Accounting Chapter 12
We use a three-step process to determine whether an OTT impairment loss must be recognized:
(1) determine if the investment is impaired, (2) determine whether any impairment is OTT, and (3) recognize any OTT impairment in the financial statements.
3 Financial instruments
1. Cash. 2. Evidence of an ownership interest in an entity. 3. Contracts meeting certain conditions.
Investments are accounted for in what 5 primary way?
1. HTM 2. TS 3. AFS 4. Equity Method 5. Consolidation
What are the three reporting methods to choose from if the investor cannot significantly influence the operating and financial policies of the investee?
1. Held-to-Maturity 2. Securities Available-For-Sale 3. Trading Securities
The 2 purposes of the JE to adjust fair value and AOCI to remove any unrealized gains or losses previously recorded that relate to sold investments are what?
1. It accounts for new changes during the year in the fair value of investments that haven't been sold. 2. Removes amounts associated with investments sold during the year.
Under the equity method, what two things can change the carrying value of an investment?
1. It can be increased by the investors share of investees net income (or decreased if loss) 2. Decreased by dividends paid.
In the long-run, funds may be set aside to
1. Pay long-term debt when due 2. Acquire treasury stock
In the short-term, funds may be set aside for
1. Petty cash fund 2. Payroll accounts
What are the four critical events that an investor experiences in the life of an investment?
1. Purchasing investment 2. Recognizing investment revenue (interest in the case of debt, dividends in case of equity) 3. Holding the investment during periods in which the investments fair value changes (and thus incurring unrealized holding gains and losses, since the security has not yet been sold. 4. Selling the investment (and thus incurring realized gains and losses, since the security has been sold and the gains or losses actually incurred).
What are the 3 characteristics of investments?
1. The investor controls the investee 2. The investor can significantly influence the operating and financial policies of the investee 3. The investor cannot significantly influence the operating and financial policies of the investee.
What two things happen when you change from a method to the equity method?
1. The original cost, the unrealized holding gain or loss, and the valuation account are closed. 2. A retroactive change is recorded to recognize the investor's share of the investee's earnings since the original investment.
What are the two purposes of the JE for the fair value adjustment at the end of the year (last payment)?
1. To account for changes in fair value of investments not yet sold. 2. It removes from the fair value adjustment and net income any unrealized holding gains or losses recognized in prior periods and that are associated with investments that have now been sold.
What are the 3 reasons why people invest?
1. To house excess cash until needed 2. To generate earnings 3. To meet strategic goals
2 Investment derivatives
1. Value is derived from other securities. 2. Derivatives are often used to "hedge" (offset) risks created by other investments or transactions
If an investor owns 20% of the voting stock of an investee, it is presumed that the investor has significant influence over the financial and operating policies of the investee. The presumption can be overcome if :
1. the investee challenges the investor's ability to exercise significant influence through litigation or other methods. 2. the investor surrenders significant shareholder rights in a signed agreement. 3. the investor is unable to acquire sufficient information about the investee to apply the equity method. 4. the investor tries and fails to obtain representation on the board of directors of the investee.
If the investor can signifcantly influence the operating and financial policies of the investee, what is the percentage he/she owns?
20%-50%
If the investor controls the investee, what is the percentage he/she owns?
50% or more
What is the difference between a share of stock and a bond or other debt security?
A bond or other debt security has a specified date on which it matures.
Where do net unrealized holding loss get closed to in AFS and TS?
AFS- AOCI TS- retained earnings
Net income in the current period that has not been distributed as dividends.
Accumulated net income
If AFS and HTM are impaired by reason of other than temporary how do we treat that?
After impairment is recognized, the ordinary treatment of unrealized gains and losses is resumed.
What is the calculation to get the appropriate balance in fair value adjustment at the end of the period?
Amortized cost-fair value=x x +/- existing balance in fair value adjustment= Increase <decrease> needed
How are securities available for sale reported?
At fair value of the investment securities on the reporting date.
All investments in debt and equity securities that don't fit the definitions of other reporting categories are classified as what?
Available for sale
JE to record the sell of TS investments
Cash (amount received) xx Discount on bond investment (acct balance) xx Investment in bonds (acct balance) xx Gain on sale of investment (to balance) xx Cash (amount received) xx Loss on sale of investments (to balance) xx Investment in stock (acct balance) xx
JE to sell AFS investments
Cash (amount received) xx Discount on bond investment (acct balance) xx Investment in bonds xx Gain on sale of investments xx Cash (amount received) xx Loss on sale of investments (to balance) xx Investment in stock (acct balance) xx
JE to record interest received for first payment period using HTM
Cash (stated amount*face amount) xx Discount on bond investment xx Investment revenue (Market rate*outstanding) xx
JE to recognize investment revenue for AFS
Cash (stated interest*principle) xx Discount on bond xx Investment revenue xx Cash xx Investment revenue (dividends) xx
JE to record the receipt of bond interest for TS
Cash (stated rate*principle amount) xx Discount on bond investment xx Investment revenue (effective interest* outstanding) xx Cash xx Investment revenue (dividends received) xx
JE to sell HTM investments
Cash xx Discount on bond xx Investment in bonds xx Gain on sale of investments (to balance) xx
Why report unrealized holding gains and losses on trading securities in net income?
Changes in market values and returns, provide an indication of management's success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable rate securities, and whether to invest in ST or LT securities.
Reporting method where the financial statements of the investor and investee are combined as if they are a single company.
Consolidation
What reporting method is used if the investor controls the investee?
Consolidation
What type of asset is a discount on a bond?
Contra-asset to investment in bonds asset account that serves to reduce the carrying value of the bond asset to its cost at the date of purchase.
Held-to-Maturity investments are what type of securities?
Debt only
SAS investments are what type of securities?
Debt or equity
TS investments are what type of securities?
Debt or equity
How do we report unrealized gain or loss from transfer at market fair value? (transfer from AFS to HTM)
Do not write off any existing unrealized holding gains or losses, but amortize to net income over remaining life of the security.
Effective market rate of interest*Outstanding balance of investment
Effective interest method
Reporting method where investment cost is adjusted for subsequent earnings and dividends of the investee.
Equity Method
What reporting method is used if the investor can significantly influence the operating and financial policies of the investee?
Equity Method
What is the calculation to get bonds to fair value?
Face amount of bond xx Less Discount of bond Initial discount xx Accumulated amortization <xx> _______________________________________ Discount at period xx Amortized cost of bonds xx +/- Fair value adjustment (to balance) xx ________________________________________ Fair value of bond at end of period xx
TS and AFS are both reported at what on B/S?
Fair value
JE to adjust fair value and AOCI to remove any unrealized gains or losses previously recorded that relate to sold investments.
Fair value adjustment xx Net unrealized holding gains and losses xx
JE to show appropriate balance in fair value adjustment at the end of period (last payment)
Fair value adjustment xx Net unrealized holding gains and losses xx
Why are TS and AFS reported at fair value rather than historical cost?
Fair value information is more relevant than for other assets intended to be used in company operations.
What is the key difference among reporting approaches?
How we account for unrealized holding gains and losses
How do you know to use the held-to-maturity reporting method?
If the investor cannot significantly influence the operating and financial policies of the investee and If the investor has the "positive intent and ability" to hold to maturity
How do you know to use the TS reporting method?
If the investor cannot significantly influence the operating and financial policies of the investee and investments are held in an active trading account for immediate resale.
How do you know to use the SAS reporting method?
If the investor cannot significantly influence the operating and financial policies of the investee and investments are not held in an active trading account for immediate resale nor to-be-held-to maturity.
The holding period for trading securities generally is measured how?
In hours and days rather than months or years
How do we report unrealized gain or loss from transfer at market fair value? (transfer from HTM or AFS to TS)
Include in current net income
Comprehensive income
Includes not only net income but also other changes in equity that don't arise from transactions with owners.
Why use an approach for accounting for AFS securities that differs from that used for TS?
Including in net income unrealized holding gains and losses on AFS investments might make income appear more volatile than really is.
TS financial statement presentation
Income statement and comprehensive income statement. For TS fair value changes are included in the income statement in the periods in which they occur, regardless of whether they are realized or unrealized. Investments in TS do not affect other comprehensive income. Balance sheet: Investments in TS are reported at fair value, typically as current assets and do not affect accumulated other comprehensive income and SHE. Cash flow statement: Cash flows from buying and selling trading securities typically are classified as operating activities because the financial institutions that routinely hold TS consider them as part of the normal operations. However, as discussed in more detail later, it may be appropriate to classify cash flows from buying and selling some TS as investing activities if they are not held for sale in the near term (which is particularly likely when an investment is classified as a trading security as a result of electing FV option).
Does a discount increase or decrease investment?
Increase
What happens in the mean time before maturity hits?
Interest equal to a specified percentage of the principle is paid to investors on specified interest dates.
JE to record the purchase of HTM investment
Investment in bonds (face amount) xx Discount on bond investment (difference) xx Cash (price paid for bonds) xx
JE to record the purchase of the bond investment for TS
Investment in bonds xx Discount on bond investment xx Cash xx Investment in stock xx Cash xx
JE to record purchase of investments for AFS
Investment in bonds xx Discount on bonds xx Cash xx Investment in stock xx Cash xx
Special purpose funds set aside for the long-term are classified as
Investments
AFS and HTM can have impairment if...
Investments value declines over time for reasons other than temporary.
Why would companies want to hedge?
It insulates the company from risk and ensures earnings are stable.
If the investor cannot significantly influence the operating and financial policies of the investee, what is the percentage he/she owns?
Less than 20%
If a bond is purchased at a discount, more or less cash is received each period than effective interest, so the unpaid difference increases or decreases the outstanding balance of investment.
Less; increases
How do you calculate the effective interest?
Market rate of interest*Outstanding balance
Where does net income and other comprehensive income accumulate in shareholders equity?
Net income- Retained earnings Other comprehensive income- Accumulates in accumulated other comprehensive income
JE to record unrealized loss in United's fair value adjustment
Net unrealized holding gains and losses-I/S xx Fair value adjustment xx
JE to record unrealized holding loss for AFS
Net unrealized holding gains and losses-OCI xx Fair value adjustment xx
The market value of a fixed rate of investment moves in the same or opposite direction of market rates of interest?
Opposite
When using the SAS method, unrealized holding gains and losses are on what part of the income statement?
Other comprehensive income
Net income as well as other gains and losses that change shareholders equity but are not included in traditional net income.
Other comprehensive net income
How do you calculate outstanding balance?
Principle+interest
How do we report unrealized gain or loss from transfer at market fair value? (transfer from HTM to AFS)
Reported as separate component of shareholders equity
How do we report net income and accumulated net income, in the current reporting period, on the balance sheet?
Retained earnings
When using the SAS method, unrealized holding gains and losses are on what part of the balance sheet?
Shareholders equity
How should you think about principle plus interest?
Stream of cashflows an investor will receive for purchasing the bond.
If someone chooses to use the fair value method when previously used HTM or AFS then the security becomes classified as...
TS
What is the difference between TS and AFS regarding unrealized holding gains and losses?
TS includes them in net income AFS is not included in net income but reported in other comprehensive income.
Where are unrealized holding gains and losses reported on the income statement when using TS and then AFS?
TS- net income AFS- Other comprehensive income
Life Insurance policies
The company pays the premium and is the beneficiary of the policy. If the officer dies, the company receives the proceeds from the policy. Some types of policies build a portion of each premium as cash surrender value. The cash surrender value of such a policy is classified as an investment on the balance sheet of the company.
What does it mean that GAAP allows companies to use fair value for equity method, HTM and AFS?
The investment is carried at fair value. Unrealized gains and losses are included in income.
What happens on a bond or other debt securities securities maturity date?
The principle (AKA face amount) is paid to investors.
How do we report unrealized gain or loss from transfer at market fair value? (transfer from TS to AFS or HTM)
There is none recognized in income
How are changes in holding gains and losses to be classifies on the income statement when security is held to maturity?
They are ignored
How are securities to be held to maturity reported on the balance sheet?
They are reported at amortized cost
Primary purpose of accounting
To provide information useful for making decisions
Investments in debt or equity securities acquired for principally for the purpose of selling them in the near term.
Trading securities
Reporting earnings-dividends paid
Undistributed earnings
Why treat unrealized gains and losses differently on the type of investment?
What's most relevant for that purpose is not necessarily the same for each investment a company might make.
Securities Available For Sale
When a company acquire an investment, net for active trading account or to be held to maturity.
What is hedging?
When companies purchase AFS investments for the purpose of having the changes in fair value of those investments offset changes in fair value of liabilities.
When does the fair value of a bond change?
When market interest changes
When do you calculate the present value of an ordinary annuity of $1?
When you are calculating interest
When do you calculate the present value of $1?
When you are calculating principle (face amount)
Under the equity method, At the transfer date, the recorded value is the initial cost of the investment
adjusted for the investor's equity in the undistributed earnings of the investee since the original investment.
ALL initial investment securities are recorded at
cost
At the transfer date, the carrying value of the investment under the equity method is regarded as
cost
If market rates of interest increase after a fixed-rate security is purchased, the value of the fixed interest payments ___, so the fair value of investment ___.
decrease; decreases
If issued interest rate is less than market interest rate it's sold at a
discount
When the investor's ownership level increases to the point where they can exert significant influence, the investor should change to the
equity method
If market rates of interest decrease after a fixed-rate security is purchased, the value of the fixed interest payments ___, so the fair value of investment ___.
increase; increases
How do you calculate the present value (price) of bonds?
interest + principle
Once the fair value option is chosen...
it cannot be changed
The investor recognizes investment income equal to
its percentage share (based on stock ownership) of the net income earned by the investee rather than the portion of that net income received as cash dividends.
If issued interest rate is more than market interest rate it's sold at a
premium
How do you calculate the amortized cost of the investment?
principle- [discount on bond (principle)-discount on bond (interest)]
How do you figure out the cash interest?
stated rate of interest*face amount
If the interest rate paid by bond ("stated rate") is more than the market rate, then
the bond can be sold for more than its maturity value ("sold at a premium")
If the interest rate paid by bond ("stated rate") is less than the market rate, then
the bond must be sold for less than its maturity value ("sold at a discount")
When using the equity method, if someone chooses to use fair value method then...
the investment is still classified on the balance sheet with equity method investments, but the portion at fair value must be clearly indicated.
