the procedures for discount and

17-9
premium amortization on bond investments.
Held-to-Maturity
Securities
Illustration: KC Company purchased $100,000 of 8 percent

bonds of Evermaster Corporation on January 1, 2009, at a
discount, paying $92,278. The bonds mature January 1,
2014 and yield 10%; interest is payable each July 1 and
January 1. KC records the investment as follows:
January 1, 2009
Held-to-Maturity Securities 92,278
Cash 92,278

17-10
Held-to-Maturity
Securities
Illustration 17-3
Schedule of
Interest
Revenue and Bond
Discount
Amortization—
Effective-
Interest Method
Chapter LO 2
17-11
Held-to-Maturity
Securities
Illustration: KC Company records the receipt of the first

semiannual interest payment on July 1, 2009, as follows:
July 1, 2009
Cash 4,000
Held-to-Maturity Securities 614
Interest Revenue
4,614

17-12
Held-to-Maturity
Securities
Illustration: KC is on a calendar-year basis, it accrues

interest and amortizes the discount at December 31, 2009,
as follows:
December 31, 2009
Interest Receivable 4,000

Interest Revenue
4,645

17-13
Held-to-Maturity
Securities
Reporting of Held-to-Maturity Securities
Illustration 17-4

17-14
Held-to-Maturity
Securities
Illustration: Assume that KC Company sells its investment

in Evermaster bonds on November 1, 2013, at 99.75 plus
accrued interest. KC records this discount amortization as
follows:
November 1, 2013

Interest Revenue
635
$952 x 4/6 = $635

17-15
Held-to-Maturity
Securities
Computation of the realized gain on sale.

Illustration 17-5
Cash 102,417
Interest Revenue (4/6 x $4,000) 2,667
Held-to-Maturity Securities 99,683
Chapter
Gain on Sale of Securities 67
17-16 LO 2
Debt
Available-for-Sale
Available-for-Sale Securities
Securities Securities
Companies report available-for-sale securities at

 fair value, with
 unrealized holding gains and losses reported as
part of comprehensive income (equity).
Any discount or premium is amortized.

17-17
Debt
Available-for-Sale
Illustration (Single Security): Graff Corporation purchases

$100,000, 10 percent, five-year bonds on January 1, 2009,
with interest payable on July 1 and January 1. The bonds sell
for $108,111, which results in a bond premium of $8,111 and
an effective interest rate of 8 percent. Graff records the
purchase of the bonds on January 1, 2009, as follows.
Available-for-Sale Securities 108,111

Cash 108,111

17-18
Debt
Available-for-Sale
Illustration 17-6
Schedule of
Interest
Revenue and Bond
Premium
Amortization—
Effective-
Interest Method
Chapter
17-19
LO 2
Debt
Available-for-Sale
Illustration (Single Security): The entry to record interest

revenue on July 1, 2009, is as follows.
Cash 5,000
Available-for-Sale Securities 676
Interest Revenue 4,324

17-20
Debt
Available-for-Sale
Illustration (Single Security): At December 31, 2009, Graff

makes the following entry to recognize interest revenue.
Interest Receivable 5,000

Available-for-Sale Securities 703
Interest Revenue 4,297
Graff reports revenue for 2009 of $8,621 ($4,324 + $4,297).

17-21
Debt
Available-for-Sale
Illustration (Single Security): To apply the fair value

method to these debt securities, assume that at year-end
the fair value of the bonds is $105,000 and that the
carrying amount of the investments is $106,732. Graff
makes the following entry.
Unrealized Holding Gain or Loss—Equity 1,732

Securities Fair Value Adjustment (AFS) 1,732

17-22
Debt
Available-for-Sale
Illustration (Portfolio of Securities): Webb Corporation has

two debt securities classified as available-for-sale. The
following illustration identifies the amortized cost, fair
value, and the amount of the unrealized gain or loss.
Illustration 17-7

17-23
Debt
Available-for-Sale
Illustration (Portfolio of Securities): Webb makes an

adjusting entry to a valuation allowance on December 31,
2010 to record the decrease in value and to record the loss
as follows.

Webb reports the unrealized holding loss of $9,537 as other

comprehensive income and a reduction of stockholders’ equity.

17-24
Debt
Available-for-Sale
Sale of Available-for-Sale Securities

If company sells bonds before maturity date:
Must make entry to remove the,

 Cost in Available-for-Sale Securities and
 Securities Fair Value Adjustment accounts.
Any realized gain or loss on sale is reported in the

“Other expenses and losses” section of the income
statement.

17-25
Debt
Available-for-Sale
Illustration (Sale of Available-for-Sale Securities): Webb

Corporation sold the Watson bonds (from Illustration 17-7)
on July 1, 2011, for $90,000, at which time it had an
amortized cost of $94,214.
Illustration 17-8
Cash 90,000
Loss on Sale of Securities 4,214
17-26
Debt
Available-for-Sale
Illustration (Sale of Available-for-Sale Securities):

Webb reports this realized loss in the “Other expenses and
losses” section of the income statement. Assuming no other
purchases and sales of bonds in 2011, Webb on December 31,
2011, prepares the information:
Illustration 17-9

17-27
Debt
Available-for-Sale
Illustration (Sale of Available-for-Sale Securities):

Webb records the following at December 31, 2011.
Illustration 17-9

17-28
Debt
Available-for-Sale
Financial Statement Presentation

Illustration 17-10

17-29
Debt
Trading
Trading Securities
Companies report trading securities at

 fair value, with
 unrealized holding gains and losses reported as
part of net income.
Any discount or premium is amortized.

17-30
Debt
Trading
Trading Securities
Illustration: On December 31, 2010, Western Publishing

Corporation determined its trading securities portfolio to
be as follows:
Illustration 17-11

17-31
Debt
Trading
Trading Securities
Illustration: At December 31, Western Publishing makes

an adjusting entry:
Illustration 17-11
Securities Fair Value Adjustment (Trading) 3,750

Unrealized Holding Gain or Loss—Income 3,750
17-32
Debt
Trading
Trading Securities
BE17-4: (Trading Securities) Hendricks Corporation

purchased trading investment bonds for $50,000 at par.
At December 31, Hendricks received annual interest of
$2,000, and the fair value of the bonds was $47,400.
Instructions:
(a) Prepare the journal entry for the purchase of the
investment.
(b) Prepare the journal entry for the interest received.
(c) Prepare the journal entry for the fair value
adjustment.
17-33
Debt
Trading
Trading Securities
BE17-4: Prepare the journal entries for (a) the purchase of

the investment, (b) the interest received, and (c) the fair value
adjustment.
(a) Trading securities 50,000

Cash 50,000
(b) Cash 2,000

Interest revenue 2,000
(c) Unrealized Holding Loss - Income 2,600

Securities Fair Value Adj.- Trading 2,600

17-34
Investments
Investments in
in Equity
Equity Securities
Securities
Represent ownership of capital stock.
Cost includes:
 price of the security, plus
 broker’s commissions and fees related to purchase.
The degree to which one corporation (investor) acquires

an interest in the common stock of another corporation
(investee) generally determines the accounting
treatment for the investment subsequent to acquisition.
Chapter LO 3 Identify the categories of equity securities and describe the

17-35
Investments
Investments in
in Equity
Equity Securities
Securities
Ownership Percentages
0 --------------20% ------------ 50% -------------- 100%

SFAS 115 APBO 18, SFAS 141,
SFAS 142 SFAS 142
No significant Significant Control

influence influence usually exists
usually exists usually exists
Investment Investment Investment valued on

valued using valued using parent’s books using Cost
Fair Value Equity Method or Equity Method
Method Method (investment eliminated in
Consolidation)
17-36
Investments
Investments in
in Equity
Equity Securities
Securities
Accounting and Reporting for Equity Securities by Category
Illustration 17-13

17-37
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Accounting Subsequent to Acquisition
Market Price Market Price

Available Unavailable
Value and report the Value and report the
investment using the investment using the
fair value method. cost method.*
* Securities are reported at cost. Dividends are recognized when

received and gains or losses only recognized on sale of securities.

17-38
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Upon acquisition, companies record available-for-sale
securities at cost.
Illustration: On November 3, 2010 Republic Corporation
purchased common stock of three companies, each investment
representing less than a 20 percent interest.

17-39
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Illustration: Republic records these investments on
November 3, 2010, as follows.

Cash 718,550
On December 6, 2010, Republic receives a cash dividend of

$4,200 from Campbell Soup Co.
Cash 4,200
Dividend revenue 4,200
17-40
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Illustration: Republic’s available-for-sale equity security
portfolio on December 31, 2010:
Illustration 17-14

17-41
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Illustration: On December 31, 2010, Republic records the
net unrealized gains and losses related to changes in the fair
value of available-for-Sale equity securities in an Unrealized
Holding Gain or Loss—Equity account.


17-42
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Illustration: On January 23, 2011, Republic sold all of its
Northwest Industries, Inc. common stock receiving net
proceeds of $287,220. Illustration 17-15
Cash 287,220
259,700
Chapter Gain
LO on Sale of
3 Identify theStock
categories of equity securities and describe the
17-43
accounting and reporting treatment for27,520
each category.
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Illustration: On February 10, 2011, Republic purchased
20,000 shares of Continental Trucking at a price of $12.75
per share plus brokerage commissions of $1,850 (total cost,
$256,850).
Illustration 17-16

17-44
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
Illustration 17-16
Illustration:

17-45
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
P17-6: McElroy Company has the following portfolio of
securities at September 30, 2010, its last reporting date.
Trading Securities Cost Fair Value

Horton, Inc. common (5,000 shares) $ 215,000 $ 200,000
Monty, Inc. preferred (3,500 shares) 133,000 140,000
Oakwood Corp. common (1,000 shares) 180,000 179,000
On Oct. 10, 2010, the Horton shares were sold at a price of

$54 per share. In addition, 3,000 shares of Patriot common
stock were acquired at $54.50 per share on Nov. 2, 2010. The
Dec. 31, 2010, fair values were: Monty $106,000, Patriot
$132,000, and the Oakwood common $193,000.

17-46
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
P17-6: Prepare the journal entries to record the sale, purchase,
and adjusting entries related to the trading securities in the last
quarter of 2010.
Portfolio at September 30, 2010

17-47
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
P17-6: Prepare the journal entries to record the sale, purchase,
and adjusting entries related to the trading securities in the last
quarter of 2010.
October 10, 2010 (Horton):

Cash (5,000 x $54) 270,000
Trading securities 215,000
Gain on sale 55,000
November 2, 2010 (Monty):

Trading securities (3,000 x $54.50) 163,500
Cash 163,500

17-48
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
P17-6: Portfolio at December 31, 2010
December 31, 2010:

Unrealized holding loss - Income 36,500
Securities fair value adj. - Trading 36,500
17-49
Holdings
Holdings of
of Less
Less Than
Than 20%
20%
P17-6: How would the entries change if the securities
were classified as available-for-sale?
The entries would be the same except that the
Unrealized Holding Gain or Loss—Equity account is used

instead of Unrealized Holding Gain or Loss—Income.
The unrealized holding loss would be deducted from the

stockholders’ equity section rather than charged to the
income statement.

17-50
Holdings
Holdings Between
Between 20%
20% and
and 50%
50%
An investment (direct or indirect) of 20 percent or

more of the voting stock of an investee should lead to a
presumption that in the absence of evidence to the
contrary, an investor has the ability to exercise
significant influence over an investee.
In instances of “significant influence,” the investor

must account for the investment using the equity
method.
Chapter LO 4 Explain the equity method of accounting and compare

17-51
it to the fair value method for equity securities.
Holdings
Holdings Between
Between 20%
20% and
and 50%
50%
Equity Method
Record the investment at cost and subsequently
adjust the amount each period for
 the investor’s proportionate share of the
earnings (losses) and
 dividends received by the investor.
If investor’s share of investee’s losses exceeds the carrying

amount of the investment, the investor ordinarily should
discontinue applying the equity method.
17-52
Holdings
Holdings Between
Between 20%
20% and
and 50%
50%
E17-17: (Equity Method) On January 1, 2010, Meredith
Corporation purchased 25% of the common shares of Pirates
Company for $200,000. During the year, Pirates earned net
income of $80,000 and paid dividends of $20,000.
Instructions: Prepare the entries for Meredith to record
the purchase and any additional entries related to this
investment in Pirates Company in 2010.

17-53
Holdings
Holdings Between
Between 20%
20% and
and 50%
50%
E17-17: Prepare the entries for Meredith to record the
purchase and any additional entries related to this investment
in Pirates Company in 2010.
Investment in Stock 200,000

Cash 200,000
Investment in Stock 20,000

Investment Revenue ($80,000 x 25%) 20,000
Cash 5,000
Investment in Stock ($20,000 x 25%) 5,000

17-54
Holdings
Holdings of
of More
More Than
Than 50%
50%
Controlling Interest - When one corporation acquires a

voting interest of more than 50 percent in another
corporation
 Investor is referred to as the parent.
 Investee is referred to as the subsidiary.
 Investment in the subsidiary is reported on the

parent’s books as a long-term investment.
 Parent generally prepares consolidated financial
statements.
17-55
Fair
Fair Value
Value Option
Option
Companies have the option to report most financial

instruments at fair value, with all gains and losses related
to changes in fair value reported in the income statement.
 Applied on an instrument-by-instrument basis.
 Fair value option is generally available only at the time

a company first purchases the financial asset or incurs
a financial liability.
 Company must measure this instrument at fair value

until the company no longer has ownership.
Chapter
17-56 LO 5 Describe the accounting for the fair value option.
Fair
Fair Value
Value Option
Option
Illustration: Hardy Company purchases stock in Fielder Company
during 2010 that it classifies as available-for-sale. At December
31, 2010, the cost of this security is $100,000; its fair value at
December 31, 2010, is $125,000. If Hardy chooses the fair value
option to account for the Fielder Company stock, it makes the
following entry at December 31, 2010.
Investment in Fielder Stock 25,000

Chapter
Fair
Fair Value
Value Option
Option
Equity Method
Illustration: Durham Company holds a 28 percent stake in
Suppan Inc. Durham purchased the investment in 2010 for
$930,000. At December 31, 2010, the fair value of the
investment is $900,000. Durham elects to report the investment
in Suppan using the fair value option. The entry to record this
investment is as follows.

Investment in Suppan Stock 30,000
Chapter
Fair
Fair Value
Value Option
Option
Financial Liabilities
Illustration: Edmonds Company has issued $500,000 of 6%
bonds at face value on May 1, 2010. Edmonds chooses the fair
value option for these bonds. At December 31, 2010, the value of
the bonds is now $480,000 because interest rates in the market
have increased to 8 percent. The value of the debt securities
falls because the bond is paying less than market rate for similar
securities. Under the fair value option, Edmonds makes the
following entry.
Bond payable 20,000

Unrealized holding gain or loss-Income 20,000
Chapter
Other
Other Reporting
Reporting Issues
Issues
Impairment of Value
Impairments of debt and equity securities are
 losses in value that are determined to be other
than temporary,
 based on a fair value test, and
 are charged to income.
Chapter
17-60 LO 6 Discuss the accounting for impairments of debt and equity investments.
Other
Other Reporting
Reporting Issues
Issues
Reclassification Adjustments
The reporting of changes in unrealized gains or losses in
comprehensive income is straightforward unless a company sells
securities during the year.
In that case, double counting results when the company reports
realized gains or losses as part of net income but also shows the
amounts as part of other comprehensive income in the current
period or in previous periods.
To ensure that gains and losses are not counted twice when a sale
occurs, a reclassification adjustment is necessary.
Chapter
17-61 LO 7 Explain why companies report reclassification adjustments.
Other
Other Reporting
Reporting Issues
Issues
Illustration: Open Company has the following two available-for-
sale securities in its portfolio at the end of 2009 (its first year
of operations).
Illustration 17-19
Chapter
Other
Other Reporting
Reporting Issues
Issues
Illustration: If Open Company reports net income in 2009 of
$350,000, it presents a statement of comprehensive income as
follows.
Illustration 17-20
Chapter
Other
Other Reporting
Reporting Issues
Issues
Illustration: During 2010, Open Company sold the Lehman Inc.
common stock for $105,000 and realized a gain on the sale of
$25,000 ($105,000 – $80,000). At the end of 2010, the fair
value of the Woods Co. common stock increased an additional
$20,000, to $155,000.
Illustration 17-21
Chapter
Other
Other Reporting
Reporting Issues
Issues
Illustration: In addition, Open realized a gain of $25,000 on the
sale of the Lehman common stock. Comprehensive income includes
both realized and unrealized components. Therefore, Open
recognizes a total holding gain (loss) in 2010 of $20,000,
computed as follows.
Illustration 17-22
Chapter
Other
Other Reporting
Reporting Issues
Issues
Illustration: Open reports net income of $720,000 in 2010,
which includes the realized gain on sale of the Lehman securities.
Illustration 17-23
Chapter
Other
Other Reporting
Reporting Issues
Issues
Transfers Between Categories

Illustration 17-30
* Assumes that adjusting entries to report changes in fair value for the current period are not
yet recorded.
Chapter LO 8 Describe the accounting for transfer of

17-67 investment securities between categories.
Other
Other Reporting
Reporting Issues
Issues
Transfers Between Categories

Illustration 17-30
Chapter **According to GAAP, these types of LO 8 Describe the accounting for transfer of
17-68 transfers should be rare. investment securities between categories.
Other
Other Reporting
Reporting Issues
Issues
Fair Value Controversy

Measurement Based on Intent
Gains Trading
Liabilities Not Fairly Valued
Subjectivity of Fair Values
Chapter LO 8 Describe the accounting for transfer of

17-69 investment securities between categories.
 The accounting for trading, available-for-sale, and held-to-maturity
securities is essentially the same between iGAAP and U.S. GAAP.
 Gains and losses related to available-for-sale securities are
reported in other comprehensive income under U.S. GAAP. Under
iGAAP, these gains and losses are reported directly in equity.
 Both iGAAP and U.S. GAAP use the same test to determine whether
the equity method of accounting should be used.
 Reclassification in and out of trading securities is prohibited under
iGAAP. It is not prohibited under U.S. GAAP, but this type of
Chapter reclassification should be rare.
17-70
 Under iGAAP, both the investor and an associate company should
follow the same accounting policies.
 The basis for consolidation under iGAAP is control. Under both
systems, for consolidation to occur, the investor company must
generally own 50 percent of another company.
 iGAAP and U.S. GAAP are similar in the accounting for the fair
value option.
 U.S. GAAP does not permit the reversal of an impairment charge
related to available-for-sale debt and equity investments. iGAAP
Chapter permits reversal for available-for-sale debt securities and held-to-
17-71
maturity securities.
Defining Derivatives
Financial instruments that derive their value from values
of other assets (e.g., stocks, bonds, or commodities).
Three different types of derivatives:

1. Financial forwards or financial futures.
2. Options.
3. Swaps.
Chapter
17-72
Who Uses Derivatives, and Why?
 Producers and Consumers
 Speculators and Arbitrageurs
Chapter
17-73 LO 9 Explain who uses derivative and why.
Basic Principles in Accounting for Derivatives
 Recognize derivatives in the financial statements as
assets and liabilities.
 Report derivatives at fair value.
 Recognize gains and losses resulting from

speculation in derivatives immediately in income.
 Report gains and losses resulting from hedge

transactions differently, depending on the type of
hedge.
Chapter
17-74 LO 10 Understand the basic guidelines for accounting for derivatives.
Example of Derivative Financial Instrument-Speculation
Illustration: Assume that a company purchases a call option
contract from Baird Investment Co.,on January 2, 2010, when
Laredo shares are trading at $100 per share. The contract gives
it the option to purchase 1,000 shares (referred to as the
notional amount) of Laredo stock at an option price of $100 per
share. The option expires on April 30, 2010. The company
purchases the call option for $400 and makes the following entry
on January 2, 2010.
Call Option 400 Option

Cash 400 Premium
Chapter
17-75 LO 11 Describe the accounting for derivative financial instruments.
The option premium consists of two amounts.

Illustration 17A-1
Intrinsic value is the difference between the market price and the
preset strike price at any point in time. It represents the amount
realized by the option holder, if exercising the option immediately. On
January 2, 2010, the intrinsic value is zero because the market price
equals the preset strike price.
Chapter
The option premium consists of two amounts.

Illustration 17A-1
Time value refers to the option’s value over and above its intrinsic
value. Time value reflects the possibility that the option has a fair
value greater than zero. How? Because there is some expectation that
the price of Laredo shares will increase above the strike price during
the option term. As indicated, the time value for the option is $400.
Chapter
Additional data available with respect to the call option:
On March 31, 2010, the price of Laredo shares increases to

$120 per share. The intrinsic value of the call option contract is now
$20,000. That is, the company can exercise the call option and
purchase 1,000 shares from Baird Investment for $100 per share.
It can then sell the shares in the market for $120 per share. This
$20,000
gives the company a gain on the option contract of ____________.
($120,000 - $100,000)
Chapter
On March 31, 2010, it records the increase in the intrinsic
value of the option as follows.
Call Option 20,000

A market appraisal indicates that the time value of the option

at March 31, 2010, is $100. The company records this
change in value of the option as follows.
Unrealized Holding Gain or Loss—Income 300

Call Option ($400 - $100) 300
Chapter
At March 31, 2010, the company reports the
 call option in its balance sheet at fair value of

$20,100.
 unrealized holding gain which increases net income.
 loss on the time value of the option which decreases

net income.
Chapter
On April 16, 2010, the company settles the option before
it expires. To properly record the settlement, it updates
the value of the option for the decrease in the intrinsic
value of $5,000 ([$20 - $15]) x 1,000) as follows.

Call option 5,000
The decrease in the time value of the option of $40 ($100 -

$60) is recorded as follows.
Call Option 40
Chapter
At the time of the settlement, the call option’s carrying
value is as follows.
Settlement of the option contract is recorded as follows.
Cash 15,000
Loss on Settlement of Call Option 60
Call Option 15,060
Chapter
Summary effects of the call option contract on net income.
Illustration 17A-2
Because the call option meets the definition of an asset, the

company records it in the balance sheet on March 31, 2010. It
also reports the call option at fair value, with any gains or losses
reported in income.
Chapter
Differences between Traditional and Derivative
Financial Instruments
A derivative financial instrument has the following three basic

characteristics.
1. The instrument has (1) one or more underlyings and (2) an

identified payment provision.
2. The instrument requires little or no investment at the

inception of the contract.
3. The instrument requires or permits net settlement.
Chapter
Features of Traditional and Derivative Financial
Instruments
Illustration 17A-3
Chapter
Derivatives Used for Hedging
Hedging: The use of derivatives to offset the negative
impacts of changes in interest rates or foreign currency
exchange rates.
FASB allows special accounting for two types of hedges—
 fair value and
 cash flow hedges.
Chapter
Fair Value Hedge
A company uses a derivative to hedge (offset) the exposure

to changes in the fair value of a recognized asset or liability
or of an unrecognized commitment.
Companies commonly use several types of fair value hedges.
 Interest rate swaps
 put options
Chapter
17-87 LO 12 Explain how to account for a fair value hedge.
Illustration: On April 1, 2010, Hayward Co. purchases 100
shares of Sonoma stock at a market price of $100 per
share. Hayward does not intend to actively trade this
investment. It consequently classifies the Sonoma
investment as available-for-sale. Hayward records this
available-for-sale investment as follows.

Cash 10,000
Chapter
Illustration: Fortunately for Hayward, the value of the
Sonoma shares increases to $125 per share during 2010.
On December 31, 2010, Hayward records the gain on this
investment as follows.
Security Fair Value Adjustment (AFS) 2,500

Chapter
Hayward reports the Sonoma investment in its balance
sheet.
Illustration 17A-4
Chapter
Hayward is exposed to the risk that the price of the
Sonoma stock will decline. To hedge this risk, Hayward locks
in its gain on the Sonoma investment by purchasing a put
option on 100 shares of Sonoma stock.
Illustration: Hayward enters into the put option contract on

January 2, 2011, and designates the option as a fair value
hedge of the Sonoma investment. This put option (which
expires in two years) gives Hayward the option to sell
Sonoma shares at a price of $125. Since the exercise price
equals the current market price, no entry is necessary at
inception of the put option.
Chapter
Illustration: At December 31, 2011, the price of the
Sonoma shares has declined to $120 per share. Hayward
records the following entry for the Sonoma investment.

Security Fair Value Adjustment (AFS) 500
Chapter
Illustration: The following journal entry records the
increase in value of the put option on Sonoma shares on
December 31, 2011.
Put Option 500

Chapter
Balance Sheet Presentation of Fair Value Hedge
Illustration 17A-5
Income Statement Presentation of Fair Value Hedge

Illustration 17A-6
Chapter
Cash Flow Hedge
Used to hedge exposures to cash flow risk, which results

from the variability in cash flows.
Reporting:
 Fair value on the balance sheet
 Gains or losses in equity, as part of other

comprehensive income.
Chapter
17-95 LO 13 Explain how to account for a cash flow hedge.
Illustration: In September 2010 Allied Can Co. anticipates
purchasing 1,000 metric tons of aluminum in January 2011. As a
result, Allied enters into an aluminum futures contract. In this
case, the aluminum futures contract gives Allied the right and
the obligation to purchase 1,000 metric tons of aluminum for
$1,550 per ton. This contract price is good until the contract
expires in January 2011. The underlying for this derivative is
the price of aluminum.
Allied enters into the futures contract on September 1, 2010.
Assume that the price to be paid today for inventory to be
delivered in January—the spot price—equals the contract price.
With the two prices equal, the futures contract has no value.
Therefore no entry is necessary.
Chapter
Illustration: At December 31, 2010, the price for
January delivery of aluminum increases to $1,575 per
metric ton. Allied makes the following entry to record the
increase in the value of the futures contract.
Futures Contract 25,000

([$1,575 - $1,550] x 1,000 tons)
Allied reports the futures contract in the balance sheet as a current

asset and the gain as part of other comprehensive income.
Chapter
Illustration: In January 2011, Allied purchases 1,000
metric tons of aluminum for $1,575 and makes the
following entry.
Aluminum Inventory 1,575,000

Cash ($1,575 x 1,000 tons) 1,575,000
At the same time, Allied makes final settlement on the

futures contract. It records the following entry.
Cash 25,000
Futures Contract ($1,575,000 - $1,550,000) 25,000
Chapter
Effect of Hedge on Cash Flows
Illustration 17A-7
There are no income effects at this point. Allied accumulates in equity the
gain on the futures contract as part of other comprehensive income until
the period when it sells the inventory.
Chapter
Illustration: Assume that Allied processes the aluminum
into finished goods (cans). The total cost of the cans
(including the aluminum purchases in January 2011) is
$1,700,000. Allied sells the cans in July 2011 for
$2,000,000, and records this sale as follows.
Cash 2,000,000
Sales Revenue 2,000,000
Cost of Goods Sold 1,700,000
Inventory (Cans) 1,700,000
Chapter
Illustration: Since the effect of the anticipated
transaction has now affected earnings, Allied makes the
following entry related to the hedging transaction.

Cost of Goods Sold 25,000
The gain on the futures contract, which Allied reported as part of other
comprehensive income, now reduces cost of goods sold. As a result, the
cost of aluminum included in the overall cost of goods sold is $1,550,000.
Chapter
Other Reporting Issues
Embedded Derivatives
Convertible bond is a hybrid instrument. Two parts:
1. a debt security, referred to as the host security, and
2. an option to convert the bond to shares of common
stock, the embedded derivative.
To account for an embedded derivative, a company should
separate it from the host security and then account for it
using the accounting for derivatives. This separation
process is referred to as bifurcation.
Chapter LO 14 Identify special reporting issues related to derivative
17-102 financial instruments that cause unique accounting problems.
Qualifying Hedge Criteria
Criteria that hedging transactions must meet before

requiring the special accounting for hedges.
1. Documentation, risk management, and designation.
2. Effectiveness of the hedging relationship.
3. Effect on reported earnings of changes in fair values

or cash flows.

Summary of Derivative Accounting under GAAP
Illustration 17A-8

What About GAAP?
Two models for consolidation:
1. Voting-interest model—If a company owns more

than 50 percent of another company, then
consolidate in most cases.
2. Risk-and-reward model—If a company is involved

substantially in the economics of another company,
then consolidate.
Chapter
17-105 LO 15 Describe the accounting for the variable-interest entitles.
Consolidation of Variable-Interest Entities
A variable-interest entity (VIE) is an entity that has
one of the following characteristics:
1. Insufficient equity investment at risk.
2. Stockholders lack decision-making rights.
3. Stockholders do not absorb the losses or receive

the benefits of a normal stockholder.
Chapter
Illustration 17B-1
VIE
Consolidation
Model
Chapter
What Is Happening in Practice?
One study of 509 companies with

total market values over $500
million found that just 17 percent
of the companies reviewed have a
material impact.
Chapter
FASB believes that fair value information is relevant
for making effective business decisions. Others
express concern about fair value measurements for
two reasons:
1. the lack of reliability related to the fair value

measurement in certain cases, and
2. the ability to manipulate fair value measurements.
Chapter
17-109
Disclosure of Fair Value Information:
Financial Instruments—No Fair Value Option
Both the cost and the fair value of all financial instruments
are to be reported in the notes to the financial statements.
FASB also decided that 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.
Chapter
17-110
Financial Instruments—No Fair Value Option
Two reasons for additional disclosure beyond the simple
itemization of fair values are:
1. Differing levels of reliability exist in the measurement

of fair value information.
2. Changes in the fair value of financial instruments are

reported differently in the financial statements,
depending upon the type of financial instrument
Chapter
involved and whether the fair value option is employed.
17-111
Levels of reliability fair value hierarchy.
 Level 1 is the most reliable measurement because fair value
is based on quoted prices in active markets for identical
assets or liabilities.
 Level 2 is less reliable; it is not based on quoted market
prices for identical assets and liabilities but instead may be
based on similar assets or liabilities.
 Level 3 is least reliable; it uses unobservable inputs that
reflect the company’s assumption as to the value of the
financial instrument.
Chapter
17-112
Example of Fair Value Hierarchy
Illustration 17C-1
Chapter
17-113
Illustration 17C-2
Reconciliation
of Level 3
Inputs
Chapter
17-114
Financial Instruments—Fair Value Option
Illustration 17C-3
Disclosure of Fair
Value Option
Chapter
17-115
Disclosure of Fair Values: Impaired Assets
or Liabilities Illustration 17C-4
Disclosure of
Fair Value with
Impairment
Chapter
17-116
Copyright
Copyright
Copyright © 2009 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.
Chapter
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Chapter

Investments in Investments in Other Reporting

Held-to-maturity Holdings of less than Impairment of value

Different motivations for investing:

To secure certain operating or financing

Companies account for investments based on

 their intent with respect to the investment.

Debt securities (creditor relationship):

Chapter LO 1 Identify the three categories of debt securities and describe

Accounting for Debt Securities by Category

Chapter LO 1 Identify the three categories of debt securities and describe

Classify a debt security as held-to-maturity only

(2) the ability to hold securities to maturity.

Accounted for at amortized cost, not fair value.

Amortize premium or discount using the effective-

Chapter LO 2 Understand the procedures for discount and

Illustration: KC Company purchased $100,000 of 8 percent

Held-to-Maturity Securities 92,278

Chapter LO 2 Understand the procedures for discount and

Illustration: KC Company records the receipt of the first

Chapter LO 2 Understand the procedures for discount and

Illustration: KC is on a calendar-year basis, it accrues

December 31, 2009

Interest Receivable 4,000

Chapter LO 2 Understand the procedures for discount and

Reporting of Held-to-Maturity Securities

Chapter LO 2 Understand the procedures for discount and

Illustration: Assume that KC Company sells its investment

Held-to-Maturity Securities 635

$952 x 4/6 = $635

Computation of the realized gain on sale.

Companies report available-for-sale securities at

Any discount or premium is amortized.

Chapter LO 2 Understand the procedures for discount and

Illustration (Single Security): Graff Corporation purchases

Available-for-Sale Securities 108,111

Chapter LO 2 Understand the procedures for discount and

Illustration (Single Security): The entry to record interest

Chapter LO 2 Understand the procedures for discount and

Illustration (Single Security): At December 31, 2009, Graff

Interest Receivable 5,000

Graff reports revenue for 2009 of $8,621 ($4,324 + $4,297).

Chapter LO 2 Understand the procedures for discount and

Illustration (Single Security): To apply the fair value

Unrealized Holding Gain or Loss—Equity 1,732

Chapter LO 2 Understand the procedures for discount and

Illustration (Portfolio of Securities): Webb Corporation has

Chapter LO 2 Understand the procedures for discount and

Illustration (Portfolio of Securities): Webb makes an

Unrealized Holding Gain or Loss—Equity 9,537

Webb reports the unrealized holding loss of $9,537 as other

Chapter LO 2 Understand the procedures for discount and

Sale of Available-for-Sale Securities

Must make entry to remove the,

Any realized gain or loss on sale is reported in the

Chapter LO 2 Understand the procedures for discount and

Illustration (Sale of Available-for-Sale Securities): Webb

Illustration (Sale of Available-for-Sale Securities):