Intermediate Financial Account Ch. 12
A financial instrument is defined as one of the following:
1. Cash. 2. Evidence of an ownership interest in an entity. 3. A contract that (a) imposes on one entity an obligation to deliver cash (say accounts payable) or another financial instrument and (b) conveys to the second entity a right to receive cash (say accounts receivable) or another financial instrument. 4. A contract that (a) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms (say the issuer of a stock option) and (b) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms (say the holder of a stock option).
The critical events over the life of an investment in the equity of another company, such as shares of common stock, include the following:
1. Purchasing the equity security. 2. Receiving dividends (for some equity securities). 3. Holding the investment during periods in which the investment's 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).
Recorded the necessary adjusting entries relating to the investments.
Accrued Interest (one month): Dr. Interest receivable (Vince-Gill) ($30 million × 12% × 1/12) 0.3 Dr. Interest receivable (Eastern Waste) ($24 million × 10% × 1/12) 0.2 Cr. Interest revenue 0.5 Fair Value Adjustments: Dr. Loss on investments (unrealized, NI) (TS) ($5.7 − $5.8) 0.1 Cr. Fair value adjustment (TS) 0.1 Dr. Fair value adjustment (AFS) ($25 million cost − $24 million fair value) 1 Cr. Gain on investments (unrealized, OCI) (AFS) 1
Balance sheet for AFS
Assets: Investment in bonds (AFS) Shareholders' equity: Accumulated other comprehensive income (AOCI) Retained Earnings
Balance sheet for TS
Assets: Investments in bonds (TS) Shareholders' equity: Retained Earnings
Reporting Categories for Equity Investments
Characteristics of the Equity Investment: The investor does not have significant influence over the operating and financial policies of the investee (typically owns less than 20% of voting stock): - Reporting Method Used by the Investor: Fair value through net income—similar to the trading-securities approach used for debt; investment reported at fair value (with unrealized holding gains and losses included in net income), unless fair value is not readily determinable Characteristics of the Equity Investment: The investor has significant influence over the operating and financial policies of the investee (typically owns between 20% and 50% of the voting stock): - Reporting Method Used by the Investor: Equity method—investment reported at cost adjusted for investor's share of subsequent earnings and dividends of the investee Characteristics of the Equity Investment: - The investor controls the investee (typically owns more than 50% of voting stock): - Reporting Method Used by the Investor: Consolidation—the financial statements of the investor and investee are combined as if they are a single company
All equity investments are recorded initially at
Cost
The journal entry to record the receipt of dividends related to the Arjent equity investment also is straightforward.
Dr. Cash Cr. Dividend revenue
The journal entry to record United's unrealized holding loss of $50,000 and the corresponding decrease in United's fair value adjustment account is
Dr. Loss on investments (unrealized, NI) 50,000 Cr. Fair value adjustment 50,000
AFS securities are reported at
Fair value
Have you ever bought a CD (Certificate of Deposit) at a bank?
If so, you've invested in a debt instrument. Let's say you buy a $500, 2-year, 4% CD. What's happened is that you are lending the bank $500 for 2 years, and the bank is promising to pay you 4% interest each year before returning your $500 after two years. The bank's debt (the $500 borrowed from you) is represented by a debt instrument (the CD), which specifies the maturity date (2 years), the principal ($500), and the annual rate of interest (4%).
As the investee earns additional net assets, the investor's investment in those net assets
Increases
If a bond is purchased at a discount,
Less cash is received each period than the effective interest earned by the investor, so the unpaid difference increases the outstanding balance of the investment.
Masterwear was offering its bonds for 12%, but investors could have obtained bonds of similar risk and maturity at a more favorable, higher rate of 14%. To attract investors,
Masterwear had to sell its bonds at a discount.
Some companies—primarily financial institutions—actively and frequently buy and sell securities, expecting to earn profits on short-term price fluctuations. Investments in debt acquired principally for the purpose of selling them in the near term are classified as
Trading securities
JE to Adjust Securities to Fair Value (2022). The journal entry to record the investment's decrease in fair value is:
We first need to update the fair value adjustment and recognize any unrealized holding gains or losses that have occurred during the current reporting period prior to the date of sale. Beg. Balance 1/1/22 +/- adjustment needed to update fair value Balance needed as of date of sale Dr. Loss on investments (unrealized , NI) Cr. FV adjustment
If the bonds were instead purchased at a premium,
a similar amortization schedule would reduce the premium over time until the bond's amortized cost reached the face amount, which is the amount to be received when the debt matures.
Held to maturity (HTM) investments are reported at
amortized cost in the balance sheet.
HTM securities are reported at
amortized cost less any allowance for credit losses.
The equity method is used when
an investor can't control, but can significantly influence, the investee.
companies classify debt investments as one of three types:
categories: held-to- maturity (HTM) securities, trading securities (TS), or available-for-sale (AFS) securities.
Cash flows from buying and selling HTM securities are
classified as investing activities.
All investment securities are initially recorded at
cost
Equity investments for which the investor does not have significant influence are classified as either
current (short-term) or noncurrent (long-term) in the balance sheet. Those that are held with an intent for short-term profit are normally treated as operating activities in the statement of cash flows, similar to debt investments that are classified as trading securities. Other current equity investments, and long-term equity investments, are classified as investing activities in the statement of cash flows. Notes to the financial statements should disclose the portion of unrealized holding gains and losses for the period that relate to any equity securities still held by the company at the end of the reporting period. Notes also should provide information about how the carrying value was calculated for equity investments for which fair value is not readily determinable.
The differences in how the two approaches (Fair Value Through Net Income, equity method) account for unrealized holding gains and losses result in
different carrying values for the investment at the time the investment is sold, and therefore result in different realized gains or losses when the investment is sold.
As the investee distributes net assets as dividends, the investor
does not recognize revenue. Rather, the investor's investment in the investee's net assets is reduced.
Trading securities are reported at
fair value in the balance sheet.
Derivatives
financial instruments that "derive" their values from some other security or index.
Dividends received for equity investments are included
in income.
Under the effective interest method,
interest for a period equals the market rate of interest when the debt was purchased multiplied by the outstanding balance of the debt at the beginning of the period.
Cash flows from buying and selling AFS securities usually are classified as
investing activities.
the purchase of a bond and the receipt of interest payments—
is handled the same way regardless of how the debt investment is classified.
A concern with fair value accounting is that
management has much discretion over fair values, and may not be able to estimate fair values accurately.
Usually an investor can control the investee if it owns
more than 50% of the investee's voting shares
For trading securities, fair value changes affect
net income in the period in which they occur.
The way an investment is accounted for affects
net income, investment book value, and the amount of gain or loss recognized when the investment is sold.
AOCI (in shareholders' equity) includes
net unrealized holding gains or losses accumulated over the current and prior periods.
If all of the unrealized holding gains or losses have been included in net income up to the time of sale,
no additional gain or loss is recognized.
When an equity method investment is sold, a gain or loss is
recognized for the difference between its selling price and its carrying amount. Dr. Cash Dr. Loss on investments (NI) (To balance) Cr. Investment in equity affiliate (account balance)
Consolidated financial statements combine
the individual elements of the parent and subsidiary statements.
if the market rate of interest falls after a bond is purchased,
the market will calculate the present value of the cash flows provided by the bond using that lower rate, so the fair value of the bond rises. In that case, the investor holding the bond enjoys an unre- alized holding gain. The fair value of the bond has increased but that gain hasn't yet been realized, because the investment hasn't been sold.
The fair value of a fixed- rate investment moves in
the opposite direction of market interest rates.
Equity investments are adjusted to
their fair value at each reporting date.
Other comprehensive income includes
unrealized holding gains and losses that occur during the reporting period.
Held-to-maturity (HTM):
used for debt for which the investor has the "positive intent and ability" to hold to maturity. Treatment of unrealized holding gains and losses: not recognized Carried in balance sheet at: amortized cost
The trading securities treatment assumes
we are planning to sell the bonds in the very near future.
AFS securities appear in the financial statements as follows:
∙ Income Statement and Statement of Comprehensive Income: Gains and losses are shown in OCI in the periods in which changes in fair value occur. Those amounts are reclassified out of OCI and recognized in net income in the periods in which securities are sold. ∙ Balance Sheet: Investments in AFS securities are reported at fair value. Unrealized holding gains and losses become part of AOCI in shareholders' equity, and are reclassified out of AOCI in the periods in which securities are sold. ∙ Cash Flow Statement: Cash flows from buying and selling AFS securities typically are classified as investing activities.
Because we recognize investment revenue when net income is recognized by the investee, it would be inappropriate to recognize revenue again when that income is distributed as dividends. That would be double counting. Instead, we view the dividend distribution as reducing the investee's net assets. The rationale is that the investee is returning assets to its investors in the form of a cash payment, so each investor's equity interest in the remaining net assets declines proportionately.
Dr. Cash Cr, investment in equity affiliate
JE to record the sale transaction to record receipt of cash and remove the investment-related accounts from the balance sheet
Dr. Cash Dr. Discount on bond investment (account balance) Cr. Investment in bonds (account balance) Cr. Fair value adjustment (account balance)
JE to Record the Sale record receipt of cash and remove the investment-related accounts from the balance sheet:
Dr. Cash Dr. FV adjustment (account balance) Cr. Investment in equity securities (account balance)
JE: Purchased $30 million of 12% bonds of Vince-Gill Amusement Corporation and $24 million of 10% bonds of Eastern Waste Disposal Corporation, both at face value. The Vince-Gill bonds are to be held until they mature, but the Eastern Waste bonds are to be held but might be sold if cash needs require it. Interest on each bond issue is payable semiannually on November 30 and May 31.
Dr. Investment in bonds (HTM, Vince-Gill) $30 Dr. Investment in bonds (AFS, Eastern Waste) 24 Cr. Cash 54
Pg 567 JE: Purchased U.S. Treasury bonds for $5.8 million as trading securities, hoping to earn profits on short-term differences in prices.
Dr. Investment in bonds (TS, U.S. Treasury bonds) 5.8 Cr. Cash 5.8
Recording United's purchase of 30% of Arjent is straightforward. The investment is recorded at cost:
Dr. Investment in equity affiliate Cr. Cash
Under the equity method, the investor includes in net income its proportionate share of the investee's net income. The reasoning is that, as the investee's net assets increase, the value of the investor's share of those net assets also increases, so the investor increases its investment by the amount of income recognized. United's entry would be as follows:
Dr. Investment in equity affiliate Cr. Investment revenue Of course, if Argent had recorded a net loss rather than net income, United would reduce its investment in Arjent and recognize a loss on investment for its share of the loss. You won't always see these amounts called "investment revenue" or "investment loss." Rather, United might call this line "equity in earnings (losses) of affiliate" or some other title that suggests it is using the equity method.
The journal entry to record the purchase of an equity investment is simple, just exchanging one asset (cash) for another (investment), as follows:
Dr. Investment in equity securities Cr. Cash
In the statement of cash flows, we report the purchase and sale of the investment as
Outflows and inflows of cash in the investing activities section, and the receipt of dividends is reported as an inflow of cash in the operating activities section.
Statement of Comprehensive Income for Ts
Revenues Expenses Other income (expense): Interest revenue Gain on investments Net income Other comprehensive income (OCI) Comprehensive income (Net income + OCI)
Statement of Comprehensive Income for AFS
Revenues Expenses Other income (expense): Interest revenue Gain on investments Net income Other comprehensive income (loss) items (OCI):* Gain on investments (unrealized) Reclassification adjustment for net gains and losses included in net income Total OCI Comprehensive income (Net income + OCI)
Because interest is paid semiannually, the present value calculations use:
a. one-half the stated rate (6%), b. one-halfthemarket rate (7%), and c. 6 (= 3 × 2) semiannual periods.
Changes in the investment account the first year are
adjusted for the fraction of the year the investor has owned the investment.
Unlike HTM securities, trading securities are carried at fair value in the balance sheet, so their carrying value must be
adjusted to fair value by the end of every reporting period. In fact, many companies adjust trading securities to fair value at the end of every day. Rather than increasing or decreasing the investment account itself, we use a valuation allowance, fair value adjustment, to increase or decrease the carrying value of the investment. At the same time, we record an unrealized holding gain or loss that is included in net income in the period in which fair value changes (remember, the gain or loss is unrealized because the securities haven't been sold).
The fair value of the bonds will
change with changes in the prevailing market interest rate, because market participants will use the prevailing rate to compute the present value of the cash flows provided by the bond.
There is one important exception to the general rule that companies don't recognize unrealized gains and losses for HTM investments.
companies are required to use the Current Expected Credit Loss (CECL) model to account for bad debts with respect to accounts receivable and notes receivable. Companies likewise are required to use the CECL model to account for credit losses on HTM investments. That requires companies to make an estimate of the amount of interest and principal payments they won't receive in the future. Companies account for that estimate by recognizing a credit loss in net income and reducing the carrying value of the HTM investment with an allowance for credit losses, just like they recognize bad debt expense and an allowance for uncollectible accounts for accounts receivable.
Reclassifications are quite unusual, so when they occur,
disclosure notes should describe the circumstances that resulted in the transfers.
The financial instruments project has three separate but related parts:
disclosure, recognition and measurement, and distinguishing between liabilities and equities.
GAAP allows a fair value option (FVO) that permits companies to
elect to account for most financial assets and liabilities at fair value. Under the FVO, HTM and AFS investments are shown in the balance sheet at their fair values, and unrealized gains and losses are recognized in net income in the period in which they occur. That accounting approach should sound familiar—it's the same approach we use to account for trading securities. However, unlike trading securities, purchases and sales of investments accounted for under the FVO are likely to be classified as investing activities in the statement of cash flows, because those investments are not held for sale in the near term and therefore are not operational in nature.
A transfer of a security between reporting categories is accounted for at
fair value and in accordance with the new reporting classification.
Like trading securities, we report AFS securities in the balance sheet at
fair value. Unlike trading securities, though, unrealized holding gains and losses on AFS securities are not included in net income. Instead, they are reported in the statement of comprehensive income as other comprehensive income (OCI).
When a trading security is sold, all of the gain or loss already has been
included in net income, so no additional gain or loss is recognized.
AFS: Only realized gains and losses are
included in net income.
When an AFS investment is sold, realized gains and losses are
included in net income.
amortization of the discount gradually
increases the amortized cost of the investment, until the investment reaches its principal amount of $700,000, which is the amount to be received when the debt matures.
The carrying amount of the investment is
its initial cost plus the investor's equity in the undistributed earnings of the investee.
Under the equity method, the investor recognizes on its own income statement
its proportionate share of the investee's income.
The FASB's ongoing financial instruments project is expected to
lead to a consistent framework for accounting for all financial instruments.
Fair Value Hierarchy
level 1: observable inputs that reflect quoted prices for identical assets or liabilities in active markets; level 2: inputs other than quoted prices included in level 1 that are observable for the asset or liability either directly or through corroboration with observable data; level 3: unobservable inputs (for example, a company's own data or assumptions)
starting in 2018, investors are not allowed to use the AFS approach for equity investments. Instead, all equity investments are accounted for
like trading securities, using an approach commonly referred to as fair value through net income. That means that equity investments for which the investor lacks sig- nificant influence are reported the same way we report debt investments that are classified as trading securities (covered in Part A of this chapter). The equity investments are carried at fair value in the balance sheet, with unrealized holding gains and losses recognized in net income in whatever period they occur.
comprehensive income is a
more all-encompassing view of operations than net income. It includes not only net income but also all other changes in equity that do not arise from transactions with owners. It therefore includes net income as well as other comprehensive income (OCI).
Cash flows from buying and selling trading securities are classified as
operating activities
A benefit of fair value accounting is that it
prevents managers from timing the sale of investments to recognize gains or losses in particular accounting periods.
Managers may structure equity investments to
qualify for their preferred accounting approach.
A series of losses or other factors could indicate that an equity-method investment's fair value has declined to an amount below its current carrying value. If that decline is viewed as other than temporary, the investor should
recognize an impairment loss in net income and reduce the carrying value of the investment to fair value in the balance sheet. The investor then continues with accounting under the equity method.
Regardless of approach (Fair Value Through Net Income, equity method), the same cash flows occur, and the same total amount of net income is
recognized over the life of the investment.
When an AFS investment is sold, accumulated unrealized gains and losses are
removed from AOCI using a reclassification entry.
Changes in fair value give
rise to unrealized holding gains and losses.
Usually an investor can exercise
significant influence over the investee when it owns at least 20% of the investee's voting shares.
At each reporting date, the appropriateness of the classification of a debt investment is reassessed. For instance, if the investor no longer has the ability to hold certain securities to maturity and will now hold them for resale, those securities would be reclassified from HTM to AFS. When a security is reclassified between two reporting categories, the security is
transferred at its fair value on the date of transfer. Any unrealized holding gain or loss at reclassification should be accounted for in a manner consistent with the classification into which the security is being transferred.
Trading (TS):
used for debt that is held in an active trading account for immediate resale. Treatment of Unrealized Holding Gains and Losses: Recognized in net income, and therefore in retained earnings as part of shareholders' equity. Carried in Balance Sheet at: fair value
The HTM treatment assumes
we hold the bonds for their entire life.
To record the purchase of an investment and the receipt of interest revenue,
we use iden- tical entries in all three approaches. (HTM, TS, AFS)
To record the purchase of an investment,
we use the same basic entry for both approaches (Fair Value Through Net Income, equity method)
The two approaches (Fair Value Through Net Income, equity method) differ in
whether we record investment revenue when dividends are received and whether we recognize unrealized holding gains and losses associated with changes in the fair value of the investment.
Investors should disclose the following in the disclosure notes for each year presented:
∙ Aggregate fair value. ∙ Gross realized and unrealized holding gains. ∙ Gross realized and unrealized holding losses. ∙ Change in net unrealized holding gains and losses. ∙ Amortized cost basis by major security type. The notes also include disclosures designed to help financial statement users understand the quality of the inputs companies use when determining fair values and to identify parts of the financial statements that are affected by those fair value estimates.
The journal entry to record the interest received for the first six months as investment revenue is
Dr. Cash (stated rate x face amount) Dr. Discount on bond investment (difference) Cr. Interest revenue (market rate x outstanding balance) This entry reduces the discount by $4,664 (from $33,367 to $28,703). Because the dis- count gets smaller, the "amortized cost" of the investment (equal to $700,000 less discount) gets larger by the same amount (from $666,633 to $671,297).
When a change to the equity method is appropriate, the previous method is
discontinued and the balance in the investment account at the date of the change (including any unrealized holding gains or losses that occurred prior to the date the investment qualifies for the equity method) is used as the starting balance for applying the equity method. Any cost of acquiring additional shares is added to that balance, and going forward that balance is adjusted for the investor's portion of investee earnings and dividends. A disclosure note also should describe the change.
One strength of the equity method is that it
prevents the income manipulation that would be possible if a company recognized income when it received dividends and could significantly influence an investee to pay dividends whenever the company needed an income boost. Remember, under the equity method dividends aren't income, but rather reduce the book value of the investment. Nevertheless, users still need to realize that managers may choose and apply methods in ways that make their company appear most attractive. For example, research suggests that investments sometimes are structured to avoid crossing the 20 to 25% threshold that typically requires using the equity method, presumably to avoid the negative effect on earnings that comes from having to recognize the investor's share of investee losses and other income adjustments. Also, a company might smooth income by timing the sale of equity method investments to realize gains in otherwise poor periods and realize losses in otherwise good periods. While consistent with GAAP, mixing these sorts of one-time gains and losses with operating income could encourage users to think that operating income is less volatile than it really is.
net income is closed to
retained earnings at the end of each accounting period, and therefore accumulates in retained earnings over time in the shareholders' equity section of the balance sheet. Similarly, OCI is closed to accumulated other comprehensive income (AOCI) at the end of each accounting period, and therefore accumulates in AOCI in the shareholders' equity section of the balance sheet. OCI relates to AOCI the same way that net income relates to retained earnings.
The investor adjusts its share of the investee's net income to reflect
revenues and expenses associated with differences between the fair value and book value of the investee's assets and liabilities that existed at the time the investment was made.
Held to maturity (HTM) investments require
the "positive intent and ability" to hold the investments to maturity.
If the Fair Value Option is chosen for investments otherwise accounted for by the equity method:
the amount that is reported at fair value is clearly indicated.
If the fair value of purchased inventory exceeds its book value, we usually assume
the inventory is sold in the next year and reduce investment revenue in the next year by the entire difference.
Regardless of approach, the cash flows are
the same, and the same total amount of gain or loss is recognized in the income statement (TS: $43,646 in 2021 + $10,057 in 2022 = $53,703 total; AFS and HTM: $53,703 in 2022). The question is not how much total net income is recognized, but when the amounts are recognized in net income.
Trading securities appear in the financial statements as follows:
∙ Income Statement and Statement of Comprehensive Income: For trading securities, gains and losses are included in the income statement in the periods in which fair value changes, regardless of whether they are realized or unrealized. Investments in trading securities do not affect other comprehensive income. ∙ Balance Sheet: Investments in trading securities are reported at fair value, typically as current assets. ∙ Cash Flow Statement: Cash flows from buying and selling trading securities typically are classified as operating activities, because the financial institutions that routinely hold trading securities consider them as part of their normal operations.
To consider accounting for unrealized gains and losses, suppose that on December 31, 2021, the market interest rate for securities similar to the Masterwear bonds has fallen to 11%.
An investor valuing the Masterwear bonds at that time would do so considering the current market interest rate (11%) because that's the rate of return available for similar bonds. Calculating the present value of the bonds using a lower discount rate results in a higher present value (price).
Why use an approach for accounting for AFS securities that differs from that used for trading securities?
Because AFS securities are likely to be held for multiple reporting periods, one could argue that there is sufficient time for unrealized holding gains in some periods to balance out with unrealized holding losses in other periods, so including unrealized holding gains and losses in income each period would confuse investors by making income appear more volatile than it really is over the long run.10 But how can we show AFS investments at fair value in the balance sheet without recording in net income the unrealized gains and losses associated with changes in fair value? The solution is to show those unrealized gains and losses in OCI as they occur and then only include realized gains and losses in net income in the period in which an investment is actually sold.
Je to Record the Sale Transaction. Now that all of the unrealized holding gains and losses and the fair value adjustment have been cleared away, the final step is to "plug" for the realized gain or loss (a gain in this case).
Dr. Cash Dr. Discount on bond investment (account balance) Cr. Investment in bonds (account balance) Cr. Gain on investments (ni) (to balance)
Typically, held-to-maturity investments are—you guessed it—held to maturity. However, suppose that due to unforeseen circumstances the company decided to sell its debt invest- ment for $725,000 on January 5, 2022. United would record the sale as follows (for sim- plicity we ignore interest earned during the first five days of 2022):
Dr. Cash $725000 Dr. Discount on bond investment (account balance) 28703 Cr. Investment in bonds (account balance) $700000 Cr. Gain on investments (NI)(to balance) $53703 In other words, United would record this sale just like any other asset sale, with a realized gain or loss determined by comparing the cash received with the carrying value (in this case, the amortized cost) of the asset sold.
JE to Adjust AFS Investments to Fair Value to record an increase in the fair value adjustment and an additional unrealized holding gain
Dr. FV adjustment Cr. Gain on investments (unrealized, OCI) At this point, the investment is carried in the balance sheet at its fair value as of the date it is being sold, and all unrealized gains and losses associated with the investment have been included in OCI. Because OCI gets closed to AOCI, the unrealized gains and losses accumulate in AOCI, which acts as a sort of "holding tank" in the shareholders' equity section of the balance sheet. Unrealized holding gains in some years offset unrealized losses in other years as they accumulate in the tank.
JE to Adjust Trading Securities to Fair Value record an increase in the fair value adjustment and an additional unrealized holding gain
Dr. Fair value adjustment Cr. Gain on investments (unrealized, NI) (to balance) Formula: beginning balance +/- adjustment needed to update fair value Balance needed as of date of sale
JE to Reverse Previous Fair Value Adjustments United has been recording changes in fair value over the life of the investment. If United now sells that investment, the effects of those fair value changes must be reversed. United reverses previous unrealized holding gains included in OCI by debiting a reclassification adjustment to OCI for the same amount. Similarly, the account balance of the fair value adjustment is eliminated.
Dr. Reclassification adjustment (OCI) Cr. FV adjustment (account balance) After this journal entry is recorded, the fair value adjustment account has a zero balance. Also, after the reclassification adjustment is closed to AOCI, all of the unrealized gains that are associated with the investment have been removed from the AOCI holding tank in shareholders' equity. It's as if no accounting for unrealized gains and losses had ever taken place. That's important, because in the next entry United recognizes in net income a gain or loss on sale. If United didn't use the reclassification entry to back out the unrealized gains and losses from AOCI, it would end up having double counted them in comprehensive income and shareholders' equity after it records the sale in the next entry.
Be sure to notice that reporting trading securities at their fair value is a departure from amortized cost, which is the way many assets are reported in the balance sheet. Why the difference?
For trading securities, fair value information is more relevant than for other assets intended primarily to be used in company operations, like buildings, land and equipment, or for debt investments intended to be held to maturity. Changes in fair values 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 long-term or short-term securities. For that reason, it makes sense to report unrealized holding gains and losses on trading securities in net income during a period that fair values change, even though those gains and losses haven't yet been realized through the sale of the securities.
Companies invest in debt too.
Like a CD, a bond or other debt security has a specified date when it matures, and on that maturity date, the principal (also called the face amount or maturity value) is paid to investors. In the meantime, interest equal to some stated interest rate multiplied by the principal is paid to investors on specified interest dates (usually twice a year). Think of the principal and interest payments of the bond as a stream of cash flows that an investor will receive in the future in exchange for purchasing the bond today. The investor values that stream of future cash flows based on the prevailing market interest rate for debt of similar risk and maturity at the time the investor purchases the bond.
effective interest method
Masterwear's bonds have a stated rate of 12%, payable semiannually. This means that every six months, United will receive exactly $42,000 in cash from Masterwear: $700,000 (face amount) × (12% ÷ 2) (stated rate) = $42,000 Interest received
Only realized gains and losses are included in
Net income
unrealized holding gains and losses
Occur as a result of holding the bond during periods in which its fair value changes.
Statement of Cash Flows (direct method) for TS
Operating Activities: Cash from interest received Purchase of trading securities Sale of trading securities
Statement of Cash Flows (direct method) for Afs
Operating activities: Cash from interest received Investing activities: Purchase of available-for-sale securities Sale of available-for-sale securities
When debt investments are purchased, they are recorded at cost—that is, the total amount paid for the investment, including any brokerage fees.
Purchased less than their face amount: Dr. Investment in bonds (face amount) Cr. Discount on bond investment (difference) Cr. Cash (price paid for the bonds) Purchased higher than the face amount of the bond: Dr. Investment in bond (face amount) Dr. Premium on bond investment (difference) Cr. Cash (amount paid)
Transfer between Investment Categories
Transfer from Either HTM or AFS to trading - Unrealized Gain or Loss from Transfer at Fair Value: Include in current net income the total unrealized gain or loss, as if it all occurred in the current period. Transfer from Trading to Either HTM or AFS - Unrealized Gain or Loss from Transfer at Fair Value: Include in current net income any unrealized gain or loss that occurred in the current period prior to the transfer. (Unrealized gains and losses that occurred in prior periods already were included in net income in those periods.) Transfer from Held-to-maturity to Available-for-sale: - Unrealized Gain or Loss from Transfer at Fair Value: No current income effect. Report total unrealized gain or loss as a separate component of shareholders' equity (in AOCI). Transfer from Available-for-sale to Held-to-maturity: - Unrealized Gain or Loss from Transfer at Fair Value: No current income effect. Don't write off any existing unrealized holding gain or loss in AOCI, but amortize it to net income over the remaining life of the security (fair value amount becomes the security's amortized cost basis).
available-for-sale (AFS) securities
We aren't planning to trade the debt investment actively, but the investment is available to sell if, for example, cash needs arise or the market is particularly favorable. In that case, the company classifies its debt investment as ___.
The amount by which interest revenue exceeds interest received ($46,664 − $42,000 = $4,664 in the first six months) represents
a piece of the cost savings from purchasing the investment at a discount. This piece of the cost savings increases United's investment return from the rate the bond pays (12%) to the higher rate (14%) that investors could have earned on other similar bonds at the time they purchased the bond. In fact, this approach is called the effective interest method because interest revenue is based on the effective interest rate that the investment earns over its lifetime.
Choosing the fair value option for HTM and AFS investments means
accounting for them like trading securities.
Trading securities
are actively managed in a trading account for the purpose of profiting from short-term price changes. The holding period for trading securities generally is measured in hours and days rather than months or years. These investments typically are reported among the investor's current assets. Usually only banks and other financial operations invest in securities in the manner and for the purpose necessary to be categorized as trading securities.
Why allow the Fair Value Option (FVO)?
companies sometimes enter into hedging arrangements that are intended to reduce earnings volatility by offsetting changes in the fair value of assets with changes in the fair value of liabilities. Complex rules apply to many hedging arrangements. The FVO simplifies this process by allowing companies to choose whether to use fair value for most types of financial assets and liabilities. Thus, when a company enters into a hedging arrangement, it just has to make sure to elect the FVO for each asset and liability in the hedging arrangement, and fair value changes of those assets and liabilities will be included in earnings.
Individual securities available for sale are classified as either
current or noncurrent assets, depending on how long they're likely to be held.
The only difference is timing, with trading securities recognizing unrealized holding gains and losses
from fair value changes as they occur but the HTM approach recognizing gains or losses only when they are realized upon sale.
AFS investments aren't
held for trading or designated as held to maturity.
It may seem odd that we bother to put all of the unrealized holding gains and losses into OCI and then take them out again. However, that approach makes it very clear how we account for AFS investment over time. We can see that unrealized gains and losses are
included in OCI and accumulated in AOCI while an investment is held, and then upon sale are backed out of OCI (and AOCI) and included in net income (and retained earnings).
Unrealized holding gains and losses for trading securities are
included in net income in the period in which fair value changes. Included in the determination of income from operations in the period of the change.
If the interest rate paid by the bond (the stated rate) is higher than the market rate,
investors are willing to purchase the bond for more than its maturity value (so it's sold at a premium).
Discount on bond investment
is a contra-asset account to the investment account that serves to reduce the carrying value of the bond/investment to its cost at date of purchase
For AFS securities, unrealized holding gains and losses from fair value changes are
not included in net income, but instead are reported as OCI. Adjustment entry: Dr. Fr adjustment Cr. Gain on investments (unrealized, OCI)
Unlike trading securities, though, unrealized holding gains and losses on AFS securities are
not included in net income. Instead, they are reported in the statement of comprehensive income as other comprehensive income (OCI).
Just like HTM investments, trading securities are
recorded at cost when they are purchased, and any discount or premium is amortized to interest revenue over time as periodic interest payments are received. However, in subsequent periods, there are two important differences between trading securities and HTM investments. 1. Trading securities are written up or down to their fair value, or "marked to market," in the balance sheet. (HTM securities are kept at amortized cost.) 2. Corresponding unrealized holding gains and losses on trading securities are included in net income in the income statement. (HTM securities do not include unrealized holdings gains and losses in net income.)
For trading securities, unrealized holding gains and losses from fair value changes are
recorded up to the date an investment is sold.
Unrealized holding gains and losses are less important if
sale before maturity isn't an alternative, because those gains and losses will never be realized by sale. For this reason, if an investor has the "positive intent and ability" to hold the securities to maturity, investments in debt securities typically are classified as held-to-maturity (HTM) and reported at their amortized cost in the balance sheet.
As with HTM investments, companies are required to account for impairments of AFS investments, but the accounting is somewhat more complex. If fair value is less than amortized cost (such that the fair value adjustment has a credit balance), some impairment exists. In that case, accounting for the impairment depends on management's belief about whether it will
sell the investment. If management either intends to sell the investment or believes it is more likely than not that it will have to sell it before fair value recovers, the AFS investment is written down to fair value and the impairment loss recognized in net income. If, on the other hand, management does not intend to sell the investment and does not believe it is more likely than not it will have to sell the investment before fair value recovers, management is required to estimate and recognize credit losses and reduce the carrying value of the AFS investment with an allowance for credit losses, just as we do for HTM investments. Any remaining impairment is accounted for normally as an unrealized holding loss in other comprehensive income.
Corporations raise funds to finance their operations by
selling equity securities (common and preferred stock) and debt securities (bonds and notes). These securities, also called financial instruments, are purchased as investments by individual investors, mutual funds, and also by other corporations.
The company decides whether to elect the FVO on
the date the company purchases the investment. The company can elect the FVO for some securities and not for identical others—it's entirely up to the company, but the company has to explain in the notes why it made a partial election. The election is irrevocable. So, for example, if a company elects the FVO and later believes that the fair value of an investment is likely to decline, it can't change the election and discontinue use of fair value accounting to avoid recognizing a loss.
A debt security cannot be classified as held-to-maturity if
the investor might sell it before maturity in response to changes in market prices or inter- est rates, to meet the investor's liquidity needs, or similar factors.
If the market rate of interest rises after a bond is purchased,
the market will compute the present value of the cash flows provided by the bond using that higher discount rate, so the fair value of the bond falls. In that case, the person holding the bond suffers an unrealized holding loss. The fair value of the bond has decreased, but that loss hasn't been realized, because the investment has not been sold.
Why treat unrealized holding gains and losses differently depending on the type of investment?
the primary purpose of accounting is to provide information useful for making decisions. What's most relevant for that purpose is not necessarily the same for each investment a company might make. For example, a company might invest in corporate bonds to provide a steady return until the bonds mature, in which case day-to-day changes in fair value may not be viewed as very relevant, so the held-to-maturity approach is preferable. On the other hand, a company might invest in the same bonds because it plans to sell them at a profit in the near future, in which case the day-to-day changes in fair value could be viewed as very relevant, and the trading security or available-for-sale approach is preferable.
To record changes in fair value, the entries we use for TS and AFS securities have
the same effect on the investment (via the fair value adjustment valuation allowance) and the same eventual effect on total shareholders' equity. What differs is whether the unrealized holding gain or loss is recognized in net income and then in retained earn- ings (TS) or recognized in OCI and then in AOCI (AFS). No fair value adjustment is reported for HTM securities.
Trading securities are adjusted to
their fair value in each reporting period.
AFS investments are reported at
their fair values.
If the bond's stated rate is lower than the market rate,
then investors are willing to purchase the bond only at an amount less than its maturity value (so it's sold at a discount).
Available-for-sale (AFS):
used for debt that does not qualify as held-to-maturity or trading. Treatment of Unrealized Holding Gains and Losses: Recognized in other comprehensive income, and therefore in accumulated other comprehensive income in shareholders' equity. Carried in Balance Sheet at: fair value
HTM securities appear in the financial statements as follows:
∙ Income Statement and Statement of Comprehensive Income: Realized gains and losses are shown in net income in the period in which securities are sold. Unrealized holding gains and losses are disclosed in the notes to financial statements. Investments in HTM securities do not affect other comprehensive income. ∙ Balance Sheet: Investments in HTM securities are reported at amortized cost, less any allowance for credit losses. Fair values of those investments are disclosed in the notes to financial statements. ∙ Cash Flow Statement: Cash flows from buying and selling HTM securities typically are classified as investing activities.