INTERMEDIATE ACCOUNTING

Transcription

1 Chapter 13 Investments and Long-Term Receivables INTERMEDIATE ACCOUNTING whole or in part.

2 Objectives 1. Explain the classification and valuation of investments. 2. Account for investments in debt securities classified as heldto-maturity, including amortization of bond premiums and discounts. 3. Account for investments in debt and equity securities classified as trading. 4. Account for investments in debt and equity securities classified as available-for-sale. 5. Understand transfers between categories and impairment of debt and equity securities. 6. Account for intercompany investments using the equity method. 7. Understand disclosures of investments. 8. Account for additional types of investments, including longterm receivables. 9. (Appendix 13.1) Account for derivatives of financial

3 Investing for the Future A debt security is a financial instrument that represents a creditor relationship with another company. Investments in debt securities include such items as U.S. treasury securities, municipal and corporate bonds, and convertible debt. An equity security is a financial instrument that represents an ownership interest in another company. Investments in equity securities include common stock, preferred stock, warrants, options, and rights. A portfolio of investments in debt and/or equity securities that have a readily determinable fair value is often referred to marketable securities (investment securities).

4 How Are Investments Classified And Valued? (Slide 1 of 4) An investment in another company that does not allow the investing company to control or exert significant influence over the other company is considered a minority passive investment. Generally, an investment is considered a passive investment when a company owns less than 20% of the voting common stock of the investee. At acquisition, a company classifies each passive investment in debt and equity securities into one of three categories based on the company s intent to hold or sell the securities.

5 How Are Investments Classified And Valued? (Slide 2 of 4) The three categories are: Held-to-Maturity Securities. Investments in debt securities for which the company has the positive intent and ability to hold until maturity. Trading Securities. Investments in debt and equity securities that are purchased and held principally to sell in the near term. Available-for-Sale Securities. Investments in debt and equity securities that are not classified as held-to-maturity or trading. The accounting for each of the three categories of securities differs based on management intent.

6 How Are Investments Classified And Valued? (Slide 3 of 4) A company reports its investments in trading securities at fair value on the balance sheet with any changes in fair value reported on the income statement as part of net income. A company may invest in the debt or equity securities of other corporations to establish long-term relationships with suppliers or to obtain significant influence over the company. Significant influence generally occurs when the investor owns between 20% and 50% of the voting common stock of the investee.

7 How Are Investments Classified And Valued? (Slide 4 of 4) Minority active investments are investments in the debt or equity securities of other corporations to establish a long-term relationships with suppliers or to obtain significant influence over the companies activities. Significant influence generally occurs when the investor owns between 20% and 50% of the voting common stock of the investee. Consolidation occurs when the investor controls the investee through an investment in equity securities. The result of consolidation is the issuance of the combined financial statements of both companies. Legal control occurs when the investor owns more than 50% of the voting common stock of the investee. Majority active investment is where an investment in another company allows the investor to control the

8 Accounting Methods for Investments

9 How Are Investments in Held-To- Maturity Securities Measured and Recorded? When a company has the positive ability and intent to hold a debt security to maturity, it can be reported as a held-to-maturity security. The investment is initially recorded at cost. The investment is subsequently reported at amortized cost on the ending balance sheet(s). Unrealized holding gains and losses are not recorded but are disclosed in the notes to the financial statements. Interest income is recognized in net income as it is earned, along with any realized gains and losses on sales.

10 Recording Initial Cost Debt securities, such as bonds, that carry a stated interest rate above the prevailing market interest rates are issued at a premium. Debt securities carrying a stated interest rate below the prevailing market are issued at a discount. Example On January 1, 2012, Drinkwitz Company invests $99,000 in bonds that have a face value of $100,000. The company intends to hold them to maturity. Drinkwitz records the purchase as follows: Investment in Held-to-Maturity Debt Securities 99,000 Cash 99,000

11 Recognition of Interest Income and Amortization of Bond Premiums and Discounts (Slide 1 of 5) The amount of interest income recognized each accounting period is based on the effective interest rate determined at the time of acquisition using the following formula: Interest Income = Market Interest Rate Book Value of the Investment at the Beginning of Period The effective interest method (interest method) of amortizing bond discounts and premiums: Amortization of Discount/Premium = Interest Revenue Cash Interest Payment

12 Recognition of Interest Income and Amortization of Bond Premiums and Discounts (Slide 2 of 5) Example Colburn Company invests in bonds that will be held to maturity. The bonds have a face value of $100,000, and Colburn pays $102, on January 1, The bonds carry a stated interest rate of 13% payable semiannually on June 30 and December 31. The bonds mature on December 31, 2014 and have an effective interest rate of 12%. Colburn records the acquisition on January 1, 2012, as follows: Investment in Held-to-Maturity Debt Securities 102, Cash 102,458.71

13 Recognition of Interest Income and Amortization of Bond Premiums and Discounts (Slide 3 of 5) Using the effective interest method, Colburn records the first interest receipt on June 30, 2012 as follows: Cash 6, Investment in Held-to-Maturity Debt Securities Interest Income 6,147.52

14 Recognition of Interest Income and Amortization of Bond Premiums and Discounts (Slide 4 of 5) Example Colburn Company invests in bonds that will be held to maturity. The bonds have a face value of $100,000, and Colburn pays $97, on January 1, Colburn uses the effective interest method. The bonds carry a stated interest rate of 13% payable semiannually on June 30 and December 31. The bonds mature on December 31, 2014 and have an effective interest rate of 14%. Colburn records the acquisition on January 1, 2012, as follows: Investment in Held-to-Maturity Debt Securities 97, Cash 97,616.71

15 Recognition of Interest Income and Amortization of Bond Premiums and Discounts (Slide 5 of 5) Using the effective interest method, Colburn records the first interest receipt on June 30, 2012 as follows: Cash 6, Investment in Held-to-Maturity Debt Securities Interest Income 6,833.17

16 Amortization of Bonds Acquired Between Interest Dates Example Tallen Company purchased 9% bonds with a face value of $200,000 at par plus accrued interest on March 1, Interest on these bonds is payable June 30 and December 31, and the bonds mature December 31, 2014 (34 months after the date of purchase). Talbert records the acquisition on March 1, 2012, Investment as in follows: Held-to-Maturity Debt Securities200,000 Interest Income ($200, /12) 3,000 Cash 203,000 The first interest receipt on June 30, 2012 of $9,000 is determined calculated as follows: $200, /12.

17 Sale of Held-to-Maturity Investment Prior to Maturity (Slide 1 of 2) Example On March 31, 2013, Colburn Company sells the $100,000, 13% bonds classified as held-to-maturity for $102,000 plus accrued interest. The bonds were purchased on January 1, 2012, for $97, (effective interest, 14%) and have a maturity date of December 31, Using the effective interest method, Colburn amortizes Investment in the Held-to-Maturity discount up Debt to the Securities date of sale Interest Income ($98, /12) ($100, /12) = $ In the second journal entry (next slide), Colburn collects the sales price plus the $3,250 interest earned in the three months since the last interest payment date.

18 Sale of Held-to-Maturity Investment Prior to Maturity (Slide 2 of 2) Cash ($102,000 + $3,250) 105, Interest Income ($100, /12) 3, Investment in Held-to-Maturity Debt Securities 98, Gain on Sale of Debt Securities 3, $ from previous slide

19 How Are Investments in Trading Securities Measured and Recorded? Recall that when investments in debt and equity securities are actively bought and sold with the intention to profit on short-term changes in price, they are classified as trading securities. The accounting for trading securities applies the most complete fair value measurement approach, as follows: The investment is initially recorded at cost. The investment is subsequently reported at fair value on the balance sheet. Unrealized holding gains and losses resulting from changes in the fair value of the securities are included in the net income of the current period. Interest and dividend income, as well as realized gains

20 Recording the Initial Cost of Trading Securities Example The accounting for trading securities is illustrated in the following slides using the information for Kent Company shown below: = $ 5,000 = 24,000 = 24,000 Kent records the purchase as follows: = 15,000 $68,000 Investment in Trading Securities 68,000 Cash 68,000

21 Recording Interest and Dividend Income Interest income related to investments in debt securities is recorded as it is earned during the period; thus, interest income should be accrued as time passes. On May 31, 2012, Kent Company accrues one month of interest on the investment in Delta Company bonds. Interest Receivable 125 Interest Income ($15, /12) 125 On October 31, 2012, Kent receives the semiannual interest payment of $750 and records it as a debit to Cash and a credit to Interest Receivable. Kent records the $3,000 of dividends from Able, Baker, and Charlie as a debit to Cash and a credit to Dividend Income.

22 Recognition of Unrealized Holding Gains and Losses (Slide 1 of 3) On its ending balance sheet, a company reports any investments in trading securities at fair value. An increase in the fair value of investment securities is an unrealized holding gain. A decrease in the fair value of investment securities is an unrealized holding loss. For investments in trading securities, the Unrealized holding Gain/Loss account is a temporary account that is closed to Retained Earnings. A debit balance in the account represents a net unrealized loss.

23 Recognition of Unrealized Holding Gains and Losses (Slide 2 of 3) On December 31, 2012, the fair value of Kent s investment in trading securities is $71,000 as follows: Cumulative 12/31/12 Change in Security Cost Fair Value Fair Value 100 shares of Able Co. common stock $ 5,000 $ 6,000 $1, shares of Baker Co. common stock 24,000 23,500 (500) 200 shares of Charlie Co. common stock 24,000 26,000 2,000 $15,000 face value of Delta Co. bonds 15,000 15, Total $68,000 $71,000 $3,000 Kent records the $3,000 net increase in the value of the securities, an unrealized holding gain, as follows: Investment in Trading Securities 3,000 Unrealized Holding Gain/Loss Trading Securities 3,000

24 Recognition of Unrealized Holding Gains and Losses (Slide 3 of 3) On December 31, 2013, the fair value of the investments in trading securities held by Kent is $66,000 as follows: Cumulative 12/31/12 12/31/13 Change in Security Fair Value Fair Value Fair Value 100 shares of Able Co. common stock $ 6,000 $ 6,100 $ shares of Baker Co. common stock 23,500 22,700 (800) 200 shares of Charlie Co. common stock 26,000 23,200 (2,800) $15,000 face value of Delta Co. bonds 15,500 14,000 (1,500) Total $71,000 $66,000 $(5,000) Kent records the $5,000 unrealized holding loss as follows: Unrealized Holding Gain/Loss Trading Securities 5,000 Investment in Trading Securities 5,000

25 Realized Gains and Losses on Sales of Trading Securities (Slide 1 of 2) On March 1, 2014, Kent sold the 100 shares of Able Company common stock for $6,000. The fair value at the previous balance sheet was $6,100. Cash 6,000 Loss on Sale of Trading Securities 100 Investment in Trading Securities 6,100 At the end of 2014, Kent reports the fair value of the securities it still owns as follows: Cumulative 12/31/13 12/31/14 Change in Security Fair Value Fair Value Fair Value 300 shares of Baker Co. common stock 22,700 23,500 $ shares of Charlie Co. common stock 23,200 24, $15,000 face value of Delta Co. bonds 15,000 14, Total $59,900 $62,300 $2,400

26 Realized Gains and Losses on Sales of Trading Securities (Slide 2 of 2) Using the information from the report of fair value (repeated below), Kent records the increase in value (unrealized holding gain) as follows: Investment in Trading Securities 2,400 Unrealized Holding Gain/Loss Trading Securities 2,400 Cumulative 12/31/13 12/31/14 Change in Security Fair Value Fair Value Fair Value 300 shares of Baker Co. common stock 22,700 23,500 $ shares of Charlie Co. common stock 23,200 24, $15,000 face value of Delta Co. bonds 15,000 14, Total $59,900 $62,300 $2,400 Kent reports the $100 realized loss on the sale of its investment in the Able Company common stock and the $2,400 unrealized holding gain in its 2014 net income.

27 How Are Investments in Available-for- Sale Securities Measured and Recorded? The investment is initially recorded at cost. The investment is subsequently reported at fair value on the balance sheet. Unrealized holding gains and losses resulting from changes in the fair value of the securities are reported as a component of other comprehensive income of the current period. Interest and dividend income are included in net income for the current period. When a security is sold, realized gains and losses are included in net income for the current period, and any unrealized holding gains or losses must be reclassified from accumulated other comprehensive income into net income.

28 Recording the Initial Cost, Interest, and Dividend Income for Available-for-Sale Securities (Slide 1 of 3) Example The accounting for available-forsale securities is illustrated in the following slides using the information for Kent Company, as follows: = $ 5,000 = 24,000 = 24,000 = 15,000 $68,000

29 Recording the Initial Cost, Interest, and Dividend Income for Available-for-Sale Securities (Slide 2 of 3) Note in the previous slide that the total cost of available-for-sale securities purchased by Kent is $68,000. Kent records the purchase as follows: Investment in Available-for Sale Securities 68,000 Cash 68,000 On May 31, 2012, Kent accrues one month interest on the investment in Delta Company bonds and records it as follows: Interest Receivable 125 Interest Income ($15, /12) 125 Interest is paid on April 30 and October 31 each year, so only one month s interest is accrued on May 31.

30 Recording the Initial Cost, Interest, and Dividend Income for Available-for-Sale Securities (Slide 3 of 3) On October 31, 2012, Kent receives the semiannual interest payment and records it as Cash follows: 750 Interest Receivable ($15, /12) 750 Kent records the $3,000 in dividends received related to investments in Able, Baker, and Charlie as follows: Cash 3,000 Dividend Income 3,000

31 Recognition of Unrealized Holding Gains and Losses (Slide 1 of 5) On its ending balance sheet, a company reports any investments in available-for-sale securities at fair value. The major difference in the accounting for investments in available-for-sale and trading securities is that in available-for-sale securities, a company reports its unrealized gains and losses in its other comprehensive income. A credit balance in the Unrealized Holding Gain/Loss account represents the cumulative net unrealized holding gains and is reported as a positive element in the accumulated other comprehensive income section of shareholders

32 Recognition of Unrealized Holding Gains and Losses (Slide 2 of 5) A debit balance in the account represents the cumulative net unrealized holding losses and is reported as a negative element in the accumulated other comprehensive income section of stockholders equity. Example On December 31, 2012, the fair value of Kent s investment in available-for-sale securities follows: Cumulative 12/31/12 Change in Security Cost Fair Value Fair Value 100 shares of Able Co. common stock $ 5,000 $ 6,000 $1, shares of Baker Co. common stock 24,000 23,500 (500) 200 shares of Charlie Co. common stock 24,000 26,000 2,000 $15,000 face value of Delta Co. bonds 15,000 15, Total $68,000 $71,000 $3,000

33 Recognition of Unrealized Holding Gains and Losses (Slide 3 of 5) Kent records the $3,000 increase in the value of the investments, an unrealized holding gain, as follows: Allowance for Change in Fair Value of Investments3,000 Unrealized Holding Gain/Loss Available for- Sale Securities 3,000 The allowance account is an adjunct/contra account to the Investment in Available-for-Sale Securities account. On its December 31, 2012, balance sheet, Kent reports the investment as an asset at the $71,000 fair value. Kent reports the $3,000 increase in the Unrealized Holding Gain/Loss account as an unrealized holding gain in its other comprehensive income for 2012.

34 Recognition of Unrealized Holding Gains and Losses (Slide 4 of 5) On December 31, 2013, the fair value of Kent s investment in available-for-sale securities is $66,000 as follows: Cumulative 12/31/13 Change in Security Cost Fair Value Fair Value 100 shares of Able Co. common stock $ 5,000 $ 6,100 $1, shares of Baker Co. common stock 24,000 22,700 (1,300) 200 shares of Charlie Co. common stock 24,000 23,200 (800) $15,000 face value of Delta Co. bonds 15,000 14,000 (1,000) Total $68,000 $66,000 $(2,000) Once a company has established an allowance account, it determines the amount of the year-end adjustment in a subsequent period by comparing the required amounts of the allowance account with its previous balance.

35 Recognition of Unrealized Holding Gains and Losses (Slide 5 of 5) On December 31, 2013, the required amount of Kent s allowance account is a $2,000 credit balance. Examine the T account below to note that the previous balance in the account at December 31, 2012, was a $3,000 debit balance. Allowance for Change in Fair Value of Investments 2012 Dec. 31 3,000 Therefore, Kent credits the allowance account for $5,000 at the end of Unrealized Holding Gain/Loss Available-for-Sale Securities 5,000 Allowance for Change in Fair Value of Investments 5,000 On its December 31, 2013, balance sheet, Kent reports the investment as an asset at the $66,000 fair value of the securities.

36 Realized Gains and Losses on Sale of Available-for-Sale Securities (Slide 1 of 3) Example On March 1, 2014, Kent sold the 100 shares of Able Company common stock for $6,000. Cumulative 12/31/13 Change in Security Cost Fair Value Fair Value 100 shares of Able Co. common stock $5,000 $6,100 $1,100 On March 1, 2014, two journal entries are needed to record the sale and to reverse the unrealized gain. Cash 6,000 Investment in Available-for-Sale Securities 5,000 Gain on Sale of Available-for-Sale Securities 1,000 Unrealized Holding Gain/Loss Available-for-Sale Securities 1,100 Allowance for Change in Fair Value of Investments 1,100

37 Realized Gains and Losses on Sale of Available-for-Sale Securities (Slide 2 of 3) Kent reports the $1,000 gain on the sale of its investment in its 2014 net income. At the end of 2014, Kent must also adjust the allowance and unrealized holding gain/loss account to report the fair values of the securities it owns. On December 31, 2014, assume the total fair value of the remaining securities is $62,300: Cumulative 12/31/14 Change in Security Cost Fair Value Fair Value 300 shares of Baker Co. common stock 24,000 23,500 $(500) 200 shares of Charlie Co. common stock 24,000 24, $15,000 face value of Delta Co. bonds 15,000 14,700 (300) Totals $63,000 $62,300 $(700)

38 Realized Gains and Losses on Sale of Available-for-Sale Securities (Slide 3 of 3) On December 31, 2014, the required amount of the Allowance account is a $700 credit balance, so Kent debits the Allowance account for $2,400 ($3,100 $700) to record the increase in fair value (unrealized holding gain) as follows: Allowance for Change in Fair Value of Investments2,400 Unrealized Holding Gain/Loss Available for Sale Securities 2,400 Kent reports the $1,100 reclassification and the $2,400 unrealized hold gain in its 2014 other comprehensive income.

39 Summary of Accounting for Investments Investment in held-to-maturity securities are reported at amortized cost while fair value is used to report investments in trading and available-forsale investments. The major difference between the accounting for investments in trading and available-for-sale is the treatment of unrealized holding gains and

40 Transfer of Investments between Categories (Slide 1 of 2) The transfer of a security between investment categories is accounted for at fair value at the time of the transfer. The accounting for any unrealized gain or loss depends on the type of transfer. A transfer from the trading category into any other category. No accounting for the unrealized holding gain or loss is needed because it has already been recognized in net income. A transfer into the trading category from any other category. The previous unrealized holding gain or loss is recognized immediately in net income and eliminated from accumulated other comprehensive income.

41 Transfer of Investments between Categories (Slide 2 of 2) A transfer into the available-for sale category from the held-to-maturity category. An unrealized holding gain or loss is established and included in other comprehensive income. A transfer of debt security into the held-tomaturity category. The unrealized holding gain or loss on the date of transfer will continue to be reported as a separate component of accumulated other comprehensive income and amortized over the remaining life of the security. Note that transfers into or out of the trading category should be rare, as should transfers from the held-to-maturity category.

42 Transfer into Trading Category from Available-for-Sale Category (Slide 1 of 2) Example The display below shows the investment in available-for-sale securities of Kent Company at December 31, 2013: Cumulative 12/31/13 Change in Security Cost Fair Value Fair Value 100 shares of Able Co. common stock $ 5,000 $ 6,100 $1, shares of Baker Co. common stock 24,000 22,700 (1,300) 200 shares of Charlie Co. common stock 24,000 23,200 (800) $15,000 face value of Delta Co. bonds 15,000 14,000 (1,000) Total $68,000 $66,000 $(2,000)

43 Transfer into Trading Category from Available-for-Sale Category (Slide 2 of 2) In 2014, Kent transfers the Able Company securities into the trading category when their fair value is $6,300. Investment in Trading Securities 6,300 Investment in Available-for-Sale Securities 5,000 Gain on Transfer of Securities 1,300 Note in this entry that the investment in trading securities is recorded at its fair market value and the cost of the securities is removed. The realized gain is included in net income for Kent eliminates the unrealized holding gain of $1,100. Unrealized Holding Gain/Loss Available-for-Sale Securities 1,100 Allowance for Change in Fair Value of Investments 1,100

44 Transfer into Available-for-Sale Category from Held-to-Maturity Category Example Devon Company has bonds with a face value of $10,000 (purchased at par) it classified as an investment in held-to-maturity securities. When the fair value of the bonds is $9,500, Devon transfers the bonds into the available-for-sale category by recording the transfer as follows: Investment in Available-for-Sale Securities 10,000 Investment in Held-to-Maturity Securities 10,000 Unrealized Holding Gain/Loss Available-for-Sale Securities 500 Allowance for Change in Fair Value of Investments 500 This transfer casts doubts on whether Devon can faithfully represent other securities as held-tomaturity.

45 Transfer into Held-to-Maturity Category from Available-for-Sale Category Example Assume Devon s bonds are currently classified as available-for-sale and it transfers them into the held-for-maturity category. The bonds had a fair market value of $9,700 on the previous balance sheet date. The current fair market value is $9,500. The transfer is recorded as follows: Investment in Held-to-Maturity Securities 9,500 Unrealized Holding Gain/Loss Held-to-Maturity Securities ($10,000 $9,500) 500 Investment in Available-for-Sale Securities 10,000 Allowance for Change in Fair Value of Investments 300 Unrealized Holding Gain/Loss Available-for- Sale Securities ($10,000 $9,700) 300

46 Impairments (Slide 1 of 2) At each reporting date, a company should evaluate each investment to determine if an impairment exists. This evaluation involves three steps: Step 1. Determine whether the investment is impaired. Step 2. Evaluate whether the impairment is other than temporary. Step 3. If the impairment is other than temporary, recognize a loss equal to the difference between the cost of the investment and its fair market value.

47 Impairments (Slide 2 of 2) Example Tracey Company has a bond investment categorized as held-to-maturity, which has a carrying value of $21,500 and a fair value of $6,500. Tracey determines that the decline of $15,000 is other than temporary, so the following entry is needed: Realized Loss on Decline in Value 15,000 Investment in Held-to-Maturity Securities 15,000 The $6,500 fair value becomes the new carrying value of the security, and Tracey computes interest income using the effective interest method based on the new effective interest rate computed.

48 Minority Active Investments: The Equity Method (Slide 1 of 5) When an investor company owns a sufficiently large percentage of the common stock of another company, it is able to exert significant influence over the financial and operating policies of the investee company. Significant influence is determined by factors such as representation on the board and participation in policy-making processes. In the absence of the contrary, an investment of 20% or more in the outstanding common stock of the investee leads to the presumption of significant influence. The equity method of accounting is used to account for investments in which significant influence

49 Minority Active Investments: The Equity Method (Slide 2 of 5) Example Cliborn Company purchases 4,200 shares (25%) of Salsa Company s outstanding common stock on January 1, Significant influence is presumed. Cliborn paid $125,000 for the shares and, on the date of acquisition, obtains the following information about Salsa: Balance Sheet Book Value Fair Depreciable assets (remaining life, 10 years)$400,000 Value $450,000 Other non-depreciable assets (e.g., land) 190, ,000 Total $590,000 $696,000 Liabilities $200,000 $220,000 Common stock 250,000 Retained earnings 140,000 Total $590,000

50 Minority Active Investments: The Equity Method (Slide 3 of 5) Salsa paid a $20,000 dividend on August 27, 2013, and reported net income for 2013 of $81,000, consisting of income from continuing operations of $73,000 and an extraordinary gain of $8,000. Cliborn s entry for the original investment on January 1, 2013: Investment in Stock: Selsa Company 125,000 Cash 125,000 Cliborn s entry for receipt of dividend on August 27, 2013: Cash 5,000 Investment in Stock: Selsa Company 5, $20,000

51 Minority Active Investments: The Equity Method (Slide 4 of 5) Cliborn s entry for 25% share of the year s net income on December 31, 2012: Investment in Stock: Selsa Company ($81, ) 20,250 Investment Income ($73, ) 18,250 Investment Income: Extraordinary Gain ($8, ) 2,000 Cliborn s entry to depreciate the increase in the recorded value of depreciable assets acquired: Investment Income ($12,500 10) 1,250 Investment in Stock: Selsa Company 1,250

52 Minority Active Investments: The Equity Method (Slide 5 of 5) Investment in Salsa Company Acquisition price, January 1, 2013 $125,000 Add: Share of 2013 reported income $18,250 Share of 2013 reported extraordinary gain 2,000 20,250 $145,250 Less: Dividends received August 27, 2013 $ 5,000 Depreciation of excess fair value of acquired assets ($12,500 10) 1,250 (6,250) Carrying value $139,000 Income from Investment Share of 2013 income $18,250 Less: Depreciation in excess of fair value of acquired assets (1,250) Investment income $17,000 Plus: Share of investee extraordinary income 2,000 Net investment income $19,000

53 Impairment: Other Than Temporary Evidence of a decline in the value of an equity investment: Bankruptcy of the investee Lengthy declines in the fair value of the stock A number of years of operating losses When the decline is determined to be other than temporary, the investor debits a Loss account and credits the Investment account for the difference between the carrying value of the investment and the fair value. If the fair value of the investment later increases, the investor does not recognize the recovery in value.

54 Change to Equity Method (Slide 1 of 2) When an investor currently using the fair value method acquires enough additional common shares during a year to obtain significant influence over the investee, the investor is required to adopt the equity method of accounting. When the equity method is adopted, the investor restates its investments in the investee by debiting the Investment account and crediting Retained Earnings for the previous percentage of investee income (minus dividends) for the period from the original date of acquisition to the date that significant influence was obtained. Once the necessary adjustments have been made, the equity method is applied in the usual manner based on the current percentage ownership.

55 Change to Equity Method (Slide 2 of 2) Example On January 2, 2012, Short Company purchased 15% of the outstanding common stock of Jones Corporation for $150,000, which it classified as an available-for-sale investment. At that time, Jones book value of net assets was $1,000,000. At the end of 2012, Jones reported net income of $300,000 and paid dividends of $60,000. The market value of Jones shares at the end of 2012 was $186,000. On January 2, 2013, to exert significant influence on Jones, Short purchased an additional 25% of its outstanding common stock for $310,000.

56 Journal Entries to Illustrate a Change to the Equity Method

57 Comparison of Book Values

58 How are Investments Disclosed in the Financial Statements? (Slide 1 of 3) Trading Securities: A company should disclose: Aggregate fair value Change in the net unrealized holding gain or loss that is included in each income statement Available-for-Sale Securities: For each balance sheet date, a company should disclose: Aggregate fair value Gross unrealized holding gains and losses Amortized cost

59 How are Investments Disclosed in the Financial Statements? (Slide 2 of 3) For each income statement period, a company should disclose: Proceeds from sales and the gross realized gains and losses on those sales Basis on which cost was determined Gross gains and gross losses included in net income from transfers of securities from this category into the trading category Change in the net unrealized holding gain or loss included as a separate component of other comprehensive income

60 How are Investments Disclosed in the Financial Statements? (Slide 3 of 3) Held-to-Maturity Debt Securities: For each balance sheet date, a company should disclose Aggregate fair value Gross unrecognized holding gains and losses Amortized cost The related realized or unrealized gain or loss and the circumstances leading to the decision to sell or transfer the security

61 Real Report: Disclosure of Investments (Slide 1 of 8)

62 Real Report: Disclosure of Investments (Slide 2 of 8)

63 Real Report: Disclosure of Investments (Slide 3 of 8)

64 Real Report: Disclosure of Investments (Slide 4 of 8)

65 Real Report: Disclosure of Investments (Slide 5 of 8)

66 Real Report: Disclosure of Investments (Slide 6 of 8) Questions: 1. What was the pretax amount of the gross unrealized holding gain and gross unrealized holding loss on available-for-sale securities that Starbucks included in other comprehensive income for 2010? Other comprehensive income for 2010 included any change in the unrealized gains and losses from securities that are classified as available-forsale. The total pretax unrealized gains and losses for Starbucks for 2010 and 2009 are shown below: (in millions) Net Change Gross Unrealized Gain $ 2.2 $ 0.8 $ 1.4 Gross Unrealized Loss (3.5) (2.1) (1.4) Net Unrealized Gain $ 0 Starbucks s other comprehensive income for 2010 would report a pretax unrealized gain of $1.4 million and a pretax unrealized loss of $1.4 million. Therefore, the net unrealized gain is zero.

67 Real Report: Disclosure of Investments (Slide 7 of 8) 2. How much did Starbucks include in accumulated other comprehensive income (pretax) at October 3, 2010, for availablefor-sale securities? Accumulated other comprehensive income would include the cumulative unrealized gains and losses for the available-for-sale securities. At October 3, 2010, Starbucks has a cumulative pretax gross unrealized loss of $1.3 million ($2.2 million gross unrealized gain $ million How much gross gain unrealized or loss related loss). to marketable securities did Starbucks include on its income statement for 2010? Were any impairment losses recognized? On its income statement for 2010, Starbucks reported proceeds of $1.1 million from the sale of marketable securities classified as available-for-sale. However, the amount of gain or loss was not disclosed separately as the amounts were considered immaterial. (continued)

68 Real Report: Disclosure of Investments (Slide 8 of 8) Starbucks reported a $4.1 million unrealized gain on its 2010 income statement related to trading securities. Although its ARS securities became liquid in 2008, Starbucks recognized no significant impairment loss on these securities because it did not intend to sell, nor is it likely it would be required to sell, the 4. Are securities any assets before and liabilities their anticipated of investees recovery. that are accounted for under the equity method reflected on Starbucks s financial statements? As of October 3, 2010, Starbucks reported $31.4 million of accounts receivable from equity investees, which are primarily related to product sales and store license fees.

69 Long-Term Notes Receivable (Slide 1 of 2) A note receivable is recorded at the fair value of the property, goods, or services or the fair value of the note, whichever is more clearly determinable. If neither of these values can be determined, the note is recorded at the present value by using the borrower s incremental interest rate. Example Joyce Company accepts a $10,000, non-interestbearing, 5-year note on January 1, 2013, in exchange for used equipment it sold to Marsden Company. Using Marden s incremental borrowing rate of 12%: Present value of the note = $10, = $5, The equipment cost $8,000 and had a book value of $5,000 at the sale.

70 Long-Term Notes Receivable (Slide 2 of 2) Joyce records the following journal entry for the exchange: January 1, 2013 Notes Receivable 10, Accumulated Depreciation 3, Discount on Notes Receivable 4, Equipment 8, Gain on Sale of Equipment The first two interest receipt entries are: December 31, 2013 Discount on Notes Receivable Interest Income [($10,000 $4,325.73).012] December 31, 2014 $10,000 $5, Discount on Notes Receivable Interest Income {[($10,000 $680.91)] 0.12}

71 Loan Fees and Loan Origination Costs The nonrefundable fees charged to borrowers for lending activities that precede the payment of funds and generally include efforts to identify and attract potential borrowers and to obligate a loan or loan commitment are called loan origination fees (or commitment fees). Generally, any loan origination fees are deferred and recognized over the life of the loan as an increase in interest income. A loan (note receivable) is impaired if it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.

72 Impairment of a Loan (Slide 1 of 3) Example Snook Company has a $100,000, 8% note receivable from Ullman Company that it is carrying at face value. Interest is payable each December 31 and the principal is to be paid on December 31, Ullman paid the interest due on December 13, but informed Snook at that time that it probably would miss the next two years interest payments due to financial difficulties. Snook also stated that the principal payment would be made one year late.

73 Impairment of a Loan (Slide 2 of 3) On December 31, 2013, Snook computes the present value of the impaired loan for a six year period from December 31, 2013, to December 31, The interest is discounted for only four years, deferred two years, because Ullman will not pay interest for two years. Present value of principal = $100,000 PV of a single sum for 6 years at 8% = $100, = $63, Present value of interest = $8,000 PV of an annuity for 4 years at 8% deferred 2 years = $8, = $22, Value of impaired loan = $63, $22, = $85,733.93

74 Impairment of a Loan (Slide 3 of 3) At December 31, 2013, Snook recognizes the impairment of $14, ($100,000 $85,733.93) as follows: Bad Debt Expense 14, Allowance for Doubtful Notes 14, The carrying value of the debt after recording the impairment is $85, At December 31, 2014, Snook recognizes the interest income of $6, as follows: Allowance for Doubtful Notes (8% $85,733.93) 6, Interest Income 6, The carrying value of the debt is: $85, $6, = $92,592.64

75 Cash Surrender Value of Life Insurance (Slide 1 of 2) Many insurance policies allow a portion of accumulated premiums to build up as a savings plan. The cash surrender value is the portion of life insurance premiums that build up as a savings plan it is returned to the purchaser if the policy is cancelled. Example At the beginning of the year, Mele Corporation pays an annual insurance premium of $5,500 Prepaid Insurance to cover the lives of its officers. 5,500 To record Cash the payment: 5,500

76 Cash Surrender Value of Life Insurance (Slide 2 of 2) According to the terms of the insurance contract, the cash surrender value of the policies increases from $7,200 to $8,300 during that year. To record the adjusting entry at the end of the year increases the cash surrender value: Insurance Expense 4,400 Cash Surrender Value of Life Insurance ($8,300 $7,200) 1,100 Prepaid Insurance 5,500 Upon the death of any of the insured officers, Mele would collect the face amount of the insurance policy and credit the Cash Surrender Value account.

77 Investment in Funds Companies may place assets in special funds for specific purposes. Special funds may be current, such as petty cash funds, or they may be long term. The most common long-term funds are as follows: Long-term funds used to accumulated cash to retire long-term liabilities (sinking funds) Long-term funds used to retire preferred stock (stock redemption funds) Long-term funds used to purchase long-term assets (plant expansion funds)

78 Derivatives of Financial Instruments (Slide 1 of 3) A financial instrument is cash, evidence of an ownership interest in an entity or a contract that both: Imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity or to exchange other financial instruments on potentially unfavorable terms with the second entity Conveys to that second entity a contractual right to receive cash or another financial instrument from the first entity or to exchange other financial instruments on potentially favorable terms with the first entity

79 Derivatives of Financial Instruments (Slide 2 of 3) A derivative financial instrument (or simply derivative) is a financial instrument, such as a future, a forward, a swap, or an option contract, that derives it value from an underlying asset, market price, interest rate, foreign exchange rate, or index. A hedge is a means of protecting against a financial loss by mitigating exposure to changes in values of underlying assets, liabilities, or future cash flows. An interest-rate swap is an agreement in which two companies agree to exchange the interest

80 Derivatives of Financial Instruments (Slide 3 of 3) A principal amount upon which interest payments of an interest-rate swap are based is referred to as a notional (i.e., imaginary) amount because the swap does not involve an actual exchange of principal at either the inception or maturity. A cash flow hedge protects against the risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain.