12sol_7e_final.pdf

Chapter 12

INVESTMENTS

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions

AACSB Tag

Brief Exercises

AACSB Tag

12–1 12–2 12–3 12–4 12–5 12–6 12–7 12–8 12–9 12–10 12–11 12–12 12–13 12–14 12–15 12–16 12–17 12–18 12–19 12–20 12–21 12–22 12–23 12–24 12–25 12–26 12–27 12–28 12–29 12–30 12–31 12–32 12–33 12–34

Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Analytic Analytic Reflective thinking Analytic

12–6 12–7 12–8 12–9 12–10 12–11 12–12 12–13 12–14 12–15 12–16 12–17 12–18 12–19 12–20

Analytic Analytic, Communications Analytic, Communications Analytic Analytic, Communications Analytic, Communications Analytic, Communications Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic

Brief Exercises 12–1 12–2 12–3 12–4

Exercises 12–1 12–2 12–3 12–4 12–5 12–6 12–7 12–8 12–9 12–10 12–11 12–12 12–13 12–14 12–15 12–16 12–17 12–18 12–19 12–20 12–21 12–22 12–23

Analytic Analytic Communications Analytic Reflective thinking, Analytic Communications Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic, Reflective thinking Analytic Analytic Analytic Analytic Analytic Communications Analytic Analytic Analytic

© The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–1

Exercises cont.

AACSB Tags

12–24 12–25 12–26 12–27 12–28 12–29 12–30 12–31

Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic

CPA/CMA 1 2 3 4 5 6 7 8 9 10 11 12 13 1 2 3

Reflective thinking Reflective thinking Analytic Analytic Reflective thinking Analytic Analytic Analytic Diversity, Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Reflective thinking Analytic Reflective thinking

Problems 12–1 12–2 12–3 12–4 12–5 12–6 12–7 12–8 12–9 12–10 12–11 12–12 12–13 12–14 12–15 12–16 12–17 12–18 12–19 12–20 12–21 12–22 12–23 12–24

Analytic Analytic Analytic, Communications Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Reflective thinking Analytic Analytic Analytic Analytic

© The McGraw-Hill Companies, Inc., 2013 12–2

Intermediate Accounting, 7e

Questions for Review of Key Topics Question 12–1 Investment securities are classified as “held-to-maturity,” “trading,” or “available-for-sale” securities.

Question 12–2 Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are ignored for a security classified as “held-tomaturity.” These changes aren’t important if sale before maturity isn’t an alternative, which is the case if an investor has the “positive intent and ability” to hold the security to maturity.

Question 12–3 GAAP distinguishes between three levels of inputs to fair value determination, with level 1 being readily observable fair values (for example, from a securities exchange), level 2 inputs are other observable amounts (for example, quoted values for similar items, or important inputs like interest rates), and level 3 inputs are unobservable, like the company’s own assumptions. GAAP requires disclosure of the amount of fair values based on each of these three classes of inputs.

Question 12–4 For investments to be held for an unspecified period of time, fair value information is more relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because sale at that fair value is not an option. The investor receives the same contracted interest payments for the period held to maturity and the stated principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in fair values indicate management’s success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.

Question 12–5 The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as “securities available-for-sale” or as “trading securities.” Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders’ equity, as part of other comprehensive income (OCI). (Available-forsale securities for which the investor has chosen the fair value option are reclassified as trading securities.)


12–3

Answers to Questions (continued) Question 12–6 Comprehensive income is a more expansive view of the change in shareholders’ equity than traditional net income. It encompasses all changes in equity from nonowner transactions. The nonincome part of comprehensive income is called “other comprehensive income.” Other comprehensive income includes net unrealized holding gains (losses) on AFS investments, and also the noncredit loss component of other-than-temporary impairments of HTM investments.

Question 12–7 Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal. On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are less relevant performance measures to be included in earnings.

Question 12–8 When acquired, debt and equity securities are assigned to one of the three reporting classifications: held-to-maturity, trading, or available-for-sale. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred: 1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period. 2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded in other comprehensive income, which will then increase accumulated other comprehensive income in shareholders’ equity. 3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity. This would be the case for Western Die-Casting’s investment in the LGB Heating Equipment bonds.



Answers to Questions (continued) Question 12–9 Yes. Although a company is not required to report individual amounts for the three categories of investments—held-to-maturity, available-for-sale, or trading—on the face of the balance sheet, that information should be presented in the disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type. Information about the level of the fair value hierarchy upon which fair values are based should be provided, and more disclosure is necessary with respect to amounts based on level 3 of the fair value hierarchy. In addition, information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least four maturity groupings: (a) within 1 year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.

Question 12–10 Under IFRS No. 9, debt investments are accounted for as either amortized cost or FVTPL (“fair value through profit and loss”), while equity investments are accounted for at FVTPL unless the equity is not held for trading and the investor elects at acquisition to account for the investment at FVTOCI (“fair value through other comprehensive income”).

Question 12–11 According to U.S. GAAP, the fair value of an equity security is considered readily determinable only if its selling price is currently available on particular securities exchanges or over-the-counter markets. If the fair value of an equity security is not readily determinable, U.S. GAAP uses the cost method. Under IFRS, equity investments typically are measured at fair value, even if they are not listed on an exchange or over-the-counter market. Under IAS No. 39, the cost method only is used if fair value cannot be measured reliably, which occurs when the range of reasonable fair value estimates is significant and the probability of various estimates within the range cannot be reasonably estimated. Under IFRS No. 9, the cost method is prohibited, although cost can sometimes be used as an estimate of fair value. Therefore, in general, use of the cost method is less prevalent under IFRS than under U.S. GAAP.

Question 12–12 When a company elects the fair value option for held-to-maturity or available-for-sale investments, it simply reclassifies those investments as trading securities and accounts for them in that fashion.


12–5

Answers to Questions (continued) Question 12–13 U.S. GAAP allows companies complete discretion in electing the fair value option when an investment is made. The only constraint is that the election is irrevocable. IFRS only allows companies to elect the fair value option in specific circumstances, for example, when electing the fair value option for an asset or liability allows a company to avoid the “accounting mismatch” that occurs when some parts of a fair value risk-hedging arrangement are accounted for at fair value and others are not.

Question 12–14 The equity method is used when an investor can’t control but can “significantly influence” the investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.

Question 12–15 The equity method, like consolidation, views the investor and investee as a special type of single entity. By the equity method, though, the investor doesn’t include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.

Question 12–16 The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investee’s net assets, indicating that the investor’s ownership interest in those net assets declines proportionately.



Answers to Questions (continued) Question 12–17 The equity method attempts to approximate the effects of accounting for the purchase of the investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values as of the date the investor acquired the investee. The accounting in the consolidated financial statements subsequent to the acquisition date is based on those fair values. So, if Finest had consolidated its acquisition of Penner, Penner’s depreciable assets would have been put on Finest’s balance sheet in their respective asset accounts at their fair value on the date of acquisition and then depreciated over 10 years. Under the equity method, Finest’s investment in Penner is shown in a single investment account. Therefore, for the equity method to approximate consolidation, it would reduce both investment revenue (as if depreciation expense were being recognized) and the investment (as if the book value of the asset were being reduced) by the negative income effect of the “extra depreciation” the higher fair value would cause. This would equal 40% x $12 million ÷ 10 years = $480,000 each year for 10 years.

Question 12–18 The investment account was decreased by $40,000 (40% x $100,000). Cash increased by the same amount. There is no effect in the income statement.

Question 12–19 When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then on. The investment account balance when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value in the next set of financial statements.

Question 12–20 IFRS require that accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Also, IFRS allow investors to account for a joint venture using either the equity method or “proportionate consolidation,” whereby the investor combines its proportionate share of the investee’s accounts with its own accounts on an item-by-item basis. U.S. GAAP generally requires that the equity method be used to account for joint ventures.

Question 12–21 When a company elects the fair value option for a significant-influence investment, that investment is not reclassified as a trading security. Rather, the investment still appears in the balance sheet as a significant-influence investment, but the amount that is accounted for at fair value is indicated in the balance sheet either parenthetically on a single line that includes the total amount of significant-influence investment or on a separate line. As with trading securities, unrealized gains and losses are included in earnings in the period in which they occur.


12–7

Answers to Questions (continued) Question 12–22 A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.

Question 12–23 These instruments “derive” their values or contractually required cash flows from some other security or index.

Question 12–24 Since this money won’t be used within the upcoming operating cycle, it is a noncurrent asset. It should be reported as part of investments.

Question 12–25 Part of each premium payment the company makes is not used by the insurance company to pay for life insurance coverage, but rather is “invested” on behalf of the insured company in a fixedincome investment. As a result, the periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset—cash surrender value.

Question 12–26 If the investor intends to sell the investment, or thinks it will be more likely than not that it will be required to sell the investment prior to recovering the impairment, the investor is required to recognize the entire impairment loss in the income statement as an OTT impairment, writing down the investment to fair value in the balance sheet. Otherwise, the investor considers whether credit losses exist. If there are no credit losses, no impairment loss is recognized. On the other hand, if there are some credit losses, then the investment is written down to fair value in the balance sheet. However, only the credit loss component is recognized in net income. Any noncredit losses are recognized in OCI. In the income statement, the entire impairment loss is shown, and then the amount of noncredit loss is subtracted, leaving only the credit loss reducing net income.



Answers to Questions (concluded) Question 12–27 If the OTT impairment relates to an equity investment, the entire amount of impairment is recognized in net income. Any previously recorded unrealized losses are reclassified out of AOCI. If the OTT impairment relates to a debt investment, the accounting is more complicated. First, if the investor intends to sell the investment, or thinks it will be more likely than not that it will be required to sell the investment prior to recovering the impairment, it is required to recognize the entire impairment loss in the income statement as an OTT impairment, writing down the investment to fair value in the balance sheet. Otherwise, the investor considers whether credit losses exist. If there are no credit losses, no impairment loss is recognized. On the other hand, if there are some credit losses, then the investment is written down to fair value in the balance sheet. However, only the credit loss component is recognized in net income. Any noncredit losses are recognized in OCI. In the income statement, the entire impairment loss is shown, and then the amount of noncredit loss is subtracted, leaving only the credit loss reducing net income.

Question 12–28 Given that the decline in shares relates to a new law banning a primary approach used by the company, it likely would be treated as an other-than-temporary impairment. So, when the investment is written down to its fair value, the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in income for the period. This could require a reclassification adjustment if any unrealized losses were included previously in OCI, just as if the investment was being sold. Subsequent to the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as a separate component of shareholders’ equity, accumulated other comprehensive income.

Question 12–29 U.S. GAAP and IFRS differ somewhat. Under IFRS, OTT impairments only are recognized on debt that is classified as HTM to the extent that credit losses exist, so there is no noncredit loss component of OTT impairments under IFRS. OTT impairments are recognized on debt classified as AFS in their entirety, with no distinction made between credit losses and noncredit losses. Also, under IFRS, OTT impairments can be recovered in earnings for debt investments, but not for equity investments. U.S. GAAP does not allow OTT impairments to be recovered in earnings for either debt or equity investments (unless the debt investment is classified as a loan).


12–9

Supplement Questions for Review of Key Topics Question 12–30 Investment securities are classified as “amortized cost,” “FV-OCI,” or “FV-NI.”

Question 12–31 To be accounted for at amortized cost, a debt investment must have the characteristics of “simple” debt: (1) the debt consists primarily of payments that include interest and return of principal, (2) the debt agreement doesn’t allow the debtor to prepay or settle the debt in a manner that provides a loss to the investor, and (3) the debt does not involve derivatives. The debt also must be held for the purpose of collecting contractual cash flows associated with lending or customer financing.

Question 12–32 To be accounted for at FV-OCI, a debt investment must have the characteristics of “simple” debt (the debt consists primarily of payments that include interest and return of principal, don’t allow the debtor to prepay or settle the debt in a manner that provides a loss to the investor, and do not involve derivatives). The debt also must be held for the purpose of maximizing investment return by selling it after it has appreciated in value or collecting contractual cash flows, or for managing risk.

Question 12–33 First, if the debt investment is “complex,” it is accounted for at FV-NI. The debt investment is complex if it lacks one or more of the characteristics of simple debt (the debt consists primarily of payments that include interest and return of principal, don’t allow the debtor to prepay or settle the debt in a manner that provides a loss to the investor, and do not involve derivatives). The debt investment also is accounted for at FV-NI if it is “simple” and either is held for sale at acquisition or issuance or does not qualify for being accounted for at amortized cost or FV-OCI.

Question 12–34 If the investor lacks the ability to significantly influence the investee, an equity investment is accounted for at FV-NI. Nonpublic organizations have a practicability exception with respect to nonmarketable investments, allowing them to account for the investment at cost less any impairments and adjusted for any changes in fair value that are observed from transactions of similar equity.



BRIEF EXERCISES Brief Exercise 12–1 (a) Investment in bonds (face amount) ....................... Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

720,000

Cash (1.5% x $720,000).......................................... Discount on bond investment (difference) ............ Interest revenue (2% x $600,000) .......................

10,800 1,200

120,000 600,000

(b)

12,000

Brief Exercise 12–2 Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in earnings. S&L reports its $2,000 holding loss in 2013 earnings. When the fair value rises by $7,000 in 2014, that amount is reported in 2014 earnings ($5,000 as a realized gain, and $2,000 as the reversal of the unrealized loss that was recognized in 2013). S&L’s journal entries for these transactions would be: 2013 December 27 Investment in Coca Cola shares ......................................... Cash .................................................................................

875,000

December 31 Net unrealized holding gains and losses—I/S ..................... Fair value adjustment ($875,000 – 873,000) ........................

2,000

875,000

2,000


12–11

Brief Exercise 12–2 (concluded) 2014 January 3 Cash (selling price) .................................................................. Gain on investments (to balance)........................................ Investment in Coca Cola shares (account balance) .............

880,000 5,000 875,000

Assuming no other trading securities, the 2014 adjusting entry to remove the fair value adjustment associated with the sold securities would be: December 31 Fair value adjustment (account balance) .................................. Net unrealized holding gains and losses—I/S (to balance)

2,000 2,000



Brief Exercise 12–3 Unlike for trading securities, unrealized holding gains and losses for securities available-for-sale are not included in earnings. S&L reports its $2,000 holding loss in 2013 as other comprehensive income in the statement of comprehensive income. When the fair value rises to $880,000 in 2014, the amount reported in 2014 earnings is the $5,000 gain realized by the sale of the securities. S&L’s journal entries for these transactions would be: 2013 December 27 Investment in Coca Cola shares ......................................... Cash .................................................................................

875,000

December 31 Net unrealized holding gains and losses–OCI..................... Fair value adjustment ($875,000 – 873,000) ........................

2,000

875,000

2,000

2014 January 3 Cash (selling price) ................................................................. Gain on investments (to balance) ....................................... Investment in Coca Cola shares (cost)..............................

880,000 5,000 875,000

Assuming no other transactions involving securities available-for-sale, the 2014 adjusting entry to remove the fair value adjustment associated with the sold securities would be: December 31 Fair value adjustment (account balance) ................................. Net unrealized holding gains and losses–OCI.................

2,000 2,000


12–13

Brief Exercise 12–4 Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of net income for the period. Rather, they are reported as “other comprehensive income” in the statement of comprehensive income. The accumulated balance of net holding gains and losses is reported as a separate component of shareholders’ equity, as part of accumulated other comprehensive income. The adjusting entry needed to increase the fair value adjustment from $110,000 to $170,000 is: Fair value adjustment ($670,000 – 610,000) ........... Net unrealized holding gains and losses–OCI

60,000 60,000

Brief Exercise 12–5 These are securities available-for-sale and are reported at their fair value, $4,000,000. We know this because securities “held-to-maturity” are debt securities that an investor has the “positive intent and ability” to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The FedEx shares have been held for over a year. They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn’t appropriate either because 40,000 shares of FedEx certainly don’t constitute “significant influence.” Investments in securities available-for-sale are reported at fair value.



Brief Exercise 12–6 Because S&L elected the fair value option, it would classify this investment as a trading security and account for it in that fashion. Therefore, S&L reports its $2,000 holding loss in 2013 earnings. When the fair value rises by $7,000 in 2014, that amount is reported in 2014 earnings ($5,000 as a realized gain, and $2,000 as the reversal of the unrealized loss that was recognized in 2013). S&L’s journal entries for these transactions would be: 2013 December 27 Investment in Coca Cola shares ......................................... Cash .................................................................................

875,000

December 31 Net unrealized holding gains and losses—I/S ..................... Fair value adjustment ($875,000 – 873,000)...................

2,000

875,000

2,000

2014 January 3 Cash (selling price) ................................................................. Gain on investments (to balance) ....................................... Investment in Coca Cola shares (account balance) .............

880,000 5,000 875,000

Assuming no other trading securities, the 2014 adjusting entry to remove the fair value adjustment associated with the sold securities would be: December 31 Fair value adjustment (account balance) ................................. Net unrealized holding gains and losses—I/S (to balance)

2,000 2,000


12–15

Brief Exercise 12–7 An investor should account for dividends from an investment not accounted for by the equity method as investment revenue. Since Turner holds only 10% of ICA stock, it’s assumed that it does not have significant influence over the company. Turner’s cash increased by $500,000 (10% x $5 million). It also reports $500,000 as investment revenue in the income statement.

Brief Exercise 12–8 An investor should account for dividends from an equity method investee as a reduction in its investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investee’s net assets, reflecting the fact that the investor’s ownership interest in those net assets declined proportionately. Turner’s cash increased by $2 million (40% x $5 million). Its investment account declined by the same amount. There is no effect in the income statement.



Brief Exercise 12–9 With the equity method we attempt to approximate the effects of accounting for the purchase of the investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values. Both investment revenue and the investment would be reduced by the negative income effect of the “extra depreciation” the higher fair value would cause. This would equal (30% x $50 million) ÷ 15 years = $1 million each year for 15 years.

Brief Exercise 12–10 Under proportionate consolidation, Park would have included its portion of Wallis’s depreciable assets in the Park depreciable asset accounts on its consolidated balance sheet. Those depreciable asset accounts would be reduced by the “extra depreciation” the higher fair value would cause. This would equal (50% x $50 million) ÷ 15 years = $1.67 million each year for 15 years.

Brief Exercise 12–11 The investment would be increased by $12 million. Financial statements would be recast to reflect the equity method for each year reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items. The answer would not be the same if Pioneer changes from the equity method. Rather, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.


12–17

Brief Exercise 12–12 Given Turner’s election of the fair value option, it would account for this investment similar to a trading security, while still preserving its classification as a significant-influence investment and showing it as a noncurrent asset in the balance sheet. 2013 January 2 Investment in ICA Company .............................................. 10,000,000 Cash .................................................................................. 10,000,000 December 30 Cash (40% x $500,000) ........................................................... Investment revenue .........................................................

200,000 200,000

December 31 Fair value adjustment ($11.5M – 10M) ................................... 1,500,000 Net unrealized holding gains and losses—I/S (may also labeled “investment revenue”) ........................ 1,500,000 Note: A different approach to reach the same outcome would be for Turner to use equity-method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Turner would recognize 40% of ICA’s $750,000 income ($300,000) as investment income, it would not recognize investment income associated with ICA’s dividend, and it would end up with an investment account containing $10,100,000 ($10,000,000 + 300,000 – 200,000). Turner then would need to make a fair value adjustment of $1,400,000 ($11,500,000 – 10,100,000) to its ICA investment. So the total amount of income recognized would be $1,700,000 ($300,000 investment income + $1,400,000 unrealized gain). Note that this alternative produces the same total amount of investment income as is produced above, $1,700,000 ($200,000 investment revenue + $1,500,000 unrealized gain).



Brief Exercise 12–13 Because the drop in the market price of stock is considered to be other-thantemporary, LED records the impairment of $450,000 ($4.50 x 100,000 shares) and reclassifies previously recognized unrealized losses of $100,000 ($1.00 x 100,000 shares) as follows: Other-than-temporary impairment loss—I/S .... AFS Investment (Branch) ..............................

450,000

Fair value adjustment ......................................... Net unrealized holding gains and losses—OCI

100,000 100,000

450,000

In the income statement, the entire $450,000 will be shown as an OTT impairment loss. A $100,000 reclassification adjustment will increase OCI (because the $100,000 decreased OCI and therefore AOCI in a prior period, it must be backed out of OCI and AOCI in the current period). Therefore, the net effect on comprehensive income during the current period will be $350,000.


12–19

Brief Exercise 12–14 LED believes it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. LED must recognize the entire OTT impairment in earnings, reducing the carrying value of the LED bonds by crediting a discount on bond investment account. LED records the impairment of $450,000 and reclassifies previously recognized unrealized losses of $100,000 as follows: Other-than-temporary impairment loss—I/S ..... Discount on bond investment .........................

450,000

Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

100,000 100,000

450,000

In the income statement, the entire $450,000 will be shown as an OTT impairment loss. A $100,000 reclassification adjustment will increase OCI (because the $100,000 decreased OCI and therefore AOCI in a prior period, it must be backed out of OCI and AOCI in the current period). Therefore, the net effect on comprehensive income during the current period will be $350,000.



Brief Exercise 12–15 LED does not intend to sell the investment, and it does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. LED must recognize the $200,000 credit loss component of the OTT impairment in earnings, and the $250,000 noncredit loss component in OCI. LED records the impairment of $450,000 and reclassifies previously recognized unrealized losses of $100,000 as follows: Other-than-temporary impairment loss—I/S .... Discount on bond investment .........................

200,000

OTT impairment loss—OCI ............................... Fair value adjustment .....................................

250,000

Fair value adjustment ......................................... Net unrealized holding gains and losses—OCI

100,000 100,000

200,000

250,000

LED still would have to include the entire $450,000 in the income statement before backing out the $250,000 to leave a $200,000 reduction of earnings. The $100,000 reclassification adjustment will increase OCI (because the $100,000 decreased OCI and therefore AOCI in a prior period, it must be backed out of OCI and AOCI in the current period). Therefore, the net effect on comprehensive income will be $350,000 during the current period ($200,000 from net income, $150,000 from OCI).


12–21

Brief Exercise 12–16 Wickum would have recorded a journal entry previously that recognized the OTT impairment in earnings and reduced the investment account: Other-than-temporary impairment loss—I/S ...... Discount on debt investment ..........................

500,000 500,000

Upon recovery of $300,000 of fair value, Wickum would reverse the impairment by that amount: Discount on debt investment ............................... 300,000 Recovery of other-than-temporary impairment loss—I/S 300,000



SUPPLEMENT BRIEF EXERCISES Brief Exercise 12–17 Lemp would account for the bond investment at FV-OCI because it has the characteristics of “simple” debt and is held for purposes of investment. Therefore, Lemp would report the bond in the balance sheet as an investment of $900 and include the $100 decline in fair value in OCI as a loss.

Brief Exercise 12–18 Fowler would account for the note at FV-NI because it has the characteristics of “simple” debt and Fowler is holding it for sale. Therefore, Fowler would report the note in the balance sheet as an investment of $80,000 and include the $5,000 increase in fair value in net income as a gain.

Brief Exercise 12–19 Fowler would account for the note at amortized cost, because it has the characteristics of “simple” debt and Fowler intends to hold it until it matures. Therefore, Fowler would report the note in the balance sheet as an investment of $75,000, and would not include the $5,000 increase in fair value in either OCI or net income.

Brief Exercise 12–20 Barrett would account for the equity at FV-NI because the equity investment does not qualify for the equity method. Therefore, Fowler would report the equity in the balance sheet as an investment of $80,000 and would include the $20,000 decrease in fair value in net income as a loss. The fact that Barrett expects the fair value to recover prior to sale is not relevant.


12–23

EXERCISES Exercise 12–1 Requirement 1 Investment in bonds (face amount) ........................ Discount on bond investment (difference)......... Cash (price of bonds) .......................................... Requirement 2 Cash (3% x $240 million) ........................................ Discount on bond investment (difference) ............ Interest revenue (4% x $200) .............................

($ in millions)

240.0 40.0 200.0 7.2 .8 8.0

Requirement 3 Tanner-UNF reports its investment in the December 31, 2013, balance sheet at its amortized cost—that is, its book value: Investment in bonds ............................................ Less: Discount on bond investment ($40 – 0.8 million) Amortized cost ................................................

$240.0 39.2 $200.8

If sale before maturity isn’t an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet. Requirement 4 Cash (proceeds from sale) ....................................... Discount on bond investment (balance, determined above) Loss on sale of investments (to balance) ............... Investment in bonds (face amount) ....................

($ in millions)

190.0 39.2 10.8 240.0



Exercise 12–2 November 1 ($ in millions)

Cash ................................................................ Investment revenue .....................................

2.4 2.4

December 1 Investment in Facsimile Enterprises bonds .... Cash.............................................................

30 30

December 31 Investment in U.S. treasury bills ................... Cash.............................................................

8.9 8.9

December 31 Investment revenue receivable—Convenience bonds ($48 million x 10% x 2/12) ....................... Investment revenue receivable—Facsimile Enterprises bonds ($30 million x 12% x 1/12) .... Investment revenue ...................................

0.8 0.3 1.1

Note: Securities held-to-maturity are not adjusted to fair value.


12–25

Exercise 12–3 Requirement 2 The specific citation that specifies the circumstances and conditions under which it is appropriate to account for investments as held-to-maturity is FASB ACS 320–10–25– 4: “Investments—Debt and Equity Securities—Overall—Recognition —Circumstances Not Consistent with Held-to-Maturity Classification.” Requirement 3 FASB ACS 320–10–25–4 reads as follows: “An entity shall not classify a debt security as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. Consequently, a debt security shall not, for example, be classified as held-to-maturity if the entity anticipates that the security would be available to be sold in response to any of the following circumstances: a. Changes in market interest rates and related changes in the security's prepayment risk b. Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims) c. Changes in the availability of and the yield on alternative investments d. Changes in funding sources and terms e. Changes in foreign currency risk.”

Exercise 12–4 Investment in GM common shares ................ Cash ([800 shares x $50] + $1,200) ...................

41,200

Cash ([800 shares x $53] – $1,300) ....................... Loss on sale of investments ............................ Investment in GM common shares ............

41,100 100

41,200

41,200



Exercise 12–5 Requirement 1 2013 December 17 Investment in Grocers’ Supply preferred shares ................ Cash .................................................................................

350,000

December 28 Cash ..................................................................................... Investment revenue ..........................................................

2,000

December 31 Fair value adjustment .......................................................... Net unrealized holding gains and losses—I/S ([$4 x 100,000 shares] – $350,000) .........................................

350,000

2,000 50,000 50,000

2014 January 5 Cash (selling price) ................................................................. Gain on investments (to balance) ....................................... Investment in Grocers’ Supply preferred shares (account balance).................................................

395,000 45,000 350,000

Assuming no other trading securities, the 2014 adjusting entry to remove the fair value adjustment associated with the sold securities would be: December 31 Net unrealized holding gains and losses—I/S ..................... Fair value adjustment (account balance) .............................

50,000 50,000


12–27

Exercise 12–5 (concluded) Requirement 2 Balance Sheet (short-term investment): Trading securities .................................................... Income Statement: Investment revenue (dividends)........................................... Net unrealized holding gains and losses (from adjusting entry)

$400,000 $ 2,000 50,000

Note: Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in income.



Exercise 12–6 The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. Unrealized holding gains for trading securities should be included in earnings: FASB ACS 320–10–35–1a: “Investments—Debt and Equity Securities— Overall—Subsequent Measurement—General.” 2. Under the equity method, the investor accounts for its share of the earnings or losses of the investee in the periods they are reported by the investee in its financial statements: FASB ACS 323–10–35–4: “Investments—Equity Method and Joint Ventures—Overall—Subsequent Measurement—General.” 3. Transfers of securities between categories shall be accounted for at fair value: FASB ACS 320–10–35–10: “Investments—Debt and Equity Securities— Overall—Subsequent Measurement—General.” 4. Disclosures for available-for-sale securities should include total losses for securities that have net losses included in accumulated other comprehensive income: FASB ACS 320–10–50–2: “Investments—Debt and Equity Securities—Overall—Disclosure—Securities Classified as Available for Sale.”


12–29

Exercise 12–7 Requirement 1 .

Net unrealized holding gains and losses—OCI Fair value adjustment ($45,000 – 20,000)

25,000 25,000

Requirement 2 None. Accumulated net holding gains and losses for securities available-forsale are reported as a component of shareholders’ equity (in accumulated other comprehensive income), and changes in the balance are reported as other comprehensive income or loss in the statement of comprehensive income rather than as part of earnings. This statement can be reported either (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income.



Exercise 12–8 Requirement 1 Securities “held-to-maturity” are debt securities that an investor has the “positive intent and ability” to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The IBM shares are neither. They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn’t appropriate either because 10,000 shares of IBM certainly don’t constitute “significant influence.” Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as other comprehensive income or loss in the statement of comprehensive income. This statement can be reported either (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income. Accumulated net holding gains and losses for securities available-for-sale are reported as a separate component of shareholders’ equity in the balance sheet. Requirement 2 December 31, 2013 Net unrealized holding gains and losses—OCI (10,000 shares x [$58 – 60]) ......................................................... Fair value adjustment ...........................................................

20,000 20,000


12–31

Exercise 12–8 (concluded) Requirement 3 December 31, 2014 ($ in 000s) Available-for-Sale Securities IBM shares – Dec. 31, 2014

Cost $600

Fair Value $610

Accumulated Unrealized Gain (Loss) $10

Moving from a negative $20 (2013) to a positive $10 (2014) requires an increase of $30: Balance needed in fair value adjustment Existing balance in fair value adjustment: Increase (decrease) needed in fair value adjustment:

Fair Value Adjustment $10 ($20) $30

--------------------------------------------------------20 0 +10 +30 ----------------------------->

Fair value adjustment 10,000 shares x [$61 – 58]) ........................... Net unrealized holding gains and losses—OCI (– $20 – 10) ....

30,000 30,000



Exercise 12–9 Requirement 1 2013 March 2 ($ in millions)

Investment in Platinum Gauges, Inc., shares .............................. Cash .........................................................................................

31 31

April 12 Investment in Zenith bonds ......................................................... Cash .........................................................................................

20

July 18 Cash ............................................................................................. Investment revenue ..................................................................

2

October 15 Cash ............................................................................................. Investment revenue ..................................................................

1

October 16 Cash ............................................................................................. Investment in Zenith bonds ..................................................... Gain on sale of investments..................................................... November 1 Investment in LTD preferred shares ........................................... Cash .........................................................................................

20

2

1 21 20 1 40 40


12–33

Exercise 12–9(continued) December 31 ($ in millions)

Available-for-Sale Securities Platinum Gauges, Inc., shares LTD preferred shares Totals

Cost $31 40 $71

Fair Value $32* 37** $69

Accumulated Unrealized Gain (Loss) $1 (3) $(2)

* $32 x 1 million shares ** $74 x 500,000 shares

Adjusting entry: Net unrealized holding gains and losses—OCI ($71 – 69) .......... Fair value adjustment ($71 – 69) ...............................................

2 2

2014 January 23 ($ in millions) ([1 million shares x 1/2] x $32)

Cash ................................................ Gain on sale of investments (difference) ................................... Investment in Platinum Gauges shares ($31 million cost x 1/2) ................................................... March 1 Cash ($76 x 500,000 shares) ............................................................ Loss on sale of investments (difference) ....................................... Investment in LTD preferred (cost) .........................................

16.0 0.5 15.5 38 2 40

Note: As part of the process of recording the normal, period-end fair value adjusting entry at 12/31/2014, Construction would debit fair value adjustment and credit net unrealized gains and losses—OCI for the $2.5 million associated with the sold investments to remove their effects from the financial statements. (Construction sold only half the Platinum investments so only half of the Platinum fair value adjustment should be removed. The 2.5 amount comes from 3.0 LTD – 0.5 Platinum.)



Exercise 12–9 (concluded) Requirement 2 2013 Income Statement ($ in millions)

Investment revenue (from July 18; Oct. 15) ..................................... Gain on sale of investments (from Oct. 16) ....................................

$3 1

Other comprehensive income:* Net unrealized holding gains and losses on investments . **

$2

* Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Rather, they are included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.

** Assuming Construction Forms chooses to report other comprehensive income in a combined statement of comprehensive income that includes net income and other comprehensive income.


12–35

Exercise 12–10 Requirement 1 Purchase

($ in millions)

Investment in Jackson Industry shares........................................ Cash ........................................................................................

90 90

Net income

No entry Dividends Cash (5% x $60 million)..................................................................

3

Investment revenue .................................................................

3

Adjusting entry

Fair value adjustment ($98 – 90 million) ........................................ Net unrealized holding gains and losses—OCI ......................

8 8

Requirement 2 Investment revenue ..........................

$3 million

Note: An unrealized holding gain is not included in income for securities available-for-sale. Rather, it is included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.



Exercise 12–11 1. Investments reported as current assets. Security A $ 910,000 Security B 100,000 Security C 780,000 Security E 490,000 Total $2,280,000 2. Investments reported as noncurrent assets. Security D $ 915,000 Security F 615,000 $1,530,000

3. Unrealized gain (or loss) component of income before taxes. Trading Securities:

Security

A B

Totals

Cost

Fair value

$ 900,000 105,000 $1,005,000

$ 910,000 100,000 $1,010,000

Unrealized gain (loss) $10,000 (5,000) $ 5,000

4. Unrealized gain (or loss) component of AOCI in shareholders’ equity. Securities Available-for-Sale:

Security

C D

Totals

Cost

Fair value

$ 700,000 900,000 $1,600,000

$ 780,000 915,000 $1,695,000

Unrealized gain (loss) $80,000 15,000 $95,000


12–37

Exercise 12–12 Requirement 1 ($ in 000s) Available-for-Sale Securities IBM shares—Dec. 31, 2013

Cost $1,345

Fair Value $1,175

Accumulated Unrealized Gain (Loss) $(170)

Moving from a negative $145 (Jan.1) to a negative $170 requires a reduction of $25: Balance needed in fair value adjustment Existing balance in fair value adjustment: Increase (decrease) needed in fair value adjustment:

Fair Value Adjustment ($170) ($145) ($ 25)

-------------------------------------------------------– 170 – 145 0 <---------------- – 25

Net unrealized holding gains and losses—OCI ..................... Fair value adjustment ($1,175,000 – 1,200,000) ..................

25,000 25,000



Exercise 12–12 (continued) Requirement 2 ($ in 000s) Available-for-Sale Securities IBM shares—Dec. 31, 2013

Cost $1,345

Fair Value $1,275

Accumulated Unrealized Gain (Loss) $(70)

Moving from a negative $145 (Jan.1) to a negative $70 requires an increase of $75: Balance needed in fair value adjustment Existing balance in fair value adjustment: Increase (decrease) needed in fair value adjustment:

Fair Value Adjustment ($ 70) ($145) $ 75

------------------------------------------------------------------------------------------– 145 – 70 0 +75 ---------------------->

Fair value adjustment ($1,275,000 – 1,200,000) ....................... Net unrealized holding gains and losses—OCI ...............

75,000 75,000


12–39

Exercise 12–12 (concluded) Requirement 3 ($ in 000s) Available-for-Sale Securities IBM shares—Dec. 31, 2013

Cost $1,345

Fair Value $1,375

Accumulated Unrealized Gain (Loss) $30

Moving from a negative $145 (Jan.1) to a positive $30 requires an increase of $175: Balance needed in fair value adjustment Existing balance in fair value adjustment: Increase (decrease) needed in fair value adjustment:

Fair Value Adjustment $ 30 ($145) $175

------------------------------------------------------------------------------------------– 145 – 70 0 + 30 +175 -------------------------------------------------------->

Fair value adjustment ($1,375,000 – 1,200,000) ....................... Net unrealized holding gains and losses—OCI ..............

175,000 175,000



Exercise 12–13 Requirement 1 The sale of the A Corporation shares decreased Harlon’s pretax earnings by $5 million. The purchase of the C Corporation shares had no effect on Harlon’s 2014 earnings (because the shares are classified as available-for-sale investments, any unrealized gains or losses occurring after purchase during 2014 would not affect 2014 earnings). Here are the entries used to record those two transactions: June 1, 2014 Cash Loss on sale of investments (difference) Investment in A Corporation shares (cost) September 12, 2014 Investment in C Corporation shares Cash

($ in millions)

15 5 20 15 15


12–41

Exercise 12–13 (concluded) Requirement 2 Harlon’s securities available-for-sale portfolio should be reported in its 2014 balance sheet at its fair value of $101 million: December 31, 2014 ($ in millions) Cost, Dec. 31 Securities Available-for-Sale 2013 2014

A Corporation shares B Corporation bonds C Corporation shares D Industries shares Totals

$20 35 na 45 $100

na $35 15 45 $95

Fair Value, Dec. 31 2013 2014

$14 35 na 46 $95

na $ 37 14 50 $101

In 2013, Harlon would have had a net unrealized loss of $5 (cost of $100 – fair value of $95). Moving from a negative $5 (2013) to a positive $6 requires an increase of $11:

Balance needed in fair value adjustment Existing balance in fair value adjustment: Increase (decrease) needed in fair value adjustment:

Fair Value Adjustment Allowance $6 (5) $11

--------------------------------------------------------–5 0 +6 + 11 ----------------------------->

Fair value adjustment ($5 credit to $6 debit) Net unrealized holding gains and losses—OCI

11 11

The adjustment has no effect on earnings. Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Rather, they are included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income. © The McGraw-Hill Companies, Inc., 2013 12–42


Exercise 12–14 Requirement 1 The investment would be accounted for as an available-for-sale investment: Purchase

Investment in AMC common shares ................................... Cash ...............................................................................

480,000 480,000

Net income

No entry Dividends

Cash (20% x 400,000 shares x $0.25) ........................................ Investment revenue.........................................................

20,000 20,000

Adjusting entry

Fair value adjustment ($505,000 – 480,000)............................ Net unrealized holding gains and losses–OCI ...............

25,000 25,000

Requirement 2 The investment would be accounted for using the equity method: Purchase

Investment in AMC common shares ................................... Cash ...............................................................................

480,000 480,000

Net income

Investment in AMC common shares (20% x $250,000) ........ Investment revenue......................................................... Dividends Cash (20% x 400,000 shares x $0.25) ........................................

Investment in AMC common shares ..............................

50,000 50,000 20,000 20,000

Adjusting entry

No entry © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–43

Exercise 12–15 Purchase

Investment in Nursery Supplies shares ................................... Cash ....................................................................................

($ in millions)

56 56

Net income

Investment in Nursery Supplies shares (30% x $40 million) ..... Investment revenue ............................................................. Dividends Cash (30% x 8 million shares x $1.25) ...........................................

12 12 3

Investment in Nursery Supplies shares ...............................

3

Adjusting entry

No entry

Exercise 12–16 Requirement 1 ($ in millions)

Investment in equity securities ($48 million – 31 million)........... Retained earnings (investment revenue from the equity method)

17 17

Requirement 2 Financial statements would be recast to reflect the equity method for each year reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items. Requirement 3 When a company changes from the equity method, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.



Exercise 12–17 Requirement 1: Error discovered before the books are adjusted or closed in 2013. The journal entry the company made is: Cash ............................................................. Investments ..............................................

100,000 100,000

The journal entry the company should have made is: Cash ............................................................. Investments .............................................. Gain on sale of investments ($100,000 – 80,000)

100,000 80,000 20,000

Therefore, to get from what was done to what should have been done, the following entry is needed: Investments ($100,000 – 80,000) ..................... Gain on sale of investments.....................

20,000 20,000

Requirement 2: Error not discovered until early 2014. Investments ($100,000 – 80,000) ..................... Retained earnings ....................................

20,000 20,000


12–45

Exercise 12–18 Purchase

($ in millions)

Investment in Carne Cosmetics shares ................................ Cash .................................................................................

68 68

Net income

Investment in Carne Cosmetics shares (25% x $40 million) .. Investment revenue .......................................................... Dividends Cash (4 million shares x $1) ......................................................

10 10 4

Investment in Carne Cosmetics shares ............................

4

Depreciation Adjustment ‡

Investment revenue ($8 million [calculation below ] ÷ 8 years) .. Investment in Carne Cosmetics shares ............................ ‡

Calculations: Investee Net Assets

Net Assets Purchased

Difference Attributed to:





 Cost

1 1

$68

 Fair value:

$224* x 25% = $56

Book value:

$192 x 25% = $48



Goodwill:$12 Undervaluation of assets: $8

*[$192 + 32] = $224 Adjusting entry

No entry to adjust for changes in fair value as this investment is accounted for under the equity method.



Exercise 12–19 Requirement 1 Purchase

($ in millions)

Investment in Lake Construction shares ............................. Cash ................................................................................

300 300

Net income

Investment in Lake Construction shares (20% x $150 million) Investment revenue ..........................................................

30 30

Dividends Cash (20% x $30 million) ........................................................

6

Investment in Lake Construction shares .........................

6

Adjustment for depreciation ‡

Investment revenue ($10 million [calculation below ] ÷ 10 years) Investment in Lake Construction shares ......................... ‡

1 1

calculation: Investee Net Assets






Cost



$300

 Fair value:

Goodwill:

$120

$900 x 20% = $180

 Book value:


$800 x 20% = $160

Undervaluation of buildings ($10) and land ($10): $20

Requirement 2 a. Investment in Lake Construction shares ________________________________________ ($ in millions)

Cost 300 Share of income 30

Balance

6 Dividends 1 Depreciation adjustment _________________ 323 © The McGraw-Hill Companies, Inc., 2013

Solutions Manual, Vol. 1, Chapter 12

12–47

Exercise 12–19 (concluded)

b. As investment revenue in the income statement. $30 million (share of income) – 1 million (depreciation adjustment) = $29 million c. Among investing activities in the statement of cash flows. $300 million [Cash dividends received ($6 million) also are reported—as part of operating activities. If Cameron reports cash flows using the indirect method, the operating activities section of its statement of cash flows would include an adjustment of ($23 million) to get from the net income figure that includes $29 million of revenue to a cash flow number that should only include $6 million of cash flow.]



Exercise 12–20 Requirement 1 First we need to identify the amount of difference between book value and fair value associated with goodwill, buildings, and land:

Investee Net Assets

 Cost







$750

 Fair value:

$300

$900 x 50% = $450

 Book value:

Goodwill:

$800 x 50% = $400

Undervaluation of buildings ($25) and land ($25): $50

a.

January 1, 2013 effect on Buildings Because half of the fair value of Lake’s individual net assets are buildings, and Lake would be consolidated with Cameron, Cameron’s buildings account would increase by 1/2 x $450 = $225 million.

b.

January 1, 2013 effect on Land Because half of the fair value of Lake’s individual net assets is land, and Lake would be consolidated with Cameron, Cameron’s land account would increase by 1/2 x $450 = $225 million.

c.

January 1, 2013 effect on Goodwill Because Lake would be consolidated with Cameron, Cameron’s goodwill account would increase by $300 million.

d.

January 1, 2013 effect on Equity method investments Because Lake would be consolidated with Cameron, there would be no effect of this investment on Cameron’s equity method investment account.


12–49

Exercise 12–20 (concluded) Requirement 2 a. December 31, 2013 effect on Buildings Because half of the fair value of Lake’s individual net assets are buildings, and Lake would be consolidated with Cameron, Cameron’s buildings account would increase by 1/2 x $450 = $225 million. Cameron would depreciate those buildings over their remaining 10-year life, so Lake would recognize $22.5 million of depreciation expense per year ($225 million ÷ 10 years). Therefore, at December 31, 2013, the buildings associated with the Lake investment would have a carrying value of $202.5 million ($225 million cost – 22.5 million accumulated depreciation). b.

December 31, 2013 effect on Land Land is not amortized, so its carrying value would not change from its value on January 1, 2013.

c.

December 31, 2013 effect on Goodwill Goodwill is not amortized, so its carrying value would not change from its value on January 1, 2013.

d.

December 31, 2013 effect on Equity method investments Because Lake would be consolidated with Cameron, there would be no effect of this investment on Cameron’s equity method investment account at December 31, 2013.

Requirement 3 The effect of the investment on Cameron’s December 31, 2013, retained earnings would not differ between the equity method and proportionate consolidation treatments. Under the equity method, Cameron would recognize investment revenue based on its share of Lake’s net income, while under proportionate consolidation, Cameron would include its share of Lake’s revenue and expenses on those lines of the consolidated income statement. Regardless, the same total amount would be included in Cameron’s net income and closed to Cameron’s retained earnings.



Exercise 12–21 Requirement 1 Electing the fair value option for held-to-maturity securities simply requires reclassifying those securities as trading securities. Therefore, this investment would be classified as a trading security on Tanner-UNF’s balance sheet. Requirement 2 Investment in bonds (face amount) ....................... Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

($ in millions)

240 40 200

Requirement 3 Cash (3% x $240 million) ....................................... Discount on bond investment (difference) ............ Interest revenue (4% x $200) ..................................

7.2 .8 8.0

Requirement 4 The carrying value of the bonds is $240 – ($40 – 0.8) = $200.8. Therefore, to adjust to fair value of $210, Tanner-UNF would need the following journal entry: Fair value adjustment ......................................... Net unrealized holding gains and losses—I/S ($210 – 200.8)

9.2 9.2

Requirement 5 Tanner-UNF reports its investment in the December 31, 2013, balance sheet at fair value of $210 million. Requirement 6 Cash (proceeds from sale) ....................................... Loss on sale of investments (to balance)............... Discount on bond investment (account balance).... Investment in bonds (account balance)...............

($ in millions)

190.0 10.8 39.2 240.0

Assuming no other trading securities, the 2014 adjusting entry would be: Net unrealized holding gains and losses—I/S .... 9.2 Fair value adjustment (account balance) ........... 9.2 © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–51

Exercise 12–22 Requirement 1 Electing the fair value option for available-for-sale securities simply requires reclassifying those securities as trading securities. Therefore, this investment would be classified as a trading security on Sanborn’s balance sheet. Requirement 2 Purchase

Investment in Jackson Industry shares........................................ Cash ........................................................................................

($ in millions)

90 90

Net income

No entry Dividends Cash (5% x $60 million)..................................................................

3

Investment revenue .................................................................

3

Adjusting entry

Fair value adjustment ($98 – 90 million) ........................................ Net unrealized holding gains and losses—I/S ........................

8 8

Requirement 3 Investment revenue (dividends)........................................... Net unrealized holding gains and losses (from adjusting entry) Total effect on 2013 net income before taxes

$ 3,000 8,000 11,000



Exercise 12–23 Requirement 1 Electing the fair value option for significant-influence investments requires use of the same basic accounting approach that is used for trading securities. However, the investments will still be classified as significant-influence investments and shown either on the same line of the balance sheet as equitymethod investments (but with the amount at fair value indicated parenthetically) or on a separate line of the balance sheet. Requirement 2 Purchase

($ in millions)

Investment in Nursery Supplies shares ................................... Cash ....................................................................................

56 56

Net income

No entry. Dividends Cash (30% x 8 million shares x $1.25) ...........................................

3

Investment revenue .............................................................. Adjusting entry ...................................................................................... Net unrealized holding gains and losses—I/S ($56 – 52 million)

Fair value adjustment ..........................................................

3 4 4

Note: A different approach to reach the same outcome would be for Florists to use equity method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Florists would recognize 30% of Nursery’s $40 million of income ($12 million) as investment income, it would not recognize investment income associated with Nursery’s dividend, and would end up with an investment account containing $65 ($56 million + 12 million – 3 million). The company would need to make a fair value adjustment of $13 million ($65 million – 52 million). So the total amount of loss recognized would be $1 million ($12 million investment income – 13 million unrealized loss). Note that this alternative produces the same total amount of investment loss as is produced above: $1 million ($3 million investment revenue – 4 million unrealized loss). © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–53

Exercise 12–24 Requirement 1 Insurance expense (difference) ............................................... Cash surrender value of life insurance ($27,000 – 21,000)...... Cash (2013 premium) .......................................................... Requirement 2 Cash (death benefit) ......................................................... Cash surrender value of life insurance (account balance) Gain on life insurance settlement (to balance) ...........

64,000 6,000 70,000 4,000,000 27,000 3,973,000

Exercise 12–25 Requirement 1 Insurance expense (difference) ....................................... Cash surrender value of life insurance ($4,600 – 2,500) .. Cash (premium) ..........................................................

22,900 2,100 25,000

Requirement 2 Cash (death benefit) ......................................................... Cash surrender value of life insurance (account balance) Gain on life insurance settlement (to balance) ...........

250,000 16,000 234,000



Exercise 12–26 Requirement 1 Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. Bloom must recognize the entire OTT impairment in earnings as follows: Other-than-temporary impairment loss—I/S .... Discount on bond investment .........................

400,000 400,000

In the income statement, the entire $400,000 will be shown as an OTT impairment loss. Requirement 2 Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Bloom must recognize the $250,000 of credit losses as an OTT impairment in earnings, and the other $150,000 as a reduction of OCI, as follows: Other-than-temporary impairment loss—I/S .... Discount on bond investment .........................

250,000

OTT impairment loss—OCI .............................. Fair value adjustment—Noncredit loss ..........

150,000 150,000

250,000

In the income statement, the entire $400,000 will be shown as an OTT impairment loss, then the amount of noncredit loss is subtracted to leave only the credit loss reducing earnings: OTT impairment on HTM investments Total OTT impairment loss ....................... Less portion recognized in OCI ................. Net OTT impairment recognized in earnings

($400,000) $150,000 ($250,000)


12–55

Exercise 12–26 (concluded) Requirement 3 Bloom does not plan to sell the investment, and does not believe it is more likely than not that Bloom will have to sell the investment before fair value recovers, but the entire impairment consists of noncredit losses, so Bloom does not record any OTT impairment.



Exercise 12–27 Requirement 1: Assuming Bloom has not previously recorded a $100,000 loss Scenario 1: Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. Bloom must recognize the entire OTT impairment in earnings. Bloom makes the following entry: Other-than-temporary impairment loss—I/S .... Discount on bond investment .........................

400,000 400,000

In the income statement, the entire $400,000 will be shown as an OTT impairment loss. There is no effect on OCI, and a $400,000 effect on comprehensive income. Scenario 2: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Bloom must recognize the $250,000 of credit losses as an OTT impairment in earnings, and the other $150,000 as a reduction of OCI. Bloom makes the following entry: Other-than-temporary impairment loss—I/S .... Discount on bond investment .........................

250,000

Net unrealized holding gains and losses—OCI.. Fair value adjustment ......................................

150,000

250,000

150,000

In the income statement, the entire $400,000 will be shown as an OTT impairment loss, then the amount of noncredit loss is subtracted to leave only the credit loss reducing earnings: OTT impairment on AFS investments Total OTT impairment loss ....................... Less portion recognized in OCI ................. Net OTT impairment recognized in earnings

($400,000) $150,000 ($250,000)

So, net income will be decreased by $250,000, OCI by $150,000, and comprehensive income by $400,000. © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–57

Exercise 12–27 (continued) Scenario 3: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, but the entire impairment consists of noncredit losses, so Bloom does not record any OTT impairment.

Requirement 2: Assuming Bloom has previously recorded a $100,000 loss Scenario 1: Bloom believes it is more likely than not it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is not relevant. Bloom must recognize the entire OTT impairment in earnings. Bloom makes the following entry: Other-than-temporary impairment loss—I/S ..... Discount on bond investment ..........................

400,000 400,000

Assuming a previously recorded $100,000 unrealized loss, Bloom must also reclassify that loss out of OCI and the fair value adjustment. In 2012 Bloom would have made the following entry: Net unrealized holding gains and losses—OCI . Fair value adjustment ......................................

100,000 100,000

So to reclassify that unrealized loss, Bloom would reverse that entry. Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

100,000 100,000

In the income statement, the entire $400,000 will be shown as an OTT impairment loss. OCI will be increased by the $100,000 reclassification, such that the net effect on comprehensive income is $300,000.



Exercise 12–27 (concluded) Scenario 2: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Bloom must recognize the $250,000 of credit losses as an OTT impairment in earnings, and the other $150,000 as a reduction of OCI. Bloom makes the following entry: Other-than-temporary impairment loss ............. Discount on bond investment .........................

250,000

Net unrealized holding gains and losses—OCI.. Fair value adjustment ......................................

150,000

250,000

150,000

Assuming a previously recorded $100,000 unrealized loss, Bloom must also reclassify that loss out of OCI and the fair value adjustment: Fair value adjustment ......................................... Net unrealized holding gains and losses—OCI

100,000 100,000

Note that, when combined with the other journal entries, the net effect is that net income is decreased by $250,000, OCI is decreased by $50,000 ($150,000 – 100,000), and comprehensive income therefore is decreased by $300,000. That makes sense, because $100,000 of decrease in OCI and comprehensive income occurred in 2012, when the $100,000 unrealized loss was recognized. Scenario 3: Bloom does not plan to sell the investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, but the entire impairment consists of noncredit losses, so Bloom does not record any OTT impairment.


12–59

Exercise 12–28 December 31, 2013: Kettle must record an unrealized loss of $10,000 to account for the fact that the fair value of Icalc’s shares has fallen from the original cost of $50,000 to $40,000. Net unrealized holding gains and losses—OCI ..................... Fair value adjustment ($50,000 – 40,000) ...........................

10,000 10,000

This adjustment has no effect on net income, but it reduces OCI and comprehensive income by $10,000. December 31, 2014: Kettle now must record an OTT impairment. To reduce the investment from its original cost of $50,000 to $25,000, Kettle makes the following entry: Other-than-temporary impairment loss ($50,000 – 25,000) Investment in Icalc ..........................................

25,000 25,000

Kettle also must reclassify the 2013 unrealized loss out of OCI and remove the fair value adjustment, making the following entry that reverses the 2013 entry: Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

10,000 10,000

In the income statement, the $25,000 will be shown as an OTT impairment loss. OCI will be increased by the $10,000 reclassification, such that the net effect on comprehensive income is $15,000. December 31, 2015: Subsequent to recording the OTT impairment, Kettle continues to treat the investment as AFS, but with an amortized cost of $25,000. Given an increase in fair value to $30,000 during 2015, Kettle records a $5,000 unrealized gain, with no effect on net income but an increase of $5,000 to OCI and comprehensive income: Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

5,000 5,000



Exercise 12–29 Requirement 1 HTM investment, December 31, 2013 Under IFRS, only credit losses are recognized as OTT impairments with respect to HTM investments. Therefore, Flower would make the following journal entry to reduce the carrying value of the investment from its amortized cost of €1,000,000 to the present value of expected future cash flows (computed at the discount rate that applied when the investment was purchased) of €750,000: Other-than-temporary impairment loss .............. Investment in James bonds .............................

250,000 250,000

Requirement 2 HTM investment, December 31, 2014 Under IFRS, OTT impairments associated with debt investments can be recovered. Therefore, Flower would record a reversal of OTT impairment to increase the carrying value of the James investment from €750,000 to €800,000 (the present value of expected future cash flows as of December 31, 2014, computed at the discount rate that applied when the investment was purchased): Investment in James bonds ................................. Recovery of other-than-temporary impairment loss

50,000 50,000

Requirement 3 AFS debt investment, December 31, 2013 Under IFRS, the entire difference between amortized cost and fair value is shown as an OTT impairment with respect to an AFS investment. Therefore, Flower would make the following journal entry to reduce the carrying value of the investment from its amortized cost of €1,000,000 to fair value of €600,000: Other-than-temporary impairment loss .............. Investment in James bonds .............................

400,000 400,000


12–61

Exercise 12–29 (concluded) Requirement 4: AFS debt investment, December 31, 2014 Under IFRS, OTT impairments associated with debt investments can be recovered. Therefore, Flower would record a reversal of OTT impairment to increase the carrying value of the James investment from €600,000 to its fair value of €875,000: Investment in James bonds ................................. Recovery of other-than-temporary impairment loss

275,000 275,000

Requirement 5: AFS equity investment, December 31, 2014 Under IFRS, OTT impairments associated with equity investments cannot be recovered. Therefore, Flower would just view the increase in fair value as an unrealized gain, adjusting the carrying value of the investment and OCI to reflect the increase in fair value from €600,000 to €875,000: Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

275,000 275,000



SUPPLEMENT EXERCISES Exercise 12–30 Requirement 1 Cash (3% x $10,000) .............................................. Interest revenue ...............................................

300 300

Requirement 2 Watney would report the bonds at amortized cost, given that the bonds are “simple” debt and Watney intends to hold the bonds to maturity. Therefore, Watney would not record any unrealized gain or loss (but would need to consider whether impairment recognition is appropriate).

Exercise 12–31 Requirement 1 Cash (3% x $10,000) .............................................. Interest revenue ...............................................

300 300

Requirement 2 The bonds are “simple” debt, so Watney would report half of the bonds at FVNI (because the bonds are held for sale) and the other half at FV-OCI (because the bonds are held for investment purposes). Therefore, Watney would prepare the following journal entry: Net unrealized holding gains and losses—I/S ([$10,000 – 9,000] ÷ 2) ............................................................. Net unrealized holding gains and losses—OCI ([$10,000 – 9,000] ÷ 2) ............................................................. Fair value adjustment ($10,000 – 9,000) ................

500 500 1,000


12–63

CPA / CMA REVIEW QUESTIONS CPA Exam Questions 1. d. Sales price (2,000 shares x $14) Less: Brokerage commission Net Proceeds Less: Cost of investment Realized loss on trading security

$28,000 (1,400) $26,600 (31,500) $(4,900)

If these securities had been categorized as available-for-sale, the total loss of $4,900 would have been recognized in net income. The prior year's unrealized holding loss would not have been included (recognized) in earnings (net income), but rather would have been reported as an element of other comprehensive income. A reclassification adjustment for the unrealized holding loss ($2,000) would also be included in other comprehensive income to remove it from the balance sheet and report it in income. Note: The question asks for realized loss. This is defined as the net cash proceeds from sale minus the original cost of the investment. That realized loss was recognized over two accounting periods: Year 4 (unrealized loss) and Year 5 (realized, due to sale). Be careful when answering these questions: watch for the difference between loss realized and loss recognized.



CPA Review Questions (continued) 2. a. Marketable equity securities (equity securities with readily determinable fair values) are categorized as either trading securities (which are classified as current assets) or available-for-sale securities (which are classified as current or noncurrent assets), as appropriate. Because Lark’s investments are longterm, they are categorized as available-for-sale securities. Available-for-sale securities are reported at fair value with unrealized holding gains and losses reported in other comprehensive income and included in the balance of accumulated other comprehensive income reported in equity. The unrealized holding gain included in other comprehensive income for 2013 would be $60,000 ($240,000 current fair value vs. $180,000 prior period fair value). The net unrealized holding gain, included in the accumulated other comprehensive income as of December 31, 2013, is $40,000 ($60,000 current period unrealized holding gain less $20,000 prior period unrealized holding loss). Alternative calculation shown below. Net unrealized holding gains at December 31, 2013: Fair value at December 31, 2013 $240,000 Cost (200,000) Net unrealized holding gain $ 40,000 3. d. $116,250. LT investments in marketable equity securities at fair value $ 96,450 Plus: Net unrealized holding gains and losses on long-term marketable equity securities 19,800 Cost of LT investments in marketable equity securities $116,250 Unrealized holding gains and losses on the noncurrent portfolio of investments in marketable equity securities (categorized as available-for-sale securities) are reported in other comprehensive income and included in the balance of accumulated other comprehensive income reported in stockholders' equity.


12–65

CPA Review Questions (continued) 4. d. Since the decline in value occurred in 2012, the available-for-sale security was reduced to fair value with a related unrealized holding loss reported in other comprehensive income in 2012. In 2013, the asset continues to be carried at the same net value but the unrealized holding loss in accumulated other comprehensive income is removed and recognized as a loss in the determination of net income since the decline is considered to be permanent. The recognition of the loss (write-down to fair value) establishes a new cost basis, which will not be changed for subsequent recoveries in fair value. However, subsequent unrealized holding gains and losses will be reported in other comprehensive income. 5. d. Neither a change in fair value of investee's common stock nor cash dividends from investee affect the investor's reported investment income (equity in earnings of investee) under the equity method. Under the equity method, cash dividends would be charged against (reduce) the investment account and have no effect on income. A change in the fair value of the investee's common stock would not be recorded under the equity method unless the change were judged a permanent and substantial decline, and then the decline would be charged to a loss account rather than investment income. These rules do not apply to investments accounted for under the equity method. 6. c. The entries should have been: Investment in affiliate (40% x 20,000) Equity in earnings of affiliate

8,000

Cash (40% x $5,000) Investment in affiliate

2,000

8,000

2,000

By erroneously recognizing the $2,000 dividend as revenue, retained earnings are overstated. The dividends should have been booked as a reduction of the investment; thus the investment is overstated.



CPA Review Questions (concluded) 7. b. Under the equity method, the investor should reflect adjustments, which would be made in consolidation, based on the investor's percentage ownership, if such adjustment (eliminations) can be recorded between investment income and the investment account. The fair value of the FIFO inventory in excess of the carrying value would reduce net income of the investee; therefore, the investor would charge investment income and credit the investment account to reflect the decrease in income. The fair value of the land in excess of its carrying value would not affect income as it is not a depreciable asset. No adjustment would be made relative to the land. 8. a. $435,000. The equity method of accounting for investments in common stock should be used if the investor has significant influence over the operating and financial policies of the investee. Well Company's significant influence is demonstrated by its officers being a majority of the investees' board of directors. Original cost of investment Add: Share of income subsequent to acquisition 10% x $500,000 Less: Dividend of investee 10% x $150,000

$400,000

50,000 (15,000) $435,000

9. b. Under IFRS No. 9, debt is classified as either amortized cost or FVTPL. 10. c. Under IFRS No. 9, equity is classified as either FVTPL or FVTOCI (if not held for trading purposes and if FVTOCI treatment is elected at acquisition of the debt). 11. c. Under IFRS No. 9, equity is classified as FVTOCI if the equity is not held for trading purposes and if FVTOCI treatment is elected at acquisition of the debt. The election is irrevocable. 12. d. IAS No. 28 requires that the accounting policies of investees be adjusted to correspond to those of the investor. 13. a. Recoveries of OTT impairments of debt investments, but not equity investments, are shown in earnings. © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–67

CMA Exam Questions 1. c. According to GAAP, available-for-sale securities are investments in debt securities that are not classified as held-to-maturity or trading securities and in equity securities with readily determinable fair values that are not classified as trading securities. They are measured at fair value in the balance sheet. 2. b. Available-for-sale securities include (1) equity securities with readily determinable fair values that are not classified as trading securities and (2) debt securities that are not classified as held-to-maturity or trading securities. Unrealized holding gains and losses are measured by the difference between the amortized cost and fair value, excluded from earnings, and reported in other comprehensive income. The balance is reported net of the tax effect (ignored in this question). Thus, the difference at May 31, year 3, is $8,005 ($643,500 fair value – 635,495 amortized cost). This unrealized gain is reported as a credit balance in accumulated other comprehensive income. 3. d. Debt securities that the company has the positive intent and ability to hold to maturity are classified as held-to-maturity. Held-to-maturity securities are reported at amortized cost. Any unrealized gains or losses are not recognized.



PROBLEMS Problem 12–1 Requirement 1 Investment in bonds (face amount) ....................... Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

($ in millions)

80 14 66

Requirement 2 Cash (4% x $80 million) ......................................... Discount on bond investment (difference) ............ Interest revenue (5% x $66) ....................................

3.20 .10

Requirement 3 Cash (4% x $80 million) ......................................... Discount on bond investment (difference) ............ Interest revenue (5% x [$66 + 0.1]) ........................

3.20 .11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2013, balance sheet at its amortized cost; that is, its book value: Investment in bonds ............................................................ Less: Discount on bond investment ($14 – 0.1 – 0.11 million) Amortized cost ................................................................

$80.00 13.79 $66.21

Increases and decreases in the fair value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant if sale before maturity isn’t an alternative. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet.


12–69

Problem 12–1 (concluded) Requirement 5 Fuzzy Monkey’s 2013 statement of cash flows would be affected as follows: Operating activities cash flows: Cash inflow from interest of $3.2 + 3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + 3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – 6.61 = ($0.21) to get from net income to cash flow from operating activities.) Investing activities cash flows: Cash outflow from purchasing investments of $66.



Problem 12–2 Requirement 1 Investment in bonds (face amount)........................ Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

($ in millions)

80 14 66


3.20 .10


3.20 .11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2013, balance sheet at its fair value, $70 million in this case. For investments in trading securities, changes in market values, and thus market returns, 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. To do this, we first need to determine the investment’s amortized cost (or book value) at the end of the year: Investment in bonds ............................................................ Less: Discount on bond investment ($14 – 0.10 – 0.11 million) Amortized cost ................................................................

$80.00 13.79 $66.21

Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million: Fair value adjustment .............................. .......... Net unrealized holding gains and losses—I/S ($70 – 66.21)

3.79 3.79

Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2013 income statement.


12–71

Problem 12–2 (concluded) Requirement 5 Fuzzy Monkey’s 2013 statement of cash flows would be affected as follows: Operating activities cash flows: Cash inflow from interest of $3.2 + 3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + 3.31 = $6.61 and an unrealized holding gain of $3.79 included in net income, totaling $10.4, so would have to include an adjustment of $6.4 – 10.4 = ($4.0) to get from net income to cash flow from operating activities.) Fuzzy Monkey would also be likely to treat the cash outflow from purchasing trading securities of $66 as an operating activities cash flow.



Problem 12–3 Requirement 1 Investment in bonds (face amount)........................ Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

($ in millions)

80 14 66


3.20 .10


3.20 .11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2013, balance sheet at its fair value, $70 million in this case. For investments in securities available-for-sale, changes in market values, and thus market returns, 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. To do this, we first need to determine the investment’s amortized cost (or book value) at the end of the year: Investment in bonds ............................................................ Less: Discount on bond investment ($14 – 0.1 – 0.11 million) Amortized cost ................................................................

$80.00 13.79 $66.21

Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million: Fair value adjustment .............................. .......... Net unrealized holding gains and losses—OCI ($70 – 66.21)

3.79 3.79

Because these are available-for-sale securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2013 other comprehensive income, and serve to increase the accumulated other comprehensive income shown in shareholders’ equity. © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

12–73

Problem 12–3 (concluded) Requirement 5 Fuzzy Monkey’s 2013 statement of cash flows would be affected as follows: Operating activities cash flows: Cash inflow from interest of $3.2 + 3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + 3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – 6.61 = ($0.21) to get from net income to cash flow from operating activities.) Investing activities cash flows: Cash outflow from purchasing investments of $66.



Problem 12–4 Note: Because Fuzzy Monkey elected the fair value option, these investments will be reclassified as trading securities and accounted for under that approach. Therefore, the answers to Requirements 1–5 are the same as those to Problem 12–2. Requirement 1 Investment in bonds (face amount)........................ Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

($ in millions)

80 14 66


3.20 .10


3.20 .11

3.30

3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2013, balance sheet at its fair value, $70 million in this case. For investments in trading securities, changes in market values, and thus market returns, 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. To determine the journal entry that Fuzzy Monkey must make, we first need to determine the investment’s amortized cost (or book value) at the end of the year: Investment in bonds ............................................................ Less: Discount on bond investment ($14 – 0.10 – 0.11 million) Amortized cost ................................................................

$80.00 13.79 $66.21


12–75

Problem 12–4 (concluded) Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million: Fair value adjustment .............................. ........... Net unrealized holding gains and losses—I/S ($70 – 66.21)

3.79 3.79

Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2013 income statement. Requirement 5 Fuzzy Monkey’s 2013 statement of cash flows would be affected as follows: Operating activities cash flows: Cash inflow from interest of $3.2 + 3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have included in net income interest revenue of $3.30 + 3.31 = $6.61 and an unrealized holding gain of $3.79, totaling $10.4, so would have to include an adjustment of $6.4 – 10.4 = ($4.0) to get from net income to the correct operating activities cash flow.) Fuzzy Monkey would also be likely to treat the cash outflow from purchasing trading securities of $66 as an operating activities cash flow. However, if Fuzzy Monkey anticipates holding these investments for a sufficiently long period, it could classify this cash outflow as an investing activities cash flow. Requirement 6 The answers to requirements 1–5 would not differ if the investment qualified for treatment as a held-to-maturity investment, because Fuzzy Monkey’s choice of the fair value option still requires reclassification of the investment as trading securities.



Problem 12–5 Requirement 1 2013 February 21 Investment in Distribution Transformers shares ........ Cash .........................................................................

400,000 400,000

March 18 Cash ............................................................................. Investment revenue ..................................................

8,000

September 1 Investment in American Instruments bonds ............... Cash .........................................................................

900,000

October 20 Cash ............................................................................. Investment in Distribution Transformers .............. Gain on sale of investments..................................... November 1 Investment in M&D Corporation shares .................... Cash .........................................................................

8,000

900,000 425,000 400,000 25,000 1,400,000 1,400,000


12–77

Problem 12–5 (continued) December 31 Adjusting entries: Investment revenue receivable ..................................... Investment revenue ($900,000 x 10% x 4/12) ................

Available-for-Sale Securities M & D Corporation shares American Instruments bonds Totals—Dec. 31, 2013

Cost $1,400,000 900,000 $2,300,000

30,000

Fair Value $1,460,000 850,000 $2,310,000

Fair value adjustment (calculated above)......................... Net unrealized holding gains and losses—OCI .......

30,000 Accumulated Unrealized Gain (Loss) $60,000 (50,000) $10,000* 10,000 10,000*

* The $10,000 credit balance in the net unrealized holding gain is reported as 2013 other comprehensive income in the statement of comprehensive income. It serves to increase accumulated other comprehensive income, a component of shareholders’ equity in the 2013 balance sheet.



Problem 12–5 (continued) Requirement 2 Income statement: Investment revenue ($8,000 + 30,000) Gain on sale of investments

$

38,000 25,000

Statement of comprehensive income*: Net unrealized holding gains and losses on investments

$

10,000

Balance sheet: Current Assets Investment revenue receivable

$

30,000

Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale.

Securities available-for-sale Plus: Fair value adjustment

$2,300,000 10,000 $2,310,000

Shareholders’ Equity Accumulated other comprehensive income Net unrealized holding gain (loss) ($60,000 – 50,000)

$ 10,000

* Can be reported either (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income.


12–79

Problem 12–5 (continued) Requirement 3 2014 January 20 Cash .............................................................................. Gain on sale of investments (to balance) .................... Investment in M&D Corporation shares (cost) ......... March 1 Cash .............................................................................. Investment revenue receivable ................................. Investment revenue ..................................................

1,485,000 85,000 1,400,000 45,000 30,000 15,000

August 12 Investment in Vast Communications shares ............... Cash ..........................................................................

650,000

September 1 Cash .............................................................................. Investment revenue ..................................................

45,000

650,000

45,000



Problem 12–5 (continued) December 31 Adjusting entries: Investment revenue receivable .................................... Investment revenue ($900,000 x 10% x 4/12) ...............

Securities Vast Communication shares American Instruments bonds Totals—Dec. 31, 2014

Cost $650,000 900,000 $1,550,000

30,000 30,000

Fair Value $670,000 830,000 $1,500,000

Accumulated Unrealized Gain (Loss) $20,000 (70,000) $(50,000)*

Moving from a positive $10,000 (2013) to a negative $50,000 requires a decrease of $60,000: Balance needed in fair value adjustment Existing balance in fair value adjustment: Increase (decrease) needed in fair value adjustment:

Fair Value Adjustment ($50) $10 ($60)

------------------------------------------------------------------------------------------– $50,000 0 + $10,000 <-------------------------------------------- $60,000

Net unrealized holding gains and losses—OCI........... Fair value adjustment (calculated above) ..................

60,000* 60,000

* The $60,000 debit balance in the net unrealized holding gains and losses is reported as 2014 other comprehensive income in the statement of comprehensive income. It serves to decrease accumulated other comprehensive income, a component of shareholders’ equity in the 2014 balance sheet, from the $10,000 credit balance it showed on the 2013 balance sheet to the $50,000 debit balance it shows in the 2014 balance sheet.


12–81

Problem 12–5 (concluded) Requirement 4 Income statement: Investment revenue ($15,000 + 45,000 + 30,000) Gain on sale of investments

$

90,000 85,000

Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Statement of comprehensive income*: Net unrealized holding gains and losses on investments

$ (60,000)

Balance sheet: Current Assets Investment revenue receivable

$

Securities available-for-sale Less: Fair value adjustment

30,000

$1,550,000 (50,000) $1,500,000

Shareholders’ Equity Accumulated other comprehensive income Net unrealized holding gain (loss) ($20,000 – 70,000)

$ (50,000)

* Can be reported either (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income.



Problem 12–6 Requirement 1

2013 December 12 Investment in FF&G Corporation bonds ..................................... Cash .......................................................................................... December 13 Investment in Ferry common shares ........................................... Cash .......................................................................................... December 15 Cash .............................................................................................. Investment in FF&G Corporation bonds ................................. Gain on sale of investments ($12.1 – 12) ....................................

($ in millions)

12 12 22 22 12.1 12.0 0.1

December 22 Investment in U.S. treasury bills ................................................. Investment in U.S. treasury bonds ............................................... Cash ..........................................................................................

56 65

December 23 Cash .............................................................................................. Loss on sale of investments ($10 – 11)........................................... Investment in Ferry common shares ($22 x 1/2) .........................

10 1

December 26 Cash (selling price) .......................................................................... Gain on sale of investments ($57 – 56) ...................................... Investment in U.S. treasury bills (account balance) ..................... December 27 Cash (selling price) .......................................................................... Loss on sale of investments ($63 – 65)........................................... Investment in U.S. treasury bonds (account balance) ..................

121

11 57 1 56 63 2 65


12–83

Problem 12–6 (continued) December 28 Cash ............................................................................................... Investment revenue ...................................................................

0.2 0.2

December 31 ($ in millions)

Adjusting entry: Net unrealized holding gains and losses—I/S ($10 million – [$22 million x 1/2]) .................................................... Fair value adjustment ................................................................ Closing entry: Income summary (to balance).......................................................... Investment revenue ($5 + 0.2 million) .............................................. Gain on sale of investments ($8 + 0.1 + 1 million) ........................... Loss on sale of investments ($11 + 1 + 2 million) ........................ Net unrealized holding gains and losses—I/S (adjusting entry)...

1.0 1.0 .7 5.2 9.1 14.0 1.0

Note: Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities. Requirement 2 ($ in millions)

Balance sheet (short-term investment): Trading Securities .............................. Less: Fair value adjustment ................ Total ....................................................

11 (1) 10

Income statement: Investment revenue (closing entry) 5.2 Gain on sale of investments (closing entry) 9.1 Loss on sale of investments (closing entry) (14.0) Net unrealized holding gains and losses on investments (closing entry) (1.0)



Problem 12–6 (concluded) Requirement 3

2014 January 2 ($ in millions)

Cash (selling price) .......................................................................... Loss on sale of investments (to balance) ........................................ Investment in Ferry common (account balance) ..........................

10.2 0.8 11.0

Assuming no other transactions involving trading securities, the 2014 adjusting entry to remove the fair value adjustment associated with the sold securities would be: December 31 Fair value adjustment (account balance) ...................................... Net unrealized holding gains and losses—I/S .......................... January 5 Investment in Warehouse Designs bonds .................................... Cash ..........................................................................................

1.0 1.0

34 34


12–85

Problem 12–7 ($ in millions) 2013 October 18 Investment in Millwork Ventures preferred shares ..................... 58 Cash ........................................................................................... 58

October 31 Cash ............................................................................................... Investment revenue ...................................................................

1.5 1.5

November 1 Investment in Holistic Entertainment bonds ................................. Cash ...........................................................................................

18

November 1 Cash ............................................................................................... Loss on sale of investments ($28 – 30) ........................................... Investment in Kansas Abstractors bonds .................................

28 2

December 1 Investment in Household Plastics bonds ...................................... Cash ...........................................................................................

60

December 20 Investment in U.S. treasury bonds ............................................... Cash ........................................................................................... December 21 Investment in NXS common shares ............................................. Cash ........................................................................................... December 23 Cash ............................................................................................... Investment in U.S. treasury bonds ........................................... Gain on sale of investments ($5.7 – 5.6) .....................................

18

30

60

5.6 5.6

44 44 5.7 5.6 .1



Problem 12–7 (continued) ($ in millions)

December 29 Cash .............................................................................................. Investment revenue ................................................................

3

December 31 Accrued interest: Investment revenue receivable - Holistic Entertainment ($18 million x 10% x 2/12) ........................................ Investment revenue receivable—Household Plastics ($60 million x 12% x 1/12) .................................................. Investment revenue ...............................................................

0.3

3

0.6 0.9

Revaluations: Net unrealized holding gains and losses—OCI ([2 million shares of Millwork Ventures x $27.50] – $58 million) .........

3

Fair value adjustment ............................................................ Fair value adjustment .................................................................. Net unrealized holding gains and losses—I/S ([4 million shares of NXS x $11.50] – $44 million) .......................

3 2 2

Note: Securities held-to-maturity are not adjusted to fair value. Closing entry: Net unrealized holding gains and losses—I/S (NXS) .................... Investment revenue ($3.0 + 1.5 + 0.9) ............................................. Gain on sale of investments (U.S. treasury bonds) ........................... Loss on sale of investments (Kansas Abstractors) ..................... Income summary (to balance) ..................................................

2.0 5.4 .1 2.0 5.5

Note: Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities.


12–87

Problem 12–7 (concluded) 2014 January 7 Cash ............................................................................................... Loss on sale of investments (to balance) ......................................... Investment in NXS common shares (account balance) ................

43 1 44

Assuming no other transactions involving trading securities, the 2014 adjusting entry to remove the fair value adjustment associated with the sold securities would be: December 31 Net unrealized holding gains and losses—I/S .............................. Fair value adjustment (account balance) ..................................

2.0 2.0



Problem 12–8 Requirement 1 Beale should report its securities available-for-sale in its December 31, 2014, balance sheet at their fair value, $54 million. Requirement 2 The journal entry needed to enable the investment to be reported at fair value is: ($ in millions)

Fair value adjustment ($4 debit to $5 debit) 1 Net unrealized holding gains and losses—OCI ($4 credit to $5 credit)

1

Requirement 3 As of December 31, 2013, the cost of the Schwab Pharmaceuticals investment was $25 million and its fair value was $27 million. Therefore, in the year-end 2013 adjustment process, Beale must have made whatever adjustment was necessary to produce a debit balance of $2 in the fair value adjustment valuation allowance for Schwab Pharmaceuticals and a credit balance of that amount in accumulated other comprehensive income. Because the Schwab Pharmaceuticals investment was sold during 2014, the reclassification adjustment would have to remove that amount in 2014. Beale’s statement of comprehensive income can be provided (a) as a combined statement of comprehensive income that includes net income and other comprehensive income, or (b) as a separate statement of comprehensive income in a manner similar to this: STATEMENT OF COMPREHENSIVE INCOME ($ in millions)

Net income ............................................... Other comprehensive income: Unrealized holding gains (losses) on investments Reclassification adjustment of prior years’ unrealized gain included in 2014 net income Net unrealized holding gains (losses) Comprehensive income

$xxx $3 (2) 1 $xxx


12–89

Problem 12–8 (concluded) Comprehensive income includes both net income and other comprehensive income. Net income in 2014 includes the $3 million gain realized from selling the Schwab shares. However, $2 million of that gain already has been reported in comprehensive income—as an unrealized holding gain in a prior year or years when the shares’ value increased from $25 million to $27 million. To avoid doublecounting, Beale must compensate by reducing comprehensive income by the $2 million portion of the 2014 realized gain that already has been reported. That’s what the reclassification adjustment does; it reduces this year’s comprehensive income by the amount that was reported previously to keep it from being reported twice. For there to be a total increase in AOCI of $1 million (from $4 million to $5 million), and the reclassification serving to reduce AOCI by $2 million, $3 million of unrealized holding gains must have occurred during 2014.



Problem 12–9 Requirement 1 Purchase Investment in Lavery Labeling shares.......................................... Cash .........................................................................................

($ in millions)

324 324

Net income Investment in Lavery Labeling shares (30% x $160 million) .......... Investment revenue ...................................................................

48

Dividends Cash (10 million shares x $2) ............................................................ Investment in Lavery Labeling shares......................................

20

Depreciation adjustment ‡ Investment revenue ([$80 million x 30%] ÷ 6 years) ....................... Investment in Lavery Labeling shares......................................

4

‡

48

20

4







Cost



$324

 Fair value:

Goodwill:

$60

Undervaluation of depr. assets:

$24

$880* x 30% = $264

 Book value:


$800 x 30% = $240

*[$800 + 80] = $880 Adjusting entry No entry to recognize changes in the fair value of the Lavery investment, as Runyan is accounting for its investment under the equity method.


12–91

Problem 12–9 (concluded) Requirement 2 Purchase Investment in Lavery Labeling shares .......................................... Cash ..........................................................................................

($ in millions)

324 324

Net income No entry Dividends Cash (10 million shares x $2) ............................................................. Investment revenue ...................................................................

20 20

Adjusting entry Net unrealized holding gains and losses—OCI ([10 million shares x $31] – $324 million) ................................................

Fair value adjustment ................................................................

14 14



Problem 12–10 Requirement 1 Purchase Investment in Lavery Labeling shares.......................................... Cash .........................................................................................

($ in millions)

324 324

Net income No entry Dividends Cash (10 million shares x $2) ............................................................ Investment revenue ...................................................................

20 20

Adjusting entry Net unrealized holding gains and losses—I/S ([10 million shares x $31] – $324 million) ..................................................

Fair value adjustment ...............................................................

14 14

Requirement 2 Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2013 net income. Therefore, total effect on net income would be $20 million – 14 million, or $6 million.


12–93

Problem 12–11 Requirement 1 (note: requirement 1 has the same answer as does P 12–10) Purchase Investment in Lavery Labeling shares .......................................... Cash ..........................................................................................

($ in millions)

324 324

Net income No entry Dividends Cash (10 million shares x $2) ............................................................. Investment revenue ...................................................................

20 20

Adjusting entry Net unrealized holding gains and losses—I/S ([10 million shares x $31] – $324 million) ................................................


14 14

Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2013 net income. Therefore, total effect on net income would be $20 of dividend – $14 of unrealized holding loss, or $6. The investment would be shown in the balance sheet at its fair value of $310.



Problem 12–11 (continued) Requirement 2 Purchase Investment in Lavery Labeling shares.......................................... Cash .........................................................................................

($ in millions)

324 324

Net income Investment in Lavery Labeling shares (30% x $160 million) .......... Investment revenue ...................................................................

48

Dividends Cash (10 million shares x $2) ............................................................ Investment in Lavery Labeling shares......................................

20

Depreciation adjustment ‡ Investment revenue ([$80 million x 30%] ÷ 6 years) ........................ Investment in Lavery Labeling shares......................................

4

‡

48

20

4







Cost



$324

 Fair value:

Goodwill:

$60

Undervaluation of depr. assets:

$24

$880* x 30% = $264

 Book value:


$800 x 30% = $240

*[$800 + 80] = $880


12–95

Problem 12–11 (concluded) Note: After the preceding journal entries are recorded, the balance in the Lavery Labeling investment account would be: Investment in Lavery Labeling shares ________________________________________ ($ in millions)

Cost 324 Share of income 48

Balance

20 Dividends 4 Depreciation adjustment _________________ 348

At December 31, 2013, the fair value of that investment is $310 (= 10 million shares x $31/share), implying need for the following adjusting entry to adjust the carrying value of the investment to fair value: Net unrealized holding gains and losses—I/S ([10 million shares x $31] – $348 million) ................................................


38 38

Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2013 net income. Therefore, total effect on net income would be $48 million for Runyan’s share of Lavery income minus $4 million of depreciation adjustment and minus the $38 million unrealized holding loss, yielding a total of $6 of income. The investment would be shown in the balance sheet at its fair value of $310 million. Note that the income effect and the carrying value in the balance sheet are the same in requirements 1 and 2.



Problem 12–12 Requirement 1 Purchase Investment in Vancouver T&M shares ........................................ Cash .........................................................................................

($ in millions)

400.0 400.0

Net income Investment in Vancouver T&M shares (40% x $140 million) ......... Investment revenue ...................................................................

56.0

Dividends Cash (40% x $30 million) ................................................................. Investment in Vancouver T&M shares ....................................

12.0

Inventory adjustment Investment revenue ($5 million x 40%: all sold in 2013) .................... Investment in Vancouver T&M shares ....................................

2.0

Depreciation adjustment ‡ Investment revenue ([$20 million x 40%] ÷ 16 years) ...................... Investment in Vancouver T&M shares ....................................

.5

‡

56.0

12.0

2.0

.5







Cost



$400

 Fair value: inventory plant facilities Book value:


Goodwill:

$80 [plug]

$800* x 40% = $320 (5) x 40% (20) x 40% $775

 

Undervaluation of inventory:

$2

Undervaluation of plant:

$8

x 40% = $310

* $775 + 5 + 20


12–97

Problem 12–12 (concluded) Requirement 2 Investment Revenue ($ in millions) 56.0 Share of income Inventory 2.0 Depreciation .5 _________________ Balance 53.5

Requirement 3 Investment in Vancouver T&M shares ($ in millions)

Cost Share of income

Balance

400.0 56.0 12.0 Dividends 2.0 Inventory .5 Depreciation _________________ 441.5

Requirement 4 $400 million cash outflow from investing activities $12 million cash inflow (dividends) among operating activities (Note: If Northwest uses the indirect method to report its cash flows from operating activities, it would need an adjustment of ($41.5) to get from the $53.5 included as investment revenue in net income to the $12 of cash actually received in dividends and needing to be shown in cash flow from operating activities.)



Problem 12–13 Requirement 1 Miller’s management should decide whether it has the ability to exercise significant influence over operating and financial policies of the Marlon Company. Ability to exercise significant influence is presumed for investments of 20 percent or more of voting stock and presumed not to exist for investments of less than 20 percent, other things being equal. Evidence to the contrary should be considered, including participation on the board of directors, technological dependency, material intercompany transactions, or interchange of managerial personnel. Requirement 2 a. Income statement: Investment revenue ($12 million x 1/6) Patent amortization adjustment ($4 million* ÷ 10)

($ in millions)

$2.0 (.4)

*([$24 million] x 1/6])

$1.6 b. Balance sheet: Investment in Marlon Company ($19 million + 2 million – 1 million – 0.4 million)

$19.6*


12–99

Problem 12–13 (concluded) *Investment in Marlon Company ($ in millions)

Cost Share of income

Balance

19.0 2.0 1.0 Dividends ($6 million x 1/6) .4 Amortization adjustment _________________ 19.6

c. Statement of cash flows: $19 million cash outflow from investing activities $1 million cash inflow (dividends) among operating activities (Note: If Marlon uses the indirect method to report its cash flows from operating activities, it would need an adjustment of ($0.6) to get from the $1.6 included as investment revenue in net income to the $1 of cash actually received in dividends and needing to be shown in cash flows from operating activities.)



Problem 12–14 Item __A_ 1. 35% of the nonvoting preferred stock of American Aircraft Company. __M_ 2. Treasury bills to be held-to-maturity. __M_ 3. Two-year note receivable from affiliate. __N_ 4. Accounts receivable. __M_ 5. Treasury bond maturing in one week.

Reporting Category T. M. A. E. C. N.

Trading securities Securities held-to-maturity Securities available-for-sale Equity method Consolidation None of these

__T_ 6. Common stock held in trading account for immediate resale. __T_ 7. Bonds acquired to profit from short-term differences in price. __E_ 8. 35% of the voting common stock of Computer Storage Devices Company. __C_ 9. 90% of the voting common stock of Affiliated Peripherals, Inc. __A_10. Corporate bonds of Primary Smelting Company to be sold if interest rates fall 1/2%. __A_11. 25% of the voting common stock of Smith Foundries Corporation: 51% family owned by Smith family; fair value determinable. __E_ 12. 17% of the voting common stock of Shipping Barrels Corporation: Investor’s CEO on the board of directors of Shipping Barrels Corporation.


12–101

Problem 12–15 Requirement 1 Bond Fair Value at 1/1/2013: Interest [($150,000 x 6%) ÷ 2] x 14.21240 * Principal $150,000 x 0.50257 ** = Present value of the receivable

=

$ 63,956 75,386 $139,342

* Present value of an ordinary annuity of $1: n = 20, i = 3.5% (= 7% ÷ 2) (from Table 4) ** Present value of $1: n = 20, i = 3.5% (= 7% ÷ 2) (from Table 2)

January 1, 2013 Investment in bonds (face amount) ........................ Discount on bond investment (difference)......... Cash (price of bonds) ..........................................

150,000 10,658 139,342

Requirement 2 January 1, 2013 Investment in bonds (face amount) ........................ Discount on bond investment (difference)......... Cash (price of bonds) ..........................................

150,000 10,658 139,342

June 30, 2013 Cash [(150,000 x 6%) ÷ 2] ...................................... Discount on bond investment (difference) ............ Interest revenue [($150,000 – 10,658) x 7%] ÷ 2

4,500 377

December 31, 2013 Cash (6% ÷ 2 x $150,000) ....................................... Discount on bond investment (difference) ............ Interest revenue [{$150,000 – ($10,658 – 377)} x 7%] ÷ 2

4,500 390

4,877

4,890

Note: For held-to-maturity investments, there are no adjustments to fair value.



Problem 12–15 (continued) Requirement 3 January 1, 2013 Investment in bonds (face amount) ....................... Discount on bond investment (difference) ........ Cash (price of bonds) ..........................................

150,000 10,658 139,342

June 30, 2013 Cash ($150,000 x 6%) ÷ 2 ..................................... Discount on bond investment (difference) ............ Interest revenue [($150,000 – 10,658) x 7%] ÷ 2 Bond Fair Value at June 30, 2013: Interest [($150,000 x 6%) ÷ 2] x 13.13394 * Principal $150,000 x 0.47464 ** = Present value of the receivable

4,500 377 4,877

=

$ 59,103 71,196 $130,299

*Present value of an ordinary annuity of $1: n = 19, i = 4% (= 8% ÷ 2) (from Table 4) **present value of $1: n = 19, i = 4% (= 8% ÷ 2) (from Table 2)

January 1 initial cost Increase from discount amortization June 30 amortized initial cost

$139,342 377 $139,719

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value. June 30 amortized initial cost June 30 fair value Fair value adjustment needed

$139,719 130,299 $ 9,420

Net unrealized holding gains and losses—I/S ........................... Fair value adjustment ..........................................................

9,420 9,420


12–103

Problem 12–15 (concluded) December 31, 2013 Cash ($150,000 x 6%) ÷ 2...................................... Discount on bond investment (difference) ............ Interest revenue [{$150,000 – ($10,658 – 377)} x 7%] ÷ 2

4,500 390 4,890

Bond Fair Value at December 31, 2013: Interest [($150,000 x 6%) ÷ 2] x 12.15999 * = $ 54,720 67,920 Principal $150,000 x 0.45280 ** = Present value of the receivable $122,640 * Present value of an ordinary annuity of $1: n = 18, i = 4.5% (= 9% ÷ 2) (from Table 4) ** Present value of $1: n = 18, i = 4.5% (= 9% ÷ 2) (from Table 2)

June 30 amortized initial cost Increase from discount amortization Dec. 31 amortized initial cost

$139,719 390 $140,109

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value. Dec. 31 amortized initial cost Dec. 31 fair value Fair value adjustment balance needed: debit/(credit) Less: Current fair value adjustment debit/(credit) Change in fair value adjustment needed Net unrealized holding gains and losses—I/S ........................... Fair value adjustment ...........................................................

$140,109 122,640 $ 17,469 (9,420) $ 8,049 8,049 8,049



Problem 12–16 Bee Company Investment 2013: Stewart does not plan to sell the Bee investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Stewart must recognize the $240,000 of credit losses as an OTT impairment in earnings, and the other $260,000 as a reduction of OCI, as follows: Other-than-temporary impairment loss—I/S ..... Discount on bond investment .........................

240,000

OTT impairment loss—OCI .............................. Fair value adjustment—Noncredit loss ..........

260,000 260,000

240,000

2014: Stewart ignores the change in Bee’s fair value during 2014, as the Bee investment is accounted for as an HTM investment and fair value changes are not relevant unless viewed as OTT impairments. GAAP does not allow recovery of prior OTT impairments when fair value increases. Over the remaining life of the bonds, Stewart would amortize the bonds as if they had a $240,000 discount. Stewart also would amortize the $260,000 of “Fair value adjustment—Noncredit loss” in AOCI over the remaining life of the bonds by crediting that account and debiting “Fair value adjustment—Noncredit loss” for a portion each period, thus gradually decreasing the amount shown in AOCI and increasing the carrying amount of the bonds. Oliver Corporation Investment 2013: Stewart accounts for the Oliver investment as a trading security, so OTT impairment accounting is not relevant. Stewart simply continues to recognize in earnings any unrealized gains and losses associated with fair value changes. Given that the bonds already have a negative fair value adjustment of $200,000, and need a negative fair value adjustment of $300,000 to adjust from amortized cost of $2,500,000 to fair value of $2,200,000, Stewart must recognize additional unrealized losses of $100,000 for 2013. Net unrealized holding gains and losses—I/S ........ Fair value adjustment .............................. .............

100,000 100,000


12–105

Problem 12–16 (continued) 2014: Fair value increased to $2,700,000 during 2014, so Stewart needs to have a positive fair value adjustment of $200,000 in the balance sheet to adjust from amortized cost of $2,500,000 to fair value of $2,700,000. Therefore, Stewart must recognize an unrealized gain $500,000 for 2014, moving the fair value adjustment from a negative $300,000 to a positive $200,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for a TS investment. Fair value adjustment .............................. ........... Net unrealized holding gains and losses—I/S

500,000 500,000

Jones, Inc Investment 2013: Stewart does not plan to sell the Jones investment, and does not believe it is more likely than not that it will have to sell the investment before fair value recovers, so the portion of the impairment that consists of credit and noncredit losses is relevant. Stewart must recognize the $225,000 of credit losses as an OTT impairment in earnings, and the other $575,000 as a reduction of OCI, as follows: Other-than-temporary impairment loss—I/S ..... Investment in Jones bonds...............................

225,000

Net unrealized holding gains and losses—OCI .. Fair value adjustment ......................................

575,000

225,000

575,000

Stewart also must reclassify the previously recognized $400,000 unrealized loss out of OCI and the fair value adjustment: Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

400,000 400,000

Note that Stewart could net the latter two journal entries together to be: Net unrealized holding gains and losses—OCI .. Fair value adjustment ......................................

175,000 175,000



Problem 12–16 (concluded) However, Stewart still would need to show on the face of the income statement the total OTT impairment of $800,000 less the $575,000 in OCI, yielding a $225,000 reduction in earnings. 2014: Stewart continues to treat the Jones investment as AFS. Therefore, Stewart would show an unrealized gain associated with an increase of fair value from $2,700,000 to $2,900,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for an AFS investment. The amount of credit loss and noncredit loss is not relevant to this subsequent accounting. Fair value adjustment ......................................... Net unrealized holding gains and losses—OCI

200,000 200,000

Helms Corp. Investment 2013: Because the Helms Corp. investment is equity, Stewart bases the OTT impairment on the entire difference between cost and fair value. Other-than-temporary impairment loss .............. Investment in Helms equity ............................

400,000 400,000

Stewart also must reclassify the previously recognized $120,000 unrealized gain out of OCI and the fair value adjustment: Net unrealized holding gains and losses—OCI.. Fair value adjustment ......................................

120,000 120,000

2014: Stewart continues to treat the Helms investment as AFS. Therefore, Stewart would show an unrealized gain associated with an increase of fair value from $600,000 to $700,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for an AFS investment. Fair value adjustment ......................................... Net unrealized holding gains and losses—OCI

100,000 100,000


12–107

Problem 12–17 Bee Company Investment 2013: Under IFRS only the credit loss component is relevant for debt impairments. Therefore, Stewart recognizes the $240,000 of credit losses as an OTT impairment in earnings, as follows: Other-than-temporary impairment loss .............. Discount on bond investment ..........................

240,000 240,000

2014: IFRS allows recovery of OTT impairments on debt investments. Therefore, Stewart would record a reversal of OTT impairment in earnings to increase the carrying value of the Bee investment to the level indicated by a $140,000 credit loss. Discount on bond investment.............................. 100,000 Recovery of other-than-temporary impairment loss—I/S 100,000 Oliver Corporation Investment 2013: Stewart accounts for the Oliver investment as a trading security, which under IFRS would be called “Fair value through profit and loss,” so OTT impairment accounting is not relevant. Stewart simply continues to recognize in earnings any unrealized gains and losses associated with fair value changes. Given that the bonds already have a negative fair value adjustment of $200,000, and need a negative fair value adjustment of $300,000 to adjust from amortized cost of $2,500,000 to fair value of $2,200,000, Stewart must recognize additional unrealized losses of $100,000 for 2013. Net unrealized holding gains and losses—I/S ........ Fair value adjustment .............................. .............

100,000 100,000



Problem 12–17 (continued) 2014: Fair value increased to $2,700,000 during 2014, so Stewart needs to have a positive fair value adjustment of $200,000 in the balance sheet to adjust from amortized cost of $2,500,000 to fair value of $2,700,000. Therefore, Stewart must recognize an unrealized gain of $500,000 for 2014, moving the fair value adjustment from a negative $300,000 to a positive $200,000. Note that this is not a recovery of the OTT impairment, but just normal ongoing accounting for a “Fair value through profit and loss” investment. Fair value adjustment .............................. .......... Net unrealized holding gains and losses—I/S

500,000 500,000

Jones Inc. Investment 2013: Given that this debt investment is AFS, IFRS bases the OTT impairment on fair value rather than on credit losses. Therefore, Stewart recognizes the entire $800,000 difference between amortized cost and fair value as an OTT impairment in earnings, as follows: Other-than-temporary impairment loss ............. Investment in Jones bonds ..............................

800,000 800,000

Stewart also must reclassify the previously recognized $400,000 unrealized loss out of OCI and the fair value adjustment: Fair value adjustment ......................................... Net unrealized holding gains and losses—OCI

400,000 400,000

2014: IFRS allows recovery of OTT impairments on debt investments. Therefore, Stewart would record a reversal of OTT impairment in earnings to increase the carrying value of the Jones investment to the fair value of $2,900,000. Investment in Jones bonds .................................. 200,000 Recovery of other-than-temporary impairment loss—I/S 200,000


12–109

Problem 12–17 (concluded) Helms Corp. Investment 2013: Because the Helms Corp. investment is classified as AFS, Stewart bases the OTT impairment on the entire difference between cost and fair value. Other-than-temporary impairment loss ............... Investment in Helms equity ............................

400,000 400,000

Stewart also must reclassify the previously recognized $120,000 unrealized gain out of OCI and the fair value adjustment: Net unrealized holding gains and losses—OCI .. Fair value adjustment ......................................

120,000 120,000

2014: IFRS does not allow recovery of OTT impairments for equity investment. However, Stewart continues to treat the Helms investment as AFS, so Stewart would show an unrealized gain associated with an increase of fair value from $600,000 to $700,000. This is not a recovery of the OTT impairment, but just normal ongoing accounting for an AFS investment. Fair value adjustment .......................................... Net unrealized holding gains and losses—OCI

100,000 100,000



SUPPLEMENT PROBLEM Problem 12–18 Requirement 1 The Donald Company bonds are “simple” debt, so Feherty’s business purpose is relevant for the purpose of classification and reporting. Ten bonds are to be held to collect contractual cash flows over the life of the debt, so they would be accounted for at amortized cost. Ten of the bonds are held for investment purposes, so they would be accounted for at FV-OCI. Thirty of the bonds are held for immediate resale, so they would be accounted for at FV-NI. The Watson company stock would be accounted for at FV-NI because it does not qualify for the equity method, and equity investments for which significant influence is absent are accounted for at FV-NI. Requirement 2 The Donald Company bonds would be reported as follows:  Ten bonds are accounted for at amortized cost. No unrealized gain or loss would be recognized in OCI or net income, but five of the bonds were sold at a price of $1,040 per bond, yielding a gain on sale of 5 x ($1,040 – 1,000) = $200. That gain would be included in net income. Ten bonds are accounted for at FV-OCI. Five of the bonds were sold at a price of $1,040 per bond, yielding a gain on sale of 5 x ($1,040 – 1,000) = $200. If there is an unrealized gain or loss already recorded in OCI associated with these bonds, that amount would be reclassified out of OCI, but in this case no such amount exists. Therefore, that gain would be included in net income and, therefore, in comprehensive income.  For the other five of the bonds accounted for at FV-OCI and not sold as of the end of the period, 5 x ($1,040 – 1,000) = $200 of unrealized gains and losses would be included in OCI and, therefore, in comprehensive income.  Thirty bonds are accounted for at FV-NI. Fifteen of the bonds were sold at a price of $1,040 per bond, yielding a gain on sale of 15 x ($1,040 – 1,000) = $600. That gain would be included in net income and, therefore, in comprehensive income.  For the other 15 of the bonds accounted for at FV-NI, unrealized gains of 15 x ($1,040 – 1,000) = $600 would be included in net income and, therefore, in comprehensive income.


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Problem 12–18(concluded) The Watson Company common stock investment is accounted for at FV-NI, so an unrealized loss of $5,000 ($25,000 – 20,000) would be included in net income and, therefore, in comprehensive income. Total effects are as follows: Net income: $200 (sold amortized cost) + 200 (sold FV-OCI) + 600 (sold FVNI) + 600 (retained FV-NI) – 5,000 (retained equity) = ($3,400) net loss. OCI: $200 (retained FV-OCI) Comprehensive income = Net income + OCI = ($3,400) + 200 = ($3,200) Note: You might expect the total amount shown in comprehensive income to equal the total change in fair value for the investments ($2,000 – 5,000 = ($3,000)), but that does not have to be the case because unrealized gains and losses on investments accounted for at amortized cost do not affect net income, OCI, or comprehensive income. In this case, $200 of unrealized gains associated with the five unsold amortized cost bonds is not recognized, which explains the difference between the change in fair value of ($3,000) and the amount of change recognize in comprehensive income of ($3,200).



CASES Real World Case 12–1 Requirement 1 Fair Value Adjustment, AFS Investments $648 gain – 19 loss on 12/25/2012

$582 gain – 25 loss on 7/2/2013

629 72 reduction over first half of 2011 ____________ 557

Requirement 2 Intel needs to record unrealized holding gains and losses associated with its AFS investments during the first half of 2013: Fair value adjustment, AFS investment ................. Net unrealized holding gains and losses—OCI

24 24

Requirement 3 Fair Value Adjustment, AFS Investments $648 gain – 19 loss on 12/25/2012 unrealized gains

$582 gain – 25 loss on 7/2/2013

629 24 96 to balance ____________ 557


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Case 12–1 (concluded) What could account for the unaccounted for credit of $96? The most likely explanation is that there are reclassification adjustments for AFS investments that have been sold or for which OTT impairments have been recognized. As shown in Table 2, Intel recognized net gains of $88 on AFS investments. Recognizing those gains would necessitate booking a reclassification entry that reduces (credits) the fair value adjustment and OCI to remove those effects. While $88 doesn’t exactly equal the $96 plug necessary to balance the account, it gets us very close.



Research Case 12–2 [Note:

This case encourages the student to reference actual annual reports.]

The note that describes an investment in securities “available-for-sale” may be headed by any one of a variety of captions or subsumed within another disclosure note. Likewise, the caption by which the investments are reported in the balance sheet can be reported separately as one of several asset titles or included within another asset caption. Investments in securities available-for-sale will be reported as current or noncurrent assets depending on the intent of management regarding the timing of their eventual sale. Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported. Investments in securities available-for-sale are reported at fair value. Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period. Rather, they are accumulated and reported as accumulated other comprehensive income, a separate component of shareholders’ equity. This means an unrealized holding gain would increase shareholders’ equity and an unrealized holding loss would decrease shareholders’ equity. The amounts of unrealized gains and losses will be shown on a combined statement of comprehensive income that includes net income and other comprehensive income, or as a separate statement of comprehensive income, or summarized in the statement and detailed in the notes to the financial statements. By definition, securities available-for-sale are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings. Cash outflows from acquiring these investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows unless trading securities are included in the operating activities section. Whether they are specifically identifiable depends on the degree of detail the company uses in reporting its cash flows. Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds. A disclosure note may provide information not available in the financial statements, in part dependent on how much information the financial statements provide. Often, the note will indicate the cost of the securities. © The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol. 1, Chapter 12

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International Case 12–3 Requirement 1 Satisfied by going to http://www.iasplus.com/standard/ias28.htm. Requirement 2 Renault’s decision appears appropriate, as the company has significant influence, but not control. Significant influence is indicated by a greater-than-20% equity stake and seats on the Nissan board. Lack of control is indicated by Renault not owning a majority of voting rights or board seats and not having full rights to use assets or the obligations with respect to liabilities. Requirement 3 It is not surprising that Renault makes adjustments that take into account the fair value of Nissan’s assets and liabilities at the time Renault invested in Nissan. For example, if the fair value of Nissan’s fixed assets was greater than the book value of those assets on the date of Renault’s purchase, Renault would need to recognize additional depreciation over the life of those assets when applying the equity method. This is consistent with IFRS and also with U.S. GAAP. Requirement 4 Renault’s harmonization adjustments are required by IFRS, which requires that, “if the associate uses accounting policies that differ from those of the investor, the associate's financial statements should be adjusted to reflect the investor's accounting policies for the purpose of applying the equity method.” [IAS 28.27]. U.S. GAAP has no such requirement.



International Case 12–4 Requirement 1 Note 13, “Investments in joint ventures,” describes Vodafone’s accounting for their participation in joint ventures. Per Note 2, “A joint venture is a contractual arrangement whereby the Group and other parties undertake an economic activity that is subject to joint control; that is, when the strategic financial and operating policy decisions relating to the activities require the unanimous consent of the parties sharing control. The Group reports its interests in jointly controlled entities using proportionate consolidation. The Group’s share of the assets, liabilities, income, expenses and cash flows of jointly controlled entities are combined with the equivalent items in the results on a line-by-line basis. Any goodwill arising on the acquisition of the Group’s interest in a jointly controlled entity is accounted for in accordance with the Group’s accounting policy for goodwill arising on the acquisition of a subsidiary.” Note 14, “Investments in associated undertakings,” describes Vodafone’s accounting for their significant-influence investments. Per Note 2, “An associate is an entity over which the Group has significant influence and that is neither a subsidiary nor an interest in a joint venture. Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. The results and assets and liabilities of associates are incorporated in the consolidated financial statements using the equity method of accounting. Under the equity method, investments in associates are carried in the consolidated statement of financial position at cost as adjusted for post-acquisition changes in the Group’s share of the net assets of the associate, less any impairment in the value of the investment. … Any excess of the cost of acquisition over the Group’s share of the net fair value of the identifiable assets, liabilities and contingent liabilities of the associate recognised at the date of acquisition is recognised as goodwill. The goodwill is included within the carrying amount of the investment.” Thus, joint ventures are accounted for under proportionate consolidation with their effects included in each of the relevant accounts in the balance sheet and income statement, while investments in associates are accounted for under the equity method with their effects shown on a single line.


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Case 12–4 (concluded) Requirement 2 After Vodafone implements IFRS No. 11, it will change from accounting for joint ventures using proportionate consolidation to accounting for joint ventures using the equity method.

Research Case 12–5 Answers to the questions will, of course, vary because students will research financial statements of different companies. The responses should identify securities held that are classified as trading securities, available-for-sale, or held-to-maturity. Although a company is not required to report individual amounts for the three categories of investments—heldto-maturity, available-for-sale, or trading—on the face of the balance sheet, that information should be presented in the disclosure notes. If securities available-forsale are held, there may be unrealized gains or losses reported in the shareholders’ equity section of the balance sheet. Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as a separate component of shareholders’ equity. Unlike the treatment of securities available-for-sale, unrealized holding gains and losses are included in income for trading securities. There may also be gains or losses from the sale of investments during the year. There also will likely be investment revenue (dividends or interest) in the income statement. The statement of cash flows will report acquisitions or disposals of investments as investing activities. Investment revenue is an operating activity.



Real World Case 12–6 Requirement 1 The 2010 balance sheet reports the following two current and one noncurrent asset categories ($ in millions): 2010

2009

Cash and cash equivalents

$10,900

$9,311

Short-term investments

$ 1,301

$293

$ 2,175

$432

CURRENT ASSETS:

NONCURRENT ASSETS: Investments

In the summary of critical accounting policies (Note 2), Merck describes its policy regarding investments classified as "cash equivalents." It is consistent with the way most companies classify "cash equivalents." Cash Equivalents—Cash equivalents are comprised of certain highly liquid investments with original maturities of less than three months.


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Case 12–6 (continued) Requirement 2 Merck (in the summary of critical accounting policies) describes its policy regarding accounting for its investments: Accounting for unrealized gains and losses (both temporary and OTT): “Investments in marketable debt and equity securities classified as availablefor-sale are reported at fair value. Fair value of the Company’s investments is determined using quoted market prices in active markets for identical assets or liabilities or quoted prices for similar assets or liabilities or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Changes in fair value that are considered temporary are reported net of tax in AOCI. For declines in the fair value of equity securities that are considered other-than-temporary, impairment losses are charged to Other (income) expense, net. The Company considers available evidence in evaluating potential impairments of its investments, including the duration and extent to which fair value is less than cost, and for equity securities, the Company’s ability and intent to hold the investment. For debt securities, an other-than-temporary impairment has occurred if the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company does not intend to sell the impaired debt security, and it is not more likely than not it will be required to sell the debt security before the recovery of its amortized cost basis, the amount of the other-than-temporary impairment recognized in earnings, recorded in Other (income) expense, net, is limited to the portion attributed to credit loss. The remaining portion of the other-than-temporary impairment related to other factors is recognized in AOCI.” Accounting for realized gains and losses: “Realized gains and losses for both debt and equity securities are included in Other (income) expense, net.”



Case 12–6 (concluded) Requirement 3 Investments accounted for using the equity method are described in note 10 (Joint Ventures and Other Equity Method Affiliates). The company has ongoing joint ventures and other equity-method investments with Merck/Schering-Plough, AstraZeneca LP, and several others. Requirement 4 As indicated in the income statement and in note 10, equity income recognized by Merck during 2010 was $587. Requirement 5 Operating activities section: Cash inflows from dividends are shown in operations on the statement of cash flows, and equal $324 million for 2010. Cash flows from interest income are included in net income, and given that Merck prepares an indirect-method statement of cash flows that starts the operating activities section with net income, interest income is included in operations via that number. Investing section: Cash outflows from acquiring investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows. Whether they are specifically identifiable depends on the degree of disaggregation the company uses in reporting its cash flows. Merck shows 2010 cash spent on “purchases of securities and other investments” of ($7,197) million, and cash received from “proceeds from sales of securities and other investments” of $4,561 million. The company also lists a distribution from AstraZeneca LP of $647.Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds.


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Real World Case 12–7 Requirement 1 The note indicates unrealized holding losses during 2011 in the amount of $1,349 million. This amount is included in other comprehensive income. It is not the amount Microsoft would include as a separate component of shareholders’ equity— that amount is accumulated other comprehensive income. The 2011 amount in the disclosure note is the 2011 addition to the accumulated amount, not the accumulated amount. Requirement 2 Reclassification adjustment for losses (gains) included in net income refers to unrealized holding gains and losses that occurred in periods prior to the period in which the securities are sold. Holding gains and losses from securities available-forsale are included in earnings when they are realized by selling the securities. When Microsoft sold securities in 2011, the entire increase in the fair value of the shares since the investment was acquired was included in earnings. The portion of that increase that occurred prior to 2011, but wasn’t recognized in prior earnings because it wasn’t yet realized by selling the investment, is what Microsoft refers to as its reclassification adjustment. Net income in 2011 includes the $295 million of realized gains on an after-tax basis (or $295 + 159 = $454 of realized losses on a before-tax basis). However, that $295 gain already has been reported in comprehensive income—as unrealized holding gains that were included in other comprehensive income in periods when price increases occurred. To avoid double-counting when those same gains are realized and included in comprehensive income via net income when the securities are actually sold, Microsoft compensates by decreasing other comprehensive income by the $295 million in that period. The basic idea is that the company only gets to report the gain in comprehensive income one time, so if the company includes it later in income, it must offset that by reducing other comprehensive income by the same amount. That’s what the reclassification adjustment does; it adjusts this year’s other comprehensive income by the amount that was reported previously to keep it from being reported twice.



Trueblood Accounting Case 12–8 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. These are available to instructors at: www.deloitte.com/more/DTF/cases_subj.htm.


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Research Case 12–9 From “Recognition and Presentation of Other-Than-Temporary Impairments,” FASB Staff Position (FSP) No. 115-2 and 124-2 (Norwalk, Conn.: FASB April 9, 2009), pp. 17–19, 1. Need to reduce net income for the full difference between amortized cost and fair value for debt investments, rather than only for credit losses, because that better suits the needs of investors: “Messrs. Linsmeier and Siegel …believe that to the extent there is an other-than-temporary impairment, it should be measured as the entire difference between the fair value and the carrying value of the impaired item with that change fully reflected in net income as an unrealized loss. a. Messrs. Linsmeier and Siegel believe that investors generally have opined that their preference is for the fair value of financial instruments to be reflected in net income. … Messrs. Linsmeier and Siegel believe that the primary purpose of financial reporting is to serve investors; therefore, if a bifurcation of the full fair value change into credit and noncredit components is needed to facilitate bank regulators in their regulatory capital decisions, that bifurcation should be provided on the face of the income statement with both components recognized in earnings consistent with investors’ preferences. b. Messrs. Linsmeier and Siegel also object to bifurcating (dividing) the impairment loss into credit and noncredit components because they do not believe the expected loss approach (as prescribed in this FSP) can isolate the credit loss from other losses.” 2. Likely that there will be fewer OTT impairments given the new recognition criteria: “Second, Messrs. Linsmeier and Siegel object to the change in the trigger for the nonrecognition of the full impairment loss in net income. The previous GAAP requirements permitted nonrecognition of the full impairment loss when an entity could assert its intent and ability to hold the instrument to recovery of its amortized cost basis. Instead, this FSP permits nonrecognition of the noncredit portion of the full impairment loss in net income if the entity can assert that it does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery to its amortized cost basis. While Messrs. Linsmeier and Siegel understand that the © The McGraw-Hill Companies, Inc., 2013 12–124


Case 12–9 (concluded) primary objective of this change is to make the held-to-recovery concept more operational, they also recognize that a likely result of this change is a reduction in the amount of impairment losses recognized in net income. A 1991 U.S. Treasury report cited delayed recognition of impairment losses as having an exacerbating effect on the length and ultimate cost of the savings and loan crisis. There also are potential parallels to the experience in Japan when delays in recognition of losses resulted in the so-called lost decade in the 1990s. Similarly, Messrs Linsmeier and Siegel are concerned that to the extent the proposed FSP results in delayed recognition of impairment losses in net income, there also may be a negative effect on investor confidence.” 3. Lack of convergence with the IASB: Finally, Messrs. Linsmeier and Siegel believe that there potentially may be other standard-setting issues that need to be addressed within the current other-than-temporary impairment model. However, they would prefer to address those concerns in the joint medium term project with the International Accounting Standards Board (IASB). Messrs. Linsmeier and Siegel believe that there is a high risk that the unilateral change to the recognition and presentation of other-than-temporary impairments could create the opportunity for an “accounting arbitrage” with pressure for FASB and IASB standards to converge to the standard perceived most lenient. In addition, when one standard setter enacts changes on its own, there is a failure to achieve convergence of accounting standards, which continues the challenges faced by investors in comparing global financial institutions reporting under two different accounting models. Note: This dissent offers interesting opportunities for classroom discussion. Points that might come up include: 1. Political pressures on the FASB (banks were pushing hard for flexibility in recognizing OTT impairments and relegating noncredit losses to OCI, and Congress pushed as well). 2. Potential effects of unilateral standard setting on progress towards convergence. 3. The fact that even very good accountants don’t always agree on which accounting approach is most correct.


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Air France-KLM Case Requirement 1 a. Per note 22, the balance of investments accounted for at FVTPL is $574 as of March 31, 2011. From note 22 we know the $574 is included in the total of $751 that is shown for “other short-term financial assets” in the balance sheet. b. Per notes 3.10.5 and 22, and the balance sheet, all of that balance is classified as current. c. Per note 32.3, the entire balance is at fair value because the note indicates that net book value = estimated market value = $574. We also know that investments accounted for at FVTPL are carried at fair value in the balance sheet. d. Per note 32.4, $7 of the $574 is estimated using level 1 inputs, and the other $567 is estimated using level 2 inputs. Level 2 inputs to fair value estimates are less reliable than level 1 inputs, but still use market-based inputs to calculate fair value. Still, this fair-value estimate isn’t as reliable as it would be if based on level 1 of the fair value hierarchy. Requirement 2 a. Per note 22, the balance of investments accounted for as available for sale is $977 as of March 31, 2011. From note 22 we know the $977 is included in the total of $1,654 that is shown for “other financial assets” in the balance sheet. b. Per note 22 and the balance sheet, all of that balance is classified as current. c. Per note 32.3, the entire balance is at fair value, because the note indicates that net book value = estimated market value = $977. We also know that investments accounted for as available-for-sale are carried at fair value in the balance sheet. d. Per note 32.4, $941 of the $977 is estimated using level 1 inputs, and the other $36 is estimated using level 2 inputs. Level 1 inputs to fair value estimates are the most reliable of the three levels of inputs, so these fair value estimates should be very reliable.



Air France-KLM Case (concluded) Requirement 3 a. If AF has the ability to exercise significant influence over the investee, it uses the equity method to account for the investment. AF assumes that it has the ability to exercise significant influence if it owns more than 20% of the voting rights of the investee. b. AF uses the equity method to account for joint ventures. Given that we are evaluating the 2011 annual report, AF could instead have accounted for the investment using proportionate consolidation. IFRS No. 11 removes that option. c. AF used the equity method to account for its investment in WAM (Amadeus), because it owned 22% of voting rights. However, subsequent to an initial public offering (IPO) by WAM, AF’s holding decreased to 15%, and AF concluded it no longer could exercise significant influence. Therefore, AF changed to accounting for the WAM investment as an available-for-sale investment. d. Per note 20 and the balance sheet, the carrying value of AF’s equity-method investments on its March 31, 2011, balance sheet is $422. e. Per note 20 and the income statement, AF’s equity-method investments reduced its net income from continuing operations by $21 during 2011.


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