After studying this chapter, you should be able to:
PREVIEW OF CHAPTER 17
As our opening story indicates, U.S. and international standard-setters are studying the measurement, recognition, and disclosure for certain investments. In this chapter we address the accounting for debt and equity investments. Appendices to this chapter discuss the accounting for derivative instruments, variable-interest entities, and fair value disclosures. The content and organization of this chapter are as follows.
Companies have different motivations for investing in securities issued by other companies.[269] One motivation is to earn a high rate of return. For example, companies like Coca-Cola and PepsiCo can receive interest revenue from a debt investment or dividend revenue from an equity investment. In addition, they can realize capital gains on both types of securities. Another motivation for investing (in equity securities) is to secure certain operating or financing arrangements with another company. As in the opening story, Coca-Cola and PepsiCo are able to exercise some control over bottler companies based on their significant (but not controlling) equity investments.
To provide useful information, companies account for investments based on the type of security (debt or equity) and their intent with respect to the investment. As indicated in Illustration 17-1, we organize our study of investments by type of security. Within each section, we explain how the accounting for investments in debt and equity securities varies according to management intent.
Debt securities represent a creditor relationship with another entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security.
Companies group investments in debt securities into three separate categories for accounting and reporting purposes:
Held-to-maturity: Debt securities that the company has the positive intent and ability to hold to maturity.
Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences.
Available-for-sale: Debt securities not classified as held-to-maturity or trading securities.
Illustration 17-2 (on page 859) identifies these categories, along with the accounting and reporting treatments required for each.
Amortized cost is the acquisition cost adjusted for the amortization of discount or premium, if appropriate. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. [3]
Only debt securities can be classified as held-to-maturity. By definition, equity securities have no maturity date. A company like Starbucks should classify a debt security as held-to-maturity only if it has both (1) the positive intent and (2) the ability to hold those securities to maturity. It should not classify a debt security as held-to-maturity if it intends to hold the security for an indefinite period of time. Likewise, if Starbucks anticipates that a sale may be necessary due to changes in interest rates, foreign currency risk, liquidity needs, or other asset-liability management reasons, it should not classify the security as held-to-maturity.[270]
Companies account for held-to-maturity securities at amortized cost, not fair value. If management intends to hold certain investment securities to maturity and has no plans to sell them, fair values (selling prices) are not relevant for measuring and evaluating the cash flows associated with these securities. Finally, because companies do not adjust held-to-maturity securities to fair value, these securities do not increase the volatility of either reported earnings or reported capital as do trading securities and available-for-sale securities.
To illustrate the accounting for held-to-maturity debt securities, assume that Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2009, at a discount, paying $92,278. The bonds mature January 1, 2014 and yield 10%; interest is payable each July 1 and January 1. Robinson records the investment as follows:
Robinson uses a Held-to-Maturity Securities account to indicate the type of debt security purchased.
As indicated in Chapter 14, companies must amortize premium or discount using the effective-interest method unless some other method—such as the straight-line method—yields a similar result. They apply the effective-interest method to bond investments in a way similar to that for bonds payable. To compute interest revenue, companies compute the effective-interest rate or yield at the time of investment and apply that rate to the beginning carrying amount (book value) for each interest period. The investment carrying amount is increased by the amortized discount or decreased by the amortized premium in each period.
The use of some simpler method that yields results similar to the effective-interest method is an application of the materiality concept.
Illustration 17-3 shows the effect of the discount amortization on the interest revenue that Robinson records each period for its investment in Evermaster bonds.
Robinson records the receipt of the first semiannual interest payment on July 1, 2009 (using the data in Illustration 17-3), as follows:
Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2009, as follows.
Again, Illustration 17-3 shows the interest and amortization amounts.
Robinson reports its investment in Evermaster bonds in its December 31, 2009, financial statements, as follows.
Sometimes a company sells a held-to-maturity debt security so close to its maturity date that a change in the market interest rate would not significantly affect the security's fair value. Such a sale may be considered a sale at maturity and would not call into question the company's original intent to hold the investment to maturity. Let's assume, as an example, that Robinson Company sells its investment in Evermaster bonds on November 1, 2013, at 99¾ plus accrued interest. The discount amortization from July 1, 2013, to November 1, 2013, is $635 (4/6 × $952). Robinson records this discount amortization as follows.
Illustration 17-5 shows the computation of the realized gain on the sale.
Robinson records the sale of the bonds as:
The credit to Interest Revenue represents accrued interest for four months, for which the purchaser pays cash. The debit to Cash represents the selling price of the bonds plus accrued interest ($99,750 + $2,667). The credit to Held-to-Maturity Securities represents the book value of the bonds on the date of sale. The credit to Gain on Sale of Securities represents the excess of the selling price over the book value of the bonds.
Companies, like Amazon.com, report available-for-sale securities at fair value. It records the unrealized gains and losses related to changes in the fair value of available-for-sale debt securities in an unrealized holding gain or loss account. Amazon adds (subtracts) this amount to other comprehensive income for the period. Other comprehensive income is then added to (subtracted from) accumulated other comprehensive income, which is shown as a separate component of stockholders' equity until realized. Thus, companies report available-for-sale securities at fair value on the balance sheet, but do not report changes in fair value as part of net income until after selling the security. This approach reduces the volatility of net income.
To illustrate the accounting for available-for-sale securities, assume that Graff Corporation purchases $100,000, 10 percent, five-year bonds on January 1, 2009, with interest payable on July 1 and January 1. The bonds sell for $108,111, which results in a bond premium of $8,111 and an effective interest rate of 8 percent.
Graff records the purchase of the bonds as follows.[271]
Illustration 17-6 discloses the effect of the premium amortization on the interest revenue Graff records each period using the effective-interest method.
The entry to record interest revenue on July 1, 2009, is as follows.
At December 31, 2009, Graff makes the following entry to recognize interest revenue.
As a result, Graff reports revenue for 2009 of $8,621 ($4,324 + $4,297).
To apply the fair value method to these debt securities, assume that at year-end the fair value of the bonds is $105,000 and that the carrying amount of the investments is $106,732. Comparing this fair value with the carrying amount (amortized cost) of the bonds at December 31, 2009, Graff recognizes an unrealized holding loss of $1,732 ($106,732 − $105,000). It reports this loss as other comprehensive income. Graff makes the following entry.
Graff uses a valuation account instead of crediting the Available-for-Sale Securities account. The use of the Securities Fair Value Adjustment (Available-for-Sale) account enables the company to maintain a record of its amortized cost. Because the adjustment account has a credit balance in this case, Graff subtracts it from the balance of the Available-for-Sale Securities account to determine fair value. Graff reports this fair value amount on the balance sheet. At each reporting date, Graff reports the bonds at fair value with an adjustment to the Unrealized Holding Gain or Loss—Equity account.
To illustrate the accounting for a portfolio of securities, assume that Webb Corporation has two debt securities classified as available-for-sale. Illustration 17-7 identifies the amortized cost, fair value, and the amount of the unrealized gain or loss.
The fair value of Webb's available-for-sale portfolio totals $284,000. The gross unrealized gains are $10,063, and the gross unrealized losses are $19,600, resulting in a net unrealized loss of $9,537. That is, the fair value of available-for-sale securities is $9,537 lower than its amortized cost. Webb makes an adjusting entry to a valuation allowance to record the decrease in value and to record the loss as follows.
Webb reports the unrealized holding loss of $9,537 as other comprehensive income and a reduction of stockholders' equity. Recall that companies exclude from net income any unrealized holding gains and losses related to available-for-sale securities.
If a company sells bonds carried as investments in available-for-sale securities before the maturity date, it must make entries to remove from the Available-for-Sale Securities account the amortized cost of bonds sold. To illustrate, assume that Webb Corporation sold the Watson bonds (from Illustration 17-7) on July 1, 2011, for $90,000, at which time it had an amortized cost of $94,214. Illustration 17-8 (on page 864) shows the computation of the realized loss.
Webb records the sale of the Watson bonds as follows.
Webb reports this realized loss in the "Other expenses and losses" section of the income statement. Assuming no other purchases and sales of bonds in 2011, Webb on December 31, 2011, prepares the information shown in Illustration 17-9.
Webb has an unrealized holding loss of $5,000. However, the Securities Fair Value Adjustment account already has a credit balance of $9,537. To reduce the adjustment account balance to $5,000, Webb debits it for $4,537, as follows.
Webb's December 31, 2011, balance sheet and the 2011 income statement include the following items and amounts (the Anacomp bonds are long-term investments but are not intended to be held to maturity).
Some favor including the unrealized holding gain or loss in net income rather than showing it as other comprehensive income.[272] However, some companies, particularly financial institutions, note that recognizing gains and losses on assets, but not liabilities, introduces substantial volatility in net income. They argue that hedges often exist between assets and liabilities so that gains in assets are offset by losses in liabilities, and vice versa. In short, to recognize gains and losses only on the asset side is unfair and not representative of the economic activities of the company.
This argument convinced the FASB. As a result, companies do not include in net income these unrealized gains and losses. [4] However, even this approach solves only some of the problems, because volatility of capital still results. This is of concern to financial institutions because regulators restrict financial institutions' operations based on their level of capital. In addition, companies can still manage their net income by engaging in gains trading (i.e., selling the winners and holding the losers).
In the fall of 2000, Wall Street brokerage firm Morgan Stanley told investors that rumor of big losses in its bond portfolio were "greatly exaggerated." As it turns out, Morgan Stanley also was exaggerating.
As a result, the SEC accused Morgan Stanley of violating securities laws by overstating the value of certain bonds by $75 million. The overvaluations stemmed more from wishful thinking than reality, in violation of generally accepted accounting principles, the SEC said. "In effect, Morgan Stanley valued its positions at the price at which it thought a willing buyer and seller should enter into an exchange, rather than at a price at which a willing buyer and a willing seller would enter into a current exchange," the SEC wrote.
Especially egregious, stated one accounting expert, were the SEC's findings that Morgan Stanley in some instances used its own more optimistic assumptions as a substitute for external pricing sources. "What that is saying is: 'Fair value is what you want the value to be. Pick a number ...' That's especially troublesome."
As indicated in the text, the FASB is assessing what is fair and what isn't when it comes to assigning valuations. Concerns over the issue caught fire after the collapses of Enron Corp. and other energy traders that abused the wide discretion given them under fair value accounting. Investors recently have expressed similar worries about some financial companies, which use internal—and subjectively designed—mathematical models to come up with valuations when market quotes aren't available.
Source: Adapted from Susanne Craig and Jonathan Weil, "SEC Targets Morgan Stanley Values," Wall Street Journal (November 8, 2004), p. C3.
Companies hold trading securities with the intention of selling them in a short period of time. "Trading" in this context means frequent buying and selling. Companies thus use trading securities to generate profits from short-term differences in price. Companies generally hold these securities for less than three months, some for merely days or hours.
Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. Similar to held-to-maturity or available-for-sale investments, they are required to amortize any discount or premium. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. In short, the FASB says to adjust the trading securities to fair value, at each reporting date. In addition, companies report the change in value as part of net income, not other comprehensive income.
To illustrate, assume that on December 31, 2010, Western Publishing Corporation determined its trading securities portfolio to be as shown in Illustration 17-11. (Assume that 2010 is the first year that Western Publishing held trading securities.) At the date of acquisition, Western Publishing recorded these trading securities at cost, including brokerage commissions and taxes, in the account entitled Trading Securities. This is the first valuation of this recently purchased portfolio.
iGAAP provides for classification as trading, available-for-sale, or held-to-maturity for all types of financial assets. U.S. GAAP applies these classifications only to securities.
The total cost of Western Publishing's trading portfolio is $314,450. The gross unrealized gains are $12,780 ($7,640 + $5,140), and the gross unrealized losses are $9,030, resulting in a net unrealized gain of $3,750. The fair value of trading securities is $3,750 greater than its cost.
At December 31, Western Publishing makes an adjusting entry to a valuation allowance, referred to as Securities Fair Value Adjustment (Trading), to record the increase in value and to record the unrealized holding gain.
Because the Securities Fair Value Adjustment account balance is a debit, Western Publishing adds it to the cost of the Trading Securities account to arrive at a fair value for the trading securities. Western Publishing reports this fair value amount on the balance sheet.
When securities are actively traded, the FASB believes that the investments should be reported at fair value on the balance sheet. In addition, changes in fair value (unrealized gains and losses) should be reported in income. Such reporting on trading securities provides more relevant information to existing and prospective stockholders.
Equity securities represent ownership interests such as common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants, rights, and call or put options. Companies do not treat convertible debt securities as equity securities. Nor do they treat as equity securities redeemable preferred stock (which must be redeemed for common stock). The cost of equity securities includes the purchase price of the security plus broker's commissions and other fees incidental to the purchase.
The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for the investment subsequent to acquisition. The classification of such investments depends on the percentage of the investee voting stock that is held by the investor:
Holdings of less than 20 percent (fair value method)—investor has passive interest.
Holdings between 20 percent and 50 percent (equity method)—investor has significant influence.
Holdings of more than 50 percent (consolidated statements)—investor has controlling interest.
Illustration 17-12 lists these levels of interest or influence and the corresponding valuation and reporting method that companies must apply to the investment.
The accounting and reporting for equity securities therefore depend on the level of influence and the type of security involved, as shown in Illustration 17-13.
When an investor has an interest of less than 20 percent, it is presumed that the investor has little or no influence over the investee. In such cases, if market prices are available subsequent to acquisition, the company values and reports the investment using the fair value method.[273] The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities. Because equity securities have no maturity date, companies cannot classify them as held-to-maturity.
Upon acquisition, companies record available-for-sale securities at cost.[274] To illustrate, assume that on November 3, 2010 Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest.
Republic records these investments as follows.
On December 6, 2010, Republic receives a cash dividend of $4,200 on its investment in the common stock of Campbell Soup Co. It records the cash dividend as follows.
All three of the investee companies reported net income for the year, but only Campbell Soup declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the common stock of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income 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, 2010, Republic's available-for-sale equity security portfolio has the cost and fair value shown in Illustration 17-14.
Figure 17-14. Computation of Securities Fair Value Adjustment—Available-for-Sale Equity Security Portfolio (2010)
For Republic's available-for-sale equity securities portfolio, the gross unrealized gains are $15,300, and the gross unrealized losses are $50,850 ($13,500 + $37,350), resulting in a net unrealized loss of $35,550. The fair value of the available-for-sale securities portfolio is below cost by $35,550.
As with available-for-sale debt securities, Republic records the net unrealized gains and losses related to changes in the fair value of available-for-sale equity securities in an Unrealized Holding Gain or Loss—Equity account. Republic reports this amount as a part of other comprehensive income and as a component of other accumulated comprehensive income (reported in stockholders' equity) until realized. In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss—Equity account and crediting the Securities Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows.
On January 23, 2011, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287,220. Illustration 17-15 shows the computation of the realized gain on the sale.
Republic records the sale as follows.
In addition, assume that on February 10, 2011, Republic purchased 20,000 shares of Continental Trucking at a market price of $12.75 per share plus brokerage commissions of $1,850 (total cost, $256,850).
Illustration 17-16 lists Republic's portfolio of available-for-sale securities, as of December 31, 2011.
Figure 17-16. Computation of Securities Fair Value Adjustment—Available-for-Sale Equity Security Portfolio (2011)
At December 31, 2011, the fair value of Republic's available-for-sale equity securities portfolio exceeds cost by $64,250 (unrealized gain). The Securities Fair Value Adjustment account had a credit balance of $35,550 at December 31, 2011. To adjust its December 31, 2011, available-for-sale portfolio to fair value, the company debits the Securities Fair Value Adjustment account for $99,800 ($35,550 + $64,250). Republic records this adjustment as follows.
The accounting entries to record trading equity securities are the same as for available-for-sale equity securities, except for recording the unrealized holding gain or loss. For trading equity securities, companies report the unrealized holding gain or loss as part of net income. Thus, the account titled Unrealized Holding Gain or Loss—Income is used.
An investor corporation may hold an interest of less than 50 percent in an investee corporation and thus not possess legal control. However, as shown in our opening story about Coca-Cola, an investment in voting stock of less than 50 percent can still give Coke (the investor) the ability to exercise significant influence over the operating and financial policies of its bottlers. [5] Significant influence may be indicated in several ways. Examples include representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency.
Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings. To achieve a reasonable degree of uniformity in application of the "significant influence" criterion, the profession concluded that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee.[275]
In instances of "significant influence" (generally an investment of 20 percent or more), the investor must account for the investment using the 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 investee's earnings increase investee's net assets, and that investee's losses and dividends decrease these net assets.
To illustrate the equity method and compare it with the fair value method, assume that Maxi Company purchases a 20 percent interest in Mini Company. To apply the fair value method in this example, assume that Maxi does not have the ability to exercise significant influence, and classifies the securities as available-for-sale. Where this example applies the equity method, assume that the 20 percent interest permits Maxi to exercise significant influence. Illustration 17-17 shows the entries.
Note that under the fair value method, Maxi reports as revenue only the cash dividends received from Mini. The earning of net income by Mini (the investee) is not considered a proper basis for recognition of income from the investment by Maxi (the investor). Why? Mini may permanently retain in the business any increased net assets resulting from its profitable operation. Therefore, Maxi only earns 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 earned. 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.
iGAAP permits companies to measure significant-influence investments using the equity, cost, or fair value methods.
For some companies, equity accounting can be a real pain to the bottom line. For example, Amazon.com, the pioneer of Internet retailing, at one time struggled to turn a profit. Furthermore, some of Amazon's equity investments had resulted in Amazon's earnings performance going from bad to worse. In a recent year, Amazon.com disclosed equity stakes in such companies as Altera International, Basis Technology, Drugstore.com, and Eziba.com. These equity investees reported losses that made Amazon's already bad bottom line even worse, accounting for up to 22 percent of its reported loss in one year alone.
Revenue to be recognized should be earned and realized or realizable. A low level of ownership indicates that a company should defer the income from an investee until cash is received.
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. [7]
When one corporation acquires a voting interest of more than 50 percent in another corporation, it is said to have a controlling interest. In such a relationship, the investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a long-term investment on the separate financial statements of the parent.
In contrast to U.S. firms, financial statements of non-U.S. companies often include both consolidated (group) statements and parent company financial statements.
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.
Presently the rules for consolidation seem very straightforward: If a company owns more than 50 percent of another company, it generally should be consolidated. If it owns less than 50 percent, it is generally not consolidated. However the FASB recognizes the artificiality of the present test. Determination of who really has control often relies on factors other than stock ownership.
In fact, specific guidelines force consolidation even though stock ownership is not above 50 percent in certain limited situations. For example, Enron's failure to consolidate three special purpose entities (SPEs) that it effectively controlled led to an overstatement of income of $569 million and overstatement of equity of $1.2 billion. In each of Enron's three SPEs, the GAAP guidelines would have led to consolidation. That is, the following factors indicate that consolidation should have occurred: the majority owner of the special purpose entity (SPE) made only a modest investment; the activities of the SPE primarily benefited Enron; and the substantive risks and rewards related to the assets or debt of the SPE rested directly or indirectly with Enron.
The FASB has issued new guidelines related to SPEs, given all the reporting problems that have surfaced related to SPEs at Enron and other companies. We discuss these new rules in Appendix 17B.
As indicated in earlier chapters, companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument-by-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.
For example, assume that Abbott Laboratories purchased debt securities in 2010 that it classified as held-to-maturity. Abbott does not choose to report this security using the fair value option. In 2011, Abbott buys another held-to-maturity debt security. Abbott decides to report this security using the fair value option. Once it chooses the fair value option for the security bought in 2011, the decision is irrevocable (may not be changed). In addition, Abbott does not have the option to value the held-to-maturity security purchased in 2010 at fair value in 2011 or in subsequent periods.
Many support the use of the fair value option as a step closer to total fair value reporting for financial instruments. They believe this treatment leads to an improvement in financial reporting. Others argue that the fair value option is confusing. A company can choose from period to period whether to use the fair value option for any new investment in a financial instrument. By permitting an instrument-by-instrument approach, companies are able to report some financial instruments at fair value but not others. To illustrate the accounting issues related to the fair value option, we discuss three different situations.
Available-for-sale securities are presently reported at fair value, and any unrealized gains and losses are recorded as part of other comprehensive income. Assume that Hardy Company purchases stock in Fielder Company during 2010 that it classifies as available-for-sale. At December 31, 2010, the cost of this security is $100,000; its fair value at December 31, 2010, is $125,000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2010.
In this situation, Hardy uses an account titled Investment in Fielder Stock to record the change in fair value at December 31. It does not use a Securities Fair Value Adjustment account because the accounting for a fair value option is on an investment-by-investment basis rather than on a portfolio basis. Because Hardy selected the fair value option, the unrealized gain or loss is recorded as part of net income. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security.
Companies may also use the fair value option for investments that otherwise follow the equity method of accounting. To illustrate, assume that Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2010 for $930,000. At December 31, 2010, the fair value of the investment is $900,000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this investment is as follows.
In contrast to equity method accounting, if the fair value option is chosen, Durham does not have to report its pro rata share of the income or loss from Suppan. In addition, any dividend payments are credited to Dividend Revenue and therefore do not reduce the Investment in Suppan Stock account.
One major advantage of using the fair value option for this type of investment is that it addresses confusion about the equity method of accounting. In other words, what exactly does the one-line consolidation related to the equity method of accounting on the balance sheet tell investors? Many believe it does not provide information about liquidity or solvency, nor does it provide an indication of the worth of the company.
One of the more controversial aspects of the fair value option relates to valuation of a company's own liabilities. Companies may apply the fair value option to their own debt instruments. As a result, changes in the fair value of the debt instrument are included as part of earnings in any given period.
To illustrate, Edmonds Company has issued $500,000 of 6% bonds at face value on May 1, 2010. Edmonds chooses the fair value option for these bonds. At December 31, 2010, the value of the bonds is now $480,000 because interest rates in the market have increased to 8 percent. The value of the debt securities falls because the bond is paying less than market rate for similar securities. Under the fair value option, Edmonds makes the following entry.
As the journal entry indicates, the value of the bonds declined. This decline leads to a reduction in the bond liability and a resulting unrealized holding gain, which is reported as part of net income. The value of Edmonds' debt declined because interest rates increased. In addition, if the creditworthiness of Edmonds Company declines, the value of its debt also declines. That is, Edmonds issued debt at rates reflecting higher creditworthiness. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. If Edmonds is using the fair value option in this case, it records an unrealized holding gain due to its worsening credit position.
Some question how Edmonds can record a gain when its creditworthiness is becoming worse. As one writer noted, "It seems counter-intuitive." However, the FASB notes that the debtholders' loss is the stockholders' gain. That is, the stockholders' claims on the assets of the company increase when the value of the debtholders declines. In addition, the worsening credit position may indicate that the assets of the company are declining in value as well. Thus, the company may be reporting losses on the asset side which will be offsetting gains on the liability side.
We have identified the basic issues involved in accounting for investments in debt and equity securities. In addition, the following issues relate to both of these types of securities.
Impairment of value.
Reclassification adjustments.
Transfers between categories.
Fair value controversy.
A company should evaluate every investment, at each reporting date, to determine if it has suffered impairment—a loss in value that is other than temporary. For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a permanent loss. If the decline is judged to be other than temporary, a company writes down the cost basis of the individual security to a new cost basis. The company accounts for the write-down as a realized loss. Therefore, it includes the amount in net income.
For debt securities, a company uses the impairment test to determine whether "it is probable that the investor will be unable to collect all amounts due according to the contractual terms."
For equity securities, the guideline is less precise. Any time realizable value is lower than the carrying amount of the investment, a company must consider an impairment. Factors involved include the length of time and the extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; and the intent and ability of the investor company to retain its investment to allow for any anticipated recovery in fair value.
To illustrate an impairment, assume that Strickler Company holds available-for-sale bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800,000. Strickler has previously reported an unrealized loss on these securities of $200,000 as part of other comprehensive income. In evaluating the securities, Strickler now determines that it probably will not collect all amounts due. In this case, it reports the unrealized loss of $200,000 as a loss on impairment of $200,000. Strickler includes this amount in income, with the bonds stated at their new cost basis. It records this impairment as follows.
The new cost basis of the investment in debt securities is $800,000. Strickler includes subsequent increases and decreases in the fair value of impaired available-for-sale securities as other comprehensive income.[276]
Companies base impairment for debt and equity securities on a fair value test. This test differs slightly from the impairment test for loans that we discuss in Appendix 7B. The FASB rejected the discounted cash flow alternative for securities because of the availability of market price information.
An example of the criteria used by Caterpillar to assess impairment is provided in Illustration 17-18.
As we indicated in Chapter 4, companies report changes in unrealized holding gains and losses related to available-for-sale securities as part of other comprehensive income. Companies may display the components of other comprehensive income in one of three ways: (1) in a combined statement of income and comprehensive income, (2) in a separate statement of comprehensive income that begins with net income, or (3) in a statement of stockholders' equity.
The reporting of changes in unrealized gains or losses in comprehensive income is straightforward unless a company sells securities during the year. In that case, double counting results when the company reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current period or in previous periods.
To ensure that gains and losses are not counted twice when a sale occurs, a reclassification adjustment is necessary. To illustrate, assume that Open Company has the following two available-for-sale securities in its portfolio at the end of 2009 (its first year of operations).
If Open Company reports net income in 2009 of $350,000, it presents a statement of comprehensive income as follows.
During 2010, Open Company sold the Lehman Inc. common stock for $105,000 and realized a gain on the sale of $25,000 ($105,000 − $80,000). At the end of 2010, the fair value of the Woods Co. common stock increased an additional $20,000, to $155,000. Illustration 17-21 shows the computation of the change in the securities fair value adjustment account.
Illustration 17-21 indicates that Open should report an unrealized holding loss of $5,000 in comprehensive income in 2010. In addition, Open realized a gain of $25,000 on the sale of the Lehman common stock. Comprehensive income includes both realized and unrealized components. Therefore, Open recognizes a total holding gain (loss) in 2010 of $20,000, computed as follows.
Open reports net income of $720,000 in 2010, which includes the realized gain on sale of the Lehman securities. Illustration 17-23 shows a statement of comprehensive income for 2010, indicating how Open reported the components of holding gains (losses).
In 2009, Open included the unrealized gain on the Lehman Co. common stock in comprehensive income. In 2010, Open sold the stock. It reported the realized gain in net income, which increased comprehensive income again. To avoid double counting this gain, Open makes a reclassification adjustment to eliminate the realized gain from the computation of comprehensive income in 2010.
A company may display reclassification adjustments on the face of the financial statement in which it reports comprehensive income. Or it may disclose these reclassification adjustments in the notes to the financial statements.
To illustrate the reporting of investment securities and related gain or loss on available-for-sale securities, assume that on January 1, 2010, Hinges Co. had cash and common stock of $50,000.[277] At that date the company had no other asset, liability, or equity balance. On January 2, Hinges purchased for cash $50,000 of equity securities classified as available-for-sale. On June 30, Hinges sold part of the available-for-sale security portfolio, realizing a gain as shown in Illustration 17-24.
Hinges did not purchase or sell any other securities during 2010. It received $3,000 in dividends during the year. At December 31, 2010, the remaining portfolio is as shown in Illustration 17-25.
Illustration 17-26 shows the company's income statement for 2010.
The company reports its change in the unrealized holding gain in a statement of comprehensive income as follows.
Its statement of stockholders' equity appears in Illustration 17-28.
The comparative balance sheet is shown on the next page in Illustration 17-29.
This example indicates how an unrealized gain or loss on available-for-sale securities affects all the financial statements. Note that a company must disclose the components that comprise accumulated other comprehensive income.
Companies account for transfers between any of the categories at fair value. Thus, if a company transfers available-for-sale securities to held-to-maturity investments, it records the new investment (held-to-maturity) at the date of transfer at fair value in the new category. Similarly, if it transfers held-to-maturity investments to available-for-sale investments, it records the new investments (available-for-sale) at fair value. This fair value rule assures that a company cannot omit recognition of fair value simply by transferring securities to the held-to-maturity category. Illustration 17-30 summarizes the accounting treatment for transfers.
The reporting of investment securities is controversial. Some believe that all securities should be reported at fair value; others believe they all should be stated at amortized cost. Others favor the present approach. In this section we look at some of the major unresolved issues.
Companies classify debt securities as held-to-maturity, available-for-sale, or trading. As a result, companies can report three identical debt securities in three different ways in the financial statements. Some argue such treatment is confusing. Furthermore, the held-to-maturity category relies solely on intent, a subjective evaluation. What is not subjective is the fair value of the debt instrument. In other words, the three classifications are subjective, resulting in arbitrary classifications.
Companies can classify certain debt securities as held-to-maturity and therefore report them at amortized cost. Companies can classify other debt and equity securities as available-for-sale and report them at fair value with the unrealized gain or loss reported as other comprehensive income. In either case, a company can become involved in "gains trading" (also referred to as "cherry picking," "snacking," or "sell the best and keep the rest"). In gains trading, companies sell their "winners," reporting the gains in income, and hold on to the losers.
Many argue that if companies report investment securities at fair value, they also should report liabilities at fair value. Why? By recognizing changes in value on only one side of the balance sheet (the asset side), a high degree of volatility can occur in the income and stockholders' equity amounts. Further, financial institutions are involved in asset and liability management (not just asset management). Viewing only one side may lead managers to make uneconomic decisions as a result of the accounting.
Both the IASB and the FASB believe that fair value information for financial assets and financial liabilities provides more useful and relevant information than a cost-based system. The Boards take this position because fair value reflects the current cash equivalent of the financial instrument rather that the cost of a past transaction. As a consequence, only fair value provides an understanding of the current worth of the investment.
Companies must report fair values for some types of financial instruments. In addition, they have the option to record fair values for any of their financial instruments. How many companies will choose this fair value option? We are hopeful that many companies will select this option; we believe that the information provided by fair value reporting for financial instruments is useful and more understandable to financial statement users.
Illustration 17-31 summarizes the major debt and equity securities and their reporting treatment.
As indicated in the last two sections, the level of disclosure for investment securities is extensive. How to account for investment securities is a particularly sensitive area, given the large amounts of equity investments involved. And presently companies report investments in equity securities at cost, equity, fair value, and full consolidation, depending on the circumstances. As a recent SEC study noted, "there are so many different accounting treatments for investments that it raises the question of whether they are all needed."
Presented below is an estimate of the percentage of companies on the major exchanges that have investments in the equity of other entities.
As the table indicates, many companies have equity investments of some type. These investments can be substantial. For example, based on the table above, the total amount of equity-method investments appearing on company balance sheets is approximately $403 billion, and the amount shown in the income statements in any one year for all companies is approximately $38 billion.
Source: "Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers," United States Securities and Exchange Commission—Office of Chief Accountant, Office of Economic Analyses, Division of Corporation Finance (June 2005), pp. 36–39.
The accounting for investment securities is discussed in IAS 27 ("Consolidated and Separate Financial Statements"), IAS 28 ("Accounting for Investments in Associates"), and IAS 39 ("Financial Instruments: Recognition and Measurement"). The accounting and reporting under iGAAP and U.S. GAAP are for the most part very similar, although the criteria used to determine the accounting is often different.
The accounting for trading, available-for-sale, and held-to-maturity securities is essentially the same between iGAAP and U.S. GAAP.
Gains and losses related to available-for-sale securities are reported in other comprehensive income under U.S. GAAP. Under iGAAP, these gains and losses are reported directly in equity.
Both iGAAP and U.S. GAAP use the same test to determine whether the equity method of accounting should be used—that is, significant influence with a general guide of over 20 percent ownership. iGAAP uses the term associate investment rather than equity investment to describe its investment under the equity method.
Reclassifications of securities from one category to another generally follow the same accounting under the two GAAP systems. Reclassification in and out of trading securities is prohibited under iGAAP. It is not prohibited under U.S. GAAP, but this type of reclassification should be rare.
Under iGAAP, both the investor and an associate company should follow the same accounting policies. As a result, in order to prepare financial information, adjustments are made to the associate's policies to conform to the investor's books.
The basis for consolidation under iGAAP is control. Under U.S. GAAP, a bipolar approach is used, which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting-interest approach. However, under both systems, for consolidation to occur, the investor company must generally own 50 percent of another company.
iGAAP and U.S. GAAP are similar in the accounting for the fair value option. That is, the selection to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses related to fair value changes are reported as part of income. The differences relate to disclosures and scope exceptions.
U.S. GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. iGAAP follows the same approach for available-for-sale equity investments but permits reversal for available-for-sale debt securities and held-to-maturity securities.
The following example illustrates the accounting for investment impairments under iGAAP. Belerus Company has an available-for-sale investment in the 8 percent, 10-year bonds of Wimbledon Company. The investment has a carrying value of 2,300,000 euros at December 31, 2010. Early in January 2011, Belerus learns that Wimbledon has lost a major customer. As a result, Belerus determines that this investment is impaired and now has a fair value of 1,500,000 euros. Belerus makes the following entry to record the impairment.
Early in 2012, Wimbledon secures several new customers, and its prospects have improved considerably. Belerus determines the fair value of its investment is now 2,000,000 euros and makes the following entry under iGAAP.
Under U.S. GAAP, Belerus is prohibited from recording the recovery in value of the impaired investment. That is, once an investment is impaired, the impaired value becomes the new basis for the investment.
As indicated earlier, both the FASB and IASB have indicated that they believe that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. It seems likely as more companies choose the fair value option for financial instruments, we will eventually arrive at fair value measurement for all financial 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.
In order to understand derivatives, consider the following examples.
Example 1—Forward Contract. Assume that a company like Dell believes that the price of Google's stock will increase substantially in the next 3 months. Unfortunately, it does not have the cash resources to purchase the stock today. Dell therefore enters into a contract with a broker for delivery of 10,000 shares of Google stock in 3 months at the price of $110 per share.
Dell has entered into a forward contract, a type of derivative. As a result of the contract, Dell has received the right to receive 10,000 shares of Google stock in 3 months. Further, it has an obligation to pay $110 per share at that time. What is the benefit of this derivative contract? Dell can buy Google stock today and take delivery in 3 months. If the price goes up, as it expects, Dell profits. If the price goes down, Dell loses.
Example 2—Option Contract. Now suppose that Dell needs 2 weeks to decide whether to purchase Google stock. It therefore enters into a different type of contract, one that gives it the right to purchase Google stock at its current price any time within the next 2 weeks. As part of the contract, the broker charges $3,000 for holding the contract open for 2 weeks at a set price.
Dell has now entered into an option contract, another type of derivative. As a result of this contract, it has received the right, but not the obligation to purchase this stock. If the price of the Google stock increases in the next 2 weeks, Dell exercises its option. In this case, the cost of the stock is the price of the stock stated in the contract, plus the cost of the option contract. If the price does not increase, Dell does not exercise the contract, but still incurs the cost for the option.
The forward contract and the option contract both involve a future delivery of stock. The value of the contract relies on the underlying asset—the Google stock. Thus, these financial instruments are known as derivatives because they derive their value from values of other assets (e.g., stocks, bonds, or commodities). Or, put another way, their value relates to a market-determined indicator (e.g., stock price, interest rates, or the Standard and Poor's 500 stock composite index).
In this appendix, we discuss the accounting for three different types of derivatives:
Financial forwards or financial futures.
Options.
Swaps.
Whether to protect for changes in interest rates, the weather, stock prices, oil prices, or foreign currencies, derivative contracts help to smooth the fluctuations caused by various types of risks. A company that wants to ensure against certain types of business risks often uses derivative contracts to achieve this objective.[279]
To illustrate, assume that Heartland Ag is a large producer of potatoes for the consumer market. The present price for potatoes is excellent. Unfortunately, Heartland needs two months to harvest its potatoes and deliver them to the market. Because Heartland expects the price of potatoes to drop in the coming months, it signs a forward contract. It agrees to sell its potatoes today at the current market price for delivery in 2 months.
Who would buy this contract? Suppose on the other side of the contract is McDonald's Corporation. McDonald's wants to have potatoes (for French fries) in 2 months and believes that prices will increase. McDonald's is therefore agreeable to accepting delivery in 2 months at current prices. It knows that it will need potatoes in 2 months, and that it can make an acceptable profit at this price level.
In this situation, if the price of potatoes increases before delivery, Heartland loses and McDonald's wins. Conversely, if the price decreases, Heartland wins and McDonald's loses. However, the objective is not to gamble on the outcome. Regardless of which way the price moves, both Heartland and McDonald's have received a price at which they obtain an acceptable profit. In this case, although Heartland is a producer and McDonald's is a consumer, both companies are hedgers. They both hedge their positions to ensure an acceptable financial result.
Commodity prices are volatile. They depend on weather, crop production, and general economic conditions. For the producer and the consumer to plan effectively, it makes good sense to lock in specific future revenues or costs in order to run their businesses successfully.
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.
Airlines, like Delta, Southwest, and United, are affected by changes in the price of jet fuel.
Financial institutions, such as Citigroup, Bankers Trust, and M&I Bank, are involved in borrowing and lending funds that are affected by changes in interest rates.
Multinational corporations, like Cisco Systems, Coca-Cola, and General Electric, are subject to changes in foreign exchange rates.
In fact, most corporations are involved in some form of derivatives transactions. Companies give these reasons (in their annual reports) as to why they use derivatives:
ExxonMobil uses derivatives to hedge its exposure to fluctuations in interest rates, foreign currency exchange rates, and hydrocarbon prices.
Caterpillar uses derivatives to manage foreign currency exchange rates, interest rates, and commodity price exposure.
Johnson & Johnson uses derivatives to manage the impact of interest rate and foreign exchange rate changes on earnings and cash flows.
Many corporations use derivatives extensively and successfully. However, derivatives can be dangerous. All parties involved must understand the risks and rewards associated with these contracts.[280]
The FASB concluded that derivatives such as forwards and options are assets and liabilities. It also concluded that companies should report them in the balance sheet at fair value[281]. 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.[282]
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.
Recognize derivatives in the financial statements as assets and liabilities.
Report derivatives at fair value.
Recognize gains and losses resulting from speculation in derivatives immediately in income.
Report gains and losses resulting from hedge transactions differently, depending on the type of hedge.
To illustrate the measurement and reporting of a derivative for speculative purposes, we examine a derivative whose value depends on the market price of Laredo Inc. common stock. A company can realize a gain from the increase in the value of the Laredo shares with the use of a derivative, such as a call option.[283] A call option gives the holder the right, but not the obligation, to buy shares at a preset price. This price is often referred to as the strike price or the exercise price.
For example, assume a company enters into a call option contract with Baird Investment Co., which gives it the option to purchase Laredo stock at $100 per share.[284] If the price of Laredo stock increases above $100, the company can exercise this option and purchase the shares for $100 per share. If Laredo's stock never increases above $100 per share, the call option is worthless.
Accounting Entries. To illustrate the accounting for a call option, assume that the company purchases a call option contract on January 2, 2010, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2010. The company purchases the call option for $400 and makes the following entry.
This payment is referred to as the option premium. It is generally much less than the cost of purchasing the shares directly. The option premium consists of two amounts: (1) intrinsic value and (2) time value. Illustration 17A-1 shows the formula to compute the option premium.
Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2010, 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.[285]
The following additional data are available with respect to the call option.
As indicated, on March 31, 2010, the price of Laredo shares increases to $120 per share. The intrinsic value of the call option contract is now $20,000. That is, the company can exercise the call option and purchase 1,000 shares from Baird Investment for $100 per share. It can then sell the shares in the market for $120 per share. This gives the company a gain of $20,000 ($120,000 − $100,000) on the option contract.[286] 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, 2010, is $100[287]. The company records this change in value of the option as follows.
At March 31, 2010, the company reports the call option in its balance sheet at fair value of $20,100.[288] 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, 2010, the company settles the option before it expires. To properly record the settlement, it updates the value of the option for the decrease in the intrinsic value of $5,000 ([$20 − $15]) × 1,000) as follows.
The decrease in the time value of the option of $40 ($100 − $60) is recorded as follows.
Thus, at the time of the settlement, the call option's carrying value is as follows.
The company records the settlement of the option contract with Baird as follows.
Illustration 17A-2 summarizes the effects of the call option contract on net income.
The accounting summarized in Illustration 17A-2 is in accord with GAAP. That is, because the call option meets the definition of an asset, the company records it in the balance sheet on March 31, 2010. Furthermore, it reports the call option at fair value, with any gains or losses reported in income.
How does a traditional financial instrument differ from a derivative one? A derivative financial instrument has the following three basic characteristics. [10]
The instrument has (1) one or more underlyings and (2) an identified payment provision. An underlying is a specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. The interaction of the underlying, with the face amount or the number of units specified in the derivative contract (the notional amounts), determines payment. For example, the value of the call option increased in value when the value of the Laredo stock increased. In this case, the underlying is the stock price. To arrive at the payment provision, multiply the change in the stock price by the number of shares (notional amount).
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.
The instrument requires or permits net settlement. As indicated in the call option example, the company could realize a profit on the call option without taking possession of the shares. This net settlement feature reduces the transaction costs associated with derivatives.
Illustration 17A-3 summarizes the differences between traditional and derivative financial instruments. Here, we use a trading security for the traditional financial instrument and a call option as an example of a derivative one.
Flexibility in use, and the low-cost features of derivatives relative to traditional financial instruments, explain the popularity of derivatives. An additional use for derivatives is in risk management. For example, companies such as Coca-Cola, ExxonMobil, and General Electric borrow and lend substantial amounts in credit markets. In doing so, they are exposed to significant interest rate risk. That is, they face substantial risk that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease. These same companies also have significant international operations. As such, they are also exposed to exchange rate risk—the risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses.
Companies can use derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. This use of derivatives is referred to as hedging.
GAAP established accounting and reporting standards for derivative financial instruments used in hedging activities. The FASB allows special accounting for two types of hedges—fair value and cash flow hedges.[289]
As shown in the graph below, use of derivatives has grown steadily in the past several years. In fact, over $450 trillion (in notional amounts) in derivative contracts were in play at the end of 2007. The primary players in the market for derivatives are large companies and various financial institutions, which continue to find new uses for derivatives for speculation and risk management.
Financial engineers continue to develop new uses for derivatives, many times through the use of increasingly complex webs of transactions, spanning a number of markets. As new uses for derivatives appear, the financial system as a whole can be dramatically affected. As a result, some market-watchers are concerned about the risk that a crisis in one company or sector could bring the entire financial system to its knees.
This concern was illustrated recently when both Fannie Mae and Freddie Mac (two federally-chartered mortgage companies) indicated problems with their derivative accounting, and both of these companies had to restate their financial results for prior periods. This has led Congress to study whether the concentration of mortgages in these institutions is too high. With so many home buyers dependent on Fannie and Freddie, there is concern that these companies may be too loaded down with debt, which could negatively affect the home mortgage market.
Source: Data from International Swaps and Derivatives Association Market Survey (2007).
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, 2010, Hayward Co. purchases 100 shares of Sonoma stock at a market price of $100 per share. Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as available-for-sale. Hayward records this available-for-sale investment as follows.
Hayward records available-for-sale securities at fair value on the balance sheet. It reports unrealized gains and losses in equity as part of other comprehensive income[290]. Fortunately for Hayward, the value of the Sonoma shares increases to $125 per share during 2010. Hayward records the gain on this investment as follows.
Illustration 17A-4 indicates how Hayward reports the Sonoma investment in its balance sheet.
While Hayward benefits from an increase in the price of Sonoma shares, it is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 shares of Sonoma stock.
Hayward enters into the put option contract on January 2, 2011, and designates the option as a fair value hedge of the Sonoma investment. This put option (which expires in two years) gives Hayward the option to sell Sonoma shares at a price of $125. Since the exercise price equals the current market price, no entry is necessary at inception of the put option.[291]
At December 31, 2011, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment.
Note that upon designation of the hedge, the accounting for the available-for-sale security changes from regular GAAP. That is, Hayward records the unrealized holding loss in income, not in equity. If Hayward had not followed this accounting, a mismatch of gains and losses in the income statement would result. Thus, special accounting for the hedged item (in this case, an available-for-sale security) is necessary in a fair value hedge.
The following journal entry records the increase in value of the put option on Sonoma shares.
The decline in the price of Sonoma shares results in an increase in the fair value of the put option. That is, Hayward could realize a gain on the put option by purchasing 100 shares in the open market for $120 and then exercise the put option, selling the shares for $125. This results in a gain to Hayward of $500 (100 shares × [$125 − $120]).[292]
Illustration 17A-5 indicates how Hayward reports the amounts related to the Sonoma investment and the put option.
The increase in fair value on the option offsets or hedges the decline in value on Hayward's available-for-sale security. By using fair value accounting for both financial instruments, the financial statements reflect the underlying substance of Hayward's net exposure to the risks of holding Sonoma stock. By using fair value accounting for both these financial instruments, the balance sheet reports the amount that Hayward would receive on the investment and the put option contract if Hayward sold and settled them, respectively.
Illustration 17A-6 illustrates the reporting of the effects of the hedging transaction on income for the year ended December 31, 2011.
The income statement indicates that the gain on the put option offsets the loss on the available-for-sale securities[293]. The reporting for these financial instruments, even when they reflect a hedging relationship, illustrates why the FASB argued that fair value accounting provides the most relevant information about financial instruments, including derivatives.
Companies use cash flow hedges to hedge exposures to cash flow risk, which results from the variability in cash flows. The FASB allows special accounting for cash flow hedges. Generally, companies measure and report derivatives at fair value on the balance sheet. They report gains and losses directly in net income. However, companies account for derivatives used in cash flow hedges at fair value on the balance sheet, but they record gains or losses in equity, as part of other comprehensive income.
To illustrate, assume that in September 2010 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2011. 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 2011. As a result, Allied enters into an aluminum futures contract.
Under iGAAP, companies record unrealized holding gains or losses on cash flow hedges as adjustments to the value of the hedged item, not as "Other comprehensive income."
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[294]. In this case, the aluminum futures contract gives Allied the right and the obligation to purchase 1,000 metric tons of aluminum for $1,550 per ton. This contract price is good until the contract expires in January 2011. The underlying for this derivative is the price of aluminum. 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.[295]
Allied enters into the futures contract on September 1, 2010. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary.
At December 31, 2010, the price for January delivery of aluminum increases to $1,575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract.
Allied reports the futures contract in the balance sheet as a current asset. It reports the gain on the futures contract as part of other comprehensive income.
Since Allied has not yet purchased and sold the inventory, this gain arises from an anticipated transaction. In this type of transaction, a company accumulates in equity gains or losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby affecting earnings.
In January 2011, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry.[296]
At the same time, Allied makes final settlement on the futures contract. It records the following entry.
Through use of the futures contract derivative, Allied fixes the cost of its inventory. The $25,000 futures contract settlement offsets the amount paid to purchase the inventory at the prevailing market price of $1,575,000. The result: net cash outflow of $1,550 per metric ton, as desired. As Illustration 17A-7 shows, Allied has therefore effectively hedged the cash flow for the purchase of inventory.
There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory, affecting earnings through cost of goods sold.
For example, assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2011) is $1,700,000. Allied sells the cans in July 2011 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.
The preceding examples illustrate the basic reporting issues related to the accounting for derivatives. Next, we discuss the following additional issues:
As we indicated at the beginning of this appendix, rapid innovation in the development of complex financial instruments drove efforts toward unifying and improving the accounting standards for derivatives. In recent years, this innovation has led to the development of hybrid securities. These securities have characteristics of both debt and equity. They often combine traditional and derivative financial instruments.
For example, a convertible bond (discussed in Chapter 16) is a hybrid instrument. It consists of two parts: (1) a debt security, referred to as the host security, combined with (2) an option to convert the bond to shares of common stock, the embedded derivative.
To provide consistency in accounting for similar derivatives, a company must account for embedded derivatives similarly to other derivatives. Therefore, to account for an embedded derivative, a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation[297]. Thus, a company investing in a convertible bond must separate the stock option component of the instrument. It then accounts for the derivative (the stock option) at fair value and the host instrument (the debt) according to GAAP, as if there were no embedded derivative.[298]
The FASB identified certain criteria that hedging transactions must meet before requiring the special accounting for hedges. The FASB designed these criteria to ensure the use of hedge accounting in a consistent manner across different hedge transactions. The general criteria relate to the following areas.
Documentation, risk management, and designation. At inception of the hedge, there must be formal documentation of the hedging relationship, the company's risk management objective, and the strategy for undertaking the hedge. Designation refers to identifying the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash flows attributable to the hedged risk.
The FASB decided that documentation and designation are critical to the implementation of the special accounting for hedges. Without these requirements, companies might try to apply the hedge accounting provisions retroactively, only in response to negative changes in market conditions, to offset the negative impact of a transaction on the financial statements. Allowing special hedge accounting in such a setting could mask the speculative nature of the original transaction.
Effectiveness of the hedging relationship. At inception and on an ongoing basis, the hedging relationship should be highly effective in achieving offsetting changes in fair value or cash flows. Companies must assess effectiveness whenever preparing financial statements.
The general guideline for effectiveness is that the fair values or cash flows of the hedging instrument (the derivative) and the hedged item exhibit a high degree of correlation. In practice, high effectiveness is assumed when the correlation is close to one (e.g., within plus or minus .10). In our earlier hedging examples (put option and the futures contract on aluminum inventory), the fair values and cash flows are perfectly correlated. That is, when the cash payment for the inventory purchase increased, it offset, dollar for dollar, the cash received on the futures contract.
If the effectiveness criterion is not met, either at inception or because of changes following inception of the hedging relationship, the FASB no longer allows special hedge accounting. The company should then account for the derivative as a free-standing derivative.[299]
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.[300] There is no need for special hedge accounting if a company accounts for both the hedging instrument and the hedged item at fair value under existing GAAP. In this case, earnings will properly reflect the offsetting gains and losses.
For example, special accounting is not needed for a fair value hedge of a trading security, because a company accounts for both the investment and the derivative at fair value on the balance sheet with gains or losses reported in earnings. Thus, "special" hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP.[301]
Illustration 17A-8 summarizes the accounting provisions for derivatives and hedging transactions.
As indicated, the general accounting for derivatives relies on fair values. GAAP also establishes special accounting guidance when companies use derivatives for hedging purposes. For example, when a company uses a put option to hedge price changes in an available-for-sale stock investment in a fair value hedge (see the Hayward example earlier), it records unrealized gains on the investment in earnings, which is not GAAP for available-for-sale securities without such a hedge. This special accounting is justified in order to accurately report the nature of the hedging relationship in the balance sheet (recording both the put option and the investment at fair value) and in the income statement (reporting offsetting gains and losses in the same period).
Special accounting also is used for cash flow hedges. Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record unrealized holding gains or losses in other comprehensive income until selling or settling the hedged item. In a cash flow hedge, a company continues to record the hedged item at its historical cost.
Disclosure requirements for derivatives are complex. Recent pronouncements on fair value information and financial instruments provide a helpful disclosure framework for reporting derivative instruments. Appendix 17C illustrates many of these disclosures, except for discussion of hedging issues. In general, companies that have derivatives are required to disclose the objectives for holding or issuing those instruments (speculation or hedging), the hedging context (fair value or cash flow), and the strategies for achieving risk-management objectives.
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.
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, 2010. 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.[302] 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:
Jones will receive fixed payments at 8 percent (based on the $1,000,000 amount).
Jones will pay variable rates, based on the market rate in effect for the life of the swap contract. The variable rate at the inception of the contract is 6.8 percent.
As Illustration 17A-10 shows, this swap allows Jones to change the interest on the bonds payable from a fixed rate to a variable rate.
The settlement dates for the swap correspond to the interest payment dates on the debt (December 31). On each interest payment (settlement) date, Jones and the counterparty compute the difference between current market interest rates and the fixed rate of 8 percent, and determine the value of the swap.[303] 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, 2010 (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 2010, Jones makes the interest payment on the bonds. It records this transaction as follows.
At the end of 2010, 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.[304]
Jones reports this swap contract in the balance sheet. It reports the gain on the hedging transaction in the income statement. Because interest rates have declined, the company records a loss and a related increase in its liability as follows.
Jones reports the loss on the hedging activity in net income. It adjusts bonds payable in the balance sheet to fair value.
Illustration 17A-11 indicates how Jones reports the asset and liability related to this hedging transaction on the balance sheet.
The effect on Jones's balance sheet is the addition of the swap asset and an increase in the carrying value of the bonds payable. Illustration 17A-12 indicates how Jones reports the effects of this swap transaction in the income statement.
On the income statement, Jones reports interest expense of $68,000. Jones has effectively changed the debt's interest rate from fixed to variable. That is, by receiving a fixed rate and paying a variable rate on the swap, the company converts the fixed rate on the bond payable to variable. This results in an effective interest rate of 6.8 percent in 2010.[305] Also, the gain on the swap offsets the loss related to the debt obligation. Therefore the net gain or loss on the hedging activity is zero.
Illustration 17A-13 shows the overall impact of the swap transaction on the financial statements.
In summary, to account for fair value hedges (as illustrated in the Jones example) record the derivative at its fair value in the balance sheet, and record any gains and losses in income. Thus, the gain on the swap offsets or hedges the loss on the bond payable, due to the decline in interest rates.
By adjusting the hedged item (the bond payable in the Jones case) to fair value, with the gain or loss recorded in earnings, the accounting for the Jones bond payable deviates from amortized cost. This special accounting is justified in order to report accurately the nature of the hedging relationship between the swap and the bond payable in the balance sheet (both the swap and the debt obligation are recorded at fair value) and in the income statement (offsetting gains and losses are reported in the same period).[306]
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 GAAP in this area.
However, we believe that the long-term benefits of using fair value and reporting derivatives at fair value will far outweigh any short-term implementation costs. As the volume and complexity of derivatives and hedging transactions continue to grow, so does the risk that investors and creditors will be exposed to unexpected losses arising from derivative transactions. Statement readers must have comprehensive information concerning many derivative financial instruments and the effects of hedging transactions using derivatives.
SUMMARY OF LEARNING OBJECTIVES FOR APPENDIX 17A
The FASB has issued an interpretation to address the concern that some companies are not reporting the risks and rewards of certain investments and other financial arrangements in their consolidated financial statements. [13] As one analyst noted, Enron showed the world the power of the idea that "if investors can't see it, they can't ask you about it—the 'it' being assets and liabilities."
What exactly did Enron do? First, it created a number of entities whose purpose was to hide debt, avoid taxes, and enrich certain management personnel to the detriment of the company and its stockholders. In effect, these entities, called special purpose entities (SPEs), appeared to be separate entities for which Enron had a limited economic interest. For many of these arrangements, Enron actually had a substantial economic interest; the risks and rewards of ownership were not shifted to the entities but remained with Enron. In short, Enron was obligated to repay investors in these SPEs when they were unsuccessful. Once Enron's problems were discovered, it soon became apparent that many other companies had similar problems.
A reasonable question to ask with regard to SPEs is, "Why didn't GAAP prevent companies from hiding SPE debt and other risks, by forcing companies to include these obligations in their consolidated financial statements?" To understand why, we have to look at the basic rules of consolidation.
The GAAP rules indicate that consolidated financial statements are "usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in other companies." They further note that "the usual condition for a controlling financial interest is ownership of a majority voting interest."[307] In other words, if a company, like Intel, owns more than 50 percent of the voting stock of another company, Intel consolidates that company. GAAP also indicates that controlling financial interest may be achieved through arrangements that do not involve voting interests. However, applying these guidelines in practice is difficult.
Whenever GAAP uses a clear line, like "greater than 50 percent," companies sometimes exploit the criterion. For example, some companies set up joint ventures in which each party owns exactly 50 percent. In that case, neither party consolidates. Or like Coca-Cola in the opening story, a company may own less than 50 percent of the voting stock, but maintain effective control through board of director relationships, supply relationships, or through some other type of financial arrangement.
So the FASB realized that changes had to be made to GAAP for consolidations, and it issued new guidelines. These guidelines define when a company should use factors other than voting interest to determine controlling financial interest. In this pronouncement, the FASB created a new risk-and-reward model to be used in situations where voting interests were unclear. The risk-and-reward model answers the basic questions of who stands to gain or lose the most from ownership in an SPE when ownership is uncertain.
In other words, we now have two models for consolidation:
Voting-interest model—If a company owns more than 50 percent of another company, then consolidate in most cases.
Risk-and-reward model—If a company is involved substantially in the economics of another company, then consolidate.
Operationally, the voting-interest model is easy to apply: It sets a "bright line" ownership standard of more than 50 percent of the voting stock. However, if companies cannot determine control based on voting interest, they may use the risk-and-reward model.
To answer the question of who gains or loses when voting rights do not determine consolidation, the FASB developed the risk-and-reward model. In this model, the FASB introduced the notion of a variable-interest entity. A variable-interest entity (VIE) is an entity that has one of the following characteristics:
Insufficient equity investment at risk. Stockholders are assumed to have sufficient capital investment to support the entity's operations. If thinly capitalized, the entity is considered a VIE and is subject to the risk-and-reward model.
Stockholders lack decision-making rights. In some cases, stockholders do not have the influence to control the company's destiny.
Stockholders do not absorb the losses or receive the benefits of a normal stockholder. In some entities, stockholders are shielded from losses related to their primary risks, or their returns are capped or must be shared with other parties.
Once the company determines that an entity is a variable-interest entity, it no longer can use the voting-interest model. The question that must then be asked is, "What party is exposed to the majority of the risks and rewards associated with the VIE?" This party is called the primary beneficiary and must consolidate the VIE. Illustration 17B-1 shows the decision model for the VIE consolidation model.
Let's look at a couple of examples to illustrate how this process works.
Assume that Citigroup sells notes receivable to another entity called RAKO. RAKO's assets are financed in two ways: Lenders provide 90 percent, and investors provide the remaining 10 percent as an equity investment. If Citigroup does not guarantee the debt, Citigroup has low or nonexistent risk. Therefore, Citigroup would not consolidate the assets and liabilities of RAKO. On the other hand, if Citigroup guarantees RAKO's debt, then RAKO is a VIE, and Citigroup is the primary beneficiary. In that case, Citigroup must consolidate.
San Diego Gas and Electric (SDGE) is required by law to buy power from small, local producers. In some cases, SDGE has contracts requiring it to purchase substantially all the power generated by these local companies over their lifetime. Because SDGE controls the outputs of the producers, they are VIEs. In this case, the risks and rewards related to ownership apply to SDGE. In other words, it is the primary beneficiary, and SDGE should include these producers in the consolidated financial statements.
Note that the primary beneficiary may have the risks and rewards of ownership through use of a variety of instruments and financial arrangements, such as equity investments, loans to the VIE, leases, derivatives, and guarantees. Potential VIEs include the following: corporations, partnerships, limited liability companies, and majority-owned subsidiaries.
For most companies, the new reporting related to VIEs will not materially affect their financial statements. As shown in Illustration 17B-2, one study of 509 companies with total market values over $500 million found that just 17 percent of the companies reviewed have a material impact.
Of the material VIEs disclosed in the study, the most common types (42 percent) were related to joint-venture equity investments, followed by off-balance-sheet lease arrangements (22 percent). In some cases, companies are restructuring transactions to avoid consolidation. For example, Pep Boys, Choice Point, Inc., and Anadarko all appear to have restructured their lease transactions to avoid consolidation. On the other hand, companies like eBay, Kimberly-Clark, and Williams-Sonoma Inc. intend to or have consolidated their VIEs.
In summary, companies are now required to consolidate certain investments and other financing arrangements that previously were reported off-balance-sheet. As a result, financial statements should be more complete in reporting the risks and rewards of these transactions.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17B
As indicated in the chapter, the FASB believes that fair value information is relevant for making effective business decisions. However, others express concern about fair value measurements for two reasons: (1) the lack of reliability related to the fair value measurement in certain cases, and (2) the ability to manipulate fair value measurements to achieve financial results inconsistent with the underlying economics of the situation.
The Board recognizes these concerns and has attempted to develop a sound conceptual basis for measuring and reporting fair value information. In addition, it has placed emphasis on developing guidelines for reporting fair value information for financial instruments, because many of these instruments have relatively active markets for which valuations can be reliably determined. The purpose of this appendix is to explain the disclosure requirements for financial instruments related to fair value information.
One requirement related to fair value disclosure is that both the cost and the fair value of all financial instruments be reported in the notes to the financial statements. [14] This enables readers of the financial statements to understand the fair value of the company's financial instruments and the potential gains and losses that might occur in the future as a result of these instruments.
The Board also decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. Two reasons for additional disclosure beyond the simple itemization of fair values are:
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.
Changes in the fair value of financial instruments are reported differently in the financial statements, depending upon the type of financial instrument involved and whether the fair value option is employed. Note disclosure provides an opportunity to explain more precisely the impact that changes in the value of financial instruments have on financial results. In assessing the inputs, the Board recognizes that the reliability of the fair value measurement is of extreme importance. Many financial instruments are traded in active markets, and their valuation is not difficult. Other instruments are complex/illiquid, and their valuation is difficult.
To highlight these levels of reliability in valuation, the FASB established a fair value hierarchy. As discussed in Chapter 2 (page 43), this hierarchy identifies three broad levels—1, 2, and 3—related to the measurement of fair values. Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities. Level 3 is least reliable; it uses unobservable inputs that reflect the company's assumption as to the value of the financial instrument.
Illustration 17C-1 is an example of a fair value note disclosure for Sabathia Company. It includes both the fair value amounts and the reliability level. (A similar disclosure would be presented for liabilities.)
For assets and liabilities measured at fair value and classified as Level 3, a reconciliation of Level 3 changes for the period is required. In addition, companies should report an analysis of how Level 3 changes in fair value affect total gains and losses and their impact on net income. Illustration 17C-2 is an example of this disclosure.
Sabathia Company's disclosure provides to the user of the financial statements an understanding of the following:
The carrying amount and the fair value of the company's financial instruments segregated by level of reliability. Thus the reader of the financial statements has a basis for judging what credence should be given to the fair value amounts.
For Level 3 financial instruments, a reconciliation of the balance from the beginning to the end of the period. This reconciliation enables the reader to understand the composition of the change. It is important because these calculations are most affected by subjective estimates and could be subject to manipulation.
The impact of changes in fair value on the net assets of the company from one period to the next.
Some companies may choose to use the fair value option for some or all of their financial instruments. [15] In that case, companies have the option of incorporating 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. Illustration 17C-3 for Sheets Company includes only information related to the fair value option. It integrates the disclosure of the carrying amount in addition to the fair value disclosure.
In addition to financial instruments, companies often have assets or liabilities that are remeasured on a nonrecurring basis due to impairment. In this case the fair value hierarchy can highlight the reliability of the measurement, coupled with the related gain or loss for the period. Illustration 17C-4 highlights this disclosure for McClung Company.
FASB Codification References
FASB ASC 810-10-25. [Predecessor literature: "Consolidation of Variable Interest Entities (revised)—An Interpretation of ARB No. 51," Financial Accounting Standards Interpretation No. 46(R) (Norwalk, Conn.: FASB, December 2003.]
FASB ASC Glossary. [Predecessor literature: "Accounting for Certain Investments in Debt and Equity Securities," Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB 1993), par. 137.]
FASB ASC 820-10-20. [Predecessor literature: "Fair Value Measurement," Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).]
FASB ASC 220. [Predecessor literature: "Reporting Comprehensive Income," Statement of Financial Accounting Standards No. 130 (Norwalk, Conn.: FASB, 1997).]
FASB ASC 323-10-15. [Predecessor literature: "The Equity Method of Accounting for Investments in Common Stock," Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 17.]
FASB ASC 323-10-15-10. [Predecessor literature: "Criteria for Applying the Equity Method of Accounting for Investments in Common Stock," Interpretations of the Financial Accounting Standards Board No. 35 (Stamford, Conn.: FASB, 1981).]
FASB ASC 323-10-35. [Predecessor literature: "The Equity Method of Accounting for Investments in Common Stock," Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 19(i).]
FASB ASC 815-10-05. [Predecessor literature: "Accounting for Derivative Instruments and Hedging Activities," Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998).]
FASB ASC 820-10. [Predecessor literature: "Fair Value Measurement," Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).]
FASB ASC 815-10-05-4. [Predecessor literature: "Accounting for Derivative Instruments and Hedging Activities," Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998), par. 249.]
FASB ASC 815-10-05-4. [Predecessor literature: "Accounting for Derivative Instruments and Hedging Activities," Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998).]
FASB ASC 825-10-25-1. [Predecessor literature: "The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115," Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).]
FASB ASC 810-10-05. [Predecessor literature: "Consolidation of Variable Interest Entities (revised)—An Interpretation of ARB No. 51," Financial Accounting Standards Interpretation No. 46(R) (FASB, Norwalk, Conn.: December 2003).]
FASB ASC 820-10. [Predecessor literature: "Fair Value Measurement," Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).]
FASB ASC 825-10-25-1. (Predecessor literature: "The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115," Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).]
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
Distinguish between a debt security and an equity security.
What purpose does the variety in bond features (types and characteristics) serve?
What is the cost of a long-term investment in bonds?
Identify and explain the three types of classifications for investments in debt securities.
When should a debt security be classified as held-to-maturity?
Explain how trading securities are accounted for and reported.
At what amount should trading, available-for-sale, and held-to-maturity securities be reported on the balance sheet?
On July 1, 2010, Wheeler Company purchased $4,000,000 of Duggen Company's 8% bonds, due on July 1, 2017. 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, 2010.
If the bonds in question 8 are classified as available-for-sale and they have a fair value at December 31, 2010, of $3,604,000, prepare the journal entry (if any) at December 31, 2010, to record this transaction.
Indicate how unrealized holding gains and losses should be reported for investment securities classified as trading, available-for-sale, and held-to-maturity.
(a) Assuming no Securities Fair Value Adjustment (Available-for-Sale) account balance at the beginning of the year, prepare the adjusting entry at the end of the year if Laura Company's available-for-sale securities have a market value $60,000 below cost. (b) Assume the same information as part (a), except that Laura Company has a debit balance in its Securities Fair Value Adjustment (Available-for-Sale) account of $10,000 at the beginning of the year. Prepare the adjusting entry at year-end.
Identify and explain the different types of classifications for investment in equity securities.
Why are held-to-maturity investments applicable only to debt securities?
Hayes Company sold 10,000 shares of Kenyon Co. common stock for $27.50 per share, incurring $1,770 in brokerage commissions. These securities were classified as trading and originally cost $260,000. Prepare the entry to record the sale of these securities.
Distinguish between the accounting treatment for available-for-sale equity securities and trading equity securities.
What constitutes "significant influence" when an investor's financial interest is below the 50% level?
Explain how the investment account is affected by investee activities under the equity method.
When the equity method is applied, what disclosures should be made in the investor's financial statements?
Hiram Co. uses the equity method to account for investments in common stock. What accounting should be made for dividends received from these investments subsequent to the date of investment?
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?
Where on the asset side of the balance sheet are trading securities, available-for-sale securities, and held-to-maturity securities reported? Explain.
Explain why reclassification adjustments are necessary.
Briefly discuss how a transfer of securities from the available-for-sale category to the trading category affects stockholders' equity and income.
When is a debt security considered impaired? Explain how to account for the impairment of an available-for-sale debt security.
What is the GAAP definition of fair value?
What is the fair value option?
Franklin Corp. has an investment that it has held for several years. When it purchased the investment, Franklin classified and accounted for it as available-for-sale. Can Franklin use the fair value option for this investment? Explain.
* What is meant by the term underlying as it relates to derivative financial instruments?
* What are the main distinctions between a traditional financial instrument and a derivative financial instrument?
* What is the purpose of a fair value hedge?
* In what situation will the unrealized holding gain or loss on an available-for-sale security be reported in income?
* Why might a company become involved in an interest rate swap contract to receive fixed interest payments and pay variable?
* What is the purpose of a cash flow hedge?
* Where are gains and losses related to cash flow hedges involving anticipated transactions reported?
* What are hybrid securities? Give an example of a hybrid security.
* Explain the difference between the voting-interest model and the risk-and-reward model used for consolidation.
* What is a variable-interest entity?
Trading Securities
Available-for-Sale Securities
Held-to-Maturity Securities
Each case is independent of the other.
A bond that will mature in 4 years was bought 1 month ago when the price dropped. As soon as the value increases, which is expected next month, it will be sold.
10% of the outstanding stock of Farm-Co was purchased. The company is planning on eventually getting a total of 30% of its outstanding stock.
10-year bonds were purchased this year. The bonds mature at the first of next year.
Bonds that will mature in 5 years are purchased. The company would like to hold them until they mature, but money has been tight recently and they may need to be sold.
A bond that matures in 10 years was purchased. The company is investing money set aside for an expansion project planned 10 years from now.
Preferred stock was purchased for its constant dividend. The company is planning to hold the preferred stock for a long time.
Instructions
Prepare the journal entry at the date of the bond purchase.
Prepare the journal entry to record the interest received for 2010.
Prepare the journal entry to record the interest received for 2011.
Instructions
Prepare the journal entry at the date of the bond purchase.
Prepare a bond amortization schedule.
Prepare the journal entry to record the interest received and the amortization for 2009.
Prepare the journal entry to record the interest received and the amortization for 2010.
Instructions
Prepare the journal entry at the date of the bond purchase.
Prepare the journal entries to record the interest received and recognition of fair value for 2009.
Prepare the journal entry to record the recognition of fair value for 2010.
Instructions
Prepare a 3-year schedule of interest revenue and bond discount amortization, applying the straight-line method. (Round to nearest dollar.)
Prepare a 3-year schedule of interest revenue and bond discount amortization, applying the effective-interest method. (Round to nearest cent.)
Prepare the journal entry for the interest receipt of December 31, 2011, and the discount amortization under the straight-line method.
Prepare the journal entry for the interest receipt of December 31, 2011, and the discount amortization under the effective-interest method.
Instructions
Prepare the adjusting entry (if any) for 2010, assuming the securities are classified as trading.
Prepare the adjusting entry (if any) for 2010, assuming the securities are classified as available-for-sale.
Discuss how the amounts reported in the financial statements are affected by the entries in (a) and (b).
During 2011, Carolina Company stock was sold for $9,500. The fair value of the stock on December 31, 2011, was: Stargate Corp. stock—$19,300; Vectorman Co. stock—$20,500.
Instructions
Prepare the adjusting journal entry needed on December 31, 2010.
Prepare the journal entry to record the sale of the Carolina Company stock during 2011.
Prepare the adjusting journal entry needed on December 31, 2011.
Instructions
Prepare the adjusting entry to report the securities properly. Indicate the statement presentation of the accounts in your entry.
On January 20, 2011, Wenger, Inc. sold security A for $15,300. The sale proceeds are net of brokerage fees.
Instructions
Prepare the adjusting entry at December 31, 2010, to report the portfolio at fair value.
Show the balance sheet presentation of the investment related accounts at December 31, 2010. (Ignore notes presentation.)
Prepare the journal entry for the 2011 sale of security A.
Instructions
Prepare a statement of comprehensive income for 2010 starting with net income.
Prepare a statement of comprehensive income for 2011 starting with net income.
On January 15, purchased 9,000 shares of Gonzalez Company's common stock at $33.50 per share plus commission $1,980.
On April 1, purchased 5,000 shares of Belmont Co.'s common stock at $52.00 per share plus commission $3,370.
On September 10, purchased 7,000 shares of Thep Co.'s preferred stock at $26.50 per share plus commission $4,910.
On May 20, 2010, Capriati sold 3,000 shares of Gonzalez Company's common stock at a market price of $35 per share less brokerage commissions, taxes, and fees of $2,850. The year-end fair values per share were: Gonzalez $30, Belmont $55, and Thep $28. In addition, the chief accountant of Capriati told you that Capriati Corporation plans to hold these securities for the long term but may sell them in order to earn profits from appreciation in prices.
Instructions
Prepare the journal entries to record the above three security purchases.
Prepare the journal entry for the security sale on May 20.
Compute the unrealized gains or losses and prepare the adjusting entries for Capriati on December 31, 2010.
Situation 1
Hatcher Cosmetics acquired 10% of the 200,000 shares of common stock of Ramirez Fashion at a total cost of $14 per share on March 18, 2010. On June 30, Ramirez declared and paid a $75,000 cash dividend. On December 31, Ramirez reported net income of $122,000 for the year. At December 31, the market price of Ramirez Fashion was $15 per share. The securities are classified as available-for-sale.
Situation 2
Holmes, Inc. obtained significant influence over Nadal Corporation by buying 25% of Nadal's 30,000 outstanding shares of common stock at a total cost of $9 per share on January 1, 2010. On June 15, Nadal declared and paid a cash dividend of $36,000. On December 31, Nadal reported a net income of $85,000 for the year.
Instructions
Prepare all necessary journal entries in 2010 for both situations.
Instructions
Use the information in the following T-account for the investment in Demo to answer the following questions.
How much was Gator Co.'s share of Demo Co.'s net income for the year?
How much was Gator Co.'s share of Demo Co.'s dividends for the year?
What was Demo Co.'s total net income for the year?
What was Demo Co.'s total dividends for the year?
Instructions
Prepare the journal entries for these transactions and any year-end adjustments.
All of the securities were purchased in 2010.
In 2011, Swanson completed the following securities transactions.
Swanson Company's portfolio of trading securities appeared as follows on December 31, 2011.
Instructions
Prepare the general journal entries for Swanson Company for:
The 2010 adjusting entry.
The sale of the Parker stock.
The purchase of the McDowell stock.
The 2011 adjusting entry for the trading portfolio.
Instructions
Prepare the journal entries for Gregory Inc. for 2010 and 2011, assuming that Gregory cannot exercise significant influence over Handerson. The securities should be classified as available-for-sale.
Prepare the journal entries for Gregory Inc. for 2010 and 2011, assuming that Gregory can exercise significant influence over Handerson.
At what amount is the investment in securities reported on the balance sheet under each of these methods at December 31, 2011? What is the total net income reported in 2011 under each of these methods?
Instructions
Prepare the entries for Meredith to record the purchase and any additional entries related to this investment in Pirates Company in 2010.
Instructions
Prepare the journal entry to recognize the impairment.
What is the new cost basis of the municipal bonds? Given that the maturity value of the bonds is $800,000, should Cairo Corporation amortize the difference between the carrying amount and the maturity value over the life of the bonds?
At December 31, 2011, the fair value of the municipal bonds is $760,000. Prepare the entry (if any) to record this information.
Instructions
What entry would Lilly make at December 31, 2010, to record the investment in Arroyo Company stock if it chooses to report this security using the fair value option?
What entry would Lilly make at December 31, 2010, to record the investment in Lee Corporation, assuming that Lilly wants to classify this security as available-for-sale? This security is the only available-for-sale security that Lilly presently owns.
What entry would Lilly make at December 31, 2010, to record the investment in Woods Inc., assuming that Lilly wants to classify this investment as a trading security?
Net income before any security gains and losses for 2011 was $905,000.
Instructions
Compute the amount of net income or net loss that Lilly should report for 2011, taking into consideration Lilly's security transactions for 2011.
Prepare the journal entry to record unrealized gain or loss related to the investment in Arroyo Company stock at December 31, 2011.
Instructions
Dawson elects to use the fair value option whenever possible. Assuming that Dawson's net income is $100,000 in 2010 before reporting any securities gains or losses, determine Dawson's net income for 2010.
Record the journal entry, if any, necessary at December 31, 2010, to record the fair value option for the bonds payable.
Instructions
Prepare the journal entry to record the purchase of the call option on January 2, 2010.
Prepare the journal entry(ies) to recognize the change in the fair value of the call option as of March 31, 2010.
What was the effect on net income of entering into the derivative transaction for the period January 2 to March 31, 2010? (Ignore tax effects.)
As a result, on January 2, 2010, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2010.
Instructions
Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2010.
Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2010.
Parton Company decides it prefers fixed-rate financing and wants to lock in a rate of 6%. As a result, Parton enters into an interest rate swap to pay 6% fixed and receive LIBOR based on $10 million. The variable rate is reset to 6.6% on January 2, 2011.
Instructions
Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2010.
Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2011.
Instructions
Prepare the journal entry to record the payment of interest expense on December 31, 2011.
Prepare the journal entry to record the receipt of the swap settlement on December 31, 2011.
Prepare the journal entry to record the change in the fair value of the swap contract on December 31, 2011.
Prepare the journal entry to record the change in the fair value of the debt on December 31, 2011.
Date
Market Price of Counting Crows Shares
Time Value of Call Option
September 30, 2010
$48 per share
$180
December 31, 2010
$46 per share
65
January 15, 2011
$47 per share
30
Instructions
Prepare the journal entries for Outkast for the following dates.
Investment in call option on Counting Crows shares on August 15, 2010.
September 30, 2010—Outkast prepares financial statements.
December 31, 2010—Outkast prepares financial statements.
January 15, 2011—Outkast settles the call option on the Counting Crows shares.
To hedge the risk of increased titanium prices, on May 1, 2010, Hart enters into a titanium futures contract and designates this futures contract as cash flow hedge of the anticipated titanium purchase. The notional amount of the contract is 200 ounces, and the terms of the contract give Hart the right and the obligation to purchase titanium at a price of $500 per ounce. The price will be good until the contract expires on November 30, 2010.
Assume the following data with respect to the price of the call options and the titanium inventory purchase.
Date
Spot Price for November Delivery
May 1, 2010
$500 per ounce
June 30, 2010
520 per ounce
September 30, 2011
525 per ounce
Instructions
Present the journal entries for the following dates/transactions.
May 1, 2010—Inception of futures contract, no premium paid.
June 30, 2010—Hart prepares financial statements.
September 30, 2010—Hart prepares financial statements.
October 5, 2010—Hart purchases 200 ounces of titanium at $525 per ounce and settles the futures contract.
December 15, 2010—Hart sells clubs containing titanium purchased in October 2010 for $250,000. The cost of the finished goods inventory is $140,000.
Indicate the amount(s) reported in the income statement related to the futures contract and the inventory transactions on December 31, 2010.
Date
Cash Received
Interest Revenue
Bond Premium Amortization
Carrying Amount of Bonds
12/31/08
$108,660
12/31/09
$7,000
$5,433
$1,567
107,093
12/31/10
7,000
5,354
1,646
105,447
12/31/11
7,000
5,272
1,728
103,719
12/31/12
7,000
5,186
1,814
101,905
12/31/13
7,000
5,095
1,905
100,000
The following schedule presents a comparison of the amortized cost and fair value of the bonds at year-end.
Instructions
Prepare the journal entry to record the purchase of these bonds on December 31, 2008, assuming the bonds are classified as held-to-maturity securities.
Prepare the journal entry(ies) related to the held-to-maturity bonds for 2009.
Prepare the journal entry(ies) related to the held-to-maturity bonds for 2011.
Prepare the journal entry(ies) to record the purchase of these bonds, assuming they are classified as available-for-sale.
Prepare the journal entry(ies) related to the available-for-sale bonds for 2009.
Prepare the journal entry(ies) related to the available-for-sale bonds for 2011.
Instructions
Prepare the journal entry to record the purchase of bonds on January 1. Assume that the bonds are classified as available-for-sale.
Prepare the amortization schedule for the bonds.
Prepare the journal entries to record the semiannual interest on July 1, 2010, and December 31, 2010.
If the fair value of Aguirre bonds is $372,726 on December 31, 2011, prepare the necessary adjusting entry. (Assume the securities fair value adjustment balance on January 1, 2011, is a debit of $3,375.)
Prepare the journal entry to record the sale of the bonds on January 1, 2012.
Instructions
(Round all computations to the nearest dollar.)
Prepare entries necessary to classify the amounts into proper accounts, assuming that all the securities are classified as available-for-sale.
Prepare the entry to record the accrued interest and the amortization of premium on December 31, 2010 using the straight-line method.
The fair values of the securities on December 31, 2010, were:
What entry or entries, if any, would you recommend be made?
The U.S. government bonds were sold on July 1, 2011, for $119,200 plus accrued interest. Give the proper entry.
Instructions
Indicate whether the bonds were purchased at a discount or at a premium.
Prepare the adjusting entry to record the bonds at fair value at December 31, 2010. The Securities Fair Value Adjustment account has a debit balance of $1,000 prior to adjustment.
Prepare the adjusting entry to record the bonds at fair value at December 31, 2011.
In 2011, Parnevik completed the following securities transactions.
On January 15, sold 3,000 shares of Anderson's common stock at $22 per share less fees of $2,150.
On April 17, purchased 1,000 shares of Castle's common stock at $33.50 per share plus fees of $1,980.
On December 31, 2011, the market values per share of these securities were: Munter $61, King $40, and Castle $29. In addition, the accounting supervisor of Parnevik told you that, even though all these securities have readily determinable fair values, Parnevik will not actively trade these securities because the top management intends to hold them for more than one year.
Instructions
Prepare the entry for the security sale on January 15, 2011.
Prepare the journal entry to record the security purchase on April 17, 2011.
Compute the unrealized gains or losses and prepare the adjusting entry for Parnevik on December 31, 2011.
How should the unrealized gains or losses be reported on Parnevik's balance sheet?
Trading Securities
Cost
Fair Value
Horton, Inc. common (5,000 shares)
$215,000
$200,000
Monty, Inc. preferred (3,500 shares)
133,000
140,000
Oakwood Corp. common (1,000 shares)
180,000
179,000
On October 10, 2010, the Horton shares were sold at a price of $54 per share. In addition, 3,000 shares of Patriot common stock were acquired at $54.50 per share on November 2, 2010. The December 31, 2010, fair values were: Monty $106,000, Patriot $132,000, and the Oakwood common $193,000. All the securities are classified as trading.
Instructions
Prepare the journal entries to record the sale, purchase, and adjusting entries related to the trading securities in the last quarter of 2010.
How would the entries in part (a) change if the securities were classified as available-for-sale?
On February 1, the company purchased 10% bonds of Gibbons Co. having a par value of $300,000 at 100 plus accrued interest. Interest is payable April 1 and October 1.
On April 1, semiannual interest is received.
On July 1, 9% bonds of Sampson, Inc. were purchased. These bonds with a par value of $200,000 were purchased at 100 plus accrued interest. Interest dates are June 1 and December 1.
On September 1, bonds with a par value of $60,000, purchased on February 1, are sold at 99 plus accrued interest.
On October 1, semiannual interest is received.
On December 1, semiannual interest is received.
On December 31, the fair value of the bonds purchased February 1 and July 1 are 95 and 93, respectively.
Instructions
Prepare any journal entries you consider necessary, including year-end entries (December 31), assuming these are available-for-sale securities.
If Wildcat classified these as held-to-maturity securities, explain how the journal entries would differ from those in part (a).
Cheryl Thomas has recently joined Brooks as assistant controller, and her first assignment is to prepare the 2010 year-end adjusting entries for the accounts that are valued by the "fair value" rule for financial reporting purposes. Thomas has gathered the following information about Brooks's pertinent accounts.
Brooks has trading securities related to Delaney Motors and Patrick Electric. During this fiscal year, Brooks purchased 100,000 shares of Delaney Motors for $1,400,000; these shares currently have a market value of $1,600,000. Brooks' investment in Patrick Electric has not been profitable; the company acquired 50,000 shares of Patrick in April 2010 at $20 per share, a purchase that currently has a value of $720,000.
Prior to 2010, Brooks invested $22,500,000 in Norton Industries and has not changed its holdings this year. This investment in Norton Industries was valued at $21,500,000 on December 31, 2009. Brooks' 12% ownership of Norton Industries has a current market value of $22,225,000.
Instructions
Prepare the appropriate adjusting entries for Brooks as of December 31, 2010, to reflect the application of the "fair value" rule for both classes of securities described above.
For both classes of securities presented above, describe how the results of the valuation adjustments made in (a) would be reflected in the body of and notes to Brooks' 2010 financial statements.
Prepare the entries for the Norton investment, assuming that Brooks owns 25% of Norton's shares. Norton reported income of $500,000 in 2010 and paid cash dividends of $100,000.
Instructions
What should be reported on Kennedy's December 31, 2010, balance sheet relative to these long-term available-for-sale securities?
On December 31, 2011, Kennedy's portfolio of available-for-sale securities consisted of the following common stocks.
At the end of year 2011, Kennedy Company changed its intent relative to its investment in Frank, Inc. and reclassified the shares to trading securities status when the shares were selling for $8 per share.
What should be reported on the face of Kennedy's December 31, 2011, balance sheet relative to available-for-sale securities investments? What should be reported to reflect the transactions above in Kennedy's 2011 income statement?
Assuming that comparative financial statements for 2010 and 2011 are presented, draft the footnote necessary for full disclosure of Kennedy's transactions and position in equity securities.
The accumulated other comprehensive income related to unrealized holding gains on available-for-sale securities. The fair value of Acker Inc.'s available-for-sale securities at December 31, 2010, was $190,000; its cost was $140,000. No securities were purchased during the year. Acker Inc.'s income statement for 2010 was as follows. (Ignore income taxes.)
Instructions
(Assume all transactions during the year were for cash.)
Prepare the journal entry to record the sale of the available-for-sale securities in 2010.
Prepare a statement of comprehensive income for 2010.
Prepare a balance sheet as of December 31, 2010.
During 2010, the following transactions took place.
On March 1, Rogers Company paid a $2 per share dividend.
On April 30, Castleman Holdings, Inc. sold 300 shares of Chance Company for $11 per share.
On May 15, Castleman Holdings, Inc. purchased 100 more shares of Evers Co. stock at $16 per share.
At December 31, 2010, the stocks had the following price per share values: Evers $17, Rogers $19, and Chance $8.
During 2011, the following transactions took place.
On February 1, Castleman Holdings, Inc. sold the remaining Chance shares for $8 per share.
On March 1, Rogers Company paid a $2 per share dividend.
On December 21, Evers Company declared a cash dividend of $3 per share to be paid in the next month.
At December 31, 2011, the stocks had the following price per shares values: Evers $19 and Rogers $21.
Instructions
Prepare journal entries for each of the above transactions.
Prepare a partial balance sheet showing the Investments account at December 31, 2010 and 2011.
Instructions
What should be reported on Fernandez's December 31, 2010, balance sheet relative to these securities? What should be reported on Fernandez's 2010 income statement?
On December 31, 2011, Fernandez's portfolio of available-for-sale securities consisted of the following common stocks.
During the year 2011, Fernandez Corp. sold 2,000 shares of Poley Corp. for $38,200 and purchased 2,000 more shares of Lindsay Jones, Inc. and 1,000 shares of Duff Company.
What should be reported on Fernandez's December 31, 2011, balance sheet? What should be reported on Fernandez's 2011 income statement?
On December 31, 2012, Fernandez's portfolio of available-for-sale securities consisted of the following common stocks.
During the year 2012, Fernandez Corp. sold 3,000 shares of Lindsay Jones, Inc. for $39,900 and 500 shares of Duff Company at a loss of $2,700.
What should be reported on the face of Fernandez's December 31, 2012, balance sheet? What should be reported on Fernandez's 2012 income statement?
What would be reported in a statement of comprehensive income at (1) December 31, 2010, and (2) December 31, 2011?
Instructions
Prepare the journal entries for Miller Co. for the following dates.
July 7, 2010—Investment in call option on Wade shares.
September 30, 2010—Miller prepares financial statements.
December 31, 2010—Miller prepares financial statements.
January 4, 2011—Miller settles the call option on the Wade shares.
Instructions
Prepare the journal entries for Johnstone Co. for the following dates.
July 7, 2010—Investment in put option on Ewing shares.
September 30, 2010—Johnstone prepares financial statements.
December 31, 2010—Johnstone prepares financial statements.
January 31, 2011—Put option expires.
Instructions
Prepare the journal entries for Warren Co. for the following dates.
January 7, 2010—Investment in put option on Echo shares.
March 31, 2010—Warren prepares financial statements.
June 30, 2010—Warren prepares financial statements.
July 6, 2010—Warren settles the put option on the Echo shares.
Mercantile Corp. designates the swap as a fair value hedge. Assume that the hedging relationship meets all the conditions necessary for hedge accounting. The 6-month LIBOR rate and the swap and debt fair values are as follows.
Instructions
Present the journal entries to record the following transactions.
The entry, if any, to record the swap on December 31, 2010.
The entry to record the semiannual debt interest payment on June 30, 2011.
The entry to record the settlement of the semiannual swap amount receivables at 8%, less amount payable at LIBOR, 7%.
The entry to record the change in the fair value of the debt on June 30, 2011.
The entry to record the change in the fair value of the swap at June 30, 2011.
Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2010.
Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on June 30, 2011.
Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2011.
To hedge the risk of increased gold prices, on April 1, 2010, LEW enters into a gold futures contract and designates this futures contract as a cash flow hedge of the anticipated gold purchase. The notional amount of the contract is 500 ounces, and the terms of the contract give LEW the right and the obligation to purchase gold at a price of $300 per ounce. The price will be good until the contract expires on October 31, 2010.
Assume the following data with respect to the price of the call options and the gold inventory purchase.
Instructions
Prepare the journal entries for the following transactions.
April 1, 2010—Inception of the futures contract, no premium paid.
June 30, 2010—LEW Co. prepares financial statements.
September 30, 2010—LEW Co. prepares financial statements.
October 10, 2010—LEW Co. purchases 500 ounces of gold at $315 per ounce and settles the futures contract.
December 20, 2010—LEW sells jewelry containing gold purchased in October 2010 for $350,000. The cost of the finished goods inventory is $200,000.
Indicate the amount(s) reported on the balance sheet and income statement related to the futures contract on June 30, 2010.
Indicate the amount(s) reported in the income statement related to the futures contract and the inventory transactions on December 31, 2010.
To hedge against potential declines in the value of Pratt stock during this period, Sprinkle also purchased a put option on the Pratt stock. Sprinkle paid an option premium of $600 for the put option, which gives Sprinkle the option to sell 4,000 Pratt shares at a strike price of $50 per share. The option expires on July 31, 2011. The following data are available with respect to the values of the Pratt stock and the put option.
Date
Market Price of Pratt Shares
Time Value of Put Option
December 31, 2010
$50 per share
$375
March 31, 2011
45 per share
175
June 30, 2011
43 per share
40
Instructions
Prepare the journal entries for Sprinkle Co. for the following dates.
November 3, 2010—Investment in Pratt stock and the put option on Pratt shares.
December 31, 2011—Sprinkle Co. prepares financial statements.
March 31, 2011—Sprinkle prepares financial statements.
June 30, 2011—Sprinkle prepares financial statements.
July 1, 2011—Sprinkle settles the put option and sells the Pratt shares for $43 per share.
Indicate the amount(s) reported on the balance sheet and income statement related to the Pratt investment and the put option on December 31, 2010.
Indicate the amount(s) reported on the balance sheet and income statement related to the Pratt investment and the put option on June 30, 2011.
CA17-1 (Issues Raised about Investment Securities) You have just started work for Warren Co. as part of the controller's group involved in current financial reporting problems. Jane Henshaw, controller for Warren, is interested in your accounting background because the company has experienced a series of financial reporting surprises over the last few years. Recently, the controller has learned from the company's auditors that there is authoritative literature that may apply to its investment in securities. She assumes that you are familiar with this pronouncement and asks how the following situations should be reported in the financial statements.
Situation 1
Trading securities in the current assets section have a fair value that is $4,200 lower than cost.
Situation 2
A trading security whose fair value is currently less than cost is transferred to the available-for-sale category.
Situation 3
An available-for-sale security whose fair value is currently less than cost is classified as noncurrent but is to be reclassified as current.
Situation 4
A company's portfolio of available-for-sale securities consists of the common stock of one company. At the end of the prior year the fair value of the security was 50% of original cost, and this reduction in market value was reported as an other than temporary impairment. However, at the end of the current year the fair value of the security had appreciated to twice the original cost.
Situation 5
The company has purchased some convertible debentures that it plans to hold for less than a year. The fair value of the convertible debentures is $7,700 below its cost.
Instructions
What is the effect upon carrying value and earnings for each of the situations above? Assume that these situations are unrelated.
CA17-2 (Equity Securities) Lexington Co. has the following available-for-sale securities outstanding on December 31, 2010 (its first year of operations).
During 2011 Summerset Company stock was sold for $9,200, the difference between the $9,200 and the "fair value" of $8,800 being recorded as a "Gain on Sale of Securities." The market price of the stock on December 31, 2011, was: Greenspan Corp. stock $19,900; Tinkers Company stock $20,500.
Instructions
What justification is there for valuing available-for-sale securities at fair value and reporting the unrealized gain or loss as part of stockholders' equity?
How should Lexington Company apply this rule on December 31, 2010? Explain.
Did Lexington Company properly account for the sale of the Summerset Company stock? Explain.
Are there any additional entries necessary for Lexington Company at December 31, 2011, to reflect the facts on the financial statements in accordance with generally accepted accounting principles? Explain.
(AICPA adapted)
CA17-3 (Financial Statement Effect of Equity Securities) Presented below are three unrelated situations involving equity securities.
Situation 1
An equity security, whose market value is currently less than cost, is classified as available-for-sale but is to be reclassified as trading.
Situation 2
A noncurrent portfolio with an aggregate market value in excess of cost includes one particular security whose market value has declined to less than one-half of the original cost. The decline in value is considered to be other than temporary.
Situation 3
The portfolio of trading securities has a cost in excess of fair value of $13,500. The available-for-sale portfolio has a fair value in excess of cost of $28,600.
Instructions
What is the effect upon carrying value and earnings for each of the situations above?
CA17-4 (Equity Securities) The Financial Accounting Standards Board issued accounting guidance to clarify accounting methods and procedures with respect to certain debt and all equity securities. An important part of the statement concerns the distinction between held-to-maturity, available-for-sale, and trading securities.
Instructions
Why does a company maintain an investment portfolio of held-to-maturity, available-for-sale, and trading securities?
What factors should be considered in determining whether investments in securities should be classified as held-to-maturity, available-for-sale, and trading? How do these factors affect the accounting treatment for unrealized losses?
CA17-5 (Investment Accounted for under the Equity Method) On July 1, 2011, Fontaine Company purchased for cash 40% of the outstanding capital stock of Knoblett Company. Both Fontaine Company and Knoblett Company have a December 31 year-end. Knoblett Company, whose common stock is actively traded in the over-the-counter market, reported its total net income for the year to Fontaine Company and also paid cash dividends on November 15, 2011, to Fontaine Company and its other stockholders.
Instructions
How should Fontaine Company report the above facts in its December 31, 2011, balance sheet and its income statement for the year then ended? Discuss the rationale for your answer.
(AICPA adapted)
Instructions
Prepare a one-page memorandum of instructions on how Selig Company should report the above facts in its December 31, 2010, balance sheet and its 2010 income statement. In your memo, identify and describe the method of valuation you recommend. Provide rationale where you can. Address your memo to the chief accountant at Selig Company.
Nielson disagrees. She wants to classify those securities that have decreased in value as trading securities and those that have increased in value as available-for-sale (equity) and held-to-maturity (debt). She contends that the company is having a good earnings year and that recognizing the losses will help to smooth the income this year. As a result, the company will have built-in gains for future periods when the company may not be as profitable.
Instructions
Answer the following questions.
Will classifying the portfolio as each proposes actually have the effect on earnings that each says it will?
Is there anything unethical in what each of them proposes? Who are the stakeholders affected by their proposals?
Assume that Beresford and Nielson properly classify the entire portfolio into trading, available-for-sale, and held-to-maturity categories. But then each proposes to sell just before year-end the securities with gains or with losses, as the case may be, to accomplish their effect on earnings. Is this unethical?
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
What investments does P&G report in 2007, and where are these investments reported in its financial statements?
How are P&G's investments valued? How does P&G determine fair value?
How does P&G use derivative financial instruments?
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
Cash used in (for) investing activities during 2007 (from the statement of cash flows).
Cash used for acquisitions and investments in unconsolidated affiliates (or principally bottling companies) during 2007.
Total investment in unconsolidated affiliates (or investments and other assets) at the end of 2007.
What conclusions concerning the management of investments can be drawn from these data?
(1) Briefly identify from Coca-Cola's December 31, 2007, balance sheet the investments it reported as being accounted for under the equity method. (2) What is the amount of investments that Coca-Cola reported in its 2007 balance sheet as "cost method investments," and what is the nature of these investments?
In its Note number 9 on Financial Instruments, what total amounts did Coca-Cola report at December 31, 2007, as: (1) trading securities, (2) available-for-sale securities, and (3) held-to-maturity securities?
Union Planters is a Tennessee bank holding company (that is, a corporation that owns banks). (Union Planters is now part of Regions Bank.) Union Planters manages $32 billion in assets, the largest of which is its loan portfolio of $19 billion. In addition to its loan portfolio, however, like other banks it has significant debt investments. The nature of these investments varies from short-term in nature to long-term in nature. As a consequence, consistent with the requirements of accounting rules, Union Planters reports its investments in two different categories—trading and available-for-sale. The following facts were found in a recent Union Planters' annual report.
Instructions
Why do you suppose Union Planters purchases investments, rather than simply making loans? Why does it purchase investments that vary in nature both in terms of their maturities and in type (debt versus stock)?
How must Union Planters account for its investments in each of the two categories?
In what ways does classifying investments into two different categories assist investors in evaluating the profitability of a company like Union Planters?
Suppose that the management of Union Planters was not happy with its net income for the year. What step could it have taken with its investment portfolio that would have definitely increased reported profit? How much could it have increased reported profit? Why do you suppose it chose not to do this?
Your client, Cascade Company, is planning to invest some of its excess cash in 5-year revenue bonds issued by the county and in the stock of one of its suppliers, Teton Co. Teton's shares trade on the over-the-counter market. Cascade plans to classify these investments as available-for-sale. They would like you to conduct some research on the accounting for these investments.
Instructions
Access the FASB Codification at http://www.asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses.
Since the Teton shares do not trade on one of the large stock markets, Cascade argues that the fair value of this investment is not readily available. According to the authoritative literature, when is the fair value of a security "readily determinable"?
How is an impairment of a security accounted for?
To avoid volatility in their financial statements due to fair value adjustments, Cascade debated whether the bond investment could be classified as held-to-maturity; Cascade is pretty sure it will hold the bonds for 5 years. How close to maturity could Cascade sell an investment and still classify it as held-to-maturity?
What disclosures must be made for any sale or transfer from securities classified as held-to-maturity?
[269] A security is a share, participation, or other interest in property or in an enterprise of the issuer or an obligation of the issuer that has the following three characteristics: (a) It either is represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer. (b) It is of a type commonly traded on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment. (c) It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations. [2]
[270] The FASB defines situations where, even though a company sells a security before maturity, it has constructively held the security to maturity, and thus does not violate the held-to-maturity requirement. These include selling a security close enough to maturity (such as three months) so that interest rate risk is no longer an important pricing factor.
However, companies must be extremely careful with debt securities held to maturity. If a company prematurely sells a debt security in this category, the sale may "taint" the entire held-to-maturity portfolio. That is, a management's statement regarding "intent" is no longer credible. Therefore the company may have to reclassify the securities. This could lead to unfortunate consequences. An interesting by-product of this situation is that companies that wish to retire their debt securities early are finding it difficult to do so. The holder will not sell because the securities are classified as held-to-maturity.
[271] Companies generally record investments acquired at par, at a discount, or at a premium in the accounts at cost, including brokerage and other fees but excluding the accrued interest. They generally do not record investments at maturity value. The use of a separate discount or premium account as a valuation account is acceptable procedure for investments, but in practice companies do not widely use it.
[272] In Chapter 4, we discussed the reporting of other comprehensive income and the concept of comprehensive income.
[273] If an equity investment is not publicly traded, a company values the investment and reports it at cost in periods subsequent to acquisition. This approach is often referred to as the cost method. Companies recognize dividends when received. They value the portfolio and report it at acquisition cost. Companies only recognize gains or losses after selling the securities.
[274] Companies should record equity securities acquired in exchange for noncash consideration (property or services) at (1) the fair value of the consideration given, or (2) the fair value of the security received, whichever is more clearly determinable. Accounting for numerous purchases of securities requires the preservation of information regarding the cost of individual purchases, as well as the dates of purchases and sales. If specific identification is not possible, companies may use an average cost for multiple purchases of the same class of security. The first-in, first-out method (FIFO) of assigning costs to investments at the time of sale is also acceptable and normally employed.
[275] Cases in which an investment of 20 percent or more might not enable an investor to exercise significant influence include:
The investee opposes the investor's acquisition of its stock.
The investor and investee sign an agreement under which the investor surrenders significant shareholder rights.
The investor's ownership share does not result in "significant influence" because majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor.
The investor tries and fails to obtain representation on the investee's board of directors. [6]
[276] Companies may not amortize any discount related to the debt securities after recording the impairment. The new cost basis of impaired held-to-maturity securities does not change unless additional impairment occurs.
[277] We adapted this example from Dennis R. Beresford, L. Todd Johnson, and Cheri L. Reither, "Is a Second Income Statement Needed?" Journal of Accountancy (April 1996), p. 71.
[278] Not surprisingly, the disclosure requirements for investments and other financial assets and liabilities are extensive. We provide an expanded discussion with examples of these disclosure requirements in Appendix 17C.
[279] Derivatives are traded on many exchanges throughout the world. In addition, many derivative contracts (primarily interest rate swaps) are privately negotiated.
[280] There are some well-publicized examples of companies that have suffered considerable losses using derivatives. For example, companies such as Fannie Mae (U.S.), Enron (U.S.), Showa Shell Sekiyu (Japan), Metallgesellschaft (Germany), Procter & Gamble (U.S.), and Air Products & Chemicals (U.S.) incurred significant losses from investments in derivative instruments.
[281] GAAP covers accounting and reporting for all derivative instruments, whether financial or not. In this appendix we focus on derivative financial instruments because of their widespread use in practice. [8]
[282] As discussed in earlier chapters, fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Fair value is therefore a market-based measure. The FASB has also developed a fair value hierarchy, which indicates the priority of valuation techniques to use to determine fair value. Level 1 fair value measures are based on observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 measures are based on inputs other than quoted prices included in Level 1 but that can be corroborated with observable data. Level 3 fair values are based on unobservable inputs (for example, a company's own data or assumptions). Thus, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. For Level 3 (the least reliable), much judgment is needed, based on the best information available, to arrive at a relevant and reliable fair value measurement. [9]
[283] Investors can use a different type of option contract—a put option—to realize a gain if anticipating a decline in the Laredo stock value. A put option gives the holder the option to sell shares at a preset price. Thus, a put option increases in value when the underlying asset decreases in value.
[284] Baird Investment Co. is referred to as the counterparty. Counterparties frequently are investment bankers or other companies that hold inventories of financial instruments.
[285] This cost is estimated using option-pricing models, such as the Black-Scholes model. The volatility of the underlying stock, the expected life of the option, the risk-free rate of interest, and expected dividends on the underlying stock during the option term affect the Black-Scholes fair value estimate.
[286] In practice, investors generally do not have to actually buy and sell the Laredo shares to settle the option and realize the gain. This is referred to as the net settlement feature of option contracts.
[287] The decline in value reflects both the decreased likelihood that the Laredo shares will continue to increase in value over the option period and the shorter time to maturity of the option contract.
[288] As indicated earlier, the total value of the option at any point in time equals the intrinsic value plus the time value.
[289] GAAP also addresses the accounting for certain foreign currency hedging transactions. In general, these transactions are special cases of the two hedges we discuss here. [11] Understanding of foreign currency hedging transactions requires knowledge related to consolidation of multinational entities, which is beyond the scope of this textbook.
[290] We discussed the distinction between trading and available-for-sale investments in the chapter.
[291] To simplify the example, we assume no premium is paid for the option.
[292] In practice, Hayward generally does not have to actually buy and sell the Sonoma shares to realize this gain. Rather, unless the counterparty wants to hold Hayward shares, Hayward can "close out" the contract by having the counterparty pay it $500 in cash. This is an example of the net settlement feature of derivatives.
[293] Note that the fair value changes in the option contract will not offset increases in the value of the Hayward investment. Should the price of Sonoma stock increase above $125 per share, Hayward would have no incentive to exercise the put option.
[294] A futures contract is a firm contractual agreement between a buyer and seller for a specified asset on a fixed date in the future. The contract also has a standard specification so both parties know exactly what is being traded. A forward is similar but is not traded on an exchange and does not have standardized conditions.
[295] As with the earlier call option example, the actual aluminum does not have to be exchanged. Rather, the parties to the futures contract settle by paying the cash difference between the futures price and the price of aluminum on each settlement date.
[296] In practice, futures contracts are settled on a daily basis. For our purposes, we show only one settlement for the entire amount.
[297] A company can also designate such a derivative as a hedging instrument. The company would apply the hedge accounting provisions outlined earlier in the chapter.
[298] The issuer of the convertible bonds would not bifurcate the option component of the convertible bonds payable. GAAP explicitly precludes embedded derivative accounting for an embedded derivative that is indexed to a company's own common stock. If the conversion feature was tied to another company's stock, then the derivative would be bifurcated.
[299] The accounting for the part of a derivative that is not effective in a hedge is at fair value, with gains and losses recorded in income.
[300] GAAP gives companies the option to measure most types of financial instruments—from equity investments to debt issued by the company—at fair value. Changes in fair value are recognized in net income each reporting period. Thus, GAAP provides companies with the opportunity to hedge their financial instruments without the complexity inherent in applying hedge accounting provisions. For example, if the fair value option is used, bifurcation of an embedded derivative is not required.[12]
[301] An important criterion specific to cash flow hedges is that the forecasted transaction in a cash flow hedge "is likely to occur." A company should support this probability (defined as significantly greater than the term "more likely than not") by observable facts such as frequency of similar past transactions and its financial and operational ability to carry out the transaction.
[302] This economic loss arises because Jones is locked into the 8 percent interest payments even if rates decline.
[303] The underlying for an interest rate swap is some index of market interest rates. The most commonly used index is the London Interbank Offer Rate, or LIBOR. In this example, we assume the LIBOR is 6.8 percent.
[304] Theoretically, this fair value change reflects the present value of expected future differences in variable and fixed interest rates.
[305] Jones will apply similar accounting and measurement at future interest payment dates. Thus, if interest rates increase, Jones will continue to receive 8 percent on the swap (records a loss) but will also be locked into the fixed payments to the bondholders at an 8 percent rate (records a gain).
[306] An interest rate swap can also be used in a cash flow hedge. A common setting is the cash flow risk inherent in having variable rate debt as part of a company's debt structure. In this situation, the variable debt issuer can hedge the cash flow risk by entering into a swap contract to receive variable rate cash flows but pay fixed rate. The cash received on the swap contract will offset the variable cash flows to be paid on the debt obligation.
[307] "Consolidation of Certain Special Purpose Entities,"Proposed Interpretation (Norwalk, Conn.: FASB, June 28, 2002).