Chapter 18 Intermediate Accounting II Otto Chang Professor of Accounting

Investment In debt securities: –Trading: fair value method –Available for sale: fair value method –Held to maturity: cost method In equity securities –Less than 20%: Fair value method –Between 20% to 50%: equity method –Greater than 50%: consolidation method

Held-to-Maturity Debt Securities At acquisition: recorded at fair value or present value (face amount adjusted for discount or premium) During the year: use effective interest method to amortize discount or premium, adjust investment by the amount amortized. Unrealized holding gain or loss is never recognized

Available-for-Sale Debt Securities At acquisition: recorded at present value Available-for-sale securities xxx Cash xxx Interest received: amortize discount/premium Cash xxx Available-for-Sale Securities xxx Interest Revenue xxx At year-end: adjusted to fair value Unrealized Holding Gain or Loss-Equity xxx Securities Fair Value Adjustment xxx Unrealizable holding gain or loss is other comprehensive income/stockholder’s equity

Trading Debt Securities At acquisition: recorded at fair value or present value During the year: discount or premium is not amortized due to the short-term nature At year-end, unrealized holding gain and loss is included in income Unrealized Holding Gain or Loss-Income xxx Securities Value Adjustment-Trading xxx

Investment in Equity Securities: Holding of Less Than 20% At acquisition: recorded at cost acquired, classify as trading or available-for-sale Dividend received: Cash xxx Dividend Revenue xxx At year-end: adjust to fair value Unrealized Holding Gain or Loss* xxx Securities Value Adjustment xxx * Income or Equity depends on type of securities

Equity Method: Holding Between 20% to 50% At acquisition: Investment in XYZ Stock xxx Cash xxx Recording proportionate share of investee’s income, losses, or extraordinary items Investment in XYZ Stock xxx Revenues from Investment xxx Dividend received: Cash xxx Investment in XYZ Stock xxx

Equity Method: More Details When the purchase price of the stock exceeds the investor’s proportionate share of investee’s book value of net assets, a purchase premium was paid for goodwill or unrecorded assets, annual amortization of this purchase premium is required: Revenues from Investment xxx Investment in XYZ stock xxx

Reclassification Adjustment for Gains Included in Income When available-for-sale securities are sold, Gains and losses are realized based on the difference between sales proceeds and its original acquisition cost. To avoid double counting, an equal amount of the unrealized holding gain or loss accumulated in the comprehensive income/stockholder’s equity is eliminated

Transfer Between Categories Transfer between any two categories are accounted for at fair value. From trading (cost $70,000, FV= $85,000) to available-for-sale or held to maturity: unrealized gain or loss recognized at transfer and included in income. Available-for-Sale Securities 85,000 Unrealized Holding Gain-Income 15,000 Trading Securities 70,000

Transfer Between Categories From available-for-sale (cost=$80,000, FV=$75,000) or held-to-maturity to trading: unrealized gain or loss recognized at transfer & included in income Trading Securities 75,000 Unrealized Holding Loss-Income 5,000 Available-for-sale Securities 80,000

Transfer Between Categories From held-to-maturity (cost=$80,000, FV=$90,000) to available-for-sale: unrealized holding gain or loss recognized at transfer and included in other comprehensive income/stockholder equity. Securities Fair Value Adjustment 10,000 Available-for-sale Securities 80,000 Unrealized Holding Gain 10,000 Held-to-maturity Securities 80,000

Transfer Between Categories From available-for-sale (cost=$100,000; FV=$104,000) to held-to-maturity (remaining life 10 years): unrealized holding gain or loss recognized at transfer and included in other comprehensive income. Securities Fair Value Adjustment 4,000 Held-to-maturity Securities 100,000 Unrealized Holding Gain-Equity 4,000 Available-for-sale Securities 100,000 Annual Amortization: Unrealized Holding Gain-Equity 400 Securities Fair Value Adjustment 400

Investment in Stock Rights At acquisition: base allocation required Investment in Stock Rights xxx Investment in Stock xxx If the rights are sold separately: Cash xxx Investment in Stock Rights xxx Gain from sale of Stock Rights xxx If the rights are exercised: Investment in Stock xxx Investment in Stock rights xxx Cash xxx

Investment in Stock Rights If stock rights are expired: Loss on Expiration of Stock Rights xxx Investment in Stock Rights xxx

Investment in Life Insurance with Cash Surrender Value Payment of periodic insurance premium Insurance Expenses xxx Cash Surrender Value xxx Cash xxx Upon receipt of death benefit at death: Cash xxx Cash Surrender Value xxx Insurance expenses xxx (unexpired) Gain on Life Insurance xxx

Accounting for Derivatives Example of derivatives –Financial forwards of futures –Options –Swaps Who uses derivatives? –Producers and consumers –Speculators and arbitrageours

Why Use Derivatives? For speculation and arbitrage profit: taking advantage of price difference in different markets Hedging against risk in: –Changes in prices of commodity –Changes in interest rate –Changes in foreign exchange rate

Basic Principles Derivatives should be recognized in the financial statements as assets and liabilities Derivatives should be reported at fair value. Gains and losses from speculation should be recognized immediately in income Gains and losses from hedging are reported differently depending on the type of hedge

Accounting for a Call Option- Speculation On 1/2/00 when X shares are $100/share, You paid $400 to purchase a call option which allows you to buy1,000 X shares at $100/share on 4/30/00. Option premium = intrinsic value + time value $400 = $0 + $400 1/2/00 Journal entry: Call Option 400 Cash 400

Call Option Example--continued 3/31/00 X shares are traded at $120/share Call Option 20,000 Unrealized Holding Gain/Loss-Income 20,000 3/31/00 Time value of the option is $100 Unrealized Holding Gain/Loss-Income 300 Call option ($400 - $100) 300 4/1/00 the call option is settled for $20,000 Cash 20,000 Loss on Settlement of Call Option 100 Call Option 20,100

Fair Value Hedge: Interest Rate Swap Example 1/2/00 you issued $1,000,000 of 5-year, 8% fixed rate bonds. You are concerned that interest rate might goes down and you are still locked into the 8% rate. So on the same date, you enter into a swap contract: –You will receive fixed payment at 8% based on the $1,000,000 on 12/31 of next 5 years –You will pay variable amount based on the effective variable rate on 12/31 of next 5 years

Journal Entries-Interest Rate Swap On 1/2/01 when the contract is signed No entry required On 12/31/01 the variable rate is 6.8% Interest Expense 80,000 Cash (8% x $1000,000) 80,000 To record paying cash interest to bondholders Cash 12,000 (80, ,000) Interest Expense 12,000 To record settlement of swap contract

Interest Rate Swap Example- continued In addition, the value of the swap contract has increased by $40,000 on 12/31/01 Swap Contract 40,000 Unrealized Holding Gain/Loss-Income $40,000 Because interest rate is going down, the fair value of bond payable increases by $40,000 Unrealized Holding Gain/Loss-Income 40,000 Bonds Payable 40,000

Presentation on Financial Statement Balance sheet on 12/31/02 Current Assets Current Assets: Long-term Liabilities: Swap Contract $40,000 B/P $1,040,000 Income Statement for the year of 2001 Interest Expense $68,000 Unrealized Holding Gain-Swap Contract $40,000 Unrealized Holding Loss-B/P ($40,000) Net Gain or loss $0

Cash Flow Hedging from Forecasted Transactions On 9/1/00, you expect to buy 1000 tons of materials in 1/1/01. To protect possible price increase, you enter a future contract to give you the right and obligation to purchase the material at $1,550/ton, the market price of the materials on that day On 9/1/00 when the contract is signed: No entry required (the value of the contract is $0)

Cash Flow Hedge Example-- continued On 12/31/00, price increase to $1,575/ton Future Contract (1,575-1,550)x1,000 25,000 Unrealized Holding Gain/Loss-Equity 25,000 On 1/1/01 purchased materials at $1,575/ton Material Inventory 1,575,000 Cash ($1,575x1,000) 1,575,000 To record cash purchase of the materials Cash 25,000 Future Contract 25,000 To record settlement of the future contract

Cash Flow Hedge Example -- continued On 7/1/01, when the finished goods made of the materials were sold for $2,000,000 with total cost of goods sold at $1,700,000. Cash 2,000,000 Sales Revenue 2,000,000 Cost of Goods Sold 1,700,000 Finished Good Inventory 1,700,000 Unrealized Holding Gain/Loss-Equity 25,000 Cost of Goods Sold 25,000

Qualifying Hedge Criteria The special accounting for Hedging can only be applied when: –Designation and documentation of risk management formally done –Effectiveness of the hedging relationship is clear evident –There must be an effect on reported earnings of changes in fair value or cash flows

Disclosure Requirements The fair value and carrying value of financial instrument The objective of holding the instrument(speculation or hedging), the strategy for achieving risk management Separate disclosure (no aggregation) Market risk of derivatives