Chapter 17 Intermediate Accounting: Questions

28. What is meant by the term "underlying" as it relates to derivative financial instruments?

*28. An underlying is a special interest rate, security price, commodity price, index of prices or rates, or other market-related variable. Changes in the underlying determine changes in the value of the derivative. Payment is determined by the interaction of the underlying with the face amount and the number of shares, or other units specified in the derivative contract (these elements are referred to as notional amounts).

32. Why might a company become involved in an interest rate swap contract to receive fixed interest payments and pay variable?

*32. Entering into an interest rate swap is likely a setting where the company is hedging the fair value of a fixed-rate debt obligation. The fixed payments received on the swap will offset fixed payments on the debt obligation. As a result, if interest rates decline, the value of the swap contract increases (a gain), while at the same time the fixed-rate debt obligation increases (a loss). The swap is an effective risk management tool in this setting because its value is related to the same underlying (interest rates) that will affect the value of the fixed-rate bond payable. Thus, if the value of the swap goes up, it offsets the loss in the value of the debt obligation.

13. Why are held-to-maturity investments applicable only to debt securities?

13. Investments in stock do not have a maturity date and therefore cannot be classified as held-to-maturity securities.

22. Explain why reclassification adjustments are necessary.

22. Reclassification adjustments are necessary to insure that double counting does not result when realized gains or losses are reported as part of net income but also are shown as part of other comprehensive income in the current period or in previous periods.

30. What is the purpose of a fair value hedge?

*30. The purpose of a fair value hedge is to offset the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment.

24. Explain how to account for the impairment of a held-to-maturity debt security.

24. A debt security is impaired when "it is probable that the investor will be unable to collect all amounts due according to the contractual terms." When an impairment has occurred, the security is written down to its fair value, which is also the security's new cost basis. The amount of the writedown is accounted for as a realized loss.

31. In what situation will the unrealized holding gain or loss on inventory be reported in income?

*31. The unrealized holding gain or loss on inventory should be reported as income when this inventory is designated as a hedged item in a qualifying fair value hedge. If the hedge meets the special hedge accounting criteria (designation, documentation, and effectiveness), the unrealized holding gain or loss is reported as income.

20. Raleigh Corp. has an investment with a carrying value (equity method) on its books of $170,000 representing a 30% interest in Borg Company, which suffered a $620,000 loss this year. How should Raleigh Corp. handle its proportionate share of Borg's loss?

20. Ordinarily, Raleigh Corp. should discontinue applying the equity method and not provide for additional losses beyond the carrying value of $170,000. However, if Raleigh Corp.'s loss is not limited to its investment (due to a guarantee of Borg's obligations or other commitment to provide further financial support or if imminent return to profitable operations by Borg appears to be assured), it is appropriate for Raleigh Corp. to provide for its entire $186,000 ($620,000 × .30) share of the $620,000 loss.

29. What are the main distinctions between a traditional financial instrument and a derivative financial instrument?

*29. See illustration below: Feature Traditional Financial Instrument (e.g., Trading Security) Derivative Financial Instrument (e.g., Call Option) Payment Provision Stock price times the number of shares. Change in stock price (underlying) times number of shares (notional amount). Initial Investment Investor pays full cost. Initial investment is less than full cost. Settlement Deliver stock to receive cash. Receive cash equivalent, based on changes in stock price times the number of shares. For a traditional financial instrument, an investor generally must pay the full cost, while derivatives require little initial investment. In addition, the holder of a traditional security is exposed to all risks of ownership, while most derivatives are not exposed to all risks associated with ownership in the underlying. For example, the intrinsic value of a call option only can increase in value. Finally, unlike a traditional financial instrument, the holder of a derivative could realize a profit without ever having to take possession of the underlying. This feature is referred to as net settlement and serves to reduce the transaction costs associated with derivatives.

33. What is the purpose of a cash flow hedge?

*33. A cash flow hedge is used to hedge exposures to cash flow risk, which is exposure to the variability in cash flows. The cash flows received on the hedging instrument (derivative) will offset the cash flows received on the hedged item. Generally, the hedged item is a transaction that is planned some time in the future (an anticipated transaction).

34. Where are gains and losses related to cash flow hedges involving anticipated transactions reported?

*34. Derivatives used in cash flow hedges are accounted for at fair value on the balance sheet but gains or losses are recorded in equity as part of other comprehensive income.

35. What are hybrid securities? Give an example of a hybrid security.

*35. A hybrid security is a security that has characteristics of both debt and equity and often is a combination of traditional and derivative financial instruments. A convertible bond is a hybrid security because it is comprised of a debt security, referred to as the host security, combined with an option to convert the bond to shares of common stock, the embedded derivative.

1. Distinguish between a debt security and an equity security.

1. A debt security is an instrument representing a creditor relationship with an entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security. An equity security is described as a security representing an ownership interest such as common, preferred, or other capital stock. It also includes rights to acquire or dispose of an ownership interest at an agreed-upon or determinable price, such as warrants, rights, and call options or put options. Convertible debt securities and redeemable preferred stocks are not treated as equity securities.

10. Indicate how unrealized holding gains and losses should be reported for debt investments classified as trading, available-for-sale, and held-to-maturity.

10. Unrealized holding gains and losses for trading debt securities should be included in net income for the current period. Unrealized holding gains and losses for available-for-sale debt securities should be reported as other comprehensive income and as a separate component of stockholders' equity. Unrealized holding gains and losses are not recognized for held-to-maturity securities.

11. (a) Assuming no Fair Value Adjustment account balance at the beginning of the year, prepare the adjusting entry at the end of the year if Laura Company's available-for-sale debt securities have a fair value $60,000 below cost. (b) Assume the same information as part (a), except that Laura Company has a debit balance in its Fair Value Adjustment account of $10,000 at the beginning of the year. Prepare the adjusting entry at year-end.

11. (a) Unrealized Holding Gain or Loss—Equity 60,000 .....Fair Value Adjustment 60,000 (b) Unrealized Holding Gain or Loss—Equity 70,000 .....Fair Value Adjustment ($60,000 + $10,000) 70,000

12. Identify and explain the different types of classifications for investments in equity securities.

12. Investments in equity securities can be classified as follows: (a) Holdings of less than 20% (fair value method)—investor has passive interest. (b) Holdings between 20% and 50% (equity method)—investor has significant influence. (c) Holdings of more than 50% (consolidated statements)—investor has controlling interest. If an equity investment is not publicly traded and is nonmarketable, a company values the investment and reports it at cost in periods subsequent to acquisition. This approach is often referred to as the cost approach. Companies recognize dividends when received and only recognize gains and losses when selling the securities.

14. Hayes Company sold 10,000 shares of Kenyon Co. common stock for $27.50 per share, incurring $1,770 in brokerage commissions. These securities originally cost $260,000. Prepare the entry to record the sale of these securities.

14. Selling price of 10,000 shares at $27.50 $275,000 Less: Brokerage commissions 1,770 Proceeds from sale 273,230 Cost of 10,000 shares (260,000) Gain on sale of investments $13,230 Cash 273,230 .....Equity Investments 260,000 .....Gain on Sale of Investments 13,230

15. Distinguish between the accounting treatment for marketable versus nonmarketable equity securities.

15. Marketable equity securities are reported at fair value. Any unrealized holding gain or loss is reported in net income. Nonmarketable securities are reported at cost less impairments. A company is encouraged to adjust for observable price changes subsequent to recording the investment at cost if it can determine prices in orderly transactions for identical investments or from similar investments of the same issuer.

16. What constitutes "significant influence" when an investor's financial interest is below the 50% level?

16. Significant influence over an investee may result from representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. An investment (direct or indirect) of 20% or more of the voting stock of an investee constitutes significant influence unless there exists evidence to the contrary.

17. Explain how the investment account is affected by investee activities under the equity method.

17. Under the equity method, the investment is originally recorded at cost, but is adjusted for changes in the investee's net assets. The investment account is increased (decreased) by the investor's proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee.

18. Your classmate Kate believes that the equity method is applied with a strict application of the "20%" rule. Do you agree? Explain.

18. The 20% rule is that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee leads to the presumption that an investor has the ability to exercise significant influence over an investee and the equity method should be used. However, there are other factors, when considered, may indicate that ownership of 20 percent or more may not enable an investor to exercise significant influence. An investor with ownership just below 20% may be able to exercise significant influence based on representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings. Factors that could lead to a conclusion of no significant ownership, when ownership is above 20 percent include: (1) The investee opposes the investor's acquisition of its stock; (2) The investor and investee sign an agreement under which the investor surrenders significant shareholder rights; (3) The investor's ownership share does not result in "significant influence" because majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor; (4) The investor tries and fails to obtain representation on the investee's board of directors.

19. Hiram Co. uses the equity method to account for investments in common stock. What accounting should be made for dividends received from these investments subsequent to the date of investment?

19. Dividends subsequent to acquisition should be accounted for as a reduction in the Equity Investment account.

2. What purpose does the variety in bond features (types and characteristics) serve?

2. The variety in bond features along with the variability in interest rates permits investors to shop for exactly the investment that satisfies their risk, yield, and marketability desires, and permits issuers to create a debt instrument best suited to their needs.

21. Where on the asset side of the balance sheet are debt investments classified as trading securities, available-for-sale securities, and held-to-maturity securities reported? Explain.

21. Trading securities should be reported at aggregate fair value as current assets. Individual held-to-maturity and available-for-sale securities are classified as current or noncurrent depending upon the circumstances. Held-to-maturity securities generally should be classified as current or noncurrent, based on the maturity date of the individual securities. Debt securities identified as available-for-sale should be classified as current or noncurrent, based on maturities and expectations as to sales and redemptions in the following year.

23. Briefly discuss how a transfer of securities from the available-for-sale category to the trading category affects stockholders' equity and income.

23. When a security is transferred from one category to another, the transfer should be recorded at fair value, which in this case becomes the new basis for the security. Any unrealized gain or loss at the date of the transfer increases or decreases stockholders' equity. The unrealized gain or loss at the date of the transfer to the trading category is recognized in income.

25. What is the GAAP definition of fair value?

25. Fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Fair value is therefore a market-based measure.

26. What is the fair value option?

26. The fair value option gives companies the option to report most financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument by instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership

27. Franklin Corp. has a debt investment that it has held for several years. When it purchased the debt investment, Franklin classified and accounted for it as available-for-sale. Can Franklin use the fair value option for this investment? Explain.

27. No. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.

3. What is the cost of a long-term investment in bonds?

3. Cost of a long-term investment in bonds includes the total consideration to acquire the investment, including brokerage fees and other costs incidental to the purchase.

4. Identify and explain the three types of classifications for investments in debt securities.

4. The three types of classifications for debt investments are: Held-to-maturity: Debt investments that the company has the positive intent and ability to hold to maturity. Trading: Debt investments bought and held primarily for sale in the near term to generate income on short-term price differences. Available-for-sale: Debt investments not classified as held-to-maturity or trading securities.

5. When should a debt security be classified as held-to-maturity?

5. A debt investment should be classified as held-to-maturity only if the company has both: (1) the positive intent and (2) the ability to hold those securities to maturity.

6. Explain how trading debt securities are accounted for and reported.

6. Debt investments classified as trading are reported at fair value, with unrealized holding gains and losses reported as part of net income. Any discount or premium is amortized.

7. At what amount should trading, available-for-sale, and held-to-maturity debt securities be reported on the balance sheet?

7. Trading and available-for-sale debt securities should be reported at fair value, whereas held-to-maturity debt securities should be reported at amortized cost.

8. On July 1, 2017, Wheeler Company purchased $4,000,000 of Duggen Company's 8% bonds, due on July 1, 2024. The bonds, which pay interest semiannually on January 1 and July 1, were purchased for $3,500,000 to yield 10%. Determine the amount of interest revenue Wheeler should report on its income statement for the year ended December 31, 2017.

8. $3,500,000 X 10% = $350,000; $350,000 ÷ 2 = $175,000. Wheeler would make the following entry: Cash ($4,000,000 X 8% X 1/2) 160,000 Debt Investments 15,000 .....Interest Revenue ($3,500,000 X 10% X 1/2) 175,000

9. If the bonds in Question 8 are classified as available-for-sale and they have a fair value at December 31, 2017, of $3,604,000, prepare the journal entry (if any) at December 31, 2017, to record this transaction.

9. Fair Value Adjustment 89,000 .....Unrealized Holding Gain or Loss—Equity [$3,604,000 - ($3,500,000 + $15,000)*] 89,000