CHAPTER 17 Investments

INVESTMENTS IN DEBT SECURITIES

Companies have different motivations for investing in securities issued by other companies.¹ One motivation is to earn a high rate of return. For example, companies like Coca-Cola and PepsiCo can receive interest revenue from a debt investment or dividend revenue from an equity investment. In addition, they can realize capital gains on both types of securities. Another motivation for investing (in equity securities) is to secure certain operating or financing arrangements with another company. For example, Coca-Cola and PepsiCo are able to exercise some control over bottler companies based on their significant (but not controlling) equity investments.

To provide useful information, companies account for investments based on the type of security (debt or equity) and their intent with respect to the investment. As indicated in Illustration 17-1, we organize our study of investments by type of security. Within this section, we explain the accounting for investments in debt. We address equity securities later in the chapter.

Debt securities represent a creditor relationship with another entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security.

Debt Investment Classifications

Companies group investments in debt securities into three separate categories for accounting and reporting purposes:

• Held-to-maturity: Debt securities that the company has the positive intent and ability to hold to maturity.
• Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences.
• Available-for-sale: Debt securities not classified as held-to-maturity or trading securities.

Illustration 17-2 identifies these categories, along with the accounting and reporting treatments required for each.

Amortized cost is the acquisition cost adjusted for the amortization of discount or premium, if appropriate. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. [2]

Held-to-Maturity Securities

Only debt securities can be classified as held-to-maturity. By definition, equity securities have no maturity date. A company like Starbucks should classify a debt security as held-to-maturity only if it has both (1) the positive intent and (2) the ability to hold those securities to maturity. It should not classify a debt security as held-to-maturity if it intends to hold the security for an indefinite period of time. Likewise, if Starbucks anticipates that a sale may be necessary due to changes in interest rates, foreign currency risk, liquidity needs, or other asset-liability management reasons, it should not classify the security as held-to-maturity.²

Companies account for held-to-maturity securities at amortized cost, not fair value. If management intends to hold certain investment securities to maturity and has no plans to sell them, fair values (selling prices) are not relevant for measuring and evaluating the cash flows associated with these securities. Finally, because companies do not adjust held-to-maturity securities to fair value, these securities do not increase the volatility of either reported earnings or reported capital as do trading securities and available-for-sale securities.

To illustrate the accounting for held-to-maturity debt securities, assume that Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2013, at a discount, paying $92,278. The bonds mature January 1, 2018 and yield 10%. Interest is payable each July 1 and January 1. Robinson records the investment as follows.

Robinson uses a Debt Investments account to indicate the type of debt security purchased.³

As indicated in Chapter 14, companies must amortize premium or discount using the effective-interest method unless some other method—such as the straight-line method—yields a similar result. They apply the effective-interest method to bond investments in a way similar to that for bonds payable. To compute interest revenue, companies compute the effective-interest rate or yield at the time of investment and apply that rate to the beginning carrying amount (book value) for each interest period. The investment carrying amount is increased by the amortized discount or decreased by the amortized premium in each period.

Illustration 17-3 shows the effect of the discount amortization on the interest revenue that Robinson records each period for its investment in Evermaster bonds.

Robinson records the receipt of the first semiannual interest payment on July 1, 2013 (using the data in Illustration 17-3), as follows.

Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2013, as follows.

Again, Illustration 17-3 shows the interest and amortization amounts.

Robinson reports its investment in Evermaster bonds in its December 31, 2013, financial statements, as follows.

Sometimes, a company sells a held-to-maturity debt security so close to its maturity date that a change in the market interest rate would not significantly affect the security's fair value. Such a sale may be considered a sale at maturity and would not call into question the company's original intent to hold the investment to maturity. Let's assume, as an example, that Robinson Company sells its investment in Evermaster bonds on November 1, 2017, at 99¾ plus accrued interest. The discount amortization from July 1, 2017, to November 1, 2017, is $635 ( × $952). Robinson records this discount amortization as follows.

Illustration 17-5 shows the computation of the realized gain on the sale.

Robinson records the sale of the bonds as:

The credit to Interest Revenue represents accrued interest for four months, for which the purchaser pays cash. The debit to Cash represents the selling price of the bonds plus accrued interest ($99,750 + $2,667). The credit to Debt Investments represents the book value of the bonds on the date of sale. The credit to Gain on Sale of Investments represents the excess of the selling price over the book value of the bonds.

Available-for-Sale Securities

Companies like Amazon.com report available-for-sale securities at fair value. It records the unrealized gains and losses related to changes in the fair value of available-for-sale debt securities in an unrealized holding gain or loss account. Amazon adds (subtracts) this amount to other comprehensive income for the period. Other comprehensive income is then added to (subtracted from) accumulated other comprehensive income, which is shown as a separate component of stockholders' equity until realized. Thus, companies report available-for-sale securities at fair value on the balance sheet but do not report changes in fair value as part of net income until after selling the security. This approach reduces the volatility of net income.

Example: Single Security

To illustrate the accounting for available-for-sale securities, assume that Graff Corporation purchases $100,000, 10 percent, five-year bonds on January 1, 2013, 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 as follows.

Illustration 17-6 discloses the effect of the premium amortization on the interest revenue Graff records each period using the effective-interest method.

The entry to record interest revenue on July 1, 2013, is as follows.

At December 31, 2013, Graff makes the following entry to recognize interest revenue.

As a result, Graff reports revenue for 2013 of $8,621 ($4,324 + $4,297).

To apply the fair value method to these debt investments, 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. Comparing this fair value with the carrying amount (amortized cost) of the bonds at December 31, 2013, Graff recognizes an unrealized holding loss of $1,732 ($106,732 − $105,000). It reports this loss as other comprehensive income. Graff makes the following entry.

Graff uses a valuation account instead of crediting the Debt Investments account. The use of the Fair Value Adjustment (available-for-sale) account enables the company to maintain a record of its amortized cost. Because the adjustment account has a credit balance in this case, Graff subtracts it from the balance of the Debt Investments account to determine fair value. Graff reports this fair value amount on the balance sheet. At each reporting date, Graff reports the bonds at fair value with an adjustment to the Unrealized Holding Gain or Loss—Equity account.

Example: Portfolio of Securities

To illustrate the accounting for a portfolio of securities, assume that Webb Corporation has two debt securities classified as available-for-sale. Illustration 17-7 identifies the amortized cost, fair value, and the amount of the unrealized gain or loss.

The fair value of Webb's available-for-sale portfolio totals $284,000. The gross unrealized gains are $10,063, and the gross unrealized losses are $19,600, resulting in a net unrealized loss of $9,537. That is, the fair value of available-for-sale securities is $9,537 lower than its amortized cost. Webb makes an adjusting entry to a valuation allowance 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. Recall that companies exclude from net income any unrealized holding gains and losses related to available-for-sale securities.

Sale of Available-for-Sale Securities

If a company sells bonds carried as investments in available-for-sale securities before the maturity date, it must make entries to remove from the Debt Investments account the amortized cost of bonds sold. To illustrate, assume that Webb Corporation sold the Watson bonds (from Illustration 17-7) on July 1, 2015, for $90,000, at which time it had an amortized cost of $94,214. Illustration 17-8 (on page 958) shows the computation of the realized loss.

Webb records the sale of the Watson bonds as follows.

Webb reports this realized loss in the “Other expenses and losses” section of the income statement.⁴ Assuming no other purchases and sales of bonds in 2015, Webb on December 31, 2015, prepares the information shown in Illustration 17-9.

Webb has an unrealized holding loss of $5,000. However, the Fair Value Adjustment (available-for-sale) account already has a credit balance of $9,537. To reduce the adjustment account balance to $5,000, Webb debits it for $4,537, as follows.

Financial Statement Presentation

Webb's December 31, 2015, balance sheet and the 2015 income statement include the following items and amounts (the Anacomp bonds are long-term investments but are not intended to be held to maturity).

Some favor including the unrealized holding gain or loss in net income rather than showing it as other comprehensive income.⁵ However, some companies, particularly financial institutions, note that recognizing gains and losses on assets, but not liabilities, introduces substantial volatility in net income. They argue that hedges often exist between assets and liabilities so that gains in assets are offset by losses in liabilities, and vice versa. In short, to recognize gains and losses only on the asset side is unfair and not representative of the economic activities of the company.

This argument convinced the FASB. As a result, companies do not include in net income these unrealized gains and losses. [3] However, even this approach solves only some of the problems because volatility of capital still results. This is of concern to financial institutions because regulators restrict financial institutions' operations based on their level of capital. However, companies can still manage their net income by engaging in gains trading (i.e., selling the winners and holding the losers).

Trading Securities

Companies hold trading securities with the intention of selling them in a short period of time. “Trading” in this context means frequent buying and selling. Companies thus use trading securities to generate profits from short-term differences in price. Companies generally hold these securities for less than three months, some for merely days or hours.

Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. Similar to held-to-maturity or available-for-sale investments, companies are required to amortize any discount or premium. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. In short, the FASB says to adjust the trading securities to fair value, at each reporting date. In addition, companies report the change in value as part of net income, not other comprehensive income.

To illustrate, assume that on December 31, 2014, Western Publishing Corporation determined its trading securities portfolio to be as shown in Illustration 17-11. (Assume that 2014 is the first year that Western Publishing held trading securities.) At the date of acquisition, Western Publishing recorded these trading securities at cost, including brokerage commissions and taxes, in the account entitled Debt Investments. This is the first valuation of this recently purchased portfolio.

The total cost of Western Publishing's trading portfolio is $314,450. The gross unrealized gains are $12,780 ($7,640 + $5,140), and the gross unrealized losses are $9,030, resulting in a net unrealized gain of $3,750. The fair value of trading securities is $3,750 greater than its cost.

At December 31, Western Publishing makes an adjusting entry to a valuation allowance, referred to as Fair Value Adjustment (trading), to record the increase in value and to record the unrealized holding gain.

Because the Fair Value Adjustment account balance is a debit, Western Publishing adds it to the cost of the Debt Investments account to arrive at a fair value for the trading securities. Western Publishing reports this fair value amount on the balance sheet.

As with other debt investments, when a trading investment is sold, the Debt Investments account is reduced by the amount of the amortized cost of the bonds. Any realized gain or loss is recorded in the “Other expenses and losses” section of the income statement. The Fair Value Adjustment account is then adjusted at year-end for the unrealized gains or losses on the remaining securities in the trading investment portfolio.

When securities are actively traded, the FASB believes that the investments should be reported at fair value on the balance sheet. In addition, changes in fair value (unrealized gains and losses) should be reported in income. Such reporting on trading securities provides more relevant information to existing and prospective stockholders.

INVESTMENTS IN EQUITY SECURITIES

Equity securities represent ownership interests 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 in warrants, rights, and call or put options. Companies do not treat convertible debt securities as equity securities. Nor do they treat as equity securities redeemable preferred stock (which must be redeemed for common stock). The cost of equity securities includes the purchase price of the security plus broker's commissions and other fees incidental to the 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. The classification of such investments depends on the percentage of the investee voting stock that is held by the investor:

1. Holdings of less than 20 percent (fair value method)—investor has passive interest.
2. Holdings between 20 percent and 50 percent (equity method)—investor has significant influence.
3. Holdings of more than 50 percent (consolidated statements)—investor has controlling interest.

Illustration 17-12 lists these levels of interest or influence and the corresponding valuation and reporting method that companies must apply to the investment.

The accounting and reporting for equity securities therefore depend on the level of influence and the type of security involved, as shown in Illustration 17-13.

Holdings of Less Than 20%

When an investor has an interest of less than 20 percent, it is presumed that the investor has little or no influence over the investee. In such cases, if market prices are available subsequent to acquisition, the company values and reports the investment using the fair value method.⁶ The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities. Because equity securities have no maturity date, companies cannot classify them as held-to-maturity.

Available-for-Sale Securities

Upon acquisition, companies record available-for-sale securities at cost.⁷ To illustrate, assume that on November 3, 2014, Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest.

Republic records these investments as follows.

On December 6, 2014, Republic receives a cash dividend of $4,200 on its investment in the common stock of Campbell Soup Co. It records the cash dividend as follows.

All three of the investee companies reported net income for the year, but only Campbell Soup declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the common stock of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income of the investee is not a proper basis for recognizing income from the investment by the investor. Why? Because the increased net assets resulting from profitable operations may be permanently retained for use in the investee's business. Therefore, the investor recognizes net income only when the investee declares cash dividends.

At December 31, 2014, Republic's available-for-sale equity security portfolio has the cost and fair value shown in Illustration 17-14.

For Republic's available-for-sale equity securities portfolio, the gross unrealized gains are $15,300, and the gross unrealized losses are $50,850 ($13,500 + $37,350), resulting in a net unrealized loss of $35,550. The fair value of the available-for-sale securities portfolio is below cost by $35,550.

As with available-for-sale debt securities, 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. Republic reports this amount as a part of other comprehensive income and as a component of other accumulated comprehensive income (reported in stockholders' equity) until realized. In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss—Equity account and crediting the Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows.

On January 23, 2015, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287,220. Illustration 17-15 shows the computation of the realized gain on the sale.

Republic records the sale as follows.

In addition, assume that on February 10, 2015, Republic purchased 20,000 shares of Continental Trucking at a market price of $12.75 per share plus brokerage commissions of $1,850 (total cost, $256,850).

Illustration 17-16 lists Republic's portfolio of available-for-sale securities, as of December 31, 2015.

At December 31, 2015, the fair value of Republic's available-for-sale equity securities portfolio exceeds cost by $64,250 (unrealized gain). The Fair Value Adjustment account had a credit balance of $35,550 at December 31, 2015. To adjust its December 31, 2015, available-for-sale portfolio to fair value, the company debits the Fair Value Adjustment account for $99,800 ($35,550 + $64,250). Republic records this adjustment as follows.

Trading Securities

The accounting entries to record trading equity securities are the same as for available-for-sale equity securities, except for recording the unrealized holding gain or loss. For trading equity securities, companies report the unrealized holding gain or loss as part of net income. Thus, the account titled Unrealized Holding Gain or Loss—Income is used.

Holdings Between 20% and 50%

An investor corporation may hold an interest of less than 50 percent in an investee corporation and thus not possess legal control. However, an investment in voting stock of less than 50 percent can still give the investor the ability to exercise significant influence over the operating and financial policies of the investee company. [4] Significant influence may be indicated in several ways. Examples include representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency.

Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings. To achieve a reasonable degree of uniformity in application of the “significant influence” criterion, the profession concluded that 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.⁸

In instances of “significant influence” (generally an investment of 20 percent or more), the investor must account for the investment using the equity method.

Equity Method

Under the equity method, the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at the cost of the shares acquired but subsequently adjusts the amount each period for changes in the investee's net assets. That is, the investor's proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investment's carrying amount. All cash dividends received by the investor from the investee also decrease the investment's carrying amount. The equity method recognizes that investee's earnings increase investee's net assets, and that investee's losses and dividends decrease these net assets.

To illustrate the equity method and compare it with the fair value method, assume that Maxi Company purchases a 20 percent interest in Mini Company. To apply the fair value method in this example, assume that Maxi does not have the ability to exercise significant influence, and classifies the securities as available-for-sale. Where this example applies the equity method, assume that the 20 percent interest permits Maxi to exercise significant influence. Illustration 17-17 shows the entries.

Note that under the fair value method, Maxi reports as revenue only the cash dividends received from Mini. The earning of net income by Mini (the investee) is not considered a proper basis for recognition of income from the investment by Maxi (the investor). Why? Mini may permanently retain in the business any increased net assets resulting from its profitable operation. Therefore, Maxi only recognizes revenue when it receives dividends from Mini.

Under the equity method, Maxi reports as revenue its share of the net income reported by Mini. Maxi records the cash dividends received from Mini as a decrease in the investment carrying value. As a result, Maxi records its share of the net income of Mini in the year when it is recognized. With significant influence, Maxi can ensure that Mini will pay dividends, if desired, on any net asset increases resulting from net income. To wait until receiving a dividend ignores the fact that Maxi is better off if the investee has earned income.

Using dividends as a basis for recognizing income poses an additional problem. For example, assume that the investee reports a net loss. However, the investor exerts influence to force a dividend payment from the investee. In this case, the investor reports income, even though the investee is experiencing a loss. In other words, using dividends as a basis for recognizing income fails to report properly the economics of the situation.

For some companies, equity accounting can be a real pain to the bottom line. For example, Amazon.com, the pioneer of Internet retailing, at one time struggled to turn a profit. Furthermore, some of Amazon's equity investments had resulted in Amazon's earnings performance going from bad to worse. At one time, Amazon disclosed equity stakes in such companies as Altera International, Basis Technology, Drugstore.com, and Eziba.com. These equity investees reported losses that made Amazon's already bad bottom line even worse, accounting for up to 22 percent of its reported loss in one year alone.

Investee Losses Exceed Carrying Amount. If an investor's share of the investee's losses exceeds the carrying amount of the investment, should the investor recognize additional losses? Ordinarily, the investor should discontinue applying the equity method and not recognize additional losses.

If the investor's potential loss is not limited to the amount of its original investment (by guarantee of the investee's obligations or other commitment to provide further financial support) or if imminent return to profitable operations by the investee appears to be assured, the investor should recognize additional losses. [6]

Holdings of More Than 50%

When one corporation acquires a voting interest of more than 50 percent in another corporation, it is said to have a controlling interest. In such a relationship, the investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a long-term investment on the separate financial statements of the parent.

When the parent treats the investment as a subsidiary, the parent generally prepares consolidated financial statements. Consolidated financial statements treat the parent and subsidiary corporations as a single economic entity. (Advanced accounting courses extensively discuss the subject of when and how to prepare consolidated financial statements.) Whether or not consolidated financial statements are prepared, the parent company generally accounts for the investment in the subsidiary using the equity method as explained in the previous section of this chapter.

ADDITIONAL MEASUREMENT ISSUES

Fair Value Option

As indicated in earlier chapters, 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. This option is applied on an instrument-by-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.

For example, assume that Abbott Laboratories purchased debt securities in 2014 that it classified as held-to-maturity. Abbott does not choose to report this security using the fair value option. In 2015, Abbott buys another held-to-maturity debt security. Abbott decides to report this security using the fair value option. Once it chooses the fair value option for the security bought in 2015, the decision is irrevocable (may not be changed). In addition, Abbott does not have the option to value the held-to-maturity security purchased in 2014 at fair value in 2015 or in subsequent periods.

Many support the use of the fair value option as a step closer to total fair value reporting for financial instruments. They believe this treatment leads to an improvement in financial reporting. Others argue that the fair value option is confusing. A company can choose from period to period whether to use the fair value option for any new investment in a financial instrument. By permitting an instrument-by-instrument approach, companies are able to report some financial instruments at fair value but not others. To illustrate the accounting issues related to the fair value option, we discuss two different situations.

Available-for-Sale Securities

Available-for-sale securities are presently reported at fair value, with any unrealized gains and losses recorded as part of other comprehensive income. Assume that Hardy Company purchases stock in Fielder Company during 2014 that it classifies as available-for-sale. At December 31, 2014, the cost of this security is $100,000; its fair value at December 31, 2014, 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, 2014.

In this situation, Hardy uses an account titled Equity Investments to record the change in fair value at December 31. It does not use a Fair Value Adjustment account because the accounting for a fair value option is on an investment-by-investment basis rather than on a portfolio basis. Because Hardy selected the fair value option, the unrealized gain or loss is recorded as part of net income. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security.

Equity Method Investments

Companies may also use the fair value option for investments that otherwise follow the equity method of accounting. To illustrate, assume that Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2014 for $930,000. At December 31, 2014, 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.

In contrast to equity method accounting, if the fair value option is chosen, Durham does not report its pro rata share of the income or loss from Suppan. In addition, any dividend payments are credited to Dividend Revenue and therefore do not reduce the Equity Investments account.

One major advantage of using the fair value option for this type of investment is that it addresses confusion about the equity method of accounting. In other words, what exactly does the one-line consolidation related to the equity method of accounting on the balance sheet tell investors? Many believe it does not provide information about liquidity or solvency, nor does it provide an indication of the worth of the company.

Impairment of Value

A company should evaluate every investment, at each reporting date, to determine if it has suffered impairment—a loss in value that is other than temporary. For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a permanent loss. If the decline is judged to be other than temporary, a company writes down the cost basis of the individual security to a new cost basis. The company accounts for the write-down as a realized loss. Therefore, it includes the amount in net income.

For debt securities, a company uses the impairment test to determine whether “it is probable that the investor will be unable to collect all amounts due according to the contractual terms.”

For equity securities, the guideline is less precise. Any time realizable value is lower than the carrying amount of the investment, a company must consider an impairment. Factors involved include the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the investor company to retain its investment to allow for any anticipated recovery in fair value.

To illustrate an impairment, assume that Strickler Company holds available-for-sale bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800,000. Strickler has previously reported an unrealized loss on these securities of $200,000 as part of other comprehensive income. In evaluating the securities, Strickler now determines that it probably will not collect all amounts due. In this case, it reports the unrealized loss of $200,000 as a loss on impairment of $200,000. Strickler includes this amount in income, with the bonds stated at their new cost basis. It records this impairment as follows.

The new cost basis of the investment in debt securities is $800,000. Strickler includes subsequent increases and decreases in the fair value of impaired available-for-sale securities as other comprehensive income.⁹

Companies base impairment for debt and equity securities on a fair value test. This test differs slightly from the impairment test for loans that we discuss in Appendix 7B. The FASB rejected the discounted cash flow alternative for securities because of the availability of market price information.¹⁰

An example of the criteria used by Caterpillar to assess impairment is provided in Illustration 17-18.

RECLASSIFICATIONS AND TRANSFERS

Reclassification Adjustments

As we indicated in Chapter 4, companies report changes in unrealized holding gains and losses related to available-for-sale securities as part of other comprehensive income. Companies may display the components of other comprehensive income in one of two ways: (1) in a combined statement of income and comprehensive income, or (2) in a separate statement of comprehensive income that begins with net income.

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. To illustrate, assume that Open Company has the following two available-for-sale securities in its portfolio at the end of 2013 (its first year of operations).

The entry to record the unrealized holding gain in 2013 is as follows.

If Open Company reports net income in 2013 of $350,000, it presents a statement of comprehensive income as follows.

At December 31, 2013, Open Company reports on its balance sheet equity investments of $240,000 (cost $200,000 plus fair value adjustment of $40,000) and accumulated other comprehensive income in stockholders' equity of $40,000. The entry to transfer the unrealized holding gain—equity to accumulated other comprehensive income is as follows.

In 2014, Open Company sells its Lehman Inc. common stock for $105,000 and realizes a gain on the sale of $25,000 ($105,000 − $80,000). The journal entry to record this transaction is as follows.

At the end of 2014, the fair value of the Woods Co. common stock increased an additional $20,000 ($155,000 − $135,000), to $155,000. Illustration 17-21 shows the computation of the change in the Fair Value Adjustment account (based on only the Woods Co. investment).

The entry to record the unrealized holding gain in 2014 is as follows.

If we assume that Open Company reports net income of $720,000 in 2014, including the realized sale on the Lehman stock, its income statement is presented as shown in Illustration 17-22.

At December 31, 2014, Open Company reports on its balance sheet equity investments of $155,000 (cost $120,000 plus a fair value adjustment of $35,000) and accumulated other comprehensive income in stockholders' equity of $35,000 ($40,000 − $5,000). The entry to transfer the unrealized holding loss—equity to accumulated other comprehensive income is as follows.

In 2013, Open included the unrealized gain on the Lehman Co. common stock in comprehensive income. In 2014, Open sold the stock. It reported the realized gain ($25,000) in net income, which increased comprehensive income again. To avoid double-counting this gain, Open makes a reclassification adjustment to eliminate the realized gain from the computation of comprehensive income in 2014.

This reclassification adjustment may be made in the income statement, in accumulated other comprehensive income or in a note to the financial statements. The FASB prefers to show the reclassification amount in accumulated other comprehensive income in the notes to the financial statements.¹¹ For Open Company, this presentation is as shown in Illustration 17-23.

Comprehensive Example

To provide a single-period example of the reporting of investment securities and related gain or loss on available-for-sale securities, assume that on January 1, 2014, Hinges Co. had cash and common stock of $50,000.¹² At that date, the company had no other asset, liability, or equity balance. On January 2, Hinges purchased for cash $50,000 of equity securities classified as available-for-sale. On June 30, Hinges sold part of the available-for-sale security portfolio, realizing a gain as shown in Illustration 17-24.

Hinges did not purchase or sell any other securities during 2014. It received $3,000 in dividends during the year. At December 31, 2014, the remaining portfolio is as shown in Illustration 17-25.

Illustration 17-26 shows the company's income statement for 2014.

The company reports its change in the unrealized holding gain in a statement of comprehensive income as follows.

Its statement of stockholders' equity appears in Illustration 17-28.

The comparative balance sheet is shown below in Illustration 17-29.

This example indicates how an unrealized gain or loss on available-for-sale securities affects all the financial statements. Note that a company must disclose the components that comprise accumulated other comprehensive income.

Transfers Between Categories

Companies account for transfers between any of the categories at fair value. Thus, if a company transfers available-for-sale securities to held-to-maturity investments, it records the new investments (held-to-maturity) at the date of transfer at fair value in the new category. Similarly, if it transfers held-to-maturity investments to available-for-sale investments, it records the new investments (available-for-sale) at fair value. This fair value rule assures that a company cannot omit recognition of fair value simply by transferring securities to the held-to-maturity category. Illustration 17-30 summarizes the accounting treatment for transfers.

Summary of Reporting Treatment of Securities

Illustration 17-31 summarizes the major debt and equity securities and their reporting treatment.

SUMMARY OF LEARNING OBJECTIVES

Identify the three categories of debt securities and describe the accounting and reporting treatment for each category. (1) Carry and report held-to-maturity debt securities at amortized cost. (2) Value trading debt securities for reporting purposes at fair value, with unrealized holding gains or losses included in net income. (3) Value available-for-sale debt securities for reporting purposes at fair value, with unrealized holding gains or losses reported as other comprehensive income and as a separate component of stockholders' equity.

Understand the procedures for discount and premium amortization on bond investments. Similar to bonds payable, companies should amortize discount or premium on bond investments using the effective-interest method. They apply the effective-interest rate or yield to the beginning carrying value of the investment for each interest period in order to compute interest revenue.

Identify the categories of equity securities and describe the accounting and reporting treatment for each category. 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. Long-term investments by one corporation in the common stock of another can be classified according to the percentage of the voting stock of the investee held by the investor.

Explain the equity method of accounting and compare it to the fair value method for equity securities. Under the equity method, the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at cost but subsequently adjusts the amount each period for changes in the net assets of the investee. That is, the investor's proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investment's carrying amount. All dividends received by the investor from the investee decrease the investment's carrying amount. Under the fair value method, a company reports the equity investment at fair value each reporting period irrespective of the investee's earnings or dividends paid to it. A company applies the equity method to investment holdings between 20 percent and 50 percent of ownership. It applies the fair value method to holdings below 20 percent.

Describe the accounting for the fair value option and for impairments of debt and equity investments. 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. This option is applied on an instrument-by-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.

Impairments of debt and equity securities are losses in value that are determined to be other than temporary, are based on a fair value test, and are charged to income.

Describe the reporting of reclassification adjustments and the accounting for transfers between categories. A company needs a reclassification adjustment when it reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current or in previous periods. Companies should report unrealized holding gains or losses related to available-for-sale securities in other comprehensive income and the aggregate balance as accumulated comprehensive income on the balance sheet.

Transfers of securities between categories of investments should be accounted for at fair value, with unrealized holding gains or losses treated in accordance with the nature of the transfer.

 

APPENDIX 17A ACCOUNTING FOR DERIVATIVE INSTRUMENTS

Until the early 1970s, most financial managers worked in a cozy, if unthrilling, world. Since then, constant change caused by volatile markets, new technology, and deregulation has increased the risks to businesses. In response, the financial community developed products to manage these risks.

These products—called derivative financial instruments or simply derivatives—are useful for managing risk. Companies use the fair values or cash flows of these instruments to offset the changes in fair values or cash flows of the at-risk assets. The development of powerful computing and communication technology has aided the growth in derivative use. This technology provides new ways to analyze information about markets as well as the power to process high volumes of payments.

DEFINING DERIVATIVES

In order to understand derivatives, consider the following examples.

Example 1—Forward Contract. Assume that a company like Dell believes that the price of Google's stock will increase substantially in the next 3 months. Unfortunately, it does not have the cash resources to purchase the stock today. Dell therefore enters into a contract with a broker for delivery of 10,000 shares of Google stock in 3 months at the price of $110 per share.

Dell has entered into a forward contract, a type of derivative. As a result of the contract, Dell has received the right to receive 10,000 shares of Google stock in 3 months. Further, it has an obligation to pay $110 per share at that time. What is the benefit of this derivative contract? Dell can buy Google stock today and take delivery in 3 months. If the price goes up, as it expects, Dell profits. If the price goes down, Dell loses.

Example 2—Option Contract. Now suppose that Dell needs 2 weeks to decide whether to purchase Google stock. It therefore enters into a different type of contract, one that gives it the right to purchase Google stock at its current price any time within the next 2 weeks. As part of the contract, the broker charges $3,000 for holding the contract open for 2 weeks at a set price.

Dell has now entered into an option contract, another type of derivative. As a result of this contract, it has received the right but not the obligation to purchase this stock. If the price of the Google stock increases in the next 2 weeks, Dell exercises its option. In this case, the cost of the stock is the price of the stock stated in the contract, plus the cost of the option contract. If the price does not increase, Dell does not exercise the contract but still incurs the cost for the option.

The forward contract and the option contract both involve a future delivery of stock. The value of the contract relies on the underlying asset—the Google stock. Thus, these financial instruments are known as derivatives because they derive their value from values of other assets (e.g., stocks, bonds, or commodities). Or, put another way, their value relates to a market-determined indicator (e.g., stock price, interest rates, or the Standard and Poor's 500 stock composite index).

In this appendix, we discuss the accounting for three different types of derivatives:

1. Financial forwards or financial futures.
2. Options.
3. Swaps.

WHO USES DERIVATIVES, AND WHY?

Whether to protect for changes in interest rates, the weather, stock prices, oil prices, or foreign currencies, derivative contracts help to smooth the fluctuations caused by various types of risks. A company that wants to ensure against certain types of business risks often uses derivative contracts to achieve this objective.¹⁴

Producers and Consumers

To illustrate, assume that Heartland Ag is a large producer of potatoes for the consumer market. The present price for potatoes is excellent. Unfortunately, Heartland needs two months to harvest its potatoes and deliver them to the market. Because Heartland expects the price of potatoes to drop in the coming months, it signs a forward contract. It agrees to sell its potatoes today at the current market price for delivery in 2 months.

Who would buy this contract? Suppose on the other side of the contract is McDonald's Corporation. McDonald's wants to have potatoes (for French fries) in 2 months and believes that prices will increase. McDonald's is therefore agreeable to accepting delivery in 2 months at current prices. It knows that it will need potatoes in 2 months and that it can make an acceptable profit at this price level.

In this situation, if the price of potatoes increases before delivery, Heartland loses and McDonald's wins. Conversely, if the price decreases, Heartland wins and McDonald's loses. However, the objective is not to gamble on the outcome. Regardless of which way the price moves, both Heartland and McDonald's have received a price at which they obtain an acceptable profit. In this case, although Heartland is a producer and McDonald's is a consumer, both companies are hedgers. They both hedge their positions to ensure an acceptable financial result.

Commodity prices are volatile. They depend on weather, crop production, and general economic conditions. For the producer and the consumer to plan effectively, it makes good sense to lock in specific future revenues or costs in order to run their businesses successfully.

Speculators and Arbitrageurs

In some cases, instead of McDonald's taking a position in the forward contract, a speculator may purchase the contract from Heartland. The speculator bets that the price of potatoes will rise, thereby increasing the value of the forward contract. The speculator, who may be in the market for only a few hours, will then sell the forward contract to another speculator or to a company like McDonald's.

Arbitrageurs also use derivatives. These market players attempt to exploit inefficiencies in markets. They seek to lock in profits by simultaneously entering into transactions in two or more markets. For example, an arbitrageur might trade in a futures contract. At the same time, the arbitrageur will also trade in the commodity underlying the futures contract, hoping to achieve small price gains on the difference between the two. Markets rely on speculators and arbitrageurs to keep the market liquid on a daily basis.

In these illustrations, we explained why Heartland (the producer) and McDonald's (the consumer) would become involved in a derivative contract. Consider other types of situations that companies face.

1. Airlines, like Delta, Southwest, and United, are affected by changes in the price of jet fuel.
2. Financial institutions, such as Citigroup, Bankers Trust, and BMO Harris, are involved in borrowing and lending funds that are affected by changes in interest rates.
3. Multinational corporations, like Cisco Systems, Coca-Cola, and General Electric, are subject to changes in foreign exchange rates.

In fact, most corporations are involved in some form of derivatives transactions. Companies give these reasons (in their annual reports) as to why they use derivatives:

1. ExxonMobil uses derivatives to hedge its exposure to fluctuations in interest rates, foreign currency exchange rates, and hydrocarbon prices.
2. Caterpillar uses derivatives to manage foreign currency exchange rates, interest rates, and commodity price exposure.
3. Johnson & Johnson uses derivatives to manage the impact of interest rate and foreign exchange rate changes on earnings and cash flows.

Many corporations use derivatives extensively and successfully. However, derivatives can be dangerous. All parties involved must understand the risks and rewards associated with these contracts.¹⁵

BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVES

The FASB concluded that derivatives such as forwards and options are assets and liabilities. It also concluded that companies should report them in the balance sheet at fair value.¹⁶ The Board believes that fair value will provide statement users the best information about derivatives. Relying on some other basis of valuation for derivatives, such as historical cost, does not make sense. Why? Because many derivatives have a historical cost of zero. Furthermore, the markets for derivatives, and the assets upon which derivatives' values rely, are well developed. As a result, the Board believes that companies can determine reliable fair value amounts for derivatives.¹⁷

On the income statement, a company should recognize any unrealized gain or loss in income, if it uses the derivative for speculation purposes. If using the derivative for hedging purposes, the accounting for any gain or loss depends on the type of hedge used. We discuss the accounting for hedged transactions later in the appendix.

In summary, companies follow these guidelines in accounting for derivatives.

1. Recognize derivatives in the financial statements as assets and liabilities.
2. Report derivatives at fair value.
3. Recognize gains and losses resulting from speculation in derivatives immediately in income.
4. Report gains and losses resulting from hedge transactions differently, depending on the type of hedge.

Example of Derivative Financial Instrument—Speculation

To illustrate the measurement and reporting of a derivative for speculative purposes, we examine a derivative whose value depends on the market price of Laredo Inc. common stock. A company can realize a gain from the increase in the value of the Laredo shares with the use of a derivative, such as a call option.¹⁸ A call option gives the holder the right, but not the obligation, to buy shares at a preset price. This price is often referred to as the strike price or the exercise price.

For example, assume a company enters into a call option contract with Baird Investment Co., which gives it the option to purchase Laredo stock at $100 per share.¹⁹ If the price of Laredo stock increases above $100, the company can exercise this option and purchase the shares for $100 per share. If Laredo's stock never increases above $100 per share, the call option is worthless.

Accounting Entries. To illustrate the accounting for a call option, assume that the company purchases a call option contract on January 2, 2014, 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, 2014. The company purchases the call option for $400 and makes the following entry.

This payment is referred to as the option premium. It is generally much less than the cost of purchasing the shares directly. The option premium consists of two amounts: (1) intrinsic value and (2) time value. Illustration 17A-1 shows the formula to compute the option premium.

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, 2014, the intrinsic value is zero because the market price equals the preset strike price.

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 $400.²⁰

The following additional data are available with respect to the call option.

As indicated, on March 31, 2014, 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 gives the company a gain of $20,000 ($120,000 − $100,000) on the option contract.²¹ It records the increase in the intrinsic value of the option as follows.

A market appraisal indicates that the time value of the option at March 31, 2014, is $100.²² The company records this change in value of the option as follows.

At March 31, 2014, the company reports the call option in its balance sheet at fair value of $20,100.²³ The unrealized holding gain increases net income for the period. The loss on the time value of the option decreases net income.

On April 16, 2014, 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]) × 1,000) as follows.

The decrease in the time value of the option of $40 ($100 − $60) is recorded as follows.

Thus, at the time of the settlement, the call option's carrying value is as follows.

The company records the settlement of the option contract with Baird as follows.

Illustration 17A-2 summarizes the effects of the call option contract on net income.

The accounting summarized in Illustration 17A-2 is in accord with GAAP. That is, because the call option meets the definition of an asset, the company records it in the balance sheet on March 31, 2014. Furthermore, it reports the call option at fair value, with any gains or losses reported in income.

Differences Between Traditional and Derivative Financial Instruments

How does a traditional financial instrument differ from a derivative one? A derivative financial instrument has the following three basic characteristics. [9]

1. The instrument has (1) one or more underlyings and (2) an identified payment provision. An underlying is a specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. The interaction of the underlying, with the face amount or the number of units specified in the derivative contract (the notional amounts), determines payment. For example, the value of the call option increased in value when the value of the Laredo stock increased. In this case, the underlying is the stock price. To arrive at the payment provision, multiply the change in the stock price by the number of shares (notional amount).
2. The instrument requires little or no investment at the inception of the contract. To illustrate, the company paid a small premium to purchase the call option—an amount much less than if purchasing the Laredo shares as a direct investment.
3. The instrument requires or permits net settlement. As indicated in the call option example, the company could realize a profit on the call option without taking possession of the shares. This net settlement feature reduces the transaction costs associated with derivatives.

Illustration 17A-3 summarizes the differences between traditional and derivative financial instruments. Here, we use a trading security for the traditional financial instrument and a call option as an example of a derivative one.

DERIVATIVES USED FOR HEDGING

Flexibility in use and the low-cost features of derivatives relative to traditional financial instruments explain the popularity of derivatives. An additional use for derivatives is in risk management. For example, companies such as Coca-Cola, ExxonMobil, and General Electric borrow and lend substantial amounts in credit markets. In doing so, they are exposed to significant interest rate risk. That is, they face substantial risk that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease. These same companies also have significant international operations. As such, they are also exposed to exchange rate risk—the risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses.

Companies can use derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. This use of derivatives is referred to as hedging. GAAP established accounting and reporting standards for derivative financial instruments used in hedging activities. The FASB allows special accounting for two types of hedges—fair value and cash flow hedges.²⁴

Fair Value Hedge

In a 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. In a perfectly hedged position, the gain or loss on the fair value of the derivative equals and offsets that of the hedged asset or liability.

Companies commonly use several types of fair value hedges. For example, companies use interest rate swaps to hedge the risk that changes in interest rates will impact the fair value of debt obligations. Or, they use put options to hedge the risk that an equity investment will decline in value.

To illustrate a fair value hedge, assume that on April 1, 2014, 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.

Hayward records available-for-sale securities at fair value on the balance sheet. It reports unrealized gains and losses in equity as part of other comprehensive income.²⁵ Fortunately for Hayward, the value of the Sonoma shares increases to $125 per share during 2014. Hayward records the gain on this investment as follows.

Illustration 17A-4 indicates how Hayward reports the Sonoma investment in its balance sheet.

While Hayward benefits from an increase in the price of Sonoma shares, it 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.

Hayward enters into the put option contract on January 2, 2015, 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.²⁶

At December 31, 2015, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment.

Note that upon designation of the hedge, the accounting for the available-for-sale security changes from regular GAAP. That is, Hayward records the unrealized holding loss in income, not in equity. If Hayward had not followed this accounting, a mismatch of gains and losses in the income statement would result. Thus, special accounting for the hedged item (in this case, an available-for-sale security) is necessary in a fair value hedge.

The following journal entry records the increase in value of the put option on Sonoma shares.

The decline in the price of Sonoma shares results in an increase in the fair value of the put option. That is, Hayward could realize a gain on the put option by purchasing 100 shares in the open market for $120 and then exercise the put option, selling the shares for $125. This results in a gain to Hayward of $500 (100 shares × [$125 − $120]).²⁷

Illustration 17A-5 indicates how Hayward reports the amounts related to the Sonoma investment and the put option.

The increase in fair value on the option offsets or hedges the decline in value on Hayward's available-for-sale security. By using fair value accounting for both financial instruments, the financial statements reflect the underlying substance of Hayward's net exposure to the risks of holding Sonoma stock. By using fair value accounting for both these financial instruments, the balance sheet reports the amount that Hayward would receive on the investment and the put option contract if Hayward sold and settled them, respectively.

Illustration 17A-6 illustrates the reporting of the effects of the hedging transaction on income for the year ended December 31, 2015.

The income statement indicates that the gain on the put option offsets the loss on the available-for-sale securities.²⁸ The reporting for these financial instruments, even when they reflect a hedging relationship, illustrates why the FASB argued that fair value accounting provides the most relevant information about financial instruments, including derivatives.

Cash Flow Hedge

Companies use cash flow hedges to hedge exposures to cash flow risk, which results from the variability in cash flows. The FASB allows special accounting for cash flow hedges. Generally, companies measure and report derivatives at fair value on the balance sheet. They report gains and losses directly in net income. However, companies account for derivatives used in cash flow hedges at fair value on the balance sheet, but they record gains or losses in equity, as part of other comprehensive income.

To illustrate, assume that in September 2014, Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2015. Concerned that prices for aluminum will increase in the next few months, Allied wants to hedge the risk that it might pay higher prices for inventory in January 2015. As a result, Allied enters into an aluminum futures contract.

A futures contract gives the holder the right and the obligation to purchase an asset at a preset price for a specified period of time.²⁹ 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 2015. The underlying for this derivative is the price of aluminum. If the price of aluminum rises above $1,550, the value of the futures contract to Allied increases. Why? Because Allied will be able to purchase the aluminum at the lower price of $1,550 per ton.³⁰

Allied enters into the futures contract on September 1, 2014. 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.

At December 31, 2014, 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.

Allied reports the futures contract in the balance sheet as a current asset. It reports the gain on the futures contract as part of other comprehensive income.

Since Allied has not yet purchased and sold the inventory, this gain arises from an anticipated transaction. In this type of transaction, a company accumulates in equity gains or losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby affecting earnings.

In January 2015, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry.³¹

At the same time, Allied makes final settlement on the futures contract. It records the following entry.

Through use of the futures contract derivative, Allied fixes the cost of its inventory. The $25,000 futures contract settlement offsets the amount paid to purchase the inventory at the prevailing market price of $1,575,000. The result: net cash outflow of $1,550 per metric ton, as desired. As Illustration 17A-7 shows, Allied has therefore effectively hedged the cash flow for the purchase of inventory.

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, affecting earnings through cost of goods sold.

For example, assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2015) is $1,700,000. Allied sells the cans in July 2015 for $2,000,000, and records this sale as follows.

Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction.

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. The futures contract has worked as planned. Allied has managed the cash paid for aluminum inventory and the amount of cost of goods sold.

OTHER REPORTING ISSUES

The preceding examples illustrate the basic reporting issues related to the accounting for derivatives. Next, we discuss the following additional issues:

1. The accounting for embedded derivatives.
2. Qualifying hedge criteria.

Embedded Derivatives

As we indicated at the beginning of this appendix, rapid innovation in the development of complex financial instruments drove efforts toward unifying and improving the accounting standards for derivatives. In recent years, this innovation has led to the development of hybrid securities. These securities have characteristics of both debt and equity. They often combine traditional and derivative financial instruments.

For example, a convertible bond (discussed in Chapter 16) is a hybrid instrument. It consists of two parts: (1) a debt security, referred to as the host security, combined with (2) an option to convert the bond to shares of common stock, the embedded derivative.

To provide consistency in accounting for similar derivatives, a company must account for embedded derivatives similarly to other derivatives. Therefore, 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.³² Thus, a company investing in a convertible bond must separate the stock option component of the instrument. It then accounts for the derivative (the stock option) at fair value and the host instrument (the debt) according to GAAP, as if there were no embedded derivative.³³

Qualifying Hedge Criteria

The FASB identified certain criteria that hedging transactions must meet before requiring the special accounting for hedges. The FASB designed these criteria to ensure the use of hedge accounting in a consistent manner across different hedge transactions. The general criteria relate to the following areas.

1. Documentation, risk management, and designation. At inception of the hedge, there must be formal documentation of the hedging relationship, the company's risk management objective, and the strategy for undertaking the hedge. Designation refers to identifying the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash flows attributable to the hedged risk.

   The FASB decided that documentation and designation are critical to the implementation of the special accounting for hedges. Without these requirements, companies might try to apply the hedge accounting provisions retroactively, only in response to negative changes in market conditions, to offset the negative impact of a transaction on the financial statements. Allowing special hedge accounting in such a setting could mask the speculative nature of the original transaction.

2. Effectiveness of the hedging relationship. At inception and on an ongoing basis, the hedging relationship should be highly effective in achieving offsetting changes in fair value or cash flows. Companies must assess effectiveness whenever preparing financial statements.

   The general guideline for effectiveness is that the fair values or cash flows of the hedging instrument (the derivative) and the hedged item exhibit a high degree of correlation. In practice, high effectiveness is assumed when the correlation is close to one (e.g., within plus or minus .10). In our earlier hedging examples (put option and the futures contract on aluminum inventory), the fair values and cash flows are perfectly correlated. That is, when the cash payment for the inventory purchase increased, it offset, dollar for dollar, the cash received on the futures contract.

   If the effectiveness criterion is not met, either at inception or because of changes following inception of the hedging relationship, the FASB no longer allows special hedge accounting. The company should then account for the derivative as a free-standing derivative.³⁴

3. Effect on reported earnings of changes in fair values or cash flows. A change in the fair value of a hedged item or variation in the cash flow of a hedged forecasted transaction must have the potential to change the amount recognized in reported earnings.³⁵ There is no need for special hedge accounting if a company accounts for both the hedging instrument and the hedged item at fair value under existing GAAP. In this case, earnings will properly reflect the offsetting gains and losses.

   For example, special accounting is not needed for a fair value hedge of a trading security, because a company accounts for both the investment and the derivative at fair value on the balance sheet with gains or losses reported in earnings. Thus, “special” hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP.³⁶

Summary of Derivatives Accounting

Illustration 17A-8 summarizes the accounting provisions for derivatives and hedging transactions.

As indicated, the general accounting for derivatives relies on fair values. GAAP also establishes special accounting guidance when companies use derivatives for hedging purposes. For example, when a company uses a put option to hedge price changes in an available-for-sale stock investment in a fair value hedge (see the Hayward example earlier), it records unrealized gains on the investment in earnings, which is not GAAP for available-for-sale securities without such a hedge. This special accounting is justified in order to accurately report the nature of the hedging relationship in the balance sheet (recording both the put option and the investment at fair value) and in the income statement (reporting offsetting gains and losses in the same period).

Special accounting also is used for cash flow hedges. Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record unrealized holding gains or losses in other comprehensive income until selling or settling the hedged item. In a cash flow hedge, a company continues to record the hedged item at its historical cost.

Disclosure requirements for derivatives are complex. Recent pronouncements on fair value information and financial instruments provide a helpful disclosure framework for reporting derivative instruments. Appendix 17C illustrates many of these disclosures, except for discussion of hedging issues. In general, companies that have derivatives are required to disclose the objectives for holding or issuing those instruments (speculation or hedging), the hedging context (fair value or cash flow), and the strategies for achieving risk-management objectives.

COMPREHENSIVE HEDGE ACCOUNTING EXAMPLE

To provide a comprehensive example of hedge accounting, we examine the use of an interest rate swap. First, let's consider how swaps work and why companies use them.

Options and futures trade on organized securities exchanges. Because of this, options and futures have standardized terms. Although that standardization makes the trading easier, it limits the flexibility needed to tailor contracts to specific circumstances. In addition, most types of derivatives have relatively short time horizons, thereby excluding their use for reducing long-term risk exposure.

As a result, many corporations instead turn to the swap, a very popular type of derivative. A swap is a transaction between two parties in which the first party promises to make a payment to the second party. Similarly, the second party promises to make a simultaneous payment to the first party.

The most common type of swap is the interest rate swap. In this type, one party makes payments based on a fixed or floating rate, and the second party does just the opposite. In most cases, large money-center banks bring together the two parties. These banks handle the flow of payments between the parties, as shown in Illustration 17A-9.

Fair Value Hedge

To illustrate the use of a swap in a fair value hedge, assume that Jones Company issues $1,000,000 of five-year, 8 percent bonds on January 2, 2014. Jones records this transaction as follows.

Jones offered a fixed interest rate to appeal to investors. But Jones is concerned that if market interest rates decline, the fair value of the liability will increase. The company will then suffer an economic loss.³⁷ To protect against the risk of loss, Jones hedges the risk of a decline in interest rates by entering into a five-year interest rate swap contract. Jones agrees to the following terms:

1. Jones will receive fixed payments at 8 percent (based on the $1,000,000 amount).
2. Jones will pay variable rates, based on the market rate in effect for the life of the swap contract. The variable rate at the inception of the contract is 6.8 percent.

As Illustration 17A-10 shows, this swap allows Jones to change the interest on the bonds payable from a fixed rate to a variable rate.

The settlement dates for the swap correspond to the interest payment dates on the debt (December 31). On each interest payment (settlement) date, Jones and the counterparty compute the difference between current market interest rates and the fixed rate of 8 percent, and determine the value of the swap.³⁸ If interest rates decline, the value of the swap contract to Jones increases (Jones has a gain), while at the same time Jones's fixed-rate debt obligation increases (Jones has an economic loss).

The swap is an effective risk-management tool in this setting. Its value relates to the same underlying (interest rates) that will affect the value of the fixed-rate bond payable. Thus, if the value of the swap goes up, it offsets the loss related to the debt obligation.

Assuming that Jones enters into the swap on January 2, 2014 (the same date as the issuance of the debt), the swap at this time has no value. Therefore, no entry is necessary.

At the end of 2014, Jones makes the interest payment on the bonds. It records this transaction as follows.

At the end of 2014, market interest rates have declined substantially. Therefore, the value of the swap contract increases. Recall (see Illustration 17A-9) that in the swap, Jones receives a fixed rate of 8 percent, or $80,000 ($1,000,000 × 8%), and pays a variable rate (6.8%), or $68,000. Jones therefore receives $12,000 ($80,000 − $68,000) as a settlement payment on the swap contract on the first interest payment date. Jones records this transaction as follows.

In addition, a market appraisal indicates that the value of the interest rate swap has increased $40,000. Jones records this increase in value as follows.³⁹

Jones reports this swap contract in the balance sheet. It reports the gain on the hedging transaction in the income statement. Because interest rates have declined, the company records a loss and a related increase in its liability as follows.

Jones reports the loss on the hedging activity in net income. It adjusts bonds payable in the balance sheet to fair value (which deviates from normal accounting at amortized cost).

Financial Statement Presentation of an Interest Rate Swap

Illustration 17A-11 indicates how Jones reports the asset and liability related to this hedging transaction on the balance sheet.

The effect on Jones's balance sheet is the addition of the swap asset and an increase in the carrying value of the bonds payable. Illustration 17A-12 indicates how Jones reports the effects of this swap transaction in the income statement.

On the income statement, Jones reports interest expense of $68,000. Jones has effectively changed the debt's interest rate from fixed to variable. That is, by receiving a fixed rate and paying a variable rate on the swap, the company converts the fixed rate on the bond payable to variable. This results in an effective-interest rate of 6.8 percent in 2014.⁴⁰ Also, the gain on the swap offsets the loss related to the debt obligation. Therefore, the net gain or loss on the hedging activity is zero.

Illustration 17A-13 shows the overall impact of the swap transaction on the financial statements.

In summary, to account for fair value hedges (as illustrated in the Jones example) record the derivative at its fair value in the balance sheet, and record any gains and losses in income. Thus, the gain on the swap offsets or hedges the loss on the bond payable, due to the decline in interest rates.

By adjusting the hedged item (the bond payable in the Jones case) to fair value, with the gain or loss recorded in earnings, the accounting for the Jones bond payable deviates from amortized cost. This special accounting is justified in order to report accurately the nature of the hedging relationship between the swap and the bond payable in the balance sheet (both the swap and the debt obligation are recorded at fair value) and in the income statement (offsetting gains and losses are reported in the same period).⁴¹

CONTROVERSY AND CONCLUDING REMARKS

Companies need rules to properly measure and report derivatives in financial statements. However, some argue that reporting derivatives at fair value results in unrealized gains and losses that are difficult to interpret. Others raise concerns about the complexity and cost of implementing GAAP in this area.

However, we believe that the long-term benefits of using fair value and reporting derivatives at fair value will far outweigh any short-term implementation costs. As the volume and complexity of derivatives and hedging transactions continue to grow, so does the risk that investors and creditors will be exposed to unexpected losses arising from derivative transactions. Statement readers must have comprehensive information concerning many derivative financial instruments and the effects of hedging transactions using derivatives.

SUMMARY OF LEARNING OBJECTIVES FOR APPENDIX 17A

Describe the uses of and accounting for derivatives. Any company or individual that wants to ensure against different types of business risks may use derivative contracts to achieve this objective. In general, these transactions involve some type of hedge. Speculators also use derivatives, attempting to find an enhanced return. Speculators are very important to the derivatives market because they keep it liquid on a daily basis. Arbitrageurs attempt to exploit inefficiencies in various derivative contracts. A company primarily uses derivatives for purposes of hedging its exposure to fluctuations in interest rates, foreign currency exchange rates, and commodity prices.

Companies should recognize derivatives in the financial statements as assets and liabilities, and report them at fair value. Companies should recognize gains and losses resulting from speculation immediately in income. They report gains and losses resulting from hedge transactions in different ways, depending on the type of hedge.

Companies report derivative financial instruments in the balance sheet, and record them at fair value. Except for derivatives used in hedging, companies record realized and unrealized gains and losses on derivative financial instruments in income.

Explain how to account for a fair value hedge. A company records the derivative used in a qualifying fair value hedge at its fair value in the balance sheet, recording any gains and losses in income. In addition, the company also accounts for the item being hedged with the derivative at fair value. By adjusting the hedged item to fair value, with the gain or loss recorded in earnings, the accounting for the hedged item may deviate from GAAP in the absence of a hedge relationship. This special accounting is justified in order to report accurately the nature of the hedging relationship between the derivative hedging instruments and the hedged item. A company reports both in the balance sheet, reporting offsetting gains and losses in income in the same period.

Explain how to account for a cash flow hedge. Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record gains or losses in equity as part of other comprehensive income. Companies accumulate these gains or losses, and reclassify them in income when the hedged transaction's cash flows affect earnings. Accounting is according to GAAP for the hedged item.

Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. A company should separate a derivative that is embedded in a hybrid security from the host security, and account for it using the accounting for derivatives. This separation process is referred to as bifurcation. Special hedge accounting is allowed only for hedging relationships that meet certain criteria. The main criteria are as follows. (1) There is formal documentation of the hedging relationship, the company's risk-management objective, and the strategy for undertaking the hedge, and the company designates the derivative as either a cash flow or fair value hedge. (2) The company expects the hedging relationship to be highly effective in achieving offsetting changes in fair value or cash flows. (3) “Special” hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP.

 

APPENDIX 17B VARIABLE-INTEREST ENTITIES

The FASB has issued rules to address the concern that some companies are not reporting the risks and rewards of certain investments and other financial arrangements in their consolidated financial statements. [12] As one analyst noted, Enron showed the world the power of the idea that “if investors can't see it, they can't ask you about it—the ‘it’ being assets and liabilities.”

What exactly did Enron do? First, it created a number of entities whose purpose was to hide debt, avoid taxes, and enrich certain management personnel to the detriment of the company and its stockholders. In effect, these entities, called special-purpose entities (SPEs), appeared to be separate entities for which Enron had a limited economic interest. However, for many of these arrangements, Enron actually had a substantial economic interest. The risks and rewards of ownership were not shifted to the entities but remained with Enron. In short, Enron was obligated to repay investors in these SPEs when they were unsuccessful. Once Enron's problems were discovered, it soon became apparent that many other companies had similar problems.

WHAT ABOUT GAAP?

A reasonable question to ask with regard to SPEs is, “Why didn't GAAP prevent companies from hiding SPE debt and other risks, by forcing companies to include these obligations in their consolidated financial statements?” To understand why, we have to look at the basic rules of consolidation.

The GAAP rules indicate that consolidated financial statements are “usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in other companies.” They further note that “the usual condition for a controlling financial interest is ownership of a majority voting interest.”⁴² In other words, if a company like Intel owns more than 50 percent of the voting stock of another company, Intel consolidates that company. GAAP also indicates that controlling financial interest may be achieved through arrangements that do not involve voting interests. However, applying these guidelines in practice is difficult.

Whenever GAAP uses a clear line, like “greater than 50 percent,” companies sometimes exploit the criterion. For example, some companies set up joint ventures in which each party owns exactly 50 percent. In that case, neither party consolidates. Or like Coca-Cola, a company may own less than 50 percent of the voting stock but maintain effective control through board of director relationships, supply relationships, or through some other type of financial arrangement.

So the FASB realized that changes had to be made to GAAP for consolidations, and it issued expanded consolidation guidelines. These guidelines define when a company should use factors other than voting interest to determine controlling financial interest. In this pronouncement, the FASB created a new risk-and-reward model to be used in situations where voting interests were unclear. The risk-and-reward model answers the basic questions of who stands to gain or lose the most from ownership in an SPE when ownership is uncertain.

In other words, we now have 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.

Operationally, the voting-interest model is easy to apply. It sets a “bright-line” ownership standard of more than 50 percent of the voting stock. However, if companies cannot determine control based on voting interest, they must use the risk-and-reward model.

CONSOLIDATION OF VARIABLE-INTEREST ENTITIES

To answer the question of who gains or loses when voting rights do not determine consolidation, the FASB developed the risk-and-reward model. In this model, the FASB introduced the notion of a variable-interest entity. A variable-interest entity (VIE) is an entity that has one of the following characteristics:

1. Insufficient equity investment at risk. Stockholders are assumed to have sufficient capital investment to support the entity's operations. If thinly capitalized, the entity is considered a VIE and is subject to the risk-and-reward model.
2. Stockholders lack decision-making rights. In some cases, stockholders do not have the influence to control the company's destiny.
3. Stockholders do not absorb the losses or receive the benefits of a normal stockholder. In some entities, stockholders are shielded from losses related to their primary risks, or their returns are capped or must be shared with other parties.

Once the company determines that an entity is a variable-interest entity, it no longer can use the voting-interest model. The question that must then be asked is, “What party is exposed to the majority of the risks and rewards associated with the VIE?” This party is called the primary beneficiary and must consolidate the VIE. Illustration 17B-1 shows the decision model for the VIE consolidation model.⁴³

Some Examples

Let's look at a couple of examples to illustrate how this process works.

Example 1

Assume that Citigroup sells notes receivable to another entity called RAKO. RAKO's assets are financed in two ways: Lenders provide 90 percent, and investors provide the remaining 10 percent as an equity investment. If Citigroup does not guarantee the debt, Citigroup has low or nonexistent risk. Therefore, Citigroup would not consolidate the assets and liabilities of RAKO. On the other hand, if Citigroup guarantees RAKO's debt, then RAKO is a VIE, and Citigroup is the primary beneficiary. In that case, Citigroup must consolidate.

Example 2

San Diego Gas and Electric (SDGE) is required by law to buy power from small, local producers. In some cases, SDGE has contracts requiring it to purchase substantially all the power generated by these local companies over their lifetime. Because SDGE controls the outputs of the producers, they are VIEs. In this case, the risks and rewards related to ownership apply to SDGE. In other words, it is the primary beneficiary, and SDGE should include these producers in the consolidated financial statements.

Note that the primary beneficiary may have the risks and rewards of ownership through use of a variety of instruments and financial arrangements, such as equity investments, loans to the VIE, leases, derivatives, and guarantees. Potential VIEs include corporations, partnerships, limited liability companies, and majority-owned subsidiaries.

What Is Happening in Practice?

For most companies, the reporting related to VIEs will not materially affect their financial statements. As shown in Illustration 17B-2, one study of 509 companies with total market values over $500 million found that just 17 percent of the companies reviewed had a material impact when the VIE rules were first implemented.

Of the material VIEs disclosed in the study, the most common types (42 percent) were related to joint-venture equity investments, followed by off-balance-sheet lease arrangements (22 percent). In some cases, companies restructured transactions to avoid consolidation. For example, Pep Boys, Choice Point, Inc., and Anadarko all appear to have restructured their lease transactions to avoid consolidation. On the other hand, companies like eBay, Kimberly-Clark, and Williams-Sonoma Inc. had to consolidate their VIEs. With respect to the new guidelines for VIEs, companies began reporting under these rules in 2010. Some estimates have as much as $5 trillion of assets that could be brought on-balance-sheet under the new rules. As an example, JP Morgan reported in a recent annual report that up to $160 billion of credit card receivables and other mortgage-backed loans will have to be consolidated when it adopts the new rules.

In summary, companies are required to consolidate certain investments and other financing arrangements that previously were reported off-balance-sheet. As a result, financial statements should be more complete in reporting the risks and rewards of these transactions.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17B

Describe the accounting for variable-interest entities. Special variable-interest accounting is used in situations where control cannot be determined based on voting rights. A company is required to consolidate a variable-interest entity if it is the primary beneficiary of the variable-interest entity.

 

APPENDIX 17C FAIR VALUE DISCLOSURES

As indicated in the chapter, the FASB believes that fair value information is relevant for making effective business decisions. However, 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 to achieve financial results inconsistent with the underlying economics of the situation.

The Board recognizes these concerns and has attempted to develop a sound conceptual basis for measuring and reporting fair value information. In addition, it has placed emphasis on developing guidelines for reporting fair value information for financial instruments because many of these instruments have relatively active markets for which valuations can be reliably determined. The purpose of this appendix is to explain the disclosure requirements for financial instruments related to fair value information.

DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTS

One requirement related to fair value disclosure is that both the cost and the fair value of all financial instruments be reported in the notes to the financial statements. [14] This enables readers of the financial statements to understand the fair value of the company's financial instruments and the potential gains and losses that might occur in the future as a result of these instruments.

The Board 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. 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. It therefore is important to understand the varying risks involved in measurement. It is difficult to incorporate these levels of uncertainty into the financial statements. Disclosure provides a framework for addressing the qualitative aspects related to risk and measurement.
2. 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. Note disclosure provides an opportunity to explain more precisely the impact that changes in the value of financial instruments have on financial results. In assessing the inputs, the Board recognizes that the reliability of the fair value measurement is of extreme importance. Many financial instruments are traded in active markets, and their valuation is not difficult. Other instruments are complex/illiquid, and their valuation is difficult.

To highlight these levels of reliability in valuation, the FASB established a fair value hierarchy. As discussed in Chapter 2 (page 57), this hierarchy identifies three broad levels—1, 2, and 3—related to the measurement of fair values. 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.

Illustration 17C-1 is an example of a fair value note disclosure for Sabathia Company. It includes both the fair value amounts and the reliability level. (A similar disclosure would be presented for liabilities.)

For assets and liabilities measured at fair value and classified as Level 3, a reconciliation of Level 3 changes for the period is required. In addition, companies should report an analysis of how Level 3 changes in fair value affect total gains and losses and their impact on net income. Illustration 17C-2 is an example of this disclosure.

Sabathia Company's disclosure provides to the user of the financial statements an understanding of the following:

1. The carrying amount and the fair value of the company's financial instruments segregated by level of reliability. Thus, the reader of the financial statements has a basis for judging what credence should be given to the fair value amounts.
2. For Level 3 financial instruments, a reconciliation of the balance from the beginning to the end of the period. This reconciliation enables the reader to understand the composition of the change. It is important because these calculations are most affected by subjective estimates and could be subject to manipulation.
3. The impact of changes in fair value on the net assets of the company from one period to the next.

For companies that choose to use the fair value option for some or all of their financial instruments [15], they are permitted to incorporate the entire guidelines related to fair value measurement into one master schedule, or they can provide in a separate schedule information related solely to the fair value option.

Finally, companies must provide the following (with special emphasis on Level 3 measurements):

1. Quantitative information about significant unobservable inputs used for all Level 3 measurements.
2. A qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed, including interrelationships between inputs.
3. A description of the company's valuation process.
4. Any transfers between Levels 1 and 2 of the fair value hierarchy.
5. Information about nonfinancial assets measured at fair value at amounts that differ from the assets' highest and best use.
6. The proper hierarchy classification for items that are not recognized on the balance sheet but are disclosed in the notes to the financial statements.

A typical disclosure related to Level 3 fair value measurements is presented in Illustration 17C-3.

DISCLOSURE OF FAIR VALUES: IMPAIRED ASSETS OR LIABILITIES

In addition to financial instruments, companies often have assets or liabilities that are remeasured on a nonrecurring basis due to impairment. In this case, the fair value hierarchy can highlight the reliability of the measurement, coupled with the related gain or loss for the period. Illustration 17C-4 highlights this disclosure for McClung Company.

CONCLUSION

With recent joint FASB and IASB standard-setting efforts, we now have convergence with respect to fair value measurement, both in terms of the definition and measurement guidelines when fair value is the measurement approach in GAAP and IFRS. In addition, GAAP and IFRS have the same fair value disclosure requirements, as illustrated in this appendix. As the former chair of the IASB noted, this “marks the completion of a major convergence project and is a fundamentally important element of our joint response to the global crisis. The result is clearer and more consistent guidance on measuring fair value, where its use is already required.”

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17C

Describe required fair value disclosures. The FASB has developed required fair value disclosures in response to concerns about the reliability of fair value measures. Disclosure elements include fair value amounts and reliability levels as well as impaired assets or liabilities.

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