Chapter 18
Intermediate Accounting II
Otto Chang
Professor of Accounting
Investment
• In debt securities:
– Trading: fair value method
– Available for sale: fair value method
– Held to maturity: cost method
• In equity securities
– Less than 20%: Fair value method
– Between 20% to 50%: equity method
– Greater than 50%: consolidation method
Held-to-Maturity Debt Securities
• At acquisition: recorded at fair value or
present value (face amount adjusted for
discount or premium)
• During the year: use effective interest
method to amortize discount or premium,
adjust investment by the amount amortized.
• Unrealized holding gain or loss is never
recognized
Available-for-Sale Debt
Securities
• At acquisition: recorded at present value
Available-for-sale securities
Cash
xxx
Cash
Available-for-Sale Securities
Interest Revenue
xxx
xxx
xxx
xxx
• Interest received: amortize discount/premium
• At year-end: adjusted to fair value
Unrealized Holding Gain or Loss-Equity xxx
Securities Fair Value Adjustment
xxx
• Unrealizable holding gain or loss is other
comprehensive income/stockholder’s equity
Trading Debt Securities
• At acquisition: recorded at fair value or
present value
• During the year: discount or premium is not
amortized due to the short-term nature
• At year-end, unrealized holding gain and
loss is included in income
Unrealized Holding Gain or Loss-Income
Securities Value Adjustment-Trading
xxx
xxx
Investment in Equity Securities:
Holding of Less Than 20%
• At acquisition: recorded at cost acquired,
classify as trading or available-for-sale
• Dividend received:
Cash
Dividend Revenue
xxx
xxx
• At year-end: adjust to fair value
Unrealized Holding Gain or Loss*
Securities Value Adjustment
xxx
xxx
* Income or Equity depends on type of securities
Equity Method: Holding
Between 20% to 50%
• At acquisition:
Investment in XYZ Stock
Cash
xxx
xxx
• Recording proportionate share of investee’s
income, losses, or extraordinary items
Investment in XYZ Stock
xxx
Revenues from Investment xxx
• Dividend received:
Cash
xxx
Investment in XYZ Stock
xxx
Equity Method: More Details
• When the purchase price of the stock
exceeds the investor’s proportionate share
of investee’s book value of net assets, a
purchase premium was paid for goodwill or
unrecorded assets, annual amortization of
this purchase premium is required:
Revenues from Investment
Investment in XYZ stock
xxx
xxx
Reclassification Adjustment for
Gains Included in Income
• When available-for-sale securities are sold,
Gains and losses are realized based on the
difference between sales proceeds and its
original acquisition cost. To avoid double
counting, an equal amount of the unrealized
holding gain or loss accumulated in the
comprehensive income/stockholder’s equity
is eliminated
Transfer Between Categories
• Transfer between any two categories are
accounted for at fair value.
• From trading (cost $70,000, FV= $85,000)
to available-for-sale or held to maturity:
unrealized gain or loss recognized at
transfer and included in income.
Available-for-Sale Securities 85,000
Unrealized Holding Gain-Income 15,000
Trading Securities
70,000
Transfer Between Categories
• From available-for-sale (cost=$80,000,
FV=$75,000) or held-to-maturity to trading:
unrealized gain or loss recognized at
transfer & included in income
Trading Securities
75,000
Unrealized Holding Loss-Income 5,000
Available-for-sale Securities
80,000
Transfer Between Categories
• From held-to-maturity (cost=$80,000,
FV=$90,000) to available-for-sale:
unrealized holding gain or loss recognized
at transfer and included in other
comprehensive income/stockholder equity.
Securities Fair Value Adjustment 10,000
Available-for-sale Securities
80,000
Unrealized Holding Gain
10,000
Held-to-maturity Securities
80,000
Transfer Between Categories
• From available-for-sale (cost=$100,000;
FV=$104,000) to held-to-maturity (remaining life 10
years): unrealized holding gain or loss recognized at
transfer and included in other comprehensive income.
Securities Fair Value Adjustment
4,000
Held-to-maturity Securities
100,000
Unrealized Holding Gain-Equity
4,000
Available-for-sale Securities
100,000
Annual Amortization:
Unrealized Holding Gain-Equity 400
Securities Fair Value Adjustment
400
Investment in Stock Rights
• At acquisition: base allocation required
Investment in Stock Rights
Investment in Stock
xxx
xxx
• If the rights are sold separately:
Cash
xxx
Investment in Stock Rights
xxx
Gain from sale of Stock Rights
xxx
• If the rights are exercised:
Investment in Stock
Investment in Stock rights
Cash
xxx
xxx
xxx
Investment in Stock Rights
• If stock rights are expired:
Loss on Expiration of Stock Rights
Investment in Stock Rights
xxx
xxx
Investment in Life Insurance with
Cash Surrender Value
• Payment of periodic insurance premium
Insurance Expenses
Cash Surrender Value
Cash
xxx
xxx
xxx
• Upon receipt of death benefit at death:
Cash
xxx
Cash Surrender Value
xxx
Insurance expenses
xxx (unexpired)
Gain on Life Insurance
xxx
Accounting for Derivatives
• Example of derivatives
– Financial forwards of futures
– Options
– Swaps
• Who uses derivatives?
– Producers and consumers
– Speculators and arbitrageours
Why Use Derivatives?
• For speculation and arbitrage profit: taking
advantage of price difference in different
markets
• Hedging against risk in:
– Changes in prices of commodity
– Changes in interest rate
– Changes in foreign exchange rate
Basic Principles
• Derivatives should be recognized in the
financial statements as assets and liabilities
• Derivatives should be reported at fair value.
• Gains and losses from speculation should be
recognized immediately in income
• Gains and losses from hedging are reported
differently depending on the type of hedge
Accounting for a Call OptionSpeculation
• On 1/2/00 when X shares are $100/share,
You paid $400 to purchase a call option
which allows you to buy1,000 X shares at
$100/share on 4/30/00.
Option premium = intrinsic value + time value
$400
= $0
+ $400
• 1/2/00 Journal entry:
Call Option
Cash
400
400
Call Option Example--continued
• 3/31/00 X shares are traded at $120/share
Call Option 20,000
Unrealized Holding Gain/Loss-Income 20,000
• 3/31/00 Time value of the option is $100
Unrealized Holding Gain/Loss-Income 300
Call option ($400 - $100)
300
• 4/1/00 the call option is settled for $20,000
Cash
20,000
Loss on Settlement of Call Option 100
Call Option
20,100
Fair Value Hedge: Interest Rate
Swap Example
• 1/2/00 you issued $1,000,000 of 5-year, 8%
fixed rate bonds. You are concerned that
interest rate might goes down and you are
still locked into the 8% rate. So on the same
date, you enter into a swap contract:
– You will receive fixed payment at 8% based on
the $1,000,000 on 12/31 of next 5 years
– You will pay variable amount based on the
effective variable rate on 12/31 of next 5 years
Journal Entries-Interest Rate
Swap
• On 1/2/01 when the contract is signed
No entry required
• On 12/31/01 the variable rate is 6.8%
Interest Expense
80,000
Cash (8% x $1000,000) 80,000
To record paying cash interest to bondholders
Cash 12,000 (80,000 - 68,000)
Interest Expense 12,000
To record settlement of swap contract
Interest Rate Swap Examplecontinued
• In addition, the value of the swap contract
has increased by $40,000 on 12/31/01
Swap Contract
40,000
Unrealized Holding Gain/Loss-Income $40,000
• Because interest rate is going down, the fair
value of bond payable increases by $40,000
Unrealized Holding Gain/Loss-Income 40,000
Bonds Payable
40,000
Presentation on Financial
Statement
• Balance sheet on 12/31/02
Current Assets:
Long-term Liabilities:
Swap Contract $40,000 B/P
$1,040,000
• Income Statement for the year of 2001
Interest Expense
$68,000
Unrealized Holding Gain-Swap Contract $40,000
Unrealized Holding Loss-B/P
($40,000)
Net Gain or loss
$0
Cash Flow Hedging from
Forecasted Transactions
• On 9/1/00, you expect to buy 1000 tons of
materials in 1/1/01. To protect possible
price increase, you enter a future contract to
give you the right and obligation to
purchase the material at $1,550/ton, the
market price of the materials on that day
• On 9/1/00 when the contract is signed:
No entry required (the value of the contract is $0)
Cash Flow Hedge Example-continued
• On 12/31/00, price increase to $1,575/ton
Future Contract (1,575-1,550)x1,000 25,000
Unrealized Holding Gain/Loss-Equity 25,000
• On 1/1/01 purchased materials at $1,575/ton
Material Inventory 1,575,000
Cash ($1,575x1,000) 1,575,000
To record cash purchase of the materials
Cash
25,000
Future Contract 25,000
To record settlement of the future contract
Cash Flow Hedge Example -continued
• On 7/1/01, when the finished goods made of
the materials were sold for $2,000,000 with
total cost of goods sold at $1,700,000.
Cash
2,000,000
Sales Revenue
2,000,000
Cost of Goods Sold
1,700,000
Finished Good Inventory
1,700,000
Unrealized Holding Gain/Loss-Equity 25,000
Cost of Goods Sold
25,000
Qualifying Hedge Criteria
• The special accounting for Hedging can
only be applied when:
– Designation and documentation of risk
management formally done
– Effectiveness of the hedging relationship is
clear evident
– There must be an effect on reported earnings of
changes in fair value or cash flows
Disclosure Requirements
• The fair value and carrying value of
financial instrument
• The objective of holding the
instrument(speculation or hedging), the
strategy for achieving risk management
• Separate disclosure (no aggregation)
• Market risk of derivatives