ACC 300B Chapter 17 Learning Objectives

LO1 Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.

(1) Carry and report held-to-maturity debt securities at amortized cost. (2) Value trading debt securities for reporting purposes at fair value, with unrealized holding gains or losses included in net income. (3) Value availablefor- sale debt securities for reporting purposes at fair value, with unrealized holding gains or losses reported as other comprehensive income and as a separate component of stockholders' equity.

LO6 Explain why companies report reclassification adjustments.

A company needs a reclassification adjustment when it reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current or in previous periods. Companies should report unrealized holding gains or losses related to available-for-sale securities in other comprehensive income and the aggregate balance as accumulated comprehensive income on the balance sheet.

LO10 Explain how to account for a fair value hedge.

A company records the derivative used in a qualifying fair value hedge at its fair value in the balance sheet, recording any gains and losses in income. In addition, the company also accounts for the item being hedged with the derivative at fair value. By adjusting the hedged item to fair value, with the gain or loss recorded in earnings, the accounting for the hedged item may deviate from GAAP in the absence of a hedge relationship. This special accounting is justified in order to report accurately the nature of the hedging relationship between the derivative hedging instruments and the hedged item. A company reports both in the balance sheet, reporting offsetting gains and losses in income in the same period.

LO12 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems.

A company should separate a derivative that is embedded in a hybrid security from the host security, and account for it using the accounting for derivatives. This separation process is referred to as bifurcation. Special hedge accounting is allowed only for hedging relationships that meet certain criteria. The main criteria are: (1) There is formal documentation of the hedging relationship, the company's risk management objective, and the strategy for undertaking the hedge, and the company designates the derivative as either a cash flow or fair value hedge. (2) The company expects the hedging relationship to be highly effective in achieving offsetting changes in fair value or cash flows. (3) "Special" hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP.

LO11 Explain how to account for a cash flow hedge.

Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record gains or losses in equity as part of other comprehensive income. Companies accumulate these gains or losses, and reclassify them in income when the hedged transaction's cash flows affect earnings. Accounting is according to GAAP for the hedged item.

LO4 Describe the accounting for the fair value option.

Companies have 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.

LO9 Describe the accounting for derivative financial instruments.

Companies report derivative financial instruments in the balance sheet, and record them at fair value. Except for derivatives used in hedging, companies record realized and unrealized gains and losses on derivative financial instruments in income.

LO8 Understand the basic guidelines for accounting for derivatives.

Companies should recognize derivatives in the financial statements as assets and liabilities, and report them at fair value. Companies should recognize gains and losses resulting from speculation immediately in income. They report gains and losses resulting from hedge transactions in different ways, depending on the type of hedge.

LO5 Discuss the accounting for impairments of debt and equity investments.

Impairments of debt and equity securities are losses in value that are determined to be other than temporary, are based on a fair value test, and are charged to income.

LO2 Understand the procedures for discount and premium amortization on bond investments.

Similar to bonds payable, companies should amortize discount or premium on bond investments using the effective-interest method. They apply the effective interest rate or yield to the beginning carrying value of the investment for each interest period in order to compute interest revenue. Identify the categories of equity securities and describe the accounting and reporting treatment for each category. The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for the investment. Long-term investments by one corporation in the common stock of another can be classified according to the percentage of the voting stock of the investee held by the investor.

LO7 Describe the accounting for transfer of investment securities between categories.

Transfers of securities between categories of investments should be accounted for at fair value, with unrealized holding gains or losses treated in accordance with the nature of the transfer. Explain who uses derivatives and why. Any company or individual that wants to ensure against different types of business risks may use derivative contracts to achieve this objective. In general, these transactions involve some type of hedge. Speculators also use derivatives, attempting to find an enhanced return. Speculators are very important to the derivatives market because they keep it liquid on a daily basis. Arbitrageurs attempt to exploit inefficiencies in various derivative contracts. A company primarily uses derivatives for purposes of hedging its exposure to fluctuations in interest rates, foreign currency exchange rates, and commodity prices.

LO3 Explain the equity method of accounting and compare it to the fair value method for equity securities.

Under the equity method the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at cost but subsequently adjusts the amount each period for changes in the net assets of the investee. That is, the investor's proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investment's carrying amount. All dividends received by the investor from the investee decrease the investment's carrying amount. Under the fair value method a company reports the equity investment at fair value each reporting period irrespective of the investee's earnings or dividends paid to it. A company applies the equity method to investment holdings between 20 percent and 50 percent of ownership. It applies the fair value method to holdings below 20 percent.