Chapter 15
Investments
Intermediate Accounting 11th edition
Nikolai Bazley Jones
An electronic presentation
By Norman Sunderman
and Kenneth Buchanan
Angelo State University
COPYRIGHT © 2010 South-Western/Cengage Learning
2
Objectives
1. Explain the classification and valuation of
investments.
2. Account for investments in debt and equity
trading securities.
3. Account for investments in available-for-sale
debt and equity securities.
4. Account for investments in held-to-maturity
debt securities, including amortization of
bond premiums and discounts.
3
Objectives
5. Understand transfers and impairments.
6. Understand disclosures of investments.
7. Explain the conceptual issues regarding
investments in marketable securities.
8. Account for investments using the equity
method.
9. Describe additional issues for investments.
10. Account for derivatives of financial
instruments (Appendix).
4
Why Companies Invest in Other Companies
1. Additional revenues from idle cash
2. Control over another company
3. Beneficial relationship with another company
5
Classification of Investments
1. Trading securities
2. Available-for-sale
securities
3. Held-to-maturity debt
securities
6
Trading Securities
Trading securities are investments in debt
and equity securities that are purchased and
held principally for the purpose of selling them
in the near term.
7
Trading Securities
These securities are reported at their fair
market value on the ending balance sheet, and
unrealized holding gains and losses are
included in net income of the current period.
8
Available-for-Sale Securities
Investments in available-forsale securities are (a) debt
securities that are not classified
as being held to maturity, and…
9
Available-for-Sale Securities
…(b) debt and equity securities that
are not classified as trading
securities.
10
Available-for-Sale Securities
Investments in available-for-sale
securities are reported at their fair
value on the ending balance sheet date,
and the unrealized holding gains or
losses are reported as a component of
other comprehensive income.
11
Available-for-Sale Securities
Therefore, the unrealized holding gains
and losses for available-for-sale
securities are not included in net
income.
12
Held-to-Maturity Debt Securities
Investments in held-to-maturity
debt securities are debt securities
for which the company has the
“positive intent and ability to hold
those securities to maturity.”
13
Held-to-Maturity Debt Securities
Investments in held-to-maturity
debt securities are reported at their
amortized cost on the balance
sheet…not their fair value.
14
Accounting for Investments
Investment Categories
Investment in Equity Securities
1. No significant influence
(less than 20% ownership)
a. Trading
b. Available for sale
2. Significant influence
(20 to 50% ownership)
3. Control
(more than 50% ownership)
Accounting
Method
Fair value
Fair value
Reporting of
Unrealized Holding
Gains and Losses
Equity method
Net income
Other comprehensive
income
Not recognized
Consolidation
Not recognized
15
Accounting for Investments
Investment Categories
Accounting
Method
Investment in Debt Securities
1. Trading
2. Available for sale
Fair value
Fair value
3. Held to maturity
Amortized cost
Reporting of
Unrealized Holding
Gains and Losses
Net income
Other comprehensive
income
Not recognized
16
Investments in Debt and Equity Trading Securities
1. The investment is initially recorded at cost.
2. It is subsequently reported at fair value on the
ending balance sheet(s).
3. Unrealized holding gains and losses are
included in net income of the current period.
4. Interest and dividend revenue, as well as
realized gains and losses on sales, are included
in net income of the current period.
17
Investments in Available-for-Sale Debt and Equity Securities
1. The investment is initially recorded at cost.
2. It is subsequently reported at fair value on the ending
balance sheet(s).
3. Unrealized holding gains and losses are reported as a
component of other comprehensive income.
4. The cumulative unrealized holding gains and losses are
reported in the accumulated other comprehensive
income section of stockholders’ equity
5. Interest and dividend revenue, as well as realized gains
and losses on sales, are included in net income for the
current period.
18
Investments in Available-for-Sale Debt and Equity Securities
Kent Company purchases the following securities
on May 1, 2009 as an investment in available-forsale securities:
• 100 shares of A Company common stock at $50
per share
• 300 shares of B Company common stock at $80
per share
• 200 shares of C Company preferred stock at
$120 per share
• $15,000 D Company 10% bonds
$ 5,000
24,000
24,000
15,000
Total $68,000
19
Investments in Available-for-Sale Debt and Equity Securities
Investment in Available-for-Sale Securities
Interest Revenue
Cash
68,000
625
68,625
Accrued interest on the D Company bonds from
November 30, 2008 to May 31, 2009:
May 31, 2009
Cash
Interest Revenue
750
750
$15,000 × 0.10 × 6/12
20
Investments in Available-for-Sale Debt and Equity Securities
December 31, 2009
Interest Receivable
Interest Revenue
125
125
During 2009 Kent Company receives dividends
of× 1/12
$15,000 × 0.10
$3,000 from its investment in the stock of A, B,
and C Companies.
Cash
Dividend Revenue
3,000
3,000
21
Investments in Available-for-Sale Debt and Equity Securities
The cost and fair value of the available-for-sale
securities held by the Kent Company is as follows:
Security
100 shares of A Company common stock
300 shares of B Company common stock
200 shares of C Company preferred stock
$15,000 face value of D Company 10% bonds
Totals
Cost
$ 5,000
24,000
24,000
15,000
$68,000
Cumulative
12/31/09 Change
Fair
in Fair
Value
Value
$ 6,000
23,500
26,000
15,500
$71,000
$ 1,000
(500)
2,000
500
$3,000
22
Investments in Available-for-Sale Debt and Equity Securities
The cost and fair value of the available-for-sale
securities held by the Kent Company is as follows:
Allowance for Change in Value of Investment
Unrealized Increase/Decrease in Value of Cost
Security
Available-for-Sale Securities
100 shares of A Company common stock
$ 5,000
300 shares of B Company common stock
24,000
200 shares of C Company preferred stock
24,000
$15,000 face value of D Company 10% bonds 15,000
Totals
$68,000
Cumulative
12/31/09 Change
Fair
in Fair
3,000
Value
Value
3,000
$ 6,000 $ 1,000
23,500
(500)
26,000
2,000
15,500
500
$71,000
$3,000
23
Investments in Available-for-Sale Debt and Equity Securities
The same securities are held on December 31,
2010.
Security
100 shares of A Company common stock
300 shares of B Company common stock
200 shares of C Company preferred stock
$15,000 face value of D Company 10% bonds
Totals
Cost
$ 5,000
24,000
24,000
15,000
$68,000
Cumulative
12/31/10 Change
Fair
in Fair
Value
Value
$ 6,100
22,700
23,200
14,000
$66,000
$ 1,100
(1,300)
(800)
(1,000)
$(2,000)
24
Allowance for Change in Value of Investment
12/31/09
3,000
5,000 adjusting entry
2,000
12/31/10
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities
Allowance for Change in Value of Investment
5,000
5,000
25
Sale of Available-for-Sale Securities
On March 1, 2011 the Kent Company sold the 100
shares of A Company stock for $6,000. The stock
had a fair value on December 31, 2010 of $6,100.
Cash
Investment in Available-for-Sale Securities
Gain on Sale of Available-for-Sale Securities
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities
Allowance for Change in Value of Investment
6,000
5,000
1,000
1,100
1,100
26
Sale of Available-for-Sale Securities
Security
300 shares of B Company common stock
200 shares of C Company preferred stock
$15,000 face value of D Company 10% bonds
Totals
Cost
$24,000
24,000
15,000
$63,000
Cumulative
12/31/11 Change
Fair
in Fair
Value
Value
$23,500
24,200
14,700
$62,300
$(500)
100
(300)
$(700)
27
Allowance for Change in Value of Investment
2,400 adjusting entry
2,000
1,100
12/31/10
3/1/11
700
12/31/11
Allowance for Change in Value of Investment
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities
2,400
2,400
28
Investments in Held-to-Maturity Debt Securities
1. The investment is initially recorded at cost.
2. It is subsequently reported at amortized cost
on the ending balance sheet(s).
3. Unrealized holding gains and losses are not
recorded.
4. Interest revenue and realized gains and losses
on sales (if any) are all included in net income.
29
Investments in Held-to-Maturity Debt Securities
A company purchases 9% bonds with a face value
of $100,000 on August 1, 2009, at 99 plus accrued
$100,000 × 0.99
interest, which is payable semiannually.
Investment in Held-to-Maturity Debt Securities
Interest Revenue
Cash
99,000
1,500
100,500
$100,000 × 0.09 × 2/12
30
Accounting for Bond Premiums
On January 1, 2009, the Colburn Company invests
in bonds that will be held to maturity, with a face
value of $100,000 and paying $102,458.71. The
stated interest rate is 13% and the effective
interest rate is 12%.
Investment in Held-to-Maturity Debt Securities 102,458.71
Cash
102,458.71
31
Accounting for Bond Premiums
32
Accounting for Bond Premiums
The Colburn Company records the first interest
receipt on June 30, 2009, using the effective interest
method.
Cash
Investment in Held-to-Maturity Debt
Securities
Interest Revenue
6,500.00
352.48
$100,000 × 0.13 × 1/26,147.52
$102,458.71 × 0.12 × 1/2
33
Accounting for Bond Discounts
On January 1, 2009, the Colburn Company invests
in bonds that will be held to maturity, with a face
value of $100,000 and paying $97,616.71. The
stated interest rate is 13% and the effective
interest rate is 14%.
Investment in Held-to-Maturity Debt Securities 97,616.71
Cash
97,616.71
34
Accounting for Bond Discounts
35
Accounting for Bond Discounts
The Colburn Company records the first interest
receipt on June 30, 2009, using the effective
interest method.
Cash
Investment in Held-to-Maturity Debt Securities
Interest Revenue
6,500.00
333.17
6,833.17
$97,616.71 × 0.14 × 1/2
Amortization of Bonds Acquired Between Interest Dates
The Tallen Company purchased 13% bonds with a
face value of $200,000 for $204,575.07 on April 3,
2009. Interest on these bonds is payable June 30
and December 31, and the bonds mature on
December 31, 2011.
Investment in Held-to-Maturity Debt Securities 204,575.07
Interest Revenue
6,500.00
Cash
211,075.07
$200,000 × 0.13 × 3/12
Continued
Amortization of Bonds Acquired Between Interest Dates
June 30, 2009
Cash
Interest Revenue
Investment in Held-to-Maturity Debt
Securities
December 31, 2009
Cash
Interest Revenue
Investment in Held-to-Maturity Debt
Securities
($204,575.07 × 0.12 × 1/4) + $6,500
13,000.00
12,637.25
362.75
($204,575.07 – $362.75) × 0.12 × 1/2
13,000.00
$13,000 – $12,637.25
12,652.74
747.26
$13,000 – $12,652.74
38
Sale of Investment in Bonds Before Maturity
The $100,000 of 13% bonds purchased by the
Colburn Company for $97,616.71 were sold on
March 31, 2010 for $102,000 plus accrued interest.
Investment in Held-to-Maturity Debt Securities
Interest Revenue
Cash
Interest Revenue
Investment in Held-to-Maturity Debt
Securities
Gain on Sale of Debt Securities
198.61
$100,000 ×198.61
0.13 × 1/4
105,250.00
($2,383.29 ÷ 6) × 1/2
3,250.00
$102,000 + $3,250 98,609.76
3,390.24
$98,411.15 + $198.61
39
Accounting for Investments
Classify
According to
Management
Intent as:
Recognize
Interest and
Dividend
Revenue in:
Recognize
Realized
Gain or
Loss in:
Compute
Realized
Gain or
Loss as:
Trading
Net Income
Net Income
Selling Price minus
Fair Value at Most
Recent Balance
Sheet Date
Available-for-Sale
Net Income
Net Income
Selling price minus
(Amortized) Cost
Held-to-Maturity
Net Income
Net Income
Selling Price minus
(Amortized) Cost
40
Transfers of Investments Between Categories
1.
2.
3.
4.
A transfer from the trading category
A transfer into the trading category
A transfer into the available-for-sale category
A transfer of a debt security into the held-tomaturity category from the available-for-sale
category
41
Transfer into Trading Category from Available-for-Sale Category
In 2010, the Kent Company transfers the
Company A securities into the trading category
when their fair value is $6,300.
Investment in Trading Securities
Investment in Available-for-Sale Securities
Gain on Transfer of Securities
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities
Allowance for Change in Value of Investment
6,300
5,000
1,300
1,100
1,100
42
Transfer into Available-for-Sale Category from Held-to-Maturity Category
The Devon Company has $10,000 in bonds that
were purchased at par. When the fair value is
$9,500, Devon transfers them into the availablefor-sale category.
Investment in Available-for-Sale Securities
10,000
Investment in Held-to-Maturity Debt Securities
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities
Allowance for Change in Value of Investment
10,000
500
500
43
Transfer into Held-to-Maturity Category from Available-for-Sale Category
The Devon Company classifies its bond investment
as available for sale with a previous fair value of
$9,700, and transfers them into the held-tomaturity category when the current market value
of the debt securities is $9,500.
Investment in Held-to-Maturity Debt Securities
Unrealized Increase/Decrease from Transfer of
Securities
Investment in Available-for-Sale Securities
Continued
9,500
500
10,000
44
Transfer into Held-to-Maturity Category from Available-for-Sale Category
An entry is needed to eliminate the previous $300
($9,700 – $10,000) amounts in the Allowance and
Unrealized Increase/Decrease accounts.
Allowance for Change in Value of Investment
Unrealized Increase/Decrease in Value of
Available-for-Sale Securities
300
300
45
Impairments
Impairments may be an “other than
temporary” decline below the amortized
cost of an investment in a debt security
classified as available for sale or held to
maturity.
46
Impairments
1. Determine Whether the Investment is
Impaired. An investment is impaired when its
fair value (selling price) is less than its cost.
2. Evaluate Whether the Impairment is Other
Than Temporary. The company must evaluate
whether it will be able to recover the cost of the
investment.
3. If the Impairment is Other Than Temporary,
the Company Recognizes a Loss Equal to the
Difference Between the Cost of the Investment
and Its Fair Value.
47
Impairments
The Tracy Company has a bond investment
categorized as held to maturity, which has an
unamortized carrying value of $21,500 and a fair
value of $6,500. The investment is considered to be
“impaired.”
Realized Loss on Decline in Value
15,000
Investment in Held-to-Maturity Debt Securities
15,000
48
Disclosures
1. Trading Securities. A company must disclose the
change in the net unrealized holding gain or loss that is
included in each income statement.
2. Available-for-Sale Securities. For each balance sheet
date, a company must disclose the aggregate fair value,
gross unrealized holding gains and gross unrealized
holding losses, and (amortized) cost by major security
types.
3. Held-to-Maturity Debt Securities. For each balance
sheet date, a company must disclose the aggregate fair
value, gross unrealized holding gains, gross unrealized
holding losses, and amortized cost by major security
types.
49
Financial Statement Classification
Current Assets
Temporary investment in available-for-sale securities (at cost) $29,000
Plus: Allowance for change in value of investment
500
Temporary investment in available-for-sale securities (at fair
value)
$29,500
Noncurrent Assets
Investment in available-for-sale securities (at cost)
Plus: Allowance for change in value of investment
Investment in available-for-sale securities (at fair value)
$39,000
2,500
$41,500
50
A Conceptual Evaluation
1. Fair value is required in the balance sheet for
trading securities and available-for-sale
securities, but amortized cost is required for
held-to-maturity securities.
2. Fair value is not required for certain liabilities.
3. Unrealized holding gains and losses are
reported in net income for trading securities
but in other comprehensive income for
available-for-sale securities.
4. The classification of securities is based on
management intent.
51
IFRS vs. U.S. GAAP
 IFRS also use the trading, available-for-sale,
and held-to-maturity categories.
 The valuation methods are the same for each
category as under U.S. GAAP.
 IFRS also apply these categories to all financial
instruments, such as loans and receivables.
 IFRS allow for the reversal of impairment
losses related to held-to-maturity securities and
available-for-sale securities.
52
Equity Method
When an investor
corporation owns a
significantly large
percentage of common
stock, it is able to exert
significant influence over the
operating and financial
policies of the investee
corporation. The equity
method is used to account
for this investment.
53
Equity Method
 Acknowledges the existence of a material
economic relationship between the investor and
the investee
 Is based upon the requirements of accrual
accounting
 Supplies more relevant information for
decision makers who rely on financial
statements
54
Equity Method
In the absence of evidence to
the contrary, an investment of
20% or more in the
outstanding common stock of
the investee leads to the
presumption of significant
influence.
55
Equity Method
According to GAAP, what are
the facts and circumstances
that indicate that investors
with 20% or more in the
investee’s stock should not use
the equity method?
56
Equity Method Not Used
 Opposition by the investee which challenges the
investor’s ability to exercise significant influence
through litigation or complaints to governmental
regulatory authorities.
 The investor and investee sign an agreement that the
investor surrenders significant rights as a shareholder.
 Majority ownership of the investee is concentrated
among a small group of shareholders who operate the
investee without regard to views of the investor
 Inability to gather financial information not available
to other shareholders
 Failure to obtain representation on the investee’s
board of directors
57
Equity Method
Cliborn Company purchases 4,200 shares of the S
Company’s outstanding stock (25%) on January 1,
2010 for $125,000 (significant influence).
Investment in Stock: S Company
Cash
125,000
125,000
S Company pays a $20,000 dividend on August 27,
2010.
Cash
Investment in Stock: S Company
5,000
5,000
58
Equity Method
S Company reported net income for 2010 of
$81,000, consisting of ordinary income of $73,000
25% of $73,000
and an extraordinary gain of $8,000.
Investment in Stock: S Company
20,250
Investment Income: Ordinary
Investment Income: Extraordinary
18,250
2,000
25% of $84,000
25% of $8,000
59
Equity Method
Balance Sheet
Book Value
Fair Value
Depreciable assets (remaining life, 10 years)
Other nondepreciable assets (e.g., land)
Total
$400,000
190,000
$590,000
$450,000
246,000
$696,000
Liabilities
Common Stock
Retained earnings
Total
$200,000
$220,000
250,000
= $590,000 – $200,000
140,000
$590,000
Investment book value
difference
×
% of investment
50,000 × 25% = 12,500
60
Equity Method
When acquired by S Company, the investee’s
depreciable assets had a fair value that exceeded
book value by $50,000 (10-year life). Cliborn’s
share of the depreciable asset value is $12,500
(25%). Additional depreciation is needed on
December 31.
Investment Income: Ordinary
Investment in Stock: S Company
1,250
1,250
Note that this entry results in a deduction from
$12,500 ÷ 10
ordinary investment income.
61
Financial Statement Disclosures—Carrying Value
Acquisition price January 1, 2010
Add: Share of 2010 reported ordinary income
Share of 2010 reported extraordinary income
Less: Dividends received August 27, 2010
Depreciation on excess fair value of acquired assets
Carrying value
$125,000
18,250
2,000
$145,250
(5,000)
(1,250)
$139,000
62
Financial Statement Disclosures—Equity Income
Share of 2010 ordinary income
Less: Depreciation on excess fair value of acquired assets
Ordinary investment income
Plus: Share of investee extraordinary income
Net investment income
$ 18,250
(1,250)
$ 17,000
(2,000)
$ 19,000
63
Change to Equity Method
 When an investor currently using the fair value
method acquires enough additional common
shares during a year to exercise significant
influence over the investee, the investor is required
to adopt the equity method of accounting.
 When the equity method is adopted, the investor
restates its investment in the investee by debiting
the Investment account and crediting Retained
Earnings for its previous percentage of investee
income (less dividends) for the period from the
original date of acquisition to the date that
significant influence was obtained.
 This is a retrospective restatement (adjustment).
64
Change to Equity Method
 The company also eliminates any amounts included in
the allowance and unrealized increase/decrease
amounts that it used to record these shares at fair
value.
 Thereafter, the equity method is applied in the usual
manner based on the current percentage of ownership.
65
Change to Equity Method
Example
Assume that on January 2, 2009, Short Company
purchased as its only investment 15% of the outstanding
common stock of J Corporation for $150,000 (when the
book value of net assets was $1,000,000). At the end of
2009, the J Corporation reported net income of $300,000
and paid dividends of $60,000; at this time, the market
value of the shares was $186,000 so the company wrote up
the carrying value of the investment (using an allowance
account) to fair value. On January 2, 2020, to exert
significant influence on J Corporation, Short purchased
an additional 25% of the outstanding common stock of the
J Corporation for $310,000.
66
Change to Equity Method
x 15% =
x 15% =
x 15% =
67
IFRS vs. U.S. GAAP
The application of the equity method is generally the same
under IFRS and U. S. GAAP. One major terminology
difference is that IFRS use the term “associate” to refer to
what would be called an “equity method investee” under
U.S. GAAP. In addition, IFRS do not address whether an
investor’s interest which is represented by something other
than an equity instrument but that is similar in substance
to equity instruments (e.g., in-substance common stock)
gives rise to significant influence over the investee. U.S.
GAAP contains more detailed guidance on such nonequity
interests. U.S. GAAP also requires more detailed
disclosures than required under IFRS.
68
Stock Dividends
Smith Corporation purchased 2,000 shares of Kell
Company common stock for $30 per share. Two
months later Kell issued a 50% stock dividend.
Memo: Received 1,000 shares of Kell Company
common stock as a stock dividend. The cost of the
shares is now $20 per share, computed as follows:
$60,000 ÷ 3,000 (2,000 + 1,000) shares.
69
Stock Dividends
Subsequently, Smith Corporation sold 500 of the
shares for $25 per share, and the fair value at the
most recent balance sheet date was $23 per share.
Cash (500 × $25)
Investment in Available-for-Sale Securities
(500 × $20)
Gain on Sale of Investment
Unrealized Increase/Decrease in Value of
Available-for Sale Securities [500 × ($23 – $20)]
Allowance for Change in Value of Investment
12,500
10,000
2,500
1,500
1,500
70
Cash Surrender Value of Life Insurance
Mele Corporation pays an annual insurance
premium of $5,500 at the beginning of the year to
cover the lives of its officers.
Prepaid Insurance
Cash
5,500
5,500
Continued
71
Cash Surrender Value of Life Insurance
According to the terms of the insurance contract,
the cash surrender value of the policies increases
from $7,200 to $8,300 during the year.
Insurance Expense
4,400
Cash Surrender Value of Life Insurance 1,100
Prepaid Insurance
$8,300 – $7,200
5,500
72
Appendix: Derivatives
 Derivatives are financial instruments are relatively new
and are becoming increasingly common and it is
important for financial statements to show the effects
of that risk management.
 Companies use derivates to reduce the risk of adverse
changes in interest rates, commodity prices, and
foreign exchange rates.
73
Appendix: Derivatives
A derivative financial instrument (or simply derivative)
derives its value from an underlying asset or index. Thus,
derivatives include futures, forward, swap, and option
contract. Derivative contracts can be very complex, and
they involve the following concepts:
 A derivative’s cash flow or fair value must fluctuate
and vary based on the changes in one or more
underlying variables.
 The contract must be based on one or more notional
amounts or payment provisions or both, even though
title to that amount never changes. The underlying
and notional amounts determine the amount of the
settlement.
74
Appendix: Derivatives
A derivative financial instrument (or simply derivative)
derives its value from an underlying asset or index. Thus,
derivatives include futures, forward, swap, and option
contract. Derivative contracts can be very complex, and
they involve the following concepts:
 Many contracts require no initial net investment.
 The contract can be readily settled by a net cash
payment.
75
Appendix: Derivatives
A hedge is a means of protecting against a financial loss.
For a derivative to be considered a hedge, it must be
“highly effective” in offsetting risk exposures because of
changes in fair values or cash flows of the hedge. The
three types of hedges are:
 Fair value hedges
 Cash flow hedges
 Hedges of foreign currency exposures or net
investments in foreign operations
76
Appendix: Derivatives
An interest-rate swap is an agreement in which two
companies agree to exchange the interest payments on
debt over a specified period. The interest payments are
based on a principal amount that often is referred to as a
notional (i.e., imaginary) amount because the swap does
not involve an actual exchange of principal at either
inception or maturity.
77
Appendix: Hedges
 A fair value hedge protects against the risk
from changes in value caused by fixed terms,
rates, or prices.
– For example, a company with debt that has a fixed
interest rate that enters into an interest rate swap
to pay a variable rate of interest and receive a
fixed rate of interest.
– This protects the company against paying more
interest than necessary if interest rates decline.
– Gains or losses on the market value of these hedges
flow through net income.
78
Appendix: Fair Value Hedge
Suppose that Laki Company has had a $1 million, 6%
bank loan (the financial instrument) from MidAmerica
Bank outstanding for several years. On January 1, 2010,
when the loan has five years remaining, Laki contracts
with Jordan Investment Bank (a swaps dealer) for a fiveyear interest-rate swap (the derivative) with a $1 million
notional amount. Laki agrees to receive from Jordan a
fixed interest rate of 6% and to pay Jordan an interest
rate each year that is variable. The variable rate is the
LIBOR (London Interank Offer Rate) interest rate at the
beginning of each year.
79
Appendix: Fair Value Hedge
80
Appendix: Fair Value Hedge
December 31, 2010
Interest paid on original loan to Mid-America
Interest Expense
Cash
60,000
60,000
Interest-rate swap payment received from Jordan
Cash
Interest Expense
7,000
7,000
81
Appendix: Fair Value Hedge
The fair value method uses market values to recognize
the value of derivatives if they are available, such as for
future contracts traded on exchanges.
 The fixed market rate of interest at the end of the year
for the remaining life of the loan or derivative (7% for
a four-year loan or derivative at December 31, 2010,
and we assume it changes to 5.5% for a three-year
loan or derivative at December 31, 2011)
 The difference in the fixed interest rates at the end of
2010 is 1% (6% fixed rate – 7% four-year market
rate.
 Present value of derivative = $10,000 × 3.387211
(n = 4, i = 0.07) = $33,872
82
Appendix: Fair Value Hedge
December 31, 2010
Loss due to market rate greater than fixed rate
Loss in Value of Derivative
Liability from Interest Rate Swap
33,872
33,872
Gain results from the decrease in the present value of
the debt due to increase in the market rate
Notes Payable
Gain in Value of Debt
33,872
33,872
83
Appendix: Fair Value Hedge
December 31, 2011
Interest paid on original loan to Mid-America
Interest Expense
Cash
60,000
60,000
Interest-rate swap payment to Jordan
Interest Expense
Cash
8,000
8,000
84
Appendix: Fair Value Hedge
Laki again determines the gain or loss for 2011 on the
derivative by computing the net present value of the
future cash flows over the remaining life of the derivative.
 The fixed market rate of interest at the end of the year
for the remaining life of the loan or derivative
changes to 5.5% for a three-year loan or derivative at
December 31, 2011.
 The difference in the fixed interest rates at the end of
2011 is 0.5% (6% fixed rate – 5.5% three-year market
rate).
 Present value of derivative = $5,000 × 2.697933
(n = 3, i = 0.55) = $13,940
85
Appendix: Fair Value Hedge
December 31, 2011
A swap derivative asset and gain exist because the current
5.5% market rate is less than the 6% fixed rate Laki receives
on the derivative. So Laki has moved from a $33,782 liability
at the end of 2010 to a $13,490 asset position at the end of
2011, and has a $47,362 ($33,872 + $13,490) gain.
Gain due to market rate less than fixed rate
Liability from Interest Rate Swap
Asset from Interest Rate Swap
Gain in Value of Derivative
33,872
13,490
47,362
86
Appendix: Fair Value Hedge
December 31, 2011
Loss results from the increase in the present value of
the debt due to decrease in the market rate
Loss in Value of Debt
Note Payable
47,362
47,362
87
Appendix: Hedges
 A cash flow hedge protects against the risk
caused by variable prices, costs, rates, or terms
that cause future cash flows to be uncertain.
– For example, a company with variable rate debt
that enters into an interest rate swap to pay a fixed
rate of interest and receive a variable rate.
– This protects the company against paying more
interest than necessary if interest rates increase.
– Gains or losses of cash flow hedges flow through
other comprehensive income.
88
Appendix: Cash Flow Hedge
Assume that Laki Company has had a $1 million, 5.3%
variable rate bank loan that is based on the LIBOR rate
(the financial instrument) from MidAmerica Bank
outstanding for several years. On January 1, 2010, when
the loan has five years remaining, Laki contracts with
Jordan Investment Bank (a swaps dealer) for a five-year
interest-rate swap (the derivative) with a $1 million
notional amount. Laki agrees to receive from Jordan a
variable interest rate of 5.3% (for 2010) and to pay
Jordan a fixed interest rate each year of 6%.
89
Appendix: Fair Value Hedge
90
Chapter 15
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