Chapter 12
Superior Company owns 40% of the outstanding stock of Bernard Company. During 2018, Bernard paid a $100,000 cash dividend on its common shares. What affect did this dividend have on Superior's financial statements?
The investment account was decreased by $40,000 (40% x $100,000). Cash increased by the same amount. There is no effect in the income statement.
Define a financial instrument. Provide 3 examples of current liabilities that represent financial instruments.
A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.
What is "comprehensive income"? Its composition varies from company to company but may include which items related available-for sale investments that are not included in net income?
Comprehensive income is a more expansive view of the change in shareholders' equity than traditional net income. It encompasses all changes in the equity from non-owner transactions. The part of comprehensive income other than net income is called "other comprehensive income." Other comprehensive income includes net unrealized holding gains (losses) on AFS investments.
When a debt investment is acquired to be held for an unspecified period of time as opposed to being held to maturity, it is reported at the fair value of the investment securities on the reporting date. why?
For debt investments to be held for an unspecified period of time, fair value information is more relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because the sale at that fair value is not an option. The investor receives the same contracted interest payments for the period held to maturity and the stated principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in the fair values indicate management's success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.
Alll investments in debt securities are classified for reporting purposes in 1 of 3 categories, and can be accounted for differently depending on the classification. What are these 3 categories?
Held-to-Maturity Trading Available-for-Sale
How does IFRS differ from U.S. GAAP with respect to using the equity method?
IFRS require that accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Also, IFRS does not provide the fair value option for most investments that qualify for the equity method. U.S. GAAP provides the fair value option for all investments that qualify for the equity method.
(Based on Appendix 12A) Whole-life insurance policies typically can be surrendered while the insured is still alive in exchange for determinable amount of money called the cash surrender value. When a company buys a life insurance policy on the life of a key officer to protect the company against the ultimately loss of a valuable resource in the event the officer dies, how should the company account for the cash surrender value?
If the investor intends to sell the investment, or thinks it will be more likely than not that it will be required to sell the investment prior to recovering the impairment, the investor is required to recognize the entire impairment loss in the income statement as an OTT impairment, writing down the investment to fair value in the balance sheet. Otherwise, the investor considers whether credit losses exist. If there are no credit losses, no impairment loss is recognized. On the other hand, if there are some credit losses, then the investment is written down to fair value in the balance sheet. However, only the credit loss component is recognized in net income. Any noncredit losses are recognized in OCI. In the income statement, the entire impairment loss is shown, and then the amount of noncredit loss is subtracted, leaving only the credit loss reducing net income.
When market rates of interest rise after a fixed-rate security is purchased, the value of the now-below-market, fixed-interest payment declines, so the market value of the investment falls. On the other hand, if market rates of interest fall after a fixed-rate security is purchased, the fixed-interest payments become relatively attractive, and the market value of the investment rises. Assuming these changes are not viewed as giving rise to an other-than-temporary impairment, how are they reflected in the investment account for a security classified as held-to-maturity?
Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are ignored for a security classified as "held-to-maturity". These changes aren't important if sale before maturity isn't an alternative, which is the case if an investor has the "positive intent and ability" to hold the security to maturity.
The fair value of depreciable assets of Penner Packaging company exceeds their book value by $12 million. The assets' average remaining useful life is 10 years. They are being depreciated by the straight-line method. Finest Foods Industries buys 40% of Penner's common shares. When adjusting investment revenue and the investment by the equity method, how will the situation described affect those two accounts?
The equity method attempts to approximate the effects of accounting for the purchase of the investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values as of the date the investor acquired the investee. The accounting in the consolidated financial statements subsequent to the acquisition date is based on those fair values. So, if Finest had consolidated its acquisition of Penner, Penner's depreciable assets would have been put on Finest's balance sheet in their respective asset accounts at their fair value on the date of acquisition and then depreciated over 10 years. Under the equity method, Finest's investment in Penner is shown in a single investment account. Therefore, for the equity method to approximate consolidation, it would reduce both investment revenue (as if depreciation expense were being recognized) and the investment (as if the book value of the asset were being reduced) by the negative income effect of the "extra depreciation" the higher fair value would cause. This would equal 40% x $12 million ÷ 10 years = $480,000 each year for 10 years.
Under what circumstances is the equity method used to account for an investment in stock?
The equity method is used when an investor can't control but can "significantly influence" the investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.
Do U.S. GAAP and IFRS differ in the amount of flexibility that companies have in electing the fair value option? Explain.
U.S. GAAP allows companies complete discretion in electing the fair value option when an investment is made. The only constraint is that the election is irrevocable. IFRS allows companies to elect the fair value option only in specific circumstances, for example, when electing the fair value option for an asset or liability allows a company to avoid the "accounting mismatch" that occurs when some parts of a fair value risk-hedging arrangement are accounted for at fair value and others are not.
Under IFRS No. 9, what reporting categories are used to account for debt investments? What about for equity investments when the investor lacks the ability to significantly influence the operations of the investee?
Under IFRS No. 9, investments in debt securities are classified either as amortized cost (accounted for like HTM investments in U.S. GAAP), fair value through other comprehensive income ("FVOCI", accounted for like AFS investments) and fair value through profit or loss ("FVPL", accounted for like trading securities).
Under IFRS No. 9, which reporting categories are used to account for equity investments when the investor lacks the ability to significantly influence the operations of the investee?
Under IFRS No. 9, investments in equity securities are classified as either fair value through profit and loss ("FVPL", accounted for like trading securities) or fair value through other comprehensive income ("FVOCI", accounted for like AFS investments). If the equity investment is held for trading, it must be classified as FVPL, but otherwise the company can irrevocably elect to classify it as FVOCI.
Why are holding gains and losses treated differently for trading securities and securities available-for-sale?
Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal. On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are less relevant performance measures to be included in earnings.
Westen Die-Casting Company holds an investment in unsecured bonds of LGB Heating Equipment, Inc. When the investment was acquired, management's intention was to hold the bonds for resale. Now management has the positive intent ability to hold the bonds to maturity. How should Western account for the reclassification of the investment?
When acquired, debt securities are assigned to one of the three reporting classifications: held-to-maturity, trading, or available-for-sale. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred: 1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period. 2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded in other comprehensive income, which will then increase accumulated other comprehensive income in shareholders' equity. 3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity. This would be the case for Western Die-Casting's investment in the LGB Heating Equipment bonds.
Does GAAP distinguish between fair values that are readily determinable from current market prices versus those needing to be calculated based on the company's own assumptions? Explain how a user will know about the reliability of the inputs used to determine fair value.
GAAP distinguishes between 3 levels of inputs to fair value determination, with level 1 being readily observable for fair values (for example, from a securities exchange), level-2 inputs are other observable amounts (for example, quoted values for similar items, or important inputs like interest rate), and level 3 inputs are unobservable, like the company's own assumptions. GAAP requires disclosure of the amount of fair values based on each of these 3 classes of inputs.
(Based on Appendix 12A) Northwest Carburetor Company established a fund in 2015 to accumulate money for a new plant scheduled for construction in 2018. How should this special purpose fund be reported in Northwest's balance sheet?
Part of each premium payment the company makes is not used by the insurance company to pay for life insurance coverage, but rather is "invested" on behalf of the insured company in a fixed-income investment. As a result, the periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset—cash surrender value.
The equity method has been referred to as a one-line consolidation. What might prompt this description?
The equity method, like consolidation, views the investor and investee as a special type of single entity. By the equity method, though, the investor doesn't include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.
In the application of the equity method, how should dividends from the investee be accounted for? Why?
The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investee's net assets, indicating that the investor's ownership interest in those net assets declines proportionately.
Reporting an investment at its fair value means adjusting its carrying amount for changes in fair value after its acquisition (or since the last reporting date if it was held at that time). Such changes are called unrealized holding gains and losses because they haven't yet been realized through the sale of the security. If the security is classified at available for sale, how are unrealized holding gains and losses typically reported.
The way unrealized holding gains and losses are reported in the financial statements depends on whether the debt investments are classified as "securities available-for-sale" or as "trading securities." Securities available-for-sale are reported at fair value, and resulting holding gains and losses are NOT included in the determination of income for the period. Rather, they are reported as a seperate component of shareholders' equity as part of other comprehensive income (OCI). (Available-for-sale securities for which the investor has chosen the fair value option are treated like trading securities.)
Some financial statements are called derivatives. Why?
These instruments "derive" their values or contractually required cash flows from some other security or index.
What is the effect of a company electing the fair value option with respect to an investment that otherwise would be accounted for using the equity method?
When a company elects the fair value option for a significant-influence investment, the investment still appears in the balance sheet as a significant-influence investment, but the amount that is accounted for at fair value is indicated in the balance sheet either parenthetically on a single line that includes the total amount of significant-influence investment or on a separate line. As with trading securities, unrealized gains and losses are included in earnings in the period in which they occur.
What is the effect of a company electing the fair value option with respect to a held-to-maturity investment or an available-for-sale investment
When a company elects the fair value option for held-to-maturity or available-for-sale investments, it accounts for the investment the same way it would account for a trading security. Specifically, it shows the investment at fair value in the balance sheet and includes unrealized gains and losses in net income.
Sometimes an investor's level of influence changes, making it necessary to change from the equity method to another method. How should the investor account for this change in accounting method?
When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then on. The investment account balance when the equity method is discontinued would serve as the new "cost" basis for writing the investment up or down to fair value in the next set of financial statements.
Is it necessary for an investor to report individual amounts for the 3 categories of investments- held-to-maturity, available-for-sale, or trading- in the financial statements? What information should be disclosed about these investments?
Yes. Although a company is not required to report individual amounts for the three categories of investments—held-to-maturity, available-for-sale, or trading—on the face of the balance sheet, that information should be presented in the disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type. Information about the level of the fair value hierarchy upon which fair values are based should be provided, and more disclosure is necessary with respect to amounts based on level 3 of the fair value hierarchy.