What to Do?

A few years ago, a bank reported an $87.3 million write-down on its mortgage-backed securities. However, the bank stated that it expected its actual losses to be only $44,000. The loss of $44,000 was equal to a modest loss on a condo foreclosure. The bank's regulator found “the accounting result absurd.” However, the rest of the story is that the bank a year later raised its credit-loss estimate by $263.1 million, quite a difference from its original loss estimate of $44,000.

This bank example highlights the challenge of valuing financial assets such as loans, derivatives, and other debt investments. The fundamental question that emerged out of the example above and, more significantly, the recent financial crisis is: Should financial instruments be valued at amortized cost, fair value, or some other measure(s)? As one analyst noted, the opinion that fair value accounting weakens financial and economic stability has persisted among many regulators and politicians. But, some investors and others believe that fair value is the right answer because it is more transparent information. OK, so what to do?

The IASB's response was to issue a new standard on financial assets (IFRS 9) that uses a mixed-attribute approach. Some of the financial assets are valued at amortized cost and others at fair value. In addition, the FASB has issued an exposure draft on how it believes financial assets should be reported. Unfortunately, at this point the two bodies do not agree as to how these instruments should be accounted for and reported.

A survey by the Chartered Financial Analysts association on IFRS 9 contained the following question on the new standard: “Do you agree that the IASB's new standard requiring classification into amortized cost or fair value will improve the decision-usefulness of overall financial instrument accounting?” The survey results indicate that 47 percent believe the IASB's approach improves the decision-usefulness of information. This lukewarm support for the new rules is somewhat troubling given that the group surveyed is representative of the IASB's key constituency—investors and creditors.

Interestingly, the European Union has refused to adopt the requirements of IFRS 9, arguing that this standard requires too much fair value information. Nevertheless, the standard was issued and other countries that follow IFRS will soon be implementing the new standard. Thus, the early reaction to IFRS 9 indicates that, unfortunately, once again politics is raising its ugly head on an accounting issue. Some European regulators have suggested that the IASB's future funding may even depend on the Board putting more regulators on it. Such an intrusion could lead to the end of the convergence efforts between the IASB and the FASB.

Sources: Adapted from Jonathan Weil, “Suing Wall Street Banks Never Looked So Shady,” http://www.bloomberg.com/apps/news?pid=20601039&sid=7ZeWzn42KX4 (February 28, 2010); Rachel Sanderson and Jennifer Hughes, “Carried Forward,” Financial Times Online (April 20, 2010); and CFA Institute, Survey on Proposed Financial Instrument Accounting Changes and International Convergence (November 2009).

ACCOUNTING FOR FINANCIAL ASSETS

A financial asset is cash, an equity investment of another company (e.g., ordinary or preference shares), or a contractual right to receive cash from another party (e.g., loans, receivables, and bonds). [1] The accounting for cash is relatively straightforward and is discussed in Chapter 7. The accounting and reporting for equity and debt investments, as discussed in the opening story, is extremely contentious, particularly in light of the credit crisis in the latter part of 2008.

See the Authoritative Literature section (page 861).

Some users of financial statements support a single measurement—fair value—for all financial assets. They view fair value as more relevant than other measurements in helping investors assess the effect of current economic events on the future cash flows of a financial asset. In addition, they believe that the use of a single method promotes consistency in valuation and reporting on the asset, thereby improving the usefulness of the financial statements. Others disagree. These financial statement users note that many investments are not held for sale but rather for the income they will generate over the life of the investment. They believe cost-based information (referred to as amortized cost) provides the most relevant information for predicting future cash flows in these cases. Finally, some express concern that using fair value information to measure financial assets is unreliable when markets for the investments are not functioning in an ordinary fashion.

After much discussion, the IASB decided that reporting all financial assets at fair value is not the most appropriate approach for providing relevant information to financial statement users. The IASB noted that both fair value and a cost-based approach can provide useful information to financial statement readers for particular types of financial assets in certain circumstances. As a result, the IASB requires that companies classify financial assets into two measurement categories—amortized cost and fair value—depending on the circumstances.

Measurement Basis–A Closer Look

In general, IFRS requires that companies determine how to measure their financial assets based on two criteria:

• The company's business model for managing its financial assets; and
• The contractual cash flow characteristics of the financial asset.

If a company has (1) a business model whose objective is to hold assets in order to collect contractual cash flows and (2) the contractual terms of the financial asset provides specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding, then the company should use amortized cost.[2]¹

For example, assume that Mitsubishi (JPN) purchases a bond investment that it intends to hold to maturity. Its business model for this type of investment is to collect interest and then principal at maturity. The payment dates for the interest rate and principal are stated on the bond. In this case, Mitsubishi accounts for the investment at amortized cost. If, on the other hand, Mitsubishi purchased the bonds as part of a trading strategy to speculate on interest rate changes (a trading investment), then the debt investment is reported at fair value. As a result, only debt investments such as receivables, loans, and bond investments that meet the two criteria above are recorded at amortized cost. All other debt investments are recorded and reported at fair value.

Equity investments are generally recorded and reported at fair value. Equity investments do not have a fixed interest or principal payment schedule and therefore cannot be accounted for at amortized cost. In summary, companies account for investments based on the type of security, as indicated in Illustration 17-1.

ILLUSTRATION 17-1
Summary of Investment Accounting Approaches

We organize our study of investments by type of investment security. Within each section, we explain how the accounting for investments in debt and equity securities varies according to how the investment is managed and the contractual cash flow characteristics of the investment.

DEBT INVESTMENTS

Debt investments are characterized by contractual payments on specified dates of principal and interest on the principal amount outstanding. Companies measure debt investments at amortized cost if the objective of the company's business model is to hold the financial asset to collect the contractual cash flows (held-for-collection). Amortized cost is the initial recognition amount of the investment minus repayments, plus or minus cumulative amortization and net of any reduction for uncollectibility. If the criteria for measurement at amortized cost are not met, then the debt investment is valued and accounted for at fair value. Fair value is the amount for which an asset could be exchanged between knowledgeable willing parties in an arm's length transaction.[4]

Debt Investments–Amortized Cost

Only debt investments can be measured at amortized cost. If a company like Carrefour (FRA) makes an investment in the bonds of Nokia (FIN), it will receive contractual cash flows of interest over the life of the bonds and repayment of the principal at maturity. If it is Carrefour's strategy to hold this investment in order to receive these cash flows over the life of the bond, it has a held-for-collection strategy and it will measure the investment at amortized cost.²

Example: Debt Investment at Amortized Cost

To illustrate the accounting for a debt investment at amortized cost, assume that Robinson Company purchased €100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2015, at a discount, paying €92,278. The bonds mature January 1, 2020, and yield 10 percent; interest is payable each July 1 and January 1. Robinson records the investment as follows.

As indicated in Chapter 14, companies must amortize premiums or discounts using the effective-interest method. 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 17-2 shows the effect of the discount amortization on the interest revenue that Robinson records each period for its investment in Evermaster bonds.

ILLUSTRATION 17-2
Schedule of Interest Revenue and Bond Discount Amortization—Effective-Interest Method

Robinson records the receipt of the first semiannual interest payment on July 1, 2015 (using the data in Illustration 17-2), as follows.

Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2015, as follows.

Again, Illustration 17-2 shows the interest and amortization amounts.

Robinson reports its investment in Evermaster bonds in its December 31, 2015, financial statements, as follows.³

ILLUSTRATION 17-3
Reporting of Bond Investments at Amortized Cost

Sometimes, a company sells a bond investment before its maturity. For example, Robinson Company may sell securities as part of a change in its investment strategy to move away from five-year debt investments, like the Evermaster bonds, to invest in shorter-term bonds. Such a strategy would allow the bonds to reprice more frequently in response to interest rate changes. Let's assume 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 €522( × €783). Robinson records this discount amortization as follows.

Illustration 17-4 shows the computation of the realized gain on the sale.

ILLUSTRATION 17-4
Computation of Gain on Sale of Bonds

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.

Debt Investments–Fair Value

In some cases, companies both manage and evaluate investment performance on a fair value basis. In these situations, these investments are managed and evaluated based on a documented risk-management or investment strategy based on fair value information. For example, some companies often hold debt investments with the intention of selling them in a short period of time. These debt investments are often referred to as trading investments because companies frequently buy and sell these investments to generate profits from short-term differences in price.

Companies that account for and report debt investments at fair value follow the same accounting entries as debt investments held-for-collection during the reporting period. That is, they are recorded at amortized cost. However, at each reporting date, companies adjust the amortized cost to fair value, with any unrealized holding gain or loss reported as part of net income (fair value method). An unrealized holding gain or loss is the net change in the fair value of a debt investment from one period to another.

Example: Debt Investment at Fair Value (Single Security)

To illustrate the accounting for debt investments using the fair value approach, assume the same information as in our previous example for Robinson Company. Recall that Robinson Company purchased €100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2015, at a discount, paying €92,278.⁴ The bonds mature January 1, 2020, and yield 10 percent; interest is payable each July 1 and January 1.

The journal entries in 2015 are exactly the same as those for amortized cost. These entries are as follows.

Again, Illustration 17-2 shows the interest and amortization amounts. If the debt investment is held-for-collection, no further entries are necessary. To apply the fair value approach, Robinson determines that, due to a decrease in interest rates, the fair value of the debt investment increased to €95,000 at December 31, 2015. Comparing the fair value with the carrying amount of these bonds at December 31, 2015, Robinson has an unrealized holding gain of €1,463, as shown in Illustration 17-5.

ILLUSTRATION 17-5
Computation of Unrealized Gain on Fair Value Debt Investment (2015)

Robinson therefore makes the following entry to record the adjustment of the debt investment to fair value at December 31, 2015.

Robinson uses a valuation account (Fair Value Adjustment) instead of debiting Debt Investments to record the investment at fair value. The use of the Fair Value Adjustment account enables Robinson to maintain a record at amortized cost in the accounts. Because the valuation account has a debit balance, in this case the fair value of Robinson's debt investment is higher than its amortized cost.

The Unrealized Holding Gain or Loss—Income account is reported in the “Other income and expense” section of the income statement as part of net income. This account is closed to net income each period. The Fair Value Adjustment account is not closed each period and is simply adjusted each period to its proper valuation. The Fair Value Adjustment balance is not shown on the statement of financial position but is simply used to restate the debt investment account to fair value.

Robinson reports its investment in Evermaster bonds in its December 31, 2015, financial statements as shown in Illustration 17-6.

ILLUSTRATION 17-6
Financial Statement Presentation of Debt Investments at Fair Value

Continuing with our example, at December 31, 2016, assume that the fair value of the Evermaster debt investment is €94,000. In this case, Robinson records an unrealized holding loss of €2,388, as shown in Illustration 17-7.

ILLUSTRATION 17-7
Computation of Unrealized Gain on Debt Investment (2016)

As indicated in Illustration 17-7, the fair value of the debt investment is now less than the amortized cost by €925. However, Robinson had recorded an unrealized gain in 2015. Therefore, Robinson records a loss of €2,388 (€925 + €1,463), which offsets the gain recorded in 2015, resulting in a credit in the Fair Value Adjustment account of €925. Robinson makes the following journal entry.

A credit balance in the Fair Value Adjustment account of €925 (€2,388 − €1,463) reduces the amortized cost amount to fair value. Robinson reports its investment in Evermaster bonds in its December 31, 2016, financial statements as shown in Illustration 17-8.

ILLUSTRATION 17-8
Financial Statement Presentation of Debt Investments at Fair Value (2016)

Assume now that Robinson sells its investment in Evermaster bonds on November 1, 2017, at 99¾ plus accrued interest, similar to our earlier illustration on page 817. All the entries and computations are the same as the amortized cost example. The only difference occurs on December 31, 2017. In that case, since the bonds are no longer owned by Robinson, the Fair Value Adjustment account should now be reported at zero. Robinson makes the following entry to record the elimination of the valuation account.

At December 31, 2017, the income related to the Evermaster bonds is as shown in Illustration 17-9.

ILLUSTRATION 17-9
Income Effects on Debt Investment (2015–2017)

As indicated, over the life of the bond investment, interest revenue and the gain on sale are the same using either amortized cost or fair value measurement. However, under the fair value approach, an unrealized gain or loss is recorded in income in each year as the fair value of the investment changes. Overall, the gains or losses net out to zero.

Example: Debt Investment at Fair Value (Portfolio)

To illustrate the accounting for a portfolio of debt investments, assume that Wang Corporation has two debt investments accounted for at fair value. Illustration 17-10 identifies the amortized cost, fair value, and the amount of the unrealized gain or loss (amounts in thousands).

ILLUSTRATION 17-10
Computation of Fair Value Adjustment—Fair Value Debt Investments (2015)

The fair value of Wang's debt investment 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 the portfolio is ¥9,537 lower than its amortized cost. Wang makes an adjusting entry to the Fair Value Adjustment account to record the decrease in value and to record the loss as follows.

Wang reports the unrealized holding loss of ¥9,537 in income.

Sale of Debt Investments

If a company sells bonds carried as fair value investments 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 Wang Corporation sold the Watson bonds (from Illustration 17-10) on July 1, 2016, for ¥90,000, at which time it had an amortized cost of ¥94,214. Illustration 17-11 shows the computation of the realized loss.

ILLUSTRATION 17-11
Computation of Loss on Sale of Bonds

Wang records the sale of the Watson bonds as follows.

Wang reports this realized loss in the “Other income and expense” section of the income statement. Assuming no other purchases and sales of bonds in 2016, Wang on December 31, 2016, has the information shown in Illustration 17-12.

ILLUSTRATION 17-12
Computation of Fair Value Adjustment (2016)

Wang has an unrealized holding loss of ¥5,000. However, the Fair Value Adjustment account already has a credit balance of ¥9,537. To reduce the adjustment account balance to ¥5,000, Wang debits it for ¥4,537, as follows.

Financial Statement Presentation

Wang's December 31, 2016, statement of financial position and the 2016 income statement include the following items and amounts (the Anacomp bonds are current assets because they are held for trading).

ILLUSTRATION 17-13
Reporting of Debt Investments at Fair Value

Fair Value Option

In some situations, a company meets the criteria for accounting for a debt investment at amortized cost, but it would rather account for the investment at fair value, with all gains and losses related to changes in fair value reported in income. The most common reason is to address a measurement or recognition “mismatch.” For example, assume that Pirelli (ITA) purchases debt investments that it plans to manage on a held-for-collection basis (and account for at amortized cost). Pirelli also manages and evaluates this investment in conjunction with a related liability that is measured at fair value. Pirelli has a mismatch on these related financial assets because, even though the fair value of the investment may change, no gains and losses are recognized, while gains and losses on the liability are recorded in income.

To address this mismatch, companies have the option to report most financial assets at fair value. This option is applied on an instrument-by-instrument basis and 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 measures this instrument at fair value until the company no longer has ownership. [8] By choosing the fair value option for the debt investment, Pirelli records gains and losses in income, which will offset the gains and losses recorded on the liability, thereby providing more relevant information about these related financial assets.

To illustrate, assume that Hardy Company purchases bonds issued by the German Central Bank. Hardy plans to hold the debt investment until it matures in five years. At December 31, 2015, the amortized cost of this investment is €100,000; its fair value at December 31, 2015, is €113,000. If Hardy chooses the fair value option to account for this investment, it makes the following entry at December 31, 2015.

In this situation, Hardy uses an account titled Debt Investment to record the change in fair value at December 31. It does not use the Fair Value Adjustment account because the accounting for the 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 even though it is managing the investment on a held-for-collection basis. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security.

Summary of Debt Investment Accounting

The following chart summarizes the basic accounting for debt investments.

ILLUSTRATION 17-14
Summary of Debt Investment Accounting

EQUITY INVESTMENTS

An equity investment represents ownership interest, such as ordinary, preference, or other capital shares. It also includes rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants and rights. The cost of equity investments is measured at the purchase price of the security. Broker's commissions and other fees incidental to the purchase are recorded as expense. [9]

The degree to which one corporation (investor) acquires an interest in the shares 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 shares 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 17-15 lists these levels of interest or influence and the corresponding valuation and reporting method that companies must apply to the investment.

ILLUSTRATION 17-15
Levels of Influence Determine Accounting Methods

The accounting and reporting for equity investments therefore depend on the level of influence and the type of security involved, as shown in Illustration 17-16.

ILLUSTRATION 17-16
Accounting and Reporting for Equity Investments by Category

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. As indicated in Illustration 17-16, there are two classifications for holdings less than 20 percent. Under IFRS, the presumption is that equity investments are held-for-trading. That is, companies hold these securities to profit from price changes. As with debt investments that are held-for-trading, the general accounting and reporting rule for these investments is to value the securities at fair value and record unrealized gains and losses in net income (fair value method).⁵

However, some equity investments are held for purposes other than trading. For example, a company may be required to hold an equity investment in order to sell its products in a particular area. In this situation, the recording of unrealized gains and losses in income, as is required for trading investments, is not indicative of the company's performance with respect to this investment. As a result, IFRS allows companies to classify some equity investments as non-trading. Non-trading equity investments are recorded at fair value on the statement of financial position, with unrealized gains and losses reported in other comprehensive income. [11]

Equity Investments–Trading (Income)

Upon acquisition, companies record equity investments at fair value.⁶ To illustrate, assume that on November 3, 2015, Republic Corporation purchased ordinary shares of three companies, each investment representing less than a 20 percent interest. These shares are held-for-trading.

Republic records these investments as follows.

On December 6, 2015, Republic receives a cash dividend of €4,200 on its investment in the ordinary shares of Nestlé. It records the cash dividend as follows.

All three of the investee companies reported net income for the year, but only Nestlé declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the shares of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income earned by 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 earns net income only when the investee declares cash dividends.

At December 31, 2015, Republic's equity investment portfolio has the carrying value and fair value shown in Illustration 17-17.

ILLUSTRATION 17-17
Computation of Fair Value Adjustment—Equity Investment Portfolio (2015)

For Republic's equity investment 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 equity investment portfolio is below cost by €35,550.

Republic records the net unrealized gains and losses related to changes in the fair value of equity investments in an Unrealized Holding Gain or Loss—Income account. Republic reports this amount as “Other income and expense.” In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss—Income 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, 2016, Republic sold all of its Burberry ordinary shares, receiving €287,220. Illustration 17-18 shows the computation of the realized gain on the sale.

ILLUSTRATION 17-18
Computation of Gain on Sale of Burberry Shares

Republic records the sale as follows.

In addition, assume that on February 10, 2016, Republic purchased €255,000 of Continental Trucking ordinary shares (20,000 shares × €12.75 per share), plus brokerage commissions of €1,850.

Illustration 17-19 lists Republic's equity investment portfolio as of December 31, 2016.

ILLUSTRATION 17-19
Computation of Fair Value Adjustment—Equity Investment Portfolio (2016)

At December 31, 2016, the fair value of Republic's equity investment portfolio exceeds carrying value by €66,100 (unrealized gain). The Fair Value Adjustment account had a credit balance of €35,550 at December 31, 2016. To adjust its December 31, 2016, equity investment portfolio to fair value, the company debits the Fair Value Adjustment account for €101,650(€35,550 + €66,100). Republic records this adjustment as follows.

Equity Investments–Non-Trading (OCI)

The accounting entries to record non-trading equity investments are the same as for trading equity investments, except for recording the unrealized holding gain or loss. For non-trading equity investments, companies report the unrealized holding gain or loss as other comprehensive income. Thus, the account titled Unrealized Holding Gain or Loss—Equity is used.

To illustrate, assume that on December 10, 2015, Republic Corporation purchased 1,000 ordinary shares of Hawthorne Company for €20.75 per share (total cost €20,750). The investment represents less than a 20 percent interest. Hawthorne is a distributor for Republic products in certain locales, the laws of which require a minimum level of share ownership of a company in that region. The investment in Hawthorne meets this regulatory requirement. As a result, Republic accounts for this investment at fair value, with unrealized gains and losses recorded in other comprehensive income (OCI).⁷ Republic records this investment as follows.

On December 27, 2015, Republic receives a cash dividend of €450 on its investment in the ordinary shares of Hawthorne Company. It records the cash dividend as follows.

Similar to the accounting for trading investments, when an investor owns less than 20 percent of the ordinary shares of another corporation, it is presumed that the investor has relatively little influence on the investee. Therefore, the investor earns income when the investee declares cash dividends.

At December 31, 2015, Republic's investment in Hawthorne has the carrying value and fair value shown in Illustration 17-20.

ILLUSTRATION 17-20
Computation of Fair Value Adjustment—Non-Trading Equity Investment (2015)

For Republic's non-trading investment, the unrealized gain is €3,250. That is, the fair value of the Hawthorne investment exceeds cost by €3,250. Because Republic has classified this investment as non-trading, Republic records the unrealized gains and losses related to changes in the fair value of this non-trading equity investment 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 equity). In this case, Republic prepares an adjusting entry crediting the Unrealized Holding Gain or Loss—Equity account and debiting the Fair Value Adjustment account to record the increase in fair value and to record the gain as follows.

Republic reports its equity investments in its December 31, 2015, financial statements as shown in Illustration 17-21.

ILLUSTRATION 17-21
Financial Statement Presentation of Equity Investments at Fair Value (2015)

During 2016, sales of Republic products through Hawthorne as a distributor did not meet management's goals. As a result, Republic withdrew from these markets. On December 20, 2016, Republic sold all of its Hawthorne Company ordinary shares, receiving proceeds of €22,500. Republic determines the unrealized gain and loss on the investment at the time of the disposition as shown in Illustration 17-22.

ILLUSTRATION 17-22
Adjustment to Carrying Value of Investment

Republic makes the following entry to adjust the carrying value of the non-trading investment.

The following entry is then made to record the sale of the investment.

As a result of these entries, the Fair Value Adjustment account is eliminated. Note that all gains and losses on the non-trading investment are recorded in equity.⁸

In summary, the accounting for non-trading equity investments deviates from the general provisions for equity investments. The IASB noted that while fair value provides the most useful information about investments in equity investments, recording unrealized gains or losses in other comprehensive income is more representative for non-trading equity investments. [14]

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 shares of less than 50 percent can still give an investor the ability to exercise significant influence over the operating and financial policies of an investee. [15] For example, Siemens AG (DEU) owns 34 percent of Areva (FRA) (which constructs power plants). Areva is very important to Siemens because the power industry is a key customer for its generators and other power-related products. Thus, Siemens has a significant (but not controlling) ownership stake in a power plant construction company, which helps Siemens push its products into the market. 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 shares 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.⁹

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 dividends received by the investor from the investee also decrease the investment's carrying amount. The equity method recognizes that the investee's earnings increase the investee's net assets, and that the 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 investment as trading. Where this example applies the equity method, assume that the 20 percent interest permits Maxi to exercise significant influence. Illustration 17-23 shows the entries.

ILLUSTRATION 17-23
Comparison of Fair Value Method and Equity Method

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 (USA), 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 (USA), Basis Technology (USA), Drugstore.com (USA), and Eziba.com (USA). 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. [17]

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 ordinary shares of the subsidiary as a long-term investment on the separate financial statements of the parent.

When the parent treats the subsidiary as an investment, 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.

OTHER REPORTING ISSUES

We have identified the basic issues involved in accounting for investments in debt and equity securities. In addition, the following issues relate to the accounting for investments.

1. Impairment of value.
2. Transfers between categories.

Impairment of Value

A company should evaluate every held-for-collection investment, at each reporting date, to determine if it has suffered impairment—a loss in value such that the fair value of the investment is below its carrying value.¹⁰ For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a permanent loss. If the company determines that an investment is impaired, it writes down the amortized cost basis of the individual security to reflect this loss in value. The company accounts for the write-down as a realized loss, and it includes the amount in net income.

For debt investments, 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.” If an investment is impaired, the company should measure the loss due to the impairment. This impairment loss is calculated as the difference between the carrying amount plus accrued interest and the expected future cash flows discounted at the investment's historical effective-interest rate. [18]

Example: Impairment Loss

At December 31, 2014, Mayhew Company has a debt investment in Bao Group, purchased at par for ¥200,000 (amounts in thousands). The investment has a term of four years, with annual interest payments at 10 percent, paid at the end of each year (the historical effective-interest rate is 10 percent). This debt investment is classified as held-for-collection. Unfortunately, Bao is experiencing significant financial difficulty and indicates that it will be unable to make all payments according to the contractual terms. Mayhew uses the present value method for measuring the required impairment loss. Illustration 17-24 shows the cash flow schedule prepared for this analysis.

ILLUSTRATION 17-24
Investment Cash Flows

As indicated, the expected cash flows of ¥264,000 are less than the contractual cash flows of ¥280,000. The amount of the impairment to be recorded equals the difference between the recorded investment of ¥200,000 and the present value of the expected cash flows, as shown in Illustration 17-25.

ILLUSTRATION 17-25
Computation of Impairment Loss

The loss due to the impairment is ¥12,680.¹¹ Why isn't it ¥16,000 (¥280,000 − ¥264,000)? A loss of ¥12,680 is recorded because Mayhew must measure the loss at a present value amount, not at an undiscounted amount. Mayhew recognizes an impairment loss of ¥12,680 by debiting Loss on Impairment for the expected loss. At the same time, it reduces the overall value of the investment. The journal entry to record the loss is therefore as follows.

Recovery of Impairment Loss

Subsequent to recording an impairment, events or economic conditions may change such that the extent of the impairment loss decreases (e.g., due to an improvement in the debtor's credit rating). In this situation, some or all of the previously recognized impairment loss shall be reversed with a debit to the Debt Investments account and crediting Recovery of Impairment Loss. Similar to the accounting for impairments of receivables shown in Chapter 7, the reversal of impairment losses shall not result in a carrying amount of the investment that exceeds the amortized cost that would have been reported had the impairment not been recognized.

Transfers Between Categories

Transferring an investment from one classification to another should occur only when the business model for managing the investment changes. The IASB expects such changes to be rare. [19] Companies account for transfers between classifications prospectively, at the beginning of the accounting period after the change in the business model.¹²

To illustrate, assume that British Sky Broadcasting Group plc (GBR) has a portfolio of debt investments that are classified as trading; that is, the debt investments are not held-for-collection but managed to profit from interest rate changes. As a result, it accounts for these investments at fair value. At December 31, 2014, British Sky has the following balances related to these securities.

As part of its strategic planning process, completed in the fourth quarter of 2014, British Sky management decides to move from its prior strategy—which requires active management—to a held-for-collection strategy for these debt investments. British Sky makes the following entry to transfer these securities to the held-for-collection classification.

Therefore, at January 1, 2015, the debt investments are stated at fair value. However, in subsequent periods, British Sky will account for the investment at amortized cost. The effective-interest rate used in the amortized cost model is the rate used to discount the future cash flows to the fair value of British Sky's debt investment of £1,325,000 on January 1, 2015.

Summary of Reporting Treatment of Investments

Illustration 17-26 summarizes the major debt and equity investment classifications and their reporting treatment.

ILLUSTRATION 17-26
Summary of Investment Accounting Approaches

KEY TERMS

amortized cost, 815

consolidated financial statements, 831

controlling interest, 831

debt investments, 815

effective-interest method, 816

equity investments, 824

equity method, 830

exchange for non-cash consideration, 825(n)

fair value, 815

Fair Value Adjustment, 819

fair value method, 818, 825

financial assets, 814

held-for-collection, 815

impairment, 832

investee, 824

investor, 824

non-trading equity investments, 825

parent, 831

significant influence, 829

subsidiary, 831

trading investments, 818

unrealized holding gain, 818

unrealized holding loss, 818

Describe the accounting framework for financial assets. Financial assets (debt and equity investments) are accounted for either at amortized cost or fair value. If a company has (1) a business model whose objective is to hold assets in order to collect contractual cash flows and (2) the contractual terms of the financial asset give specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding, then the company should use amortized cost. Thus, only debt investments can be accounted for at amortized cost. Equity investments are generally recorded and reported at fair value. Equity investments do not have a fixed interest or principal payment schedule and therefore cannot be accounted for at amortized cost. In general, equity investments are valued at fair value, with all gains and losses reported in income.

Understand the accounting for debt investments at amortized cost. Similar to bonds payable, companies should amortize discounts or premiums on debt 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.

Understand the accounting for debt investments at fair value. Companies that account for and report debt investments at fair value follow the same accounting entries as debt investments held-for-collection during the reporting period. That is, they are recorded at amortized cost. However, at each reporting date, companies adjust the amortized cost to fair value, with any unrealized holding gain or loss reported as part of net income.

Describe the accounting for the fair value option. Companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement. 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.

Understand the accounting for equity investments at fair value. For equity investment holdings less than 20 percent, it is presumed that companies hold the investment to profit from price changes. The accounting and reporting rule for these investments is to value the investments at fair value and record unrealized gains and losses in net income (the fair value method). Dividends received are recorded in income. Equity investments held for purposes other than trading are recorded at fair value on the statement of financial position, with unrealized gains and losses reported in other comprehensive income.

Explain the equity method of accounting and compare it to the fair value method for equity investments. The equity method is used when an investor company acquires ordinary shares of another company (investee), such that the investor has significant influence—a holding between 20 and 50 percent. 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. In contrast to the fair value method, all dividends received by the investor from the investee decrease the investment's carrying amount.

Discuss the accounting for impairments of debt investments. Companies use 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. This impairment loss is reported in income, calculated as the difference between the carrying amount plus accrued interest and the expected future cash flows discounted at the investment's historical effective-interest rate.

Describe the accounting for transfer of investments between categories. Transfers of securities between categories of investments occur when a company changes it business model for managing the investments. The transfers are accounted for prospectively, at the beginning of the period following the business model change.

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 Lenovo (CHN) believes that the price of Yahoo!'s (USA) shares will increase substantially in the next three months. Unfortunately, it does not have the cash resources to purchase the shares today. Lenovo therefore enters into a contract with a broker for delivery of 1,000,000 Yahoo! shares in three months at the price of $37 per share.

Lenovo has entered into a forward contract, a type of derivative. As a result of the contract, Lenovo has received the right to receive 1,000,000 Yahoo! shares in three months. Further, it has an obligation to pay $37 per share at that time. What is the benefit of this derivative contract? Lenovo can buy Yahoo! shares today and take delivery in three months. If the price goes up, as it expects, Lenovo profits. If the price goes down, Lenovo loses.

Example 2—Option Contract. Now suppose that Lenovo needs two weeks to decide whether to purchase Yahoo! shares. It therefore enters into a different type of contract, one that gives it the right to purchase Yahoo! shares at its current price any time within the next two weeks. As part of the contract, the broker charges $30,000 for holding the contract open for two weeks at a set price.

Lenovo 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 these shares. If the price of the Yahoo! shares increases in the next two weeks, Lenovo exercises its option. In this case, the cost of the shares is the price of the shares stated in the contract, plus the cost of the option contract. If the price does not increase, Lenovo 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 shares. The value of the contract relies on the underlying asset—the Yahoo! shares. Thus, these financial instruments are known as derivatives because they derive their value from values of other assets (e.g., ordinary shares, bonds, or commodities). Or, put another way, their value relates to a market-determined indicator (e.g., share price, interest rates, or the London Stock Exchange 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, share 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.¹³

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 two months.

Who would buy this contract? Suppose on the other side of the contract is McDonald's Corporation (USA). McDonald's wants to have potatoes (for French fries) in two months and believes that prices will increase. McDonald's is therefore agreeable to accepting delivery in two months at current prices. It knows that it will need potatoes in two 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 Japan Airlines (JPN), British Airways (GBR), and Delta (USA), are affected by changes in the price of jet fuel.
2. Financial institutions, such as Barclays (GBR), Deutsche Bank (DEU), and ING (NLD), are involved in borrowing and lending funds that are affected by changes in interest rates.
3. Multinational corporations, like Nokia (FIN), Coca-Cola (USA), and Siemens (DEU), 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 (USA) uses derivatives to hedge its exposure to fluctuations in interest rates, foreign currency exchange rates, and hydrocarbon prices.
2. HSBC (GBR) uses derivatives to manage foreign currency exchange rates and interest rates.
3. GlaxoSmithKline (GBR) 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.¹⁴

BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVES

The IASB concluded that derivatives such as forwards and options are assets and liabilities. It also concluded that companies should report them in the statement of financial position at fair value.¹⁵ 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.¹⁶

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.

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. ordinary shares. 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.¹⁷ 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 shares at €100 per share.¹⁸ If the price of Laredo shares increases above €100, the company can exercise this option and purchase the shares for €100 per share. If Laredo's shares never increase 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, 2015, 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 shares at an option price of €100 per share. The option expires on April 30, 2015. 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.

ILLUSTRATION 17A-1
Option Premium Formula

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, 2015, 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 €400.¹⁹

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

As indicated, on March 31, 2015, 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.²⁰ 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, 2015, is €100.²¹ The company records this change in value of the option as follows.

At March 31, 2015, the company reports the call option in its statement of financial position at fair value of €20,100.²² 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, 2015, 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.

ILLUSTRATION 17A-2
Effect on Income—Derivative Financial Instrument

The accounting summarized in Illustration 17A-2 is in accord with IFRS. That is, because the call option meets the definition of an asset, the company records it in the statement of financial position on March 31, 2015. 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. [23]

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 shares increased. In this case, the underlying is the share price. To arrive at the payment provision, multiply the change in the share 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 an equity investment (trading) for the traditional financial instrument and a call option as an example of a derivative one.

ILLUSTRATION 17A-3
Features of Traditional and Derivative Financial Instruments

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 (USA), BP (GBR), and Siemens (DEU) 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.

The IASB established accounting and reporting standards for derivative financial instruments used in hedging activities. IFRS allows special accounting for two types of hedges—fair value and cash flow hedges.²³

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, 2015, Hayward Co. purchases 100 ordinary shares of Sonoma Company at a market price of €100 per share. Due to a legal requirement, Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as a non-trading equity investment. Hayward records this investment as follows.

Hayward records non-trading equity investments at fair value on the statement of financial position. It reports unrealized gains and losses in equity as part of other comprehensive income.²⁴ Fortunately for Hayward, the value of the Sonoma shares increases to €125 per share during 2015. Hayward records the gain on this investment as follows.

Illustration 17A-4 indicates how Hayward reports the Sonoma investment in its statement of financial position.

ILLUSTRATION 17A-4
Statement of Financial Position Presentation of Non-Trading Equity Investment

While Hayward benefits from an increase in the price of Sonoma shares, it is exposed to the risk that the price of the Sonoma shares will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 Sonoma shares.

Hayward enters into the put option contract on January 2, 2016, 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.²⁵

At December 31, 2016, the price of the Sonoma shares has declined to €120 per share. Hayward records the following entry for the Sonoma investment.

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]).²⁶

Note that upon designation of the hedge, the accounting for the put option changes from regular IFRS. That is, Hayward records the unrealized holding loss in equity, not in income. If Hayward had not followed this accounting, a mismatch of gains and losses in the income statement would result. Thus, special accounting for the hedging instrument (in this case, a put option) is necessary in a fair value hedge.[25]

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

ILLUSTRATION 17A-5
Statement of Financial Position Presentation of Fair Value Hedge

The increase in fair value on the option offsets or hedges the decline in value on Hayward's non-trading investment. The financial statements reflect the underlying substance of Hayward's net exposure to the risks of holding Sonoma shares. By using fair value accounting for both these financial instruments, the statement of financial position 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, 2016.

ILLUSTRATION 17A-6
Income Statement Presentation of Fair Value Hedge

The statement of comprehensive income indicates that the gain on the put option offsets the loss on the equity investment.²⁷ The reporting for these financial instruments, even when they reflect a hedging relationship, illustrates why the IASB 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 IASB allows special accounting for cash flow hedges. Generally, companies measure and report derivatives at fair value on the statement of financial position. They report gains and losses directly in net income. However, companies account for derivatives used in cash flow hedges at fair value on the statement of financial position, but they record gains or losses in equity, as part of other comprehensive income.

To illustrate, assume that in September 2015 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2016. 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 2016. 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.²⁸ 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 (amounts in thousands). This contract price is good until the contract expires in January 2016. 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.²⁹

Allied enters into the futures contract on September 1, 2015. 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, 2015, 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 statement of financial position 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 2016, Allied purchases 1,000 metric tons of aluminum for ¥1,575 and makes the following entry.³⁰

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.

ILLUSTRATION 17A-7
Effect of Hedge on Cash Flows

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 2016) is ¥1,700,000. Allied sells the cans in July 2016 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.³¹

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 ordinary shares, the embedded derivative.

In accounting for embedded derivatives, some support an approach similar to the accounting for other derivatives; that is, separate the embedded derivative from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation. However, the IASB, based on concerns about the complexity of the bifurcation approach, required that the embedded derivative and host security be accounted for as a single unit.³² The accounting followed is based on the classification of the host security.³³

Qualifying Hedge Criteria

The IASB identified certain criteria that hedging transactions must meet before requiring the special accounting for hedges. The IASB 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.[26]

   The IASB 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 effective in achieving offsetting changes in fair value or cash flows. Companies must assess effectiveness whenever preparing financial statements.[27]

   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 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, euro for euro, 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, IFRS no longer allows special hedge accounting. The company should then account for the derivative or the part of the derivative that is not effective in the hedging relationship 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. 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 IFRS. In this case, earnings will properly reflect the offsetting gains and losses.³⁵

   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 statement of financial position 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 IFRS.³⁶

Summary of Derivatives Accounting

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

ILLUSTRATION 17A-8
Summary of Derivative Accounting under IFRS

As indicated, the general accounting for derivatives relies on fair values. IFRS 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 a non-trading equity investment in a fair value hedge (see the Hayward example earlier), it records unrealized gains on the investment in earnings, which is not IFRS for these investments without such a hedge. This special accounting is justified in order to accurately report the nature of the hedging relationship in the statement of financial position (recording both the put option and the investment at fair value) and in the 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 statement of financial position 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. 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.

ILLUSTRATION 17A-9
Swap Transaction

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, 2015. 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.

ILLUSTRATION 17A-10
Interest Rate Swap

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, 2015 (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 2015, Jones makes the interest payment on the bonds. It records this transaction as follows.

At the end of 2015, 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 statement of financial position. 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 statement of financial position to fair value.

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 statement of financial position.

ILLUSTRATION 17A-11
Statement of Financial Position Presentation of Fair Value Hedge

The effect on Jones's statement of financial position 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.

ILLUSTRATION 17A-12
Income Statement Presentation of Fair Value Hedge

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 2015.⁴⁰ 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.

ILLUSTRATION 17A-13
Impact on Financial Statements of Fair Value Hedge

In summary, to account for fair value hedges (as illustrated in the Jones example) record the derivative at its fair value in the statement of financial position, 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 statement of financial position (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. Still, others raise concerns about the complexity and cost of implementing IFRS in this area.

However, we believe that the benefits of using fair value and reporting derivatives at fair value will far outweigh any 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.

KEY TERMS

anticipated transaction, 848

arbitrageurs, 840

bifurcation, 850

call option, 841

cash flow hedge, 848

counterparty, 841 (n)

derivative financial instrument, derivative, 838

designation, 850

documentation, 850

effective, 850

embedded derivative, 850

exercise price, 841

fair value hedge, 845

forward contract, 838

futures contract, 848

hedging, 844

host security, 850

hybrid security, 850

interest rate swap, 852

intrinsic value, 842

net settlement, 842 (n)

notional amount, 842

option contract, 839

option premium, 842

put option, 841 (n)

risk management, 850

speculators, 840

spot price, 848

strike price, 841

swap, 852

time value, 842

underlying, 844

Explain who uses derivatives and why. 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.

Understand the basic guidelines for accounting for derivatives. 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.

Describe the accounting for derivative financial instruments. Companies report derivative financial instruments in the statement of financial position 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 statement of financial position, 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 IFRS 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 statement of financial position, 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 statement of financial position 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 IFRS for the hedged item.

Identify special reporting issues related to derivative financial instruments that cause unique accounting problems. A company should, based on the classification of the host security, account for a hybrid security containing a host security and an embedded derivative as a single unit. 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 IFRS.

APPENDIX 17B FAIR VALUE DISCLOSURES

As indicated in the chapter, the IASB 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 measurements 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. This enables financial statement users 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 IASB established a fair value hierarchy. As discussed in Chapter 2 (page 41), 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 17B-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.)

ILLUSTRATION 17B-1
Example of Fair Value Hierarchy

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 17B-2 is an example of this disclosure.

ILLUSTRATION 17B-2
Reconciliation of Level 3 Inputs

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, financial statement users have 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 users 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, 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 non-financial 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 statement of financial position but are disclosed in the notes to the financial statements.

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

ILLUSTRATION 17B-3
Quantitative Information about Level 3 Fair Value Measurements

DISCLOSURE OF FAIR VALUES: IMPAIRED ASSETS OR LIABILITIES

In addition to financial instruments, companies often have assets or liabilities that are remeasured on a non-recurring 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 17B-4 highlights this disclosure for McClung Company.

ILLUSTRATION 17B-4
Disclosure of Fair Value, with Impairment

CONCLUSION

With recent joint IASB and FASB 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 IFRS and U.S. GAAP. In addition, IFRS and U.S. GAAP 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.”

Describe required fair value disclosures. The IASB 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 and liabilities.

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

1. 1. Describe the two criteria for determining the valuation of financial assets.
2. 2. Which types of investments are valued at amortized cost? Explain the rationale for this accounting.
3. 3. What is amortized cost? What is fair value?
4. 4. Lady Gaga Co. recently made an investment in the bonds issued by Chili Peppers Inc. Lady Gaga's business model for this investment is to profit from trading in response to changes in market interest rates. How should this investment be classified by Lady Gaga? Explain.
5. 5. Consider the bond investment by Lady Gaga in Question 4. Discuss the accounting for this investment if Lady Gaga's business model is to hold the investment to collect interest while outstanding and to receive the principal at maturity.
6. 6. On July 1, 2015, Wheeler Company purchased €4,000,000 of Duggen Company's 8% bonds, due on July 1, 2022. The bonds, which pay interest semiannually on January 1 and July 1, were purchased for €3,500,000 to yield 10%. Determine the amount of interest revenue Wheeler should report on its income statement for year ended December 31, 2015, assuming Wheeler plans to hold this investment to collect contractual cash flows.
7. 7. If the bonds in Question 6 are classified as trading and they have a fair value at December 31, 2015, of €3,604,000, prepare the journal entry (if any) at December 31, 2015, to record this transaction.
8. 8. Indicate how unrealized holding gains and losses should be reported for investments classified as trading and held-for-collection.
9. 9. (a) Assuming no Fair Value Adjustment account balance at the beginning of the year, prepare the adjusting entry at the end of the year if Laura Company's trading bond investment has a fair value €60,000 below carrying value.
10.    (b) Assume the same information as part (a), except that Laura Company has a debit balance in its Fair Value Adjustment account of €10,000 at the beginning of the year. Prepare the adjusting entry at year-end.
11. 10. What is the fair value option? Briefly describe its application to debt investments.
12. 11. Franklin Corp. has an investment that it has held for several years. When it purchased the investment, Franklin accounted for the investment at amortized cost. Can Franklin use the fair value option for this investment? Explain.
13. 12. Identify and explain the different types of classifications for equity investments.
14. 13. Why is the held-for-collection classification not applicable to equity investments?
15. 14. Hayes Company purchased 10,000 ordinary shares of Kenyon Co., paying $26 per share plus $1,500 in broker fees. Hayes plans to actively trade this investment. Prepare the entry to record this investment.
16. 15. Hayes Company sold 10,000 shares of Kenyon Co. that it bought in Question 14 for $27.50 per share, incurring $1,770 in brokerage commissions. The carrying value of the investment is $260,000. Prepare the entry to record the sale of this investment.
17. 16. Distinguish between the accounting treatment for non-trading equity investments and trading equity investments.
18. 17. What constitutes “significant influence” when an investor's financial interest is below the 50% level?
19. 18. Explain how the investment account is affected by investee activities under the equity method.
20. 19. When the equity method is applied, what amounts relate to the investment, and where will these amounts be reported in the financial statements?
21. 20. Hiram Co. uses the equity method to account for investments in ordinary shares. What accounting should be made for dividends received from these investments subsequent to the date of investment?
22. 21. Raleigh Corp. has an investment with a carrying value (equity method) on its books of £170,000 representing a 30% interest in Borg Company, which suffered a £620,000 loss this year. How should Raleigh Corp. handle its proportionate share of Borg's loss?
23. 22. Where on the asset side of the statement of financial position are amounts related to equity investments classified as trading and non-trading reported? Explain.
24. 23. When is a debt investment considered impaired? Explain how to account for the impairment of a held-for-collection debt investment.
25. 24. Briefly discuss how a transfer of investments from the trading category to the held-for-collection category affects the financial statements.
26. 25. Briefly describe the unresolved issues related to fair value accounting.
27. 26. Briefly describe some of the similarities and differences between U.S. GAAP and IFRS with respect to the accounting for investments.
28. 27. Ramirez Company has a held-for-collection investment in the 6%, 20-year bonds of Soto Company. The investment was originally purchased for R$1,200,000 in 2013. Early in 2014, Ramirez recorded an impairment of R$300,000 on the Soto investment, due to Soto's financial distress. In 2015, Soto returned to profitability and the Soto investment was no longer impaired. What entry does Ramirez make in 2015 under (a) U.S. GAAP and (b) IFRS?
29. 28. Discuss how recent IFRS developments in the accounting for investments might affect convergence with U.S. GAAP.
30. *29. What is meant by the term underlying as it relates to derivative financial instruments?
31. *30. What are the main distinctions between a traditional financial instrument and a derivative financial instrument?
32. *31. What is the purpose of a fair value hedge?
33. *32. In what situation will the unrealized holding gain or loss on a non-trading equity investment be reported in income?
34. *33. Why might a company become involved in an interest rate swap contract to receive fixed interest payments and pay variable?
35. *34. What is the purpose of a cash flow hedge?
36. *35. Where are gains and losses related to cash flow hedges involving anticipated transactions reported?
37. *36. What are hybrid securities? Give an example of a hybrid security.

BE17-2 Use the information from BE17-1 but assume Garfield plans to actively trade the bonds to profit from market interest rates changes. Prepare Garfield's journal entries for (a) the purchase of the investment, (b) the receipt of annual interest and discount amortization, and (c) the year-end fair value adjustment. The bonds have a year-end fair value of €75,500.

E17-1 (Investment Classifications) For the following investments, identify whether they are:

E17-13 (Journal Entries for Fair Value and Equity Methods) Presented below are two independent situations.

E17-17 (Fair Value and Equity Method Compared) Chen Inc. acquired 20% of the outstanding ordinary shares of Cho Corp. on December 31, 2015. The purchase price was ¥125,000,000 for 50,000 shares. Cho Corp. declared and paid an ¥80 per share cash dividend on June 30 and on December 31, 2016. Cho reported net income of ¥73,000,000 for 2016. The fair value of Cho's shares was ¥2,700 per share at December 31, 2016.

P17-1 (Debt Investments) Presented below is an amortization schedule related to Spangler Company's 5-year, $100,000 bond with a 7% interest rate and a 5% yield, purchased on December 31, 2012, for $108,660.

P17-2 (Debt Investments, Fair Value Option) On January 1, 2015, Novotna Company purchased €400,000, 8% bonds of Aguirre Co. for €369,114. The bonds were purchased to yield 10% interest. Interest is payable semiannually on July 1 and January 1. The bonds mature on January 1, 2020. Novotna Company plans to hold the bonds to collect contractual cash flows. On January 1, 2017, after receiving interest, Novotna Company sold the bonds for €370,726 after receiving interest to meet its liquidity needs.

P17-3 (Debt and Equity Investments) Cardinal Paz Corp. carries an account in its general ledger called Investments, which contained debits for investment purchases, and no credits, with the following descriptions.

P17-7 (Debt Investment Entries) The following information relates to the debt investments of Wildcat Company.

P17-8 (Fair Value and Equity Methods) Brooks Corp. is a medium-sized corporation specializing in quarrying stone for building construction. The company has long dominated the market, at one time achieving a 70% market penetration. During prosperous years, the company's profits, coupled with a conservative dividend policy, resulted in funds available for outside investment. Over the years, Brooks has had a policy of investing idle cash in equity investments. In particular, Brooks has made periodic investments in the company's principal supplier, Norton Industries. Although the firm currently owns 12% of the outstanding ordinary shares of Norton Industries, Brooks does not have significant influence over the operations of Norton Industries.

CA17-6 (Equity Investments) On July 1, 2015, Selig Company purchased for cash 40% of the outstanding ordinary shares of Spoor Corporation. Both Selig and Spoor have a December 31 year-end. Spoor Corporation, whose shares are actively traded on the American Stock Exchange, paid a cash dividend on November 15, 2015, to Selig Company and its other shareholders. It also reported its total net income for the year of $920,000 to Selig Company.

CA17-7 (Fair Value) Addison Manufacturing holds a large portfolio of debt and equity investments. The fair value of the portfolio is greater than its original cost, even though some investments have decreased in value. Sam Beresford, the financial vice president, and Angie Nielson, the controller, are near year-end in the process of classifying for the first time this investment portfolio in accordance with IFRS. Beresford wants to classify those investments that have increased in value during the period as trading investments in order to increase net income this year. He wants to classify all the investments that have decreased in value as non-trading (the equity investments) and as held-for-collection (the debt investments).