Accounting Ch 15

Available-for-sale debt securities

A company reports available-for-sale securities at fair value and includes unrealized gains or losses in other comprehensive income. This reduces any volatility in earnings that could occur due to dramatic changes in the securities' fair value. Because a company holds the securities with the intent to have them available for sale, the earnings volatility would not reflect the way it manages its business nor the impact of economic events on performance. Consequently, a company defers unrealized gains or losses by including them in accumulated other comprehensive income on the balance sheet. When the company sells the securities, it reports any realized gains or losses in net income. Similar to trading securities, the company debits or credits a fair value adjustment account for the difference between the asset's fair value and its amortized cost. In addition, the company amortizes any discount or premium using the effective interest rate method.

Subsequent valuation of held-to-maturity debt securities

After purchase, companies report held-to-maturity (HTM) debt security investments at amortized cost. Amortized cost is original cost less the unamortized amount of the premium or discount. Any discount or premium is amortized to income after acquisition. Amortized cost is a more relevant value than fair value for securities held until maturity. Companies usually combine any discount or premium with the debt's face value. Using separate premium and discount accounts for investments is acceptable, but it is not typically found in practice. Fair values are not relevant if management does not intend to sell the debt investment before maturity. In accounting for the debt investment, companies usually combine any discount or premium with the debt's face value. The debtor uses a separate premium or discount account when accounting; however, the investor typically combines these accounts into a single investment account.

The process for determining a held-to-market debt security's purchase price is identical to determining the initial price of a bond.

The bond's purchase price is the sum of the present value of the face or par value and the present value of the interest payments. When the purchase price is less than the face value, the company purchases the bonds at a discount. When the purchase price is greater than face value, the company purchases the bonds at a premium.

The portfolio classification determines:

The valuation of the security on the balance sheet. If and where changes in fair value are reported.

The fair value option for reporting investments

Under the fair value option, companies can elect to value most types of financial assets and obligations at fair value. The fair value option improves financial reporting by enabling entities to offset volatility in reported earnings. Consider a company that has an asset and a liability whose fair values are related to one another. If the liability is reported at fair value but the asset is not, then the company will report an earnings stream that is more volatile than if both the asset and liability (whose fair values are negatively correlated) are reported at fair value. Thus, in this case, the fair value option allows management to report both the asset and liability at fair value. A company can choose the fair value option for some assets without choosing it for all assets. Typically, the company must elect the fair value option at the time it acquires the asset. After a company elects the fair value option, it is typically irrevocable. When electing the fair value option at initial recognition, the company reports the asset on the balance sheet at fair value and reports all unrealized gains and losses in net income. The company adjusts the asset account by making an entry to a fair value adjustment account and then uses this account to increase or decrease the investment account on the balance sheet.

For example, if Farnon Company issued 1,000 shares of its $2 par value common stock for $10 per share, it would record...

$2,000 in the common stock account at par and record the excess over par ($8,000) as additional paid-in capital.

Items affecting retained earnings include:

- Net income (loss). - Dividends. - The sale of treasury stock below cost. - Prior-period adjustments.

The primary elements of Other Comprehensive Income (OCI) are:

- Unrealized gains and losses from the available-for-sale portfolio of investment securities and derivatives classified as cash flow hedges. - Foreign currency translation adjustments. - Unrecognized pension costs and benefits.

Accounting for cash dividends ---Four key dates:

1. Declaration date—dividend declared by the board of directors and the firm records a legal liability for the dividend. 2. Record date—firm determines the registered stockholders. 3. Ex-dividend date—date determined by the relevant stock exchange (generally two business days before the record date). Investors purchasing the stock on or after this date will not receive the dividend. 4. Payment date—firm distributes the dividend.

or all debt securities and equity securities over which a company does not exert significant influence, management classifies the securities into one of three portfolio categories at acquisition

1. Held-to-maturity securities 2. Trading securities 3. Available-for-sale securities

A company has two options for reporting OCI:

1. Include components of OCI after net income on one continuous statement summing to comprehensive income. 2. Present a separate statement of other comprehensive income that begins with net income on the first line and details the components of OCI. This approach results in presenting two statements: one displaying the details of net income and the other displaying the details of other comprehensive income.

Criteria for possible levels of influence ---The appropriate accounting method for equity investments depends on the investor's level of influence over the investee company. There are three possible levels of influence:

1. No significant influence: The investor lacks the ability to participate in the decisions of the investee company. 2. Significant influence: The investor company has the ability to exert influence over operating and financial policy decisions of the investee company even though it does not legally control the investee company, generally holding 20% to 50% of the investee's stock. 3. Control: Typically gained by an investor company holding more than 50% of the voting shares of the investee company.

Small (ordinary) stock dividend-----Accounting steps:

1. Value the dividend at the market price at the date of declaration. 2. On the date of declaration, increase the dividends account by the dividend at market value, which will ultimately be closed to retained earnings. 3. Increase the common stock dividend distributable account for the par value of the stock. This account is a capital stock account. 4. Increase the additional paid-in-capital account for the difference between the market value and the par value of the stock to be distributed. 5. When the dividend is distributed, remove the common stock dividend distributable account with a debit and credit the common stock account. At the end of the period the dividends account is closed to retained earnings.

Large stock dividend ---Accounting steps:

1. When declaring a large stock dividend, debit dividends for the par value of the stock. 2. Credit stock dividend distributable, an equity account, for the par value of the stock. 3. When distributing the stock dividend, reduce the stock dividend distributable and increase common stock at par.

Example: Authorized shares 75,000 Issued Shares 58,000 Shares held in the treasury 16,000 How many shares are outstanding? How many are unissued?

42,000 Outstanding (issued 58,000 less 16,000 treasury) 17,000 unissued (75,000 authorized less 58,000 issued

Accounting for share repurchase transactions

A company can hold or retire repurchased shares. Retired shares are similar to treasury shares except that these share are no longer consider issued.

Large stock dividend

A stock dividend is considered a large stock dividend if the number of shares issued is more than 20% to 25% of the previously outstanding shares. Unless there is evidence to the contrary, the accountant assumes that a dividend of this size would materially reduce the market price per share of the stock when the additional shares are distributed. The dividend is accounted for at the par value of the stock.

Small (ordinary) stock dividend

A stock dividend is considered a small stock dividend if the number of shares issued does not exceed 20% to 25% of the previously outstanding shares. Unless there is evidence to the contrary, the accountant assumes that a dividend of this size would not have a material, negative effect on the market price per share of the stock when the additional shares are distributed. The dividend is valued at the fair market value of the shares

Reissuance

Above Cost—Excess over cost recorded as additional paid-in capital. Below Cost—Reduce the additional paid-in capital related to treasury stock for the amount below cost if possible. If not possible, reduce retained earnings.

Classification of debt and equity securities

Accounting for debt and certain equity securities depends on management's reason for purchasing the securities.

Example: Common Stock (with no par Value) issued for cash Piper decided to raise additional financing by issuing common stock. The company received $4,000 in exchange for 1,000 shares of $1 par value common stock. Piper paid an underwriter $200 in stock issue costs. Record this transaction?

Cash 3,800 Common stock -$1 par 1,000 Additional Paid-in Capital in Excess of Par- Common 2,800

Example: Common Stock (with no par Value) issued for cash Piper decided to raise additional financing by issuing common stock. The company received $4,000 in exchange for 1,000 shares of $1 par value common stock. Record this transaction?

Cash 4,000 Common Stock -$1 par 1,000 Additional Paid-in capital inExcess of Par -Common 3,000

Example: Common Stock (with no par Value) issued for cash Piper decided to raise additional financing by issuing common stock. The company received $4,000 in exchange for 1,000 shares of its no-par stock. Record this transaction?

Cash 4,000 Common Stock no-par 4,000

Initial valuation of held-to-maturity debt securities

Companies record held-to-maturity (HTM) debt security investments at cost when purchased. When purchasing bonds between interest payment dates, the purchaser pays the seller any accrued interest on the bonds. Because the interest payment is a part of the bond agreement, the issuing corporation pays the full interest payment to the current bondholder on the payment date regardless of how long he held the bond. To ensure the purchaser receives the cash related to the interest revenue earned over the period the bonds were held, the seller requires the purchaser to pay for the interest accrued up to the purchase date

Equity investments: readily determinable fair value

Companies report an equity investment with a readily determinable fair value at its fair value. Similar to debt investments, equity investments are classified as either trading or available-for-sale. The accounting for the two classifications is also the same as for debt securities, except that there is no discount or premium amortization for equity securities. Companies cannot classify equity securities as held-to-maturity because equity securities do not have a maturity date

Stock issue costs

Companies will typically incur costs related to legal and underwriting fees. These costs reduce additional paid-in capital.

Example: Small Corp. repurchases shares from a shareholder for $1,000. Three months later, the shareholder buys the same shares back at $1,100. What journal entries are required to record these transactions?

Date of Acquisition: Treasury Stock 1,000 Cash 1,000 Date of Reissue Cash 1,100 Treasury Stock 1,000 Additional Paid-in Capital from Treasury Stock Transactions 100

Example: Small Corp. repurchases shares from a shareholder for $1,000. Three months later, the shareholder buys the same shares back at $800 and has zero balance in additional paid-in capital from treasury stock. Record?

Date of Reissue: Cash 800 Retained Earnings 200 Treasury Stock 1,000

Acquisition

Debit treasury stock for the cost of the repurchased shares. Credit cash for the amount paid.

Accounting for stock dividends

Distributions in the form of the firm's own equity shares. The declaration of a stock dividend does not lead to a legal liability. Stock dividends do not change the total equity balance Retained earnings are decreased. Contributed capital is increased. The amount depends on the size of the dividend

Accounting for cash dividends

Distributions to shareholders in cash. Cash is the most common type of dividend. Cash, stock, and property dividends are all distributed form retained earnings. Property and liquidating dividends are rare.

Common stock issued for cash

Firms allocate the total proceeds between the par or stated value and the additional paid-in capital. If the shares have no par or stated value, firms record the total proceeds in the common stock account.

Accounting for other comprehensive income

Firms do not include the effects of certain events and transactions in net income. Because some changes in equity bypass net income, companies report comprehensive income, which is a measure of changes in a company's equity that result from recognized transactions and all economic events of the period other than transactions with owners.

Purposes of Share Repurchases

For stock option plans, stock bonus plans, and employee stock purchase plans For exchanges for another firm's voting shares in a merger or acquisition To support the market price of the stock To prevent takeover attempts To distribute cash to shareholder

Prior period adjustments

If a company finds an error after releasing the financial statements, it must determine if corrections to past years' financial statements are necessary. This correction of a prior-period's financial statements is called a prior-period adjustment. Firms are required to report only material errors that would influence the economic decisions of financial statements users.

Example: Common Stock Issued for Noncash Consideration Bordeaux issued common stock in exchange for legal services received. The common stock has a fair value of $2,000 and a par value of $600. Record this transaction?

Legal Fees Expense 2,000 Common Stock 600 Additional Paid-in Capital in Excess of Par-Common 1,400

Accounting for Treasury Stock transactions

Recorded in a contra-stockholders' equity account and reported as a reduction of total stockholders' equity on the balance sheet. Treasury shares reduce the number of shares outstanding. Treasury shares do not have voting rights and cannot receive cash dividends. Treasury shares do split and can receive stock dividends in some states The most common method of accounting for treasury stock is cost method.

Accounting for retained earnings

Retained earnings are the cumulative earnings of the firm that it has not distributed as dividends.

Cumulative preferred shares

Stipulate that if the board of directors does not declare a dividend, the dividends accumulate. Accumulated dividends are referred to as dividends in arrears. Footnotes disclose dividends in arrears. Dividends in arrears are not liabilities because the dividends only become a legal liability of the corporation when they are declared. Firms cannot pay common dividends until all preferred dividends are paid.

Contributed capital

The amounts paid in by common and preferred shareholders.

Common stock issued for non-cash consideration

The corporation should value the goods and services received at the fair value of the consideration given up in the exchange. Therefore, the corporation records the noncash assets or services at the fair value of the stock issued in the exchange. If the stock does not have reliable fair value, the corporation uses the fair value of the consideration received.

Convertible preferred shares

allow the shareholder to convert its shares to common shares at a predetermined rate or exchange ratio. Carry the same preferences as non-convertible preferred stock; however, they may also convert to common shares. U.S. GAAP accounts for the issuance of convertible shares in the same way as non-convertible preferred shares.

Preferred shareholders

are investors holding shares in a company who have preferential rights over common shares.

Unissued shares

are shares authorized but not issued.

Treasury shares

are the corporation's own shares repurchased by the corporation and held for some future use. (Example, to be distributed to satisfy the terms of an employee stock option plan)

Issued shares

are the number of shares sold or otherwise distributed to shareholders.

Outstanding shares

are the number of shares still in the hands of the stockholders, computed as issued shares less treasury shares. Used for financial statistics, such as earning per share and book value per share, cash dividends payments, and determines those with voting rights.

Common shareholders

are the residual claimants (individuals, other corporations, or institutions) of the firm who receive dividend distributions after the company has paid all other providers of capital their return on investment.

Authorized shares

are the total number of shares that the firm can legally issue. Typically, approved by the attorney general in the state of incorporation and included in the articles of incorporation.

The effective interest method

computes interest revenue by multiplying the historical market rate of interest by the carrying value of the debt investment at the beginning of the period.

Participating preferred shares

contain a provision requiring that preferred shareholders share ratably in distributions with common shareholders. Participation occurs most often when dividends to common shareholders exceed the percentage stated for the preferred shares.

Retained earnings

firm's cumulative earnings of losses that it has not distributed as dividends.

Accumulated other comprehensive income

includes items such as unrealized gains and losses on available-for-sale investment securities, foreign currency translation adjustments, and certain pension cost adjustments.

Trading equity securities

is an equity investment with a readily determinable fair value for which the investor does not have significant influence or control over the investee company. A company classifies equity securities as trading only when it intends to hold the securities for the short term. Each reporting period, the company revalues the investment to its current fair value and reports changes in fair values and unrealized gains or losses in net income. The company reports realized gains and losses in net income when it sells the securities. Any dividends received are reported as dividend income

Preferred Stock

is an equity security that has two common preferences over common stock. Priority over receiving dividends. Priority claim to assets in liquidation. Usually nonvoting

Available-for-sale equity securities

is an investment in an equity security with a readily determinable fair value that is not held for trading and for which the investor does not have significant control. A company reports available-for-sale equity investments at fair value. A company reports any unrealized gains and losses from fluctuations in fair value in other comprehensive income. Realized gains and losses are reported in net income when the investor sells the securities. Any dividends received are reported as dividend income.

Par value

is the face or stated value on the share certificate, which is an arbitrary value that corporate organizers assigned to each class of stock.

The historical market rate

is the interest rate used to value the investment at the date of acquisition

Additional paid-in capital

represents the amounts that common and preferred shareholders contribute in excess of the par or stated value.

Stock splits

results in a proportionate increase in the number of equity shares and a proportionate decrease in the share's par value, if the shares have a par value.