ACCTG 302 - Chapter 17

(LO17-4) Evaluate other major issues related to investments in debt and equity securities.

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

Debt securities

Financial securities that represent a creditor relationship with another entity. Examples are U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper.

Equity Securities

Financial securities that represent ownership interests such as common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership interests at an agreed-upon or determinable price, such as in warrants, rights, and call or put options. The cost of equity securities includes the purchase price of the security plus broker's commissions and other fees incidental to the purchase.

Consolidated financial statements

Financial statements that treat the parent and subsidiary corporations as a single economic entity.

Trading securities

Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences. Companies report trading securities at fair value at each reporting date, with unrealized holding gains and losses recognized as net income. Interest is recorded when earned.

Available-for-sale securities

Debt securities not classified as held-to-maturity or trading securities. Companies report available-for-sale securities at fair value, but do not report changes in fair value as part of net income until after they sell the security. Interest on available-for-sale securities is recorded when earned. Unrealized holding gains and losses on available-for-sale debt securities are recognized as other comprehensive income and as a separate component of stockholders' equity. Companies report available-for-sale securities at fair value on the balance sheet but do not report changes in fair value as part of net income until after selling the security

Held-to-maturity securities

Debt securities that the company has the positive intent and ability to hold to maturity. Companies report held-to-maturity securities at amortized cost, recognize interest when earned, and do not recognize unrealized holding gains or losses.

(LO17-1) Understand the accounting for investments in DEBT securities.

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 available-for-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 stockholder's equity.

Derivative financial statement

1. The instrument has (1) one or more underlyings and (2) an identified payment provision. 2. The instrument requires little or no investment at the inception of the contract. 3. The instrument requires or permits net settlement.

Subsidary

A corporation in which another corporation (parent) has a controlling interest (voting interest of more than 50 percent). The investment in the subsidiary is presented as a long-term investment on the financial statements of the parent.

Investor

A corporation that acquires an interest in the common stock of another corporation (investee) for investment purposes. The percentage of the investee voting stock that is held by the investor, which determines the amount of influence the investor has over the investee, generally determines the accounting treatment for the investment.

Parent

A corporation that has a controlling interest (voting interest of more than 50 percent) in another corporation (the subsidiary) Companies present the investment in the subsidiary as a long-term investment on the financial statements of the parent.

Investee

A corporation whose common stock is bought by another corporation (investor) for investment purposes.

Option contract

A derivative that gives the right but not the obligation to purchase or sell an underlying asset.

Derivative financial instrument (derivatives)

A financial instrument that derives its value from the values of other assets or other market-determined indicator. Examples include forward contracts, option contracts, and swaps. Used by producers, consumers, speculators, and arbitrageurs.

Controlling interest

A relationship in which one corporation acquires a voting interest of more than 50 percent in another corporation. The investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a long-term investment on the separate financial statements of the parent.

underlying

A specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable.

Forward contract

A type of derivative that gives the holder the right and the obligation to purchase an asset at a preset price at a specific time in the future.

Anticipated transaction

A type of transaction is which a company accumulates in equity gains or losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby affecting earnings.

Fair value adjustment

A valuation account that when added to the amortized cost of the investment yields fair value; use of this account enables a company to maintain a record of its amortized cost of available-for-sale and trading securities.

Reclassification adjustment

Adjustment made when at the end of a period in which a company sold securities, to ensure that gains and losses are not counted twice in comprehensive income. Without such an adjustment, a company might report realized gains or losses as part of net income but also show the gains or losses as part of other comprehensive income in the current or previous periods. Companies generally report reclassification adjustments in the notes to the financial statements.

(LO17-5) Describe the uses of and accounting for derivatives..

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 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. 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 in the type of hedge. 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.

(LO17-3) Explain the equity and consolidation methods of accounting.

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. Fair Value Method - a company reports the equity investment at fair value each reporting period irrespective of the investee's earning or dividends paid to it. Application Fair Value Method: holdings < 20% ownership Equity Method: holdings 20%-50% ownership Consolidating Procedures: holdings > 50% ownership

Futures contract

Gives the holder the right and the obligation to purchase an asset at a preset price for a specified period of time.

Call option

Gives the holder the right, but not the obligation, to buy shares at a preset price.

Speculator

Investors in forward contracts or other derivative instruments, who bet that the price of an asset will rise, thereby increasing the value of the derivative.

Arbitgraguers

Investors who use derivatives to lock in profits by simultaneously entering into transactions in two or more markets.

Equity method

Method of accounting for investment holdings of 20 percent or more (investments in which the investor and the investee acknowledge a substantive economic relationship). The investor records the investment at cost but adjusts the amount each period for changes in the investee's net assets. That is, the investor's proportionate share of the earnings (losses) of the investee periodically increase (decrease) the investment's carrying value. All dividends received by the investor from the investee decrease the investment's carrying amount. The earning of net income by the investee is not considered a proper basis for recognition of income from the investment by the investor.

Fair value method

Method of accounting for investment holdings of less than 20 percent (investments in which the investor has little or no influence over the investee), assuming that market prices are available subsequent to acquisition. The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities.

Gains trading

Method of managing net income by selling investment "winners" in order to report the gains in income, and holding on to the losers. Also referred to as "cherry picking," "snacking," or "sell the best and keep the rest."

Significant influence

The ability of an investor corporation to affect the operating and financial policies of an investee corporation, without possessing legal control of the investee. Examples include representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency

Amortized cost

The acquisition cost of debt securities adjusted for the amortization of discount or premium, if appropriate. Amortized cost is the valuation amount companies use to account for held-to-maturity debt securities.

Notional amount

The amount of shares available for purchase that is specified in a call option.

Option premium

The amount paid when entering into an option contract.

(LO17-2) Understand the accounting for investments in EQUITY securities.

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 voting stock of the investee held by the investor.

Intrinsic value

The difference between the market price and the preset strike price of an option at the grant date.

Holding gain or loss

The net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received.

Time value

The option's value over and above its intrinsic value, reflecting the possibility that the option has a fair value greater than zero.

Effective interest method

The preferred procedure for computing the amortization of a discount or premium. Under this method, companies compute bond interest expense (revenue) at the beginning of the period (by the effective-interest rate) and then subtract bond interest paid (calculated as the face amount of the bonds times the stated interest rate); the result is the amortization amount.

Exercise price

The price of shares specified in a call option.

Strike price

The price of shares specified in a call option.

Fair value

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.

Spot price

The price to be paid today for assets to be delivered at a future date.

Fair value hedge

The use of a derivative to offset the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment.

Cash flow hedge

Used by companies to hedge exposures to cash flow risk, which results from the variability in cash flows. Companies account for derivatives used in cash flow hedges at fair value on the balance sheet, but they record gains or losses in equity, as part of other comprehensive income.