Unit 07 - Investments - Ch 17

Hybrid Security

A security with the characteristics of both debt and equity often combining traditional and derivative financial instruments. // Made up of a host security and an embedded derivative.

Derivative: Define 'Swap Contract'

Exchange of cash flow stream usually associated with interest on debt; fixed interest payments for variable rate payments.

Derivative TYPE: Define 'Cash Flow Hedge'

These hedge exposures to cash flow risk. 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.

IFRS Similarities

Classifications for trading investments. //// Accounting for trading investments. // Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. //// Same test to determine if the equity method should be used. //// The decision to account for an item at fair value or not is made upon purchase and can not be changed. //// Measurements of impairments.

Debt Investment Classifications

Companies group investments in debt securities into three separate categories for accounting and reporting purposes: *HELD-TO-MATURITY*: Debt securities that the company has the positive intent and ability to hold to maturity. *TRADING*: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences. *AVAILABLE-FOR-SALE*: Debt securities not classified as held-to-maturity or trading securities. ///// Under IFRS, debt investments are classified as either HELD-FOR-COLLECTION (amortized cost) or TRADING (fair value).

This special accounting is justified because

For example, when a company uses a put option to hedge price changes in an available-for-sale stock investment in a fair value hedge (see the Hayward example earlier), it records unrealized gains on the investment in earnings, which is not GAAP for available-for-sale securities without such a hedge. This special accounting is justified in order to accurately report the nature of the hedging relationship in the balance sheet (recording both the put option and the investment at fair value) and in the income statement (reporting offsetting gains and losses in the same period).

Qualifying Hedge Criteria

Criteria of when to use hedge accounting. /// *(1) Documentation, risk management, and designation*: Formal documentation at inception of several things including risk management objective. Designation is identifying the instrument and it's details. /// *(2) Effectiveness of the hedging relationship*: At inception and on an ongoing basis, the hedging relationship should be highly effective in achieving offsetting changes in fair value or cash flows. /// *(3) Effect on reported earnings of changes in fair values or cash flows*: There is no need for special hedge accounting if a company accounts for both the hedging instrument and the hedged item at fair value under existing GAAP.

Two methods to determine if consolidated financial statements are needed

*VOTING-INTEREST* Model: If a company owns more than 50 percent of another company, then consolidate in most cases. /// *RISK-AND-REWARD* Model: If a company is involved substantially in the economics of another company, then consolidate. Creates Variable-Interest Entity VIE. /// The question that must then be asked is, "What party is exposed to the majority of the risks and rewards associated with the VIE?" This party is called the primary beneficiary and must consolidate the VIE.

Disclosure of Fair Value Information: Level 3 - 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.

Variable-Interest Entity (VIE)

Determined by the 'Risk-and-Reward' model for consolidating financials. /// An entity that has *1 one 1* of the following characteristics: // *Insufficient equity investment at risk*. Stockholders are assumed to have sufficient capital investment to support the entity's operations. If thinly capitalized, the entity is considered a VIE and is subject to the risk-and-reward model. // *Stockholders lack decision-making rights*. In some cases, stockholders do not have the influence to control the company's destiny. // *Stockholders do not absorb the losses or receive the benefits of a normal stockholder*. In some entities, stockholders are shielded from losses related to their primary risks, or their returns are capped or must be shared with other parties.

Derivative TYPE: Define 'Fair Value Hedge'

A company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment. For example, a company buys stock in another company but also buys a put option to sell the stock at the current rate if they want to. So, if the rate goes up they gain, and if the rate goes down then they use the put option and don't lose.

Derivative: Define 'Option Contract'

A contract between a purchaser and a broker giving the purchaser the option to buy certain third party stock in the future at today's price for a flat fee now. If the price of the stock goes up then the purchaser buys it and profits and the cost of the stock is todays price plus the cost of the contract. If the price does not go up the purchaser does not purchase the stock but still pays the flat fee for the contract.

Derivative: Define 'Forward Contract'

A contract between the purchaser and a broker to buy certain third party stocks in the future at a set price. If the stock goes up the purchaser profits and vice versa. // Like a forward contract but this is between direct parties not a clearinghouse or an exchange.

Differences between a Derivative and a Traditional Financial Instrument

A derivative financial instrument has the following three basic characteristics: (1) The instrument has one or more underlyings and an identified payment provision. An underlying is a specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. (2) The instrument requires little or no investment at the inception of the contract. (3) The instrument requires or permits net settlement. The company could realize a profit on the call option without taking possession of the shares. This net settlement feature reduces the transaction costs associated with derivatives.

Derivative: Define 'Futures Contract'

A futures contract gives the holder the right and the obligation to purchase an asset at a preset price for a specified period of time. // Like a forward contract but purchased through a clearinghouse or an exchange rather than direct parties. // If the cost of the product increases then the value of the contract increases because it allows the purchase at the lower rate. // The Spot Price is the price to be paid today for inventory to be delivered in January. // When the spot price and the contract price are equal the contract has no value so no entry is required. // Because the term is short it is a current asset. Because it is a cash flow hedge the unrealized gain/loss is in Other Comprehensive Income. // The gain isn't fully realized into net income until after the inventory is sold and the COGS is reduced by the gain.

Summary of Derivatives Used for Hedging: Fair Value

Accounting: At fair value with holding gains and losses recorded in income. // Hedges: At fair value with gains and losses recorded in income. // Example: Put option to hedge an equity investment.

Summary of Derivatives Used for Hedging: Cash Flow

Accounting: At fair value with unrealized holding gains and losses from the hedge recorded in other comprehensive income, and reclassified in income when the hedged transaction's cash flows affect earnings. // Hedges: Use other generally accepted accounting principles for the hedged item. // Example: Use of a futures contract to hedge a forecasted purchase of inventory.

Summary of Derivatives Used for Speculation

Accounting: At fair value with unrealized holding gains and losses recorded in income. // Hedges: No special accounting. // Example: Call or put option on an equity security.

Accounting for Derivatives

Balance Sheet: These are *assets and liabilities* reported at *fair value*. // Income Statement: Speculators should recognize any unrealized gain or loss in income. Hedgers account for it depending on the type of hedge used. (discussed later).

Fair Value Option

If a company chooses to use the fair value option upon purchase, it must measure this instrument at fair value until the company no longer has ownership. Each new instrument can be designated as held-to-maturity using equity method or as available-for-sale using fair value. Once it is designated it can't be changed.

Impairment of Value

If the decline is judged to be other than temporary, a company writes down the cost basis of the individual security to a new cost basis. /// Debt securities use a test to see if it is probably that the investor will be unable to collect all amounts due to the contractual terms. /// Equity securities have no test. Realizable value has to be lower than the carrying amount of the investment with many other considerations.

Passive Interest - Equity Holdings of Less Than 20%

Little or no influence over the investee. /// Fair value method. /// Trading and available-for-sale securities. Can't be held-to-maturity because equity securities have no maturity. Unrealized holding gains / losses in Other Comprehensive Income for available-for-sale securities or in net income for trading securities.

Who Uses Derivatives? Arbitrageurs

Market players that attempt to exploit inefficiencies in markets. They seek to lock in profits by simultaneously entering into transactions in two or more markets. For example, an arbitrageur might trade in a futures contract. At the same time, the arbitrageur will also trade in the commodity underlying the futures contract, hoping to achieve small price gains on the difference between the two. //// Markets rely on speculators and arbitrageurs to keep the market liquid on a daily basis.

Who Uses Derivatives? Speculators

Market players that bet that the market will go up or down so they purchase the producers forward contract and then quickly sell it to another speculator or to a consumer. //// Markets rely on speculators and arbitrageurs to keep the market liquid on a daily basis.

Transfer Equity Securities from Trading to Available-for-Sale or Vice Versa

Measurement Basis: Security transferred at fair value at the date of transfer, which is the new cost basis of the security. /// Impact of Transfer on Stockholders Equity: The unrealized gain or loss at the date of transfer increases or decreases stockholders' equity. /// Impact of Transfer on Net Income: The unrealized gain or loss at the date of transfer is recognized in income.

Transfer Equity Securities from Held-to-Maturity to Available-for-Sale

Measurement Basis: Security transferred at fair value at the date of transfer. /// Impact of Transfer on Stockholders' Equity: The separate component of stockholders' equity is increased or decreased by the unrealized gain or loss at the date of transfer. /// Impact of Transfer on Net Income: None. /// According to GAAP, these types of transfers should be RARE.

Transfer Equity Securities from Available-for-Sale to Held-to-Maturity

Measurement Basis: Security transferred at fair value at the date of transfer. /// Impact of Transfer on Stockholders' Equity: The unrealized gain or loss at the date of transfer carried as a separate component of stockholders' equity is amortized over the remaining life of the security. /// Impact of Transfer on Net Income: None.

Disclosure of Fair Value Information: General

Must report cost and fair value for all instruments. /// Disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. /// The level used in the fair value hierarchy. 1: most reliable, active markets for identical assets/liab. 2: less reliable, quoted market prices on similar assets/liab. 3: least reliable, unobservable inputs that reflect the company's assumptions as to the value. //// For items measured at fair value using level 3 the company should report an analysis of ow the changes in fair value affect total gains and losses and their impact on net income.

Significant Influence - Equity Holdings of Between 20% and 50%

Possible significant influence. /// Equity method. /// Unrealized holding gains / losses are not recognized. Income is a proportionate share of investee's net income. /// The company originally records the investment at the cost of the shares acquired but subsequently adjusts the amount each period for changes in the investee's net assets. /// The investor's proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investment's carrying amount. All cash dividends received by the investor from the investee also decrease the investment's carrying amount.

The cost of equity securities includes

The purchase price of the security plus broker's commissions and other fees incidental to the purchase.

Debt Securities

These represent a creditor relationship with another entity. /// These include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. /// Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security.

Who Uses Derivatives? Producers and Consumers

These use a forward contract to agree to purchase the commodity at a future time using todays price. Both agree that the current price is acceptable. Both think the market will go their way and they will profit more. Regardless of which way it goes they both can turn a profit at the current price. Both are protected from large swings in the market. Both are "hedgers" because they are both "hedging their positions".

Derivative: Define 'Call Option'

This gives the holder the right, but not the obligation, to buy shares at a preset price. This price is often referred to as the strike price or the exercise price. The number of shares available to be purchased is he notional amount. The contract costs a flat fee called the option premium. The option premium is a calculated amount of the [intrinsic value] + [time value]. // Intrinsic value is the difference between the market price and the preset strike price at any point in time. // Time value reflects the possibility that the option has a fair value greater than zero.

Bifurcation

To separate a hybrid security into the host security and the embedded derivative. //// 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.

Displaying Other Comprehensive Income on Financial Statements

Two ways: (1) in a combined statement of income and comprehensive income, or (2) in a separate statement of comprehensive income that begins with net income.

Debt Investment Classifications: Held-to-Maturity Securities

Valuation: amortized cost, current or long-term asset. // Unrealized holding gains or losses: not recognized. // Other income effects: interest when earned; gains and losses from sale. //// Classify a debt security as this only if it has both (1) the positive intent and (2) the ability to hold those securities to maturity. Should not classify as this if holding period is indefinite or if company anticipates that a sale may be necessary in the future due to other influences.

Debt Investment Classifications: Trading Securities

Valuation: fair value as current assets (for debt and equity securities). // Unrealized holding gains or losses: recognized as other comprehensive income on the supplementary income stmt and as separate component of stockholders' equity. // Other income effects: interest and dividends when earned; gains and losses from sale. //// Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. A holding gain or loss is 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. In short, the FASB says to adjust the trading securities to fair value, at each reporting date. In addition, companies report the change in value as part of net income, not other comprehensive income. // As with other debt investments, when a trading investment is sold, the Debt Investments account is reduced by the amount of the amortized cost of the bonds. Any realized gain or loss is recorded in the "Other expenses and losses" section of the income statement. The Fair Value Adjustment account is then adjusted at year-end for the unrealized gains or losses on the remaining securities in the trading investment portfolio.

Debt Investment Classifications: Available-for-Sale Securities

Valuation: fair value as current or long-term assets (for debt and equity securities). // Unrealized holding gains or losses: recognized in net income as other comprehensive income on the supplementary income stmt. // Other income effects: interest when earned; gains and losses from sale. //// Value these securities *at fair value*. It records the *unrealized* gains and losses related to changes in the fair value of available-for-sale debt securities *in an unrealized holding gain or loss account*. Amazon adds (subtracts) this amount *to other comprehensive income for the period*. Other comprehensive income is then added to (subtracted from) *accumulated other comprehensive income*, which is shown as a separate *component of stockholders' equity until realized*. Thus, 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. This approach reduces the volatility of net income.

Debt Investment Valuation Methods

*FAIR VALUE* is 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. *AMORTIZED COST* is the acquisition cost adjusted for the amortization of discount or premium, if appropriate. Must use the *effective-interest method* (compute the effective-interest rate or yield at the time of investment and apply that rate to the beginning carrying amount (book value) for each interest period).

Host Security and Embedded Derivative

A hybrid security is made up of two parts. *HOST SECURITY*: in a convertible bond this is the initial debt security. *EMBEDDED DERIVATIVE*: in a convertible bond this is the option to convert the bond to shares of common stock. /// The hybrid security is bifurcated/split into two separate securities the each is accounted for as if they were separate.

Controlling Interest - Equity Holdings of More Than 50%

Controlling interest. Voting interest of over 50%. Parent / subsidiary relationship and titles. /// Consolidated statements. /// Unrealized holding gains / losses are not recognized.

IFRS Differences

IFRS uses held-for-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications. //// The basis of when to consolidate financial statements is only percent control of the company. //// IFRS allows reversals of impairments of held-for-collection investments. //// GAAP permits the fair value option for equity method investments; IFRS does not. //// IFRS says only debt investments can be measured at amortized cost.

Define Derivatives aka Derivative Financial Instruments

These are designed to manage the risk of volatile markets. Companies use the fair values or cash flows of these instruments to offset the changes in fair values or cash flows of the at-risk assets. /// These are called derivatives because these kind of contracts derive their value from the value of other assets such as third party stocks, bonds, or commodities.