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Basic EPS (a 4 b) $ 3.00 $ 2.70 Diluted EPS Net income $30,000 $27,000 Add: Interest savings ($200,000 3 6%) 12,000 12,000 Adjusted net income (a) $42,000 $39,000 Outstanding shares 10,000 10,000 Shares upon conversion (200 3 30) 6,000 6,000 Options (treasury-stock method) 800* 364* Total shares for diluted EPS (b) 16,800 16,364 Diluted EPS (a 4 b) $ 2.50 $ 2.38 *Treasury-stock method: 2014 2013 Cash proceeds ($4 3 4,000) $16,000 $16,000 Shares repurchased ($16,000 4 $5) 3,200 ($16,000 4 $4.40) 3,636 Net shares issued (4,000 2 3,200) 800 (4,000 2 3,636) 364 FASB Codifi cation 923 (d) Bond Conversion Expense** 300 Bonds Payable 150,000 Common Stock* 9,000 Paid-in-Capital in Excess of Par—Common Stock* 141,000 Cash 300 *$200,000 3 75% 5 $150,000 of bonds converted $150,000 4 $1,000 per bond 5 150 bonds 150 bonds 3 30 shares per bond 5 4,500 new shares issued 4,500 shares 3 $2 par value 5 $9,000 increase in common stock account $150,000 2 $9,000 5 $141,000 increase in paid-in capital account **150 bonds X $2 per bond 5 $300 bond conversion expense FASB CODIFICATION FASB Codification References [1] FASB ASC 480-10-25. [Predecessor literature: “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” Statement of Financial Accounting Standards No. 150 (Norwalk, Conn.: FASB, 2003), par. 23.] [2] FASB ASC 470-20-45. [Predecessor literature: “Induced Conversions of Convertible Debt,” Statement of Financial Accounting Standards No. 84 (Stamford, Conn.: FASB, 1985).] [3] FASB ASC 470-20-25-1 to 2. [Predecessor literature: “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants,” Opinions of the Accounting Principles Board No. 14 (New York, NY: AICPA, 1973).] [4] FASB ASC 470-20-30. [Predecessor literature: “Accounting for Convertible Debt Instruments that May Be Settled in Cash Upon Conversion,” FASB Staff Position No. 14-1 (Norwalk, Conn: FASB, 2008).] [5] FASB ASC 718-10-10. [Predecessor literature: “Accounting for Stock-Based Compensation,” Statement of Financial Account- ing Standards No. 123 (Norwalk, Conn: FASB, 1995); and “Share-Based Payment,” Statement of Financial Accounting Standard No. 123(R) (Norwalk, Conn: FASB, 2004).] [6] FASB ASC 260-10-45-2. [Predecessor literature: “Earnings per Share,” Statement of Financial Accounting Standards No. 128 (Norwalk, Conn: FASB, 1997).] [7] FASB ASC 260-10-50. [Predecessor literature: “Earnings per Share,” Statement of Financial Accounting Standards No. 128, (Norwalk, Conn.: FASB, 1997.)] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE16-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is the definition of “basic earnings per share”? (b) What is “dilution”? (c) What is a “warrant”? (d) What is a “grant date”? CE16-2 For how many periods must a company present EPS data? CE16-3 For each period that an income statement is presented, what must a company disclose about its EPS? CE16-4 If a company’s outstanding shares are increased through a stock dividend or a stock split, how would that alter the presentation of its EPS data? An additional Codification case can be found in the Using Your Judgment section, on page 941. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. 924 Chapter 16 Dilutive Securities and Earnings per Share Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter. QUESTIONS 1. What is meant by a dilutive security? 12. What date or event does the profession believe should be 2. Briefly explain why corporations issue convertible used in determining the value of a stock option? What arguments support this position? securities. 3. Discuss the similarities and the differences between con- 13. Over what period of time should compensation cost be

allocated? vertible debt and debt issued with stock warrants. 4. Bridgewater Corp. offered holders of its 1,000 convertible 14. How is compensation expense computed using the fair value approach? bonds a premium of $160 per bond to induce conversion into shares of its common stock. Upon conversion of all 15. What are the advantages of using restricted stock to the bonds, Bridgewater Corp. recorded the $160,000 pre- compensate employees? mium as a reduction of paid-in capital. Comment on 16. At December 31, 2014, Reid Company had 600,000 shares Bridgewater’s treatment of the $160,000 “sweetener.” of common stock issued and outstanding, 400,000 of 5. Explain how the conversion feature of convertible debt which had been issued and outstanding throughout the has a value (a) to the issuer and (b) to the purchaser. year and 200,000 of which were issued on October 1, 2014. 6. What are the arguments for giving separate accounting Net income for 2014 was $2,000,000, and dividends de- clared on preferred stock were $400,000. Compute Reid’s recognition to the conversion feature of debentures? earnings per common share. (Round to the nearest penny.) 7. Four years after issue, debentures with a face value of 17. What effect do stock dividends or stock splits have on the $1,000,000 and book value of $960,000 are tendered for computation of the weighted-average number of shares conversion into 80,000 shares of common stock immedi- outstanding? ately after an interest payment date. At that time, the mar- ket price of the debentures is 104, and the common stock 18. Define the following terms. is selling at $14 per share (par value $10). The company (a) Basic earnings per share. records the conversion as follows. (b) Potentially dilutive security. Bonds Payable 1,000,000 (c) Diluted earnings per share. Discount on Bonds Payable 40,000 (d) Complex capital structure. Common Stock 800,000 (e) Potential common stock. Paid-in Capital in Excess of Par— Common Stock 160,000 19. What are the computational guidelines for determining whether a convertible security is to be reported as part of Discuss the propriety of this accounting treatment. diluted earnings per share? 8. On July 1, 2014, Roberts Corporation issued $3,000,000 of 9% bonds payable in 20 years. The bonds include detachable 20. Discuss why options and warrants may be considered warrants giving the bondholder the right to purchase for $30 potentially dilutive common shares for the computation one share of $1 par value common stock at any time during of diluted earnings per share. the next 10 years. The bonds were sold for $3,000,000. The 21. Explain how convertible securities are determined to be value of the warrants at the time of issuance was $100,000. potentially dilutive common shares and how those con- Prepare the journal entry to record this transaction. vertible securities that are not considered to be potentially 9. What are stock rights? How does the issuing company dilutive common shares enter into the determination of earnings per share data. account for them? 10. Briefly explain the accounting requirements for stock 22. Explain the treasury-stock method as it applies to options compensation plans under GAAP. and warrants in computing dilutive earnings per share data. 11. Cordero Corporation has an employee stock-purchase 23. Earnings per share can affect market prices of common stock. Can market prices affect earnings per share? Explain. plan which permits all full-time employees to purchase 10 shares of common stock on the third anniversary of their 24. What is meant by the term antidilution? Give an example. employment and an additional 15 shares on each subse- 25. What type of earnings per share presentation is required quent anniversary date. The purchase price is set at the in a complex capital structure? market price on the date purchased and no commission is * 2 6. How is antidilution determined when multiple securities charged. Discuss whether this plan would be considered are involved? compensatory. Brief Exercises 925 BRIEF EXERCISES

1 BE16-1 Archer Inc. issued $4,000,000 par value, 7% convertible bonds at 99 for cash. If the bonds had not included the conversion feature, they would have sold for 95. Prepare the journal entry to record the issu- ance of the bonds. 1 BE16-2 Petrenko Corporation has outstanding 2,000 $1,000 bonds, each convertible into 50 shares of $10 par value common stock. The bonds are converted on December 31, 2014, when the unamortized discount is $30,000 and the market price of the stock is $21 per share. Record the conversion using the book value approach. 2 BE16-3 Pechstein Corporation issued 2,000 shares of $10 par value common stock upon conversion of 1,000 shares of $50 par value preferred stock. The preferred stock was originally issued at $60 per share. The common stock is trading at $26 per share at the time of conversion. Record the conversion of the preferred stock. 3 BE16-4 Eisler Corporation issued 2,000 $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market price of $40. Use the proportional method to record the issuance of the bonds and warrants. 3 BE16-5 McIntyre Corporation issued 2,000 $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling separately at 98. The market price of the warrants without the bonds cannot be determined. Use the incremental method to record the issuance of the bonds and warrants. 4 BE16-6 On January 1, 2014, Barwood Corporation granted 5,000 options to executives. Each option entitles the holder to purchase one share of Barwood’s $5 par value common stock at $50 per share at any time during the next 5 years. The market price of the stock is $65 per share on the date of grant. The fair value of the options at the grant date is $150,000. The period of benefit is 2 years. Prepare Barwood’s journal entries for January 1, 2014, and December 31, 2014 and 2015. 4 BE16-7 Refer to the data for Barwood Corporation in BE16-6. Repeat the requirements assuming that instead of options, Barwood granted 2,000 shares of restricted stock. 4 BE16-8 On January 1, 2014 (the date of grant), Lutz Corporation issues 2,000 shares of restricted stock to its executives. The fair value of these shares is $75,000, and their par value is $10,000. The stock is forfeited if the executives do not complete 3 years of employment with the company. Prepare the journal entry (if any) on January 1, 2014, and on December 31, 2014, assuming the service period is 3 years. 6 BE16-9 Kalin Corporation had 2014 net income of $1,000,000. During 2014, Kalin paid a dividend of $2 per share on 100,000 shares of preferred stock. During 2014, Kalin had outstanding 250,000 shares of common stock. Compute Kalin’s 2014 earnings per share. 6 BE16-10 Douglas Corporation had 120,000 shares of stock outstanding on January 1, 2014. On May 1, 2014, Douglas issued 60,000 shares. On July 1, Douglas purchased 10,000 treasury shares, which were reissued on October 1. Compute Douglas’s weighted-average number of shares outstanding for 2014. 6 BE16-11 Tomba Corporation had 300,000 shares of common stock outstanding on January 1, 2014. On May 1, Tomba issued 30,000 shares. (a) Compute the weighted-average number of shares outstanding if the 30,000 shares were issued for cash. (b) Compute the weighted-average number of shares outstanding if the 30,000 shares were issued in a stock dividend. 7 BE16-12 Rockland Corporation earned net income of $300,000 in 2014 and had 100,000 shares of common stock outstanding throughout the year. Also outstanding all year was $800,000 of 10% bonds, which are convertible into 16,000 shares of common. Rockland’s tax rate is 40%. Compute Rockland’s 2014 diluted earnings per share. 7 BE16-13 DiCenta Corporation reported net income of $270,000 in 2014 and had 50,000 shares of common stock outstanding throughout the year. Also outstanding all year were 5,000 shares of cumulative preferred stock, each convertible into 2 shares of common. The preferred stock pays an annual dividend of $5 per

share. DiCenta’s tax rate is 40%. Compute DiCenta’s 2014 diluted earnings per share. 7 BE16-14 Bedard Corporation reported net income of $300,000 in 2014 and had 200,000 shares of common stock outstanding throughout the year. Also outstanding all year were 45,000 options to purchase common stock at $10 per share. The average market price of the stock during the year was $15. Compute diluted earnings per share. 926 Chapter 16 Dilutive Securities and Earnings per Share 6 BE16-15 The 2014 income statement of Wasmeier Corporation showed net income of $480,000 and an extraordinary loss of $120,000. Wasmeier had 100,000 shares of common stock outstanding all year. Prepare Wasmeier’s income statement presentation of earnings per share. 8 * BE16-16 Ferraro, Inc. established a stock-appreciation rights (SAR) program on January 1, 2014, which entitles executives to receive cash at the date of exercise for the difference between the market price of the stock and the pre-established price of $20 on 5,000 SARs. The required service period is 2 years. The fair value of the SARs are determined to be $4 on December 31, 2014, and $9 on December 31, 2015. Compute Ferraro’s compensation expense for 2014 and 2015. EXERCISES 1 3 E16-1 (Issuance and Conversion of Bonds) For each of the unrelated transactions described below, present the entry(ies) required to record each transaction. 1. Grand Corp. issued $20,000,000 par value 10% convertible bonds at 99. If the bonds had not been convertible, the company’s investment banker estimates they would have been sold at 95. Expenses of issuing the bonds were $70,000. 2. Hoosier Company issued $20,000,000 par value 10% bonds at 98. One detachable stock purchase warrant was issued with each $100 par value bond. At the time of issuance, the warrants were selling for $4. 3. Suppose Sepracor, Inc. called its convertible debt in 2014. Assume the following related to the trans- action. The 11%, $10,000,000 par value bonds were converted into 1,000,000 shares of $1 par value common stock on July 1, 2014. On July 1, there was $55,000 of unamortized discount applicable to the bonds, and the company paid an additional $75,000 to the bondholders to induce conversion of all the bonds. The company records the conversion using the book value method. 1 E16-2 (Conversion of Bonds) Aubrey Inc. issued $4,000,000 of 10%, 10-year convertible bonds on June 1, 2014, at 98 plus accrued interest. The bonds were dated April 1, 2014, with interest payable April 1 and October 1. Bond discount is amortized semiannually on a straight-line basis. On April 1, 2015, $1,500,000 of these bonds were converted into 30,000 shares of $20 par value common stock. Accrued interest was paid in cash at the time of conversion. Instructions (a) Prepare the entry to record the interest expense at October 1, 2014. Assume that accrued interest payable was credited when the bonds were issued. (Round to nearest dollar.) (b) Prepare the entry(ies) to record the conversion on April 1, 2015. (Book value method is used.) Assume that the entry to record amortization of the bond discount and interest payment has been made. 1 E16-3 (Conversion of Bonds) Vargo Company has bonds payable outstanding in the amount of $500,000, and the Premium on Bonds Payable account has a balance of $7,500. Each $1,000 bond is convertible into 20 shares of preferred stock of par value of $50 per share. All bonds are converted into preferred stock. Instructions Assuming that the book value method was used, what entry would be made? 1 E16-4 (Conversion of Bonds) On January 1, 2013, when its $30 par value common stock was selling for $80 per share, Plato Corp. issued $10,000,000 of 8% convertible debentures due in 20 years. The conversion option allowed the holder of each $1,000 bond to convert the bond into five shares of the corporation’s common stock. The debentures were issued for $10,800,000. The present value of the bond payments at the time of issuance was $8,500,000, and the corporation believes the difference between the present value and

the amount paid is attributable to the conversion feature. On January 1, 2014, the corporation’s $30 par value common stock was split 2 for 1, and the conversion rate for the bonds was adjusted accordingly. On January 1, 2015, when the corporation’s $15 par value common stock was selling for $135 per share, holders of 30% of the convertible debentures exercised their conversion options. The corporation uses the straight- line method for amortizing any bond discounts or premiums. Instructions (a) Prepare in general journal form the entry to record the original issuance of the convertible debentures. Exercises 927 (b) Prepare in general journal form the entry to record the exercise of the conversion option, using the book value method. Show supporting computations in good form. 1 E16-5 (Conversion of Bonds) The December 31, 2014, balance sheet of Kepler Corp. is as follows. 10% callable, convertible bonds payable (semiannual interest dates April 30 and October 31; convertible into 6 shares of $25 par value common stock per $1,000 of bond principal; maturity date April 30, 2020) $500,000 Discount on bonds payable 10,240 $489,760 On March 5, 2015, Kepler Corp. called all of the bonds as of April 30 for the principal plus interest through April 30. By April 30, all bondholders had exercised their conversion to common stock as of the interest payment date. Consequently, on April 30, Kepler Corp. paid the semiannual interest and issued shares of common stock for the bonds. The discount is amortized on a straight-line basis. Kepler uses the book value method. Instructions Prepare the entry(ies) to record the interest expense and conversion on April 30, 2015. Reversing entries were made on January 1, 2015. (Round to the nearest dollar.) 1 E16-6 (Conversion of Bonds) On January 1, 2014, Gottlieb Corporation issued $4,000,000 of 10-year, 8% convertible debentures at 102. Interest is to be paid semiannually on June 30 and December 31. Each $1,000 debenture can be converted into eight shares of Gottlieb Corporation $100 par value common stock after December 31, 2015. On January 1, 2016, $400,000 of debentures are converted into common stock, which is then selling at $110. An additional $400,000 of debentures are converted on March 31, 2016. The market price of the common stock is then $115. Accrued interest at March 31 will be paid on the next interest date. Bond premium is amortized on a straight-line basis. Instructions Make the necessary journal entries for: (a) December 31, 2015. (c) March 31, 2016. (b) January 1, 2016. (d) June 30, 2016. Record the conversions using the book value method. 3 E16-7 (Issuance of Bonds with Warrants) Illiad Inc. has decided to raise additional capital by issuing $170,000 face value of bonds with a coupon rate of 10%. In discussions with investment bankers, it was determined that to help the sale of the bonds, detachable stock warrants should be issued at the rate of one warrant for each $100 bond sold. The value of the bonds without the warrants is considered to be $136,000, and the value of the warrants in the market is $24,000. The bonds sold in the market at issuance for $152,000. Instructions (a) What entry should be made at the time of the issuance of the bonds and warrants? (b) If the warrants were nondetachable, would the entries be different? Discuss. 3 E16-8 (Issuance of Bonds with Detachable Warrants) On September 1, 2014, Sands Company sold at 104 (plus accrued interest) 4,000 of its 9%, 10-year, $1,000 face value, nonconvertible bonds with detachable stock warrants. Each bond carried two detachable warrants. Each warrant was for one share of common stock at a specified option price of $15 per share. Shortly after issuance, the warrants were quoted on the market for $3 each. No fair value can be determined for the Sands Company bonds. Interest is payable on December 1 and June 1. Bond issue costs of $30,000 were incurred. Instructions Prepare in general journal format the entry to record the issuance of the bonds. (AICPA adapted) 3 E16-9 (Issuance of Bonds with Stock Warrants) On May 1, 2014, Friendly Company issued 2,000 $1,000

bonds at 102. Each bond was issued with one detachable stock warrant. Shortly after issuance, the bonds were selling at 98, but the fair value of the warrants cannot be determined. Instructions (a) Prepare the entry to record the issuance of the bonds and warrants. (b) Assume the same facts as part (a), except that the warrants had a fair value of $30. Prepare the entry to record the issuance of the bonds and warrants. 928 Chapter 16 Dilutive Securities and Earnings per Share 4 E16-10 (Issuance and Exercise of Stock Options) On November 1, 2014, Columbo Company adopted a stock-option plan that granted options to key executives to purchase 30,000 shares of the company’s $10 par value common stock. The options were granted on January 2, 2015, and were exercisable 2 years after the date of grant if the grantee was still an employee of the company. The options expired 6 years from date of grant. The option price was set at $40, and the fair value option-pricing model determines the total compensation expense to be $450,000. All of the options were exercised during the year 2017: 20,000 on January 3 when the market price was $67, and 10,000 on May 1 when the market price was $77 a share. Instructions Prepare journal entries relating to the stock option plan for the years 2015, 2016, and 2017. Assume that the employee performs services equally in 2015 and 2016. 4 E16-11 (Issuance, Exercise, and Termination of Stock Options) On January 1, 2015, Titania Inc. granted stock options to officers and key employees for the purchase of 20,000 shares of the company’s $10 par common stock at $25 per share. The options were exercisable within a 5-year period beginning January 1, 2017, by grantees still in the employ of the company, and expiring December 31, 2021. The service period for this award is 2 years. Assume that the fair value option-pricing model determines total compensation expense to be $350,000. On April 1, 2016, 2,000 options were terminated when the employees resigned from the company. The market price of the common stock was $35 per share on this date. On March 31, 2017, 12,000 options were exercised when the market price of the common stock was $40 per share. Instructions Prepare journal entries to record issuance of the stock options, termination of the stock options, exercise of the stock options, and charges to compensation expense, for the years ended December 31, 2015, 2016, and 2017. 4 E16-12 (Issuance, Exercise, and Termination of Stock Options) On January 1, 2013, Nichols Corporation granted 10,000 options to key executives. Each option allows the executive to purchase one share of Nichols’ $5 par value common stock at a price of $20 per share. The options were exercisable within a 2-year period beginning January 1, 2015, if the grantee is still employed by the company at the time of the exercise. On the grant date, Nichols’ stock was trading at $25 per share, and a fair value option-pricing model determines total compensation to be $400,000. On May 1, 2015, 8,000 options were exercised when the market price of Nichols’ stock was $30 per share. The remaining options lapsed in 2017 because executives decided not to exercise their options. Instructions Prepare the necessary journal entries related to the stock option plan for the years 2013 through 2017. 4 E16-13 (Accounting for Restricted Stock) Derrick Company issues 4,000 shares of restricted stock to its CFO, Dane Yaping, on January 1, 2014. The stock has a fair value of $120,000 on this date. The service period related to this restricted stock is 4 years. Vesting occurs if Yaping stays with the company for 4 years. The par value of the stock is $5. At December 31, 2015, the fair value of the stock is $145,000. Instructions (a) Prepare the journal entries to record the restricted stock on January 1, 2014 (the date of grant), and December 31, 2015. (b) On March 4, 2016, Yaping leaves the company. Prepare the journal entry (if any) to account for this forfeiture. 4 E16-14 (Accounting for Restricted Stock) Tweedie Company issues 10,000 shares of restricted stock to

its CFO, Mary Tokar, on January 1, 2014. The stock has a fair value of $500,000 on this date. The service period related to this restricted stock is 5 years. Vesting occurs if Tokar stays with the company until December 31, 2018. The par value of the stock is $10. At December 31, 2014, the fair value of the stock is $450,000. Instructions (a) Prepare the journal entries to record the restricted stock on January 1, 2014 (the date of grant), and December 31, 2015. (b) On July 25, 2018, Tokar leaves the company. Prepare the journal entry (if any) to account for this forfeiture. Exercises 929 6 E16-15 (Weighted-Average Number of Shares) Newton Inc. uses a calendar year for financial reporting. The company is authorized to issue 9,000,000 shares of $10 par common stock. At no time has Newton is- sued any potentially dilutive securities. Listed below is a summary of Newton’s common stock activities. 1. Number of common shares issued and outstanding at December 31, 2012 2,000,000 2. Shares issued as a result of a 10% stock dividend on September 30, 2013 200,000 3. Shares issued for cash on March 31, 2014 2,000,000 Number of common shares issued and outstanding at December 31, 2014 4,200,000 4. A 2-for-1 stock split of Newton’s common stock took place on March 31, 2015 Instructions (a) Compute the weighted-average number of common shares used in computing earnings per common share for 2013 on the 2014 comparative income statement. (b) Compute the weighted-average number of common shares used in computing earnings per common share for 2014 on the 2014 comparative income statement. (c) Compute the weighted-average number of common shares to be used in computing earnings per common share for 2014 on the 2015 comparative income statement. (d) Compute the weighted-average number of common shares to be used in computing earnings per common share for 2015 on the 2015 comparative income statement. (CMA adapted) 6 E16-16 (EPS: Simple Capital Structure) On January 1, 2015, Wilke Corp. had 480,000 shares of common stock outstanding. During 2015, it had the following transactions that affected the common stock account. February 1 Issued 120,000 shares March 1 Issued a 10% stock dividend May 1 Acquired 100,000 shares of treasury stock June 1 Issued a 3-for-1 stock split October 1 Reissued 60,000 shares of treasury stock Instructions (a) Determine the weighted-average number of shares outstanding as of December 31, 2015. (b) Assume that Wilke Corp. earned net income of $3,456,000 during 2015. In addition, it had 100,000 shares of 9%, $100 par nonconvertible, noncumulative preferred stock outstanding for the entire year. Because of liquidity considerations, however, the company did not declare and pay a preferred dividend in 2015. Compute earnings per share for 2015, using the weighted-average number of shares determined in part (a). (c) Assume the same facts as in part (b), except that the preferred stock was cumulative. Compute earn- ings per share for 2015. (d) Assume the same facts as in part (b), except that net income included an extraordinary gain of $864,000 and a loss from discontinued operations of $432,000. Both items are net of applicable income taxes. Compute earnings per share for 2015. 6 E16-17 (EPS: Simple Capital Structure) Ace Company had 200,000 shares of common stock outstanding on December 31, 2015. During the year 2016, the company issued 8,000 shares on May 1 and retired 14,000 shares on October 31. For the year 2016, Ace Company reported net income of $249,690 after a casualty loss of $40,600 (net of tax). Instructions What earnings per share data should be reported at the bottom of its income statement, assuming that the casualty loss is extraordinary? 6 E16-18 (EPS: Simple Capital Structure) Flagstad Inc. presented the following data. Net income $2,500,000 Preferred stock: 50,000 shares outstanding, $100 par, 8% cumulative, not convertible 5,000,000 Common stock: Shares outstanding 1/1 750,000 Issued for cash, 5/1 300,000 Acquired treasury stock for cash, 8/1 150,000 2-for-1 stock split, 10/1

Instructions Compute earnings per share. 930 Chapter 16 Dilutive Securities and Earnings per Share 6 E16-19 (EPS: Simple Capital Structure) A portion of the combined statement of income and retained earnings of Seminole Inc. for the current year follows. Income before extraordinary item $15,000,000 Extraordinary loss, net of applicable income tax (Note 1) 1,340,000 Net income 13,660,000 Retained earnings at the beginning of the year 83,250,000 96,910,000 Dividends declared: On preferred stock—$6.00 per share $ 300,000 On common stock—$1.75 per share 14,875,000 15,175,000 Retained earnings at the end of the year $81,735,000 Note 1. During the year, Seminole Inc. suffered a major casualty loss of $1,340,000 after applicable income tax reduction of $1,200,000. At the end of the current year, Seminole Inc. has outstanding 8,500,000 shares of $10 par common stock and 50,000 shares of 6% preferred. On April 1 of the current year, Seminole Inc. issued 1,000,000 shares of common stock for $32 per share to help finance the casualty. Instructions Compute the earnings per share on common stock for the current year as it should be reported to stock- holders. 6 E16-20 (EPS: Simple Capital Structure) On January 1, 2014, Lennon Industries had stock outstanding as follows. 6% Cumulative preferred stock, $100 par value, issued and outstanding 10,000 shares $1,000,000 Common stock, $10 par value, issued and outstanding 200,000 shares 2,000,000 To acquire the net assets of three smaller companies, Lennon authorized the issuance of an additional 160,000 common shares. The acquisitions took place as shown below. Date of Acquisition Shares Issued Company A April 1, 2014 50,000 Company B July 1, 2014 80,000 Company C October 1, 2014 30,000 On May 14, 2014, Lennon realized a $90,000 (before taxes) insurance gain on the expropriation of investments originally purchased in 2000. On December 31, 2014, Lennon recorded net income of $300,000 before tax and exclusive of the gain. Instructions Assuming a 50% tax rate, compute the earnings per share data that should appear on the financial state- ments of Lennon Industries as of December 31, 2014. Assume that the expropriation is extraordinary. 6 E16-21 (EPS: Simple Capital Structure) At January 1, 2014, Langley Company’s outstanding shares included the following. 280,000 shares of $50 par value, 7% cumulative preferred stock 900,000 shares of $1 par value common stock Net income for 2014 was $2,530,000. No cash dividends were declared or paid during 2014. On February 15, 2015, however, all preferred dividends in arrears were paid, together with a 5% stock dividend on com- mon shares. There were no dividends in arrears prior to 2014. On April 1, 2014, 450,000 shares of common stock were sold for $10 per share, and on October 1, 2014, 110,000 shares of common stock were purchased for $20 per share and held as treasury stock. Instructions Compute earnings per share for 2014. Assume that financial statements for 2014 were issued in March 2015. 7 E16-22 (EPS with Convertible Bonds, Various Situations) In 2013, Chirac Enterprises issued, at par, 60 $1,000, 8% bonds, each convertible into 100 shares of common stock. Chirac had revenues of $17,500 and Exercises 931 expenses other than interest and taxes of $8,400 for 2014. (Assume that the tax rate is 40%.) Throughout 2014, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed. Instructions (a) Compute diluted earnings per share for 2014. (b) Assume the same facts as those assumed for part (a), except that the 60 bonds were issued on September 1, 2014 (rather than in 2013), and none have been converted or redeemed. (c) Assume the same facts as assumed for part (a), except that 20 of the 60 bonds were actually converted on July 1, 2014. 7 E16-23 (EPS with Convertible Bonds) On June 1, 2012, Andre Company and Agassi Company merged to form Lancaster Inc. A total of 800,000 shares were issued to complete the merger. The new corporation reports on a calendar-year basis. On April 1, 2014, the company issued an additional 400,000 shares of stock for cash. All 1,200,000

shares were outstanding on December 31, 2014. Lancaster Inc. also issued $600,000 of 20-year, 8% convertible bonds at par on July 1, 2014. Each $1,000 bond converts to 40 shares of common at any interest date. None of the bonds have been converted to date. Lancaster Inc. is preparing its annual report for the fiscal year ending December 31, 2014. The annual report will show earnings per share figures based upon a reported after-tax net income of $1,540,000. (The tax rate is 40%.) Instructions Determine the following for 2014. (a) The number of shares to be used for calculating: (1) Basic earnings per share. (2) Diluted earnings per share. (b) The earnings figures to be used for calculating: (1) Basic earnings per share. (2) Diluted earnings per share. (CMA adapted) 7 E16-24 (EPS with Convertible Bonds and Preferred Stock) The Simon Corporation issued 10-year, $5,000,000 par, 7% callable convertible subordinated debentures on January 2, 2014. The bonds have a par value of $1,000, with interest payable annually. The current conversion ratio is 14:1, and in 2 years it will increase to 18:1. At the date of issue, the bonds were sold at 98. Bond discount is amortized on a straight- line basis. Simon’s effective tax was 35%. Net income in 2014 was $9,500,000, and the company had 2,000,000 shares outstanding during the entire year. Instructions (a) Prepare a schedule to compute both basic and diluted earnings per share. (b) Discuss how the schedule would differ if the security was convertible preferred stock. 7 E16-25 (EPS with Convertible Bonds and Preferred Stock) On January 1, 2014, Crocker Company issued 10-year, $2,000,000 face value, 6% bonds, at par. Each $1,000 bond is convertible into 15 shares of Crocker common stock. Crocker’s net income in 2014 was $300,000, and its tax rate was 40%. The company had 100,000 shares of common stock outstanding throughout 2014. None of the bonds were converted in 2014. Instructions (a) Compute diluted earnings per share for 2014. (b) Compute diluted earnings per share for 2014, assuming the same facts as above, except that $1,000,000 of 6% convertible preferred stock was issued instead of the bonds. Each $100 preferred share is convertible into 5 shares of Crocker common stock. 7 E16-26 (EPS with Options, Various Situations) Venzuela Company’s net income for 2014 is $50,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2013, each exercisable for one share at $6. None has been exercised, and 10,000 shares of common were outstanding during 2014. The average market price of Venzuela’s stock during 2014 was $20. Instructions (a) Compute diluted earnings per share. (Round to nearest cent.) (b) Assume the same facts as those assumed for part (a), except that the 1,000 options were issued on October 1, 2014 (rather than in 2013). The average market price during the last 3 months of 2014 was $20. 7 E16-27 (EPS with Contingent Issuance Agreement) Winsor Inc. recently purchased Holiday Corp., a large midwestern home painting corporation. One of the terms of the merger was that if Holiday’s income 932 Chapter 16 Dilutive Securities and Earnings per Share for 2014 was $110,000 or more, 10,000 additional shares would be issued to Holiday’s stockholders in 2015. Holiday’s income for 2013 was $120,000. Instructions (a) Would the contingent shares have to be considered in Winsor’s 2013 earnings per share com- putations? (b) Assume the same facts, except that the 10,000 shares are contingent on Holiday’s achieving a net income of $130,000 in 2014. Would the contingent shares have to be considered in Winsor’s earnings per share computations for 2013? 7 E16-28 (EPS with Warrants) Howat Corporation earned $360,000 during a period when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of $15 per share during the period. Also outstanding were 15,000 warrants that could be exercised to purchase one share of common stock for $10 for each warrant exercised. Instructions

(a) Are the warrants dilutive? (b) Compute basic earnings per share. (c) Compute diluted earnings per share. 8 *E 16-29 (Stock-Appreciation Rights) On December 31, 2010, Beckford Company issues 150,000 stock- appreciation rights to its officers entitling them to receive cash for the difference between the market price of its stock and a pre-established price of $10. The fair value of the SARs is estimated to be $4 per SAR on December 31, 2011; $1 on December 31, 2012; $10 on December 31, 2013; and $9 on December 31, 2014. The service period is 4 years, and the exercise period is 7 years. Instructions (a) Prepare a schedule that shows the amount of compensation expense allocable to each year affected by the stock-appreciation rights plan. (b) Prepare the entry at December 31, 2014, to record compensation expense, if any, in 2014. (c) Prepare the entry on December 31, 2014, assuming that all 150,000 SARs are exercised. 8 *E 16-30 (Stock-Appreciation Rights) Capulet Company establishes a stock-appreciation rights program that entitles its new president Ben Davis to receive cash for the difference between the market price of the stock and a pre-established price of $30 (also market price) on December 31, 2010, on 30,000 SARs. The date of grant is December 31, 2010, and the required employment (service) period is 4 years. President Davis exercises all of the SARs in 2016. The fair value of the SARs is estimated to be $6 per SAR on December 31, 2011; $9 on December 31, 2012; $15 on December 31, 2013; $6 on December 31, 2014; and $18 on December 31, 2015. Instructions (a) Prepare a 5-year (2011–2015) schedule of compensation expense pertaining to the 30,000 SARs granted president Davis. (b) Prepare the journal entry for compensation expense in 2011, 2014, and 2015 relative to the 30,000 SARs. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 1 3 P16-1 (Entries for Various Dilutive Securities) The stockholders’ equity section of Martino Inc. at the 4 beginning of the current year appears below. Common stock, $10 par value, authorized 1,000,000 shares, 300,000 shares issued and outstanding $3,000,000 Paid-in capital in excess of par—common stock 600,000 Retained earnings 570,000 Problems 933 During the current year, the following transactions occurred. 1. The company issued to the stockholders 100,000 rights. Ten rights are needed to buy one share of stock at $32. The rights were void after 30 days. The market price of the stock at this time was $34 per share. 2. The company sold to the public a $200,000, 10% bond issue at 104. The company also issued with each $100 bond one detachable stock purchase warrant, which provided for the purchase of com- mon stock at $30 per share. Shortly after issuance, similar bonds without warrants were selling at 96 and the warrants at $8. 3. All but 5,000 of the rights issued in (1) were exercised in 30 days. 4. At the end of the year, 80% of the warrants in (2) had been exercised, and the remaining were out- standing and in good standing. 5. During the current year, the company granted stock options for 10,000 shares of common stock to company executives. The company, using a fair value option-pricing model, determines that each option is worth $10. The option price is $30. The options were to expire at year-end and were con- sidered compensation for the current year. 6. All but 1,000 shares related to the stock-option plan were exercised by year-end. The expiration resulted because one of the executives failed to fulfill an obligation related to the employment contract. Instructions (a) Prepare general journal entries for the current year to record the transactions listed above. (b) Prepare the stockholders’ equity section of the balance sheet at the end of the current year. Assume that retained earnings at the end of the current year is $750,000. 1 P16-2 (Entries for Conversion, Amortization, and Interest of Bonds) Volker Inc. issued $2,500,000 of convertible 10-year bonds on July 1, 2014. The bonds provide for 12% interest payable semiannually on

January 1 and July 1. The discount in connection with the issue was $54,000, which is being amortized monthly on a straight-line basis. The bonds are convertible after one year into 8 shares of Volker Inc.’s $100 par value common stock for each $1,000 of bonds. On August 1, 2015, $250,000 of bonds were turned in for conversion into common stock. Interest has been accrued monthly and paid as due. At the time of conversion, any accrued interest on bonds being converted is paid in cash. Instructions Prepare the journal entries to record the conversion, amortization, and interest in connection with the bonds as of the following dates. (Round to the nearest dollar.) (a) August 1, 2015. (Assume the book value method is used.) (b) August 31, 2015. (c) December 31, 2015, including closing entries for end-of-year. (AICPA adapted) 4 P16-3 (Stock-Option Plan) Berg Company adopted a stock-option plan on November 30, 2013, that pro- vided that 70,000 shares of $5 par value stock be designated as available for the granting of options to of- ficers of the corporation at a price of $9 a share. The market price was $12 a share on November 30, 2014. On January 2, 2014, options to purchase 28,000 shares were granted to president Tom Winter—15,000 for services to be rendered in 2014 and 13,000 for services to be rendered in 2015. Also on that date, options to purchase 14,000 shares were granted to vice president Michelle Bennett—7,000 for services to be ren- dered in 2014 and 7,000 for services to be rendered in 2015. The market price of the stock was $14 a share on January 2, 2014. The options were exercisable for a period of one year following the year in which the services were rendered. The fair value of the options on the grant date was $4 per option. In 2015, neither the president nor the vice president exercised their options because the market price of the stock was below the exercise price. The market price of the stock was $8 a share on December 31, 2015, when the options for 2014 services lapsed. On December 31, 2016, both president Winter and vice president Bennett exercised their options for 13,000 and 7,000 shares, respectively, when the market price was $16 a share. Instructions Prepare the necessary journal entries in 2013 when the stock-option plan was adopted, in 2014 when options were granted, in 2015 when options lapsed, and in 2016 when options were exercised. 4 P16-4 (Stock-Based Compensation) Assume that Amazon.com has a stock-option plan for top manage- ment. Each stock option represents the right to purchase a share of Amazon $1 par value common stock in 934 Chapter 16 Dilutive Securities and Earnings per Share the future at a price equal to the fair value of the stock at the date of the grant. Amazon has 5,000 stock options outstanding, which were granted at the beginning of 2014. The following data relate to the option grant. Exercise price for options $40 Market price at grant date (January 1, 2014) $40 Fair value of options at grant date (January 1, 2014) $6 Service period 5 years Instructions (a) Prepare the journal entry(ies) for the first year of the stock-option plan. (b) Prepare the journal entry(ies) for the first year of the plan assuming that, rather than options, 700 shares of restricted stock were granted at the beginning of 2014. (c) Now assume that the market price of Amazon stock on the grant date was $45 per share. Repeat the requirements for (a) and (b). (d) Amazon would like to implement an employee stock-purchase plan for rank-and-file employees, but it would like to avoid recording expense related to this plan. Which of the following provisions must be in place for the plan to avoid recording compensation expense? (1) Substantially all employees may participate. (2) The discount from market is small (less than 5%). (3) The plan offers no substantive option feature. (4) There is no preferred stock outstanding. 7 P16-5 (EPS with Complex Capital Structure) Amy Dyken, controller at Fitzgerald Pharmaceutical Indus- tries, a public company, is currently preparing the calculation for basic and diluted earnings per share and

the related disclosure for Fitzgerald’s financial statements. Below is selected financial information for the fiscal year ended June 30, 2014. FITZGERALD PHARMACEUTICAL INDUSTRIES SELECTED BALANCE SHEET INFORMATION JUNE 30, 2014 Long-term debt Notes payable, 10% $ 1,000,000 8% convertible bonds payable 5,000,000 10% bonds payable 6,000,000 Total long-term debt $12,000,000 Shareholders’ equity Preferred stock, 6% cumulative, $50 par value, 100,000 shares authorized, 25,000 shares issued and outstanding $ 1,250,000 Common stock, $1 par, 10,000,000 shares authorized, 1,000,000 shares issued and outstanding 1,000,000 Additional paid-in capital 4,000,000 Retained earnings 6,000,000 Total shareholders’ equity $12,250,000 The following transactions have also occurred at Fitzgerald. 1. Options were granted on July 1, 2013, to purchase 200,000 shares at $15 per share. Although no options were exercised during fiscal year 2014, the average price per common share during fiscal year 2014 was $20 per share. 2. Each bond was issued at face value. The 8% convertible bonds will convert into common stock at 50 shares per $1,000 bond. The bonds are exercisable after 5 years and were issued in fiscal year 2013. 3. The preferred stock was issued in 2013. 4. There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal year 2014. 5. The 1,000,000 shares of common stock were outstanding for the entire 2014 fiscal year. 6. Net income for fiscal year 2014 was $1,500,000, and the average income tax rate is 40%. Problems 935 Instructions For the fiscal year ended June 30, 2014, calculate the following for Fitzgerald Pharmaceutical Industries. (a) Basic earnings per share. (b) Diluted earnings per share. 6 P16-6 (Basic EPS: Two-Year Presentation) Melton Corporation is preparing the comparative financial statements for the annual report to its shareholders for fiscal years ended May 31, 2014, and May 31, 2015. The income from operations for each year was $1,800,000 and $2,500,000, respectively. In both years, the company incurred a 10% interest expense on $2,400,000 of debt, an obligation that requires interest-only payments for 5 years. The company experienced a loss of $600,000 from a fire in its Scotsland facility in February 2015, which was determined to be an extraordinary loss. The company uses a 40% effective tax rate for income taxes. The capital structure of Melton Corporation on June 1, 2013, consisted of 1 million shares of common stock outstanding and 20,000 shares of $50 par value, 6%, cumulative preferred stock. There were no preferred dividends in arrears, and the company had not issued any convertible securities, options, or warrants. On October 1, 2013, Melton sold an additional 500,000 shares of the common stock at $20 per share. Melton distributed a 20% stock dividend on the common shares outstanding on January 1, 2014. On December 1, 2014, Melton was able to sell an additional 800,000 shares of the common stock at $22 per share. These were the only common stock transactions that occurred during the two fiscal years. Instructions (a) Identify whether the capital structure at Melton Corporation is a simple or complex capital struc- ture, and explain why. (b) Determine the weighted-average number of shares that Melton Corporation would use in calculat- ing earnings per share for the fiscal year ended: (1) May 31, 2014. (2) May 31, 2015. (c) Prepare, in good form, a comparative income statement, beginning with income from operations, for Melton Corporation for the fiscal years ended May 31, 2014, and May 31, 2015. This statement will be included in Melton’s annual report and should display the appropriate earnings per share presentations. (CMA adapted) 7 P 16-7 (Computation of Basic and Diluted EPS) Charles Austin of the controller’s office of Thompson Corporation was given the assignment of determining the basic and diluted earnings per share values for the year ending December 31, 2015. Austin has compiled the information listed below. 1. The company is authorized to issue 8,000,000 shares of $10 par value common stock. As of

December 31, 2014, 2,000,000 shares had been issued and were outstanding. 2. The per share market prices of the common stock on selected dates were as follows. Price per Share July 1, 2014 $20.00 January 1, 2015 21.00 April 1, 2015 25.00 July 1, 2015 11.00 August 1, 2015 10.50 November 1, 2015 9.00 December 31, 2015 10.00 3. A total of 700,000 shares of an authorized 1,200,000 shares of convertible preferred stock had been issued on July 1, 2014. The stock was issued at its par value of $25, and it has a cumulative dividend of $3 per share. The stock is convertible into common stock at the rate of one share of convertible preferred for one share of common. The rate of conversion is to be automatically adjusted for stock splits and stock dividends. Dividends are paid quarterly on September 30, December 31, March 31, and June 30. 4. Thompson Corporation is subject to a 40% income tax rate. 5. The after-tax net income for the year ended December 31, 2015, was $11,550,000. The following specific activities took place during 2015. 1. January 1—A 5% common stock dividend was issued. The dividend had been declared on December 1, 2014, to all stockholders of record on December 29, 2014. 936 Chapter 16 Dilutive Securities and Earnings per Share 2. April 1—A total of 400,000 shares of the $3 convertible preferred stock was converted into common stock. The company issued new common stock and retired the preferred stock. This was the only conversion of the preferred stock during 2015. 3. July 1—A 2-for-1 split of the common stock became effective on this date. The board of directors had authorized the split on June 1. 4. August 1—A total of 300,000 shares of common stock were issued to acquire a factory building. 5. November 1—A total of 24,000 shares of common stock were purchased on the open market at $9 per share. These shares were to be held as treasury stock and were still in the treasury as of December 31, 2015. 6. Common stock cash dividends—Cash dividends to common stockholders were declared and paid as follows. April 15—$0.30 per share October 15—$0.20 per share 7. Preferred stock cash dividends—Cash dividends to preferred stockholders were declared and paid as scheduled. Instructions (a) Determine the number of shares used to compute basic earnings per share for the year ended December 31, 2015. (b) Determine the number of shares used to compute diluted earnings per share for the year ended December 31, 2015. (c) Compute the adjusted net income to be used as the numerator in the basic earnings per share calcu- lation for the year ended December 31, 2015. 7 P16-8 (Computation of Basic and Diluted EPS) The information below pertains to Barkley Company for 2015. Net income for the year $1,200,000 7% convertible bonds issued at par ($1,000 per bond); each bond is convertible into 30 shares of common stock 2,000,000 6% convertible, cumulative preferred stock, $100 par value; each share is convertible into 3 shares of common stock 4,000,000 Common stock, $10 par value 6,000,000 Tax rate for 2015 40% Average market price of common stock $25 per share There were no changes during 2015 in the number of common shares, preferred shares, or convertible bonds outstanding. There is no treasury stock. The company also has common stock options (granted in a prior year) to purchase 75,000 shares of common stock at $20 per share. Instructions (a) Compute basic earnings per share for 2015. (b) Compute diluted earnings per share for 2015. 6 P16-9 (EPS with Stock Dividend and Extraordinary Items) Agassi Corporation is preparing the com- parative financial statements to be included in the annual report to stockholders. Agassi employs a fiscal year ending May 31. Income from operations before income taxes for Agassi was $1,400,000 and $660,000, respectively, for fiscal years ended May 31, 2015 and 2014. Agassi experienced an extraordinary loss of $400,000 because of an earthquake on March 3, 2015. A 40% combined income tax rate pertains to any and all of Agassi Corpo- ration’s profits, gains, and losses. Agassi’s capital structure consists of preferred stock and common stock. The company has not issued

any convertible securities or warrants and there are no outstanding stock options. Agassi issued 40,000 shares of $100 par value, 6% cumulative preferred stock in 2011. All of this stock is outstanding, and no preferred dividends are in arrears. There were 1,000,000 shares of $1 par common stock outstanding on June 1, 2013. On September 1, 2013, Agassi sold an additional 400,000 shares of the common stock at $17 per share. Agassi distributed a 20% stock dividend on the common shares outstanding on December 1, 2014. These were the only common stock transactions during the past 2 fiscal years. Instructions (a) Determine the weighted-average number of common shares that would be used in computing earn- ings per share on the current comparative income statement for: (1) The year ended May 31, 2014. (2) The year ended May 31, 2015. Concepts for Analysis 937 (b) Starting with income from operations before income taxes, prepare a comparative income statement for the years ended May 31, 2015 and 2014. The statement will be part of Agassi Corporation’s annual report to stockholders and should include appropriate earnings per share presentation. (c) The capital structure of a corporation is the result of its past financing decisions. Furthermore, the earnings per share data presented on a corporation’s financial statements is dependent upon the capital structure. (1) Explain why Agassi Corporation is considered to have a simple capital structure. (2) Describe how earnings per share data would be presented for a corporation that has a complex capital structure. (CMA adapted) PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate. Instructions (a) (1) D escribe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock. (2) Discuss the underlying rationale for the differences described in (a)(1) above. (3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants. (b) At the start of the year, Huish Company issued $18,000,000 of 12% bonds along with detachable warrants to buy 1,200,000 shares of its $10 par value common stock at $18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of $1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have sold in the market at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received. (AICPA adapted) CA16-2 (Ethical Issues—Compensation Plan) The executive officers of Rouse Corporation have a performance-based compensation plan. The performance criteria of this plan is linked to growth in earn- ings per share. When annual EPS growth is 12%, the Rouse executives earn 100% of the shares; if growth is 16%, they earn 125%. If EPS growth is lower than 8%, the executives receive no additional compensation. In 2014, Joan Devers, the controller of Rouse, reviews year-end estimates of bad debt expense and warranty expense. She calculates the EPS growth at 15%. Kurt Adkins, a member of the executive group, remarks over lunch one day that the estimate of bad debt expense might be decreased, increasing EPS growth to 16.1%. Devers is not sure she should do this because she believes that the current estimate of

bad debts is sound. On the other hand, she recognizes that a great deal of subjectivity is involved in the computation. Instructions Answer the following questions. (a) What, if any, is the ethical dilemma for Devers? (b) Should Devers’s knowledge of the compensation plan be a factor that influences her estimate? (c) How should Devers respond to Adkins’s request? 938 Chapter 16 Dilutive Securities and Earnings per Share CA16-3 (Stock Warrants—Various Types) For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued: 1. To existing stockholders on a pro rata basis. 2. To certain key employees under an incentive stock-option plan. 3. To purchasers of the corporation’s bonds. Instructions For each of the three examples of how stock warrants are used: (a) Explain why they are used. (b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in rela- tion to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised. (c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above. (AICPA adapted) CA16-4 (Stock Compensation Plans) The following two items appeared on the Internet concerning the GAAP requirement to expense stock options. WASHINGTON, D.C.—February 17, 2005 Congressman David Dreier (R–CA), Chairman of the House Rules Committee, and Congresswoman Anna Eshoo (D–CA) reintroduced legislation today that will preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares. “Last year, the U.S. House of Representatives overwhelmingly voted for legislation that would have ensured the continued ability of innovative companies to offer stock options to rank-and-file employees,” Dreier stated. “Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) continue to ignore our calls to address legitimate concerns about the impact of FASB’s new standard on workers’ ability to have an ownership stake in the New Economy, and its failure to address the real need of shareholders: accurate and meaningful information about a company’s use of stock options.” “In December 2004, FASB issued a stock option expensing standard that will render a huge blow to the 21st century economy,” Dreier said. “Their action and the SEC’s apparent lack of concern for protect- ing shareholders, requires us to once again take a firm stand on the side of investors and economic growth. Giving investors the ability to understand how stock options impact the value of their shares is critical. And equally important is preserving the ability of companies to use this innovative tool to attract talented employees.” “Here We Go Again!” by Jack Ciesielski (2/21/2005, http://www.accountingobserver.com/blog/2005/02/here- we-go-again) On February 17, Congressman David Dreier (R–CA), and Congresswoman Anna Eshoo (D–CA), officially entered Silicon Valley’s bid to gum up the launch of honest reporting of stock option compensation: They co-sponsored a bill to “preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.” You know what “critical information” they mean: stuff like the stock compensa- tion for the top five officers in a company, with a rigged value set as close to zero as possible. Investors crave this kind of information. Other ways the good Congresspersons want to “help” investors: The bill “also requires the SEC to study the effectiveness of those disclosures over three years, during which time, no new accounting standard related to the treatment of stock options could be recognized.

Finally, the bill requires the Secretary of Commerce to conduct a study and report to Congress on the impact of broad-based employee stock option plans on expanding employee corporate ownership, skilled worker recruitment and retention, research and innovation, economic growth, and interna- tional competitiveness.” It’s the old “four corners” basketball strategy: stall, stall, stall. In the meantime, hope for regime change at your opponent, the FASB. Instructions (a) What are the major recommendations of the stock-based compensation pronouncement? (b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.) Using Your Judgment 939 (c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting. CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) “Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study. Instructions (a) Explain how dividends or dividend requirements on any class of preferred stock that may be out- standing affect the computation of EPS. (b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury-stock method. (c) Convertible debentures are considered potentially dilutive common shares. Explain how convert- ible debentures are handled for purposes of EPS computations. (AICPA adapted) CA16-6 (EPS, Antidilution) Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm’s accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calcula- tion, and why some securities are antidilutive and thus not included in this calculation. Rhode Corporation earned $228,000 during the period, when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of $25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant. Instructions Write Mr. Dolan a 1–1.5-page letter explaining why the warrants are not included in the calculation. USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and accompanying notes to answer the following questions. (a) Under P&G’s stock-based compensation plan, stock options are granted annually to key managers and directors. (1) How many options were granted during 2011 under the plan? (2) How many options were exercisable at June 30, 2011? (3) How many options were exercised in 2011, and what was the average price of those exercised? (4) How many years from the grant date do the options expire? (5) To what accounts are the proceeds from these option exercises credited? (6) What was the number of outstanding options at June 30, 2011, and at what average exercise price? (b) What number of diluted weighted-average common shares outstanding was used by P&G in computing earnings per share for 2011, 2010, and 2009? What was P&G’s diluted earnings per share in 2011, 2010, and 2009?

(c) What other stock-based compensation plans does P&G have? 940 Chapter 16 Dilutive Securities and Earnings per Share Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What employee stock-option compensation plans are offered by Coca-Cola and PepsiCo? (b) How many options are outstanding at year-end 2011 for both Coca-Cola and PepsiCo? (c) How many options were granted by Coca-Cola and PepsiCo to officers and employees during 2011? (d) How many options were exercised during 2011? (e) What was the average exercise price for Coca-Cola and PepsiCo employees during 2011? (f) What are the weighted-average number of shares used by Coca-Cola and PepsiCo in 2011, 2010, and 2009 to compute diluted earnings per share? (g) What was the diluted net income per share for Coca-Cola and PepsiCo for 2011, 2010, and 2009? Financial Statement Analysis Case Ragatz, Inc. Ragatz, Inc., a drug company, reported the following information. The company prepares its financial statements in accordance with GAAP. 2014 (,000) Current liabilities $ 554,114 Convertible subordinated debt 648,020 Total liabilities 1,228,313 Stockholders’ equity 176,413 Net income 58,333 Analysts attempting to compare Ragatz to drug companies that issue debt with detachable warrants may face a challenge due to differences in accounting for convertible debt. Instructions (a) Compute the following ratios for Ragatz, Inc. (Assume that year-end balances approximate annual averages.) (1) Return on assets. (2) Return on common stock equity. (3) Debt to assets ratio. (b) Briefly discuss the operating performance and financial position of Ragatz. Industry averages for these ratios in 2014 were ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis, would you make an investment in the company’s 5% convertible bonds? Explain. (c) Assume you want to compare Ragatz to an IFRS company like Merck (which issues nonconvertible debt with detachable warrants). Assuming that the fair value of the equity component of Ragatz’s convertible bonds is $150,000, how would you adjust the analysis above to make valid comparisons between Ragatz and Merck? Accounting, Analysis, and Principles On January 1, 2013, Garner issued 10-year, $200,000 face value, 6% bonds at par. Each $1,000 bond is con- vertible into 30 shares of Garner $2 par value common stock. The company has had 10,000 shares of com- mon stock (and no preferred stock) outstanding throughout its life. None of the bonds have been converted as of the end of 2014. (Ignore all tax effects.) Accounting (a) Prepare the journal entry Garner would have made on January 1, 2013, to record the issuance of the bonds. (b) Garner’s net income in 2014 was $30,000 and was $27,000 in 2013. Compute basic and diluted earnings per share for Garner for 2014 and 2013. (c) Assume that 75% of the holders of Garner’s convertible bonds convert their bonds to stock on June 30, 2015, when Garner’s stock is trading at $32 per share. Garner pays $50 per bond to induce bondholders to convert. Prepare the journal entry to record the conversion. IFRS Insights 941 Analysis Show how Garner will report income and EPS for 2014 and 2013. Briefly discuss the importance of GAAP for EPS to analysts evaluating companies based on price-earnings ratios. Consider comparisons for a com- pany over time, as well as comparisons between companies at a point in time. Principles In order to converge GAAP and IFRS, the FASB is considering whether the equity element of a convertible bond should be reported as equity. Describe how the journal entry you made in part (a) above would differ under IFRS. In terms of the accounting principles discussed in Chapter 2, what does IFRS for convertible debt accomplish that GAAP potentially sacrifices? What does GAAP for convertible debt accomplish that IFRS potentially sacrifices? BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation

Richardson Company is contemplating the establishment of a share-based compensation plan to provide long-run incentives for its top management. However, members of the compensation committee of the board of directors have voiced some concerns about adopting these plans, based on news accounts related to a recent accounting standard in this area. They would like you to conduct some research on this recent standard so they can be better informed about the accounting for these plans. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Identify the authoritative literature that addresses the accounting for share-based payment compensa- tion plans. (b) Briefly discuss the objectives for the accounting for stock compensation. What is the role of fair value measurement? (c) The Richardson Company board is also considering an employee share-purchase plan, but the Board does not want to record expense related to the plan. What criteria must be met to avoid recording expense on an employee stock-purchase plan? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS The primary IFRS related to financial instruments, including dilutive securities, is 10 LEARNING OBJECTIVE IAS 39, “Financial Instruments: Recognition and Measurement.” The accounting for Compare the accounting for dilutive various forms of stock-based compensation under IFRS is found in IFRS 2, “Share- securities and earnings per share Based Payment.” This standard was recently amended, resulting in significant con- under GAAP and IFRS. vergence between IFRS and GAAP in this area. The IFRS addressing accounting and reporting for earnings per share computations is IAS 33, “Earnings per Share.” RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to dilutive securities and earnings per share. 994422 CChhaapptteerr 1166 DDiilluuttiivvee SSeeccuurriittiieess aanndd EEaarrnniinnggss ppeerr SShhaarree Similarities • IFRS and GAAP follow the same model for recognizing stock-based compensation: The fair value of shares and options awarded to employees is recognized over the period to which the employees’ services relate. • Although the calculation of basic and diluted earnings per share is similar between IFRS and GAAP, the Boards are working to resolve the few minor differences in EPS reporting. One proposal in the FASB project concerns contracts that can be settled in either cash or shares. IFRS requires that share settlement must be used, while GAAP gives companies a choice. The FASB project proposes adopting the IFRS approach, thus converging GAAP and IFRS in this regard. Differences • A signifi cant difference between IFRS and GAAP is the accounting for securities with characteristics of debt and equity, such as convertible debt. Under GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under IFRS, convertible bonds are “bifurcated”—separated into the equity component (the value of the con- version option) of the bond issue and the debt component. • Related to employee share-purchase plans, under IFRS, all employee share-purchase plans are deemed to be compensatory; that is, compensation expense is recorded for the amount of the discount. Under GAAP, these plans are often considered noncom- pensatory and therefore no compensation is recorded. Certain conditions must exist before a plan can be considered noncompensatory—the most important being that the discount generally cannot exceed 5 percent. • Modifi cation of a share option results in the recognition of any incremental fair value under both IFRS and GAAP. However, if the modifi cation leads to a reduction, IFRS does not permit the reduction but GAAP does. • Other EPS differences relate to (1) the treasury-stock method and how the proceeds

from extinguishment of a liability should be accounted for, and (2) how to compute the weighted average of contingently issuable shares. ABOUT THE NUMBERS Accounting for Convertible Debt Convertible debt is accounted for as a compound instrument because it contains both a liability and an equity component. IFRS requires that compound instruments be sepa- rated into their liability and equity components for purposes of accounting. Companies use the “with-and-without” method to value compound instruments. Illustration IFRS16-1 identifies the components used in the with-and-without method. ILLUSTRATION IFRS16-1 Fair value of convertible debt Fair value of liability component Equity component at Convertible Debt at date of issuance (with 2 at date of issuance, based on 5 date of issuance Components both debt and equity present value of cash fl ows (without the debt components) component) As indicated, the equity component is the residual amount after subtracting the liability component. IFRS does not permit companies to assign a value to the equity amount first and then determine the liability component. To do so would be inconsistent with the IFRS Insights 943 definition of equity, which is considered a residual amount. To implement the with-and- without approach, companies do the following. 1. First, the company determines the total fair value of the convertible debt with both the liability and equity component. This is straightforward, as this amount is the proceeds received upon issuance. 2. The company then determines the liability component by computing the net present value of all contractual future cash fl ows discounted at the market rate of interest. This market rate is the rate the company would pay on similar nonconvert- ible debt. 3. In the fi nal step, the company subtracts the liability component estimated in the second step from the fair value of the convertible debt (issue proceeds) to arrive at the equity component. That is, the equity component is the fair value of the convert- ible debt without the liability component. Accounting at Time of Issuance To illustrate the accounting for convertible debt, assume that Roche Group issues 2,000 convertible bonds at the beginning of 2013. The bonds have a four-year term with a stated rate of interest of 6 percent, and are issued at par with a face value of $1,000 per bond (the total proceeds received from issuance of the bonds are $2,000,000). Interest is payable annually at December 31. Each bond is convertible into 250 ordinary shares with a par value of $1. The market rate of interest on similar nonconvertible debt is 9 percent. The time diagram in Illustration IFRS16-2 depicts both the interest and principal cash flows. ILLUSTRATION IFRS16-2 PPPVVV $2,000,000 Principal Time Diagram for i = 9% Convertible Bond PPPVVV--OOOAAA $120,000 $120,000 $120,000 $120,000 Interest 0 1 2 3 4 n = 4 The liability component of the convertible debt is computed as shown in Illustration IFRS16-3. ILLUSTRATION Present value of principal: $2,000,000 3 .70843 (Table 6-2; n 5 4, i 5 9%) $1,416,860 IFRS16-3 Present value of the interest payments: $120,000 3 3.23972 (Table 6-4; n 5 4, i 5 9%) 388,766 Fair Value of Liability Present value of the liability component $1,805,626 Component of Convertible Bond The equity component of Roche’s convertible debt is then computed as shown in Illus- tration IFRS16-4. ILLUSTRATION Fair value of convertible debt at date of issuance $2,000,000 IFRS16-4 Less: Fair value of liability component at date of issuance 1,805,626 Equity Component of Fair value of equity component at date of issuance $ 194,374 Convertible Bond 944 Chapter 16 Dilutive Securities and Earnings per Share The journal entry to record this transaction is as follows. Cash 2,000,000 Bonds Payable 1,805,626 Share Premium—Conversion Equity 194,374 The liability component of Roche’s convertible debt issue is recorded as Bonds Payable. As shown in Chapter 14, the amount of the discount relative to the face value of the bond is amortized at each reporting period so at maturity, the Bonds Payable account is

reported at $2,000,000 (face value). The equity component of the convertible bond is re- corded in the Share Premium—Conversion Equity account and is reported in the equity section of the statement of financial position. Because this amount is considered part of contributed capital, it does not change over the life of the convertible. Transaction costs related to the liability and equity components are allocated in proportion to the proceeds received from the two components. For purposes of homework, use the Share Premium—Conversion Equity account to record the equity component. In practice, there may be considerable variation in the accounts used to record this component. Settlement of Convertible Bonds We illustrate four settlement situations: (1) repurchase at maturity, (2) conversion at maturity, (3) conversion before maturity, and (4) repurchase before maturity. Repurchase at Maturity. If the bonds are not converted at maturity, Roche makes the following entry to pay off the convertible debtholders. Bonds Payable 2,000,000 Cash 2,000,000 (To record the purchase of bonds at maturity) Because the carrying value of the bonds equals the face value, there is no gain or loss on repurchase at maturity. The amount originally allocated to equity of $194,374 either remains in the Share Premium—Conversion Equity account or is transferred to Share Premium—Ordinary. Conversion of Bonds at Maturity. If the bonds are converted at maturity, Roche makes the following entry. Share Premium—Conversion Equity 194,374 Bonds Payable 2,000,000 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,694,374 (To record the conversion of bonds at maturity) As indicated, Roche records a credit to Share Capital—Ordinary for $500,000 (2,000 bonds 3 250 shares 3 $1 par) and the remainder to Share Premium—Ordinary for $1,694,374. There is no gain or loss on conversion at maturity. The original amount allocated to equity ($194,374) is transferred to the Share Premium—Ordinary account. As a result, Roche’s equity has increased by a total of $2,194,374 through issuance and conversion of the convertible bonds. This accounting approach is often referred to as the book value method in that the carrying amount (book value) of the bond and related conversion equity determines the amount in the ordinary equity accounts. Conversion of Bonds before Maturity. What happens if bonds are converted before maturity? To understand the accounting, we again use the Roche Group example. A schedule of bond amortization related to Roche’s convertible bonds is shown in Illustra- tion IFRS16-5. IFRS Insights 945 ILLUSTRATION SCHEDULE OF BOND AMORTIZATION IFRS16-5 EFFECTIVE-INTEREST METHOD 6% BOND DISCOUNTED AT 9% Convertible Bond Amortization Schedule Cash Interest Discount Carrying Amount Date Paid Expense Amortized of Bonds 1/1/13 $1,805,626 12/31/13 $120,000 $162,506 $42,506 1,848,132 12/31/14 120,000 166,332 46,332 1,894,464 12/31/15 120,000 170,502 50,502 1,944,966 12/31/16 120,000 175,034* 55,034 2,000,000 *$13 difference due to rounding. Assuming that Roche converts its bonds into ordinary shares on December 31, 2014, Roche debits the Bonds Payable account for its carrying value of $1,894,464 (see Illustra- tion IFRS16-5). In addition, Roche credits Share Capital—Ordinary for $500,000 (2,000 3 250 3 $1) and credits Share Premium—Ordinary for $1,588,838. The entry to record this conversion is as follows. Share Premium—Conversion Equity 194,374 Bonds Payable 1,894,464 Share Capital—Ordinary 500,000 Share Premium—Ordinary 1,588,838 (To record the conversion of bonds before maturity) There is no gain or loss on conversion before maturity: The original amount allocated to equity ($194,374) is transferred to the Share Premium—Ordinary account. Repurchase before Maturity. In some cases, companies decide to repurchase the con- vertible debt before maturity. The approach used for allocating the amount paid upon repurchase follows the approach used when the convertible bond was originally issued. That is, Roche determines the fair value of the liability component of the convertible

bonds at December 31, 2014, and then subtracts this amount from the fair value of the convertible bond issue (including the equity component) to arrive at the value for the equity. After this allocation is completed: 1. The difference between the consideration allocated to the liability component and the carrying amount of the liability is recognized as a gain or loss, and 2. The amount of consideration relating to the equity component is recognized (as a reduction) in equity. To illustrate, instead of converting the bonds on December 31, 2014, assume that Roche repurchases the convertible bonds from the bondholders. Pertinent information related to this conversion is as follows. • Fair value of the convertible debt (including both liability and equity components), based on market prices at December 31, 2014, is $1,965,000. • The fair value of the liability component is $1,904,900. This amount is based on computing the present value of a nonconvertible bond with a two-year term (which corresponds to the shortened time to maturity of the repurchased bonds). We first determine the gain or loss on the liability component, as computed in Illustration IFRS16-6. ILLUSTRATION Present value of liability component at December 31, 2014 (given above) $ 1,904,900 IFRS16-6 Carrying value of liability component at December 31, 2014 (per Illustration IFRS16-5) (1,894,464) Gain or Loss on Debt Loss on repurchase $ 10,436 Repurchase 946 Chapter 16 Dilutive Securities and Earnings per Share Roche has a loss on this repurchase because the value of the debt extinguished is greater than its carrying amount. To determine any adjustment to equity, we compute the value of the equity as shown in Illustration IFRS16-7. ILLUSTRATION Fair value of convertible debt at December 31, 2014 (with equity component) $1,965,000 IFRS16-7 Less: Fair value of liability component at December 31, 2014 (similar 2-year Equity Adjustment on nonconvertible debt) 1,904,900 Repurchase of Fair value of equity component at December 31, 2014 (without debt component) $ 60,100 Convertible Bonds Roche makes the following compound journal entry to record the entire repurchase transaction. Bonds Payable 1,894,464 Share Premium—Conversion Equity 60,100 Loss on Repurchase 10,436 Cash 1,965,000 (To record the repurchase of convertible bonds) In summary, the repurchase results in a loss related to the liability component and a reduction in Share Premium—Conversion Equity. The remaining balance in Share Premium—Conversion Equity of $134,274 ($194,374 2 $60,100) is often transferred to Share Premium—Ordinary upon the repurchase. Employee Share-Purchase Plans Employee share-purchase plans (ESPPs) generally permit all employees to purchase shares at a discounted price for a short period of time. The company often uses such plans to secure equity capital or to induce widespread ownership of its ordinary shares among employees. These plans are considered compensatory and should be recorded as expense over the service period. To illustrate, assume that Masthead Company offers all its 1,000 employees the oppor- tunity to participate in an employee share-purchase plan. Under the terms of the plan, the employees are entitled to purchase 100 ordinary shares (par value $1 per share) at a 20 percent discount. The purchase price must be paid immediately upon acceptance of the offer. In total, 800 employees accept the offer, and each employee purchases on average 80 shares. That is, the employees purchase a total of 64,000 shares. The weighted-average market price of the shares at the purchase date is $30 per share, and the weighted- average purchase price is $24 per share. The entry to record this transaction is as follows. Cash (64,000 3 $24) 1,536,000 Compensation Expense [64,000 3 ($30 2 $24)] 384,000 Share Capital—Ordinary (64,000 3 $1) 64,000 Share Premium—Ordinary 1,856,000 (Issue shares in an employee share-purchase plan) The IASB indicates that there is no reason to treat broad-based employee share plans differently from other employee share plans. Some have argued that because these plans

are used to raise capital, they should not be compensatory. However, IFRS requires recording expense for these arrangements. The Board notes that because these arrange- ments are available only to employees, it is sufficient to conclude that the benefits provided represent employee compensation. ON THE HORIZON The FASB has been working on a standard that will likely converge to IFRS in the ac- counting for convertible debt. Similar to the FASB, the IASB is examining the classifica- tion of hybrid securities; the IASB is seeking comment on a discussion document similar to the FASB Preliminary Views document, “Financial Instruments with Characteristics of IFRS Insights 947 Equity.” It is hoped that the Boards will develop a converged standard in this area. While GAAP and IFRS are similar as to the presentation of EPS, the Boards have been working together to resolve remaining differences related to earnings per share computations. IFRS SELF-TEST QUESTIONS 1. All of the following are key similarities between GAAP and IFRS with respect to accounting for dilutive securities and EPS except: (a) the model for recognizing stock-based compensation. (b) the calculation of basic and diluted EPS. (c) the accounting for convertible debt. (d) the accounting for modifications of share options, when the value increases. 2. Which of the following statements is correct? (a) IFRS separates the proceeds of a convertible bond between debt and equity by determining the fair value of the debt component before the equity component. (b) Both IFRS and GAAP assume that when there is choice of settlement of an option for cash or shares, share settlement is assumed. (c) IFRS separates the proceeds of a convertible bond between debt and equity, based on relative fair values. (d) Both GAAP and IFRS separate the proceeds of convertible bonds between debt and equity. 3. Under IFRS, convertible bonds: (a) are separated into the bond component and the expense component. (b) are separated into debt and equity components. (c) are separated into their components based on relative fair values. (d) All of the above. 4. Mae Jong Corp. issues $1,000,000 of 10% bonds payable which may be converted into 10,000 shares of $2 par value ordinary shares. The market rate of interest on similar bonds is 12%. Interest is payable annually on December 31, and the bonds were issued for total proceeds of $1,000,000. In accounting for these bonds, Mae Jong Corp. will: (a) first assign a value to the equity component, then determine the liability component. (b) assign no value to the equity component since the conversion privilege is not separable from the bond. (c) first assign a value to the liability component based on the face amount of the bond. (d) use the “with-and-without” method to value the compound instrument. 5. Anazazi Co. offers all its 10,000 employees the opportunity to participate in an employee share- purchase plan. Under the terms of the plan, the employees are entitled to purchase 100 ordinary shares (par value $1 per share) at a 20% discount. The purchase price must be paid immediately upon acceptance of the offer. In total, 8,500 employees accept the offer, and each employee purchases on average 80 shares at $22 share (market price $27.50). Under IFRS, Anazazi Co. will record: (a) no compensation since the plan is used to raise capital, not compensate employees. (b) compensation expense of $5,500,000. (c) compensation expense of $18,700,000. (d) compensation expense of $3,740,000. IFRS CONCEPTS AND APPLICATION IFRS16-1 Where can authoritative IFRS be found related to dilutive securities, stock-based compensation, and earnings per share? IFRS16-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for dilutive securities, stock-based compensation, and earnings per share. IFRS16-3 Norman Co., a fast-growing golf equipment company, uses GAAP. It is considering the issuance of convertible bonds. The bonds mature in 10 years, have a face value of $400,000, and pay interest annually

at a rate of 4%. The equity component of the bond issue has a fair value of $35,000. Greg Shark is curious as to the difference in accounting for these bonds if the company were to use IFRS. (a) Prepare the entry to record issuance of the bonds at par under GAAP. (b) Repeat the requirement for part (a), assuming application of IFRS to the bond issuance. (c) Which approach provides the better accounting? Explain. 948 Chapter 16 Dilutive Securities and Earnings per Share IFRS16-4 Briefly discuss the convergence efforts that are under way by the IASB and FASB in the area of dilutive securities and earnings per share. IFRS16-5 Explain how the conversion feature of convertible debt has a value (a) to the issuer and (b) to the purchaser. IFRS16-6 What are the arguments for giving separate accounting recognition to the conversion feature of debentures? IFRS16-7 Four years after issue, debentures with a face value of $1,000,000 and book value of $960,000 are tendered for conversion into 80,000 ordinary shares immediately after an interest payment date. At that time, the market price of the debentures is 104, and the ordinary shares are selling at $14 per share (par value $10). At date of issue, the company recorded Share Premium—Conversion Equity of $50,000. The company records the conversion as follows. Bonds Payable 960,000 Share Premium—Conversion Equity 50,000 Share Capital—Ordinary 800,000 Share Premium—Ordinary 210,000 Discuss the propriety of this accounting treatment. IFRS16-8 Cordero Corporation has an employee share-purchase plan which permits all full-time employees to purchase 10 ordinary shares on the third anniversary of their employment and an additional 15 shares on each subsequent anniversary date. The purchase price is set at the market price on the date purchased less a 10% discount. How is this discount accounted for by Cordero? IFRS16-9 Archer Company issued $4,000,000 par value, 7% convertible bonds at 99 for cash. The net pres- ent value of the debt without the conversion feature is $3,800,000. Prepare the journal entry to record the issuance of the convertible bonds. IFRS16-10 Petrenko Corporation has outstanding 2,000 $1,000 bonds, each convertible into 50 shares of $10 par value ordinary shares. The bonds are converted on December 31, 2014. The bonds payable has a carrying value of $1,950,000 and conversion equity of $20,000. Record the conversion using the book value method. IFRS16-11 Angela Corporation issues 2,000 convertible bonds at January 1, 2013. The bonds have a 3-year life, and are issued at par with a face value of $1,000 per bond, giving total proceeds of $2,000,000. Interest is payable annually at 6%. Each bond is convertible into 250 ordinary shares (par value of $1). When the bonds are issued, the market rate of interest for similar debt without the conversion option is 8%. Instructions (a) Compute the liability and equity component of the convertible bond on January 1, 2013. (b) Prepare the journal entry to record the issuance of the convertible bond on January 1, 2013. (c) Prepare the journal entry to record the repurchase of the convertible bond for cash at January 1, 2016, its maturity date. IFRS16-12 Assume the same information in IFRS16-11, except that Angela Corporation converts its con- vertible bonds on January 1, 2014. Instructions (a) Compute the carrying value of the bond payable on January 1, 2014. (b) Prepare the journal entry to record the conversion on January 1, 2014. (c) Assume that the bonds were repurchased on January 1, 2014, for $1,940,000 cash instead of being converted. The net present value of the liability component of the convertible bonds on January 1, 2014, is $1,900,000. Prepare the journal entry to record the repurchase on January 1, 2014. IFRS16-13 Assume that Sarazan Company has a share-option plan for top management. Each share option represents the right to purchase a $1 par value ordinary share in the future at a price equal to the fair value of the shares at the date of the grant. Sarazan has 5,000 share options outstanding, which were granted at

the beginning of 2014. The following data relate to the option grant. Exercise price for options $40 Market price at grant date (January 1, 2014) $40 Fair value of options at grant date (January 1, 2014) $6 Service period 5 years IFRS Insights 949 Instructions (a) Prepare the journal entry(ies) for the first year of the share-option plan. (b) Prepare the journal entry(ies) for the first year of the plan assuming that, rather than options, 700 shares of restricted shares were granted at the beginning of 2014. (c) Now assume that the market price of Sarazan shares on the grant date was $45 per share. Repeat the requirements for (a) and (b). (d) Sarazan would like to implement an employee share-purchase plan for rank-and-file employees, but it would like to avoid recording expense related to this plan. Explain how employee share- purchase plans are recorded. Professional Research IFRS16-14 Richardson Company is contemplating the establishment of a share-based compensation plan to provide long-run incentives for its top management. However, members of the compensation committee of the board of directors have voiced some concerns about adopting these plans, based on news accounts related to a recent accounting standard in this area. They would like you to conduct some research on this recent standard so they can be better informed about the accounting for these plans. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Identify the authoritative literature that addresses the accounting for share-based payment compen- sation plans. (b) Briefly discuss the objectives for the accounting for share-based compensation. What is the role of fair value measurement? (c) The Richardson Company board is also considering an employee share-purchase plan, but the Board does not want to record expense related to the plan. What are the IFRS requirements for the accounting for an employee share-purchase plan? International Financial Reporting Problem Marks and Spencer plc IFRS16-15 The financial statements of Marks and Spencer plc (M&S) are available at the book’s companion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/ Marks-and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) Under M&S’s share-based compensation plan, share options are granted annually to key managers and directors. (1) How many options were granted during 2012 under the plan? (2) How many options were exercisable at 31 March 2012? (3) How many options were exercised in 2012, and what was the average price of those exercised? (4) How many years from the grant date do the options expire? (5) To what accounts are the proceeds from these option exercises credited? (6) What was the number of outstanding options at 31 March 2012, and at what average exercise price? (b) What number of diluted weighted-average shares outstanding was used by M&S in computing earnings per share for 2012 and 2011? What was M&S’s diluted earnings per share in 2012 and 2011? (c) What other share-based compensation plans does M&S have? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. a 3. b 4. d 5. d Remember to check the book’s companion website to fi nd additional resources for this chapter. Investments 1 Identify the three categories of debt securities and 4 Explain the equity method of accounting and describe the accounting and reporting treatment compare it to the fair value method for equity for each category. securities. 2 Understand the procedures for discount and 5 Describe the accounting for the fair value option and premium amortization on bond investments. for impairments of debt and equity investments. 3 Identify the categories of equity securities and 6 Describe the reporting of reclassification

describe the accounting and reporting treatment adjustments and the accounting for transfers for each category. between categories. What to Do? A few years ago, a bank reported an $87.3 million write-down on its mortgage-backed securities for the third quarter of 2008. However, the bank stated that it expected its actual losses to be only $44,000. The loss of $44,000 was equal to a modest loss on a condo foreclosure. The bank’s regulator found “the accounting result absurd.” And the bank regulator was right, as the bank, in the third quarter of 2009, raised its credit-loss estimate by $263.1 million, quite a difference from its original loss estimate of $44,000. The discussion above highlights the challenge of valuing financial assets such as loans, deriva- tives, and other debt investments. The fundamental question that arose out of the example above and, more significantly, the recent financial crisis is: Should financial instruments be valued at amortized cost, fair value, or some other measure(s)? As one writer noted, the opinion that fair value accounting weakens financial and economic stability has persisted among many regulators and politicians. But some investors and others believe that fair value is the right answer because it is more transparent information. OK, so what to do? Well, the FASB originally issued a proposal to account for just about all financial assets at fair value with gains and losses recorded in income (amortized cost would be disclosed for some financial assets). The FASB indicated this approach will provide the most relevant and transparent information about financial assets. In contrast, the IASB issued a new standard on financial assets (IFRS 9) that uses a mixed-attribute approach. Some of the financial assets are valued at amortized cost and others at fair value. Interestingly, the European Union refused to consider adopting the requirements of IFRS 9, arguing that it contained too much fair value information. Nevertheless, the standard was issued and other countries that follow IFRS will have to implement the new standard in 2015. At the same time, as soon as the FASB issues its new standard, the IASB has indicated that it may revisit the valuation issue once again. Thus, the early reaction to IFRS 9 indicates that, unfortunately, once again politics RETPAHC 17 LEARNING OBJECTIVES After studying this chapter, you should be able to: CONCEPTUAL FOCUS > See the Underlying Concepts on pages 954, 955, and 957. > Read the Evolving Issues on pages 968 and 975 for a discussion of the fair value is raising its ugly head on an accounting issue. Some European controversy, and proposed classification and regulators have suggested that the IASB’s future funding may measurement model for financial instruments. even depend on the IASB putting more limits on the use of fair value. INTERNATIONAL FOCUS Now, let’s go back to the FASB. Recently, the FASB dropped its plan to value loans at fair value and permits amor- > See the International Perspectives on tized cost accounting for these loans. This decision means pages 952, 953, 966, 968, 987, 989, banks will continue to value loans as they do today. This rever- and 995. sal is a big victory for the banking industry, which argued that > Read the IFRS Insights on pages 1026–1039 the fair value approach would hurt lending and provide unnec- for a discussion of: essary volatility in their financial results. As a consequence, the —Accounting for financial assets FASB is moving much closer to the IASB’s position. So after —Debt investments much discussion about what went wrong in the accounting for —Equity investments financial instruments during the financial crises, it looks like we —Impairments are headed back to most of the same measurement rules that occurred before the financial collapse of 2008. We deem that unfortunate. Sources: Adapted from Jonathan Weil, “Suing Wall Street Banks Never Looked So Shady,” http://www.bloomberg.com/ (February 28, 2010); and Rachel Sanderson and Jennifer Hughes, “Carried Forward,” Financial Times Online (April 20, 2010).

As indicated in the opening story, the accounting for financial assets PREVIEW OF CHAPTER 17 is highly controversial. How to measure, recognize, and disclose this information is now being debated and discussed extensively. In this chapter, we address the accounting for debt and equity investments. Appendices to this chapter discuss the accounting for derivative instruments, variable-interest entities, and fair value disclosures. The content and organization of this chapter are as follows. Investments Investments in Debt Investments in Equity Additional Measurement Reclassifications Securities Securities Issues and Transfers • Debt investment • Holdings of less than 20% • Fair value option • Reclassification classifications • Holdings between 20% • Impairment of value adjustments • Held-to-maturity securities and 50% • Transfers between • Available-for-sale securities • Holdings of more than 50% categories • Trading securities • Summary 951 952 Chapter 17 Investments INVESTMENTS IN DEBT SECURITIES Companies have different motivations for investing in securities issued by other LEARNING OBJECTIVE 1 companies.1 One motivation is to earn a high rate of return. For example, com- Identify the three categories of debt panies like Coca-Cola and PepsiCo can receive interest revenue from a debt securities and describe the accounting investment or dividend revenue from an equity investment. In addition, they can and reporting treatment for each category. realize capital gains on both types of securities. Another motivation for investing (in equity securities) is to secure certain operating or financing arrangements with another company. For example, Coca-Cola and PepsiCo are able to exercise some control over bottler companies based on their significant (but not controlling) equity investments. To provide useful information, companies account for investments based on the type of security (debt or equity) and their intent with respect to the investment. As indicated in Illustration 17-1, we organize our study of investments by type of security. Within this section, we explain the accounting for investments in debt. We address equity securities later in the chapter. ILLUSTRATION 17-1 Type of Security Management Intent Valuation Approach Summary of Investment Debt No plans to sell Amortized cost Accounting Approaches Plan to sell Fair value Equity Plan to sell Fair value Exercise some control Equity method Debt securities represent a creditor relationship with another entity. Debt securi- ties include U.S. government securities, municipal securities, corporate bonds, convert- ible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security. Debt Investment Classifi cations Companies group investments in debt securities into three separate categories for accounting and reporting purposes: International • Held-to-maturity: Debt securities that the company has the positive intent Perspective and ability to hold to maturity. Under IFRS, debt investments • Trading: Debt securities bought and held primarily for sale in the near term are classifi ed as either held- to generate income on short-term price differences. for-collection or trading. • Available-for-sale: Debt securities not classified as held-to-maturity or trading securities. Illustration 17-2 identifies these categories, along with the accounting and reporting treatments required for each. 1A security is a share, participation, or other interest in property or in an enterprise of the issuer or an obligation of the issuer that has the following three characteristics. (1) It either is represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer. (2) It is commonly traded on securities exchanges or markets or, when represented by an instrument, is commonly See the FASB recognized in any area in which it is issued or dealt in as a medium for investment. (3) It either

Codification section is one of a class or series or by its terms is divisible into a class or series of shares, participations, (page 1005). interests, or obligations. [1] Investments in Debt Securities 953 ILLUSTRATION 17-2 Unrealized Holding Accounting for Debt Category Valuation Gains or Losses Other Income Effects Securities by Category Held-to-maturity Amortized cost Not recognized Interest when earned; gains and losses from sale. Trading securities Fair value Recognized in net income Interest when earned; gains and losses from sale. Available-for-sale Fair value Recognized as other Interest when earned; comprehensive income gains and losses and as separate from sale. component of stockholders’ equity International Perspective Amortized cost is the acquisition cost adjusted for the amortization of discount or Under IFRS, held-for- premium, if appropriate. Fair value is the price that would be received to sell an asset or collection debt investments paid to transfer a liability in an orderly transaction between market participants at the are valued at amortized measurement date. [2] cost; all other investments are measured at fair value. Held-to-Maturity Securities Only debt securities can be classified as held-to-maturity. By definition, equity 2 LEARNING OBJECTIVE securities have no maturity date. A company like Starbucks should classify a debt Understand the procedures for discount security as held-to-maturity only if it has both (1) the positive intent and (2) the and premium amortization on bond ability to hold those securities to maturity. It should not classify a debt security investments. as held-to-maturity if it intends to hold the security for an indefinite period of time. Likewise, if Starbucks anticipates that a sale may be necessary due to changes in interest rates, foreign currency risk, liquidity needs, or other asset-liability management reasons, it should not classify the security as held-to-maturity.2 Companies account for held-to-maturity securities at amortized cost, not fair value. If management intends to hold certain investment securities to maturity and has no plans to sell them, fair values (selling prices) are not relevant for measuring and evaluating the cash Calculator Solution for Bond Price flows associated with these securities. Finally, because companies do not adjust held-to- maturity securities to fair value, these securities do not increase the volatility of either re- Inputs Answer ported earnings or reported capital as do trading securities and available-for-sale securities. N 10 To illustrate the accounting for held-to-maturity debt securities, assume that Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2013, at a discount, paying $92,278. The bonds mature January 1, 2018 and yield 10%. Interest I 5 is payable each July 1 and January 1. Robinson records the investment as follows. January 1, 2013 PV ? –92,278 Debt Investments 92,278 Cash 92,278 PMT 4,000 2The FASB defines situations where, even though a company sells a security before maturity, it has constructively held the security to maturity, and thus does not violate the held-to-maturity FV 100,000 requirement. These include selling a security close enough to maturity (such as three months) so that interest rate risk is no longer an important pricing factor. However, companies must be extremely careful with debt securities held to maturity. If a company prematurely sells a debt security in this category, the sale may “taint” the entire held-to-maturity portfolio. That is, a management’s statement regarding “intent” is no longer credible. Therefore, the company may have to reclassify the securities. This could lead to unfortunate consequences. An interesting by-product of this situation is that companies that wish to retire their debt securities early are finding it difficult to do so. The holder will not sell because the securities are classified as held-to-maturity. 954 Chapter 17 Investments Robinson uses a Debt Investments account to indicate the type of debt security

purchased.3 As indicated in Chapter 14, companies must amortize premium or discount using the effective-interest method unless some other method—such as the straight-line method—yields a similar result. They apply the effective-interest method to bond investments in a way similar to that for bonds payable. To compute interest Underlying Concepts revenue, companies compute the effective-interest rate or yield at the time of The use of some simpler method investment and apply that rate to the beginning carrying amount (book value) that yields results similar to the for each interest period. The investment carrying amount is increased by the effective-interest method is an amortized discount or decreased by the amortized premium in each period. application of the materiality Illustration 17-3 shows the effect of the discount amortization on the interest concept. revenue that Robinson records each period for its investment in Evermaster bonds. ILLUSTRATION 17-3 8% BONDS PURCHASED TO YIELD 10% Schedule of Interest Bond Carrying Revenue and Bond Cash Interest Discount Amount Discount Amortization— Date Received Revenue Amortization of Bonds Effective-Interest Method 1/1/13 $ 92,278 7/1/13 $ 4,000a $ 4,614b $ 614c 92,892d 1/1/14 4,000 4,645 645 93,537 7/1/14 4,000 4,677 677 94,214 1/1/15 4,000 4,711 711 94,925 7/1/15 4,000 4,746 746 95,671 1/1/16 4,000 4,783 783 96,454 7/1/16 4,000 4,823 823 97,277 1/1/17 4,000 4,864 864 98,141 7/1/17 4,000 4,907 907 99,048 1/1/18 4,000 4,952 952 100,000 $40,000 $47,722 $7,722 a$4,000 5 $100,000 3 .08 3 6y12 b$4,614 5 $92,278 3 .10 3 6y12 c$614 5 $4,614 2 $4,000 d$92,892 5 $92,278 1 $614 Robinson records the receipt of the first semiannual interest payment on July 1, 2013 (using the data in Illustration 17-3), as follows. July 1, 2013 Cash 4,000 Debt Investments 614 Interest Revenue 4,614 Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2013, as follows. December 31, 2013 Interest Receivable 4,000 Debt Investments 645 Interest Revenue 4,645 Again, Illustration 17-3 shows the interest and amortization amounts. 3Companies generally record investments acquired at par, at a discount, or at a premium in the accounts at cost, including brokerage and other fees but excluding the accrued interest. They generally do not record investments at maturity value. The use of a separate discount or premium account as a valuation account is acceptable procedure for investments, but in practice companies do not widely use it. Investments in Debt Securities 955 Robinson reports its investment in Evermaster bonds in its December 31, 2013, financial statements, as follows. ILLUSTRATION 17-4 Balance Sheet Reporting of Held-to- Current assets Maturity Securities Interest receivable $ 4,000 Long-term investments Debt investments (held-to-maturity) $93,537 Income Statement Other revenues and gains Interest revenue $ 9,259 Sometimes, a company sells a held-to-maturity debt security so close to its maturity date that a change in the market interest rate would not significantly affect the security’s fair value. Such a sale may be considered a sale at maturity and would not call into ques- tion the company’s original intent to hold the investment to maturity. Let’s assume, as an example, that Robinson Company sells its investment in Evermaster bonds on November 1, 2017, at 993y4 plus accrued interest. The discount amortization from July 1, 2017, to November 1, 2017, is $635 (4y6 3 $952). Robinson records this discount amortiza- tion as follows. November 1, 2017 Debt Investments 635 Interest Revenue 635 Illustration 17-5 shows the computation of the realized gain on the sale. ILLUSTRATION 17-5 Selling price of bonds (exclusive of accrued interest) $99,750 Computation of Gain on Less: Book value of bonds on November 1, 2017: Sale of Bonds Amortized cost, July 1, 2017 $99,048 Add: Discount amortized for the period July 1, 2017, to November 1, 2017 635 99,683 Gain on sale of bonds $ 67 Robinson records the sale of the bonds as: November 1, 2017 Cash 102,417 Interest Revenue (4/6 3 $4,000) 2,667

Debt Investments 99,683 Gain on Sale of Investments 67 The credit to Interest Revenue represents accrued interest for four months, for which the purchaser pays cash. The debit to Cash represents the selling price of the bonds plus accrued interest ($99,750 1 $2,667). The credit to Debt Investments represents the book value of the bonds on the date of sale. The credit to Gain on Sale of Investments repre- sents the excess of the selling price over the book value of the bonds. Available-for-Sale Securities Underlying Concepts Recognizing unrealized gains Companies like Amazon.com report available-for-sale securities at fair value. It and losses is an application of records the unrealized gains and losses related to changes in the fair value of the concept of comprehensive available-for-sale debt securities in an unrealized holding gain or loss account. income. Amazon adds (subtracts) this amount to other comprehensive income for the 956 Chapter 17 Investments period. Other comprehensive income is then added to (subtracted from) accumulated Calculator Solution for other comprehensive income, which is shown as a separate component of stockholders’ Bond Price equity until realized. Thus, companies report available-for-sale securities at fair value Inputs Answer on the balance sheet but do not report changes in fair value as part of net income until after selling the security. This approach reduces the volatility of net income. N 10 Example: Single Security I 4 To illustrate the accounting for available-for-sale securities, assume that Graff Corpora- tion purchases $100,000, 10 percent, five-year bonds on January 1, 2013, with interest PV ? –108,111 payable on July 1 and January 1. The bonds sell for $108,111, which results in a bond premium of $8,111 and an effective-interest rate of 8 percent. Graff records the purchase of the bonds as follows. PMT 5,000 January 1, 2013 Debt Investments 108,111 FV 100,000 Cash 108,111 Illustration 17-6 discloses the effect of the premium amortization on the interest revenue Graff records each period using the effective-interest method. ILLUSTRATION 17-6 10% BONDS PURCHASED TO YIELD 8% Schedule of Interest Bond Carrying Revenue and Bond Cash Interest Premium Amount Premium Amortization— Date Received Revenue Amortization of Bonds Effective-Interest Method 1/1/13 $108,111 7/1/13 $ 5,000a $ 4,324b $ 676c 107,435d 1/1/14 5,000 4,297 703 106,732 7/1/14 5,000 4,269 731 106,001 1/1/15 5,000 4,240 760 105,241 7/1/15 5,000 4,210 790 104,451 1/1/16 5,000 4,178 822 103,629 7/1/16 5,000 4,145 855 102,774 1/1/17 5,000 4,111 889 101,885 7/1/17 5,000 4,075 925 100,960 1/1/18 5,000 4,040 960 100,000 $50,000 $41,889 $8,111 a$5,000 5 $100,000 3 .10 3 6y12 b$4,324 5 $108,111 3 .08 3 6y12 c$676 5 $5,000 2 $4,324 d$107,435 5 $108,111 2 $676 The entry to record interest revenue on July 1, 2013, is as follows. July 1, 2013 Cash 5,000 Debt Investments 676 Interest Revenue 4,324 At December 31, 2013, Graff makes the following entry to recognize interest revenue. December 31, 2013 Interest Receivable 5,000 Debt Investments 703 Interest Revenue 4,297 As a result, Graff reports revenue for 2013 of $8,621 ($4,324 1 $4,297). To apply the fair value method to these debt investments, assume that at year-end the fair value of the bonds is $105,000 and that the carrying amount of the investments is $106,732. Comparing this fair value with the carrying amount (amortized cost) of the Investments in Debt Securities 957 bonds at December 31, 2013, Graff recognizes an unrealized holding loss of $1,732 ($106,732 2 $105,000). It reports this loss as other comprehensive income. Graff makes the following entry. December 31, 2013 Unrealized Holding Gain or Loss—Equity 1,732 Fair Value Adjustment (available-for-sale) 1,732 Graff uses a valuation account instead of crediting the Debt Investments Underlying Concepts account. The use of the Fair Value Adjustment (available-for-sale) account Companies report some debt enables the company to maintain a record of its amortized cost. Because the securities at fair value not only adjustment account has a credit balance in this case, Graff subtracts it from the

because the information is balance of the Debt Investments account to determine fair value. Graff reports relevant but also because it is this fair value amount on the balance sheet. At each reporting date, Graff representationally faithful. reports the bonds at fair value with an adjustment to the Unrealized Holding Gain or Loss—Equity account. Example: Portfolio of Securities To illustrate the accounting for a portfolio of securities, assume that Webb Corporation has two debt securities classified as available-for-sale. Illustration 17-7 identifies the amortized cost, fair value, and the amount of the unrealized gain or loss. ILLUSTRATION 17-7 AVAILABLE-FOR-SALE DEBT SECURITY PORTFOLIO Computation of Fair DECEMBER 31, 2014 Value Adjustment— Amortized Available-for-Sale Investments Cost Fair Value Unrealized Gain (Loss) Securities (2014) Watson Corporation 8% bonds $ 93,537 $103,600 $ 10,063 Anacomp Corporation 10% bonds 200,000 180,400 (19,600) Total of portfolio $293,537 $284,000 (9,537) Previous fair value adjustment balance –0– Fair value adjustment—Cr. $ (9,537) The fair value of Webb’s available-for-sale portfolio totals $284,000. The gross unre- alized gains are $10,063, and the gross unrealized losses are $19,600, resulting in a net unrealized loss of $9,537. That is, the fair value of available-for-sale securities is $9,537 lower than its amortized cost. Webb makes an adjusting entry to a valuation allowance to record the decrease in value and to record the loss as follows. December 31, 2014 Unrealized Holding Gain or Loss—Equity 9,537 Fair Value Adjustment (available-for-sale) 9,537 Webb reports the unrealized holding loss of $9,537 as other comprehensive income and a reduction of stockholders’ equity. Recall that companies exclude from net income any unrealized holding gains and losses related to available-for-sale securities. Sale of Available-for-Sale Securities If a company sells bonds carried as investments in available-for-sale securities before the maturity date, it must make entries to remove from the Debt Investments account the amortized cost of bonds sold. To illustrate, assume that Webb Corporation sold the Watson bonds (from Illustration 17-7) on July 1, 2015, for $90,000, at which time it had an amortized cost of $94,214. Illustration 17-8 (on page 958) shows the computation of the realized loss. 958 Chapter 17 Investments ILLUSTRATION 17-8 Amortized cost (Watson bonds) $94,214 Computation of Loss on Less: Selling price of bonds 90,000 Sale of Bonds Loss on sale of bonds $ 4,214 Webb records the sale of the Watson bonds as follows. July 1, 2015 Cash 90,000 Loss on Sale of Investments 4,214 Debt Investments 94,214 Webb reports this realized loss in the “Other expenses and losses” section of the income statement.4 Assuming no other purchases and sales of bonds in 2015, Webb on December 31, 2015, prepares the information shown in Illustration 17-9. ILLUSTRATION 17-9 AVAILABLE-FOR-SALE DEBT SECURITY PORTFOLIO Computation of Fair DECEMBER 31, 2015 Value Adjustment— Amortized Fair Available-for-Sale (2015) Investments Cost Value Unrealized Gain (Loss) Anacomp Corporation 10% bonds (total portfolio) $200,000 $195,000 $(5,000) Previous fair value adjustment balance—Cr. (9,537) Fair value adjustment—Dr. $ 4,537 Webb has an unrealized holding loss of $5,000. However, the Fair Value Adjustment (available-for-sale) account already has a credit balance of $9,537. To reduce the adjust- ment account balance to $5,000, Webb debits it for $4,537, as follows. December 31, 2015 Fair Value Adjustment (available-for-sale) 4,537 Unrealized Holding Gain or Loss—Equity 4,537 Financial Statement Presentation Webb’s December 31, 2015, balance sheet and the 2015 income statement include the following items and amounts (the Anacomp bonds are long-term investments but are not intended to be held to maturity). ILLUSTRATION 17-10 Balance Sheet Reporting of Available- Current assets for-Sale Securities Interest receivable $ xxx Investments Debt investments (available-for-sale) $195,000 Stockholders’ equity Accumulated other comprehensive loss $ 5,000

Income Statement Other revenues and gains Interest revenue $ xxx Other expenses and losses Loss on sale of investments $ 4,214 4On the date of sale, any unrealized gains or losses on the sold security is not adjusted in accumulated other comprehensive income. This adjustment occurs at year-end when the portfolio is evaluated for fair value adjustment. Investments in Debt Securities 959 Some favor including the unrealized holding gain or loss in net income rather than showing it as other comprehensive income.5 However, some companies, particularly financial institutions, note that recognizing gains and losses on assets, but not liabilities, introduces substantial volatility in net income. They argue that hedges often exist between assets and liabilities so that gains in assets are offset by losses in liabilities, and vice versa. In short, to recognize gains and losses only on the asset side is unfair and not representative of the economic activities of the company. This argument convinced the FASB. As a result, companies do not include in net income these unrealized gains and losses. [3] However, even this approach solves only some of the problems because volatility of capital still results. This is of concern to financial institutions because regulators restrict financial institutions’ operations based on their level of capital. However, companies can still manage their net income by engaging in gains trading (i.e., selling the winners and holding the losers). What do the numbers mean? WHAT IS FAIR VALUE? In the fall of 2000, Wall Street brokerage fi rm Morgan used its own more optimistic assumptions as a substitute for Stanley told investors that rumors of big losses in its bond external pricing sources. “What that is saying is: ‘Fair value portfolio were “greatly exaggerated.” As it turns out, Morgan is what you want the value to be. Pick a number . . .’ That’s Stanley also was exaggerating. especially troublesome.” As a result, the SEC accused Morgan Stanley of violating As indicated in the opening story, both the FASB and the securities laws by overstating the value of certain bonds by IASB are assessing what is fair and what isn’t when it comes $75 million. The SEC said the overvaluations stemmed more to assigning valuations. Concerns over the issue caught fi re from wishful thinking than reality, which violated generally after the collapses of Enron Corp. and other energy traders accepted accounting principles. “In effect, Morgan Stanley that abused the wide discretion given them under fair value valued its positions at the price at which it thought a willing accounting. Investors have expressed similar worries about buyer and seller should enter into an exchange, rather than at some fi nancial companies, which use internal—and subjec- a price at which a willing buyer and a willing seller would tively designed—mathematical models to come up with enter into a current exchange,” the SEC wrote. valuations when market quotes aren’t available. Similar con- Especially egregious, stated one accounting expert, were cerns have been raised when companies revalue their debt the SEC’s fi ndings that Morgan Stanley in some instances obligations when they apply the fair value option. Sources: Adapted from Susanne Craig and Jonathan Weil, “SEC Targets Morgan Stanley Values,” Wall Street Journal (November 8, 2004), p. C3; Floyd Norris, “Distortions in Baffl ing Financial Statements,” The New York Times (November 10, 2011); and Marie Leone, “The Fair Value Deadbeat Debate Returns,” CFO.com (June 25, 2009). Trading Securities Companies hold trading securities with the intention of selling them in a short period of time. “Trading” in this context means frequent buying and selling. Companies thus use trading securities to generate profits from short-term differences in price. Companies generally hold these securities for less than three months, some for merely days or hours. Companies report trading securities at fair value, with unrealized holding gains and losses reported as part of net income. Similar to held-to-maturity or available-

for-sale investments, companies are required to amortize any discount or premium. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. In short, the FASB says to adjust the trading securities to fair value, at each reporting date. In addition, companies report the change in value as part of net income, not other comprehensive income. 5In Chapter 4, we discussed the concept of, and reporting for, other comprehensive income. 960 Chapter 17 Investments To illustrate, assume that on December 31, 2014, Western Publishing Corporation determined its trading securities portfolio to be as shown in Illustration 17-11. (Assume that 2014 is the first year that Western Publishing held trading securities.) At the date of acquisition, Western Publishing recorded these trading securities at cost, including brokerage commissions and taxes, in the account entitled Debt Investments. This is the first valuation of this recently purchased portfolio. ILLUSTRATION 17-11 TRADING DEBT SECURITY PORTFOLIO Computation of Fair DECEMBER 31, 2014 Value Adjustment— Investments Amortized Cost Fair Value Unrealized Gain (Loss) Trading Securities Portfolio (2014) Burlington Northern 6% bonds $ 43,860 $ 51,500 $ 7,640 GM Corporation 7% bonds 184,230 175,200 (9,030) Time Warner 8% bonds 86,360 91,500 5,140 Total of portfolio $314,450 $318,200 3,750 Previous fair value adjustment balance –0– Fair value adjustment—Dr. $ 3,750 The total cost of Western Publishing’s trading portfolio is $314,450. The gross unre- alized gains are $12,780 ($7,640 1 $5,140), and the gross unrealized losses are $9,030, resulting in a net unrealized gain of $3,750. The fair value of trading securities is $3,750 greater than its cost. At December 31, Western Publishing makes an adjusting entry to a valuation allow- ance, referred to as Fair Value Adjustment (trading), to record the increase in value and to record the unrealized holding gain. December 31, 2014 Fair Value Adjustment (trading) 3,750 Unrealized Holding Gain or Loss—Income 3,750 Because the Fair Value Adjustment account balance is a debit, Western Publishing adds it to the cost of the Debt Investments account to arrive at a fair value for the trading securities. Western Publishing reports this fair value amount on the balance sheet. As with other debt investments, when a trading investment is sold, the Debt Invest- ments account is reduced by the amount of the amortized cost of the bonds. Any real- ized gain or loss is recorded in the “Other expenses and losses” section of the income statement. The Fair Value Adjustment account is then adjusted at year-end for the unre- alized gains or losses on the remaining securities in the trading investment portfolio. When securities are actively traded, the FASB believes that the investments should be reported at fair value on the balance sheet. In addition, changes in fair value (unreal- ized gains and losses) should be reported in income. Such reporting on trading securi- ties provides more relevant information to existing and prospective stockholders. INVESTMENTS IN EQUITY SECURITIES Equity securities represent ownership interests such as common, preferred, or LEARNING OBJECTIVE 3 other capital stock. They also include rights to acquire or dispose of ownership in- Identify the categories of equity terests at an agreed-upon or determinable price, such as in warrants, rights, and call securities and describe the accounting or put options. Companies do not treat convertible debt securities as equity securi- and reporting treatment for each category. ties. Nor do they treat as equity securities redeemable preferred stock (which must be redeemed for common stock). The cost of equity securities includes the purchase price of the security plus broker’s commissions and other fees incidental to the purchase. Investments in Equity Securities 961 The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment

for the investment subsequent to acquisition. The classification of such investments depends on the percentage of the investee voting stock that is held by the investor: 1. Holdings of less than 20 percent (fair value method)—investor has passive interest. 2. Holdings between 20 percent and 50 percent (equity method)—investor has signifi - cant infl uence. 3. Holdings of more than 50 percent (consolidated statements)—investor has control- ling interest. Illustration 17-12 lists these levels of interest or influence and the corresponding valuation and reporting method that companies must apply to the investment. ILLUSTRATION 17-12 Percentage Levels of Infl uence of Ownership 0% —¡ 20% —¡ 50% —¡ 100% Determine Accounting Level of Little or Methods Influence None Significant Control Valuation Fair Value Equity Method Method Method Consolidation The accounting and reporting for equity securities therefore depend on the level of influence and the type of security involved, as shown in Illustration 17-13. ILLUSTRATION 17-13 Unrealized Holding Accounting and Category Valuation Gains or Losses Other Income Effects Reporting for Equity Holdings less Securities by Category than 20% 1. Available- Fair value Recognized in “Other Dividends declared; for-sale comprehensive gains and losses income” and as from sale. separate component of stockholders’ equity 2. Trading Fair value Recognized in net Dividends declared; income gains and losses from sale. Holdings between Equity Not recognized Proportionate share 20% and 50% of investee’s net income. Holdings more Consolidation Not recognized Not applicable. than 50% Holdings of Less Than 20% When an investor has an interest of less than 20 percent, it is presumed that the investor has little or no influence over the investee. In such cases, if market prices are available subsequent to acquisition, the company values and reports the investment using the fair value method.6 The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities. Because equity secu- rities have no maturity date, companies cannot classify them as held-to-maturity. 6If an equity investment is not publicly traded, a company values the investment and reports it at cost in periods subsequent to acquisition. This approach is often referred to as the cost method. Companies recognize dividends when received. They value the portfolio and report it at acquisition cost. Companies only recognize gains or losses after selling the securities. 962 Chapter 17 Investments Available-for-Sale Securities Upon acquisition, companies record available-for-sale securities at cost.7 To illustrate, assume that on November 3, 2014, Republic Corporation purchased common stock of three companies, each investment representing less than a 20 percent interest. Cost Northwest Industries, Inc. $259,700 Campbell Soup Co. 317,500 St. Regis Pulp Co. 141,350 Total cost $718,550 Republic records these investments as follows. November 3, 2014 Equity Investments 718,550 Cash 718,550 On December 6, 2014, Republic receives a cash dividend of $4,200 on its investment in the common stock of Campbell Soup Co. It records the cash dividend as follows. December 6, 2014 Cash 4,200 Dividend Revenue 4,200 All three of the investee companies reported net income for the year, but only Camp- bell Soup declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the common stock of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income of the investee is not a proper basis for recognizing income from the investment by the investor. Why? Because the increased net assets resulting from profitable operations may be permanently retained for use in the investee’s business. Therefore, the investor recognizes net income only when the investee declares cash dividends. At December 31, 2014, Republic’s available-for-sale equity security portfolio has the cost and fair value shown in Illustration 17-14.

ILLUSTRATION 17-14 AVAILABLE-FOR-SALE EQUITY SECURITY PORTFOLIO Computation of Fair DECEMBER 31, 2014 Value Adjustment— Fair Unrealized Available-for-Sale Equity Investments Cost Value Gain (Loss) Security Portfolio (2014) Northwest Industries, Inc. $259,700 $275,000 $ 15,300 Campbell Soup Co. 317,500 304,000 (13,500) St. Regis Pulp Co. 141,350 104,000 (37,350) Total of portfolio $718,550 $683,000 (35,550) Previous fair value adjustment balance –0– Fair value adjustment—Cr. $(35,550) 7Companies should record equity securities acquired in exchange for noncash consideration (property or services) at (1) the fair value of the consideration given, or (2) the fair value of the security received, whichever is more clearly determinable. Accounting for numerous purchases of securities requires the preservation of information regarding the cost of individual purchases, as well as the dates of purchases and sales. If specific identification is not possible, companies may use average-cost for multiple purchases of the same class of security. The first-in, first-out method (FIFO) of assigning costs to investments at the time of sale is also acceptable and normally employed. Investments in Equity Securities 963 For Republic’s available-for-sale equity securities portfolio, the gross unrealized gains are $15,300, and the gross unrealized losses are $50,850 ($13,500 1 $37,350), result- ing in a net unrealized loss of $35,550. The fair value of the available-for-sale securities portfolio is below cost by $35,550. As with available-for-sale debt securities, Republic records the net unrealized gains and losses related to changes in the fair value of available-for-sale equity securities in an Unrealized Holding Gain or Loss—Equity account. Republic reports this amount as a part of other comprehensive income and as a component of other accumulated comprehensive income (reported in stockholders’ equity) until realized. In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss— Equity account and crediting the Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows. December 31, 2014 Unrealized Holding Gain or Loss—Equity 35,550 Fair Value Adjustment (available-for-sale) 35,550 On January 23, 2015, Republic sold all of its Northwest Industries, Inc. common stock receiving net proceeds of $287,220. Illustration 17-15 shows the computation of the realized gain on the sale. ILLUSTRATION 17-15 Net proceeds from sale $287,220 Computation of Gain on Cost of Northwest shares 259,700 Sale of Stock Gain on sale of stock $ 27,520 Republic records the sale as follows. January 23, 2015 Cash 287,220 Equity Investments 259,700 Gain on Sale of Investments 27,520 In addition, assume that on February 10, 2015, Republic purchased 20,000 shares of Continental Trucking at a market price of $12.75 per share plus brokerage commissions of $1,850 (total cost, $256,850). Illustration 17-16 lists Republic’s portfolio of available-for-sale securities, as of December 31, 2015. ILLUSTRATION 17-16 AVAILABLE-FOR-SALE EQUITY SECURITY PORTFOLIO Computation of Fair DECEMBER 31, 2015 Value Adjustment— Fair Unrealized Available-for-Sale Equity Investments Cost Value Gain (Loss) Security Portfolio (2015) Continental Trucking $256,850 $278,350 $ 21,500 Campbell Soup Co. 317,500 362,550 45,050 St. Regis Pulp Co. 141,350 139,050 (2,300) Total of portfolio $715,700 $779,950 64,250 Previous fair value adjustment balance—Cr. (35,550) Fair value adjustment—Dr. $ 99,800 At December 31, 2015, the fair value of Republic’s available-for-sale equity securities portfolio exceeds cost by $64,250 (unrealized gain). The Fair Value Adjustment account had a credit balance of $35,550 at December 31, 2015. To adjust its December 31, 2015, 964 Chapter 17 Investments available-for-sale portfolio to fair value, the company debits the Fair Value Adjustment account for $99,800 ($35,550 1 $64,250). Republic records this adjustment as follows. December 31, 2015 Fair Value Adjustment (available-for-sale) 99,800

Unrealized Holding Gain or Loss—Equity 99,800 Trading Securities The accounting entries to record trading equity securities are the same as for available-for- sale equity securities, except for recording the unrealized holding gain or loss. For trading equity securities, companies report the unrealized holding gain or loss as part of net income. Thus, the account titled Unrealized Holding Gain or Loss—Income is used. What do the numbers mean? MORE DISCLOSURE, PLEASE How to account for investment securities is a particularly Investments in the Equity of Other Companies sensitive area, given the large amounts of equity investments Categorized by Percent of involved. And presently companies report investments in Accounting Treatment Companies equity securities at cost, equity, fair value, and full consolida- Presenting consolidated fi nancial tion, depending on the circumstances. As a recent SEC study statements 91.1% noted, “there are so many different accounting treatments for Reporting equity method investments 23.5 investments that it raises the question of whether they are all Reporting cost method investments* 17.4 needed.” Reporting available-for-sale investments 37.4 Reporting trading investments 6.2 Presented in the right-hand column is an estimate of the percentage of companies on the major exchanges that have *If the equity investments are not publicly traded, the company often investments in the equity of other entities. accounts for the investment under the cost method. Changes in value are therefore not recognized unless there is impairment. As the table indicates, many companies have equity i nvestments of some type. These investments can be substan- tial. For example, the total amount of equity-method invest- $403 billion, and the amount shown in the income statements ments appearing on company balance sheets is approximately in any one year for all companies is approximately $38 billion. Source: “Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers,” United States Securities and Exchange Commission—Offi ce of Chief Accountant, Offi ce of Economic Analyses, Division of Corporation Finance (June 2005), pp. 36–39. Holdings Between 20% and 50% An investor corporation may hold an interest of less than 50 percent in an investee LEARNING OBJECTIVE 4 corporation and thus not possess legal control. However, an investment in voting Explain the equity method of stock of less than 50 percent can still give the investor the ability to exercise signifi- accounting and compare it to the fair cant influence over the operating and financial policies of the investee company. [4] value method for equity securities. Significant influence may be indicated in several ways. Examples include represen- tation on the board of directors, participation in policy-making processes, material inter- company transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in rela- tion to the concentration of other shareholdings. To achieve a reasonable degree of uni- formity in application of the “significant influence” criterion, the profession concluded that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee.8 8Cases in which an investment of 20 percent or more might not enable an investor to exercise significant influence include (1) the investee opposes the investor’s acquisition of its stock, (2) the investor and investee sign an agreement under which the investor surrenders significant shareholder rights, (3) the investor’s ownership share does not result in “significant influence” because majority ownership of the investee is concentrated among a small group of shareholders

who operate the investee without regard to the views of the investor, and (4) the investor tries and fails to obtain representation on the investee’s board of directors. [5] Investments in Equity Securities 965 In instances of “significant influence” (generally an investment of 20 percent or more), the investor must account for the investment using the equity method. Equity Method Under the equity method, the investor and the investee acknowledge a substantive economic relationship. The company originally records the investment at the cost of the shares acquired but subsequently adjusts the amount each period for changes in the investee’s net assets. That is, the investor’s proportionate share of the earnings (losses) of the investee periodically increases (decreases) the investment’s carrying amount. All cash dividends received by the investor from the investee also decrease the investment’s carrying amount. The equity method recognizes that investee’s earnings increase investee’s net assets, and that investee’s losses and dividends decrease these net assets. To illustrate the equity method and compare it with the fair value method, assume that Maxi Company purchases a 20 percent interest in Mini Company. To apply the fair value method in this example, assume that Maxi does not have the ability to exercise significant influence, and classifies the securities as available-for-sale. Where this example applies the equity method, assume that the 20 percent interest permits Maxi to ILLUSTRATION 17-17 exercise significant influence. Illustration 17-17 shows the entries. Comparison of Fair Value Method and Equity Method ENTRIES BY MAXI COMPANY Fair Value Method Equity Method On January 2, 2014, Maxi Company acquired 48,000 shares (20% of Mini Company common stock) at a cost of $10 a share. Equity Investments 480,000 Equity Investments 480,000 Cash 480,000 Cash 480,000 For the year 2014, Mini Company reported net income of $200,000; Maxi Company’s share is 20%, or $40,000. N o entry Equity Investments 40,000 Investment Income 40,000 At December 31, 2014, the 48,000 shares of Mini Company have a fair value (market price) of $12 a share, or $576,000. Fair Value Adjustment No entry (available-for-sale) 96,000 Unrealized Holding Gain or Loss—Equity 96,000 On January 28, 2015, Mini Company announced and paid a cash dividend of $100,000; Maxi Company received 20%, or $20,000. Cash 20,000 Cash 20,000 Dividend Revenue 20,000 Equity Investments 20,000 For the year 2015, Mini reported a net loss of $50,000; Maxi Company’s share is 20%, or $10,000. N o entry Investment Loss 10,000 Equity Investments 10,000 At December 31, 2015, the Mini Company 48,000 shares have a fair value (market price) of $11 a share, or $528,000. Unrealized Holding Gain or Loss—Equity 48,000 Fair Value Adjustment No entry (available-for-sale) 48,000 Note that under the fair value method, Maxi reports as revenue only the cash divi- dends received from Mini. The earning of net income by Mini (the investee) is not 966 Chapter 17 Investments considered a proper basis for recognition of income from the investment by Maxi (the investor). Why? Mini may permanently retain in the business any increased net assets resulting from its profitable operation. Therefore, Maxi only recognizes revenue when it receives dividends from Mini. International Under the equity method, Maxi reports as revenue its share of the net Perspective income reported by Mini. Maxi records the cash dividends received from Mini as a decrease in the investment carrying value. As a result, Maxi records IFRS has similar accounting rules for signifi cant infl uence its share of the net income of Mini in the year when it is recognized. With equity investments. significant influence, Maxi can ensure that Mini will pay dividends, if desired, on any net asset increases resulting from net income. To wait until receiving a dividend ignores the fact that Maxi is better off if the investee has earned income. Using dividends as a basis for recognizing income poses an additional problem.

For example, assume that the investee reports a net loss. However, the investor exerts influence to force a dividend payment from the investee. In this case, the investor reports income, even though the investee is experiencing a loss. In other words, using dividends as a basis for recognizing income fails to report properly the economics of the situation. For some companies, equity accounting can be a real pain to the bottom line. For example, Amazon.com, the pioneer of Internet retailing, at one time struggled to turn a profit. Furthermore, some of Amazon’s equity investments had resulted in Amazon’s earnings performance going from bad to worse. At one time, Amazon disclosed equity stakes in such companies as Altera International, Basis Technology, Drugstore.com, and Eziba.com. These equity investees reported losses that made Amazon’s already bad bottom line even worse, accounting for up to 22 percent of its reported loss in one year alone. Investee Losses Exceed Carrying Amount. If an investor’s share of the investee’s losses exceeds the carrying amount of the investment, should the investor recognize addi- tional losses? Ordinarily, the investor should discontinue applying the equity method and not recognize additional losses. If the investor’s potential loss is not limited to the amount of its original investment (by guarantee of the investee’s obligations or other commitment to provide further financial support) or if imminent return to profitable operations by the investee appears to be assured, the investor should recognize additional losses. [6] Holdings of More Than 50% When one corporation acquires a voting interest of more than 50 percent in another corporation, it is said to have a controlling interest. In such a relationship, the investor corporation is referred to as the parent and the investee corporation as the subsidiary. Companies present the investment in the common stock of the subsidiary as a International long-term investment on the separate financial statements of the parent. Perspective When the parent treats the investment as a subsidiary, the parent generally In contrast to U.S. fi rms, prepares consolidated financial statements. Consolidated financial statements fi nancial statements of non-U.S. treat the parent and subsidiary corporations as a single economic entity. companies often include both (Advanced accounting courses extensively discuss the subject of when and how consolidated (group) statements to prepare consolidated financial statements.) Whether or not consolidated and parent company fi nancial financial statements are prepared, the parent company generally accounts for statements. the investment in the subsidiary using the equity method as explained in the previous section of this chapter. Additional Measurement Issues 967 What do the numbers mean? WHO’S IN CONTROL HERE? Molson Coors Brewing Company owns 42 percent of the the equity method. Under the equity method, Lenovo reports a MillerCoors’ brewing venture operating in the United States single income item for its profi ts from Beijing Lenovo and only and Puerto Rico. As part of the agreement, Molson helps the the net amount of its investment in the statement of fi nancial MillerCoors unit produce and sell its products in the U.S. position. Equity method accounting gives Lenovo a pristine and Puerto Rican markets. Lenovo Group owns a signifi cant statement of fi nancial position and income statement, by percentage (45 percent) of the shares of Beijing Lenovo separating the assets and liabilities and the profi t margins of Parasaga Information Technology Co. (which develops and the related companies from its laptop-computer businesses. distributes computer software). Beijing Lenovo is important Some are critical of equity method accounting. They to Lenovo because it develops and sells the software that is argue that some investees, like Beijing Lenovo, should be used with Lenovo computers. In return, Beijing Lenovo de- consolidated. The FASB has issued rules to consider other pends on Lenovo to provide the products that make its soft- factors, in addition to voting interests, when determining

ware and services valuable, as well as perform signifi cant whether an entity should be consolidated. We discuss these customer and market support. Indeed, it can be said that to rules in Appendix 17B. The FASB has tightened up consoli- some extent Lenovo controls Beijing Lenovo, which would dation rules, so that companies will be more likely to con- likely not exist without the support of Lenovo. solidate more of their 20–50-percent-owned investments. As you have learned, because a company like Lenovo owns Consolidation of entities, such as MillerCoors and Beijing less than 50 percent of the shares, it does not consolidate Lenovo, is warranted if Molson and Lenovo effectively control Beijing Lenovo but instead accounts for its investment using their equity method investments. ADDITIONAL MEASUREMENT ISSUES Fair Value Option As indicated in earlier chapters, companies have the option to report most finan- 5 LEARNING OBJECTIVE cial instruments at fair value, with all gains and losses related to changes in fair Describe the accounting for the fair value reported in the income statement. This option is applied on an instrument- value option and for impairments of by-instrument basis. The fair value option is generally available only at the time a debt and equity investments. company first purchases the financial asset or incurs a financial liability. If a com- pany chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. For example, assume that Abbott Laboratories purchased debt securities in 2014 that it classified as held-to-maturity. Abbott does not choose to report this security using the fair value option. In 2015, Abbott buys another held-to-maturity debt security. Abbott decides to report this security using the fair value option. Once it chooses the fair value option for the security bought in 2015, the decision is irrevocable (may not be changed). In addition, Abbott does not have the option to value the held-to-maturity security purchased in 2014 at fair value in 2015 or in subsequent periods. Many support the use of the fair value option as a step closer to total fair value report- ing for financial instruments. They believe this treatment leads to an improvement in financial reporting. Others argue that the fair value option is confusing. A company can choose from period to period whether to use the fair value option for any new investment in a financial instrument. By permitting an instrument-by-instrument approach, compa- nies are able to report some financial instruments at fair value but not others. To illustrate the accounting issues related to the fair value option, we discuss two different situations. Available-for-Sale Securities Available-for-sale securities are presently reported at fair value, with any unrealized gains and losses recorded as part of other comprehensive income. Assume that Hardy Company purchases stock in Fielder Company during 2014 that it classifies 968 Chapter 17 Investments as available-for-sale. At December 31, 2014, the cost of this security is $100,000; its fair value at December 31, 2014, is $125,000. If Hardy chooses the fair value option to account for the Fielder Company stock, it makes the following entry at December 31, 2014. Equity Investments 25,000 Unrealized Holding Gain or Loss—Income 25,000 In this situation, Hardy uses an account titled Equity Investments to record the change in fair value at December 31. It does not use a Fair Value Adjustment account because the accounting for a fair value option is on an investment-by-investment basis rather than on a portfolio basis. Because Hardy selected the fair value option, the unrealized gain or loss is recorded as part of net income. Hardy must continue to use the fair value method to record this investment until it no longer has ownership of the security. Equity Method Investments Companies may also use the fair value option for investments that otherwise follow the equity method of accounting. To illustrate, assume that Durham Company holds a

28 percent stake in Suppan Inc. Durham purchased the investment in 2014 for $930,000. At December 31, 2014, the fair value of the investment is $900,000. Durham elects to report the investment in Suppan using the fair value option. The entry to record this invest- ment is as follows. Unrealized Holding Gain or Loss—Income 30,000 Equity Investments 30,000 In contrast to equity method accounting, if the fair value option is chosen, Durham does not report its pro rata share of the income or loss from Suppan. In addition, any divi- dend payments are credited to Dividend Revenue and therefore do not reduce International the Equity Investments account. Perspective One major advantage of using the fair value option for this type of invest- IFRS does not allow the use of ment is that it addresses confusion about the equity method of accounting. In the fair value option for equity other words, what exactly does the one-line consolidation related to the equity method investments. The FASB method of accounting on the balance sheet tell investors? Many believe it does is considering a proposal to not provide information about liquidity or solvency, nor does it provide an converge to IFRS in this area. indication of the worth of the company. Evolving Issue FAIR VALUE CONTROVERSY The reporting of investment securities is controversial. Some statements. Some argue such treatment is confusing. believe that all securities should be reported at fair value. Furthermore, the held-to-maturity category relies on Others believe they all should be stated at amortized cost. i ntent, a subjective evaluation. What is not subjective is Still others favor the present approach. Here are some of the the fair value of the debt instrument. In other words, the major unresolved issues: three classifications are subjective, resulting in arbitrary • Measurement based on intent. Companies classify debt classifications. securities as held-to-maturity, available-for-sale, or • Gains trading. Companies can classify certain debt securi- trading. As a result, companies can report three identical ties as held-to-maturity and therefore report them at amor- debt securities in three different ways in the financial tized cost. Companies can classify other debt and equity Additional Measurement Issues 969 securities as available-for-sale and report them at fair nizing changes in value on only one side of the balance value, with the unrealized gain or loss reported as other sheet (the asset side), a high degree of volatility can comprehensive income. In either case, a company can occur in the income and stockholders’ equity amounts. become involved in “gains trading” (also referred to as Further, financial institutions are involved in asset and “cherry picking,” “snacking,” or “sell the best and keep the liability management (not just asset management). rest”). In gains trading, companies sell their “winners,” Viewing only one side may lead managers to make un- reporting the gains in income, and hold on to the losers. economic decisions as a result of the accounting. The fair • Liabilities not fairly valued. Many argue that if compa- value option may address this concern to some extent. However, there is debate on the usefulness of fair value nies report investment securities at fair value, they also estimates for liabilities. should report liabilities at fair value. Why? By recog- Impairment of Value A company should evaluate every investment, at each reporting date, to determine if it has suffered impairment—a loss in value that is other than temporary. For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a permanent loss. If the decline is judged to be other than temporary, a company writes down the cost basis of the individual security to a new cost basis. The company accounts for the write-down as a realized loss. Therefore, it includes the amount in net income. For debt securities, a company uses the impairment test to determine whether “it is probable that the investor will be unable to collect all amounts due according to the

contractual terms.” For equity securities, the guideline is less precise. Any time realizable value is lower than the carrying amount of the investment, a company must consider an impair- ment. Factors involved include the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the investor company to retain its investment to allow for any anticipated recovery in fair value. To illustrate an impairment, assume that Strickler Company holds available-for-sale bond securities with a par value and amortized cost of $1 million. The fair value of these securities is $800,000. Strickler has previously reported an unrealized loss on these secu- rities of $200,000 as part of other comprehensive income. In evaluating the securities, Strickler now determines that it probably will not collect all amounts due. In this case, it reports the unrealized loss of $200,000 as a loss on impairment of $200,000. Strickler includes this amount in income, with the bonds stated at their new cost basis. It records this impairment as follows. Loss on Impairment 200,000 Debt Investments 200,000 The new cost basis of the investment in debt securities is $800,000. Strickler includes subsequent increases and decreases in the fair value of impaired available-for-sale secu- rities as other comprehensive income.9 Companies base impairment for debt and equity securities on a fair value test. This test differs slightly from the impairment test for loans that we discuss in Appendix 7B. 9In addition, any balance in the Unrealized Gain or Loss—Equity and Fair Value Adjustment accounts related to the impaired security would be eliminated. Companies may not amortize any discount related to the debt securities after recording the impairment. The new cost basis of impaired held-to-maturity securities does not change unless additional impairment occurs. 970 Chapter 17 Investments The FASB rejected the discounted cash flow alternative for securities because of the availability of market price information.10 An example of the criteria used by Caterpillar to assess impairment is provided in Illustration 17-18. ILLUSTRATION 17-18 Caterpillar, Inc. Disclosure of Impairment Notes to Financial Statements Assessment Criteria Note 1. Impairment of available-for-sale securities Available-for-sale securities are reviewed monthly to identify market values below cost of 20% or more. If a decline for a debt security is in excess of 20% for six months, the investment is evaluated to determine if the decline is due to general declines in the marketplace or if the investment has been impaired and should be written down to market value. . . . After the six-month period, debt securities with declines from cost in excess of 20% are evaluated monthly for impairment. For equity securities, if a decline from cost of 20% or more continues for a 12-month period, an other than temporary impairment is recognized without continued analysis. RECLASSIFICATIONS AND TRANSFERS Reclassifi cation Adjustments As we indicated in Chapter 4, companies report changes in unrealized holding gains LEARNING OBJECTIVE 6 and losses related to available-for-sale securities as part of other comprehensive in- Describe the reporting of come. Companies may display the components of other comprehensive income in reclassification adjustments and the one of two ways: (1) in a combined statement of income and comprehensive income, accounting for transfers between categories. or (2) in a separate statement of comprehensive income that begins with net income. The reporting of changes in unrealized gains or losses in comprehensive in- come is straightforward unless a company sells securities during the year. In that case, double-counting results when the company reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current period or in previous periods. To ensure that gains and losses are not counted twice when a sale occurs, a reclas-

sification adjustment is necessary. To illustrate, assume that Open Company has the following two available-for-sale securities in its portfolio at the end of 2013 (its first year of operations). ILLUSTRATION 17-19 Unrealized Holding Available-for-Sale Investments Cost Fair Value Gain (Loss) Security Portfolio (2013) Lehman Inc. common stock $ 80,000 $105,000 $25,000 Woods Co. common stock 120,000 135,000 15,000 Total of portfolio $200,000 $240,000 40,000 Previous fair value adjustment balance –0– Fair value adjustment—Dr. $40,000 The entry to record the unrealized holding gain in 2013 is as follows. Fair Value Adjustment (available-for-sale) 40,000 Unrealized Holding Gain or Loss—Equity 40,000 10The FASB is currently exploring a new impairment model for financial instruments. The model focuses on the recognition of all expected losses which are “an estimate of contractual cash flows not expected to be collected.” This differs from the current model, known as the incurred loss model, which requires evidence that a loss actually has occurred before the loss can be recorded. Reclassifi cations and Transfers 971 If Open Company reports net income in 2013 of $350,000, it presents a statement of comprehensive income as follows. ILLUSTRATION 17-20 OPEN COMPANY Statement of STATEMENT OF COMPREHENSIVE INCOME Comprehensive FOR THE YEAR ENDED DECEMBER 31, 2013 Income (2013) Net income $350,000 Other comprehensive income Unrealized holding gain 40,000 Comprehensive income $390,000 At December 31, 2013, Open Company reports on its balance sheet equity invest- ments of $240,000 (cost $200,000 plus fair value adjustment of $40,000) and accumulated other comprehensive income in stockholders’ equity of $40,000. The entry to transfer the unrealized holding gain—equity to accumulated other comprehensive income is as follows. Unrealized Holding Gain or Loss—Equity 40,000 Accumulated Other Comprehensive Income 40,000 In 2014, Open Company sells its Lehman Inc. common stock for $105,000 and real- izes a gain on the sale of $25,000 ($105,000 2 $80,000). The journal entry to record this transaction is as follows. Cash 105,000 Equity Investments 80,000 Gain on Sale of Investments 25,000 At the end of 2014, the fair value of the Woods Co. common stock increased an additional $20,000 ($155,000 2 $135,000), to $155,000. Illustration 17-21 shows the c omputation of the change in the Fair Value Adjustment account (based on only the Woods Co. investment). ILLUSTRATION 17-21 Unrealized Holding Available-for-Sale Investments Cost Fair Value Gain (Loss) Security Portfolio (2014) Woods Co. common stock $120,000 $155,000 $35,000 Previous fair value adjustment balance—Dr. (40,000) Fair value adjustment—Cr. $ (5,000) The entry to record the unrealized holding gain in 2014 is as follows. Unrealized Holding Gain or Loss—Equity 5,000 Fair Value Adjustment (available-for-sale) 5,000 If we assume that Open Company reports net income of $720,000 in 2014, including the realized sale on the Lehman stock, its income statement is presented as shown in Illustration 17-22. ILLUSTRATION 17-22 OPEN COMPANY Statement of STATEMENT OF COMPREHENSIVE INCOME Comprehensive FOR THE YEAR ENDED DECEMBER 31, 2014 Income (2014) Net income (includes $25,000 realized gain on Lehman shares) $720,000 Other comprehensive income Unrealized holding loss (5,000) Comprehensive income $715,000 972 Chapter 17 Investments At December 31, 2014, Open Company reports on its balance sheet equity invest- ments of $155,000 (cost $120,000 plus a fair value adjustment of $35,000) and accumu- lated other comprehensive income in stockholders’ equity of $35,000 ($40,000 2 $5,000). The entry to transfer the unrealized holding loss—equity to accumulated other compre- hensive income is as follows. Accumulated Other Comprehensive Income 5,000 Unrealized Holding Gain or Loss—Equity 5,000 In 2013, Open included the unrealized gain on the Lehman Co. common stock in comprehensive income. In 2014, Open sold the stock. It reported the realized gain ($25,000) in net income, which increased comprehensive income again. To avoid double-

counting this gain, Open makes a reclassification adjustment to eliminate the realized gain from the computation of comprehensive income in 2014. This reclassification adjustment may be made in the income statement, in accumu- lated other comprehensive income or in a note to the financial statements. The FASB prefers to show the reclassification amount in accumulated other comprehensive income in the notes to the financial statements.11 For Open Company, this presentation is as shown in Illustration 17-23. ILLUSTRATION 17-23 OPEN COMPANY Note Disclosure of NOTES TO FINANCIAL STATEMENTS Reclassifi cation CHANGES IN ACCUMULATED OTHER COMPREHENSIVE INCOME Adjustments Beginning balance, January 1, 2014 $40,000 Current-period other comprehensive income ($155,000 2 $135,000) $ 20,000 Amount reclassified from accumulated other comprehensive income (25,000) Unrealized holding loss (5,000) Ending balance, December 31, 2014 $35,000 Comprehensive Example To provide a single-period example of the reporting of investment securities and related gain or loss on available-for-sale securities, assume that on January 1, 2014, Hinges Co. had cash and common stock of $50,000.12 At that date, the company had no other asset, liability, or equity balance. On January 2, Hinges purchased for cash $50,000 of equity securities classified as available-for-sale. On June 30, Hinges sold part of the available- for-sale security portfolio, realizing a gain as shown in Illustration 17-24. ILLUSTRATION 17-24 Fair value of securities sold $22,000 Computation of Realized Less: Cost of securities sold 20,000 Gain Realized gain $ 2,000 11Recently, the FASB has proposed requiring companies to provide a tabular disclosure about items reclassified out of accumulated other comprehensive income. In general, for items reclassified to net income (e.g., gains or losses on available-for-sale securities), the disclosure includes the amount reclassified and identifies the line item affected on the income statement. 12We adapted this example from Dennis R. Beresford, L. Todd Johnson, and Cheri L. Reither, “Is a Second Income Statement Needed?” Journal of Accountancy (April 1996), p. 71. Reclassifi cations and Transfers 973 Hinges did not purchase or sell any other securities during 2014. It received $3,000 in dividends during the year. At December 31, 2014, the remaining portfolio is as shown in Illustration 17-25. ILLUSTRATION 17-25 Fair value of portfolio $34,000 Computation of Less: Cost of portfolio 30,000 Unrealized Gain Unrealized gain $ 4,000 Illustration 17-26 shows the company’s income statement for 2014. ILLUSTRATION 17-26 HINGES CO. Income Statement INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Dividend revenue $3,000 Realized gains on investment in securities 2,000 Net income $5,000 The company reports its change in the unrealized holding gain in a statement of comprehensive income as follows. ILLUSTRATION 17-27 HINGES CO. Statement of STATEMENT OF COMPREHENSIVE INCOME Comprehensive Income FOR THE YEAR ENDED DECEMBER 31, 2014 Net income (includes realized gain of $2,000) $5,000 Other comprehensive income: Unrealized holding gain 4,000 Comprehensive income $9,000 Its statement of stockholders’ equity appears in Illustration 17-28. ILLUSTRATION 17-28 HINGES CO. Statement of STATEMENT OF STOCKHOLDERS’ EQUITY Stockholders’ Equity FOR THE YEAR ENDED DECEMBER 31, 2014 Common Retained Accumulated Other Stock Earnings Comprehensive Income Total Beginning balance $50,000 $ –0– $–0– $50,000 Add: Net income 5,000 5,000 Other comprehensive income 4,000* 4,000 Ending balance $50,000 $5,000 $4,000 $59,000 *Total holding gains of $6,000 less reclassification adjustment of $2,000. 974 Chapter 17 Investments The comparative balance sheet is shown below in Illustration 17-29. ILLUSTRATION 17-29 HINGES CO. Comparative Balance COMPARATIVE BALANCE SHEET Sheet 1/1/14 12/31/14 Assets Cash $50,000 $25,000 Equity investments (available-for-sale) 34,000 Total assets $50,000 $59,000 Stockholders’ equity Common stock $50,000 $50,000 Retained earnings 5,000 Accumulated other comprehensive income 4,000

Total stockholders’ equity $50,000 $59,000 This example indicates how an unrealized gain or loss on available-for-sale securi- ties affects all the financial statements. Note that a company must disclose the compo- nents that comprise accumulated other comprehensive income. Transfers Between Categories Companies account for transfers between any of the categories at fair value. Thus, if a company transfers available-for-sale securities to held-to-maturity investments, it records the new investments (held-to-maturity) at the date of transfer at fair value in the new category. Similarly, if it transfers held-to-maturity investments to available-for-sale investments, it records the new investments (available-for-sale) at fair value. This fair value rule assures that a company cannot omit recognition of fair value simply by transferring securities to the held- to-maturity category. Illustration 17-30 summarizes the accounting treatment for transfers. ILLUSTRATION 17-30 Impact of Transfer Impact of Accounting for Transfers Type of Measurement on Stockholders’ Transfer on Transfer Basis Equity* Net Income* Transfer from Security transferred at The unrealized gain or The unrealized gain or trading to fair value at the date loss at the date of loss at the date of available-for- of transfer, which is transfer increases transfer is recognized sale the new cost basis of or decreases in income. the security. stockholders’ equity. Transfer from Security transferred at The unrealized gain or The unrealized gain or Gateway to available-for- fair value at the date loss at the date of loss at the date of the Profession sale to trading of transfer, which is transfer increases transfer is recognized the new cost basis or decreases in income. Examples of the Entries of the security. stockholders’ equity. for Recording Transfers Between Categories Transfer from Security transferred at The separate component None held-to-maturity fair value at the date of stockholders’ equity to available- of transfer. is increased or for-sale** decreased by the unrealized gain or loss at the date of transfer. Transfer from Security transferred at The unrealized gain or None available-for- fair value at the date loss at the date of sale to held-to- of transfer. transfer carried as a maturity separate component of stockholders’ equity is amortized over the remaining life of the security. *Assumes that adjusting entries to report changes in fair value for the current period are not yet recorded. **According to GAAP, these types of transfers should be rare. Reclassifi cations and Transfers 975 Summary of Reporting Treatment of Securities Illustration 17-31 summarizes the major debt and equity securities and their reporting treatment. ILLUSTRATION 17-31 Category* Balance Sheet Income Statement Summary of Treatment of Trading (debt and equity Investments shown at fair value. Interest and dividends are recognized Major Debt and Equity securities) Current assets. as revenue. Unrealized holding Securities gains and losses are included in net income. Available-for-sale (debt Investments shown at fair value. Interest and dividends are recognized Gateway to and equity securities) Current or long-term assets. as revenue. Unrealized holding the Profession Unrealized holding gains and gains and losses are not included Discussion of Special losses are a separate component in net income but in other Issues Related to of stockholders’ equity. comprehensive income. Investments Held-to-maturity (debt Investments shown at amortized Interest is recognized as revenue. securities) cost. Current or long-term assets. Equity method and/or Investments originally are carried Revenue is recognized to the consolidation (equity at cost, are periodically adjusted extent of the investee’s earnings You will securities) by the investor’s share of the or losses reported subsequent to want to investee’s earnings or losses, and the date of investment. read the are decreased by all dividends IFRS INSIGHTS received from the investee. on pages 1026–1039 Classified as long-term. for discussion of

*Companies have the option to report financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. If a company chooses to use the fair option for some of its financial instruments, these assets IFRS related to or liabilities should be reported separately from other financial instruments that use a different valuation basis. To accomplish the accounting for separate reporting, a company may either (a) report separate line items for the fair value and non–fair value amounts or (b) report investments. the total fair value and non–fair value amounts in one line and parenthetically report the fair value amount in that line also.13 Evolving Issue CLASSIFICATION AND MEASUREMENT—THE LONG ROAD As discussed in the opening story, the FASB and IASB have Other Comprehensive Income” category for some debt in- been on divergent approaches to financial instrument classi- struments. The following table summarizes the agreed-upon fication and measurement. These differences have narrowed approach in comparison to current GAAP. recently with the decision to permit a “Fair Value through Current Classification Proposed Classification Fair value through Trading net income (FV-NI) S o m e s hift to F V-NI Fair value through other Available-for-sale comprehensive income S o m e s hift to F V-O CI (FV-OCI) Held-to-maturity Amortized cost Source: J.P. Morgan. As indicated, under the new model, there will still be the FV-NI category will likely be larger than the current trad- three “buckets” although the proportions of financial instru- ing category because publicly traded companies will likely ments within the new classifications will change. For example, be required to classify all equity securities (both marketable 13Not surprisingly, the disclosure requirements for investments and other financial assets and liabilities are extensive. We provide an expanded discussion with examples of these disclosure requirements in Appendix 17C. 976 Chapter 17 Investments and nonmarketable) in FV-NI. Currently, companies are able maturity will not be eligible for amortized cost classifica- to classify some equities in the available-for-sale category if tion and instead will end up being moved into the FV-OCI particular criteria are met. To the extent a company has tradi- category. tionally classified a large portion of its equity securities in the For most companies, the amortized cost category generally available-for-sale category, more equity instruments accounted will be smaller than the current held-to-maturity category for in the FV-NI category could create more net income vola- because securities will no longer be eligible for classification in tility than under current GAAP. this category. Our expectation is that most of the instruments The FV-OCI category may be larger or smaller than a that will no longer meet the eligibility criteria for amortized company’s current available-for-sale category. On the one cost accounting will likely move to the FV-OCI category. hand, equities will no longer be eligible for classification in The FASB is expected to issue a revised proposal in 2013. this category, which will make it smaller. On the other hand, The IASB has specified that a revised IFRS 9 will be effective some instruments that are currently classified as held-to- for annual periods beginning on or after January 1, 2015. Source: Adapted from D. Mott, “FASB and IASB Come Together on the Classification and Measurement of Debt Instruments,” Global Equity Research—Accounting Issues, J.P. Morgan (25 May 2012). KEY TERMS SUMMARY OF LEARNING OBJECTIVES amortized cost, 953 available-for-sale securities, 952 1 Identify the three categories of debt securities and describe the consolidated financial accounting and reporting treatment for each category. (1) Carry and report statements, 966 held-to-maturity debt securities at amortized cost. (2) Value trading debt securities for reporting controlling interest, 966 purposes at fair value, with unrealized holding gains or losses included in net income.

debt securities, 952 (3) Value available-for-sale debt securities for reporting purposes at fair value, with unreal- effective-interest ized holding gains or losses reported as other comprehensive income and as a separate method, 954 component of stockholders’ equity. equity method, 965 equity securities, 960 2 Understand the procedures for discount and premium amortization exchange for noncash on bond investments. Similar to bonds payable, companies should amortize dis- consideration, 962(n) count or premium on bond investments using the effective-interest method. They apply fair value, 953 the effective-interest rate or yield to the beginning carrying value of the investment for Fair Value Adjustment, 957 each interest period in order to compute interest revenue. fair value method, 961 3 Identify the categories of equity securities and describe the ac- gains trading, 959 counting and reporting treatment for each category. The degree to which held-to-maturity one corporation (investor) acquires an interest in the common stock of another corpo- securities, 952 ration (investee) generally determines the accounting treatment for the investment. holding gain or loss, 959 Long-term investments by one corporation in the common stock of another can be impairment, 969 classified according to the percentage of the voting stock of the investee held by the investee, 961 investor. investor, 961 4 Explain the equity method of accounting and compare it to the fair parent, 966 value method for equity securities. Under the equity method, the investor and the reclassification investee acknowledge a substantive economic relationship. The company originally adjustment, 970 records the investment at cost but subsequently adjusts the amount each period for security, 952(n) changes in the net assets of the investee. That is, the investor’s proportionate share of significant influence, 964 the earnings (losses) of the investee periodically increases (decreases) the investment’s subsidiary, 966 carrying amount. All dividends received by the investor from the investee decrease the trading securities, 952 investment’s carrying amount. Under the fair value method, a company reports the equity investment at fair value each reporting period irrespective of the investee’s earn- ings or dividends paid to it. A company applies the equity method to investment hold- ings between 20 percent and 50 percent of ownership. It applies the fair value method to holdings below 20 percent. Appendix 17A: Accounting for Derivative Instruments 977 5 Describe the accounting for the fair value option and for impairments of debt and equity investments. Companies have the option to report most finan- cial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument-by-instrument basis. The fair value option is generally available only at the time a company first pur- chases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. Impairments of debt and equity securities are losses in value that are determined to be other than temporary, are based on a fair value test, and are charged to income. 6 Describe the reporting of reclassification adjustments and the ac- counting for transfers between categories. A company needs a reclassification adjustment when it reports realized gains or losses as part of net income but also shows the amounts as part of other comprehensive income in the current or in previous periods. Companies should report unrealized holding gains or losses related to available-for-sale securities in other comprehensive income and the aggregate balance as accumulated comprehensive income on the balance sheet. Transfers of securities between categories of investments should be accounted for at fair value, with unrealized holding gains or losses treated in accordance with the nature of the transfer.

APPENDIX 17A ACCOUNTING FOR DERIVATIVE INSTRUMENTS Until the early 1970s, most financial managers worked in a cozy, if unthrilling, 7 LEARNING OBJECTIVE world. Since then, constant change caused by volatile markets, new technology, Describe the uses of and accounting and deregulation has increased the risks to businesses. In response, the financial for derivatives. community developed products to manage these risks. These products—called derivative financial instruments or simply derivatives— are useful for managing risk. Companies use the fair values or cash flows of these in- struments to offset the changes in fair values or cash flows of the at-risk assets. The development of powerful computing and communication technology has aided the growth in derivative use. This technology provides new ways to analyze information about markets as well as the power to process high volumes of payments. DEFINING DERIVATIVES In order to understand derivatives, consider the following examples. Example 1—Forward Contract. Assume that a company like Dell believes that the price of Google’s stock will increase substantially in the next 3 months. Unfortunately, it does not have the cash resources to purchase the stock today. Dell therefore enters into a contract with a broker for delivery of 10,000 shares of Google stock in 3 months at the price of $110 per share. Dell has entered into a forward contract, a type of derivative. As a result of the con- tract, Dell has received the right to receive 10,000 shares of Google stock in 3 months. Further, it has an obligation to pay $110 per share at that time. What is the benefit of this derivative contract? Dell can buy Google stock today and take delivery in 3 months. If the price goes up, as it expects, Dell profits. If the price goes down, Dell loses. 978 Chapter 17 Investments Example 2—Option Contract. Now suppose that Dell needs 2 weeks to decide whether to purchase Google stock. It therefore enters into a different type of contract, one that gives it the right to purchase Google stock at its current price any time within the next 2 weeks. As part of the contract, the broker charges $3,000 for holding the contract open for 2 weeks at a set price. Dell has now entered into an option contract, another type of derivative. As a result of this contract, it has received the right but not the obligation to purchase this stock. If the price of the Google stock increases in the next 2 weeks, Dell exercises its option. In this case, the cost of the stock is the price of the stock stated in the contract, plus the cost of the option contract. If the price does not increase, Dell does not exercise the contract but still incurs the cost for the option. The forward contract and the option contract both involve a future delivery of stock. The value of the contract relies on the underlying asset—the Google stock. Thus, these financial instruments are known as derivatives because they derive their value from values of other assets (e.g., stocks, bonds, or commodities). Or, put another way, their value relates to a market-determined indicator (e.g., stock price, interest rates, or the Standard and Poor’s 500 stock composite index). In this appendix, we discuss the accounting for three different types of derivatives: 1. Financial forwards or fi nancial futures. 2. Options. 3. Swaps. WHO USES DERIVATIVES, AND WHY? Whether to protect for changes in interest rates, the weather, stock prices, oil prices, or foreign currencies, derivative contracts help to smooth the fluctuations caused by vari- ous types of risks. A company that wants to ensure against certain types of business risks often uses derivative contracts to achieve this objective.14 Producers and Consumers To illustrate, assume that Heartland Ag is a large producer of potatoes for the consumer market. The present price for potatoes is excellent. Unfortunately, Heart- land needs two months to harvest its potatoes and deliver them to the market. Because Heartland expects the price of potatoes to drop in the coming months, it

signs a forward contract. It agrees to sell its potatoes today at the current market price for delivery in 2 months. Who would buy this contract? Suppose on the other side of the contract is McDonald’s Corporation. McDonald’s wants to have potatoes (for French fries) in 2 months and believes that prices will increase. McDonald’s is therefore agreeable to accepting de- livery in 2 months at current prices. It knows that it will need potatoes in 2 months and that it can make an acceptable profit at this price level. In this situation, if the price of potatoes increases before delivery, Heartland loses and McDonald’s wins. Conversely, if the price decreases, Heartland wins and McDonald’s loses. However, the objective is not to gamble on the outcome. Regardless of which way the price moves, both Heartland and McDonald’s have received a price at 14Derivatives are traded on many exchanges throughout the world. In addition, many derivative contracts (primarily interest rate swaps) are privately negotiated. Appendix 17A: Accounting for Derivative Instruments 979 which they obtain an acceptable profit. In this case, although Heartland is a producer and McDonald’s is a consumer, both companies are hedgers. They both hedge their posi- tions to ensure an acceptable financial result. Commodity prices are volatile. They depend on weather, crop production, and general economic conditions. For the producer and the consumer to plan effectively, it makes good sense to lock in specific future revenues or costs in order to run their businesses successfully. Speculators and Arbitrageurs In some cases, instead of McDonald’s taking a position in the forward contract, a specu- lator may purchase the contract from Heartland. The speculator bets that the price of potatoes will rise, thereby increasing the value of the forward contract. The speculator, who may be in the market for only a few hours, will then sell the forward contract to another speculator or to a company like McDonald’s. Arbitrageurs also use derivatives. These market players attempt to exploit ineffi- ciencies in markets. They seek to lock in profits by simultaneously entering into transac- tions in two or more markets. For example, an arbitrageur might trade in a futures contract. At the same time, the arbitrageur will also trade in the commodity underlying the futures contract, hoping to achieve small price gains on the difference between the two. Markets rely on speculators and arbitrageurs to keep the market liquid on a daily basis. In these illustrations, we explained why Heartland (the producer) and McDonald’s (the consumer) would become involved in a derivative contract. Consider other types of situations that companies face. 1. Airlines, like Delta, Southwest, and United, are affected by changes in the price of jet fuel. 2. Financial institutions, such as Citigroup, Bankers Trust, and BMO Harris, are involved in borrowing and lending funds that are affected by changes in interest rates. 3. Multinational corporations, like Cisco Systems, Coca-Cola, and General Electric, are subject to changes in foreign exchange rates. In fact, most corporations are involved in some form of derivatives transactions. Companies give these reasons (in their annual reports) as to why they use derivatives: 1. ExxonMobil uses derivatives to hedge its exposure to fl uctuations in interest rates, foreign currency exchange rates, and hydrocarbon prices. 2. Caterpillar uses derivatives to manage foreign currency exchange rates, interest rates, and commodity price exposure. 3. Johnson & Johnson uses derivatives to manage the impact of interest rate and foreign exchange rate changes on earnings and cash fl ows. Many corporations use derivatives extensively and successfully. However, deriva- tives can be dangerous. All parties involved must understand the risks and rewards associated with these contracts.15 15There are some well-publicized examples of companies that have suffered considerable losses using derivatives. For example, companies such as Fannie Mae (U.S.), Enron (U.S.), Showa

Shell Sekiyu (Japan), Metallgesellschaft (Germany), Procter & Gamble (U.S.), and Air Products & Chemicals (U.S.) incurred significant losses from investments in derivative instruments. 980 Chapter 17 Investments BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVES The FASB concluded that derivatives such as forwards and options are assets and liabil- ities. It also concluded that companies should report them in the balance sheet at fair value.16 The Board believes that fair value will provide statement users the best information about derivatives. Relying on some other basis of valuation for derivatives, such as historical cost, does not make sense. Why? Because many derivatives have a historical cost of zero. Furthermore, the markets for derivatives, and the assets upon which derivatives’ values rely, are well developed. As a result, the Board believes that companies can determine reliable fair value amounts for derivatives.17 On the income statement, a company should recognize any unrealized gain or loss in income, if it uses the derivative for speculation purposes. If using the derivative for hedging purposes, the accounting for any gain or loss depends on the type of hedge used. We discuss the accounting for hedged transactions later in the appendix. In summary, companies follow these guidelines in accounting for derivatives. 1. Recognize derivatives in the fi nancial statements as assets and liabilities. 2. Report derivatives at fair value. 3. Recognize gains and losses resulting from speculation in derivatives immediately in income. 4. Report gains and losses resulting from hedge transactions differently, depending on the type of hedge. Example of Derivative Financial Instrument—Speculation To illustrate the measurement and reporting of a derivative for speculative purposes, we examine a derivative whose value depends on the market price of Laredo Inc. common stock. A company can realize a gain from the increase in the value of the Laredo shares with the use of a derivative, such as a call option.18 A call option gives the holder the right, but not the obligation, to buy shares at a preset price. This price is often referred to as the strike price or the exercise price. 16GAAP covers accounting and reporting for all derivative instruments, whether financial or not. In this appendix, we focus on derivative financial instruments because of their widespread use in practice. [7] 17As discussed in earlier chapters, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is therefore a market-based measure. The FASB has also developed a fair value hierarchy, which indicates the priority of valuation techniques to use to determine fair value. Level 1 fair value measures are based on observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 measures are based on inputs other than quoted prices included in Level 1 but that can be corroborated with observable data. Level 3 fair values are based on unobservable inputs (for example, a company’s own data or assumptions). Thus, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. For Level 3 (the least reliable), much judgment is needed, based on the best information available, to arrive at a relevant and reliable fair value measurement. [8] 18Investors can use a different type of option contract—a put option—to realize a gain if anticipating a decline in the Laredo stock value. A put option gives the holder the option to sell shares at a preset price. Thus, a put option increases in value when the underlying asset decreases in value. Appendix 17A: Accounting for Derivative Instruments 981 For example, assume a company enters into a call option contract with Baird Invest- ment Co., which gives it the option to purchase Laredo stock at $100 per share.19 If the

price of Laredo stock increases above $100, the company can exercise this option and purchase the shares for $100 per share. If Laredo’s stock never increases above $100 per share, the call option is worthless. Accounting Entries. To illustrate the accounting for a call option, assume that the company purchases a call option contract on January 2, 2014, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2014. The company purchases the call option for $400 and makes the following entry. January 2, 2014 Call Option 400 Cash 400 This payment is referred to as the option premium. It is generally much less than the cost of purchasing the shares directly. The option premium consists of two amounts: (1) intrinsic value and (2) time value. Illustration 17A-1 shows the formula to compute the option premium. ILLUSTRATION 17A-1 Option Premium " ! Option Premium Intrinsic Value Time Value Formula Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2014, the intrinsic value is zero because the market price equals the preset strike price. Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is $400.20 The following additional data are available with respect to the call option. Date Market Price of Laredo Shares Time Value of Call Option March 31, 2014 $120 per share $100 April 16, 2014 $115 per share $ 60 As indicated, on March 31, 2014, the price of Laredo shares increases to $120 per share. The intrinsic value of the call option contract is now $20,000. That is, the company can exercise the call option and purchase 1,000 shares from Baird Investment for $100 per share. It can then sell the shares in the market for $120 per share. This gives the 19Baird Investment Co. is referred to as the counterparty. Counterparties frequently are investment bankers or other companies that hold inventories of financial instruments. 20This cost is estimated using option-pricing models, such as the Black-Scholes equation. The volatility of the underlying stock, the expected life of the option, the risk-free rate of interest, and expected dividends on the underlying stock during the option term affect the Black-Scholes fair value estimate. 982 Chapter 17 Investments company a gain of $20,000 ($120,000 2 $100,000) on the option contract.21 It records the increase in the intrinsic value of the option as follows. March 31, 2014 Call Option 20,000 Unrealized Holding Gain or Loss—Income 20,000 A market appraisal indicates that the time value of the option at March 31, 2014, is $100.22 The company records this change in value of the option as follows. March 31, 2014 Unrealized Holding Gain or Loss—Income 300 Call Option ($400 2 $100) 300 At March 31, 2014, the company reports the call option in its balance sheet at fair value of $20,100.23 The unrealized holding gain increases net income for the period. The loss on the time value of the option decreases net income. On April 16, 2014, the company settles the option before it expires. To properly re- cord the settlement, it updates the value of the option for the decrease in the intrinsic value of $5,000 ([$20 2 $15]) 3 1,000) as follows. April 16, 2014 Unrealized Holding Gain or Loss—Income 5,000 Call Option 5,000 The decrease in the time value of the option of $40 ($100 2 $60) is recorded as follows. April 16, 2014 Unrealized Holding Gain or Loss—Income 40 Call Option 40 Thus, at the time of the settlement, the call option’s carrying value is as follows. Call Option

January 2, 2014 400 March 31, 2014 300 March 31, 2014 20,000 April 16, 2014 5,000 April 16, 2014 40 Balance, April 16, 2014 15,060 The company records the settlement of the option contract with Baird as follows. April 16, 2014 Cash 15,000 Loss on Settlement of Call Option 60 Call Option 15,060 Illustration 17A-2 summarizes the effects of the call option contract on net income. ILLUSTRATION 17A-2 Date Transaction Income (Loss) Effect Effect on Income— March 31, 2014 Net increase in value of call $19,700 Derivative Financial option ($20,000 2 $300) Instrument April 16, 2014 Decrease in value of call option (5,040) ($5,000 1 $40) April 16, 2014 Settle call option (60) Total net income $14,600 21In practice, investors generally do not have to actually buy and sell the Laredo shares to settle the option and realize the gain. This is referred to as the net settlement feature of option contracts. 22The decline in value reflects both the decreased likelihood that the Laredo shares will continue to increase in value over the option period and the shorter time to maturity of the option contract. 23As indicated earlier, the total value of the option at any point in time equals the intrinsic value plus the time value. Appendix 17A: Accounting for Derivative Instruments 983 The accounting summarized in Illustration 17A-2 is in accord with GAAP. That is, because the call option meets the definition of an asset, the company records it in the balance sheet on March 31, 2014. Furthermore, it reports the call option at fair value, with any gains or losses reported in income. Differences Between Traditional and Derivative Financial Instruments How does a traditional financial instrument differ from a derivative one? A derivative financial instrument has the following three basic characteristics. [9] 1. The instrument has (1) one or more underlyings and (2) an identifi ed payment pro- vision. An underlying is a specifi ed interest rate, security price, commodity price, index of prices or rates, or other market-related variable. The interaction of the underlying, with the face amount or the number of units specifi ed in the derivative contract (the notional amounts), determines payment. For example, the value of the call option increased in value when the value of the Laredo stock increased. In this case, the underlying is the stock price. To arrive at the payment provision, multiply the change in the stock price by the number of shares (notional amount). 2. The instrument requires little or no investment at the inception of the contract. To illustrate, the company paid a small premium to purchase the call option—an amount much less than if purchasing the Laredo shares as a direct investment. 3. The instrument requires or permits net settlement. As indicated in the call option example, the company could realize a profi t on the call option without taking possession of the shares. This net settlement feature reduces the transaction costs associated with derivatives. Illustration 17A-3 summarizes the differences between traditional and derivative financial instruments. Here, we use a trading security for the traditional financial instru- ment and a call option as an example of a derivative one. ILLUSTRATION 17A-3 Traditional Financial Instrument Derivative Financial Instrument Features of Traditional Feature (Trading Security) (Call Option) and Derivative Financial Payment provision Stock price times the number of Change in stock price (underlying) Instruments shares. times number of shares (notional amount). Initial investment Investor pays full cost. Initial investment is much less than full cost. Settlement Deliver stock to receive cash. Receive cash equivalent, based on changes in stock price times the number of shares. DERIVATIVES USED FOR HEDGING Flexibility in use and the low-cost features of derivatives relative to traditional financial instruments explain the popularity of derivatives. An additional use for derivatives is in risk management. For example, companies such as Coca-Cola, ExxonMobil, and General Electric borrow and lend substantial amounts in credit markets. In doing so, they are

exposed to significant interest rate risk. That is, they face substantial risk that the fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease. These same companies also have significant international operations. As such, 984 Chapter 17 Investments they are also exposed to exchange rate risk—the risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses. Companies can use derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. This use of derivatives is referred to as hedging. GAAP established accounting and reporting standards for derivative financial instruments used in hedging activities. The FASB allows special accounting for two types of hedges—fair value and cash flow hedges.24 What do the numbers mean? RISKY BUSINESS As shown in the graph below, use of derivatives has grown derivatives are large companies and various fi nancial insti- substantially in the past 10 years. In fact, over $450 trillion tutions, which continue to fi nd new uses for derivatives for (in notional amounts) in derivative contracts were in play speculation and risk management at the end of 2010. The primary players in the market for Total Swaps and Equity Derivatives ($ in trillions) $500 400 300 200 100 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Data from International Swaps and Derivatives Association Market Survey (2011). Financial engineers continue to develop new uses for de- (MBS). However, when the real estate market went south, the rivatives, many times through the use of increasingly complex MBS defaulted, exposing large international fi nancial institu- webs of transactions, spanning a number of markets. As new tions, like Barclays, AIG, and Bank of America, to massive uses for derivatives appear, the fi nancial system as a whole losses. The losses were so widespread that government bail- can be dramatically affected. As a result, some market-watchers outs were required to prevent international securities markets are concerned about the risk that a crisis in one company or from collapsing. In response, market regulators are propos- sector could bring the entire fi nancial system to its knees. ing new rules to mitigate risks to broader markets from This was the case recently when credit default swaps were derivatives trading. used to facilitate the sales of mortgage-backed securities Source: P. Eavis, “Bill on Derivatives Overhaul Is Long Overdue,” Wall Street Journal (April 14, 2010). Fair Value Hedge In a fair value hedge, a company uses a derivative to hedge (offset) the exposure LEARNING OBJECTIVE 8 to changes in the fair value of a recognized asset or liability or of an unrecognized Explain how to account for a fair commitment. In a perfectly hedged position, the gain or loss on the fair value of value hedge. the derivative equals and offsets that of the hedged asset or liability. 24GAAP also addresses the accounting for certain foreign currency hedging transactions. In general, these transactions are special cases of the two hedges we discuss here. [10] Understand- ing of foreign currency hedging transactions requires knowledge related to consolidation of multinational entities, which is beyond the scope of this textbook. Appendix 17A: Accounting for Derivative Instruments 985 Companies commonly use several types of fair value hedges. For example, companies use interest rate swaps to hedge the risk that changes in interest rates will impact the fair value of debt obligations. Or, they use put options to hedge the risk that an equity investment will decline in value. To illustrate a fair value hedge, assume that on April 1, 2014, Hayward Co. purchases 100 shares of Sonoma stock at a market price of $100 per share. Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as available-for-sale. Hayward records this available-for-sale investment as follows.

April 1, 2014 Equity Investments 10,000 Cash 10,000 Hayward records available-for-sale securities at fair value on the balance sheet. It reports unrealized gains and losses in equity as part of other comprehensive income.25 Fortunately for Hayward, the value of the Sonoma shares increases to $125 per share during 2014. Hayward records the gain on this investment as follows. December 31, 2014 Fair Value Adjustment (available-for-sale) 2,500 Unrealized Holding Gain or Loss—Equity 2,500 Illustration 17A-4 indicates how Hayward reports the Sonoma investment in its balance sheet. ILLUSTRATION 17A-4 HAYWARD CO. Balance Sheet BALANCE SHEET (PARTIAL) Presentation of Available- DECEMBER 31, 2014 for-Sale Securities Assets Equity investments (available-for-sale) $12,500 Stockholders’ Equity Accumulated other comprehensive income Unrealized holding gain $2,500 While Hayward benefits from an increase in the price of Sonoma shares, it is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 shares of Sonoma stock. Hayward enters into the put option contract on January 2, 2015, and designates the op- tion as a fair value hedge of the Sonoma investment. This put option (which expires in two years) gives Hayward the option to sell Sonoma shares at a price of $125. Since the exercise price equals the current market price, no entry is necessary at inception of the put option.26 January 2, 2015 No entry required. A memorandum indicates the signing of the put option contract and its designation as a fair value hedge for the Sonoma investment. At December 31, 2015, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment. December 31, 2015 Unrealized Holding Gain or Loss—Income 500 Fair Value Adjustment (available-for-sale) 500 25We discussed the distinction between trading and available-for-sale investments in the chapter. 26To simplify the example, we assume no premium is paid for the option. 986 Chapter 17 Investments Note that upon designation of the hedge, the accounting for the available-for-sale security changes from regular GAAP. That is, Hayward records the unrealized holding loss in income, not in equity. If Hayward had not followed this accounting, a mismatch of gains and losses in the income statement would result. Thus, special accounting for the hedged item (in this case, an available-for-sale security) is necessary in a fair value hedge. The following journal entry records the increase in value of the put option on Sonoma shares. December 31, 2015 Put Option 500 Unrealized Holding Gain or Loss—Income 500 The decline in the price of Sonoma shares results in an increase in the fair value of the put option. That is, Hayward could realize a gain on the put option by purchasing 100 shares in the open market for $120 and then exercise the put option, selling the shares for $125. This results in a gain to Hayward of $500 (100 shares 3 [$125 2 $120]).27 Illustration 17A-5 indicates how Hayward reports the amounts related to the Sonoma investment and the put option. ILLUSTRATION 17A-5 HAYWARD CO. Balance Sheet BALANCE SHEET (PARTIAL) Presentation of Fair Value DECEMBER 31, 2015 Hedge Assets Equity investments (available-for-sale) $12,000 Put option 500 The increase in fair value on the option offsets or hedges the decline in value on Hayward’s available-for-sale security. By using fair value accounting for both financial instruments, the financial statements reflect the underlying substance of Hayward’s net exposure to the risks of holding Sonoma stock. By using fair value accounting for both these financial instruments, the balance sheet reports the amount that Hayward would receive on the investment and the put option contract if Hayward sold and settled them, respectively. Illustration 17A-6 illustrates the reporting of the effects of the hedging transaction on income for the year ended December 31, 2015. ILLUSTRATION 17A-6 HAYWARD CO.

Income Statement INCOME STATEMENT (PARTIAL) Presentation of Fair Value FOR THE YEAR ENDED DECEMBER 31, 2015 Hedge Other Income Unrealized holding gain—put option $ 500 Unrealized holding loss—available-for-sale securities (500) The income statement indicates that the gain on the put option offsets the loss on the available-for-sale securities.28 The reporting for these financial instruments, even when 27In practice, Hayward generally does not have to actually buy and sell the Sonoma shares to realize this gain. Rather, unless the counterparty wants to hold Hayward shares, Hayward can “close out” the contract by having the counterparty pay it $500 in cash. This is an example of the net settlement feature of derivatives. 28Note that the fair value changes in the option contract will not offset increases in the value of the Hayward investment. Should the price of Sonoma stock increase above $125 per share, Hayward would have no incentive to exercise the put option. Appendix 17A: Accounting for Derivative Instruments 987 they reflect a hedging relationship, illustrates why the FASB argued that fair value ac- counting provides the most relevant information about financial instruments, including derivatives. Cash Flow Hedge Companies use cash flow hedges to hedge exposures to cash flow risk, which 9 LEARNING OBJECTIVE results from the variability in cash flows. The FASB allows special accounting for Explain how to account for a cash cash flow hedges. Generally, companies measure and report derivatives at fair flow hedge. value on the balance sheet. They report gains and losses directly in net income. However, companies account for derivatives used in cash flow hedges at fair value on the balance sheet, but they record gains or losses in equity, as part of other comprehen- sive income. To illustrate, assume that in September 2014, Allied Can Co. anticipates pur- International chasing 1,000 metric tons of aluminum in January 2015. Concerned that prices Perspective for aluminum will increase in the next few months, Allied wants to hedge the Under IFRS, companies record risk that it might pay higher prices for inventory in January 2015. As a result, unrealized holding gains or Allied enters into an aluminum futures contract. losses on cash fl ow hedges as A futures contract gives the holder the right and the obligation to purchase adjustments to the value of the an asset at a preset price for a specified period of time.29 In this case, the alumi- hedged item, not as “Other num futures contract gives Allied the right and the obligation to purchase 1,000 comprehensive income.” metric tons of aluminum for $1,550 per ton. This contract price is good until the contract expires in January 2015. The underlying for this derivative is the price of alumi- num. If the price of aluminum rises above $1,550, the value of the futures contract to Allied increases. Why? Because Allied will be able to purchase the aluminum at the lower price of $1,550 per ton.30 Allied enters into the futures contract on September 1, 2014. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore, no entry is necessary. September 2014 No entry required. A memorandum indicates the signing of the futures contract. At December 31, 2014, the price for January delivery of aluminum increases to $1,575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract. December 31, 2014 Futures Contract 25,000 Unrealized Holding Gain or Loss—Equity ([$1,575 2 $1,550] 3 1,000 tons) 25,000 Allied reports the futures contract in the balance sheet as a current asset. It reports the gain on the futures contract as part of other comprehensive income. 29A futures contract is a firm contractual agreement between a buyer and seller for a specified asset on a fixed date in the future which also trades on an exchange. The contract also has a standard specification so both parties know exactly what is being traded. A forward is similar

but is not traded on an exchange and does not have standardized conditions. 30As with the earlier call option example, the actual aluminum does not have to be exchanged. Rather, the parties to the futures contract settle by paying the cash difference between the futures price and the price of aluminum on each settlement date. 988 Chapter 17 Investments Since Allied has not yet purchased and sold the inventory, this gain arises from an anticipated transaction. In this type of transaction, a company accumulates in equity gains or losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby affecting earnings. In January 2015, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry.31 January 2015 Aluminum Inventory 1,575,000 Cash ($1,575 3 1,000 tons) 1,575,000 At the same time, Allied makes final settlement on the futures contract. It records the following entry. January 2015 Cash 25,000 Futures Contract ($1,575,000 2 $1,550,000) 25,000 Through use of the futures contract derivative, Allied fixes the cost of its inventory. The $25,000 futures contract settlement offsets the amount paid to purchase the inven- tory at the prevailing market price of $1,575,000. The result: net cash outflow of $1,550 per metric ton, as desired. As Illustration 17A-7 shows, Allied has therefore effectively hedged the cash flow for the purchase of inventory. ILLUSTRATION 17A-7 Effect of Hedge on Cash Flows Anticipated Cash Flows Actual Cash Flows Actual cash paid $1,575,000 Wish to fix cash paid = Less: Cash received for inventory at $1,550,000 on futures contract (25,000) Final cash paid $1,550,000 There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory, affecting earnings through cost of goods sold. For example, assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2015) is $1,700,000. Allied sells the cans in July 2015 for $2,000,000, and records this sale as follows. July 2015 Cash 2,000,000 Sales Revenue 2,000,000 Cost of Goods Sold 1,700,000 Inventory (cans) 1,700,000 Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction. 31In practice, futures contracts are settled on a daily basis. For our purposes, we show only one settlement for the entire amount. Appendix 17A: Accounting for Derivative Instruments 989 July 2015 Unrealized Holding Gain or Loss—Equity 25,000 Cost of Goods Sold 25,000 The gain on the futures contract, which Allied reported as part of other comprehen- sive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is $1,550,000. The futures contract has worked as planned. Allied has managed the cash paid for aluminum inventory and the amount of cost of goods sold. OTHER REPORTING ISSUES The preceding examples illustrate the basic reporting issues related to the account- 10 LEARNING OBJECTIVE ing for derivatives. Next, we discuss the following additional issues: Identify special reporting issues related to derivative financial instruments that 1. The accounting for embedded derivatives. cause unique accounting problems. 2. Qualifying hedge criteria. Embedded Derivatives As we indicated at the beginning of this appendix, rapid innovation in the development of complex financial instruments drove efforts toward unifying and improving the accounting standards for derivatives. In recent years, this innovation has led to the development of hybrid securities. These securities have characteristics of both debt and equity. They often combine traditional and derivative financial instruments. For example, a convertible bond (discussed in Chapter 16) is a hybrid instrument. It consists of two parts: (1) a debt security, referred to as the host security, combined with

(2) an option to convert the bond to shares of common stock, the embedded derivative. To provide consistency in accounting for similar derivatives, a company must ac- count for embedded derivatives similarly to other derivatives. Therefore, to account for an embedded derivative, a company should separate it from the host security and then account for it using the accounting for derivatives. This separation process is referred to as bifurcation.32 Thus, a company investing in a convertible bond must separate the stock option component of the instrument. It then accounts for the derivative (the stock option) at fair value and the host instrument (the debt) according to GAAP, as if there were no embedded derivative.33 Qualifying Hedge Criteria The FASB identified certain criteria that hedging transactions must meet before International requiring the special accounting for hedges. The FASB designed these criteria Perspective to ensure the use of hedge accounting in a consistent manner across different IFRS qualifying hedge criteria hedge transactions. The general criteria relate to the following areas. are similar to those used in GAAP. 1. Documentation, risk management, and designation. At inception of the hedge, there must be formal documentation of the hedging relationship, the company’s risk management objective, and the strategy for undertaking the hedge. Designation 32A company can also designate such a derivative as a hedging instrument. The company would apply the hedge accounting provisions outlined earlier in the chapter. 33The issuer of the convertible bonds would not bifurcate the option component of the convert- ible bonds payable. GAAP explicitly precludes embedded derivative accounting for an embedded derivative that is indexed to a company’s own common stock. If the conversion feature was tied to another company’s stock, then the derivative would be bifurcated. 990 Chapter 17 Investments refers to identifying the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and how the hedging instrument will offset changes in the fair value or cash fl ows attributable to the hedged risk. The FASB decided that documentation and designation are critical to the im- plementation of the special accounting for hedges. Without these requirements, companies might try to apply the hedge accounting provisions retroactively, only in response to negative changes in market conditions, to offset the negative impact of a transaction on the fi nancial statements. Allowing special hedge accounting in such a setting could mask the speculative nature of the original transaction. 2. Effectiveness of the hedging relationship. At inception and on an ongoing basis, the hedging relationship should be highly effective in achieving offsetting changes in fair value or cash fl ows. Companies must assess effectiveness whenever preparing fi nancial statements. The general guideline for effectiveness is that the fair values or cash fl ows of the hedging instrument (the derivative) and the hedged item exhibit a high degree of correlation. In practice, high effectiveness is assumed when the correlation is close to one (e.g., within plus or minus .10). In our earlier hedging examples (put option and the futures contract on aluminum inventory), the fair values and cash fl ows are perfectly correlated. That is, when the cash payment for the inventory purchase in- creased, it offset, dollar for dollar, the cash received on the futures contract. If the effectiveness criterion is not met, either at inception or because of changes following inception of the hedging relationship, the FASB no longer allows special hedge accounting. The company should then account for the derivative as a free- standing derivative.34 3. Effect on reported earnings of changes in fair values or cash fl ows. A change in the fair value of a hedged item or variation in the cash fl ow of a hedged forecasted transaction must have the potential to change the amount recognized in reported earnings.35 There is no need for special hedge accounting if a company accounts for

both the hedging instrument and the hedged item at fair value under existing GAAP. In this case, earnings will properly refl ect the offsetting gains and losses. For example, special accounting is not needed for a fair value hedge of a trading security, because a company accounts for both the investment and the derivative at fair value on the balance sheet with gains or losses reported in earnings. Thus, “special” hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP.36 Summary of Derivatives Accounting Illustration 17A-8 summarizes the accounting provisions for derivatives and hedging transactions. 34That is, the accounting for the part of a derivative that is not effective in a hedge is at fair value, with gains and losses recorded in income. 35GAAP gives companies the option to measure most types of financial instruments—from equity investments to debt issued by the company—at fair value. Changes in fair value are recognized in net income each reporting period. Thus, GAAP provides companies with the opportunity to hedge their financial instruments without the complexity inherent in applying hedge accounting provisions. For example, if the fair value option is used, bifurcation of an embedded derivative is not required. [11] 36An important criterion specific to cash flow hedges is that the forecasted transaction in a cash flow hedge “is likely to occur.” A company should support this probability (defined as significantly greater than the term “more likely than not”) by observable facts such as frequency of similar past transactions and its financial and operational ability to carry out the transaction. Appendix 17A: Accounting for Derivative Instruments 991 ILLUSTRATION 17A-8 Accounting for Accounting for Summary of Derivative Derivative Use Derivative Hedged Item Common Example Accounting under GAAP Speculation At fair value with unreal- Not applicable. Call or put option on ized holding gains and an equity security. losses recorded in income. Hedging Fair value At fair value with At fair value with gains Put option to hedge holding gains and losses and losses recorded an equity recorded in income. in income. investment. Cash flow At fair value with unrealized Use other generally Use of a futures holding gains and losses accepted accounting contract to hedge from the hedge recorded principles for the a forecasted in other comprehensive hedged item. purchase of income, and reclassified inventory. in income when the hedged transaction’s cash flows affect earnings. As indicated, the general accounting for derivatives relies on fair values. GAAP also establishes special accounting guidance when companies use derivatives for hedging purposes. For example, when a company uses a put option to hedge price changes in an available-for-sale stock investment in a fair value hedge (see the Hayward example ear- lier), it records unrealized gains on the investment in earnings, which is not GAAP for available-for-sale securities without such a hedge. This special accounting is justified in order to accurately report the nature of the hedging relationship in the balance sheet (recording both the put option and the investment at fair value) and in the income state- ment (reporting offsetting gains and losses in the same period). Special accounting also is used for cash flow hedges. Companies account for de- rivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record unrealized holding gains or losses in other comprehensive income until selling or settling the hedged item. In a cash flow hedge, a company continues to record the hedged item at its historical cost. Disclosure requirements for derivatives are complex. Recent pronouncements on fair value information and financial instruments provide a helpful disclosure framework for reporting derivative instruments. Appendix 17C illustrates many of these disclo- sures, except for discussion of hedging issues. In general, companies that have deriva-

tives are required to disclose the objectives for holding or issuing those instruments (speculation or hedging), the hedging context (fair value or cash flow), and the strate- gies for achieving risk-management objectives. COMPREHENSIVE HEDGE ACCOUNTING EXAMPLE To provide a comprehensive example of hedge accounting, we examine the use of an interest rate swap. First, let’s consider how swaps work and why companies use them. Options and futures trade on organized securities exchanges. Because of this, options and futures have standardized terms. Although that standardization makes the trading easier, it limits the flexibility needed to tailor contracts to specific circumstances. In addition, most types of derivatives have relatively short time horizons, thereby excluding their use for reducing long-term risk exposure. As a result, many corporations instead turn to the swap, a very popular type of derivative. A swap is a transaction between two parties in which the first party promises 992 Chapter 17 Investments to make a payment to the second party. Similarly, the second party promises to make a simultaneous payment to the first party. The most common type of swap is the interest rate swap. In this type, one party makes payments based on a fixed or floating rate, and the second party does just the opposite. In most cases, large money-center banks bring together the two parties. These banks handle the flow of payments between the parties, as shown in Illustration 17A-9. ILLUSTRATION 17A-9 Swap Transaction A pays B Party Party A B B pays A Facilitates Transaction Fair Value Hedge To illustrate the use of a swap in a fair value hedge, assume that Jones Company issues $1,000,000 of five-year, 8 percent bonds on January 2, 2014. Jones records this transaction as follows. January 2, 2014 Cash 1,000,000 Bonds Payable 1,000,000 Jones offered a fixed interest rate to appeal to investors. But Jones is concerned that if market interest rates decline, the fair value of the liability will increase. The company will then suffer an economic loss.37 To protect against the risk of loss, Jones hedges the risk of a decline in interest rates by entering into a five-year interest rate swap contract. Jones agrees to the following terms: 1. Jones will receive fi xed payments at 8 percent (based on the $1,000,000 amount). 2. Jones will pay variable rates, based on the market rate in effect for the life of the swap contract. The variable rate at the inception of the contract is 6.8 percent. As Illustration 17A-10 shows, this swap allows Jones to change the interest on the bonds payable from a fixed rate to a variable rate. ILLUSTRATION 17A-10 Interest Rate Swap Jones pays variable rate of 6.8% Swap Jones Jones pays fixed Bond Counterparty Company rate of 8% Investors Jones receives fixed rate of 8% Swap Contract Bonds Payable 37This economic loss arises because Jones is locked into the 8 percent interest payments even if rates decline. Appendix 17A: Accounting for Derivative Instruments 993 The settlement dates for the swap correspond to the interest payment dates on the debt (December 31). On each interest payment (settlement) date, Jones and the counter- party compute the difference between current market interest rates and the fixed rate of 8 percent, and determine the value of the swap.38 If interest rates decline, the value of the swap contract to Jones increases (Jones has a gain), while at the same time Jones’s fixed-rate debt obligation increases (Jones has an economic loss). The swap is an effective risk-management tool in this setting. Its value relates to the same underlying (interest rates) that will affect the value of the fixed-rate bond payable. Thus, if the value of the swap goes up, it offsets the loss related to the debt obligation. Assuming that Jones enters into the swap on January 2, 2014 (the same date as the issuance of the debt), the swap at this time has no value. Therefore, no entry is necessary. January 2, 2014 No entry required. A memorandum indicates the signing of the swap contract. At the end of 2014, Jones makes the interest payment on the bonds. It records this

transaction as follows. December 31, 2014 Interest Expense 80,000 Cash (8% 3 $1,000,000) 80,000 At the end of 2014, market interest rates have declined substantially. Therefore, the value of the swap contract increases. Recall (see Illustration 17A-9) that in the swap, Jones receives a fixed rate of 8 percent, or $80,000 ($1,000,000 3 8%), and pays a variable rate (6.8%), or $68,000. Jones therefore receives $12,000 ($80,000 2 $68,000) as a settle- ment payment on the swap contract on the first interest payment date. Jones records this transaction as follows. December 31, 2014 Cash 12,000 Interest Expense 12,000 In addition, a market appraisal indicates that the value of the interest rate swap has increased $40,000. Jones records this increase in value as follows.39 December 31, 2014 Swap Contract 40,000 Unrealized Holding Gain or Loss—Income 40,000 Jones reports this swap contract in the balance sheet. It reports the gain on the hedging transaction in the income statement. Because interest rates have declined, the company records a loss and a related increase in its liability as follows. December 31, 2014 Unrealized Holding Gain or Loss—Income 40,000 Bonds Payable 40,000 Jones reports the loss on the hedging activity in net income. It adjusts bonds payable in the balance sheet to fair value (which deviates from normal accounting at amortized cost). 38The underlying for an interest rate swap is some index of market interest rates. The most commonly used index is the London Interbank Offer Rate, or LIBOR. In this example, we assume the LIBOR is 6.8 percent. 39Theoretically, this fair value change reflects the present value of expected future differences in variable and fixed interest rates. 994 Chapter 17 Investments Financial Statement Presentation of an Interest Rate Swap Illustration 17A-11 indicates how Jones reports the asset and liability related to this hedging transaction on the balance sheet. ILLUSTRATION 17A-11 JONES COMPANY Balance Sheet BALANCE SHEET (PARTIAL) Presentation of Fair DECEMBER 31, 2014 Value Hedge Current assets Swap contract $40,000 Long-term liabilities Bonds payable $1,040,000 The effect on Jones’s balance sheet is the addition of the swap asset and an increase in the carrying value of the bonds payable. Illustration 17A-12 indicates how Jones reports the effects of this swap transaction in the income statement. ILLUSTRATION 17A-12 JONES COMPANY Income Statement INCOME STATEMENT (PARTIAL) Presentation of Fair FOR THE YEAR ENDED DECEMBER 31, 2014 Value Hedge Interest expense ($80,000 2 $12,000) $68,000 Other income Unrealized holding gain—swap contract $40,000 Unrealized holding loss—bonds payable (40,000) Net gain (loss) $–0– On the income statement, Jones reports interest expense of $68,000. Jones has effec- tively changed the debt’s interest rate from fixed to variable. That is, by receiving a fixed rate and paying a variable rate on the swap, the company converts the fixed rate on the bond payable to variable. This results in an effective-interest rate of 6.8 percent in 2014.40 Also, the gain on the swap offsets the loss related to the debt obligation. Therefore, the net gain or loss on the hedging activity is zero. Illustration 17A-13 shows the overall impact of the swap transaction on the finan- cial statements. ILLUSTRATION 17A-13 Impact on Financial Statements of Fair Value $40,000 Hedge Increase in gain and increase in swap asset – $0 $40,000 Increase in loss and increase in bonds payable 40Jones will apply similar accounting and measurement at future interest payment dates. Thus, if interest rates increase, Jones will continue to receive 8 percent on the swap (records a loss) but will also be locked into the fixed payments to the bondholders at an 8 percent rate (records a gain). Summary of Learning Objectives for Appendix 17A 995 In summary, to account for fair value hedges (as illustrated in the Jones example) record the derivative at its fair value in the balance sheet, and record any gains and losses in income. Thus, the gain on the swap offsets or hedges the loss on the bond pay-

able, due to the decline in interest rates. By adjusting the hedged item (the bond payable in the Jones case) to fair value, with the gain or loss recorded in earnings, the accounting for the Jones bond payable International deviates from amortized cost. This special accounting is justified in order to re- Perspective port accurately the nature of the hedging relationship between the swap and the International accounting for bond payable in the balance sheet (both the swap and the debt obligation are hedges (IAS 39) is similar to recorded at fair value) and in the income statement (offsetting gains and losses the provisions of GAAP. are reported in the same period).41 CONTROVERSY AND CONCLUDING REMARKS Companies need rules to properly measure and report derivatives in financial state- ments. However, some argue that reporting derivatives at fair value results in unreal- ized gains and losses that are difficult to interpret. Others raise concerns about the complexity and cost of implementing GAAP in this area. However, we believe that the long-term benefits of using fair value and reporting derivatives at fair value will far outweigh any short-term implementation costs. As the volume and complexity of derivatives and hedging transactions continue to grow, so does the risk that investors and creditors will be exposed to unexpected losses arising from derivative transactions. Statement readers must have comprehensive information concerning many derivative financial instruments and the effects of hedging transac- tions using derivatives. KEY TERMS SUMMARY OF LEARNING OBJECTIVES anticipated transaction, FOR APPENDIX 17A 988 arbitrageurs, 979 bifurcation, 989 7 Describe the uses of and accounting for derivatives. Any company call option, 980 or individual that wants to ensure against different types of business risks may use cash flow hedge, 987 derivative contracts to achieve this objective. In general, these transactions involve counterparty, 981(n) some type of hedge. Speculators also use derivatives, attempting to find an enhanced derivative financial return. Speculators are very important to the derivatives market because they keep instruments, it liquid on a daily basis. Arbitrageurs attempt to exploit inefficiencies in various derivatives, 977 derivative contracts. A company primarily uses derivatives for purposes of hedging designation, 989 its exposure to fluctuations in interest rates, foreign currency exchange rates, and documentation, 989 commodity prices. embedded Companies should recognize derivatives in the financial statements as assets derivative, 989 and liabilities, and report them at fair value. Companies should recognize gains and fair value hedge, 984 losses resulting from speculation immediately in income. They report gains and forward contract, 977 losses resulting from hedge transactions in different ways, depending on the type of futures contract, 987 hedge. hedging, 984 highly effective, 990 41An interest rate swap can also be used in a cash flow hedge. A common setting is the cash flow host security, 989 risk inherent in having variable rate debt as part of a company’s debt structure. In this situation, hybrid security, 989 the variable debt issuer can hedge the cash flow risk by entering into a swap contract to receive interest rate swap, 992 variable rate cash flows but pay fixed rate. The cash received on the swap contract will offset the intrinsic value, 981 variable cash flows to be paid on the debt obligation. 996 Chapter 17 Investments net settlement, 982(n) Companies report derivative financial instruments in the balance sheet, and record notional amount, 981 them at fair value. Except for derivatives used in hedging, companies record realized option contract, 978 and unrealized gains and losses on derivative financial instruments in income. option premium, 981 8 Explain how to account for a fair value hedge. A company records the put option, 980(n) derivative used in a qualifying fair value hedge at its fair value in the balance sheet, risk management, 989 recording any gains and losses in income. In addition, the company also accounts for

speculators, 979 the item being hedged with the derivative at fair value. By adjusting the hedged item spot price, 987 to fair value, with the gain or loss recorded in earnings, the accounting for the hedged strike (exercise) price, 980 item may deviate from GAAP in the absence of a hedge relationship. This special swap, 991 accounting is justified in order to report accurately the nature of the hedging relation- time value, 981 ship between the derivative hedging instruments and the hedged item. A company reports both in the balance sheet, reporting offsetting gains and losses in income in the underlying, 983 same period. 9 Explain how to account for a cash flow hedge. Companies account for derivatives used in qualifying cash flow hedges at fair value on the balance sheet, but record gains or losses in equity as part of other comprehensive income. Companies accumulate these gains or losses, and reclassify them in income when the hedged transaction’s cash flows affect earnings. Accounting is according to GAAP for the hedged item. 10 Identify special reporting issues related to derivative financial instru- ments that cause unique accounting problems. A company should separate a derivative that is embedded in a hybrid security from the host security, and account for it using the accounting for derivatives. This separation process is referred to as bifurca- tion. Special hedge accounting is allowed only for hedging relationships that meet cer- tain criteria. The main criteria are as follows. (1) There is formal documentation of the hedging relationship, the company’s risk-management objective, and the strategy for undertaking the hedge, and the company designates the derivative as either a cash flow or fair value hedge. (2) The company expects the hedging relationship to be highly ef- fective in achieving offsetting changes in fair value or cash flows. (3) “Special” hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and the hedged item under GAAP. APPENDIX 17B VARIABLE-INTEREST ENTITIES The FASB has issued rules to address the concern that some companies are not LEARNING OBJECTIVE 11 reporting the risks and rewards of certain investments and other financial arrange- Describe the accounting for ments in their consolidated financial statements. [12] As one analyst noted, Enron variable-interest entities. showed the world the power of the idea that “if investors can’t see it, they can’t ask you about it—the ‘it’ being assets and liabilities.” What exactly did Enron do? First, it created a number of entities whose purpose was to hide debt, avoid taxes, and enrich certain management personnel to the detriment of the company and its stockholders. In effect, these entities, called special-purpose entities (SPEs), appeared to be separate entities for which Enron had a limited economic interest. However, for many of these arrangements, Enron actually had a substantial economic interest. The risks and rewards of ownership were not shifted to the enti- ties but remained with Enron. In short, Enron was obligated to repay investors in these SPEs when they were unsuccessful. Once Enron’s problems were discovered, it soon became apparent that many other companies had similar problems. Appendix 17B: Variable-Interest Entities 997 WHAT ABOUT GAAP? A reasonable question to ask with regard to SPEs is, “Why didn’t GAAP prevent com- panies from hiding SPE debt and other risks, by forcing companies to include these obligations in their consolidated financial statements?” To understand why, we have to look at the basic rules of consolidation. The GAAP rules indicate that consolidated financial statements are “usually neces- sary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in other companies.” They further note that “the usual condition for a controlling financial interest is ownership of a majority voting interest.”42 In other words, if a company like Intel owns more than 50 percent of the

voting stock of another company, Intel consolidates that company. GAAP also indicates that controlling financial interest may be achieved through arrangements that do not involve voting interests. However, applying these guidelines in practice is difficult. Whenever GAAP uses a clear line, like “greater than 50 percent,” companies some- times exploit the criterion. For example, some companies set up joint ventures in which each party owns exactly 50 percent. In that case, neither party consolidates. Or like Coca-Cola, a company may own less than 50 percent of the voting stock but maintain effective control through board of director relationships, supply relationships, or through some other type of financial arrangement. So the FASB realized that changes had to be made to GAAP for consolidations, and it issued expanded consolidation guidelines. These guidelines define when a company should use factors other than voting interest to determine controlling financial interest. In this pro- nouncement, the FASB created a new risk-and-reward model to be used in situations where voting interests were unclear. The risk-and-reward model answers the basic questions of who stands to gain or lose the most from ownership in an SPE when ownership is uncertain. In other words, we now have two models for consolidation: 1. Voting-interest model—If a company owns more than 50 percent of another com- pany, then consolidate in most cases. 2. Risk-and-reward model—If a company is involved substantially in the economics of another company, then consolidate. Operationally, the voting-interest model is easy to apply. It sets a “bright-line” owner- ship standard of more than 50 percent of the voting stock. However, if companies cannot determine control based on voting interest, they must use the risk-and-reward model. CONSOLIDATION OF VARIABLE-INTEREST ENTITIES To answer the question of who gains or loses when voting rights do not determine con- solidation, the FASB developed the risk-and-reward model. In this model, the FASB introduced the notion of a variable-interest entity. A variable-interest entity (VIE) is an entity that has one of the following characteristics: 1. Insuffi cient equity investment at risk. Stockholders are assumed to have suffi cient capital investment to support the entity’s operations. If thinly capitalized, the entity is considered a VIE and is subject to the risk-and-reward model. 42“Consolidation of Certain Special Purpose Entities,” Proposed Interpretation (Norwalk, Conn.: FASB, June 28, 2002). 998 Chapter 17 Investments 2. Stockholders lack decision-making rights. In some cases, stockholders do not have the infl uence to control the company’s destiny. 3. Stockholders do not absorb the losses or receive the benefi ts of a normal stock- holder. In some entities, stockholders are shielded from losses related to their pri- mary risks, or their returns are capped or must be shared with other parties. Once the company determines that an entity is a variable-interest entity, it no longer can use the voting-interest model. The question that must then be asked is, “What party is exposed to the majority of the risks and rewards associated with the VIE?” This party is called the primary beneficiary and must consolidate the VIE. Illustration 17B-1 shows the decision model for the VIE consolidation model.43 ILLUSTRATION 17B-1 VIE Consolidation Model Question Answer Investors Do Is Entity Is Equity No Do Investors No Not Absorb Losses No It's Not a a VIE? Inadequate? Lack Control? or Receive VIE Gains? Yes Yes Yes It's a VIE Primary Beneficiary Test Is Entity a Primary Beneficiary? No Yes Do Not Consolidate Consolidate Some Examples Let’s look at a couple of examples to illustrate how this process works. Example 1 Assume that Citigroup sells notes receivable to another entity called RAKO. RAKO’s assets are financed in two ways: Lenders provide 90 percent, and investors provide the remaining 10 percent as an equity investment. If Citigroup does not guarantee the debt, Citigroup has low or nonexistent risk. Therefore, Citigroup would not consolidate the

assets and liabilities of RAKO. On the other hand, if Citigroup guarantees RAKO’s debt, then RAKO is a VIE, and Citigroup is the primary beneficiary. In that case, Citigroup must consolidate. 43In a recent amendment to the VIE consolidation rules, the FASB expanded the factors to be considered when deciding whether a VIE should be consolidated. The new guidelines require evaluation of qualitative factors related to the power to direct activities of the VIE and assessment of obligations to absorb losses or rights to receive benefits from the VIE. These qualitative factors must be considered in addition to the quantitative analysis of the expected losses of the entity to determine consolidation. [13] The IASB has recently issued new rules on consolidation that are similar to GAAP. Appendix 17C: Fair Value Disclosures 999 Example 2 San Diego Gas and Electric (SDGE) is required by law to buy power from small, local producers. In some cases, SDGE has contracts requiring it to purchase substantially all the power generated by these local companies over their lifetime. Because SDGE con- trols the outputs of the producers, they are VIEs. In this case, the risks and rewards related to ownership apply to SDGE. In other words, it is the primary beneficiary, and SDGE should include these producers in the consolidated financial statements. Note that the primary beneficiary may have the risks and rewards of ownership through use of a variety of instruments and financial arrangements, such as equity in- vestments, loans to the VIE, leases, derivatives, and guarantees. Potential VIEs include corporations, partnerships, limited liability companies, and majority-owned subsidiaries. ILLUSTRATION 17B-2 Impact of Rule Involving What Is Happening in Practice? Risk-and-Reward Model For most companies, the reporting related to VIEs will not materially affect their finan- cial statements. As shown in Illustration 17B-2, one study of 509 companies with total Material impact 17% market values over $500 million found that just 17 percent of the companies reviewed No disclosure 13% had a material impact when the VIE rules were first implemented. Of the material VIEs disclosed in the study, the most common types (42 percent) No were related to joint-venture equity investments, followed by off-balance-sheet lease material impact arrangements (22 percent). In some cases, companies restructured transactions to avoid 51% consolidation. For example, Pep Boys, Choice Point, Inc., and Anadarko all appear to have restructured their lease transactions to avoid consolidation. On the other hand, Impact not yet companies like eBay, Kimberly-Clark, and Williams-Sonoma Inc. had to consolidate determined 19% their VIEs. With respect to the new guidelines for VIEs, companies began reporting under these rules in 2010. Some estimates have as much as $5 trillion of assets that could be Source: Company Reports; Glass, brought on-balance-sheet under the new rules. As an example, JP Morgan reported in a Lewis, & Co. Research Report recent annual report that up to $160 billion of credit card receivables and other mort- (November 6, 2003). gage-backed loans will have to be consolidated when it adopts the new rules. In summary, companies are required to consolidate certain investments and other fi- nancing arrangements that previously were reported off-balance-sheet. As a result, financial statements should be more complete in reporting the risks and rewards of these transactions. KEY TERMS SUMMARY OF LEARNING OBJECTIVE risk-and-reward FOR APPENDIX 17B model, 997 special-purpose entity (SPE), 996 11 Describe the accounting for variable-interest entities. Special variable- variable-interest entity (VIE), 997 interest accounting is used in situations where control cannot be determined based on voting-interest voting rights. A company is required to consolidate a variable-interest entity if it is the model, 997 primary beneficiary of the variable-interest entity. APPENDIX 17C FAIR VALUE DISCLOSURES As indicated in the chapter, the FASB believes that fair value information is relevant

12 LEARNING OBJECTIVE for making effective business decisions. However, others express concern about Describe required fair value fair value measurements for two reasons: (1) the lack of reliability related to the disclosures. fair value measurement in certain cases, and (2) the ability to manipulate fair value 1000 Chapter 17 Investments measurements to achieve financial results inconsistent with the underlying economics of the situation. The Board recognizes these concerns and has attempted to develop a sound conceptual basis for measuring and reporting fair value information. In addition, it has placed emphasis on developing guidelines for reporting fair value information for financial instruments because many of these instruments have relatively active markets for which valuations can be reliably determined. The purpose of this appen- dix is to explain the disclosure requirements for financial instruments related to fair value information. DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTS One requirement related to fair value disclosure is that both the cost and the fair value of all financial instruments be reported in the notes to the financial statements. [14] This enables readers of the financial statements to understand the fair value of the com- pany’s financial instruments and the potential gains and losses that might occur in the future as a result of these instruments. The Board also decided that companies should disclose information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. Two reasons for additional disclosure beyond the simple item- ization of fair values are: 1. Differing levels of reliability exist in the measurement of fair value information. It therefore is important to understand the varying risks involved in measurement. It is diffi cult to incorporate these levels of uncertainty into the fi nancial statements. Disclosure provides a framework for addressing the qualitative aspects related to risk and measurement. 2. Changes in the fair value of fi nancial instruments are reported differently in the fi nancial statements, depending on the type of fi nancial instrument involved and whether the fair value option is employed. Note disclosure provides an opportunity to explain more precisely the impact that changes in the value of fi nancial instruments have on fi nancial results. In assessing the inputs, the Board recognizes that the reliability of the fair value measurement is of extreme impor- tance. Many fi nancial instruments are traded in active markets, and their valua- tion is not diffi cult. Other instruments are complex/illiquid, and their valuation is diffi cult. To highlight these levels of reliability in valuation, the FASB established a fair value hierarchy. As discussed in Chapter 2 (page 57), this hierarchy identifies three broad levels—1, 2, and 3—related to the measurement of fair values. Level 1 is the most reli- able measurement because fair value is based on quoted prices in active markets for identical assets or liabilities. Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities. Level 3 is least reliable; it uses unobservable inputs that reflect the company’s assump- tion as to the value of the financial instrument. Illustration 17C-1 is an example of a fair value note disclosure for Sabathia Com- pany. It includes both the fair value amounts and the reliability level. (A similar disclo- sure would be presented for liabilities.) Appendix 17C: Fair Value Disclosures 1001 ILLUSTRATION 17C-1 SABATHIA COMPANY Example of Fair Value NOTES TO THE FINANCIAL STATEMENTS Hierarchy ($ in 000s) Fair Value Measurements at Reporting Data Using Quoted Prices Significant in Active Other Significant Fair Markets for Observable Unobservable Value Identical Assets Inputs Inputs Description 12/31/14 (Level 1) (Level 2) (Level 3) Trading securities $115 $105 $10 Available-for-sale securities 75 75

Derivatives 60 25 15 $20 Venture capital investments 10 10 Total $260 $205 $25 $30 For assets and liabilities measured at fair value and classified as Level 3, a recon- ciliation of Level 3 changes for the period is required. In addition, companies should report an analysis of how Level 3 changes in fair value affect total gains and losses and their impact on net income. Illustration 17C-2 is an example of this disclosure. ILLUSTRATION 17C-2 SABATHIA COMPANY Reconciliation of Level 3 NOTES TO THE FINANCIAL STATEMENTS Inputs ($ in 000s) Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Venture Capital Derivatives Investments Total Beginning balance $14 $11 $25 Total gains or losses (realized/unrealized) Included in earnings (or changes in net assets) 11 (3) 8 Included in other comprehensive income 4 4 Purchases, issuances, and settlements (7) 2 (5) Transfers in and/or out of Level 3 (2) (2) Ending balance $20 $10 $30 The amount of total gains or losses for the period included in earnings (or changes in net assets) attributable to the change in unrealized gains or losses relating to assets still held at the reporting date $7 $2 $9 Gains and losses (realized and unrealized) included in earnings (or changes in net assets) for the period (above) are reported in trading revenues and in other revenues as follows. Trading Other Revenues Revenues Total gains or losses included in earnings (or changes in net assets) for the period (as shown in the table above) $11 $(3) Change in unrealized gains or losses relating to assets still held at reporting date $7 $2 Sabathia Company’s disclosure provides to the user of the financial statements an understanding of the following: 1. The carrying amount and the fair value of the company’s fi nancial instruments segregated by level of reliability. Thus, the reader of the fi nancial statements has a basis for judging what credence should be given to the fair value amounts. 1002 Chapter 17 Investments 2. For Level 3 fi nancial instruments, a reconciliation of the balance from the beginning to the end of the period. This reconciliation enables the reader to understand the composition of the change. It is important because these calculations are most affected by subjective estimates and could be subject to manipulation. 3. The impact of changes in fair value on the net assets of the company from one period to the next. For companies that choose to use the fair value option for some or all of their financial instruments [15], they are permitted to incorporate the entire guidelines related to fair value measurement into one master schedule, or they can provide in a separate schedule information related solely to the fair value option. Finally, companies must provide the following (with special emphasis on Level 3 measurements): 1. Quantitative information about signifi cant unobservable inputs used for all Level 3 measurements. 2. A qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed, including interrelationships between inputs. 3. A description of the company’s valuation process. 4. Any transfers between Levels 1 and 2 of the fair value hierarchy. 5. Information about nonfi nancial assets measured at fair value at amounts that differ from the assets’ highest and best use. 6. The proper hierarchy classifi cation for items that are not recognized on the balance sheet but are disclosed in the notes to the fi nancial statements. ILLUSTRATION 17C-3 Quantitative Information A typical disclosure related to Level 3 fair value measurements is presented in about Level 3 Fair Value Illustration 17C-3. Measurements Fair Value at ($ in millions) 12/31/2014 Valuation Technique(s) Unobservable Input Range (Weighted-Average) Residential 125 Discounted cash fl ow Constant prepayment rate 3.5%–5.5% (4.5%) mortgage-backed Probability of default 5%–50% (10%) securities Loss severity 40%–100% (60%) Collateralized 35 Consensus pricing Offered quotes 20–45 debt obligations Comparability adjustments (%) 210%–115% (15%)

Direct 53 Discounted cash flow Weighted-average cost of capital 7%–16% (12.1%) venture Long-term revenue growth rate 2%–5% (4.2%) capital Long-term pretax operating margin 3%–20% (10.3%) investments: Discount for lack of marketabilitya 5%–20% (17%) Healthcare Control premiuma 10%–30% (20%) Market-comparable companies EBITDA multipleb 6.5–12 (9.5) Revenue multipleb 1.0–3.0 (2.0) Discount for lack of marketabilitya 5%–20% (10%) Control premiuma 10%–20% (12%) Credit 38 Option model Annualized volatility of creditc 10%–20% contracts Counterparty credit riskd 0.5–3.5% Own credit riskd 0.3–2.0% aRepresents amounts used when the reporting entity has determined that market participants would take into account these premiums and discounts when pricing the investments. bRepresents amounts used when the reporting entity has determined that market participants would use such multiples when pricing the investments. cRepresents the range of the volatility curves used in the valuation analysis that the reporting entity has determined market participants would use when pricing the contracts. dRepresents the range of the credit default swap spread curves used in the valuation analysis that the reporting entity has determined market participants would use when pricing the contracts. (Note: For liabilities, a similar table should be presented.) Summary of Learning Objective for Appendix 17C 1003 DISCLOSURE OF FAIR VALUES: IMPAIRED ASSETS OR LIABILITIES In addition to financial instruments, companies often have assets or liabilities that are remeasured on a nonrecurring basis due to impairment. In this case, the fair value hier- archy can highlight the reliability of the measurement, coupled with the related gain or loss for the period. Illustration 17C-4 highlights this disclosure for McClung Company. ILLUSTRATION 17C-4 McCLUNG COMPANY Disclosure of Fair Value, NOTES TO THE FINANCIAL STATEMENTS with Impairment ( $ in millions) Fair Value Measurements Using Quoted Prices in Active Significant Markets for Other Significant Year Identical Observable Unobservable Ended Assets Inputs Inputs Description 12/31/14 (Level 1) (Level 2) (Level 3) Long-lived assets held and used $75 — $75 — Goodwill 30 — — $30 Long-lived assets held for sale 26 — 26 — Long-lived assets held and used with a carrying amount of $100 million were written down to their fair value of $75 million, resulting in an impairment charge of $25 million, which was included in earnings for the period. Goodwill with a carrying amount of $65 million was written down to its implied fair value of $30 million, resulting in an impairment charge of $35 million, which was included in earnings for the period. In accordance with the provisions of the Impairment or Disposal of Long-Lived Assets Subsections of FASB Codification Subtopic 360-10, long-lived assets held for sale with a carrying amount of $35 million were written down to their fair value of $26 million, less cost to sell of $6 million (or $20 million), resulting in a loss of $15 million, which was included in earnings for the period. CONCLUSION With recent joint FASB and IASB standard-setting efforts, we now have convergence with respect to fair value measurement, both in terms of the definition and measure- ment guidelines when fair value is the measurement approach in GAAP and IFRS. In addition, GAAP and IFRS have the same fair value disclosure requirements, as illus- trated in this appendix. As the former chair of the IASB noted, this “marks the comple- tion of a major convergence project and is a fundamentally important element of our joint response to the global crisis. The result is clearer and more consistent guidance on measuring fair value, where its use is already required.” SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17C 12 Describe required fair value disclosures. The FASB has developed required fair value disclosures in response to concerns about the reliability of fair value measures. Disclosure elements include fair value amounts and reliability levels as well as impaired assets or liabilities.

1004 Chapter 17 Investments DEMONSTRATION PROBLEM Rogers Corporation carries an account in its general ledger called Investments, which contained the following debits for investment purchases and no credits. Feb. 1, 2014 Jordy Company common stock, $100 par, 200 shares $ 37,400 April 1 U.S. government bonds, 11%, due April 1, 2024, interest payable April 1 and October 1, 100 bonds at $1,000 each 100,000 July 1 Driver Company 12% bonds, par $50,000, dated March 1, 2010, purchased at par plus accrued interest, interest payable annually on March 1, due March 1, 2034 52,000 Instructions (a) Prepare the entries necessary to classify the amounts into proper accounts, assuming that all the securities are classified as available-for-sale. (b) Prepare the entry to record the accrued interest on December 31, 2014. (c) The fair values of the securities on December 31, 2014, were: Jordy Company common stock $ 33,800 (1% of total shares) U.S. government bonds 124,700 Driver Company bonds 58,600 What entry or entries, if any, would you recommend be made? (d) The U.S. government bonds were sold on July 1, 2015, for $119,200 plus accrued interest. Give the proper entry. (e) Now assume Rogers’ investment in Jordy Company represents 30% of Jordy’s shares. Prepare the 2014 entries for the investment in Jordy stock. In 2014, Jordy declared and paid dividends of $9,000 (on September 30) and reported net income of $30,000. Solution (a) Equity Investments (available-for-sale) 37,400 Debt Investments (available-for-sale) 150,000 Interest Revenue ($50,000 3 .12 3 4/12) 2,000 Investments 189,400 (b) December 31, 2014 Interest Receivable 7,750 Interest Revenue 7,750 (c) Available-for-Sale Portfolio December 31, 2014 Securities Cost Fair Value Unrealized Gain (Loss) Jordy Company stock $ 37,400 $ 33,800 $ (3,600) U.S. government bonds 100,000 124,700 24,700 Driver Company bonds 50,000 58,600 8,600 Total $187,400 $217,100 29,700 Previous fair value adjustment balance 0 Fair value adjustment—Dr. $29,700 Fair Value Adjustment (available-for-sale) 29,700 Unrealized Holding Gain or Loss—Equity 29,700 (d) July 1, 2015 Cash ($119,200 1 $2,750) 121,950 Debt Investments (available-for-sale) 100,000 Interest Revenue ($100,000 3 .11 3 3/12) 2,750 Gain on Sale of Investments 19,200 FASB Codifi cation 1005 (e) February 1, 2014 Equity Investments (Jordy Company) 37,400 Cash 37,400 September 30, 2014 Cash 2,700 Equity Investments (Jordy Company) (30% 3 $9,000) 2,700 December 31, 2014 Equity Investments (Jordy Company) 9,000 Investment Income (30% 3 $30,000) 9,000 FASB CODIFICATION FASB Codification References [1] FASB ASC Glossary. [Predecessor literature: “Accounting for Certain Investments in Debt and Equity Securities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB, 1993), par. 137.] [2] FASB ASC 820-10-20. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] [3] FASB ASC 220. [Predecessor literature: “Reporting Comprehensive Income,” Statement of Financial Accounting Standards No. 130 (Norwalk, Conn.: FASB, 1997).] [4] FASB ASC 323-10-15. [Predecessor literature: “The Equity Method of Accounting for Investments in Common Stock,” Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 17.] [5] FASB ASC 323-10-15-10. [Predecessor literature: “Criteria for Applying the Equity Method of Accounting for Investments in Common Stock,” Interpretations of the Financial Accounting Standards Board No. 35 (Stamford, Conn.: FASB, 1981).] [6] FASB ASC 323-10-35. [Predecessor literature: “The Equity Method of Accounting for Investments in Common Stock,” Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 19(i).] [7] FASB ASC 815-10-05. [Predecessor literature: “Accounting for Derivative Instruments and Hedging Activities,” Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998).] [8] FASB ASC 820-10. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157

(Norwalk, Conn.: FASB, September 2006).] [9] FASB ASC 815-10-05-4. [Predecessor literature: “Accounting for Derivative Instruments and Hedging Activities,” Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998), par. 249.] [10] FASB ASC 815-10-05-4. [Predecessor literature: “Accounting for Derivative Instruments and Hedging Activities,” Statement of Financial Accounting Standards No. 133 (Stamford, Conn.: FASB, 1998).] [11] FASB ASC 825-10-25-1. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).] [12] FASB ASC 810-10-05. [Predecessor literature: “Consolidation of Variable Interest Entities (revised)—An Interpretation of ARB No. 51,” Financial Accounting Standards Interpretation No. 46(R) (Norwalk, Conn.: FASB, December 2003).] [13] FASB ASC 810-10-15. [Predecessor literature: “Consolidation of Variable Interest Entities (revised)—An Interpretation of ARB No. 51,” Financial Accounting Standards Interpretation No. 46(R) (Norwalk, Conn.: FASB, December 2003).] [14] FASB ASC 820-10. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] [15] FASB ASC 825-10-25-1. (Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. 1006 Chapter 17 Investments CE17-1 Access the glossary (“Master Glossary”) to answer the following. (a) What are trading securities? (b) What is the definition of “holding gain or loss”? (c) What is a cash flow hedge? (d) What is a fair value hedge? CE17-2 What guidance does the SEC give for disclosures regarding accounting policies used for derivatives? CE17-3 When would an investor discontinue applying the equity method in an investment? Are there any exceptions to this rule? CE17-4 For balance sheet purposes, can the fair value of a derivative in a loss position be netted against the fair value of a derivative in a gain position? An additional Codification case can be found in the Using Your Judgment section, on page 1026. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter. QUESTIONS 1. Distinguish between a debt security and an equity security. $3,604,000, prepare the journal entry (if any) at December 31, 2014, to record this transaction. 2. What purpose does the variety in bond features (types and characteristics) serve? 10. Indicate how unrealized holding gains and losses should 3. What is the cost of a long-term investment in bonds? be reported for investments securities classified as trading, available-for-sale, and held-to-maturity. 4. Identify and explain the three types of classifications for investments in debt securities. 11. (a) Assuming no Fair Value Adjustment (available-for- 5. When should a debt security be classified as held-to- sale) account balance at the beginning of the year, prepare the adjusting entry at the end of the year if Laura Com- maturity? pany’s available-for-sale securities have a fair value 6. Explain how trading securities are accounted for and $60,000 below cost. (b) Assume the same information as reported. part (a), except that Laura Company has a debit balance in 7. At what amount should trading, available-for-sale, and its Fair Value Adjustment account of $10,000 at the begin- held-to-maturity securities be reported on the balance ning of the year. Prepare the adjusting entry at year-end. sheet?

12. Identify and explain the different types of classifications 8. On July 1, 2014, Wheeler Company purchased $4,000,000 for investments in equity securities. of Duggen Company’s 8% bonds, due on July 1, 2021. The bonds, which pay interest semiannually on January 1 13. Why are held-to-maturity investments applicable only to and July 1, were purchased for $3,500,000 to yield 10%. debt securities? Determine the amount of interest revenue Wheeler 14. Hayes Company sold 10,000 shares of Kenyon Co. com- should report on its income statement for the year ended mon stock for $27.50 per share, incurring $1,770 in broker- December 31, 2014. age commissions. These securities were classified as 9. If the bonds in Question 8 are classified as available-for- trading and originally cost $260,000. Prepare the entry to sale and they have a fair value at December 31, 2014, of record the sale of these securities. Brief Exercises 1007 15. Distinguish between the accounting treatment for available- 25. What is the GAAP definition of fair value? for-sale equity securities and trading equity securities. 26. What is the fair value option? 16. What constitutes “significant influence” when an investor’s 27. Franklin Corp. has an investment that it has held for financial interest is below the 50% level? several years. When it purchased the investment, Frank- 17. Explain how the investment account is affected by lin classified and accounted for it as available-for-sale. investee activities under the equity method. Can Franklin use the fair value option for this invest- 18. Your classmate Kate believes that the equity method is ment? Explain. applied with a strict application of the “20%” rule. Do you * 2 8. What is meant by the term “underlying” as it relates to agree? Explain. derivative financial instruments? 19. Hiram Co. uses the equity method to account for invest- * 2 9. What are the main distinctions between a traditional ments in common stock. What accounting should be financial instrument and a derivative financial instrument? made for dividends received from these investments * 3 0. What is the purpose of a fair value hedge? subsequent to the date of investment? 20. Raleigh Corp. has an investment with a carrying value * 3 1. In what situation will the unrealized holding gain or (equity method) on its books of $170,000 representing a loss on an available-for-sale security be reported in 30% interest in Borg Company, which suffered a $620,000 income? loss this year. How should Raleigh Corp. handle its * 3 2. Why might a company become involved in an interest proportionate share of Borg’s loss? rate swap contract to receive fixed interest payments and 21. Where on the asset side of the balance sheet are trading pay variable? securities, available-for-sale securities, and held-to-maturity * 3 3. What is the purpose of a cash flow hedge? securities reported? Explain. * 3 4. Where are gains and losses related to cash flow hedges 22. Explain why reclassification adjustments are necessary. involving anticipated transactions reported? 23. Briefly discuss how a transfer of securities from the avail- * 3 5. What are hybrid securities? Give an example of a hybrid able-for-sale category to the trading category affects security. stockholders’ equity and income. * 3 6. Explain the difference between the voting-interest model 24. When is a debt security considered impaired? Explain and the risk-and-reward model used for consolidation. how to account for the impairment of an available-for-sale debt security. * 3 7. What is a variable-interest entity? BRIEF EXERCISES 2 BE17-1 Garfield Company purchased, as a held-to-maturity investment, $80,000 of the 9%, 5-year bonds of Chester Corporation for $74,086, which provides an 11% return. Prepare Garfield’s journal entries for (a) the purchase of the investment, and (b) the receipt of annual interest and discount amortization. Assume effective-interest amortization is used. 2 BE17-2 Use the information from BE17-1 but assume the bonds are purchased as an available-for-sale

security. Prepare Garfield’s journal entries for (a) the purchase of the investment, (b) the receipt of annual interest and discount amortization, and (c) the year-end fair value adjustment. (Assume a zero balance in the Fair Value Adjustment account.) The bonds have a year-end fair value of $75,500. 2 BE17-3 Carow Corporation purchased, as a held-to-maturity investment, $60,000 of the 8%, 5-year bonds of Harrison, Inc. for $65,118, which provides a 6% return. The bonds pay interest semiannually. Prepare Carow’s journal entries for (a) the purchase of the investment, and (b) the receipt of semiannual interest and premium amortization. Assume effective-interest amortization is used. 2 BE17-4 Hendricks Corporation purchased trading investment bonds for $50,000 at par. At December 31, Hendricks received annual interest of $2,000, and the fair value of the bonds was $47,400. Prepare Hendricks’ journal entries for (a) the purchase of the investment, (b) the interest received, and (c) the fair value adjustment. (Assume a zero balance in the Fair Value Adjustment account.) 3 BE17-5 Fairbanks Corporation purchased 400 shares of Sherman Inc. common stock as an available- for-sale investment for $13,200. During the year, Sherman paid a cash dividend of $3.25 per share. At year- end, Sherman stock was selling for $34.50 per share. Prepare Fairbanks’ journal entries to record (a) the purchase of the investment, (b) the dividends received, and (c) the fair value adjustment. (Assume a zero balance in the Fair Value Adjustment account.) 1008 Chapter 17 Investments 3 BE17-6 Use the information from BE17-5 but assume the stock was purchased as a trading security. Prepare Fairbanks’ journal entries to record (a) the purchase of the investment, (b) the dividends received, and (c) the fair value adjustment. 4 BE17-7 Zoop Corporation purchased for $300,000 a 30% interest in Murphy, Inc. This investment enables Zoop to exert significant influence over Murphy. During the year, Murphy earned net income of $180,000 and paid dividends of $60,000. Prepare Zoop’s journal entries related to this investment. 3 BE17-8 Cleveland Company has a stock portfolio valued at $4,000 (available-for-sale). Its cost was $3,300. If the Fair Value Adjustment account has a debit balance of $200, prepare the journal entry at year-end. 6 BE17-9 The following information relates to Starbucks for the year ended October 2, 2011: net income 1,245.7 million; unrealized holding loss of $10.9 million related to available-for-sale securities during the year; accumulated other comprehensive income of $57.2 million on October 3, 2010. Assuming no other changes in accumulated other comprehensive income, determine (a) other comprehensive income for 2011, (b) comprehensive income for 2011, and (c) accumulated other comprehensive income at October 2, 2011. 5 BE17-10 Hillsborough Co. has an available-for-sale investment in the bonds of Schuyler Corp. with a carrying (and fair) value of $70,000. Hillsborough determined that due to poor economic prospects for Schuyler, the bonds have decreased in value to $60,000. It is determined that this loss in value is other-than- temporary. Prepare the journal entry, if any, to record the reduction in value. EXERCISES 1 3 E17-1 (Investment Classifications) For the following investments identify whether they are: 1. Trading Securities 2. Available-for-Sale Securities 3. Held-to-Maturity Securities Each case is independent of the other. (a) A bond that will mature in 4 years was bought 1 month ago when the price dropped. As soon as the value increases, which is expected next month, it will be sold. (b) 10% of the outstanding stock of Farm-Co was purchased. The company is planning on eventually getting a total of 30% of its outstanding stock. (c) 10-year bonds were purchased this year. The bonds mature at the first of next year. (d) Bonds that will mature in 5 years are purchased. The company would like to hold them until they mature, but money has been tight recently and they may need to be sold. (e) Preferred stock was purchased for its constant dividend. The company is planning to hold the pre-

ferred stock for a long time. (f) A bond that matures in 10 years was purchased. The company is investing money set aside for an expansion project planned 10 years from now. 2 E17-2 (Entries for Held-to-Maturity Securities) On January 1, 2013, Dagwood Company purchased at par 12% bonds having a maturity value of $300,000. They are dated January 1, 2013, and mature January 1, 2018, with interest receivable December 31 of each year. The bonds are classified in the held-to-maturity category. Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare the journal entry to record the interest received for 2013. (c) Prepare the journal entry to record the interest received for 2014. 2 E17-3 (Entries for Held-to-Maturity Securities) On January 1, 2013, Hi and Lois Company purchased 12% bonds having a maturity value of $300,000 for $322,744.44. The bonds provide the bondholders with a 10% yield. They are dated January 1, 2013, and mature January 1, 2018, with interest receivable December 31 of each year. Hi and Lois Company uses the effective-interest method to allocate unamortized discount or premium. The bonds are classified in the held-to-maturity category. Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare a bond amortization schedule. Exercises 1009 (c) Prepare the journal entry to record the interest received and the amortization for 2013. (d) Prepare the journal entry to record the interest received and the amortization for 2014. 2 E17-4 (Entries for Available-for-Sale Securities) Assume the same information as in E17-3 except that the securities are classified as available-for-sale. The fair value of the bonds at December 31 of each year-end is as follows. 2013 $320,500 2016 $310,000 2014 $309,000 2017 $300,000 2015 $308,000 Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare the journal entries to record the interest received and recognition of fair value for 2013. (c) Prepare the journal entry to record the recognition of fair value for 2014. 2 E17-5 (Effective-Interest versus Straight-Line Bond Amortization) On January 1, 2013, Phantom Company acquires $200,000 of Spiderman Products, Inc., 9% bonds at a price of $185,589. The interest is payable each December 31, and the bonds mature December 31, 2015. The investment will provide Phantom Company a 12% yield. The bonds are classified as held-to-maturity. Instructions (a) Prepare a 3-year schedule of interest revenue and bond discount amortization, applying the straight- line method. (b) Prepare a 3-year schedule of interest revenue and bond discount amortization, applying the effective-interest method. (c) Prepare the journal entry for the interest receipt of December 31, 2014, and the discount amortiza- tion under the straight-line method. (d) Prepare the journal entry for the interest receipt of December 31, 2014, and the discount amortiza- tion under the effective-interest method. 3 E17-6 (Entries for Available-for-Sale and Trading Securities) The following information is available for Barkley Company at December 31, 2014, regarding its investments. Securities Cost Fair Value 3,000 shares of Myers Corporation Common Stock $40,000 $48,000 1,000 shares of Cole Incorporated Preferred Stock 25,000 22,000 $65,000 $70,000 Instructions (a) Prepare the adjusting entry (if any) for 2014, assuming the securities are classified as trading. (b) Prepare the adjusting entry (if any) for 2014, assuming the securities are classified as available- for-sale. (c) Discuss how the amounts reported in the financial statements are affected by the entries in (a) and (b). 3 E17-7 (Trading Securities Entries) On December 21, 2013, Bucky Katt Company provided you with the following information regarding its trading securities. December 31, 2013 Investments (Trading) Cost Fair Value Unrealized Gain (Loss) Clemson Corp. stock $20,000 $19,000 $(1,000) Colorado Co. stock 10,000 9,000 (1,000) Buffaloes Co. stock 20,000 20,600 600 Total of portfolio $50,000 $48,600 (1,400)

Previous fair value adjustment balance –0– Fair value adjustment—Cr. $(1,400) During 2014, Colorado Company stock was sold for $9,400. The fair value of the stock on December 31, 2014, was Clemson Corp. stock—$19,100; Buffaloes Co. stock—$20,500. 1010 Chapter 17 Investments Instructions (a) Prepare the adjusting journal entry needed on December 31, 2013. (b) Prepare the journal entry to record the sale of the Colorado Company stock during 2014. (c) Prepare the adjusting journal entry needed on December 31, 2014. 3 E17-8 (Available-for-Sale Securities Entries and Reporting) Satchel Corporation purchases equity secu- rities costing $73,000 and classifies them as available-for-sale securities. At December 31, the fair value of the portfolio is $65,000. Instructions Prepare the adjusting entry to report the securities properly. Indicate the statement presentation of the accounts in your entry. 3 E17-9 (Available-for-Sale Securities Entries and Financial Statement Presentation) At December 31, 2013, the available-for-sale equity portfolio for Steffi Graf, Inc. is as follows. Security Cost Fair Value Unrealized Gain (Loss) A $17,500 $15,000 ($2,500) B 12,500 14,000 1,500 C 23,000 25,500 2,500 Total $53,000 $54,500 1,500 Previous fair value adjustment balance—Dr. 400 Fair value adjustment—Dr. $1,100 On January 20, 2014, Steffi Graf, Inc. sold security A for $15,100. The sale proceeds are net of brokerage fees. Instructions (a) Prepare the adjusting entry at December 31, 2013, to report the portfolio at fair value. (b) Show the balance sheet presentation of the investment-related accounts at December 31, 2013. (Ignore notes presentation.) (c) Prepare the journal entry for the 2014 sale of security A. 6 E17-10 (Comprehensive Income Disclosure) Assume the same information as E17-9 and that Steffi Graf Inc. reports net income in 2013 of $120,000 and in 2014 of $140,000. Total holding gains (including any real- ized holding gain or loss) total $40,000. Instructions (a) Prepare a statement of comprehensive income for 2013 starting with net income. (b) Prepare a statement of comprehensive income for 2014 starting with net income. 3 E17-11 (Equity Securities Entries) Arantxa Corporation made the following cash purchases of securities during 2014, which is the first year in which Arantxa invested in securities. 1. On January 15, purchased 10,000 shares of Sanchez Company’s common stock at $33.50 per share plus commission $1,980. 2. On April 1, purchased 5,000 shares of Vicario Co.’s common stock at $52.00 per share plus commis- sion $3,370. 3. On September 10, purchased 7,000 shares of WTA Co.’s preferred stock at $26.50 per share plus commission $4,910. On May 20, 2014, Arantxa sold 4,000 shares of Sanchez Company’s common stock at a market price of $35 per share less brokerage commissions, taxes, and fees of $3,850. The year-end fair values per share were Sanchez $30, Vicario $55, and WTA $28. In addition, the chief accountant of Arantxa told you that Arantxa Corporation plans to hold these securities for the long term but may sell them in order to earn profits from appreciation in prices. Instructions (a) Prepare the journal entries to record the above three security purchases. (b) Prepare the journal entry for the security sale on May 20. (c) Compute the unrealized gains or losses and prepare the adjusting entries for Arantxa on December 31, 2014. 3 4 E17-12 (Journal Entries for Fair Value and Equity Methods) The following are two independent situations. Exercises 1011 Situation 1: Conchita Cosmetics acquired 10% of the 200,000 shares of common stock of Martinez Fashion at a total cost of $13 per share on March 18, 2014. On June 30, Martinez declared and paid a $75,000 cash dividend. On December 31, Martinez reported net income of $122,000 for the year. At December 31, the market price of Martinez Fashion was $15 per share. The securities are classified as available-for-sale. Situation 2: Monica, Inc. obtained significant influence over Seles Corporation by buying 30% of Seles’s 30,000 outstanding shares of common stock at a total cost of $9 per share on January 1, 2014. On June 15,

Seles declared and paid a cash dividend of $36,000. On December 31, Seles reported a net income of $85,000 for the year. Instructions Prepare all necessary journal entries in 2014 for both situations. 4 E17-13 (Equity Method) Parent Co. invested $1,000,000 in Sub Co. for 25% of its outstanding stock. Sub Co. pays out 40% of net income in dividends each year. Instructions Use the information in the following T-account for the investment in Sub to answer the following questions. Investment in Sub Co. 1,000,000 110,000 44,000 (a) How much was Parent Co.’s share of Sub Co.’s net income for the year? (b) How much was Parent Co.’s share of Sub Co.’s dividends for the year? (c) What was Sub Co.’s total net income for the year? (d) What was Sub Co.’s total dividends for the year? 3 E17-14 (Equity Investment—Trading) Oregon Co. had purchased 200 shares of Washington Co. for $40 each this year and classified the investment as a trading security. Oregon Co. sold 100 shares of the stock for $45 each. At year-end, the price per share of the Washington Co. stock had dropped to $35. Instructions Prepare the journal entries for these transactions and any year-end adjustments. 3 E17-15 (Equity Investments—Trading) Kenseth Company has the following securities in its trading port- folio of securities on December 31, 2013. Investments (Trading) Cost Fair Value 1,500 shares of Gordon, Inc., Common $ 73,500 $ 69,000 5,000 shares of Wallace Corp., Common 180,000 175,000 400 shares of Martin, Inc., Preferred 60,000 61,600 $313,500 $305,600 All of the securities were purchased in 2013. In 2014, Kenseth completed the following securities transactions. March 1 Sold the 1,500 shares of Gordon, Inc., Common, @ $45 less fees of $1,200 April 1 Bought 700 shares of Earnhart Corp., Common, @ $75 plus fees of $1,300 Kenseth Company’s portfolio of trading securities appeared as follows on December 31, 2014. Investments (Trading) Cost Fair Value 5,000 shares of Wallace Corp., Common $180,000 $175,000 700 shares of Earnhart Corp., Common 53,800 50,400 400 shares of Martin, Inc., Preferred 60,000 58,000 $293,800 $283,400 Instructions Prepare the general journal entries for Kenseth Company for: (a) The 2013 adjusting entry. (b) The sale of the Gordon stock. (c) The purchase of the Earnhart stock. (d) The 2014 adjusting entry for the trading portfolio. 1012 Chapter 17 Investments 3 4 E17-16 (Fair Value and Equity Method Compared) Jaycie Phelps Inc. acquired 20% of the outstanding common stock of Theresa Kulikowski Inc. on December 31, 2013. The purchase price was $1,200,000 for 50,000 shares. Kulikowski Inc. declared and paid an $0.85 per share cash dividend on June 30 and on December 31, 2014. Kulikowski reported net income of $730,000 for 2014. The fair value of Kulikowski’s stock was $27 per share at December 31, 2014. Instructions (a) Prepare the journal entries for Jaycie Phelps Inc. for 2013 and 2014, assuming that Phelps cannot exercise significant influence over Kulikowski. The securities should be classified as available- for-sale. (b) Prepare the journal entries for Jaycie Phelps Inc. for 2013 and 2014, assuming that Phelps can exercise significant influence over Kulikowski. (c) At what amount is the investment in securities reported on the balance sheet under each of these methods at December 31, 2014? What is the total net income reported in 2014 under each of these methods? 4 E17-17 (Equity Method) On January 1, 2014, Pennington Corporation purchased 30% of the common shares of Edwards Company for $180,000. During the year, Edwards earned net income of $80,000 and paid dividends of $20,000. Instructions Prepare the entries for Pennington to record the purchase and any additional entries related to this invest- ment in Edwards Company in 2014. 5 E17-18 (Impairment of Debt Securities) Hagar Corporation has municipal bonds classified as available- for-sale at December 31, 2013. These bonds have a par value of $800,000, an amortized cost of $800,000, and a fair value of $720,000. The unrealized loss of $80,000 previously recognized as other compre-

hensive income and as a separate component of stockholders’ equity is now determined to be other than temporary. That is, the company believes that impairment accounting is now appropriate for these bonds. Instructions (a) Prepare the journal entry to recognize the impairment. No entry is needed to adjust accumulated other comprehensive income. (b) What is the new cost basis of the municipal bonds? Given that the maturity value of the bonds is $800,000, should Hagar Corporation amortize the difference between the carrying amount and the maturity value over the life of the bonds? (c) At December 31, 2014, the fair value of the municipal bonds is $760,000. Prepare the entry (if any) to record this information. 3 5 E17-19 (Fair Value Measurement) Presented below is information related to the purchases of common stock by Lilly Company during 2014. Cost Fair Value (at purchase date) (at December 31) Investment in Arroyo Company stock $100,000 $ 80,000 Investment in Lee Corporation stock 250,000 300,000 Investment in Woods Inc. stock 180,000 190,000 Total $530,000 $570,000 Instructions (Assume a zero balance for any Fair Value Adjustment account.) (a) What entry would Lilly make at December 31, 2014, to record the investment in Arroyo Company stock if it chooses to report this security using the fair value option? (b) What entry would Lilly make at December 31, 2014, to record the investment in Lee Corporation, assuming that Lilly wants to classify this security as available-for-sale? This security is the only available-for-sale security that Lilly presently owns. (c) What entry would Lilly make at December 31, 2014, to record the investment in Woods Inc., assum- ing that Lilly wants to classify this investment as a trading security? 3 5 E17-20 (Fair Value Measurement Issues) Assume the same information as in E17-19 for Lilly Com- pany. In addition, assume that the investment in the Woods Inc. stock was sold during 2015 for $195,000. Exercises 1013 At December 31, 2015, the following information relates to its two remaining investments of common stock. Cost Fair Value (at purchase date) (at December 31) Investment in Arroyo Company stock $100,000 $140,000 Investment in Lee Corporation stock 250,000 310,000 Total $350,000 $450,000 Net income before any security gains and losses for 2015 was $905,000. Instructions (a) Compute the amount of net income or net loss that Lilly should report for 2015, taking into consid- eration Lilly’s security transactions for 2015. (b) Prepare the journal entry to record unrealized gain or loss related to the investment in Arroyo Company stock at December 31, 2015. 2 3 E17-21 (Fair Value Option) Presented below is selected information related to the financial instruments of 5 Dawson Company at December 31, 2014. This is Dawson Company’s first year of operations. Carrying Fair Value Amount (at December 31) Investment in debt securities (intent is to hold to maturity) $ 40,000 $ 41,000 Investment in Chen Company stock 800,000 910,000 Bonds payable 220,000 195,000 Instructions (a) Dawson elects to use the fair value option whenever possible. Assuming that Dawson’s net income is $100,000 in 2014 before reporting any securities gains or losses, determine Dawson’s net income for 2014. (b) Record the journal entry, if any, necessary at December 31, 2014, to record the fair value option for the bonds payable. 7 * E17-22 (Derivative Transaction) On January 2, 2014, Jones Company purchases a call option for $300 on Merchant common stock. The call option gives Jones the option to buy 1,000 shares of Merchant at a strike price of $50 per share. The market price of a Merchant share is $50 on January 2, 2014 (the intrinsic value is therefore $0). On March 31, 2014, the market price for Merchant stock is $53 per share, and the time value of the option is $200. Instructions (a) Prepare the journal entry to record the purchase of the call option on January 2, 2014. (b) Prepare the journal entry(ies) to recognize the change in the fair value of the call option as of March 31, 2014. (c) What was the effect on net income of entering into the derivative transaction for the period January 2

to March 31, 2014? 8 * E17-23 (Fair Value Hedge) On January 2, 2014, MacCloud Co. issued a 4-year, $100,000 note at 6% fixed interest, interest payable semiannually. MacCloud now wants to change the note to a variable-rate note. As a result, on January 2, 2014, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR of 5.7% for the first 6 months on $100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset to 6.7% on June 30, 2014. Instructions (a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2014. (b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2014. 9 * E17-24 (Cash Flow Hedge) On January 2, 2014, Parton Company issues a 5-year, $10,000,000 note at LIBOR, with interest paid annually. The variable rate is reset at the end of each year. The LIBOR rate for the first year is 5.8%. Parton Company decides it prefers fixed-rate financing and wants to lock in a rate of 6%. As a result, Parton enters into an interest rate swap to pay 6% fixed and receive LIBOR based on $10 million. The variable rate is reset to 6.6% on January 2, 2015. 1014 Chapter 17 Investments Instructions (a) Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2014. (b) Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2015. 8 *E 17-25 (Fair Value Hedge) Sarazan Company issues a 4-year, 7.5% fixed-rate interest only, nonprepayable $1,000,000 note payable on December 31, 2013. It decides to change the interest rate from a fixed rate to variable rate and enters into a swap agreement with M&S Corp. The swap agreement specifies that Sarazan will receive a fixed rate at 7.5% and pay variable with settlement dates that match the interest payments on the debt. Assume that interest rates have declined during 2014 and that Sarazan received $13,000 as an adjustment to interest expense for the settlement at December 31, 2014. The loss related to the debt (due to interest rate changes) was $48,000. The value of the swap contract increased $48,000. Instructions (a) Prepare the journal entry to record the payment of interest expense on December 31, 2014. (b) Prepare the journal entry to record the receipt of the swap settlement on December 31, 2014. (c) Prepare the journal entry to record the change in the fair value of the swap contract on December 31, 2014. (d) Prepare the journal entry to record the change in the fair value of the debt on December 31, 2014. 7 * E17-26 (Call Option) On August 15, 2013, Outkast Co. invested idle cash by purchasing a call option on Counting Crows Inc. common shares for $360. The notional value of the call option is 400 shares, and the option price is $40. The option expires on January 31, 2014. The following data are available with respect to the call option. Market Price of Counting Time Value of Call Date Crows Shares Option September 30, 2013 $48 per share $180 December 31, 2013 $46 per share 65 January 15, 2014 $47 per share 30 Instructions Prepare the journal entries for Outkast for the following dates. (a) Investment in call option on Counting Crows shares on August 15, 2013. (b) September 30, 2013—Outkast prepares financial statements. (c) December 31, 2013—Outkast prepares financial statements. (d) January 15, 2014—Outkast settles the call option on the Counting Crows shares. 9 * E17-27 (Cash Flow Hedge) Hart Golf Co. uses titanium in the production of its specialty drivers. Hart anticipates that it will need to purchase 200 ounces of titanium in November 2014, for clubs that will be shipped in the spring and summer of 2015. However, if the price of titanium increases, this will increase the cost to produce the clubs, which will result in lower profit margins. To hedge the risk of increased titanium prices, on May 1, 2014, Hart enters into a titanium futures con- tract and designates this futures contract as a cash flow hedge of the anticipated titanium purchase. The

notional amount of the contract is 200 ounces, and the terms of the contract give Hart the option to purchase titanium at a price of $500 per ounce. The price will be good until the contract expires on November 30, 2014. Assume the following data with respect to the price of the call options and the titanium inventory purchase. Spot Price for Date November Delivery May 1, 2014 $500 per ounce June 30, 2014 520 per ounce September 30, 2014 525 per ounce Instructions Present the journal entries for the following dates/transactions. (a) May 1, 2014—Inception of futures contract, no premium paid. (b) June 30, 2014—Hart prepares financial statements. (c) September 30, 2014—Hart prepares financial statements. (d) October 5, 2014—Hart purchases 200 ounces of titanium at $525 per ounce and settles the futures contract. Problems 1015 (e) December 15, 2014—Hart sells clubs containing titanium purchased in October 2014 for $250,000. The cost of the finished goods inventory is $140,000. (f) Indicate the amount(s) reported in the income statement related to the futures contract and the inventory transactions on December 31, 2014. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 2 P17-1 (Debt Securities) Presented below is an amortization schedule related to Spangler Company’s 5-year, $100,000 bond with a 7% interest rate and a 5% yield, purchased on December 31, 2012, for $108,660. Cash Interest Bond Premium Carrying Amount Date Received Revenue Amortization of Bonds 12/31/12 $108,660 12/31/13 $7,000 $5,433 $1,567 107,093 12/31/14 7,000 5,354 1,646 105,447 12/31/15 7,000 5,272 1,728 103,719 12/31/16 7,000 5,186 1,814 101,905 12/31/17 7,000 5,095 1,905 100,000 The following schedule presents a comparison of the amortized cost and fair value of the bonds at year-end. 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17 Amortized cost $107,093 $105,447 $103,719 $101,905 $100,000 Fair value $106,500 $107,500 $105,650 $103,000 $100,000 Instructions (a) Prepare the journal entry to record the purchase of these bonds on December 31, 2012, assuming the bonds are classified as held-to-maturity securities. (b) Prepare the journal entry(ies) related to the held-to-maturity bonds for 2013. (c) Prepare the journal entry(ies) related to the held-to-maturity bonds for 2015. (d) Prepare the journal entry(ies) to record the purchase of these bonds, assuming they are classified as available-for-sale. (e) Prepare the journal entry(ies) related to the available-for-sale bonds for 2013. (f) Prepare the journal entry(ies) related to the available-for-sale bonds for 2015. 2 P17-2 (Available-for-Sale Debt Securities) On January 1, 2014, Novotna Company purchased $400,000, 8% bonds of Aguirre Co. for $369,114. The bonds were purchased to yield 10% interest. Interest is payable semiannually on July 1 and January 1. The bonds mature on January 1, 2019. Novotna Company uses the effective-interest method to amortize discount or premium. On January 1, 2016, Novotna Company sold the bonds for $370,726 after receiving interest to meet its liquidity needs. Instructions (a) Prepare the journal entry to record the purchase of bonds on January 1. Assume that the bonds are classified as available-for-sale. (b) Prepare the amortization schedule for the bonds. (c) Prepare the journal entries to record the semiannual interest on July 1, 2014, and December 31, 2014. (d) If the fair value of Aguirre bonds is $372,726 on December 31, 2015, prepare the necessary adjusting entry. (Assume the fair value adjustment balance on January 1, 2015, is a debit of $3,375.) (e) Prepare the journal entry to record the sale of the bonds on January 1, 2016. 1016 Chapter 17 Investments 2 3 P17-3 (Available-for-Sale Investments) Cardinal Paz Corp. carries an account in its general ledger called Investments, which contained debits for investment purchases, and no credits, with the following descriptions. Feb. 1, 2014 Sharapova Company common stock, $100 par, 200 shares $ 37,400 April 1 U.S. government bonds, 11%, due April 1, 2024, interest payable

April 1 and October 1, 110 bonds of $1,000 par each 110,000 July 1 McGrath Company 12% bonds, par $50,000, dated March 1, 2014, purchased at 104 plus accrued interest, interest payable annually on March 1, due March 1, 2034 54,000 Instructions (Round all computations to the nearest dollar.) (a) Prepare entries necessary to classify the amounts into proper accounts, assuming that all the securi- ties are classified as available-for-sale. (b) Prepare the entry to record the accrued interest and the amortization of premium on December 31, 2014, using the straight-line method. (c) The fair values of the investments on December 31, 2014, were: Sharapova Company common stock $ 31,800 U.S. government bonds 124,700 McGrath Company bonds 58,600 What entry or entries, if any, would you recommend be made? (d) The U.S. government bonds were sold on July 1, 2015, for $119,200 plus accrued interest. Give the proper entry. 2 P17-4 (Available-for-Sale Debt Investments) Presented below is information taken from a bond investment amortization schedule with related fair values provided. These bonds are classified as available-for-sale. 12/31/14 12/31/15 12/31/16 Amortized cost $491,150 $519,442 $550,000 Fair value $497,000 $509,000 $550,000 Instructions (a) Indicate whether the bonds were purchased at a discount or at a premium. (b) Prepare the adjusting entry to record the bonds at fair value at December 31, 2014. The Fair Value Adjustment account has a debit balance of $1,000 prior to adjustment. (c) Prepare the adjusting entry to record the bonds at fair value at December 31, 2015. 3 P17-5 (Equity Securities Entries and Disclosures) Parnevik Company has the following securities in its investment portfolio on December 31, 2014 (all securities were purchased in 2014): (1) 3,000 shares of Anderson Co. common stock which cost $58,500, (2) 10,000 shares of Munter Ltd. common stock which cost $580,000, and (3) 6,000 shares of King Company preferred stock which cost $255,000. The Fair Value Adjust- ment account shows a credit of $10,100 at the end of 2014. In 2015, Parnevik completed the following securities transactions. 1. On January 15, sold 3,000 shares of Anderson’s common stock at $22 per share less fees of $2,150. 2. On April 17, purchased 1,000 shares of Castle’s common stock at $33.50 per share plus fees of $1,980. On December 31, 2015, the market prices per share of these securities were Munter $61, King $40, and Castle $29. In addition, the accounting supervisor of Parnevik told you that, even though all these securi- ties have readily determinable fair values, Parnevik will not actively trade these securities because the top management intends to hold them for more than one year. Instructions (a) Prepare the entry for the security sale on January 15, 2015. (b) Prepare the journal entry to record the security purchase on April 17, 2015. (c) Compute the unrealized gains or losses and prepare the adjusting entry for Parnevik on December 31, 2015. (d) How should the unrealized gains or losses be reported on Parnevik’s balance sheet? 3 P17-6 (Trading and Available-for-Sale Securities Entries) McElroy Company has the following portfolio of investment securities at September 30, 2014, its last reporting date. Problems 1017 Trading Securities Cost Fair Value Horton, Inc. common (5,000 shares) $215,000 $200,000 Monty, Inc. preferred (3,500 shares) 133,000 140,000 Oakwood Corp. common (1,000 shares) 180,000 179,000 On October 10, 2014, the Horton shares were sold at a price of $54 per share. In addition, 3,000 shares of Patriot common stock were acquired at $54.50 per share on November 2, 2014. The December 31, 2014, fair values were Monty $106,000, Patriot $132,000, and the Oakwood common $193,000. All the securities are classified as trading. Instructions (a) Prepare the journal entries to record the sale, purchase, and adjusting entries related to the trading securities in the last quarter of 2014. (b) How would the entries in part (a) change if the securities were classified as available-for-sale? 2 P17-7 (Available-for-Sale and Held-to-Maturity Debt Securities Entries) The following information

relates to the debt securities investments of Wildcat Company. 1. On February 1, the company purchased 10% bonds of Gibbons Co. having a par value of $300,000 at 100 plus accrued interest. Interest is payable April 1 and October 1. 2. On April 1, semiannual interest is received. 3. On July 1, 9% bonds of Sampson, Inc. were purchased. These bonds with a par value of $200,000 were purchased at 100 plus accrued interest. Interest dates are June 1 and December 1. 4. On September 1, bonds with a par value of $60,000, purchased on February 1, are sold at 99 plus accrued interest. 5. On October 1, semiannual interest is received. 6. On December 1, semiannual interest is received. 7. On December 31, the fair value of the bonds purchased February 1 and July 1 are 95 and 93, respectively. Instructions (a) Prepare any journal entries you consider necessary, including year-end entries (December 31), assuming these are available-for-sale securities. (b) If Wildcat classified these as held-to-maturity investments, explain how the journal entries would differ from those in part (a). 3 4 P17-8 (Fair Value and Equity Methods) Brooks Corp. is a medium-sized corporation specializing in quar- 5 rying stone for building construction. The company has long dominated the market, at one time achieving a 70% market penetration. During prosperous years, the company’s profits, coupled with a conservative dividend policy, resulted in funds available for outside investment. Over the years, Brooks has had a policy of investing idle cash in equity securities. In particular, Brooks has made periodic investments in the com- pany’s principal supplier, Norton Industries. Although the firm currently owns 12% of the outstanding common stock of Norton Industries, Brooks does not have significant influence over the operations of Norton Industries. Cheryl Thomas has recently joined Brooks as assistant controller, and her first assignment is to prepare the 2014 year-end adjusting entries for the accounts that are valued by the “fair value” rule for financial reporting purposes. Thomas has gathered the following information about Brooks’ pertinent accounts. 1. Brooks has trading securities related to Delaney Motors and Patrick Electric. During this fiscal year, Brooks purchased 100,000 shares of Delaney Motors for $1,400,000; these shares currently have a fair value of $1,600,000. Brooks’ investment in Patrick Electric has not been profitable; the company acquired 50,000 shares of Patrick in April 2014 at $20 per share, a purchase that currently has a value of $720,000. 2. Prior to 2014, Brooks invested $22,500,000 in Norton Industries and has not changed its holdings this year. This investment in Norton Industries was valued at $21,500,000 on December 31, 2013. Brooks’ 12% ownership of Norton Industries has a current fair value of $22,225,000. Instructions (a) Prepare the appropriate adjusting entries for Brooks as of December 31, 2014, to reflect the applica- tion of the “fair value” rule for both classes of securities described above. (b) For both classes of securities presented above, describe how the results of the valuation adjustments made in (a) would be reflected in the body of and notes to Brooks’ 2014 financial statements. (c) Prepare the entries for the Norton investment, assuming that Brooks owns 25% of Norton’s shares. Norton reported income of $500,000 in 2014 and paid cash dividends of $100,000. 1018 Chapter 17 Investments 3 6 P17-9 (Financial Statement Presentation of Available-for-Sale Investments) Kennedy Company has the following portfolio of available-for-sale securities at December 31, 2014. Percent Per Share Security Quantity Interest Cost Price Frank, Inc. 2,000 shares 8% $11 $16 Ellis Corp. 5,000 shares 14% 23 19 Mendota Company 4,000 shares 2% 31 24 Instructions (a) What should be reported on Kennedy’s December 31, 2014, balance sheet relative to these long-term available-for-sale securities? On December 31, 2015, Kennedy’s portfolio of available-for-sale securities consisted of the following common stocks.

Percent Per Share Security Quantity Interest Cost Price Ellis Corp. 5,000 shares 14% $23 $28 Mendota Company 4,000 shares 2% 31 23 Mendota Company 2,000 shares 1% 25 23 At the end of 2015, Kennedy Company changed its intent relative to its investment in Frank, Inc. and reclassified the shares to trading securities status when the shares were selling for $8 per share. (b) What should be reported on the face of Kennedy’s December 31, 2015, balance sheet relative to available-for-sale securities investments? What should be reported to reflect the transactions above in Kennedy’s 2015 income statement? 3 5 P17-10 (Gain on Sale of Investments and Comprehensive Income) On January 1, 2014, Acker Inc. had the following balance sheet. ACKER INC. BALANCE SHEET AS OF JANUARY 1, 2014 Assets Equity Cash $ 50,000 Common stock $260,000 Equity investments (available-for-sale) 240,000 Accumulated other comprehensive income 30,000 Total $290,000 Total $290,000 The accumulated other comprehensive income related to unrealized holding gains on available-for-sale securities. The fair value of Acker Inc.’s available-for-sale securities at December 31, 2014, was $190,000; its cost was $140,000. No securities were purchased during the year. Acker Inc.’s income statement for 2014 was as follows. (Ignore income taxes.) ACKER INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Dividend revenue $ 5,000 Gain on sale of investments 30,000 Net income $35,000 Instructions (Assume all transactions during the year were for cash.) (a) Prepare the journal entry to record the sale of the available-for-sale securities in 2014. (b) Prepare a statement of comprehensive income for 2014. (c) Prepare a balance sheet as of December 31, 2014. Problems 1019 3 P17-11 (Equity Investments—Available-for-Sale) Castleman Holdings, Inc. had the following available- for-sale investment portfolio at January 1, 2014. Evers Company 1,000 shares @ $15 each $15,000 Rogers Company 900 shares @ $20 each 18,000 Chance Company 500 shares @ $9 each 4,500 Equity investments (available-for-sale) @ cost 37,500 Fair value adjustment (available-for-sale) (7,500) Equity investments (available-for-sale) @ fair value $30,000 During 2014, the following transactions took place. 1. On March 1, Rogers Company paid a $2 per share dividend. 2. On April 30, Castleman Holdings, Inc. sold 300 shares of Chance Company for $11 per share. 3. On May 15, Castleman Holdings, Inc. purchased 100 more shares of Evers Co. stock at $16 per share. 4. At December 31, 2014, the stocks had the following price per share values: Evers $17, Rogers $19, and Chance $8. During 2015, the following transactions took place. 5. On February 1, Castleman Holdings, Inc. sold the remaining Chance shares for $8 per share. 6. On March 1, Rogers Company paid a $2 per share dividend. 7. On December 21, Evers Company declared a cash dividend of $3 per share to be paid in the next month. 8. At December 31, 2015, the stocks had the following price per share values: Evers $19 and Rogers $21. Instructions (a) Prepare journal entries for each of the above transactions. (b) Prepare a partial balance sheet showing the investment-related amounts to be reported at December 31, 2014 and 2015. 3 5 P17-12 (Available-for-Sale Securities—Statement Presentation) Fernandez Corp. invested its excess cash in available-for-sale securities during 2014. As of December 31, 2014, the portfolio of available-for-sale securities consisted of the following common stocks. Security Quantity Cost Fair Value Lindsay Jones, Inc. 1,000 shares $ 15,000 $ 21,000 Poley Corp. 2,000 shares 40,000 42,000 Arnold Aircraft 2,000 shares 72,000 60,000 Totals $127,000 $123,000 Instructions (a) What should be reported on Fernandez’s December 31, 2014, balance sheet relative to these securities? What should be reported on Fernandez’s 2014 income statement? On December 31, 2015, Fernandez’s portfolio of available-for-sale securities consisted of the following common stocks. Security Quantity Cost Fair Value Lindsay Jones, Inc. 1,000 shares $ 15,000 $20,000

Lindsay Jones, Inc. 2,000 shares 33,000 40,000 Duff Company 1,000 shares 16,000 12,000 Arnold Aircraft 2,000 shares 72,000 22,000 Totals $136,000 $94,000 During the year 2015, Fernandez Corp. sold 2,000 shares of Poley Corp. for $38,200 and purchased 2,000 more shares of Lindsay Jones, Inc. and 1,000 shares of Duff Company. (b) What should be reported on Fernandez’s December 31, 2015, balance sheet? What should be reported on Fernandez’s 2015 income statement? On December 31, 2016, Fernandez’s portfolio of available-for-sale securities consisted of the following common stocks. 1020 Chapter 17 Investments Security Quantity Cost Fair Value Arnold Aircraft 2,000 shares $72,000 $82,000 Duff Company 500 shares 8,000 6,000 Totals $80,000 $88,000 During the year 2016, Fernandez Corp. sold 3,000 shares of Lindsay Jones, Inc. for $39,900 and 500 shares of Duff Company at a loss of $2,700. (c) What should be reported on the face of Fernandez’s December 31, 2016, balance sheet? What should be reported on Fernandez’s 2016 income statement? (d) What would be reported in a statement of comprehensive income at (1) December 31, 2014, and (2) December 31, 2015? 7 *P 17-13 (Derivative Financial Instrument) The treasurer of Miller Co. has read on the Internet that the stock price of Wade Inc. is about to take off. In order to profit from this potential development, Miller Co. purchased a call option on Wade common shares on July 7, 2014, for $240. The call option is for 200 shares (notional value), and the strike price is $70. (The market price of a share of Wade stock on that date is $70.) The option expires on January 31, 2015. The following data are available with respect to the call option. Date Market Price of Wade Shares Time Value of Call Option September 30, 2014 $77 per share $180 December 31, 2014 75 per share 65 January 4, 2015 76 per share 30 Instructions Prepare the journal entries for Miller Co. for the following dates. (a) July 7, 2014—Investment in call option on Wade shares. (b) September 30, 2014—Miller prepares financial statements. (c) December 31, 2014—Miller prepares financial statements. (d) January 4, 2015—Miller settles the call option on the Wade shares. 7 *P 17-14 (Derivative Financial Instrument) Johnstone Co. purchased a put option on Ewing common shares on July 7, 2014, for $240. The put option is for 200 shares, and the strike price is $70. (The market price of a share of Ewing stock on that date is $70.) The option expires on January 31, 2015. The following data are available with respect to the put option. Date Market Price of Ewing Shares Time Value of Put Option September 30, 2014 $77 per share $125 December 31, 2014 75 per share 50 January 31, 2015 78 per share 0 Instructions Prepare the journal entries for Johnstone Co. for the following dates. (a) July 7, 2014—Investment in put option on Ewing shares. (b) September 30, 2014—Johnstone prepares financial statements. (c) December 31, 2014—Johnstone prepares financial statements. (d) January 31, 2015—Put option expires. 7 *P 17-15 (Free-Standing Derivative) Warren Co. purchased a put option on Echo common shares on January 7, 2014, for $360. The put option is for 400 shares, and the strike price is $85 (which equals the price of an Echo share on the purchase date). The option expires on July 31, 2014. The following data are available with respect to the put option. Date Market Price of Echo Shares Time Value of Put Option March 31, 2014 $80 per share $200 June 30, 2014 82 per share 90 July 6, 2014 77 per share 25 Instructions Prepare the journal entries for Warren Co. for the following dates. (a) January 7, 2014—Investment in put option on Echo shares. (b) March 31, 2014—Warren prepares financial statements. (c) June 30, 2014—Warren prepares financial statements. (d) July 6, 2014—Warren settles the put option on the Echo shares. Problems 1021 8 *P 17-16 (Fair Value Hedge Interest Rate Swap) On December 31, 2014, Mercantile Corp. had a $10,000,000, 8% fixed-rate note outstanding, payable in 2 years. It decides to enter into a 2-year swap with Chicago First

Bank to convert the fixed-rate debt to variable-rate debt. The terms of the swap indicate that Mercantile will receive interest at a fixed rate of 8.0% and will pay a variable rate equal to the 6-month LIBOR rate, based on the $10,000,000 amount. The LIBOR rate on December 31, 2014, is 7%. The LIBOR rate will be reset every 6 months and will be used to determine the variable rate to be paid for the following 6-month period. Mercantile Corp. designates the swap as a fair value hedge. Assume that the hedging relationship meets all the conditions necessary for hedge accounting. The 6-month LIBOR rate and the swap and debt fair values are as follows. Date 6-Month LIBOR Rate Swap Fair Value Debt Fair Value December 31, 2014 7.0% — $10,000,000 June 30, 2015 7.5% (200,000) 9,800,000 December 31, 2015 6.0% 60,000 10,060,000 Instructions (a) Present the journal entries to record the following transactions. (1) The entry, if any, to record the swap on December 31, 2014. (2) The entry to record the semiannual debt interest payment on June 30, 2015. (3) The entry to record the settlement of the semiannual swap amount receivables at 8%, less amount payable at LIBOR, 7%. (4) The entry to record the change in the fair value of the debt on June 30, 2015. (5) The entry to record the change in the fair value of the swap at June 30, 2015. (b) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2014. (c) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on June 30, 2015. (d) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2015. 9 *P 17-17 (Cash Flow Hedge) LEW Jewelry Co. uses gold in the manufacture of its products. LEW antici- pates that it will need to purchase 500 ounces of gold in October 2014, for jewelry that will be shipped for the holiday shopping season. However, if the price of gold increases, LEW’s cost to produce its jewelry will increase, which would reduce its profit margins. To hedge the risk of increased gold prices, on April 1, 2014, LEW enters into a gold futures contract and designates this futures contract as a cash flow hedge of the anticipated gold purchase. The notional amount of the contract is 500 ounces, and the terms of the contract give LEW the right and the obligation to purchase gold at a price of $300 per ounce. The price will be good until the contract expires on October 31, 2014. Assume the following data with respect to the price of the futures contract and the gold inventory purchase. Date Spot Price for October Delivery April 1, 2014 $300 per ounce June 30, 2014 310 per ounce September 30, 2014 315 per ounce Instructions Prepare the journal entries for the following transactions. (a) April 1, 2014—Inception of the futures contract, no premium paid. (b) June 30, 2014—LEW Co. prepares financial statements. (c) September 30, 2014—LEW Co. prepares financial statements. (d) October 10, 2014—LEW Co. purchases 500 ounces of gold at $315 per ounce and settles the futures contract. (e) December 20, 2014—LEW sells jewelry containing gold purchased in October 2014 for $350,000. The cost of the finished goods inventory is $200,000. (f) Indicate the amount(s) reported on the balance sheet and income statement related to the futures contract on June 30, 2014. (g) Indicate the amount(s) reported in the income statement related to the futures contract and the in- ventory transactions on December 31, 2014. 8 * P17-18 (Fair Value Hedge) On November 3, 2014, Sprinkle Co. invested $200,000 in 4,000 shares of the common stock of Pratt Co. Sprinkle classified this investment as available-for-sale. Sprinkle Co. is consid- ering making a more significant investment in Pratt Co. at some point in the future but has decided to wait and see how the stock does over the next several quarters. 1022 Chapter 17 Investments To hedge against potential declines in the value of Pratt stock during this period, Sprinkle also pur-

chased a put option on the Pratt stock. Sprinkle paid an option premium of $600 for the put option, which gives Sprinkle the option to sell 4,000 Pratt shares at a strike price of $50 per share. The option expires on July 31, 2015. The following data are available with respect to the values of the Pratt stock and the put option. Date Market Price of Pratt Shares Time Value of Put Option December 31, 2014 $50 per share $375 March 31, 2015 45 per share 175 June 30, 2015 43 per share 40 Instructions (a) Prepare the journal entries for Sprinkle Co. for the following dates. (1) November 3, 2014—Investment in Pratt stock and the put option on Pratt shares. (2) December 31, 2014—Sprinkle Co. prepares financial statements. (3) March 31, 2015—Sprinkle prepares financial statements. (4) June 30, 2015—Sprinkle prepares financial statements. (5) July 1, 2015—Sprinkle settles the put option and sells the Pratt shares for $43 per share. (b) Indicate the amount(s) reported on the balance sheet and income statement related to the Pratt investment and the put option on December 31, 2014. (c) Indicate the amount(s) reported on the balance sheet and income statement related to the Pratt investment and the put option on June 30, 2015. PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA17-1 (Issues Raised about Investment Securities) You have just started work for Warren Co. as part of the controller’s group involved in current financial reporting problems. Jane Henshaw, controller for Warren, is interested in your accounting background because the company has experienced a series of financial reporting surprises over the last few years. Recently, the controller has learned from the company’s auditors that there is authoritative literature that may apply to its investment in securities. She assumes that you are familiar with this pronouncement and asks how the following situations should be reported in the financial statements. Situation 1: Trading securities in the current assets section have a fair value that is $4,200 lower than cost. Situation 2: A trading security whose fair value is currently less than cost is transferred to the available- for-sale category. Situation 3: An available-for-sale security whose fair value is currently less than cost is classified as noncurrent but is to be reclassified as current. Situation 4: A company’s portfolio of available-for-sale securities consists of the common stock of one company. At the end of the prior year, the fair value of the security was 50% of original cost, and this reduc- tion in fair value was reported as an other than temporary impairment. However, at the end of the current year, the fair value of the security had appreciated to twice the original cost. Situation 5: The company has purchased some convertible debentures that it plans to hold for less than a year. The fair value of the convertible debentures is $7,700 below its cost. Instructions What is the effect upon carrying value and earnings for each of the situations above? Assume that these situations are unrelated. CA17-2 (Equity Securities) Lexington Co. has the following available-for-sale securities outstanding on December 31, 2014 (its first year of operations). Cost Fair Value Greenspan Corp. Stock $20,000 $19,000 Summerset Company Stock 9,500 8,800 Tinkers Company Stock 20,000 20,600 $49,500 $48,400 Concepts for Analysis 1023 During 2015, Summerset Company stock was sold for $9,200, the difference between the $9,200 and the “fair value” of $8,800 being recorded as a “Gain on Sale of Investments.” The market price of the stock on December 31, 2015, was Greenspan Corp. stock $19,900; Tinkers Company stock $20,500. Instructions (a) What justification is there for valuing available-for-sale securities at fair value and reporting the unrealized gain or loss as part of stockholders’ equity? (b) How should Lexington Company apply this rule on December 31, 2014? Explain. (c) Did Lexington Company properly account for the sale of the Summerset Company stock? Explain.

(d) Are there any additional entries necessary for Lexington Company at December 31, 2015, to reflect the facts on the financial statements in accordance with generally accepted accounting principles? Explain. (AICPA adapted) CA17-3 (Financial Statement Effect of Equity Securities) Presented below are three unrelated situations involving equity securities. Situation 1: An equity security, whose fair value is currently less than cost, is classified as available-for-sale but is to be reclassified as trading. Situation 2: A noncurrent portfolio with an aggregate fair value in excess of cost includes one particular security whose fair value has declined to less than one-half of the original cost. The decline in value is con- sidered to be other than temporary. Situation 3: The portfolio of trading securities has a cost in excess of fair value of $13,500. The available- for-sale portfolio has a fair value in excess of cost of $28,600. Instructions What is the effect upon carrying value and earnings for each of the situations above? CA17-4 (Investment Accounted for under the Equity Method) On July 1, 2015, Fontaine Company pur- chased for cash 40% of the outstanding capital stock of Knoblett Company. Both Fontaine Company and Knoblett Company have a December 31 year-end. Knoblett Company, whose common stock is actively traded in the over-the-counter market, reported its total net income for the year to Fontaine Company and also paid cash dividends on November 15, 2015, to Fontaine Company and its other stockholders. Instructions How should Fontaine Company report the above facts in its December 31, 2015, balance sheet and its income statement for the year then ended? Discuss the rationale for your answer. (AICPA adapted) CA17-5 (Equity Investment) On July 1, 2014, Selig Company purchased for cash 40% of the outstanding capital stock of Spoor Corporation. Both Selig and Spoor have a December 31 year-end. Spoor Corporation, whose common stock is actively traded on the American Stock Exchange, paid a cash dividend on Novem- ber 15, 2014, to Selig Company and its other stockholders. It also reported its total net income for the year of $920,000 to Selig Company. Instructions Prepare a one-page memorandum of instructions on how Selig Company should report the above facts in its December 31, 2014, balance sheet and its 2014 income statement. In your memo, identify and describe the method of valuation you recommend. Provide rationale where you can. Address your memo to the chief accountant at Selig Company. CA17-6 (Fair Value) Addison Manufacturing holds a large portfolio of debt and equity securities as an investment. The fair value of the portfolio is greater than its original cost, even though some securities have decreased in value. Sam Beresford, the financial vice president, and Angie Nielson, the controller, are near year-end in the process of classifying for the first time this securities portfolio in accordance with GAAP. Beresford wants to classify those securities that have increased in value during the period as trading securities in order to increase net income this year. He wants to classify all the securities that have decreased in value as available-for-sale (the equity securities) and as held-to-maturity (the debt securities). Nielson disagrees. She wants to classify those securities that have decreased in value as trading securi- ties and those that have increased in value as available-for-sale (equity) and held-to-maturity (debt). She contends that the company is having a good earnings year and that recognizing the losses will help to smooth the income this year. As a result, the company will have built-in gains for future periods when the company may not be as profitable. 1024 Chapter 17 Investments Instructions Answer the following questions. (a) Will classifying the portfolio as each proposes actually have the effect on earnings that each says it will? (b) Is there anything unethical in what each of them proposes? Who are the stakeholders affected by their proposals? (c) Assume that Beresford and Nielson properly classify the entire portfolio into trading, available-

for-sale, and held-to-maturity categories. But then each proposes to sell just before year-end the securities with gains or with losses, as the case may be, to accomplish their effect on earnings. Is this unethical? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What investments does P&G report in 2011, and how are these investments accounted for in its finan- cial statements? (b) How are P&G’s investments valued? How does P&G determine fair value? (c) How does P&G use derivative financial instruments? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) Based on the information contained in these financial statements, determine each of the following for each company. (1) Cash used in (for) investing activities during 2011 (from the statement of cash flows). (2) Cash used for acquisitions and investments in unconsolidated affiliates (or principally bottling companies) during 2011. (3) Total investment in unconsolidated affiliates (or investments and other assets) at the end of 2011. (b) (1) Briefly identify from Coca-Cola’s December 31, 2011, balance sheet the investments it reported as being accounted for under the equity method. (2) What is the amount of investments that Coca-Cola reported in its 2011 balance sheet as “cost method investments,” and what is the nature of these investments? (c) In its Note 2 on Investments, what total amounts did Coca-Cola report at December 31, 2011, as: (1) trading securities, (2) available-for-sale securities, and (3) held-to-maturity securities? Financial Statement Analysis Case Union Planters Union Planters is a Tennessee bank holding company (that is, a corporation that owns banks). (Union Planters is now part of Regions Bank.) Union Planters manages $32 billion in assets, the largest of which is its loan portfolio of $19 billion. In addition to its loan portfolio, however, like other banks it has signifi- cant debt investments. The nature of these investments varies from short-term in nature to long-term in nature. As a consequence, consistent with the requirements of accounting rules, Union Planters reports its Using Your Judgment 1025 investments in two different categories—trading and available-for-sale. The following facts were found in a recent Union Planters’ annual report. Gross Gross Amortized Unrealized Unrealized Fair (all dollars in millions) Cost Gains Losses Value Trading account assets $ 275 — — $ 275 Securities available for sale 8,209 $108 $15 8,302 Net income 224 Net securities gains (losses) (9) Instructions (a) Why do you suppose Union Planters purchases investments, rather than simply making loans? Why does it purchase investments that vary in nature both in terms of their maturities and in type (debt versus stock)? (b) How must Union Planters account for its investments in each of the two categories? (c) In what ways does classifying investments into two different categories assist investors in evaluating the profitability of a company like Union Planters? (d) Suppose that the management of Union Planters was not happy with its net income for the year. What step could it have taken with its investment portfolio that would have definitely increased reported profit? How much could it have increased reported profit? Why do you suppose it chose not to do this? Accounting, Analysis, and Principles Instar Company has several investments in the securities of other companies. The following information regarding these investments is available at December 31, 2014. 1. Instar holds bonds issued by Dorsel Corp. The bonds have an amortized cost of $320,000 and their

fair value at December 31, 2014, is $400,000. Instar intends to hold the bonds until they mature on December 31, 2022. 2. Instar has invested idle cash in the equity securities of several publicly traded companies. Instar in- tends to sell these securities during the first quarter of 2015, when it will need the cash to acquire seasonal inventory. These equity securities have a cost basis of $800,000 and a fair value of $920,000 at December 31, 2014. 3. Instar has a significant ownership stake in one of the companies that supplies Instar with various components Instar uses in its products. Instar owns 6% of the common stock of the supplier, does not have any representation on the supplier’s board of directors, does not exchange any personnel with the supplier, and does not consult with the supplier on any of the supplier’s operating, financial, or strategic decisions. The cost basis of the investment in the supplier is $1,200,000 and the fair value of the investment at December 31, 2014, is $1,550,000. Instar does not intend to sell the investment in the foreseeable future. The supplier reported net income of $80,000 for 2014 and paid no dividends. 4. Instar owns some common stock of Forter Corp. The cost basis of the investment in Forter is $200,000 and the fair value at December 31, 2014, is $50,000. Instar believes the decline in the value of its invest- ment in Forter is other than temporary, but Instar does not intend to sell its investment in Forter in the foreseeable future. 5. Instar purchased 25% of the stock of Slobbaer Co. for $900,000. Instar has significant influence over the operating activities of Slobbaer Co. During 2014, Slobbaer Co. reported net income of $300,000 and paid a dividend of $100,000. Accounting (a) Determine whether each of the investments described above should be classified as available-for-sale, held-to-maturity, trading, or equity method. (b) Prepare any December 31, 2014, journal entries needed for Instar relating to Instar’s various invest- ments in other companies. Assume 2014 is Instar’s first year of operations. Analysis What is the effect on Instar’s 2014 net income (as reported on Instar’s income statement) of Instar’s invest- ments in other companies? 1026 Chapter 17 Investments Principles Briefly explain the different rationales for the different accounting and reporting rules for different types of investments in the securities of other companies. BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Your client, Cascade Company, is planning to invest some of its excess cash in 5-year revenue bonds issued by the county and in the stock of one of its suppliers, Teton Co. Teton’s shares trade on the over-the-counter market. Cascade plans to classify these investments as available-for-sale. They would like you to conduct some research on the accounting for these investments. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Since the Teton shares do not trade on one of the large stock markets, Cascade argues that the fair value of this investment is not readily available. According to the authoritative literature, when is the fair value of a security “readily determinable”? (b) How is an impairment of a security accounted for? (c) To avoid volatility in their financial statements due to fair value adjustments, Cascade debated whether the bond investment could be classified as held-to-maturity; Cascade is pretty sure it will hold the bonds for 5 years. How close to maturity could Cascade sell an investment and still classify it as held- to-maturity? (d) What disclosures must be made for any sale or transfer from securities classified as held-to-maturity? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS The accounting for investments is discussed in IAS 27 (“Consolidated and

LEARNING OBJECTIVE 13 Separate Financial Statements”), IAS 28 (“Accounting for Investments in Associ- Compare the accounting for ates”), IAS 39 (“Financial Instruments: Recognition and Measurement”), and investments under GAAP and IFRS. IFRS 9 (“Financial Instruments”). Until recently, when the IASB issued IFRS 9, the accounting and reporting for investments under IFRS and GAAP were for the most part very similar. However, IFRS 9 introduces new investment classifications and increases the situations when investments are accounted for at fair value, with gains and losses recorded in income. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to investments. Similarities • GAAP and IFRS use similar classifi cations for trading investments. • The accounting for trading investments is the same between GAAP and IFRS. Held- to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at IFRS Insights 1027 amortized cost. Gains and losses on some investments are reported in other compre- hensive income. • Both GAAP and IFRS use the same test to determine whether the equity method of accounting should be used, that is, signifi cant infl uence with a general guideline of over 20 percent ownership. • GAAP and IFRS are similar in the accounting for the fair value option. That is, the option to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income. • The measurement of impairments is similar under GAAP and IFRS. Differences • While GAAP classifi es investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (only for debt investments), IFRS uses held-for-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifi cations. • The basis for consolidation under IFRS is control. Under GAAP, a bipolar approach is used, which is a risk-and-reward model (often referred to as a variable-entity approach, discussed in Appendix 17B) and a voting-interest approach. However, under both sys- tems, for consolidation to occur, the investor company must generally own 50 percent of another company. • While the measurement of impairments is similar under GAAP and IFRS, GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. IFRS allows reversals of impairments of held-for-collection investments. • While GAAP and IFRS are similar in the accounting for the fair value option, one dif- ference is that GAAP permits the fair value option for equity method investments; IFRS does not. ABOUT THE NUMBERS Accounting for Financial Assets A financial asset is cash, an equity investment of another company (e.g., ordinary or preference shares), or a contractual right to receive cash from another party (e.g., loans, receivables, and bonds). The accounting for cash is relatively straightforward and is discussed in Chapter 7. The accounting and reporting for equity and debt investments, as discussed in the opening story, is extremely contentious, particularly in light of the credit crisis in the latter part of 2008. IFRS requires that companies determine how to measure their financial assets based on two criteria: • The company’s business model for managing its fi nancial assets; and • The contractual cash fl ow characteristics of the fi nancial asset. If a company has (1) a business model whose objective is to hold assets in order to collect contractual cash flows and (2) the contractual terms of the financial asset provides spec- ified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding, then the company should use amortized cost. For example, assume that Mitsubishi purchases a bond investment that it intends to hold to maturity. Its business model for this type of investment is to collect interest and then principal at maturity. The payment dates for the interest rate and principal are

stated on the bond. In this case, Mitsubishi accounts for the investment at amortized cost. If, on the other hand, Mitsubishi purchased the bonds as part of a trading strategy to 1028 Chapter 17 Investments speculate on interest rate changes (a trading investment), then the debt investment is reported at fair value. As a result, only debt investments such as receivables, loans, and bond investments that meet the two criteria above are recorded at amortized cost. All other debt investments are recorded and reported at fair value. Equity investments are generally recorded and reported at fair value. Equity invest- ments do not have a fixed interest or principal payment schedule and therefore cannot be accounted for at amortized cost. In summary, companies account for investments based on the type of security, as indicated in Illustration IFRS17-1. ILLUSTRATION Type of Investment Assessment of Accounting Criteria Valuation Approach IFRS17-1 Meets business model (held-for-collection) and Amortized cost Summary of Investment contractual cash flow tests. Accounting Approaches Debt Does not meet the business model test Fair value (not held-for-collection). Does not meet contractual cash flow test. Fair value Equity Exercises some control. Equity method Debt Investments Debt Investments—Amortized Cost Only debt investments can be measured at amortized cost. If a company like Carrefour makes an investment in the bonds of Nokia, it will receive contractual cash flows of interest over the life of the bonds and repayment of the principal at maturity. If it is Carrefour’s strategy to hold this investment in order to receive these cash flows over the life of the bond, it has a held-for-collection strategy and it will measure the investment at amortized cost.44 Example: Debt Investment at Amortized Cost. To illustrate the accounting for a debt investment at amortized cost, assume that Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2014, at a discount, paying $92,278. The bonds mature January 1, 2019, and yield 10 percent; interest is payable each July 1 and January 1. Robinson records the investment as follows. January 1, 2014 Debt Investments 92,278 Cash 92,278 As indicated in Chapter 14, companies must amortize premiums or discounts using the effective-interest method. They apply the effective-interest method to bond invest- ments in a way similar to that for bonds payable. To compute interest revenue, compa- nies compute the effective-interest rate or yield at the time of investment and apply that rate to the beginning carrying amount (book value) for each interest period. The invest- ment carrying amount is increased by the amortized discount or decreased by the amortized premium in each period. Illustration IFRS17-2 shows the effect of the discount amortization on the interest revenue that Robinson records each period for its investment in Evermaster bonds. 44Classification as held-for-collection does not mean the security must be held to maturity. For example, a company may sell an investment before maturity if (1) the security does not meet the company’s investment strategy (e.g., the company has a policy to invest in only AAA-rated bonds but the bond investment has a decline in its credit rating), (2) a company changes its strategy to invest only in securities within a certain maturity range, or (3) the company needs to sell a security to fund certain capital expenditures. However, if a company begins trading held-for-collection investments on a regular basis, it should assess whether such trading is consistent with the held-for-collection classification. IFRS Insights 1029 ILLUSTRATION 8% BONDS PURCHASED TO YIELD 10% IFRS17-2 Bond Carrying Schedule of Interest Cash Interest Discount Amount Revenue and Bond Date Received Revenue Amortization of Bonds Discount Amortization— 1/1/14 $ 92,278 Effective-Interest Method 7/1/14 $ 4,000a $ 4,614b $ 614c 92,892d 1/1/15 4,000 4,645 645 93,537 7/1/15 4,000 4,677 677 94,214 1/1/16 4,000 4,711 711 94,925 7/1/16 4,000 4,746 746 95,671

1/1/17 4,000 4,783 783 96,454 7/1/17 4,000 4,823 823 97,277 1/1/18 4,000 4,864 864 98,141 7/1/18 4,000 4,907 907 99,048 1/1/19 4,000 4,952 952 100,000 $40,000 $47,722 $7,722 a$4,000 5 $100,000 3 .08 3 6y12 b$4,614 5 $92,278 3 .10 3 6y12 c$614 5 $4,614 2 $4,000 d$92,892 5 $92,278 1 $614 Robinson records the receipt of the first semiannual interest payment on July 1, 2014 (using the data in Illustration IFRS17-2), as follows. July 1, 2014 Cash 4,000 Debt Investments 614 Interest Revenue 4,614 Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2014, as follows. December 31, 2014 Interest Receivable 4,000 Debt Investments 645 Interest Revenue 4,645 Again, Illustration IFRS17-2 shows the interest and amortization amounts. Thus, the accounting for held-for-collection investments in IFRS is the same as held-to-maturity investments under GAAP. Debt Investments—Fair Value In some cases, companies both manage and evaluate investment performance on a fair value basis. In these situations, these investments are managed and evaluated based on a documented risk-management or investment strategy based on fair value informa- tion. For example, some companies often hold debt investments with the intention of selling them in a short period of time. These debt investments are often referred to as trading investments because companies frequently buy and sell these investments to generate profits in short-term differences in price. Companies that account for and report debt investments at fair value follow the same accounting entries as debt investments held-for-collection during the reporting period. That is, they are recorded at amortized cost. However, at each reporting date, companies adjust the amortized cost to fair value, with any unrealized holding gain or loss reported as part of net income (fair value method). An unrealized holding gain or loss is the net change in the fair value of a debt investment from one period to another. Example: Debt Investment at Fair Value. To illustrate the accounting for debt invest- ments using the fair value approach, assume the same information as in our previous 1030 Chapter 17 Investments illustration for Robinson Company. Recall that Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2014, at a discount, paying $92,278.45 The bonds mature January 1, 2019, and yield 10 percent; interest is payable each July 1 and January 1. The journal entries in 2014 are exactly the same as those for amortized cost. These entries are as follows. January 1, 2014 Debt Investments 92,278 Cash 92,278 July 1, 2014 Cash 4,000 Debt Investments 614 Interest Revenue 4,614 December 31, 2014 Interest Receivable 4,000 Debt Investments 645 Interest Revenue 4,645 Again, Illustration IFRS17-2 shows the interest and amortization amounts. If the debt investment is held-for-collection, no further entries are necessary. To apply the fair value approach, Robinson determines that, due to a decrease in interest rates, the fair value of the debt investment increased to $95,000 at December 31, 2014. Comparing the fair value with the carrying amount of these bonds at December 31, 2014, Robinson has an unrealized holding gain of $1,463, as shown in Illustration IFRS17-3. ILLUSTRATION Fair value at December 31, 2014 $95,000 IFRS17-3 Amortized cost at December 31, 2014 (per Illustration IFRS17-2) 93,537 Computation of Unrealized holding gain or (loss) $ 1,463 Unrealized Gain on Fair Value Debt Investment (2014) Robinson therefore makes the following entry to record the adjustment of the debt investment to fair value at December 31, 2014. Fair Value Adjustment 1,463 Unrealized Holding Gain or Loss—Income 1,463 Robinson uses a valuation account (Fair Value Adjustment) instead of debiting Debt Investments to record the investment at fair value. The use of the Fair Value Adjustment account enables Robinson to maintain a record at amortized cost in the accounts. Because the valuation account has a debit balance, in this case the fair value of

Robinson’s debt investment is higher than its amortized cost. The Unrealized Holding Gain or Loss—Income account is reported in the other in- come and expense section of the income statement as part of net income. This account is closed to net income each period. The Fair Value Adjustment account is not closed each period and is simply adjusted each period to its proper valuation. The Fair Value Adjustment balance is not shown on the statement of financial position but is simply used to restate the debt investment account to fair value. 45Companies may incur brokerage and transaction costs in purchasing securities. For investments accounted for at fair value (both debt and equity), IFRS requires that these costs be recorded in net income as other income and expense and not as an adjustment to the carrying value of the investment. IFRS Insights 1031 Robinson reports its investment in Evermaster bonds in its December 31, 2014, financial statements as shown in Illustration IFRS17-4. ILLUSTRATION Statement of Financial Position IFRS17-4 Current assets Financial Statement Interest receivable $ 4,000 Presentation of Debt Debt investments (trading) 95,000 Investments at Fair Value Income Statement Other income and expense Interest revenue ($4,614 1 $4,645) $ 9,259 Unrealized holding gain or (loss) 1,463 As you can see from this example, the accounting for trading debt investments under IFRS is the same as GAAP. Equity Investments As in GAAP, under IFRS, the degree to which one corporation (investor) acquires an interest in the shares of another corporation (investee) generally determines the accounting treatment for the investment subsequent to acquisition. To review, the classification of such investments depends on the percentage of the investee voting shares that is held by the investor: 1. Holdings of less than 20 percent (fair value method)—investor has passive interest. 2. Holdings between 20 percent and 50 percent (equity method)—investor has signifi cant infl uence. 3. Holdings of more than 50 percent (consolidated statements)—investor has controlling interest. The accounting and reporting for equity investments therefore depend on the level of influence and the type of security involved, as shown in Illustration IFRS17-5. ILLUSTRATION Unrealized Holding IFRS17-5 Category Valuation Gains or Losses Other Income Effects Accounting and Holdings less Reporting for Equity than 20% Investments by Category 1. Trading Fair value Recognized in net Dividends declared; income gains and losses from sale. 2. Non- Fair value Recognized in “Other Dividends declared; Trading comprehensive gains and losses income” (OCI) and as from sale. separate component of equity Holdings between Equity Not recognized Proportionate share 20% and 50% of investee’s net income. Holdings more Consolidation Not recognized Not applicable. than 50% Equity Investments at Fair Value When an investor has an interest of less than 20 percent, it is presumed that the investor has little or no influence over the investee. As indicated in Illustration IFRS17-5, there are two classifications for holdings less than 20 percent. Under IFRS, the presumption is 1032 Chapter 17 Investments that equity investments are held-for-trading. That is, companies hold these securities to profit from price changes. As with debt investments that are held-for trading, the gen- eral accounting and reporting rule for these investments is to value the securities at fair value and record unrealized gains and losses in net income (fair value method).46 However, some equity investments are held for purposes other than trading. For example, a company may be required to hold an equity investment in order to sell its products in a particular area. In this situation, the recording of unrealized gains and losses in income, as is required for trading investments, is not indicative of the company’s performance with respect to this investment. As a result, IFRS allows companies to classify some equity investments as non-trading. Non-trading equity investments are recorded at fair value on the statement of financial position, with unrealized gains and

losses reported in other comprehensive income. Example: Equity Investment (Income). Upon acquisition, companies record equity in- vestments at fair value. To illustrate, assume that on November 3, 2014, Republic Cor- poration purchased ordinary shares of three companies, each investment representing less than a 20 percent interest. Cost Burberry $259,700 Nestlé 317,500 St. Regis Pulp Co. 141,350 Total cost $718,550 Republic records these investments as follows. November 3, 2014 Equity Investments 718,550 Cash 718,550 On December 6, 2014, Republic receives a cash dividend of $4,200 on its investment in the ordinary shares of Nestlé. It records the cash dividend as follows. December 6, 2014 Cash 4,200 Dividend Revenue 4,200 All three of the investee companies reported net income for the year, but only Nestlé declared and paid a dividend to Republic. But, recall that when an investor owns less than 20 percent of the shares of another corporation, it is presumed that the investor has relatively little influence on the investee. As a result, net income of the investee is not a proper basis for recognizing income from the investment by the investor. Why? Because the increased net assets resulting from profitable operations may be permanently retained for use in the investee’s business. Therefore, the investor recog- nizes net income only when the investee declares cash dividends. At December 31, 2014, Republic’s equity investment portfolio has the carrying value and fair value shown in Illustration IFRS17-6. 46Fair value at initial recognition is the transaction price (exclusive of brokerage and other transaction costs). Subsequent fair value measurements should be based on market prices, if available. For non-traded investments, a valuation technique based on discounted expected cash flows can be used to develop a fair value estimate. While IFRS requires that all equity investments be measured at fair value, in certain limited cases, cost may be an appropriate estimate of fair value for an equity investment. IFRS Insights 1033 ILLUSTRATION EQUITY INVESTMENT PORTFOLIO IFRS17-6 DECEMBER 31, 2014 Computation of Fair Carrying Value Adjustment— Investments Value Fair Value Unrealized Gain (Loss) Equity Investment Burberry $259,700 $275,000 $ 15,300 Portfolio (2014) Nestlé 317,500 304,000 (13,500) St. Regis Pulp Co. 141,350 104,000 (37,350) Total of portfolio $718,550 $683,000 (35,550) Previous fair value adjustment balance –0– Fair value adjustment—Cr. $(35,550) For Republic’s equity investment portfolio, the gross unrealized gains are $15,300, and the gross unrealized losses are $50,850 ($13,500 1 $37,350), resulting in a net unrealized loss of $35,550. The fair value of the equity investment portfolio is below cost by $35,550. As with debt investments, Republic records the net unrealized gains and losses related to changes in the fair value of equity investments in an Unrealized Holding Gain or Loss—Income account. Republic reports this amount as other income and expense. In this case, Republic prepares an adjusting entry debiting the Unrealized Holding Gain or Loss—Income account and crediting the Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows. December 31, 2014 Unrealized Holding Gain or Loss—Income 35,550 Fair Value Adjustment 35,550 On January 23, 2015, Republic sold all of its Burberry ordinary shares, receiving $287,220. Illustration IFRS17-7 shows the computation of the realized gain on the sale. ILLUSTRATION Net proceeds from sale $287,220 IFRS17-7 Cost of Burberry shares 259,700 Computation of Gain on Gain on sale of shares $ 27,520 Sale of Burberry Shares Republic records the sale as follows. January 23, 2015 Cash 287,220 Equity Investments 259,700 Gain on Sale of Equity Investment 27,520 As indicated in this example, the fair value method accounting for trading equity investments under IFRS is the same as GAAP for trading equity investments. As shown in the next section, the accounting for non-trading equity investments under IFRS is similar to the accounting for available-for-sale equity investments under GAAP.

Example: Equity Investments (OCI). The accounting entries to record non-trading equity investments are the same as for trading equity investments, except for recording the unrealized holding gain or loss. For non-trading equity investments, companies report the unrealized holding gain or loss as other comprehensive income (OCI). Thus, the account titled Unrealized Holding Gain or Loss—Equity is used. To illustrate, assume that on December 10, 2014, Republic Corporation purchased $20,750 of 1,000 ordinary shares of Hawthorne Company for $20.75 per share (which represents less than a 20 percent interest). Hawthorne is a distributor for Republic products in certain locales, the laws of which require a minimum level of share ownership of a company in that region. The investment in Hawthorne meets this regulatory 1034 Chapter 17 Investments requirement. As a result, Republic accounts for this investment at fair value, with unre- alized gains and losses recorded in OCI.47 Republic records this investment as follows. December 10, 2014 Equity Investments 20,750 Cash 20,750 On December 27, 2014, Republic receives a cash dividend of $450 on its investment in the ordinary shares of Hawthorne Company. It records the cash dividend as follows. December 27, 2014 Cash 450 Dividend Revenue 450 Similar to the accounting for trading investments, when an investor owns less than 20 percent of the ordinary shares of another corporation, it is presumed that the investor has relatively little influence on the investee. Therefore, the investor earns income when the investee declares cash dividends. At December 31, 2014, Republic’s investment in Hawthorne has the carrying value and fair value shown in Illustration IFRS17-8. ILLUSTRATION Unrealized IFRS17-8 Non-Trading Equity Investment Carrying Value Fair Value Gain (Loss) Computation of Fair Hawthorne Company $20,750 $24,000 $3,250 Value Adjustment— Previous fair value adjustment balance 0 Non-Trading Equity Fair value adjustment (Dr.) $3,250 Investment (2014) For Republic’s non-trading investment, the unrealized gain is $3,250. That is, the fair value of the Hawthorne investment exceeds cost by $3,250. Because Republic has classified this investment as non-trading, Republic records the unrealized gains and losses related to changes in the fair value of this non-trading equity investment in an Unrealized Holding Gain or Loss—Equity account. Republic reports this amount as a part of other comprehen- sive income and as a component of other accumulated comprehensive income (reported in equity) until realized. In this case, Republic prepares an adjusting entry crediting the Unrealized Holding Gain or Loss—Equity account and debiting the Fair Value Adjustment account to record the decrease in fair value and to record the loss as follows. December 31, 2014 Fair Value Adjustment 3,250 Unrealized Holding Gain or Loss—Equity 3,250 Republic reports its equity investments in its December 31, 2014, financial statements as shown in Illustration IFRS17-9. ILLUSTRATION Statement of Financial Position IFRS17-9 Investments Financial Statement Equity investments (non-trading) $24,000 Presentation of Equity Equity Investments at Fair Value Accumulated other comprehensive gain $ 3,250 (2014) Statement of Comprehensive Income Other income and expense Dividend revenue $ 450 Other comprehensive income Unrealized holding gain $ 3,250 47The classification of an equity investment as non-trading is irrevocable. This approach is designed to provide some discipline to the application of the non-trading classification, which allows unrealized gains and losses to bypass net income. IFRS Insights 1035 During 2015, sales of Republic products through Hawthorne as a distributor did not meet management’s goals. As a result, Republic withdrew from these markets and on December 20, 2015, Republic sold all of its Hawthorne Company ordinary shares, receiving net proceeds of $22,500. Illustration IFRS17-10 shows the computation of the realized gain on the sale. ILLUSTRATION Net proceeds from sale $22,500 IFRS17-10 Cost of Hawthorne shares 20,750

Computation of Gain on Gain on sale of shares $ 1,750 Sale of Shares Republic records the sale as follows. December 20, 2015 Cash 22,500 Equity Investments 20,750 Gain on Sale of Equity Investment 1,750 Because Republic no longer holds any equity investments, it makes the following entry to eliminate the Fair Value Adjustment account. December 31, 2015 Unrealized Holding Gain or Loss—Equity 3,250 Fair Value Adjustment 3,250 In summary, the accounting for non-trading equity investments deviates from the general provisions for equity investments. The IASB noted that while fair value pro- vides the most useful information about investments in equity investments, recording unrealized gains or losses in other comprehensive income is more representative for non-trading equity investments. Impairments A company should evaluate every held-for-collection investment, at each reporting date, to determine if it has suffered impairment—a loss in value such that the fair value of the investment is below its carrying value.48 For example, if an investee experiences a bankruptcy or a significant liquidity crisis, the investor may suffer a permanent loss. If the company determines that an investment is impaired, it writes down the amortized cost basis of the individual security to reflect this loss in value. The company accounts for the write-down as a realized loss, and it includes the amount in net income. For debt investments, a company uses the impairment test to determine whether “it is probable that the investor will be unable to collect all amounts due according to the contractual terms.” If an investment is impaired, the company should measure the loss due to the impairment. This impairment loss is calculated as the difference between the carrying amount plus accrued interest and the expected future cash flows discounted at the investment’s historical effective-interest rate. Example: Impairment Loss At December 31, 2013, Mayhew Company has a debt investment in Bellovary Inc., pur- chased at par for $200,000. The investment has a term of four years, with annual interest payments at 10 percent, paid at the end of each year (the historical effective-interest rate is 10 percent). This debt investment is classified as held-for-collection. Unfortunately, Bellovary is experiencing significant financial difficulty and indicates that it will be unable 48Note that impairments tests are conducted only for debt investments that are held-for-collection (which are accounted for at amortized cost). Other debt and equity investments are measured at fair value each period; thus, an impairment test is not needed. 1036 Chapter 17 Investments to make all payments according to the contractual terms. Mayhew uses the present value method for measuring the required impairment loss. Illustration IFRS17-11 shows the cash flow schedule prepared for this analysis. ILLUSTRATION Contractual Expected Loss of IFRS17-11 Dec. 31 Cash Flows Cash Flows Cash Flows Investment Cash Flows 2014 $ 20,000 $ 16,000 $ 4,000 2015 20,000 16,000 4,000 2016 20,000 16,000 4,000 2017 220,000 216,000 4,000 Total cash flows $280,000 $264,000 $16,000 As indicated, the expected cash flows of $264,000 are less than the contractual cash flows of $280,000. The amount of the impairment to be recorded equals the difference between the recorded investment of $200,000 and the present value of the expected cash flows, as shown in Illustration IFRS17-12. ILLUSTRATION Recorded investment $200,000 IFRS17-12 Less: Present value of $200,000 due in 4 years at 10% Computation of (Table 6-2); FV(PVF ); ($200,000 3 .68301) $136,602 4,10% Impairment Loss Present value of $16,000 interest receivable annually for 4 years at 10% (Table 6-4); R(PVF-OA ); 4,10% ($16,000 3 3.16986) 50,718 187,320 Loss on impairment $ 12,680 The loss due to the impairment is $12,680. Why isn’t it $16,000 ($280,000 2 $264,000)? A loss of $12,680 is recorded because Mayhew must measure the loss at a present value amount, not at an undiscounted amount. Mayhew recognizes an impairment loss of $12,680 by debiting Loss on Impairment for the expected loss. At the same time, it reduces the

overall value of the investment. The journal entry to record the loss is therefore as follows. Loss on Impairment 12,680 Debt Investments 12,680 Recovery of Impairment Loss Subsequent to recording an impairment, events or economic conditions may change such that the extent of the impairment loss decreases (e.g., due to an improvement in the debtor’s credit rating). In this situation, some or all of the previously recognized impair- ment loss shall be reversed with a debit to the Debt Investments account and a credit to Recovery of Impairment Loss. Similar to the accounting for impairments of receivables shown in Chapter 7, the reversal of impairment losses shall not result in a carrying amount of the investment that exceeds the amortized cost that would have been reported had the impairment not been recognized. ON THE HORIZON At one time, both the FASB and IASB have indicated that they believe that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. However, the recently issued IFRS indicates that the IASB believes that certain debt investments should not be reported at fair value. The IASB’s decision to issue new rules on investments, prior to the FASB’s completion of its deliberations on financial instrument accounting, could create obstacles for the Boards in converging the accounting in this area. IFRS Insights 1037 IFRS SELF-TEST QUESTIONS 1. All of the following are key similarities between GAAP and IFRS with respect to accounting for investments except: (a) IFRS and GAAP have a held-to-maturity investment classification. (b) IFRS and GAAP apply the equity method to significant influence equity investments. (c) IFRS and GAAP have a fair value option for financial instruments. (d) the accounting for impairment of investments is similar, although IFRS allows recovery of impairment losses. 2. Which of the following statements is correct? (a) GAAP has a held-for-collection investment classification. (b) GAAP permits recovery of impairment losses. (c) Under IFRS, non-trading equity investments are accounted for at amortized cost. (d) IFRS and GAAP both have a trading investment classification. 3. IFRS requires companies to measure their financial assets at fair value based on: (a) the company’s business model for managing its financial assets. (b) whether the financial asset is a debt investment. (c) whether the financial asset is an equity investment. (d) All of the choices are IFRS requirements. 4. Select the investment accounting approach with the correct valuation approach: Not Held-for-Collection Held-for-Collection (a) Amortized cost Amortized cost (b) Fair value Fair value (c) Fair value Amortized cost (d) Amortized cost Fair value 5. Under IFRS, a company: (a) should evaluate only equity investments for impairment. (b) accounts for an impairment as an unrealized loss, and includes it as a part of other comprehen- sive income and as a component of other accumulated comprehensive income until realized. (c) calculates the impairment loss on debt investments as the difference between the carrying amount plus accrued interest and the expected future cash flows discounted at the investment’s historical effective-interest rate. (d) All of the above. IFRS CONCEPTS AND APPLICATION IFRS17-1 Where can authoritative IFRS be found related to investments? IFRS17-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for investments. IFRS17-3 Describe the two criteria for determining the valuation of financial assets. IFRS17-4 Which types of investments are valued at amortized cost? Explain the rationale for this accounting. IFRS17-5 Lady Gaga Co. recently made an investment in the bonds issued by Chili Peppers Inc. Lady Gaga’s business model for this investment is to profit from trading in response to changes in market inter- est rates. How should this investment be classified by Lady Gaga? Explain. IFRS17-6 Consider the bond investment by Lady Gaga in IFRS17-5. Discuss the accounting for this invest-

ment if Lady Gaga’s business model is to hold the investment to collect interest while outstanding and to receive the principal at maturity. IFRS17-7 Indicate how unrealized holding gains and losses should be reported for investments classified as trading and held for-collection. IFRS17-8 Ramirez Company has a held-for-collection investment in the 6%, 20-year bonds of Soto Com- pany. The investment was originally purchased for $1,200,000 in 2013. Early in 2014, Ramirez recorded an impairment of $300,000 on the Soto investment, due to Soto’s financial distress. In 2015, Soto returned to 1038 Chapter 17 Investments profitability and the Soto investment was no longer impaired. What entry does Ramirez make in 2015 under (a) GAAP and (b) IFRS? IFRS17-9 Carow Corporation purchased, as a held-for-collection investment, $60,000 of the 8%, 5-year bonds of Harrison, Inc. for $65,118, which provides a 6% return. The bonds pay interest semiannually. Prepare Carow’s journal entries for (a) the purchase of the investment, and (b) the receipt of semiannual interest and premium amortization. IFRS17-10 Fairbanks Corporation purchased 400 ordinary shares of Sherman Inc. as a trading investment for $13,200. During the year, Sherman paid a cash dividend of $3.25 per share. At year-end, Sherman shares were selling for $34.50 per share. Prepare Fairbanks’ journal entries to record (a) the purchase of the investment, (b) the dividends received, and (c) the fair value adjustment. IFRS17-11 Use the information from IFRS17-10 but assume the shares were purchased to meet a non-trading regulatory requirement. Prepare Fairbanks’ journal entries to record (a) the purchase of the investment, (b) the dividends received, and (c) the fair value adjustment. IFRS17-12 On January 1, 2014, Roosevelt Company purchased 12% bonds, having a maturity value of $500,000, for $537,907.40. The bonds provide the bondholders with a 10% yield. They are dated January 1, 2014, and mature January 1, 2019, with interest receivable December 31 of each year. Roosevelt’s business model is to hold these bonds to collect contractual cash flows. Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare a bond amortization schedule. (c) Prepare the journal entry to record the interest received and the amortization for 2014. (d) Prepare the journal entry to record the interest received and the amortization for 2015. IFRS17-13 Assume the same information as in IFRS17-12 except that Roosevelt has an active trading strat- egy for these bonds. The fair value of the bonds at December 31 of each year-end is as follows. 2014 $534,200 2017 $517,000 2015 $515,000 2018 $500,000 2016 $513,000 Instructions (a) Prepare the journal entry at the date of the bond purchase. (b) Prepare the journal entries to record the interest received and recognition of fair value for 2014. (c) Prepare the journal entry to record the recognition of fair value for 2015. IFRS17-14 On December 21, 2014, Zurich Company provided you with the following information regarding its trading investments. December 31, 2014 Investments (Trading) Cost Fair Value Unrealized Gain (Loss) Stargate Corp. shares $20,000 $19,000 $(1,000) Carolina Co. shares 10,000 9,000 (1,000) Vectorman Co. shares 20,000 20,600 600 Total of portfolio $50,000 $48,600 $(1,400) Previous fair value adjustment balance –0– Fair value adjustment—Cr. $ (1,400) During 2015, Carolina Company shares were sold for $9,500. The fair value of the shares on December 31, 2015, was Stargate Corp. shares—$19,300; Vectorman Co. shares—$20,500. Instructions (a) Prepare the adjusting journal entry needed on December 31, 2014. (b) Prepare the journal entry to record the sale of the Carolina Company shares during 2015. (c) Prepare the adjusting journal entry needed on December 31, 2015. IFRS17-15 Komissarov Company has a debt investment in the bonds issued by Keune Inc. The bonds were purchased at par for $400,000 and, at the end of 2014, have a remaining life of 3 years with annual interest payments at 10%, paid at the end of each year. This debt investment is classified as held-for-collection.

Keune is facing a tough economic environment and informs all of its investors that it will be unable to IFRS Insights 1039 make all payments according to the contractual terms. The controller of Komissarov has prepared the following revised expected cash flow forecast for this bond investment. Dec. 31 Expected Cash Flows 2015 $ 35,000 2016 35,000 2017 385,000 Total cash flows $455,000 Instructions (a) Determine the impairment loss for Komissarov at December 31, 2014. (b) Prepare the entry to record the impairment loss for Komissarov at December 31, 2014. (c) On January 15, 2015, Keune receives a major capital infusion from a private equity investor. It informs Komissarov that the bonds now will be paid according to the contractual terms. Briefly describe how Komissarov would account for the bond investment in light of this new information. Professional Research IFRS17-16 Your client, Cascade Company, is planning to invest some of its excess cash in 5-year revenue bonds issued by the county and in the shares of one of its suppliers, Teton Co. Teton’s shares trade on the over-the-counter market. Cascade plans to classify these investments as trading. They would like you to conduct some research on the accounting for these investments. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Since the Teton shares do not trade on one of the large securities exchanges, Cascade argues that the fair value of this investment is not readily available. According to the authoritative literature, when is the fair value of a security “readily determinable”? (b) How is an impairment of a debt investment accounted for? (c) To avoid volatility in their financial statements due to fair value adjustments, Cascade debated whether the bond investment could be classified as held-for-collection; Cascade is pretty sure it will hold the bonds for 5 years. What criteria must be met for Cascade to classify it as held-for-collection? International Financial Reporting Problem Marks and Spencer plc IFRS17-17 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks- and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What investments does M&S report in 2012, and where are these investments reported in its financial statements? (b) How are M&S’s investments valued? How does M&S determine fair value? (c) How does M&S use derivative financial instruments? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. a 2. d 3. a 4. c 5. c Remember to check the book’s companion website to fi nd additional resources for this chapter. Revenue Recognition 1 Describe and apply the revenue recognition 4 Apply the completed-contract method for principle. long-term contracts. 2 Describe accounting issues for revenue recognition 5 Identify the proper accounting for losses on at point of sale. long-term contracts. 3 Apply the percentage-of-completion method for 6 Describe the installment-sales method of accounting. long-term contracts. 7 Explain the cost-recovery method of accounting. It’s Back Several years after passage, the accounting world continues to be preoccupied with the Sarbanes-Oxley Act of 2002 (SOX). Unfortunately, SOX did not solve one of the classic accounting issues—how to properly account for revenue. In fact, revenue recognition practices are the most prevalent reasons for accounting restatements. A number of the revenue recognition issues relate to possible fraudulent behavior by company executives and employees. As a result of such revenue recognition problems, the SEC has increased its enforcement actions in this area.

In some of these cases, companies made significant adjustments to previously issued financial statements. As Lynn Turner, a former chief accountant of the SEC, indicated, “When people cross over the boundaries of legiti- mate reporting, the Commission will take appropriate action to ensure the fairness and integrity that investors need and depend on every day.” Consider some SEC actions: • The SEC charged the former co-chairman and CEO of Qwest Communications International Inc. and eight other former Qwest officers and employees with fraud and other violations of the federal securities laws. Three of these people fraudulently characterized nonrecurring revenue from one-time sales as revenue from recurring data and Internet services. The SEC release notes that internal correspondence likened Qwest’s dependence on these transactions to fill the gap between actual and projected revenue to an addiction. • The SEC filed a complaint against three former senior officers of iGo Corp., alleging that the defendants collectively caused iGo to improperly recognize revenue on consignment sales and products that were not shipped or that were shipped after the end of a fiscal quarter. • The SEC filed a complaint against the former CEO and chairman of Homestore Inc. and its former execu- tive vice president of business development, alleging that they engaged in a fraudulent scheme to overstate advertising and subscription revenues. The scheme involved a complex structure of “round-trip” transac- tions using various third-party companies that, in essence, allowed Homestore to recognize its own cash as revenue. • The SEC claims that Lantronix deliberately sent excessive product to distributors and granted them gener- ous return rights and extended payment terms. In addition, as part of its alleged channel stuffing and to prevent product returns, Lantronix loaned funds to a third party to purchase Lantronix products from one of its distributors. The third party later returned the product. The SEC also asserted that Lantronix engaged in RETPAHC 18 LEARNING OBJECTIVES After studying this chapter, you should be able to: CONCEPTUAL FOCUS > See the Underlying Concepts on pages 1043, other improper revenue recognition practices, including 1057, 1068, and 1069. shipping without a purchase order and recognizing revenue > Read the Evolving Issue on this page. on a contingent sale. INTERNATIONAL FOCUS Though the cases cited involved fraud and irregularity, not all revenue recognition errors are intentional. For example, in April 2005 American Home Mortgage Investment Corp. > See the International Perspectives on pages 1042, 1063, and 1079. announced that it would reverse revenue recognized from its fourth-quarter 2004 loan securitization and would recognize it in > Read the IFRS Insights on pages 1109–1115 for a discussion of: the first quarter of 2005 instead. As a result, American Home —Long-term contracts restated its financial results for 2004. —Cost-recovery method So, how does a company ensure that revenue transactions are recorded properly? Some answers will become apparent after you study this chapter. Sources: Cheryl de Mesa Graziano, “Revenue Recognition: A Perennial Problem,” Financial Executive (July 14, 2005), www.fei.org/mag/ articles/7-2005_revenue.cfm; and S. Taub, “SEC Accuses Ex-CFO of Channel Stuffing,” CFO.com (September 30, 2006). Evolving Issue REVENUE RECOGNITION This chapter provides the present GAAP related to revenue information concerning how the new guidelines will impact recognition as of February 28, 2013. It is highly likely that revenue recognition, go to the book’s companion website, later in 2013, the FASB and IASB will issue a new converged www.wiley.com/college/kieso. pronouncement on revenue recognition. For the most recent As indicated in the opening story, the issue of when revenue should PREVIEW OF CHAPTER 18 be recognized is complex. The many methods of marketing products and services make it difficult to develop guidelines that will apply to all situations. This chapter provides you with general guidelines used in most business transactions. The

content and organization of the chapter are as follows. Revenue Recognition Revenue Recognition at Revenue Recognition Revenue Recognition Overview Point of Sale before Delivery after Delivery • Guidelines for revenue • Sales with discounts • Percentage-of-completion • Installment-sales method recognition • Sales with right of return method • Cost-recovery method • Departures from sale basis • Sales with buybacks • Completed-contract method • Deposit method • Bill and hold sales • Long-term contract losses • Summary and concluding • Principal-agent relationships • Disclosures remarks • Trade loading and channel • Completion-of-production stuffing basis • Multiple-deliverable arrangements 1041 1042 Chapter 18 Revenue Recognition OVERVIEW OF REVENUE RECOGNITION Most revenue transactions pose few problems for revenue recognition. This is LEARNING OBJECTIVE 1 because, in many cases, the transaction is initiated and completed at the same Describe and apply the revenue time. However, not all transactions are that simple. For example, consider a cus- recognition principle. tomer who enters into a mobile phone contract with a company such as Verizon. The customer is often provided with a package that may include a handset, free minutes of talk time, data downloads, and text messaging service. In addition, some providers will bundle that with a fixed-line broadband service. At the same time, customers may pay for these services in a variety of ways, possibly receiving a discount on the handset, then paying higher prices for connection fees, and so forth. In some cases, depending on the package purchased, the company may provide free applications in subsequent peri- ods. How then should the various pieces of this sale be reported by Verizon? The answer is not obvious. It is therefore not surprising that a recent survey of financial executives noted that the revenue recognition process is increasingly more complex to manage, prone to error, and material to financial statements compared to any other area in financial reporting. The report went on to note that revenue recognition is a top fraud risk and that regard- less of the accounting rules followed (GAAP or IFRS), the risk or errors and inaccuracies in revenue reporting is significant.1 International Indeed, both the FASB and the IASB indicate that the present state of Perspective reporting for revenue is unsatisfactory. IFRS is criticized because it lacks guid- ance in a number of areas. For example, IFRS has one basic standard on revenue The FASB and IASB have recognition—IAS 18—plus some limited guidance related to certain minor topics. a joint project to improve the In contrast, GAAP has numerous standards related to revenue recognition accounting for revenue. (by some counts over 100), but many believe the standards are often inconsis- tent with one another. Thus, the accounting for revenues provides a most fitting contrast of the principles-based (IFRS) and rules-based (GAAP) approaches. While both sides have their advocates, the FASB and IASB recognize a number of deficiencies in this area.2 Unfortunately, inappropriate recognition of revenue can occur in any industry. Products that are sold to distributors for resale pose different risks than products or services that are sold directly to customers. Sales in high-technology industries, where rapid product obsolescence is a significant issue, pose different risks than sales of inven- tory with a longer life, such as farm or construction equipment, automobiles, trucks, and appliances.3 As a consequence, as discussed in the opening story, restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments. 1See www.prweb.com/releases/RecognitionRevenue/IFRS/prweb1648994.htm. 2See, for example, “Preliminary Views on Revenue Recognition in Contracts with Customers,” IASB/FASB Discussion Paper (December 19, 2008). Some of the problems noted are that GAAP has so many standards that at times they are inconsistent with each other in applying basic

principles. In addition, even with the many standards, no guidance is provided for service transactions. Conversely, IFRS has a lack of guidance in certain fundamental areas such as multiple-deliverable arrangements, which are becoming increasingly common. In addition, there is inconsistency in applying revenue recognition principles to long-term contracts versus other elements of revenue recognition. 3Adapted from American Institute of Certified Public Accountants, Inc., Audit Issues in Revenue Recognition (New York: AICPA, 1999). Overview of Revenue Recognition 1043 Guidelines for Revenue Recognition Revenue arises from ordinary operations and is referred to by various names such as sales, fees, rent, interest, royalties, and service revenue. Gains, on the other hand, may or may not arise in the normal course of operations. Typical gains are gains on sale of noncurrent assets or unrealized gains related to investments or noncurrent assets. The primary issue related to revenue recognition is when to recognize the revenue. As indicated in Chapter 2, the revenue recognition principle developed by the FASB and IASB in a recent exposure draft indicates that companies recognize revenue in the accounting period when a performance obligation is satisfied. Until new revenue recog- nition rules are adopted, existing GAAP guidelines for revenue recognition are quite broad. On top of the broad guidelines, certain industries have specific additional guide- lines that provide further insight into when revenue should be recognized. The revenue recognition principle under current GAAP provides that companies should recognize revenue4 (1) when it is realized or realizable, and (2) when it is earned.5 Therefore, proper revenue recognition revolves around three terms: • Revenues are realized when a company exchanges goods and services for cash or claims to cash (receivables). • Revenues are realizable when assets a company receives in exchange are readily convertible to known amounts of cash or claims to cash. • Revenues are earned when a company has substantially accomplished what it must do to be entitled to the benefi ts represented by the revenues—that is, when the earnings process is complete or virtually complete.6 Four revenue transactions are recognized in accordance with this principle: 1. Companies recognize revenue from selling products at the date of sale. This Underlying Concepts date is usually interpreted to mean the date of delivery to customers. Revenues are infl ows of assets 2. Companies recognize revenue from services provided, when services have and/or settlements of liabilities been performed and are billable. from delivering or producing 3. Companies recognize revenue from permitting others to use enterprise goods, providing services, or other earning activities that assets, such as interest, rent, and royalties, as time passes or as the assets constitute a company’s ongoing are used. major or central operations 4. Companies recognize revenue from disposing of assets other than products during a period. at the date of sale. 4Recognition is “the process of formally recording or incorporating an item in the accounts and financial statements of an entity” (SFAC No. 3, par. 83). “Recognition includes depiction of an item in both words and numbers, with the amount included in the totals of the financial statements” (SFAC No. 5, par. 6). For an asset or liability, recognition involves recording not only acquisition or incurrence of the item but also later changes in it, including removal from the financial statements previously recognized. Recognition is not the same as realization, although the two are sometimes used interchange- ably in accounting literature and practice. Realization is “the process of converting noncash resources and rights into money and is most precisely used in accounting and financial report- ing to refer to sales of assets for cash or claims to cash” (SFAC No. 3, par. 83). 5“Recognition and Measurement in Financial Statements of Business Enterprises,” Statement of

Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984), par. 83. 6Gains (as contrasted to revenues) commonly result from transactions and other events that do not involve an “earning process.” For gain recognition, being earned is generally less significant than being realized or realizable. Companies commonly recognize gains at the time of an asset’s sale, disposition of a liability, or when prices of certain assets change. 1044 Chapter 18 Revenue Recognition These revenue transactions are diagrammed in Illustration 18-1. Type of Sale of product Rendering a Permitting use Sale of asset other transaction from inventory service of an asset than inventory Description Revenue from Revenue from interest, Gain or loss on Revenue from sales of revenue fees or services rents, and royalties disposition Timing of Date of sale Services performed As time passes or Date of sale revenue (date of delivery) and billable assets are used or trade-in recognition ILLUSTRATION 18-1 Revenue Recognition The preceding statements are the basis of accounting for revenue transactions. Yet, Classifi ed by Nature of in practice there are departures from the revenue recognition principle. Companies Transaction sometimes recognize revenue at other points in the earning process, owing in great mea- sure to the considerable variety of revenue transactions.7 Departures from the Sale Basis An FASB study found some common reasons for departures from the sale basis.8 One reason is a desire to recognize earlier than the time of sale the effect of earning activities. Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. A second reason is a desire to delay recognition of revenue beyond the time of sale. Delayed recognition is appropriate if the degree of uncertainty concern- ing the amount of either revenue or costs is sufficiently high or if the sale does not represent substantial completion of the earnings process. This chapter focuses on two of the four general types of revenue transactions described earlier: (1) selling products and (2) providing services. Both of these are sales transactions. (In several other sections of the textbook, we discuss the other two types of revenue transactions—revenue from permitting others to use enterprise assets, and revenue from disposing of assets other than products.) Our discussion of product sales transactions in this chapter is organized around the following topics: 1. Revenue recognition at point of sale (delivery). 2. Revenue recognition before delivery. 3. Revenue recognition after delivery. Illustration 18-2 depicts this organization of revenue recognition topics. 7As indicated earlier, the FASB and IASB are now involved in a joint project on revenue recogni- tion. The purpose of this project is to develop comprehensive conceptual guidance on when to recognize revenue. Presently, the Boards are evaluating a customer-consideration model. In this model, a company accounts for the contract asset or liability that arises from the rights and performance obligations in an enforceable contract with the customer. At contract inception, the rights in the contract are measured at the amount of the promised customer payment (that is, the customer consideration). That amount is then allocated to the individual performance obligations identified within the contract in proportion to the standalone selling price of each good or service underlying the performance obligation. It is hoped that this approach (rather than using the earned and realized or realizable criteria) will lead to a better basis for revenue recognition. See www.fasb.org/project/revenue_recognition.shtml. 8Henry R. Jaenicke, Survey of Present Practices in Recognizing Revenues, Expenses, Gains, and Losses, A Research Report (Stamford, Conn.: FASB, 1981), p. 11. Revenue Recognition at Point of Sale (Delivery) 1045 ILLUSTRATION 18-2 Revenue Recognition Alternatives At point of sale Before delivery After delivery (delivery) Before During At As cash After “The General Rule” production production completion is costs

of collected are production recovered What do the numbers mean? LIABILITY OR REVENUE? Suppose you purchased a gift card for spa services at Unfortunately, Sundara may still have a problem. It may Sundara Spa for $300. The gift card expires at the end of be required to turn over the value of the spa services to the six months. When should Sundara record the revenue? Here state. The treatment for unclaimed gift cards may fall under are two choices: the abandoned-and-unclaimed-property laws. Most com- mon unclaimed items are required to be remitted to the 1. At the time Sundara receives the cash for the gift card. states after a fi ve-year period. Failure to report and remit the 2. At the time Sundara provides the service to the gift-card property can result in additional fi nes and penalties. So if holder. Sundara is in a state where unclaimed property must be sent If you answered number 2, you would be right. Com- to the state, Sundara should report a liability on its balance panies should recognize revenue when the obligation is sheet. satisfi ed—which is when Sundara performs the service. New federal laws enacted in 2010 added additional Now let’s add a few more facts. Suppose that the gift-card complexity for gift-card issuers. The Federal Reserve rules holder fails to use the card in the six-month period. Statistics expand disclosure requirements to consumers and put re- show that between 2 and 15 percent of gift-card holders strictions on dormancy, inactivity, and service fees, which never redeem their cards. So, do you still believe that Sundara can kick in only after a consumer has not used a gift card for should record the revenue at the expiration date? at least a year. It also generally prohibits the sale or issuance If you say you are not sure, you are probably right. Here of gift cards if they have an expiration date of less than is why: Certain states do not recognize expiration dates, and fi ve years. While the legislation aims to improve consumer therefore the customer has the right to redeem an otherwise protections, it may compete with a morass of confl icting expired gift card at any time. Let’s say for the moment we are state laws. The biggest challenge for gift-card programs is to in one of these states. Because the card holder may never re- determine on a state-by-state basis whether or not their deem, when can Sundara recognize the revenue? In that case, gift-card programs are compliant. As one analyst noted, Sundara would have to show statistically that after a certain “you need three sets of books—GAAP books, tax books, period of time, the likelihood of redemption is remote. If it and what I’ll call legal books.” So while customers and can make that case, it can recognize the revenue. Otherwise, marketing departments love gift cards, they can create it may have to wait a long time. headaches for the fi nance department. Sources: PricewaterhouseCoopers, “Issues Surrounding the Recognition of Gift Card Sales and Escheat Liabilities,” Quick Brief (December 2004); and R. Banham, “Looking in the Mouth of the Gift Card,” CFO.com (September 1, 2011). REVENUE RECOGNITION AT POINT OF SALE (DELIVERY) 2 LEARNING OBJECTIVE According to the FASB’s Concepts Statement No. 5, companies usually meet the two Describe accounting issues for revenue conditions for recognizing revenue (being realized or realizable and being earned) recognition at point of sale. by the time they deliver products or render services to customers.9 Therefore, 9The SEC believes that revenue is realized or realizable and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been provided, (3) the seller’s price to the buyer is fixed or determinable, and See the FASB (4) collectibility is reasonably assured. [1] The SEC provided more specific guidance because Codification section the general criteria were difficult to interpret. (page 1086). 1046 Chapter 18 Revenue Recognition companies commonly recognize revenues from manufacturing and selling activities at

point of sale (usually meaning delivery).10 Implementation problems, however, can arise. We discuss some of these problematic situations on the following pages. Sales with Discounts Any trade discounts or volume rebates should reduce consideration received and reduce revenue earned. In addition, if the payment is delayed, the seller should impute an interest rate for the difference between the cash or cash equivalent price and the deferred amount. In essence, the seller is financing the sale and should record interest revenue over the payment term. Illustrations 18-3 and 18-4 provide examples of transac- tions that illustrate these points. ILLUSTRATION 18-3 VOLUME DISCOUNT Revenue Measurement— Volume Discount Facts: Sansung Company has an arrangement with its customers that it will provide a 3% volume discount to its customers if they purchase at least $2 million of its product during the calendar year. On March 31, 2014, Sansung has made sales of $700,000 to Artic Co. In the previous two years, Sansung sold over $3,000,000 to Artic in the period April 1 to December 31. Question: How much revenue should Sansung recognize for the first three months of 2014? Solution: In this case, Sansung should reduce its revenue by $21,000 ($700,000 3 3%) because it is probable that it will provide this rebate. Revenue should therefore be reported at $679,000 ($700,000 2 $21,000). To not recognize this volume discount overstates Sansung’s revenue for the first three months of 2014. In other words, the appropriate revenue is $679,000, not $700,000. In this case, Sansung makes the following entry on March 31, 2014. Accounts Receivable 679,000 Sales Revenue 679,000 Assuming that Sansung’s customers meet the discount threshold, Sansung makes the following entry. Cash 679,000 Accounts Receivable 679,000 If Sansung’s customers fail to meet the discount threshold, Sansung makes the following entry upon payment. Cash 700,000 Accounts Receivable 679,000 Sales Discounts Forfeited 21,000 As indicated in Chapter 7 (page 352), Sales Discounts Forfeited is reported in the “Other revenue” section of the income statement. In some cases, companies provide cash discounts to customers for a short period of time (often referred to as prompt settlement discounts). For example, assume that terms are payment due in 60 days, but if payment is made within 5 days, a 2 percent discount is given. These prompt settlement discounts should reduce revenues, if material. In most cases, companies record the revenue at full price (gross) and record a sales dis- count if payment is made within the discount period. When a sales transaction involves a financing arrangement, the fair value is deter- mined either by measuring the consideration received or by discounting the payment using an imputed interest rate. The imputed interest rate is the more clearly determinable 10Statement of Financial Accounting Concepts No. 5, op. cit., par. 84. Revenue Recognition at Point of Sale (Delivery) 1047 of either (1) the prevailing rate for a similar instrument of an issuer with a similar credit rating, or (2) a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services. [2] This issue is addressed in Illustration 18-4. ILLUSTRATION 18-4 EXTENDED PAYMENT TERMS Revenue Measurement— Facts: On July 1, 2014, SEK Company sold goods to Grant Company for $900,000 in exchange for a Deferred Payment 4-year, zero-interest-bearing note in the face amount of $1,416,163. The goods have an inventory cost on SEK’s books of $590,000. Questions: (a) How much revenue should SEK Company record on July 1, 2014? (b) How much revenue should it report related to this transaction on December 31, 2014? Solution: (a) SEK should record revenue of $900,000 on July 1, 2014, which is the fair value of the inventory in this case. (b) SEK is also financing this purchase and records interest revenue on the note over the 4-year period. In this case, the interest rate is imputed and is determined to be 12%. SEK records interest