Chapter 12 Investments In this chapter you will learn about various approaches used to account for investments that companies make in the debt and equity.

Chapter 12 Investments In this chapter you will learn about various approaches used to account for investments that companies make in the debt and equity of other companies. In appendices to this chapter, you will learn about other types of investments, and also about how to deal with other-than-temporarily impairments.

Investments Financial instruments:
Purchased by individual investors, mutual funds, and corporations Objective: To earn a return from the dividends or interest the securities pay or from increases in the market prices of the securities To develop ongoing affiliations with the companies whose securities are acquired Equity securities Debt securities Common stock Preferred stock Bonds Notes To finance its operations, and often the expansion of those operations, a corporation raises funds by selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities, also called financial instruments, are purchased as investments by individual investors, mutual funds, and also by other corporations. Our focus in this chapter is on the corporations that invest in debt and equity securities issued by other corporations as well as debt securities issued by governmental units (bonds, Treasury bills, and Treasury bonds). Most companies invest in financial instruments issued by other companies. Some investments are made simply to earn a return from the dividends or interest the securities pay or from increases in the market prices of the securities—the same reasons that might motivate you to buy stocks, bonds, or other investment securities. Other investments represent ongoing affiliations with the companies whose securities are acquired. With such diversity in investment objectives, it’s not surprising that there is diversity in the approaches used to account for investments.

Illustration: Reporting Categories for Investments
Investments are accounted for in five primary ways, depending on the nature of the investment relationship and the preferences of the investor. As shown in the illustration, when the investor lacks significant influence over the investee, the investment is classified in one of three categories: held-to-maturity securities (HTM), trading securities (TS), and available-for-sale securities (AFS). Each type of investment has its own reporting method. Illustration 12-1

Investor Lacks Significant Influence
LO12-1 Purchasing the investment Recognizing investment revenue For debt: Interest For equity: Dividends Critical Events that an Investor Experiences in the Life of an Investment Holding the investment during periods in which the investment’s fair value changes Unrealized holding gains and losses The reporting approaches we use for investments differ according to how the approaches account for one or more of the four critical events that an investor experiences in the life of an investment: 1. Purchasing the investment. 2. Recognizing investment revenue (interest in the case of debt, dividends in the case of equity). 3. Holding the investment during periods in which the investment’s fair value changes (and thus incurring unrealized holding gains and losses, since the security has not yet been sold). 4. Selling the investment (and thus incurring realized gains and losses, since the security has been sold and the gains or losses actually incurred). Selling the investment

Illustration: Accounting for Unrealized Holding Gains and Losses When the Investor Lacks Significant Influence LO12-1 As we discussed earlier, when the investor lacks significant influence over the investee, the investment is classified in one of three categories: Held-to-maturity securities (HTM) Trading securities (TS) Available-for-sale securities (AFS) Each type of investment has its own reporting method. The key difference among the reporting approaches is how we account for unrealized holding gains and losses (critical event number 3 above), as shown in the above illustration. However, regardless of the investment type, investors can elect the “fair value option” that we discuss later in the chapter and classify HTM and AFS securities as TS. Illustration 12-2 Key difference among the reporting approaches is how we account for unrealized holding gains and losses

Illustration: Disclosure about Investments—Bank of America
Here’s part of a note from Bank of America’s 2013 annual report describing how it accounts for its debt investments in each of the three reporting categories. Securities that will be held to maturity are classified as held to maturity. Securities that are part of Bank of America’s trading activities are treated as trading securities. The other securities are treated as available for sale investments. Why treat unrealized gains and losses differently depending on the type of investment? As you know, the primary purpose of accounting is to provide information useful for making decisions. What’s most relevant for that purpose is not necessarily the same for each investment a company might make. For example, a company might invest in corporate bonds to provide a steady return until the bonds mature, in which case day-to-day changes in market value may not be viewed as very relevant, so the held-to-maturity approach could be preferable. On the other hand, a company might invest in the same bonds because it plans to sell them at a profit in the near future, in which case the day-to-day changes in market value could be viewed as very relevant, and the trading security or available-for-sale approach may be preferable. Illustration 12-3

Securities to Be Held to Maturity (HTM)
LO12-1 Investor has the “positive intent and ability” to hold the securities to maturity Securities mature Maturity date Also called the face amount Principal Unlike a share of stock, a bond or other debt security has a specified date on which it matures. On its maturity date, the principal (also called the “face amount”) is paid to investors. In the meantime, interest equal to a specified percentage of the principal is paid to investors on specified interest dates. Think of the principal and interest payments of the bond as a stream of cash flows that an investor will receive in exchange for purchasing the bond. Increases and decreases in fair value between the day a debt security is acquired and the day it matures to a prearranged maturity value are less important if sale before maturity isn’t an alternative. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities can be classified as held-to-maturity (HTM) and reported at their amortized cost in the balance sheet. A debt security cannot be classified as held-to-maturity if the investor might sell it before maturity in response to changes in market prices or interest rates, to meet the investor’s liquidity needs, or similar factors. Paid to investors Interest paid to investors Interest dates

HTM Investments: Premiums and Discounts
LO12-1 Fair value of a bond changes when market interest rates change Market value of a fixed-rate investment moves in the opposite direction of market rates of interest Interest rate (stated rate) Market rate sold at Premium > The investor values the stream of cash flows that is promised in a debt security using the prevailing market interest rate for debt of similar risk and maturity. If the interest rate paid by the bond (the “stated rate”) is higher than the market rate, the bond can be sold for more than its maturity value (so it is “sold at a premium”). If the stated rate is lower than the market rate, the bond must be sold for less than its maturity value (so it is “sold at a discount”). The fair value of a bond changes when market interest rates change because investors use the current market interest rate to calculate the present value of the bond’s future cash flows. If market rates of interest rise after a fixed-rate security is purchased, the present value of the fixed-interest payments declines. So, the fair value of the investment falls. Conversely, if market rates of interest fall after a fixed-rate security is purchased, the present value of the fixed interest payments increases, so the fair value of the investment rises. In other words, the market value of a fixed-rate investment moves in the opposite direction of market rates of interest. As we will see, the investor has to account for any premium or discount that exists at the time a debt investment is purchased. However, if the debt investment is classified as HTM, the investor won’t usually account for subsequent changes in fair value. Interest rate (stated rate) Market rate sold at Discount >

Illustration: Bonds Purchased at a Discount (HTM)
LO12-1 On July 1, 2016, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, The market interest rate for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Calculation of the Price of the Bonds Interest $ 42,000 × = $200,195 Principal (face amount) $700,000 × = 466,438 Present value (price) of the bonds $666,633 Present value of $1 table: n = 6, i = 7% Present value of an ordinary annuity of $1 table: n = 6, i = 7% Let’s work through an example of accounting for a bond investment as held to maturity. First we’ll calculate the present value of interest. It’s calculated by multiplying semiannual interest of $42,000 with present value of an ordinary annuity of $1, where n = 6, i = 7%, of This gives us the present value of interest of $200,195. The present value of principal is calculated by multiplying principal of $700,000 with present value of $1, where n = 6, i = 7%, of This gives us the present value of principal of $466,438. By totaling the present values of interest and principal, we determine the present value of the bonds, that is the price of the bonds, to be $666,633. Next, we see how the purchase of the HTM investment is recorded. All investment securities are initially recorded at cost. Discount on bond investment is a contra asset to the investment in bonds asset account that serves to reduce the carrying value of the bond asset to its cost at the date of purchase. Illustration 12-4 Journal Entry – July 1, 2016 Debit Credit Investment in Bonds 700,000 Discount on bond investment 33,367 Cash 666,633

Concept Check √ Chan Inc. purchased bonds for $800,000 that have a maturity value of $900,000. Chan’s journal entry to record the purchase would include a: a. Debit of $100,000 to Discount on bond investment. b. Credit of $100,000 to Discount on bond investment. c. Debit of $100,000 to Premium on bond investment. d. Credit of $100,000 to Premium on bond investment. Bond investment 900,000 Cash ,000 Discount on bond investment 100,000

Bonds Purchased at a Discount (HTM) (Illustration continued)
LO12-1 On July 1, 2016, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, The market interest rate for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Calculation of the Price of the Bonds Interest $ 42,000 × = $200,195 Principal (face amount) $700,000 × = 466,438 Present value (price) of the bonds $666,633 $666,633 × [14% ÷ 2] $46,664 The Masterwear bonds pay cash interest at a rate of 12%, but were issued at a time when the market rate of interest was 14%. As a result, the bonds were sold at a discount that was large enough to provide bond purchasers with the same effective rate of return on their investment (14%) that they could get elsewhere in the market. Think of it this way: the purchaser of the Masterwear bonds pays less up front, and a little piece of that initial discount serves each period to make up the difference between the relatively low rate of interest that the bond pays (12%) and the higher rate of interest that the market demands (14%). Recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the investment is referred to as the effective interest method. This simply is an application of the accrual concept, consistent with accruing all revenues as they are earned, regardless of when cash is received. Continuing our example, the initial investment is $666,633. Since the effective interest rate is 14%, interest recorded as revenue to the investor for the first six-month interest period is $46,664: $666,633 Outstanding balance × [14% ÷ 2] Effective rate = $46,664 Effective interest. The bond pays for semiannual interest payments of only $42,000—the stated rate (12% ÷ 2 = 6%) times the face amount ($700,000). As always, when only a portion of revenue is received, the remainder becomes an asset (a receivable). In this case we increase the investment by $4,664 by reducing the contra-asset discount to $28,703 ($33,367 − 4,664). Here’s the journal entry to record the interest received for the first six months as investment revenue. = Outstanding balance Effective rate Effective interest Journal Entry – December 31, 2016 Debit Credit Cash 42,000 Discount on bond investment 4,664 Investment revenue 46,664

Concept Check √ Chan Inc. purchased bonds for $800,000 that have a maturity value of $900,000. Which of the following is true about the first semi-annual interest payment that Chan receives: a. Chan will record interest revenue that is greater than cash received. b. Chan will record interest revenue that is equal to cash received. c. Chan will record interest revenue that is less than cash received. d. Chan will not record interest revenue. Chan will record interest revenue that is greater than cash received. It paid less for the bond than its maturity value, so it must have done so to achieve an effective interest rate that is greater than the stated rate on the bond. The journal entry will have the form: Cash xx Discount on bond investment yy Interest revenue zz with zz > xx.

Illustration: Amortization Schedule—Discount
LO12-1 On July 1, 2016, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, The market interest rate for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. $700,000 × 6% $46,664 - $42,000 $666,633 + $4,664 Cash Interest Effective Interest Increase in Balance Outstanding Balance Date 7/1/2016 $666,633 12/31/2016 $ 42,000 .07 (666,633) = $ 46,664 $ 4,664 671,297 6/30/2017 42,000 .07 (671,297) = ,991 4,991 676,288 Here’s the amortization table that would be used for the Masterwear bond. It shows interest being recorded at the effective rate over the life of this investment. As you can see, the amortization of discount gradually increases the carrying value of the investment, until the investment reaches its face amount of $700,000 at the time when the debt matures. Illustration 12-5 12/31/2017 42,000 .07 (676,288) = ,340 5,340 681,628 6/30/2018 42,000 .07 (681,628) = ,714 5,714 687,342 12/31/2018 42,000 .07 (687,342) = ,114 6,114 693,456 6/30/2019 42,000 .07 (693,456) = ,544 6,544 700,000 $252,000 $285,367 $33,367

For HTM Investments, Do Not Recognize Unrealized Holding Gains and Losses
If viewed as an HTM investment: The change in fair value will be ignored so long as it is viewed as temporary The investment simply will be recorded at amortized cost United will disclose the fair value of its HTM investments in a note to the financial statements It will not recognize any fair value changes in the income statement or balance sheet Example: The Wall Street Journal indicates that the fair value of the Masterwear bonds on 12/31/2016 is $714,943. How will United account for this increase in fair value? Suppose that, as of the end of the first reporting period, the market interest rate for similar securities has fallen to 11%. A market participant valuing the Masterwear bonds at that time would do so at the current market interest rate (11%) because that’s the rate of return she could get from similar bonds. Calculating the present value of the bonds using a lower discount rate results in a higher present value. Let’s say that market prices in The Wall Street Journal indicate that the fair value of the Masterwear bonds on that date is $714,943. How will United account for this increase in fair value? If United views the bonds as HTM investments, that change in fair value will be ignored so long as it is viewed as temporary. The investment simply will be recorded at amortized cost. United will disclose the fair value of its HTM investments in a note to the financial statements, but will not recognize any fair value changes in the income statement or balance sheet. Later we’ll discuss impairment accounting, which handles declines in fair value that aren’t viewed as temporary.

Sell HTM Investments (Illustration continued)
LO12-1 On July 1, 2016, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, The market interest rate for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Due to unforeseen circumstances the company decided to sell its debt investment for $725,000 on January 15, 2017 Journal Entry – January 15, 2017 Debit Credit Cash 725,000 Discount on bond investment 28,703 Typically, held-to-maturity investments are held to maturity. However, suppose that due to unforeseen circumstances the company decided to sell its debt investment for $725,000 on January 15, 2017. United would record this sale just like any other asset sale, with a gain or loss determined by comparing the cash received with the carrying value (in this case, the amortized cost) of the asset given up. Investment in Masterwear bonds 700,000 Gain on sale of investments 53,703 ($33,367 − $4,664)

Concept Check √ Williams has a HTM investment in bonds with a maturity value of $900,000 and a carrying value of $825,000. Due to unexpected cash flow needs, Williams sold the bonds for $800,000. Williams’ journal entry to record the sale would include a: a. Credit to cash for $800,000. b. Credit to discount on bond investment for $75,000. Credit to gain for $25,000. Debit to loss for $25,000. Williams will record the following entry: Cash ,000 Loss (to balance) ,000 Discount on bond investment ,000 Bond investment 900,000

Trading Securities (TS)
LO12-2 Investments in debt or equity securities acquired principally for the purpose of selling them in the near term Active buying and selling of securities Holding period generally is measured in hours and days rather than months or years Typically reported among the investor’s current assets Fair value information is more relevant, so Carried at fair value on the balance sheet, and Unrealized holding gains and losses are included in net income in the period in which fair value changes Obviously, not all investments are intended to be held to maturity. When an investment is acquired to be held for an unspecified period of time, we classify the investment as either (a) “trading securities” or (b) “securities available-for-sale.” These include investments in debt securities that are not classified as held-to-maturity and equity securities that have readily determinable fair values. You’ll notice that, unlike held-to-maturity securities, we report investments in the other two categories at their fair values. Some companies—primarily financial institutions—actively and frequently buy and sell securities, expecting to earn profits on short-term differences in price. Investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as trading securities. The holding period for trading securities generally is measured in hours and days rather than months or years. These investments typically are reported among the investor’s current assets. Relatively few investments are classified this way, because usually only banks and other financial operations invest in securities in the manner and for the purpose necessary to be categorized as trading securities. Just like other investments, trading securities initially are recorded at cost—that is, the total amount paid for the securities, including any brokerage fees. However, when a balance sheet is prepared in subsequent periods, this type of investment is written up or down to its fair value, or “marked to market.” For these investments, fair value information is more relevant than for other assets intended primarily to be used in company operations, like buildings, land and equipment, or for investments to be held to maturity. For instance, consider an investment in debt. As interest rates rise or fall, the fair value of the investment will decrease or increase. Movements in fair values are less relevant if the investment is to be held to maturity; the investor receives the same contracted interest payments and principal at maturity, regardless of changes in fair value. However, if the debt investment is held for active trading, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities. For that reason, it makes sense to report unrealized holding gains and losses on trading securities in net income during a period that fair values change, even though those gains and losses haven’t yet been realized through the sale of the securities.

Illustration: Purchase Investments (TS)
LO12-2 Illustration: Purchase Investments (TS) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Purchase Investments Purchased Masterwear Industries’ 12%, 3-year bonds for $666,633 to yield an effective interest rate of 14%. July 1, 2016 Purchased $1,500,000 of Arjent, Inc., common stock. Purchased $1,000,000 of Bendac common stock. Journal Entry – July 1, 2016 Debit Credit Investment in Masterwear bonds 700,000 Let’s work through an illustration to consider accounting for trading securities. The journal entry to record the purchase of the bond investment is the same as it is for HTM securities. The journal entries to record the equity investments are even simpler, just exchanging one asset (cash) for another (investment). Illustration 12-6 Discount on bond investment 33,367 Cash 666,633 Investment in Arjent stock 1,500,000 Cash 1,500,000 Investment in Bendac stock 1,000,000 Cash 1,000,000

Recognize Investment Revenue (TS) (Illustration continued)
LO12-2 Recognize Investment Revenue (TS) (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Receive Investment Revenue Received a semi-annual cash interest payment of $42,000 from Masterwear. Received a cash dividend of $75,000 from Arjent. (Bendac does not pay dividends) December 31, 2016 $666,633 × (14% ÷ 2) Journal Entry – December 31, 2016 Debit Credit The journal entry to record the receipt of bond interest is the same as it is for HTM securities, with the carrying value of the investment increasing due to amortization of $4,664 of discount. The journal entry to record the receipt of dividends related to the Arjent equity investment is straightforward. There is no entry for the Bendac equity investment, because Bendac doesn’t pay dividends. Illustration 12-6 Cash (6% × $700,000) 42,000 Discount on bond investment (difference) 4,664 Investment revenue 46,664 Cash 75,000 Investment revenue 75,000

Adjust TS Investments to Fair Value (2016) (Illustration continued)
LO12-2 Adjust TS Investments to Fair Value (2016) (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Investments to Fair Value Valued the Masterwear bonds at $714,943. Valued the Arjent stock at $1,450,000. December 31, 2016 Valued the Bendac stock at $990,000. December 31, 2016 Amortized Cost Fair Value Adjustment Security Fair Value Masterwear $ 671,297 $ 714,943 $ 43,646 Unlike HTM securities, trading securities are carried at fair value in the balance sheet, so their carrying value must be adjusted to fair value at the end of every reporting period. Rather than increasing or decreasing the investment account itself, we use a valuation allowance, called the “fair value adjustment” account, to increase or decrease the carrying value of the investment. At the same time, we record an unrealized holding gain or loss that is included in net income in the period in which fair value changes (the gain or loss is unrealized because the securities haven’t actually been sold). The table summarizes the relevant facts for United’s investments. United has an unrealized loss of $16,354. Illustration 12-6 Arjent 1,500,000 1,450,000 (50,000) Bendac 1,000,000 990,000 (10,000) Total $3,171,297 $3,154,943 $(16,354) Existing balance in fair value adjustment: –0– Increase (decrease) needed in fair value adjustment: $(16,354)

LO12-2 Adjust TS Investments to Fair Value (2016) (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Investments to Fair Value Valued the Masterwear bonds at $714,943. Valued the Arjent stock at $1,450,000. December 31, 2016 Valued the Bendac stock at $990,000. Face amount of the bond $700,000 Less: Discount on bond investment $33,367 initial discount Note that, to determine the amount of unrealized holding gain or loss on the Masterwear bonds, United first identifies the bonds’ amortized cost and then determines the amount necessary to adjust them to fair value. The amortized cost is the same amount as United would record if the bonds were treated as held to maturity. Recording a fair value adjustment to amortized cost is what differs between treating the investment as held to maturity and treating it as a trading security. Illustration 12-6 (4,664) accumulated amortization $28,703 discount at 12/31/2016 (28,703) Amortized cost of the bonds 671,297 +/- Fair value adjustment (plug) + 43,646 Fair value of the bond at 12/31/2016 $714,943

LO12-2 Adjust TS Investments to Fair Value (2016) (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Investments to Fair Value Valued the Masterwear bonds at $714,943. Valued the Arjent stock at $1,450,000. December 31, 2016 Valued the Bendac stock at $990,000. Fair Value Adjustment 16,354 There is no discount to amortize for the equity investments, so for the Arjent and Bendac investments, their amortized cost is simply their initial cost. The journal entry to record the total unrealized loss in United’s fair value adjustment is shown above. This entry combines the individual unrealized gains and losses for United’s investments in Masterwear bonds, Arjent stock and Bendac stock. United makes the entry by determining the total fair value adjustment it needs to reflect the difference between the amortized cost of these investments and their fair value. In this case, that is the $16,354 shown in black bold. Then United makes whatever entry is necessary to reach that ending balance. Since United had a zero opening balance in the fair value adjustment, the necessary entry is a credit of $16,354, shown in bold pink. Note that the debit is to “net unrealized holding gains and losses – I/S”. The “I/S” helps us remember that this entry, which is a loss in this case, gets reflected on United’s income statement. We’ll return to this topic when we discuss accounting for available-for-sale investments. Illustration 12-6 16,354 Journal Entry – December 31, 2016 Debit Credit Net unrealized holding gains and losses—I/S 16,354 Fair value adjustment 16,354

Sell TS Investments (Illustration continued)
LO12-2 Sell TS Investments (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Sell Investments Sold the Masterwear bonds for $725,000. January 15, 2017 Sold the Arjent stock for $1,446,000. Journal Entry – January 15, 2017 Debit Credit Cash 725,000 Discount on bond investment 28,703 Investment in Masterwear bonds 700,000 Now let’s assume that United sells the Masterwear bonds and the Arjent stock. To record the gain or loss realized on the sale, United records the receipt of cash ($725,000 for Masterwear and $1,446,000 for Arjent), removes all balance sheet accounts that are directly associated with the investments, and calculates the difference to determine realized gain or loss. For the Masterwear bonds, this journal entry is identical to what United used when recording the sale of held-to-maturity investments. For the Arjent stock, the journal entry is very simple, recording a gain or loss to capture the difference between what United paid for the investment and the amount of cash it received upon sale. However, United isn’t done yet. Now that those investments are sold, United needs to remove the fair value adjustment from the balance sheet. Also, because United has recognized in this period’s net income the entire gain or loss realized on sale of the investments, it must back out of this period’s net income any unrealized gains and losses that were included in net income in prior periods. That way, this period’s net income includes only the fair value changes arising since the last period, and United avoids double counting gains and losses (once when unrealized, and again when realized). United can accomplish all of this when it adjusts its investment portfolio to fair value at the end of the reporting period. Illustration 12-6 Gain on sale of investments 53,703 Cash 1,446,000 Loss on sale of investments 54,000 Investment in Arjent stock 1,500,000 ($33,367 - $4,664)

LO12-2 Adjust TS Investments to Fair Value (2017) (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Remaining Investments to Fair Value Valued the Bendac stock at $985,000. December 31, 2017 December 31, 2017 Amortized Cost Fair Value Adjustment Security Fair Value Masterwear (sold) –0– –0– Now that United has sold the Masterwear and Arjent investments, they shouldn’t be included in the fair value adjustment. Therefore, the fair value adjustment should only have $15,000 of unrealized loss in it to capture the fact that the Bendac investment has an amortized cost of $1,000,000 but a fair value of only $985,000. To get that account from its opening credit balance of $16,354 to the necessary closing credit balance of $15,000, United needs to debit it for $1,354. Illustration 12-6 Arjent (sold) –0– –0– Bendac $1,000,000 $985,000 ($15,000) Total $1,000,000 $985,000 ($15,000) Existing balance in fair value adjustment: ($16,354) Increase (decrease) needed in fair value adjustment: $ 1,354

LO12-2 Adjust TS Investments to Fair Value (2017) (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Remaining Investments to Fair Value Valued the Bendac stock at $985,000. December 31, 2017 Fair Value Adjustment 16,354 1,354 The journal entry necessary to show the appropriate balance in the fair value adjustment at the end of 2017 is shown above. This journal entry really serves two purposes: it (a) accounts for changes in the fair value of investments that have not been sold (in this case, Bendac), and (b) removes from the fair value adjustment and net income any unrealized holding gains or losses that were recognized in prior periods and that are associated with investments that were sold during the period (in this case, Masterwear and Arjent). We’ll analyze those two purposes in more detail when we cover accounting for available-for-sale investments. Illustration 12-6 15,000 Journal Entry – December 31, 2017 Debit Credit Fair value adjustment 1,354 Net unrealized holding gains and losses—I/S 1,354

Concept Check √ The Bali Company has trading securities that cost $200,000. At the beginning of 2016 those securities had a fair value of $220,000, and at the end of 2016 they had a fair value of $190,000. Bali’s journal entry to record unrealized gains and losses for 2016 would include a: a. Debit to Fair value adjustment for $30,000. b. Credit to Fair value adjustment for $30,000. Credit to Fair value adjustment for $10,000. Debit to Fair value adjustment for $10,000. Bali’s fair value adjustment needs to change from a debit of $20,000 to a credit of $10,000. Therefore, it will record the following entry: Net unrealized holding gains and losses—I/S $30,000 Fair value adjustment 30,000

Financial Statement Presentation: TS
LO12-2 Income Statement and Statement of Comprehensive Income: Fair value changes affect net income in the period in which they occur Do not affect other comprehensive income (OCI) Balance Sheet: Reported at fair value Do not affect accumulated other comprehensive income (AOCI) Cash Flow Statement: Cash flows from buying and selling trading securities are classified as operating activities We present trading securities in the financial statements as follows: • Income Statement and Statement of Comprehensive Income: For trading securities, fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income. • Balance Sheet: Investments in trading securities are reported at fair value, typically as current assets, and do not affect accumulated other comprehensive income in shareholders’ equity. • Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the financial institutions that routinely hold trading securities consider them as part of their normal operations. However, it may be appropriate to classify cash flows from buying and selling some trading securities as investing activities if they are not held for sale in the near term (which is particularly likely when an investment is classified as a trading security as a result of electing the fair value option).

Illustration: Reporting Trading Securities
LO12-2 For example, United’s 2016 and 2017 financial statements will include the amounts shown in the above illustration. $121,664 is the sum of $46,664 interest revenue from Masterwear and $75,000 dividends from Arjent. $16,354 is the net unrealized loss from the 2016 fair value adjustment. $1,057 is the $1,354 net unrealized gain from the 2017 fair value adjustment minus the $297 loss realized on sale of investments during 2017 (the $297 net realized loss results from the $54,000 loss realized on sale of the Arjent stock and the $53,703 gain realized on sale of the Masterwear bonds). Illustration 12-7

Securities Available-for-Sale (AFS)
LO12-3 Investment that is acquired by a company neither for an active trading account nor to be held to maturity (so AFS defined as not HTM or TS) Reported in the balance sheet at fair value Unrealized holding gains and losses on AFS securities: are not included in net income are included in other comprehensive income (OCI) Realized gains and losses are included in net income (so have to be backed out of OCI in the period the investment is sold) Now let’s talk about the third category of accounting for investments: Securities Available for Sale. When a company acquires an investment, but not for an active trading account (as a financial institution might) or to be held to maturity (which of course couldn’t be stock because it has no maturity date), the company classifies its investment as securities available-for-sale (AFS). Like trading securities, we report investments in AFS securities in the balance sheet at fair value. Unlike trading securities, though, unrealized holding gains and losses on AFS securities are not included in net income. Instead, they are reported in the statement of comprehensive income as other comprehensive income (OCI).

Rationale for AFS Treatment of Unrealized Holding Gains and Losses
Why use an approach for accounting for AFS securities that differs from that used for trading securities? Many companies purchase AFS investments: as long term investments, so fluctuations in their fair value aren’t that informative about current operations. to hedge liabilities, so changes in fair value of investments offset changes in the fair value of liabilities. Hedging insulates the company from risk, but can make earnings appear volatile if changes in the fair value of the investment are included in earnings but changes in the fair value of the liability are not. Including unrealized holding gains and losses on AFS investments in net income might make income appear more volatile than actually is the case. Why use an approach for accounting for AFS securities that differs from that used for trading securities? The big concern is that including in net income unrealized holding gains and losses on AFS investments might make income appear more volatile than it really is. For example, if companies are purchasing investments as long-term investments, short-term fluctuations in value aren’t that informative about current operations. Also, many companies purchase AFS investments for the purpose of having the changes in fair value of those investments offset changes in the fair value of liabilities. This hedging insulates the company from risk and ensures that earnings are stable. However, if fair value changes for investments were to be recognized in income (as is the case with trading securities), but the offsetting fair value changes for liabilities were not recognized in income as well, we could end up with income appearing very volatile when in fact the underlying assets and liabilities are hedged effectively.

Illustration: Purchase Available-for-Sale Investments
LO12-3 Illustration: Purchase Available-for-Sale Investments United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Purchase Investments Purchase Masterwear Industries’ 12%, 3-year bonds for $666,633 to yield an effective interest rate of 14%. July 1, 2016 Purchased $1,500,000 of Arjent, Inc., common stock. Purchased $1,000,000 of Bendac common stock. Journal Entry – July 1, 2016 Debit Credit Investment in Masterwear bonds 700,000 In this example, we’ll assume that United classifies its investments as AFS rather than trading securities. The journal entries to record the purchase of the investments are the same for AFS securities as they are for trading securities. Discount on bond investment 33,367 Cash 666,633 Investment in Arjent stock 1,500,000 Cash 1,500,000 Investment in Bendac stock 1,000,000 Cash 1,000,000

Recognize Investment Revenue
LO12-3 Recognize Investment Revenue United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Receive Investment Revenue Received a semi-annual cash interest payment of $42,000 from Masterwear. Received a cash dividend of $75,000 from Arjent. (Bendac does not pay dividends) December 31, 2016 Journal Entry – December 31, 2016 Debit Credit The journal entries to record the receipt of investment revenue also are the same for AFS securities as they are for trading securities. Cash 42,000 Discount on bond investment 4,664 Investment revenue 46,664 Cash 75,000 Investment revenue 75,000

Adjust AFS Investments to Fair Value (2016)
LO12-3 Adjust AFS Investments to Fair Value (2016) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Investments to Fair Value Valued the Masterwear bonds at 714,943. Valued the Arjent stock at $1,450,000. December 31, 2016 Valued the Bendac stock at $990,000. December 31, 2016 Amortized Cost Fair Value Adjustment Security Fair Value Masterwear $ 671,297 $ 714,943 $ 43,646 Like trading securities, AFS securities are adjusted to fair value at the end of each reporting period, which produces an unrealized holding gain or loss due to holding the securities while their fair values change. Arjent 1,500,000 1,450,000 (50,000) Bendac 1,000,000 990,000 (10,000) Total $3,171,297 $3,154,943 $(16,354) Existing balance in fair value adjustment: –0– Increase (decrease) needed in fair value adjustment: $(16,354)

Adjust AFS Investments to Fair Value (2016) (Continued)
LO12-3 Adjust AFS Investments to Fair Value (2016) (Continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Investments to Fair Value Valued the Masterwear bonds at $714,943. Valued the Arjent stock at $1,450,000. December 31, 2016 Valued the Bendac stock at $990,000. Fair Value Adjustment 16,354 The journal entry to record United’s unrealized holding loss is shown above. Notice that the amount of unrealized holding loss is the same as with trading securities. What differs is that the net unrealized holding loss of $16,354 is included in net income for trading securities and in OCI for AFS securities. At the end of the reporting period the net unrealized holding loss ends up being closed to a shareholders’ equity account for both approaches. What differs is that it gets closed to retained earnings for trading securities and to AOCI for AFS securities. 16,354 Journal Entry – December 31, 2016 Debit Credit Net unrealized holding gains and losses—OCI 16,354 Fair value adjustment 16,354

Journal Entry – January 15, 2017
LO12-3 Sell AFS Investments United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Sell Investments Sold the Masterwear bonds for $725,000. January 15, 2017 Sold the Arjent stock for $1,446,000. Journal Entry – January 15, 2017 Debit Credit Cash 725,000 Discount on bond investment 28,703 Investment in Masterwear bonds 700,000 AFS investments require the same journal entry on the date of sale as is made to record the sale of trading securities. United simply records the receipt of cash, removes from the balance sheet any accounts that are directly associated with the investment, and calculates the difference to determine realized gain or loss. Gain on sale of investments 53,703 Cash 1,446,000 Loss on sale of investments 54,000 Investment in Arjent stock 1,500,000

Adjust AFS Investments to Fair Value (2017)
LO12-3 Adjust AFS Investments to Fair Value (2017) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Remaining Investments to Fair Value Valued the Bendac stock at $985,000. December 31, 2017 December 31, 2017 Amortized Cost Fair Value Adjustment Security Fair Value Masterwear (sold) –0– –0– The above table summarizes the situation at the end of This analysis indicates that United needs to increase the fair value adjustment by $1,354 and record an unrealized gain of the same amount in OCI. Once again, the analysis is the same as with trading securities, but now it includes a $1,354 entry to OCI rather than to net income. Arjent (sold) –0– –0– Bendac $1,000,000 $985,000 ($15,000) Total $1,000,000 $985,000 ($15,000) Existing balance in fair value adjustment: ($16,354) Increase (decrease) needed in fair value adjustment: $ 1,354

LO12-3 Adjust AFS Investments to Fair Value (2017) (Continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Adjust Remaining Investments to Fair Value Valued the Bendac stock at $985,000. December 31, 2017 Fair Value Adjustment 16,354 1,354 As with trading securities, United adjusts the fair value adjustment account and AOCI to remove any unrealized gains or losses previously recorded that relate to the sold investments. That is typically done at the end of the accounting period as part of the journal entry that adjusts the AFS investment portfolio to fair value, as we see above. As mentioned when we covered accounting for trading securities, this journal entry serves two purposes: it (a) accounts for changes in the fair value of investments that have not been sold (in this case, Bendac), and (b) removes from the fair value adjustment and net income any unrealized holding gains or losses that were recognized in prior periods and that are associated with investments that were sold during the period (in this case, Masterwear and Arjent). Let’s discuss those two purposes in more detail. 15,000 Journal Entry – December 31, 2017 Debit Credit Fair value adjustment 1,354 Net unrealized holding gains and losses—OCI 1,354

Concept Check √ Singapore Associates has AFS securities that cost $100,000. At the beginning of 2016 those securities had a fair value of $88,000, and at the end of 2016 they had a fair value of $110,000. Singapore’s journal entry to record unrealized gains and losses for 2016 would include a: a. Debit to Net unrealized holding gains and losses—OCI for $12,000. b. Credit to Net unrealized holding gains and losses—OCI for $22,000. Credit to Net unrealized holding gains and losses—OCI for $10,000. Debit to Net unrealized holding gains and losses—OCI for $22,000. Bali’s fair value adjustment needs to change from a debit of $20,000 to a credit of $10,000. Therefore, it will record the following entry: Fair value adjustment 22,000 Net unrealized holding gains and losses—OCI $22,000

LO12-3 ($5,000) to add 2017 unrealized loss associated with investments not sold 6,354 to remove 2016 net unrealized loss that’s no longer unrealized $1,354 2017 adjustment to OCI New changes in the fair value of investments held $1,000,000 initial cost of Bendac stock (985,000) fair value at the end of 2017 $ ,000 balance needed at end of 2017 (10,000) balance at end of 2016 The first purpose of the journal entry is to record in OCI any new unrealized gains or losses associated with investments that have not been sold. For United, that’s the Bendac stock. The new unrealized gain or loss equals whatever amount is necessary to report the Bendac investment at fair value as of the end of 2017. United already recognized a loss of $10,000 in Given a further decline in value of $5,000, if the 2017 journal entry had focused only on this first purpose, the journal entry would have been to recognize an unrealized holding loss of $5,000. $ ,000 new unrealized loss in 2017 Journal Entry – December 31, 2017 Debit Credit Net unrealized holding gains and losses-OCI 5,000 Fair value adjustment 5,000

LO12-3 ($5,000) to add 2017 unrealized loss associated with investments not sold 6,354 to remove 2016 net unrealized loss that’s no longer unrealized $1,354 2017 adjustment to OCI Reclassification adjustment $50,000 2016 unrealized loss for the Arjent stock 43,646 2016 unrealized gain for the Masterwear bonds $6,354 net unrealized loss in 2016 If only the net unrealized loss on the Arjent and Masterwear investments is included: The second purpose of the journal entry is to remove from OCI any amounts associated with sold investments. What amounts must United consider? Last year, in 2016, United recorded a net unrealized loss of $6,354 on the Arjent and Masterwear investments as part of the $16,354 fair value adjustment made at the end of that year. If the 2016 fair value adjustment had only included the net unrealized loss on the Arjent and Masterwear investments, it would appear as this journal entry. Entry at the end of 2016 Journal Entry – December 31, 2016 Debit Credit Net unrealized holding gains and losses-OCI 6,354 Fair value adjustment 6,354

LO12-3 Reclassification adjustment: reverses previously recorded unrealized gain or loss: Entry at the end of 2017 Journal Entry – December 31, 2017 Debit Credit Fair value adjustment 6,354 Net unrealized holding gains and losses-OCI 6,354 The 2017 FV adjustment combines the two parts: $6,354 − 5,000 Because those investments have now been sold, United must reverse this entry in 2017 to remove their effects from OCI and the fair value adjustment. If the 2017 journal entry had focused only on this second purpose, it would have been as shown in the first entry above. See how the two purposes combine to create the single journal entry we use? Now, why is this often referred to as a “reclassification adjustment”? Remember that United included a $6,354 unrealized loss in 2016 OCI (and therefore in AOCI). Then, in 2017, it backed out that amount from OCI (and AOCI) as part of the fair value adjustment entry, and included the realized gain or loss in net income (and therefore retained earnings) as part of the journal entry that recorded the sale of those investments. From the perspective of shareholders’ equity, the amount was basically reclassified from AOCI to retained earnings in the period of sale. Note that we don’t separately record this reclassification. That happens automatically as part of the fair value adjustment entry at the end of the period. What we do is report the reclassification in the statement of comprehensive income. Journal Entry – December 31, 2017 Debit Credit Fair value adjustment 1,354 Net unrealized holding gains and losses-OCI 1,354

Financial Statement Presentation
LO12-3 Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur Reclassified out of OCI in the periods in which securities are sold Balance Sheet: Investments are reported at fair value Unrealized gains and losses affect AOCI in shareholders’ equity Reclassified out of AOCI in the periods in which securities are sold We present AFS securities in the financial statements as follows: • Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized gains and losses are shown in OCI in the periods in which changes in fair value occur, and reclassified out of OCI in the periods in which securities are sold. • Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized gains and losses affect AOCI in shareholders’ equity, and are reclassified out of AOCI in the periods in which securities are sold.

Financial Statement Presentation (Continued)
LO12-3 Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities • Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.

Illustration: Reporting Available-for-Sale Securities
LO12-3 United’s 2016 and 2017 financial statements will include the amounts shown in the illustration. $121,664 is the sum of $46,664 interest revenue from Masterwear and $75,000 dividends from Arjent. $16,354 is the net unrealized loss from the 2016 fair value adjustment. $297 is the loss realized on sale of investments during 2017, resulting from the $54,000 loss realized on sale of the Arjent stock and the $53,703 gain realized on sale of the Masterwear bonds. $5,000 is the new net unrealized loss included in the 2017 fair value adjustment for Bendac. $6,354 is the reclassification adjustment included in the 2017 fair value adjustment to remove from AOCI amounts Illustration 12-8

Illustration: Investments in Securities Available-for-Sale—Cisco Systems
LO12-3 Individual securities available for sale are classified as either current or noncurrent assets, depending on how long they’re likely to be held. An example from the 2013 annual report of Cisco Systems is shown in this illustration. Illustration 12-9

Illustration: Comparison of HTM, TS, and AFS Approaches
LO12-3 This illustration compares accounting for the Masterwear bonds under the three different approaches used when an investor lacks significant influence. This side-by-side comparison highlights several aspects of these accounting approaches: • To record the purchase of an investment and the receipt of investment revenue, we use identical entries in all three approaches. • To record changes in fair value, the entries we use for TS and AFS securities have the same effect on the investment (via the fair value adjustment valuation allowance) and the same eventual effect on shareholders’ equity. What differs is whether the unrealized gain or loss is recognized in the income statement and then in retained earnings (TS) or recognized in OCI and then in AOCI (AFS). • To record the sale of the security, we use identical entries in all three approaches. For TS and AFS securities, the fair value adjustment and unrealized holding gains and losses associated with sold securities are dealt with automatically as part of the next adjustment to fair value. • Regardless of approach, the cash flows are the same, and the same total amount of gain or loss is recognized in the income statement (TS: $43,646 in [$53,703 − $43,646] in 2017 = $53,703 total; AFS and HTM: $53,703 in 2017). Thus, the question is not how much total net income is recognized, but when that net income is recognized. Illustration 12-10

Transfers between Investment Categories
LO12-3 At each reporting date, the appropriateness of the classification is reassessed Example: If the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. Transfer of a security between reporting categories is accounted for at fair value and in accordance with the new reporting classification Disclosure notes should describe the circumstances that resulted in the transfer At acquisition, an investor assigns debt and equity securities to one of the three reporting classifications—held-to-maturity, available-for-sale, or trading. At each reporting date, the appropriateness of the classification is reassessed. For instance, if the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. When a security is reclassified between two reporting categories, the security is transferred at its fair value on the date of transfer. Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred. Reclassifications are quite unusual, so when they occur, disclosure notes should describe the circumstances that resulted in the transfers.

Illustration: Transfer between Investment Categories
LO12-3 When either held-to-maturity or available-for-sale securities are transferred to trading securities, the total unrealized gain or loss is included in the current net income, as if it all occurred in the current period. When trading securities are transferred to either held-to-maturity or available-for-sale securities, the total unrealized gain or loss that occurred in the current period prior to the transfer is included in the current net income. When held-to-maturity is transferred to available-for-sale securities, the unrealized gain or loss has no effect on the current income. The total unrealized gain or loss is reported as a separate component of shareholders’ equity, in accumulated other comprehensive income. When available-for-sale security is transferred to held-to-maturity, there is no effect on the current income. Any existing unrealized holding gain or loss in AOCI is not written off, but it is amortized to the net income over the remaining life of the security. Illustration 12-11

Concept Check √ Which of the following is true? Note: there may be more than one correct answer. a. TS and AFS both are shown at fair value on the balance sheet. b. Unrealized gains and losses are included in OCI for TS investments and in net income for AFS investments. The same basic journal entry is used to record purchase and sale of HTM, TS, and AFS investments. The same basic journal entry is used to record changes in unrealized gains and losses for HTM and AFS investments. Answer b is not correct because unrealized gains and losses are included in OCI for AFS investments and in net income for TS investments. Answer d is not correct because changes in unrealized gains and losses are not recognized for HTM investments.

Fair Value Option LO12-7 Trading securities are accounted for at fair value, so there is no need to choose the fair value option for them Choosing the fair value option for HTM and AFS investments means reclassifying these investments as TS investments Electing the fair value option is irrevocable Why allow the fair value option? To avoid excess earnings volatility GAAP allows a fair value option that permits companies to elect to account for most financial assets and liabilities at fair value. Under the fair value option, unrealized gains and losses are recognized in net income in the period in which they occur. That accounting approach should sound familiar—it’s the same approach we use to account for trading securities. Here’s how the fair value option works for these investments. When a security that qualifies for HTM or AFS treatment is purchased, the investor makes an irrevocable decision about whether to elect the fair value option. The company can elect the fair value option for some securities and not for identical others—it’s entirely up to the company, but the company has to explain in the notes why it made a partial election. If the fair value option is elected for a security that would normally be accounted for as HTM or AFS, the company just classifies that security as a trading security, and that’s how it appears in the financial statements. The only difference is that, unlike most trading securities, purchases and sale of investments accounted for under the fair value option are likely to be classified as investing activities in the statement of cash flows, because those investments are not held for sale in the near term and therefore are not operational in nature. Also, note that electing the fair value option is irrevocable. If a company elects the fair value option and later believes that the fair value of an investment is likely to decline, it can’t change the election and discontinue use of fair value accounting. Why allow the fair value option? Recall that a primary reason for creating the AFS approach was to allow companies to avoid excess earnings volatility that would result from reporting in earnings the fair value changes of only part of a hedging arrangement. Other accounting rules apply to hedging arrangements that involve derivatives, but those rules are very complex and don’t cover all forms of hedging arrangements. The fair value option simplifies this process by allowing companies to choose whether to use fair value for most types of financial assets and liabilities.

OTT Impairments of Investments
Declines or increases in the fair value of some investments are always reported in earnings Trading Securities Securities for which the fair value option has been elected For HTM and AFS investments, declines in fair value normally are only recognized when the investment is sold. However, an “other-than-temporary” impairment loss is recognized in net income, even if the security is not sold The process for determining whether an investment has an OTT impairment differs between equity and debt investments Equity: recognize if company doesn’t have the intent and ability to hold the investment until fair value recovers. Debt: more complicated. In this chapter we’ve seen that declines (as well as increases) in the fair value of some investments are reported in earnings. For instance, if the fair value of an investment in trading securities declines, we reduce the reported amount of that investment in the balance sheet and include the loss from the fair value decline in the income statement. Likewise, if the investor has elected the fair value option for HTM or AFS investments, those investments are accounted for as trading securities, so fair value changes always are recognized in earnings. Otherwise, fair value changes for HTM and AFS investment typically are not recognized in earnings. However, there is an exception. If the fair value of an HTM or AFS investment declines below the amortized cost of the investment, and that decline is deemed to be other-than-temporary (OTT), the company recognizes an OTT impairment loss in earnings. This topic is covered in an appendix to this chapter. As a quick overview, understand that the specific process for determining whether an investment has an OTT impairment differs between equity and debt investments. For equity investments, the question is whether the company has the intent and ability to hold the investment until fair value recovers. If that isn’t the case, the company recognizes an OTT impairment loss in earnings and reduces the carrying value of the investment in the balance sheet by that amount. For debt investments, the process is more complicated than for equity investments, both in determining whether an impairment is OTT and in determining the amount of the impairment to include in earnings. For both equity and debt investments, after an OTT impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed. That is, further changes in fair value are reported in OCI for AFS investments and not recognized for HTM investments.

Financial Statement Presentation and Disclosure
On the statement of cash flows, inflows and outflows of cash from buying and selling trading securities are considered operating activities. Cash flows from the purchase, sale, and maturity of HTM or AFS securities are considered investing activities. Cash flows of HTM or AFS securities for which the fair value option has been selected (and so are treated as trading securities) may be classified as investing. Trading securities, held-to-maturity securities and available-for-sale securities are classified as either current or noncurrent depending on when they are expected to mature or to be sold. However, it’s not necessary that a company report individual amounts for the three categories of on the face of the balance sheet as long as that information is presented in the disclosure notes. On the statement of cash flows, inflows and outflows of cash from buying and selling trading securities typically are considered operating activities because, for companies that routinely transact in trading securities (financial institutions), trading in those securities constitutes an appropriate part of the companies’ normal operations. Because held-to-maturity and available-for-sale securities are not purchased and held to be sold in the near term, cash flows from the purchase, sale, and maturity of these securities are considered investing activities. Also, if an investment that normally would be HTM or AFS is classified as a trading security because the company chose the fair value option, cash flows may be classified as investing, because they are viewed as nonoperating in nature.

Financial Statement Presentation and Disclosure (Continued)
The information to be disclosed in the disclosure notes for every year it is presented includes: Aggregate fair value Gross realized and unrealized holding gains Gross realized and unrealized holding losses Change in net unrealized holding gains and losses Amortized cost basis by major security type Total gains or losses for the period (realized and unrealized) Purchases, sales, issuances and settlements Investors should disclose much information relevant to investments in the disclosure notes for each year presented, including, Aggregate fair value. Gross realized and unrealized holding gains. Gross realized and unrealized holding losses. Change in net unrealized holding gains and losses. Amortized cost basis by major security type. The notes also include disclosures designed to help financial statement users understand the quality of the inputs companies use when determining fair values and to identify parts of the financial statements that are affected by those fair value estimates. For example, the notes should include the level of the fair value hierarchy (levels 1, 2, or 3) in which all fair value measurements fall. For fair value measurements that use unobservable inputs (level 3), the notes need to provide information about the effect of fair value measurements on earnings, including a reconciliation of beginning and ending balances of the investment that identifies: Total gains or losses for the period (realized and unrealized), unrealized gains and losses associated with assets and liabilities still held at the reporting date, and where those amounts are included in earnings or shareholders’ equity. Purchases, sales, issuances and settlements. Transfers in and out of level 3 of the fair value hierarchy (for example, because of changes in the observability of inputs used to determine fair values). For instruments accounted for under the fair value option, an estimate of the gains or losses included in earnings that are attributable to changes in credit risk.

Illustration: Fair Value Disclosure of Investment Securities—General Electric
Here’s an example of some of the fair-value-related disclosure that firms are required to provide. This example is from GE’s 2013 annual report and its discussion of fair values of investments in its pension plan. We can see here that GE has significant investments in all three levels of the fair-value hierarchy. The second part of this example shows us that GE had unrealized gains of $1.118 billion on its Level 3 investments. Because those gains relate to Level 3 investments, users of the financial statements might be concerned about their reliability. Recent changes in U.S. GAAP and IFRS have only increased the amount of disclosure that is required about fair values. For example, for level 2 or 3 fair values, the notes to the financial statements must include a description of the valuation technique(s) and the inputs used in the fair value measurement process, and for level 3 fair values, the notes must indicate the significant inputs used in the fair value measurement and the sensitivity of fair values to significant changes in those inputs. All of this disclosure is designed to provide financial statement users with information about those fair values that are most vulnerable to bias or error in the estimation process. Illustration 12-12

Investor Has Significant Influence
Illustration: Reporting Classifications for Investment Relationships When a company invests in the equity securities (primarily common stock) of another company, the investing company can benefit either (a) directly through dividends and/or market price appreciation or (b) indirectly through the creation of desirable operating relationships with the investee. The way we report a company’s investment in the stock of another company depends on the nature of the relationship between the investor and the investee. For reporting purposes, we classify the investment relationship in one of three ways, and account for the investment differently depending on the classification. The first part of the chapter dealt with circumstances in which the investor lacks a significant influence over the investee. Now we’ll discuss how to account for an investment in which the investor has significant influence. We use the equity method. Illustration 12-13

What Is Significant Influence?
LO12-4 Significant influence is assumed to exist if the investor owns between 20% and 50% of the investee’s voting shares Absence of control (not > 50% ownership) Significant influence over the operating and financial policies of the investee Decisions often can be swayed in the direction the investor desires Investment is accounted for by the equity method When an investor owns enough of the shares of a company, it may be able to exercise significant influence over the operating and financial policies of the investee. For example, the investor might own a large percentage of the outstanding shares relative to other shareholders. By voting those shares, decisions often can be swayed in the direction the investor desires. When significant influence exists, the investment should be accounted for by the equity method. It should be presumed, in the absence of evidence to the contrary, that the investor has the ability to exercise significant influence over the investee when it owns between 20% and 50% of the investee’s voting shares.

How the Equity Method Relates to Consolidated Financial Statements
Consolidate if the investor has a controlling interest: Company owns more than 50% of the voting stock of another company The investor is referred to as the parent and the investee is termed the subsidiary The parent and subsidiary are considered to be a single reporting entity Consolidated financial statements: Combine the individual elements of the parent and subsidiary statements into a single financial statement Goodwill: Difference between the acquisition price and the sum of the fair values of the acquired net assets Recognized as an asset To understand the equity method, it helps to understand how companies deal for an investment in which they control the investee. If a company acquires more than 50% of the voting stock of another company, it’s said to have a controlling interest, because by voting those shares, the investor actually can control the company acquired. The investor is referred to as the parent, and the investee is called the subsidiary. Both companies continue to operate as separate legal entities, and the subsidiary reports separate financial statements. However, because of the controlling interest, the parent company reports consolidated financial statements. Consolidated financial statements combine the separate financial statements of the parent and the subsidiary each period into a single aggregate set of financial statements as if there were only one company. This entails an item-by-item combination of the parent and subsidiary statements (after first eliminating any amounts that are shared by the separate financial statements). For instance, if the parent has $8 million cash and the subsidiary has $3 million cash, the consolidated balance sheet would report $11 million cash. Two aspects of the consolidation process are of particular interest to us in understanding the equity method. First, in consolidated financial statements, the acquired company’s assets are included in the financial statements at their fair values as of the date of the acquisition, rather than their book values on that date. Second, if the acquisition price is more than the sum of the separate fair values of the acquired net assets (assets less liabilities), that difference is recorded as an intangible asset—goodwill.

Equity Method: A Single Entity Concept
LO12-5 Equity method views the investor and investee collectively as a special type of single entity The investor’s ownership interest in individual assets and liabilities of the investee is represented by a single investment account Referred to as a one-line consolidation Initial investment is recorded at cost. The carrying amount of this investment subsequently is: Increased by the investor’s percentage share of the investee’s net income Decreased by dividends paid by investee to investor Much like consolidation, the equity method views the investor and investee collectively as a special type of single entity (as if the two companies were one company). However, using the equity method, the investor doesn’t include separate financial statement items of the investee on an item-by-item basis as in consolidation. Instead, the investor reports its equity interest in the investee as a single investment account. For that reason, the equity method sometimes is referred to as a “one-line consolidation,” because it essentially collapses the consolidation approach into single lines in the balance sheet and income statement, while having the same effect on total income and shareholders’ equity. Under the equity method, the investor recognizes investment income equal to its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends. As the investee earns additional net assets, the investor’s share of those net assets increases. Initially, the investment is recorded at cost. The carrying amount of this investment subsequently is: • Increased by the investor’s percentage share of the investee’s net income (or decreased by its share of a loss). • Decreased by dividends paid.

Illustration: Equity Method—Purchase of Investment
LO12-5 United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash. Book Value on Arjent’s Financial Statement Fair Value at Time of United’s Investment Account Buildings (10-year remaining useful life, no salvage value) $1,000,000 $2,000,000 Land 500,000 1,000,000 Other net assets 600,000 600,000 Net assets 2,100,000 3,600,000 Goodwill 1,400,000 (to balance) Total fair value of Arjent $5,000,000 × 30% purchased To see how the equity method works, let’s assume that United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash. This illustration highlights that buying 30% of Arjent can be viewed as buying 30% of all of Arjent’s assets and liabilities. Those assets and liabilities likely have book values on Arjent’s balance sheet that differ from their separate fair values. We can think of United as paying a price equal to 30% of the sum of the fair values of all of those assets and liabilities, plus an extra amount, goodwill, that captures 30% of the value of other attractive aspects of Arjent (e.g., loyal customers, well-trained workers) that GAAP doesn’t capture as separate assets or liabilities. Recording United’s purchase of 30% of Arjent is straightforward. In fact, it requires the same entry used to record the purchase of the Arjent investment earlier in this chapter. Illustration 12-14 Other information: $1,500,000 purchase price Arjent’s 2016 net income: $500,000 Arjent’s 2016 dividends: $250,000 Journal Entry Debit Credit Investment in Arjent stock 1,500,000 Cash 1,500,000

Equity Method—Recognizing Investment Income (Illustration continued)
LO12-5 United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash. Book Value on Arjent’s Financial Statement Fair Value at Time of United’s Investment Account Buildings (10-year remaining useful life, no salvage value) $1,000,000 $2,000,000 Land 500,000 1,000,000 Other net assets 600,000 600,000 Net assets 2,100,000 3,600,000 Goodwill 1,400,000 (to balance) Total fair value of Arjent $5,000,000 × 30% purchased Under the equity method, the investor includes in net income its proportionate share of the investee’s net income. The reasoning is that, as the investee earns additional net assets, the investor’s equity interest in those net assets also increases, so the investor increases its investment by the amount of income recognized. United’s entry would be as shown above. Of course, if Argent had recorded a net loss rather than net income, United would reduce its investment in Arjent and recognize a loss on investment for its share of the loss. Note that you won’t always see these amounts called “investment revenue” or “investment loss.” Rather, United might call this line “equity in earnings (losses) of affiliate” or some other title that suggests it is using the equity method. Illustration 12-14 Other information: $1,500,000 purchase price Arjent’s 2016 net income: $500,000 Arjent’s 2016 dividends: $250,000 30% × 500,000 Journal Entry Debit Credit Investment in Arjent stock 150,000 Investment revenue 150,000

Equity Method—Receiving Dividends (Illustration continued)
LO12-5 United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash. Book Value on Arjent’s Financial Statement Fair Value at Time of United’s Investment Account Buildings (10-year remaining useful life, no salvage value) $1,000,000 $2,000,000 Land 500,000 1,000,000 Other net assets 600,000 600,000 Net assets 2,100,000 3,600,000 Goodwill 1,400,000 (to balance) Total fair value of Arjent $5,000,000 × 30% purchased Because investment revenue is recognized as it is earned by the investee, it would be inappropriate to recognize revenue again when earnings are distributed as dividends. That would be double counting. Instead, we view the dividend distribution as a reduction of the investee’s net assets. The rationale is that the investee is returning assets to its investors in the form of a cash payment, so each investor’s equity interest in the remaining net assets declines proportionately. Illustration 12-14 Other information: $1,500,000 purchase price Arjent’s 2016 net income: $500,000 Arjent’s 2016 dividends: $250,000 30% × 250,000 Journal Entry Debit Credit Cash 75,000 Investment in Arjent stock 75,000

Concept Check √ Scotts purchased 40% of the stock of Yonkers, Inc. for $500,000 on 1/1/2016, and accounts for the investment using the equity method. In 2016, Yonkers earned net income of $150,000, and paid dividends of $50,000. As of 12/31/16, Scotts’ Yonkers investment account should have a balance of: a. $650,000 b. $600,000. $540,000. $500,000. $500,000 + (40% x $150,000) – (40% x $50,000) = $540,000.

Further Adjustments Under the Equity Method
LO12-6 Occur when investor’s expenditure to acquire an investment exceeds the book value of the underlying net assets acquired Purpose: To approximate the effects of consolidation, without actually consolidating financial statements Amortizing the differential between purchase price and book value: Adjust investment account and investment revenue to act as if consolidation procedures had been followed If assets would have been written up to fair value, act as if that happened Impute higher expenses in subsequent periods when those assets are expensed, such that Earnings are lower by the investor’s share in that additional expense When the investor’s expenditure to acquire an investment exceeds the book value of the underlying net assets acquired, additional adjustments to both the investment account and investment revenue might be needed. The purpose is to approximate the effects of consolidation, without actually consolidating financial statements. More specifically, after the date of acquisition, both the investment account and investment revenue are adjusted for differences between net income reported by the investee and what that amount would have been if consolidation procedures had been followed. This process is often referred to as “amortizing the differential,” because it mimics the process of expensing some of the difference between the price paid for the investment and the book value of the investment. Consolidated financial statements report (a) the acquired company’s assets at their fair values on the date of acquisition rather than their book values, subsequently adjusted for amortization, and (b) goodwill for the excess of the acquisition price over the fair value of the identifiable net assets acquired. The first of these two consequences of the consolidation process usually has an effect on income, and it’s the income effect that we’re interested in when applying the equity method. Increasing asset balances to their fair values usually will result in higher expenses in subsequent periods. For instance, if buildings, equipment, or other depreciable assets are written up to higher values, depreciation expense will be higher during their remaining useful lives. Likewise, if the recorded amount of inventory is increased, cost of goods sold will be higher when the inventory is sold. As a consequence of increasing these asset balances to fair value, expenses will rise and income will fall. It is this negative effect on income that the equity method seeks to imitate. However, if it’s land that’s increased, there is no income effect because we don’t depreciate land. Also, goodwill will not result in higher expenses. Goodwill is an intangible asset, but one whose cost usually is not charged to earnings.

Difference Attributed to:
Illustration: Source of Differences between the Investment and the Book Value of Net Assets Acquired LO12-6 ($ in thousands) Investee Net Assets Net Assets Purchased Difference Attributed to: Cost $5,000 × 30% = $1,500 Goodwill: $420 Fair value In our example, United needs to make adjustments for the fact that, at the time it purchased its investment in Arjent, the fair values of Arjent’s assets and liabilities were higher than the book values of those assets and liabilities in Arjent’s balance sheet. The illustration highlights the portions of United’s investment that may require adjustment. Notice in the illustration that United paid (in thousands) $1,500 for identifiable net assets that, sold separately, would be worth $1,080 and the $420 difference is attributable to goodwill. The identifiable net assets worth $1,080 have a book value of only $630. We’ll assume the $450 difference is attributable to undervalued buildings ($300) and land ($150). Illustration 12-15 $3,600 × 30% = $1,080 Undervaluation of: Buildings $300 Land $150 Book value $2,100 × 30% = $630

Equity Method—Adjustments for Additional Depreciation
LO12-6 Equity Method—Adjustments for Additional Depreciation United Intergroup purchased 30% of Arjent, Inc.’s, common stock for $1,500,000 cash. Book Value on Arjent’s Financial Statement Fair Value at Time of United’s Investment Account Buildings (10-year remaining useful life, no salvage value) $1,000,000 $2,000,000 Land 500,000 1,000,000 Other net assets 600,000 600,000 Net assets 2,100,000 3,600,000 Goodwill 1,400,000 (to balance) Total fair value of Arjent $5,000,000 × 30% purchased When Arjent determines its net income, it bases depreciation expense on the book value of its buildings, but United needs to depreciate its share of the fair value of those buildings at the time it made its investment. Therefore, United must adjust its investment revenue for additional depreciation expense. Over the life of the buildings, United will need to recognize its 30% share of a total of $1,000,000 of additional depreciation expense ($2,000,000 fair value less $1,000,000 book value), or $300,000. Assuming a 10-year life of the buildings and straight-line depreciation, United must recognize $30,000 of additional depreciation each year. Had Arjent recorded that additional depreciation, United’s portion of Arjent’s net income would have been lower by $30,000 (ignoring taxes). To act as if Arjent had recorded the additional depreciation, United adjusts the accounts to reduce investment revenue and reduce its investment in Arjent stock by $30,000. Other information: $1,500,000 purchase price Arjent’s 2016 net income: $500,000 30% × [$2,000,000 – 1,000,000] ÷ 10 yrs. Arjent’s 2016 dividends: $250,000 Journal Entry Debit Credit Investment revenue 30,000 Investment in Arjent stock 30,000

No Adjustments for Land or Goodwill
LO12-6 Land: Land is not depreciated Difference between the fair value and book value of the land would not cause higher expenses Goodwill: Unlike most of the other intangible assets, goodwill is not amortized Acquiring goodwill will not cause higher expenses United makes no adjustments for land or goodwill. Land, unlike buildings, is not an asset that we depreciate. As a result, the difference between the fair value and book value of the land would not cause higher expenses, and we have no need to adjust investment revenue or the investment in Arjent stock for the land. Goodwill, unlike most other intangible assets, is not amortized. In that sense, goodwill resembles land. Thus, acquiring goodwill will not cause higher expenses, so we have no need to adjust investment revenue or the investment in Arjent stock for goodwill.

Concept Check √ KB purchased 40% of the stock of RiteCo, Inc. for $500,000 on 1/1/2016, and accounts for the investment using the equity method. At 1/1/2016, 40% of the fair value of Rite Co's net assets is $500,000, and 40% of the book value of RiteCo's net assets is $200,000. One half of the difference is attributable to land, and the other half to a building being depreciated over 10 years. To account for this difference, during 2016 KB would reduce its investment in RiteCo by: a. $300,000. b. $150,000. $15,000. $6,000. ½ x ($500,000 - $200,000) ÷ 10 = $15,000.

Adjustments for Other Assets and Liabilities
LO12-6 If the fair value of purchased inventory exceeds its book value, the period in which that inventory is sold should be identified Inventory is usually sold in the next year Investment revenue and its investment in the stock is reduced in the next year by the amount of the differential attributable to inventory Because in our example there was no difference between the book value and fair value of the remaining net assets, we don’t need an adjustment for them either. However, that often will not be the case. For example, Arjent’s inventory could have had a fair value that exceeded its book value at the time United purchased its Arjent investment. To recognize expense associated with that higher fair value, United would need to identify the period in which that inventory is sold (usually the next year) and, in that period, reduce its investment revenue and its investment in Arjent stock by its 30% share of the difference between the fair value and book value of the inventory. If, for instance, the $300,000 difference between fair value and book value had been attributable to inventory rather than buildings, and that inventory was sold by Arjent in the year following United’s investment, United would reduce investment revenue by the entire $300,000 in the year following the investment. By so doing, United would be making an adjustment that yielded the same net investment revenue as if Arjent had carried the inventory on its books at fair value at the time the Arjent investment was made and therefore recorded higher cost of goods sold ($300,000) when it was sold in the next year. More generally, an equity method investor needs to make these sorts of adjustments whenever there are revenues or expenses associated with an asset or liability that had a difference between book value and fair value at the time the investment was made.

Reporting the Investment (Illustration continued)
LO12-6 The fair value of the investment shares at the end of the reporting period is not reported when using the equity method Instead, the investment account is reported at: Original Cost Investor’s share of the investee’s net income The portion of the earnings received as dividends The balance of United’s 30% investment in Arjent at December 31, 2016 is calculated as: The fair value of the investment shares at the end of the reporting period is not reported when using the equity method. The investment account is reported at its original cost, increased by the investor’s share of the investee’s net income (adjusted for additional expenses like depreciation), and decreased by the portion of those earnings actually received as dividends. In other words, the investment account represents the investor’s share of the investee’s net assets initially acquired, adjusted for the investor’s share of the subsequent increase in the investee’s net assets (net assets earned and not yet distributed as dividends). The balance of United’s 30% investment in Arjent at December 31, 2016, would be calculated as shown above. In the statement of cash flows, the purchase and sale of the investment are reported as outflows and inflows of cash in the investing activities section, and the receipt of dividends is reported as an inflow of cash in the operating activities section. Investment in Arjent Stock Cost 1,500,000 Share of income 150,000 30,000 Depreciation adjustment 75,000 Dividends 1,545,000

Reporting the Investment (Illustration continued)
LO12-6 When the Investee Reports a Net Loss: The investment account would be decreased by the investor’s share of the investee’s net loss When the Investment is Acquired in Mid-year: Only recognize the investor’s share of the year’s activity Example: If United purchased 30% of Arjent on October 1: Investment in Arjent Stock Cost 1,500,000 Share of income Our illustration assumed the investee earned net income. If the investee reports a net loss instead, the investment account would be decreased by the investor’s share of the investee’s net loss (adjusted for additional expenses). Obviously, we’ve simplified the illustration by assuming the investment was acquired at the beginning of 2016, including a full year’s income, dividends, and adjustments to account for the income effects of any differences between book value and fair value on the date the investment was acquired. In the more likely event that an investment is acquired sometime after the beginning of the year, the application of the equity method is easily modified to include the appropriate fraction of each of those amounts. For example, if United’s purchase of 30% of Arjent had occurred on October 1 rather than January 2, we would simply record income, dividends, and adjustments for three months (3/12) of the year. This would result in the above entries to the investment account. Depreciation adjustment (3/12 × $150,000) 37,500 7,500 (3/12 × $30,000) Dividends 18,750 (3/12 × $75,000) 1,511,250

Illustration: Equity Method Investments on the Balance Sheet—AT&T
LO12-6 Here’s an example of an equity method disclosure. AT&T reported its 2013 investments in affiliated companies for which it exercised significant influence using the equity method as shown in this illustration. Illustration 12-16

What If Conditions Change?
LO12-6 A change from the equity method to another method No adjustment is made to the remaining carrying amount of the investment Equity method is discontinued and the new method applied from then on The balance in the investment account would serve as the new cost basis for writing the investment up or down to fair value on the next set of financial statements When the investor’s level of influence changes, it may be necessary to change from the equity method to another method. When this situation happens, no adjustment is made to the remaining carrying amount of the investment. Instead, the equity method is simply discontinued and the new method applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to fair value on the next set of financial statements. For example, when Visa ’s influence over one of its investees was reduced during 2013, Visa changed from accounting for the investment by the equity method to accounting for the investment as available-for-sale. The investment had been carried at $12 million under the equity method, but its fair value was $99 million. So when Visa made the change it recognized an $87 million gain in other comprehensive income, just as if the investment had initially cost Visa $12 million and had appreciated $87 million in value during the year.

What If Conditions Change?
LO12-6 A change from another method to the equity method The investment account should be retroactively adjusted to the balance that would have existed if the equity method always had been used As income also would have been different, retained earnings would be adjusted as well Example: It is determined that an investor’s share of investee net income, reduced by dividends, was $4,000,000 during a period when the equity method was not used, but additional purchases of shares cause the equity method to be appropriate now. Sometimes companies change from another method to the equity method. For example, recently the Mitsubishi UFJ Financial Group converted its investment in the convertible preferred stock of Morgan Stanley into common stock, and as a result started accounting for that investment under the equity method. When a change to the equity method is appropriate, the investment account should be retroactively adjusted to the balance that would have existed if the equity method always had been used. As income also would have been different, retained earnings would be adjusted as well. For example, assume it’s determined that an investor’s share of investee net income, reduced by dividends, was $4 million during a period when the equity method was not used, but additional purchases of shares cause the equity method to be appropriate now. The above journal entry would record the change (ignoring taxes). In addition to the adjustment of account balances, financial statements would be restated to the equity method for each year reported in the annual report for comparative purposes. Also, the income effect for years prior to those shown in the comparative statements is reported on the statement of retained earnings as an adjustment to beginning retained earnings of the earliest year reported. A disclosure note also should describe the change. Journal Entry Debit Credit Investment in equity securities 4,000,000 Retained earnings 4,000,000

If an Equity Method Investment is Sold
LO12-6 When an investment reported by the equity method is sold: Selling price > Book (carrying) value Gain is recognized Selling price > Book (carrying) value Loss is recognized Example: The balance of United’s 30% investment in Arjent at December 31, 2016 is $1,545,000. United sells its investment in Arjent on January 1, 2017, for $1,446,000. When an investment reported by the equity method is sold, a gain or loss is recognized if the selling price is more or less than the carrying amount (book value) of the investment. For example, let’s continue our illustration and assume United sells its investment in Arjent on January 1, 2017, for $1,446,000. A journal entry would record a loss as shown above. If the sale of the equity-method investment meets the criteria for a discontinued operation, it is reported in the financial statements as a discontinued operation. Journal Entry – January 1, 2017 Debit Credit Cash 1,446,000 Loss on sale of investment 99,000 Investment in Arjent stock 1,545,000

Illustration: Comparison of Fair Value and the Equity Methods
LO12-6 This illustration compares accounting for the Arjent investment at fair value (as trading securities or securities available for sale) and under the equity method. This side-by-side comparison highlights several aspects of these accounting approaches: • To record the purchase of an investment, we use identical entries for both approaches. • The two approaches differ in whether we record investment revenue when dividends are received and whether we recognize unrealized holding gains and losses associated with changes in the fair value of the investment. • The differences in how the two approaches account for unrealized holding gains and losses result in different book values for the investment at the time the investment is sold, and therefore result in different realized gains or losses when the investment is sold. • Regardless of approach, the same cash flows occur, and the same total amount of net income is recognized over the life of the investment. In the case of Arjent: ■ Fair value method: A total of $21,000 of net income is recognized over the life of the investment, equal to $75,000 of dividend revenue minus $54,000 realized loss on sale of investment. ■ Equity method: A total of $21,000 of net income is recognized over the life of the investment, equal to $150,000 of United’s portion of Arjent’s income minus $30,000 depreciation adjustment and minus $99,000 realized loss on sale of investment. ■ Thus, the question is not how much total net income is recognized, but when that net income is recognized. Illustration 12-17

Alternatives for bookkeeping
Fair Value Option LO12-7 Irrevocable decision about whether to elect the fair value option or not is made by the company Company carries the investment at fair value in the balance sheet and unrealized gains and losses are included in earnings Investments are shown on their own line in the balance sheet or are combined with equity method investments with the amount at fair value shown parenthetically (1) Investment is accounted for using entries similar to those that would be used to account for trading securities Companies can choose the fair value option for “significant influence” investments that otherwise would be accounted for under the equity method. The company makes an irrevocable decision about whether to elect the fair value option, and can make that election for some investments and not for others. As shown for the fair value method in the prior illustration, the company carries the investment at fair value in the balance sheet and includes unrealized gains and losses in earnings. However, investments that otherwise would be accounted for under the equity method but for which the fair value option has been elected are not reclassified as trading securities. Instead, these investments are shown on their own line in the balance sheet or are combined with equity method investments with the amount at fair value shown parenthetically. Still, they are reported at fair value with changes in fair value reported in earnings as if they were trading securities. Also, all of the disclosures that are required when reporting fair values as well as some of those that would be required under the equity method still must be provided. Exactly how a company does the bookkeeping necessary to comply with these broad requirements is up to the company. One alternative is to account for the investment using entries similar to those that would be used to account for trading securities. A second alternative is to record all of the accounting entries during the period under the equity method, and then record a fair value adjustment at the end of the period. Regardless of which alternative the company uses to account for the investment during the period, though, the same fair value is reported in the balance sheet at the end of the period, and the same total amount is shown on the income statement (the fair value adjustment amount plus the investment revenue recorded). Alternatives for bookkeeping (2) Record all the accounting entries during the period under the equity method, and then record a fair value adjustment at the end of the period

Differences between IFRS and U.S. GAAP
LO12-8 IFRS U.S. GAAP Accounting for Investments When Investor Lacks Significant Influence The primary categories under IAS No. 39 consists of “Fair Value through Profit & Loss” (“FVPL,” similar to TS), HTM, and AFS. The primary categories are same as IFRS. Investments in debt securities are classified either as amortized cost, fair value through other comprehensive income (“FVOCI”), or fair value through profit or loss (“FVPL”). Investments in debt securities are classified either as HTM investments, AFS investments, or trading securities. Under the FVOCI category, realized gains and losses associated with a sold equity investment is transferred from AOCI to retained earnings without passing through the income statement. Under AFS, realized gains and losses on equity investments are reclassified out of OCI and into net income when the investment is later sold. Until recently, IAS No. 39 was the standard that specified appropriate accounting for investments under IFRS. The primary categories in IAS No. 39 are similar to those in U.S. GAAP, consisting of “Fair Value through Profit & Loss” (“FVPL,” similar to TS), HTM, and AFS. IFRS No. 9, amended July 24, 2014, will be required after January 1, 2018, and earlier adoption is allowed in some jurisdictions, so until 2018 either IAS No. 39 or IFRS No. 9 might be in effect for a particular company. IFRS No. 9 eliminates the HTM and AFS classifications, replaced by new classifications that are more restrictive. Specifically, under IFRS No. 9: • Investments in debt securities are classified either as amortized cost (accounted for like HTM investments in U.S. GAAP), fair value through other comprehensive income (“FVOCI,” accounted for like AFS investments) and fair value through profit or loss (“FVPL,” accounted for like trading securities). Classification depends on two criteria: (1) whether the investment’s contractual cash flows consist solely of payments of principal and interest (this criterion is called “SPPI”), and (2) whether the business purpose of the investment is to collect contractual cash flows, sell investments, or both. If the investment qualifies as SPPI and is held only to collect cash flows, it is classified as amortized cost. If it qualifies as SPPI and is held both to collect cash flows and potentially be sold, it is classified as FVOCI. Otherwise it is classified as FVPL. • Investments in equity securities are classified as either “FVPL” (“Fair Value through Profit & Loss”) or “FVOCI” (“Fair Value through Other Comprehensive Income”). If the equity is held for trading, it must be classified as FVPL, but otherwise the company can irrevocably elect to classify it as FVOCI. The FVOCI classification is similar to AFS in U.S. GAAP. However, there is an important difference between accounting for AFS in U.S. GAAP and accounting for FVOCI under IFRS No. 9, which applies to equity (but not debt) investments. Like the AFS classification, the FVOCI category includes unrealized gains and losses in OCI. However, unlike AFS, realized gains and losses on equity investments are not reclassified out of OCI and into net income when the investment is later sold. Rather, the accumulated gain or loss associated with a sold investment is just transferred from AOCI to retained earnings (both shareholders’ equity accounts), without passing through the income statement. One other difference between U.S. GAAP and IFRS is worth noting. U.S. GAAP allows specialized accounting for particular industries like securities brokers/dealers, investment companies, and insurance companies. IFRS does not.

Differences between IFRS and U.S. GAAP (Continued)
LO12-8 IFRS U.S. GAAP Transfer Between Investment Categories Allows transfers of debt investments out of the FVPL category into AFS or HTM in “rare circumstances,” and indicated that the financial crisis qualified as one of those circumstances. Allows transfers out of the trading security category, but reclassifications under this continue to be rarer events than that occurred under IFRS with this change. Fair Value Option It is more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option. Under both IAS No. 39 and IFRS No. 9, companies can elect the fair value option only in specific circumstances. Less restrictive than IFRS. It indicates that the intent of the fair value option is to address specific circumstances. But it does not require that those circumstances exist. Transfers Between Investment Categories. Until recently, IFRS did not allow transfers out of the “Fair Value through P&L” (FVPL) classification (which is roughly equivalent to the trading securities classification in U.S. GAAP). However, in October 2008 the IASB responded to the financial crisis underway at that time by amending IAS No. 39 to allow transfers of debt investments out of the FVPL category into AFS or HTM in “rare circumstances,” and indicated that the financial crisis qualified as one of those circumstances. The change was justified as increasing convergence to U.S. GAAP, which also allows transfers out of the trading security category, but in fact reclassifications in U.S. GAAP continue to be rarer events than occurred under IFRS with this change. Fair Value Option. International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option. Under both IAS No. 39 and IFRS No. 9, companies can elect the fair value option only in specific circumstances. For example, a firm could elect the fair value option for an asset or liability in order to avoid the “accounting mismatch” that occurs when some parts of a fair value risk-hedging arrangement are accounted for at fair value and others are not. Although U.S. GAAP indicates that the intent of the fair value option is to address these sorts of circumstances, it does not require that those circumstances exist.

LO12-8 Differences between IFRS and U.S. GAAP (Continued) IFRS U.S. GAAP Cost Method Under IAS No. 39, equity investments typically are measured at fair value, even if they are not listed on an exchange or over-the-counter market. The cost method is used only if fair value cannot be measured reliably. IFRS No. 9 does not allow the cost method, but may allow cost as an estimate of fair value in some circumstances. This method is more prevalent than under IFRS. Cost Method. Under IAS No. 39, equity investments typically are measured at fair value, even if they are not listed on an exchange or over-the-counter market. The cost method is used only if fair value cannot be measured reliably, which occurs when the range of reasonable fair value estimates is significant and the probability of various estimates within the range cannot be reasonably estimated. IFRS No. 9 does not allow the cost method, but may allow cost as an estimate of fair value in some circumstances. In general, use of the cost method is less prevalent under IFRS than under U.S. GAAP.

LO12-8 Differences between IFRS and U.S. GAAP (Continued) IFRS U.S. GAAP IAS No. 28 governs application of the equity method and requires that the accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. It has has no such requirement. It does not provide the fair value option for most investments that qualify for the equity method. It provides the fair value option for all investments that qualify for the equity method. Like U.S. GAAP, international accounting standards require the equity method for use with significant influence investees (which they call “associates”), but you should understand two important differences. First, IAS No. 28 governs application of the equity method and requires that the accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Second, IFRS does not provide the fair value option for most investments that qualify for the equity method. U.S. GAAP provides the fair value option for all investments that qualify for the equity method.

Financial Instruments and Investment Derivatives
A financial instrument is defined as: Cash Evidence of an ownership interest in an entity A contract that Imposes on one entity an obligation to deliver cash or another financial instrument Conveys to the second entity a right to receive cash Imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms Conveys to a second entity a right to exchange other financial instruments on potentially favorable terms A financial instrument is defined as: • Cash, • Evidence of an ownership interest in an entity, • A contract that (a) imposes on one entity an obligation to deliver cash (say accounts payable) or another financial instrument and (b) conveys to the second entity a right to receive cash (say accounts receivable) or another financial instrument, or • A contract that (a) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms (say the issuer of a stock option) and (b) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms (say the holder of a stock option).

Financial Instruments and Investment Derivatives (Continued)
Instruments that “derive” their values from some other security or index Complex class of financial instrument Created solely to hedge against risks created by: other financial instruments or by transactions that have yet to occur but are anticipated A complex class of financial instruments exists in financial markets in response to the desire of firms to manage risks. In fact, these financial instruments would not exist in their own right, but have been created to hedge against risks created by other financial instruments or by transactions that have yet to occur but are anticipated. Financial futures, interest rate swaps, forward contracts, and options have become commonplace. These financial instruments often are called derivatives because they “derive” their values or contractually required cash flows from some other security or index. For instance, an option to buy an asset in the future at a preset price has a value that is dependent on, or derived from, the value of the underlying asset. Their rapid acceptance as indispensable components of the corporate capital structure has left the accounting profession scrambling to keep pace. Derivatives Financial Futures Interest Rate Swaps Forward Contracts Options

Financial Instruments and Investment Derivatives (Continued)
FASB Wants to provide a consistent framework for resolving financial instrument accounting issues, including those related to derivatives and other off- balance-sheet instruments The financial instruments project has three separate but related parts: disclosure, recognition and measurement, and distinguishing between liabilities and equities To help fill the disclosure gap, the FASB has offered a series of temporary, “patchwork” solutions in the form of additional disclosures for financial instruments The urgency to establish accounting standards for financial instruments has been accelerated by headline stories in the financial press reporting multibillion-dollar losses on exotic derivatives by J.P. Morgan and UPS , to mention a couple. The headlines have tended to focus attention on the misuse of these financial instruments rather than their legitimate use in managing risk. The FASB has for many years been involved in a project to provide a consistent framework for resolving financial instrument accounting issues, including those related to derivatives and other “off-balance-sheet” instruments. The financial instruments project has three separate but related parts: disclosure, recognition and measurement, and distinguishing between liabilities and equities. Unfortunately, issues to be resolved are extremely complex and will likely require several more years to resolve. To help fill the disclosure gap in the meantime, the FASB has offered a series of temporary, “patchwork” solutions. These are primarily in the form of additional disclosures for financial instruments. More recently, the FASB has tackled the issues of recognition and measurement. Note to the instructor: See Appendix A for more thorough coverage of accounting for derivatives.

Other Investments Special Purpose Funds
APPENDIX 12A Special Purpose Funds Amount set aside by companies to be used for specific purposes A special purpose fund can be established for virtually any purpose Fund is established to accumulate money to expand facilities, provide for unexpected losses, buy back shares of stock Noncurrent special purpose funds are reported within the category investments and funds Investments in Life Insurance Policies Objective: To compensate the company for the untimely loss of a valuable resource in the event the officer dies When the insured is still alive, life insurance policy can be surrendered in exchange for a determinable amount of money (called the cash surrender value). That’s an investment Special Purpose Funds: It’s often convenient for companies to set aside money to be used for specific purposes. Recall that a petty cash fund is money set aside to conveniently make small expenditures using currency rather than having to follow the time-consuming, formal procedures normally used to process checks. Similar funds sometimes are used to pay interest, payroll, or other short-term needs. Like petty cash, these short-term special purpose funds are reported as current assets. Special purpose funds also are sometimes established to serve longer-term needs. It’s common, for instance, to periodically set aside cash into a fund designated to repay bonds and other long-term debt. Such funds usually accumulate cash over the debt’s term to maturity and are composed of the company’s periodic contributions plus interest or dividends from investing the money in various return-generating investments. Of course, funds that won’t be used within the upcoming operating cycle are noncurrent assets. They typically are reported as part of investments. The same criteria for classifying securities into reporting categories that we discussed previously should be used to classify securities in which funds are invested. Any investment revenue from these funds is reported as such on the income statement. Investments in Life Insurance Policies: Companies frequently buy life insurance policies on the lives of their key officers. Under normal circumstances, the company pays the premium for the policy and, as beneficiary, receives the proceeds when the officer dies. Of course, the objective is to compensate the company for the untimely loss of a valuable resource in the event the officer dies. However, some types of life insurance policies can be surrendered while the insured is still alive in exchange for a determinable amount of money, called the cash surrender value. In effect, a portion of each premium payment is not used by the insurance company to pay for life insurance coverage, but instead is invested on behalf of the insured company in a fixed-income investment. Accordingly, the cash surrender value increases each year by the portion of premiums invested plus interest on the previous amount invested. From an accounting standpoint, the periodic insurance premium should not be expensed in its entirety. Rather, part of each premium payment, the investment portion, is recorded as an asset.

Illustration: Cash Surrender Value
APPENDIX 12A Several years ago, American Capital acquired a $1 million insurance policy on the life of its chief executive officer, naming American Capital as beneficiary. Annual premiums are $18,000, payable at the beginning of each year. In 2016, the cash surrender value of the policy increased according to the contract from $5,000 to $7,000. The CEO died at the end of 2016. $7,000 − $5,000 Journal Entry Debit Credit Here’s an example of accounting for cash surrender values. The entry to record insurance expense and the increase in the investment is shown above. Part of each insurance premium represents an increase in the cash surrender value, and that amount is recorded in an asset account rather than being expensed. Illustration 12A-1 Insurance expense 16,000 Cash surrender value of life insurance 2,000 Cash (2016 premium) 18,000

Illustration: Cash Surrender Value (Continued)
APPENDIX 12A Several years ago, American Capital acquired a $1 million insurance policy on the life of its chief executive officer, naming American Capital as beneficiary. Annual premiums are $18,000, payable at the beginning of each year. In 2016, the cash surrender value of the policy increased according to the contract from $5,000 to $7,000. The CEO died at the end of 2016. Journal Entry Debit Credit The cash surrender value is considered to be a noncurrent investment and would be reported in the investments and funds section of the balance sheet. If the insured officer dies, the corporation receives the death benefit of the insurance policy, and the cash surrender value ceases to exist because canceling the policy no longer is an option. The corporation recognizes a gain for the amount of the death benefit less the cash surrender value. The entry to record the proceeds at death is shown above. When the death benefit is paid, the cash surrender value becomes null and void. Cash 1,000,000 Cash surrender value of life insurance 7,000 Gain on life insurance settlement 993,000

Concept Check √ RangeCo insured its CFO for $2,000,0000, and the CFO died at a time when the cash surrender value of the insurance policy had grown to $100, The journal entry to record RangeCo’s receipt of cash from the insurance company would include a: a. Debit to Cash for $1,900,000. b. Credit to Surrender value of $100,000. Debit to Insurance investment of $1,900,000. Credit to Cash for $2,000,000. RangeCo’s journal entry would be: Cash 2,000,000 Surrender value ,000 Gain on life insurance settlement 1,900,000

Temporary v. OTT Impairment of Investments
APPENDIX 12B Impairment: The fair value of an investment declines to a level below cost If the impairment is temporary, it is: Recognized in earnings for TS investments Recognized in earnings for investments for which fair value option has been elected Ignored for HTM investments Recorded in OCI for AFS investments But what if the decline is OTT (other than temporary)? We have talked about how different methods account for temporary changes in the fair value of investments. If the fair value of an investment declines to a level below cost, and that decline is not viewed as temporary, companies typically have to recognize an other-than-temporary (OTT) impairment loss in earnings. We don’t need to worry about OTT impairments for trading securities or other investments for which a company has chosen the fair value option, because all changes in the fair values of those investments (whether temporary or OTT) always are recognized in earnings. However, that is not the case for HTM and AFS investments. Declines in fair value typically are ignored for HTM investments and recorded in OCI for AFS investments. Therefore, companies need to evaluate HTM and AFS investments to determine whether an OTT impairment loss has occurred. That evaluation differs between equity and debt investments. OTT Impairment of Investments OTT Impairments of Equity Investments OTT Impairments of Debt Investments

OTT Impairments of Equity Investments
APPENDIX 12B Is the investment impaired? Impairment occurs when fair value has declined to a level below the investment’s cost Investment’s cost equals the investment’s purchase price less previously recognized impairments and other adjustments Is any impairment other-than-temporary (OTT)? Equity impairments are OTT if the investor cannot assert it has the intent and ability to hold the investment until fair value recovers Where is the OTT impairment reported? The investor recognizes the loss in the income statement, just as if the loss had been realized by selling the investment Must reclassify amounts out of OCI that were recorded previously as unrealized gains or losses We use a three-step process to determine whether an OTT impairment loss must be recognized and how that loss is to be measured and recorded. Let’s start by considering equity investments. Recall that OTT impairments don’t apply to trading securities and that equity investments cannot be classified as held-to-maturity. Therefore, when we consider OTT impairments of equity investments, we are looking at available-for-sale investments. Here are the three steps: 1. Is the investment impaired? Impairment occurs when fair value has declined to a level below the investment’s cost (which equals the investment’s purchase price less previously recognized impairments and other adjustments). 2. Is any impairment other-than-temporary (OTT)? The impairment is temporary if the investing company can assert that it has the intent and ability to hold the investment until fair value recovers to a level that once again exceeds cost. That assertion is more difficult to defend if the expected recovery period is relatively long, the amount of impairment is large, or the financial condition of the investor or the issuer of the equity is weak. 3. Where is the OTT impairment reported? A temporary impairment of an equity investment is accounted for as an unrealized loss in OCI, as demonstrated previously for fair value declines in AFS securities. However, if the impairment is viewed as OTT, the investor recognizes the loss in the income statement, just as if the loss had been realized by selling the investment. Also, because the equity investment is classified as AFS, recognizing an OTT impairment likely will involve reclassifying amounts out of OCI that were recorded previously as unrealized gains or losses.

Illustration: Disclosure about OTT Impairments of Equity Investments—Bank of America
APPENDIX 12B This illustration provides a description of the OTT equity impairment process from Bank of America’s annual report. Illustration 12B-2

Illustration: OTT Impairment of an Equity Investment
APPENDIX 12B United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Purchase Investments - July 1, 2016 Purchased $1,000,000 of Bendac common stock. Adjust Investments to Fair Value Dec. 31, Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment. Dec. 31, Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment. Let’s walk through an illustration of accounting for an OTT impairment of equity. At the end of the year 2016, the Bendac stock is valued at $990,000. This gives us a fair value adjustment of $10,000. United views this decline in fair value as temporary, so it does not consider it to be an OTT impairment, and a fair value adjustment of $10,000 is recorded and the unrealized loss is recognized in net unrealized holding gains and losses-OCI. Thus, net unrealized holding gains and losses-OCI is debited for $10,000 and fair value adjustment is credited for the same amount. Illustration 12B-3 Journal Entry – December 31, 2016 Debit Credit Net unrealized holding gains and losses-OCI 10,000 Fair value adjustment 10,000 $1,000,000 − $990,000

OTT Impairment of an Equity Investment (Illustration continued)
APPENDIX 12B United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events during 2016 and 2017 pertain to the investment portfolio. Purchase Investments - July 1, 2016 $1,000,000 − $985,000 Purchased $1,000,000 of Bendac common stock. $1,000,000 − $990,000 Adjust Investments to Fair Value Dec. 31, Valued the Bendac stock at $990,000 and determined that the decline in FV should not be treated as an OTT impairment. Dec. 31, Valued the Bendac stock at $985,000 and determined that the decline in FV should be treated as an OTT impairment. Now let’s assume the Bendac investment declines another $5,000 in fair value, and United concludes that the entire drop in fair value is OTT. The first 2017 journal entry above reduces the Bendac investment to reflect the OTT impairment and recognizes the entire $15,000 in 2017 earnings. United adjusts the Bendac investment directly rather than using a fair value adjustment account because the OTT impairment cannot be recovered. The second 2017 journal entry reclassifies any previously recognized unrealized losses associated with the investment, the same as if the investment had been sold. In 2016 United debited OCI and credited the fair value adjustment for $10,000 to reflect the decline in Bendac’s fair value to $990,000, so the second 2017 journal entry reverses the 2016 entry to remove those amounts. Journal Entry– December 31, 2017 Debit Credit Other-than-temporary impairment loss-I/S 15,000 Investment in Bendac 15,000 Fair value adjustment 10,000 Net unrealized holding gains and losses-OCI 10,000

Concept Check √ Criterion Inc. has an AFS investment in Skinner Co.’s equity for which fair value is $100,000 but cost is $150,000. The investment currently has a fair value adjustment account with a credit balance of $10,000. Criterion concludes that the impairment is OTT. Criterion’s journal entry to record the OTT impairment would include a: a. Debit to OTT impairment loss—OCI of $50,000. b. Debit to OTT impairment loss—N/I of $40,000. Credit to Skinner AFS investment of $50,000. Credit to OTT impairment loss—OCI of $10,000. Criterion’s journal entry would be: OTT impairment loss—I/S 50,000 Skinner AFS investment 50,000 Note: Criterion also would have to reclassify the previously recognized unrealized loss out of OCI: Fair value adjustment 10,000 Net unrealized holding gains and losses—OCI 10,000

OTT Impairments of Debt Investments
APPENDIX 12B Is the investment impaired? Total amount of impairment is split into: Credit losses: occur due to anticipated reductions in cash flows from the debt investment Noncredit losses: it captures other reductions in fair value such as those due to changes in general economic conditions Is any impairment other-than-temporary (OTT)? Debt impairment is viewed as OTT if the investor: Intends to sell the investment Believes it is more likely than not that they will sell the investment prior to fair value recovery Determines that a credit loss exists on the investment Where is the OTT impairment reported? Investment is written down to fair value in the balance sheet Amount included in net income or OCI depends on the reason that: If OTT is because of 2(a) or 2(b), all of the OTT impairment loss is recognized in net income If OTT is because of 2(c), only the credit loss is recognized in net income; noncredit loss in OCI As with equity investments, we use a three-step process to determine whether an impairment loss on debt investments must be recognized and how that loss is to be measured and recorded. Debt investments can be classified either as HTM or AFS. We’ll start with the assumption that the investment is AFS, and then indicate what is different if it is HTM. 1. Is the investment impaired? As with equity, impairment of a debt investment occurs when its fair value has declined to a level below amortized cost. For debt investments, though, it also may be necessary to split the total amount of impairment into credit losses and noncredit losses. Credit losses reflect expected reductions in future cash flows from anticipated defaults on interest or principal payments. We calculate credit losses as the difference between the amortized cost of the debt and the present value of the cash flows expected to be collected, using a discount rate equal to the effective interest rate that existed at the date the investment was acquired. Noncredit losses capture other reductions in fair value such as those due to changes in general economic conditions. 2. Is any impairment other-than-temporary (OTT)? We view a debt impairment as OTT if one of three conditions holds: a. The investor intends to sell the investment, b. The investor believes it is “more likely than not” that the investor will be required to sell the investment prior to recovering the amortized cost of the investment less any current-period credit losses, or c. The investor determines that a credit loss exists on the investment. The rationale for 2a and 2b is that an impairment is OTT if the investor is likely to sell the investment before fair value can recover. The rationale for 2c is that an impairment is OTT if the company believes the cash flows provided by the investment won’t be enough to allow it to recover the amortized cost of the investment over the life of the investment. 3. Where is the OTT impairment reported? If the debt impairment is considered OTT, the investor always writes the investment down to fair value in the balance sheet, but the amount included in net income or other comprehensive income depends on the reason the impairment is considered OTT: a. If the impairment is considered OTT due to reasons 2a or 2b above, the entire impairment loss is included in net income, because it is likely that the company will incur a loss equal to the entire difference between fair value and amortized cost. b. If the impairment is considered OTT due to reason 2c above, only the credit loss component is included in net income, as that amount of amortized cost is unlikely to be recovered. Any noncredit loss component reduces OCI, similar to how we normally account for unrealized gains and losses on AFS investments. Also, if the debt investment is classified as AFS, recognizing an OTT impairment may involve reclassifying amounts out of OCI that were recorded previously as unrealized gains or losses.

Illustration: Disclosure about OTT Impairments of Debt Investments—Bank of America
APPENDIX 12B This illustration provides a description of the OTT debt impairment process from Bank of America’s recent annual report. Illustration 12B-4

Illustration: OTT Impairment of Debt Investment
APPENDIX 12B United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events occurred during 2017 Purchase Investments - July 1, 2016 Purchased $1,000,000 of Bendac bonds, maturing on December 31, 2022. Adjust Investments to Fair Value - December 31, 2017 Valued the Bendac bonds at $950,000. Of the $50,000 impairment, $30,000 is credit loss and $20,000 is noncredit loss. Case 1: United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers. Now let’s consider an example of an OTT debt impairment. When we recognize the impairment, the amortized cost of the investment is reduced by the amount of OTT impairment that is recognized in earnings. United achieves this by crediting a contra asset, discount on bond investment, which United amortizes over the remaining life of the debt the same way it would if it had initially purchased the debt at that discounted amount. The carrying value of the debt becomes $950,000, reduced by the entire amount of the OTT impairment. In Case 1 the entire $50,000 impairment is recognized in net income. That’s because the impairment qualifies as OTT because United either plans to sell the investment or believes it is more likely than not that it will have to sell the investment before fair value recovers. Illustration 12B-5 $1,000,000 − $950,000 Journal Entry– December 31, 2017 Debit Credit OTT impairment loss – I/S 50,000 Discount on bond investment 50,000

OTT Impairment of Debt Investment (Illustration continued)
APPENDIX 12B OTT Impairment of Debt Investment (Illustration continued) United Intergroup, Inc., buys and sells both debt and equity securities of other companies as investments. United’s fiscal year-end is December 31. The following events occurred during 2017 Purchase Investments - July 1, 2016 Purchased $1,000,000 of Bendac bonds, maturing on December 31, 2022. Adjust Investments to Fair Value - December 31, 2017 Valued the Bendac bonds at $950,000. Of the $50,000 impairment, $30,000 is credit loss and $20,000 is noncredit loss. Case 2: United does not intend to sell the investment and does not believe it is more likely than not that it will have to sell the Bendac investment before fair value recovers, but estimates that $30,000 of credit losses have occurred. Case 2 is the same as case 1, except United does not think it will have to sell the investment before fair value recovers. In that case, only the credit loss component has to be recognized in net income. The noncredit loss component of the impairment is recognized in OCI, the same way it would be if it were viewed as an unrealized loss under normal accounting for fair value declines of AFS investments. Illustration 12B-5 Journal Entry– December 31, 2017 Debit Credit OTT impairment loss – I/S 30,000 Discount on bond investment 30,000 OTT impairment loss – OCI 20,000 Fair value adjustment-Noncredit loss 20,000

Concept Check √ AB&C has an AFS investment in Bacon, Inc. debt for which fair value is $200,000 but cost is $500,000. The present value of expected future principal and interest payments is $400,000. AB&C has a credit loss of: a. $100,000. b. $200,000. $300,000. $400,000. AB&C’s credit loss is $500,000 — $400,000 = $100,000 The noncredit loss is $400,000 — $200,000 = ,000 The total OTT impairment is $500,000 — $200,000 = $300,000

Income Statement Presentation of OTT Impairment of Debt Investment (Illustration continued)
APPENDIX 12B Income Statement Presentation, December 31, 2017 Case 1 Case 2 OTT impairment of AFS investments: $50,000 $50,000 Total OTT impairment loss Less: portion recognized in OCI –0– 20,000 Net impairment loss recognized in net income $50,000 $30,000 In both cases all of the OTT impairment is reflected in comprehensive income. The question is how much is reflected in net income as opposed to OCI. To clarify this distinction, GAAP requires that the entire OTT impairment be shown in the income statement, and then the portion attributed to noncredit losses backed out, such that only the credit loss portion reduces net income. That way, financial statement users are aware of the total amount as well as the amount included in net income. Income statement presentation of the two cases would be as shown above.

Illustration: Other-Than-Temporary Impairment of Equity Investments and Debt Investments Compared
APPENDIX 12B We use a three-step process to determine whether an OTT impairment loss must be recognized and how that loss is to be measured and recorded: (1) determine if the investment is impaired, (2) determine whether any impairment is OTT, (3) determine where to report the OTT impairment. The above illustration summarizes those steps. As you can see, the specifics of accounting for OTT impairments depend on whether the investment is in equity or debt. Illustration 12B-1

LO12-8 IFRS U.S. GAAP Accounting for OTT impairments For an HTM investment, the impairment is calculated as the difference between the amortized cost of the asset and the present value of expected future cash flows, estimated at the asset’s original effective rate. For an HTM investment, the impairment is calculated as the difference between the amortized cost of the asset and the present value of expected future cash flows, estimated at the asset’s original effective rate. So, the impairment is essentially equal to the amount that would be considered a credit loss. Allows recoveries of impairments to be recognized in earnings for debt investments, but not for equity investments. Does not allow recoveries of any OTT impairment of equity or debt (other than debt that is classified as a loan). Accounting for OTT impairments. Under IAS No. 39, companies recognize OTT impairments if there exists objective evidence of impairment. Objective evidence must relate to one or more events occurring after initial recognition of the asset that affect the future cash flows that are going to be generated by the asset. Examples of objective evidence include significant financial difficulty of the issuer and default on interest or principal payments. For an equity security, a significant or prolonged decline in fair value below cost is viewed as objective evidence. Calculation of the amount of impairment differs depending on the classification of an investment. For an HTM investment, the impairment is calculated as the difference between the amortized cost of the asset and the present value of expected future cash flows, estimated at the asset’s original effective rate. So, the impairment is essentially equal to the amount that would be considered a credit loss in U.S. GAAP. For an AFS investment (debt or equity), the impairment is calculated as the difference between amortized cost and fair value. Thus, under IAS No. 39, an OTT impairment for a debt investment is likely to be larger if it is classified as AFS than if it is classified as HTM, because it includes the entire decline in fair value if classified as AFS but only the credit loss if classified as HTM. All OTT impairments are recognized in earnings (there is no equivalent to recognizing in OCI any non-credit losses on debt investments). Also, when an OTT impairment is recognized, either the investment account is reduced directly or an allowance account is used. IAS No. 39 allows recoveries of impairments to be recognized in earnings for debt investments, but not for equity investments. This is a difference from U.S. GAAP, which does not allow recoveries of any OTT impairment of equity or debt (other than debt that is classified as a loan).

LO12-8 IFRS U.S. GAAP Impairments Impairment of debt investments is calculated using the expected credit loss (“ECL”) model. Impairment of debt investments is calculated using CECL model. IFRS ECL model calculates the expected credit losses over the remaining life of the investment if there has been a significant increase in credit risk. If the credit risk of a debt investment has not increased, the estimate of credit losses only considers credit losses that result from default events that are possible within the next twelve months. Accrues very little credit loss, because the credit risk of the investment hasn’t changed. U.S. CECL model calculates the expected credit losses over the remaining life of the investment if there has been or has not been a significant increase in credit risk. Because of this, it tends to recognize impairment losses earlier, and in higher amounts, than are recognized under IFRS. Impairments. IFRS No. 9, amended on July 24, 2014, will be required after January 1, 2018, and earlier adoption is permitted. IFRS No. 9 calculates impairment of debt investments using the expected credit loss (“ECL”) model, which is somewhat similar to the CECL model likely to be required soon in U.S. GAAP. Both the U.S. CECL model, and the IFRS ECL model calculate expected credit losses over the remaining life of the investment if there has been a significant increase in credit risk. The U.S. CECL model also does that if there has not been a significant increase in credit risk. In contrast, under the IFRS ECL model, if the credit risk of a debt investment has not increased, the estimate of credit losses only considers credit losses that result from default events that are possible within the next twelve months. For many debt investments, this approach accrues very little credit loss, because the credit risk of the investment hasn’t changed and default within the next twelve months is very unlikely. That means that U.S. GAAP will tend to recognize impairment losses earlier, and in higher amounts, than are recognized under IFRS.

End of Chapter 12

Chapter 12 Investments In this chapter you will learn about various approaches used to account for investments that companies make in the debt and equity.

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Chapter 12 Investments In this chapter you will learn about various approaches used to account for investments that companies make in the debt and equity.

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Presentation on theme: "Chapter 12 Investments In this chapter you will learn about various approaches used to account for investments that companies make in the debt and equity."— Presentation transcript:

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