Intermediate II Accounting: Chapter 17

People express concern about fair value measurements for two reasons:

(1) the lack of reliability related to the fair value measurement in certain cases, and (2) the ability to manipulate fair value measurements to achieve financial results inconsistent with the underlying economics of the situation.

Companies' motivations for investing in debt or equity securities issued by other companies:

1) To earn a high rate of return 2) To secure certain operating or financing arrangements with another company

It should not classify debt security as held-to-maturity if

1) it intends to hold the security for an indefinite period of time 2) a sale may be necessary due to changes in interest rates, foreign currency risk, liquidity needs, or other asset-liability management reason

In summary, companies follow these guidelines in accounting for derivatives.

1. Recognize derivatives in the financial statements as assets and liabilities. 2. Report derivatives at fair value. 3. Recognize gains and losses resulting from speculation in derivatives immediately in income. 4. Report gains and losses resulting from hedge transactions differently, depending on the type of hedge.

subsidiary

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. The parent company generally accounts for the investment in the subsidiary using the equity method.

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 instruments/Derivatives

A financial instrument that derives its value from the values of other assets or other market-determined indicator.

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.

hybrid security

A security that has both the characteristics of debt and equity, such as a convertible bond.

underlying

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

swap

A transaction between two parties in which the first party promises to make a payment to the second party. The second party, in turn, promises to make a simultaneous payment to the first party.

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.

Transfers Related to Debt Securities

Companies account for transfers between any of the categories at fair value. Thus, if a company transfers available-for-sale debt securities to held-to-maturity investments, it records the new investments (held-to-maturity) at the date of transfer at fair value in the new category. Similarly, if it transfers held-to-maturity investments to available-for-sale debt investments, it records the new investments (available-for-sale) at fair value. This fair value rule assures that a company cannot omit recognition of fair value simply by transferring securities to the held-to-maturity category.

The company purchases the call option for $400 and makes the following entry

Debit: Call option Credit: cash

Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2016, at a discount, paying $92,278. The bonds mature January 1, 2021, and yield 10%. Interest is payable each July 1 and January 1. Robinson records the investment as follows.

Debt Investments 92,278 Cash 92,278

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.

consolidated financial statements

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

speculators

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.

arbitrageurs

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

a convertible bond (discussed in Chapter 16) is a hybrid instrument

It consists of two parts: (1) a debt security, referred to as the host security, combined with (2) an option to convert the bond to shares of common stock, the embedded derivative.

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."

special accounting for the hedged item (in this case, the tire inventory) is necessary in a fair value hedge.

Note that upon designation of the hedge, the accounting for the inventory fair value change deviates from regular GAAP. That is, Hayward records an unrealized holding loss in income, even though it has not yet sold the inventory. If Hayward had not followed this accounting, a mismatch of gains and losses in the income statement would result

notional amount

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

bifurcation

The separation process required to account for an embedded derivative in another security (e.g., a convertible bond).

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.

hedging

The use of derivatives to offset the negative impacts of changes in interest rates, cash flows, or foreign currency exchange rates. The FASB allows special accounting for two types of hedges—fair value and cash flow hedges.

To provide consistency in accounting for similar derivatives, a company must account for embedded derivatives similarly to other derivatives.

Therefore, to account for an embedded derivative, a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation, Thus, a company investing in a convertible bond must separate the stock option component of the instrument. It then accounts for the derivative (the stock option) at fair value and the host instrument (the debt) according to GAAP, as if there were no embedded derivative.

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.

The extent of ownership by an investor in relation to the concentration of other shareholdings

To achieve a reasonable degree of uniformity in application of the "significant influence" criterion, the profession concluded that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption, that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee.

Double-counting of the realized gains or losses

When a company sells securities during the year, double-counting of the realized gains or losses in comprehensive income can occur. This double-counting results when the company reports realized gains or losses as part of net income in the current period but also shows the unrealized gains or losses as part of other comprehensive income as a result of recording fair value adjustments in previous periods. To ensure that gains and losses are not counted twice when a sale occurs, a reclassification adjustment is necessary.

Net income of the investee is not a proper basis for recognizing income from the investment by the investor

Why? Because the increased net assets resulting from profitable operations may be permanently retained for use in the investee's business. Therefore, the investor recognizes net income only when the investee declares cash dividends.

The earning of net income by Mini (the investee) is not considered a proper basis for recognition of income from the investment by Maxi (the investor)

Why? Mini may permanently retain in the business any increased net assets resulting from its profitable operation. Therefore, Maxi only recognizes revenue when it receives dividends from Mini.

3 categories of companies group investments in debt securities

1) Held to maturity 2) Trading 3) Available-for-sale

Two reasons for additional disclosure beyond the simple itemization of fair values are:

1. Differing levels of reliability exist in the measurement of fair value information. 2. Changes in the fair value of financial instruments are reported differently in the financial statements, depending on the type of financial instrument involved and whether the fair value option is employed.

designation

At inception of a hedge, the identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash flows attributable to the hedged risk.

Using dividends as a basis for recognizing income fails to report properly the economics of the situation.

For example, assume that the investee reports a net loss. However, the investor exerts influence to force a dividend payment from the investee. In this case, the investor reports income, even though the investee is experiencing a loss

Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2016, as follows.

Interest Receivable 4,000 Debt Investments 645 Interest Revenue 4,645

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.

Debt security can only be classified as held-to-maturity if it has both

1) the positive intent 2) the ability to hold those securities to maturity

The FASB identified certain criteria that hedging transactions must meet before requiring the special accounting for hedges. The FASB designed these criteria to ensure the use of hedge accounting in a consistent manner across different hedge transactions. The general criteria relate to the following areas.

1. Documentation, risk management, and designation 2. Effectiveness of the hedging relationship. 3. Effect on reported earnings of changes in fair values or cash flows.

The classification of such investments depends on the percentage of the investee voting stock that is held by the investor:

1. Holdings of less than 20 percent (fair value method)—investor has passive interest. 2. Holdings between 20 percent and 50 percent (equity method)—investor has significant influence. 3. Holdings of more than 50 percent (consolidated statements)—investor has controlling interest.

companies must provide the following (with special emphasis on Level 3 measurements):

1. Quantitative information about significant unobservable inputs used for all Level 3 measurements. 2. A qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed, including interrelationships between inputs. 3. A description of the company's valuation process. 4. Any transfers between Levels 1 and 2 of the fair value hierarchy. 5. Information about nonfinancial assets measured at fair value at amounts that differ from the assets' highest and best use. 6. The proper hierarchy classification for items that are not recognized on the balance sheet but are disclosed in the notes to the financial statements.

A derivative financial instrument has the following three basic characteristics:

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.

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.

documentation

At inception of a hedge, written proof of the hedging relationship.

Robinson records the sale of the bonds as:

Cash 102,417 Interest Revenue (4/6 × $4,000) 2,667 Debt Investments 99,683 Gain on Sale of Investments 67 The credit to Interest Revenue represents accrued interest for four months, for which the purchaser pays cash. The debit to Cash represents the selling price of the bonds plus accrued interest. The credit to Debt Investments represents the book value of the bonds on the date of sale. The credit to Gain on Sale of Investments represents the excess of the selling price over the book value of the bonds.

Robinson records the receipt of the first semiannual interest payment on July 1, 2016

Cash 4,000 Debt Investments 614 Interest Revenue 4,614

How to provide useful information

Companies account for investment based on the type of security (debt or equity) and their intent with respect to the investment.

Trading securities

Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. Similar to held-to-maturity or available-for-sale investments, companies are required to amortize any discount or premium.

Available-for-Sale Debt Securities Illustration: Assume that Hardy Company purchases bonds in Fielder Company during 2017 that it classifies as available-for-sale. At December 31, 2017, the cost of this security is $100,000; its fair value at December 31, 2017, is $125,000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2017.

Debt Investments 25,000 Unrealized Holding Gain or Loss—Income 25,000 In this situation, Hardy uses the titled Debt Investments account to record the change in fair value at December 31. It does not use a Fair Value Adjustment account because the accounting for a fair value option is on an investment-by-investment basis rather than on a portfolio basis. Because Hardy selected the fair value option, the unrealized gain or loss is recorded as part of net income. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security.

Trading

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

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.

Held to maturity

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. Only debt securities could be classified as this.

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.

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.

Some favor including the unrealized holding gain or loss in net income rather than showing it as other comprehensive income.

However, some companies, particularly financial institutions, note that recognizing gains and losses on assets, but not liabilities, introduces substantial volatility in net income. They argue that hedges often exist between assets and liabilities so that gains in assets are offset by losses in liabilities, and vice versa. In short, to recognize gains and losses only on the asset side is unfair and not representative of the economic activities of the company.

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.

fair value method (investments)

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.

For example, companies such as Coca-Cola, ExxonMobil, and General Electric borrow and lend substantial amounts in credit markets. In doing so, they are exposed to significant interest rate risk.

That is, they face substantial risk that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease. These same companies also have significant international operations. As such, they are also exposed to exchange rate risk—the risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses.

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. In instances of "significant influence" (generally an investment of 20 percent or more), the investor must account for the investment using the equity method.

option premium

The amount paid when entering into an option contract. It is generally much less than the cost of purchasing the shares directly. The option premium consists of two amounts: (1) intrinsic value and (2) time value.

host security

The basic element of a security that when combined with a derivative creates a hybrid security. For example, a debt security is the host security of a convertible bond.

risk management

The company's objective for entering into a hedge.

highly effective

The degree to which a hedge should offset changes in fair values or cash flows, in order to receive hedge accounting treatment.

intrinsic value

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

interest rate swap

The most common type of swap, in which one party makes payments based on a fixed or floating rate, and the second party does just the opposite.

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.

embedded derivative

The option, in a convertible bond, to convert the bond to shares of common stock.

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.

strike (exercise) 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.

The FASB established a fair value hierarchy.

This hierarchy identifies three broad levels—1, 2, and 3—related to the measurement of fair values. Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities. Level 3 is least reliable; it uses unobservable inputs that reflect the company's assumption as to the value of the financial instrument.

Companies that have debt securities that are classified as available-for-sale use a different impairment model

Under this model, if the fair value is greater than amortized cost, no expected credit loss is recognized.

Equity Method Investments Illustration: Assume that Durham Company holds a 28 percent stake in Suppan Inc. Durham purchased the investment in 2017 for $930,000. At December 31, 2017, the fair value of the investment is $900,000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this investment is as follows.

Unrealized Holding Gain or Loss—Income 30,000 Equity Investments 30,000

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.

to account for fair value hedges

record the derivative at its fair value in the balance sheet, and record any gains and losses in income. Thus, the gain on the swap offsets or hedges the loss on the bond payable, due to the decline in interest rates.