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Chapter
17-1
CHAPTER
17
INVESTMENTS
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
17-2
Learning Objectives
1.
Identify the three categories of debt securities and describe the
accounting and reporting treatment for each category.
2.
Understand the procedures for discount and premium amortization on bond
investments.
3.
Identify the categories of equity securities and describe the accounting and
reporting treatment for each category.
4.
Explain the equity method of accounting and compare it to the fair value
method for equity securities.
5.
Describe the accounting for the fair value option.
6.
Discuss the accounting for impairments of debt and equity investments.
7.
Explain why companies report reclassification adjustments.
8.
Describe the accounting for transfer of investment securities between
categories.
Chapter
17-3
Investments
Investments in
Debt Securities
Investments in
Equity Securities
Other Reporting
Issues
Held-to-maturity
securities
Holdings of less than
20%
Impairment of value
Available-for-sale
securities
Holdings between 20%
and 50%
Trading securities
Holdings of more than
50%
Fair value option
Reclassification
adjustments
Transfers between
categories
Fair value
controversy
Summary
Chapter
17-4
Investment Accounting Approaches
Different motivations for investing:
To earn a high rate of return.
To secure certain operating or financing
arrangements with another company.
Chapter
17-5
Investment Accounting Approaches
Companies account for investments based on
 the type of security (debt or equity) and
 their intent with respect to the investment.
Illustration 17-1
Chapter
17-6
Investments in Debt Securities
Debt securities (creditor relationship):
Type
Accounting
Category
U.S. government
securities
Held-to-maturity
Municipal securities
Trading
Corporate bonds
Available-for-sale
Convertible debt
Commercial paper
Chapter
17-7
LO 1 Identify the three categories of debt securities and describe
the accounting and reporting treatment for each category.
Investments in Debt Securities
Accounting for Debt Securities by Category
Illustration 17-2
Chapter
17-8
LO 1 Identify the three categories of debt securities and describe
the accounting and reporting treatment for each category.
Held-to-Maturity Securities
Classify a debt security as held-to-maturity only
if it has both
(1) the positive intent and
(2) the ability to hold securities to maturity.
Accounted for at amortized cost, not fair value.
Amortize premium or discount using the effectiveinterest method unless the straight-line method yields
a similar result.
Chapter
17-9
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Held-to-Maturity Securities
Illustration: KC Company purchased $100,000 of 8 percent
bonds of Evermaster Corporation on January 1, 2009, at a
discount, paying $92,278. The bonds mature January 1,
2014 and yield 10%; interest is payable each July 1 and
January 1. KC records the investment as follows:
January 1, 2009
Held-to-Maturity Securities
Cash
Chapter
17-10
92,278
92,278
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Held-to-Maturity Securities
Illustration 17-3
Schedule of
Interest
Revenue and Bond
Discount
Amortization—
EffectiveInterest Method
Chapter
17-11
LO 2
Held-to-Maturity Securities
Illustration: KC Company records the receipt of the first
semiannual interest payment on July 1, 2009, as follows:
July 1, 2009
Cash
4,000
Held-to-Maturity Securities
Interest Revenue
Chapter
17-12
614
4,614
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Held-to-Maturity Securities
Illustration: KC is on a calendar-year basis, it accrues
interest and amortizes the discount at December 31, 2009,
as follows:
December 31, 2009
Interest Receivable
Held-to-Maturity Securities
Interest Revenue
Chapter
17-13
4,000
645
4,645
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Held-to-Maturity Securities
Reporting of Held-to-Maturity Securities
Illustration 17-4
Chapter
17-14
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Held-to-Maturity Securities
Illustration: Assume that KC Company sells its investment
in Evermaster bonds on November 1, 2013, at 99.75 plus
accrued interest. KC records this discount amortization as
follows:
November 1, 2013
Held-to-Maturity Securities
Interest Revenue
635
635
$952 x 4/6 = $635
Chapter
17-15
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Held-to-Maturity Securities
Computation of the realized gain on sale.
Illustration 17-5
Cash
Interest Revenue (4/6 x $4,000)
Held-to-Maturity Securities
Chapter
17-16
Gain on Sale of Securities
102,417
2,667
99,683
67
LO 2
Available-for-Sale Securities
Debt
Securities
Companies report available-for-sale securities at

fair value, with

unrealized holding gains and losses reported as
part of comprehensive income (equity).
Any discount or premium is amortized.
Chapter
17-17
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Single Security): Graff Corporation purchases
$100,000, 10 percent, five-year bonds on January 1, 2009,
with interest 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 on January 1, 2009, as follows.
Available-for-Sale Securities
Cash
Chapter
17-18
108,111
108,111
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration 17-6
Schedule of
Interest
Revenue and Bond
Premium
Amortization—
EffectiveInterest Method
Chapter
17-19
LO 2
Available-for-Sale Securities
Debt
Securities
Illustration (Single Security): The entry to record interest
revenue on July 1, 2009, is as follows.
Cash
5,000
Available-for-Sale Securities
Interest Revenue
Chapter
17-20
676
4,324
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Single Security): At December 31, 2009, Graff
makes the following entry to recognize interest revenue.
Interest Receivable
Available-for-Sale Securities
Interest Revenue
5,000
703
4,297
Graff reports revenue for 2009 of $8,621 ($4,324 + $4,297).
Chapter
17-21
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Single Security): To apply the fair value
method to these debt securities, 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. Graff
makes the following entry.
Unrealized Holding Gain or Loss—Equity
Securities Fair Value Adjustment (AFS)
Chapter
17-22
1,732
1,732
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Portfolio of Securities): Webb Corporation
has two debt securities classified as available-for-sale. The
following illustration identifies the amortized cost, fair
value, and the amount of the unrealized gain or loss.
Illustration 17-7
Chapter
17-23
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Portfolio of Securities): Webb makes an
adjusting entry to a valuation allowance on December 31,
2010 to record the decrease in value and to record the loss
as follows.
Unrealized Holding Gain or Loss—Equity
9,537
Securities Fair Value Adjustment (AFS)
9,537
Webb reports the unrealized holding loss of $9,537 as other
comprehensive income and a reduction of stockholders’ equity.
Chapter
17-24
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Sale of Available-for-Sale Securities
If company sells bonds before maturity date:
Must make entry to remove the,

Cost in Available-for-Sale Securities and

Securities Fair Value Adjustment accounts.
Any realized gain or loss on sale is reported in the
“Other expenses and losses” section of the income
statement.
Chapter
17-25
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Debt
Securities
Available-for-Sale Securities
Illustration (Sale of Available-for-Sale Securities):
Webb Corporation sold the Watson bonds (from Illustration
17-7) on July 1, 2011, for $90,000, at which time it had an
amortized cost of $94,214.
Cash
90,000
Loss on Sale of Securities
Available-for-Sale Securities
Chapter
17-26
Illustration 17-8
4,214
94,214
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Sale of Available-for-Sale Securities):
Webb reports this realized loss in the “Other expenses and
losses” section of the income statement. Assuming no other
purchases and sales of bonds in 2011, Webb on December 31,
2011, prepares the information:
Illustration 17-9
Chapter
17-27
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Illustration (Sale of Available-for-Sale Securities):
Webb records the following at December 31, 2011.
Illustration 17-9
Securities Fair Value Adjustment (AFS)
Unrealized Holding Gain or Loss—Equity
Chapter
17-28
4,537
4,537
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Available-for-Sale Securities
Debt
Securities
Financial Statement Presentation
Illustration 17-10
Chapter
17-29
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Trading Securities
Debt
Securities
Companies report trading securities at

fair value, with

unrealized holding gains and losses reported as
part of net income.
Any discount or premium is amortized.
Chapter
17-30
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Trading Securities
Debt
Securities
Illustration: On December 31, 2010, Western Publishing
Corporation determined its trading securities portfolio to
be as follows:
Illustration 17-11
Chapter
17-31
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Trading Securities
Debt
Securities
Illustration: At December 31, Western Publishing makes
an adjusting entry:
Illustration 17-11
Securities Fair Value Adjustment (Trading)
Unrealized Holding Gain or Loss—Income
Chapter
17-32
3,750
3,750
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Trading Securities
Debt
Securities
BE17-4: (Trading Securities) 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.
Instructions:
(a) Prepare the journal entry for the purchase of the
investment.
(b) Prepare the journal entry for the interest received.
(c) Prepare the journal entry for the fair value
adjustment.
Chapter
17-33
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Trading Securities
Debt
Securities
BE17-4: Prepare the journal entries for (a) the purchase
of the investment, (b) the interest received, and (c) the fair
value adjustment.
(a)
Trading securities
50,000
Cash
(b)
50,000
Cash
2,000
Interest revenue
(c)
Unrealized Holding Loss - Income
Securities Fair Value Adj.- Trading
Chapter
17-34
2,000
2,600
2,600
LO 2 Understand the procedures for discount and
premium amortization on bond investments.
Investments in Equity Securities
Represent ownership of capital stock.
Cost includes:
 price of the security, plus
 broker’s commissions and fees related to purchase.
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.
Chapter
17-35
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Investments in Equity Securities
Ownership Percentages
0 --------------20% ------------ 50% -------------- 100%
SFAS 115
Chapter
17-36
APBO 18,
SFAS 142
No significant
influence
usually exists
Significant
influence
usually exists
Investment
valued using
Fair Value
Method
Investment
valued using
Equity
Method
SFAS 141,
SFAS 142
Control
usually exists
Investment valued on
parent’s books using Cost
Method or Equity Method
(investment eliminated in
Consolidation)
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Investments in Equity Securities
Accounting and Reporting for Equity Securities by Category
Illustration 17-13
Chapter
17-37
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Accounting Subsequent to Acquisition
Market Price
Available
Market Price
Unavailable
Value and report the
investment using the
fair value method.
Value and report the
investment using the
cost method.*
* Securities are reported at cost. Dividends are recognized when
received and gains or losses only recognized on sale of securities.
Chapter
17-38
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Upon acquisition, companies record available-for-sale
securities at cost.
Illustration: On November 3, 2010 Republic Corporation
purchased common stock of three companies, each investment
representing less than a 20 percent interest.
Chapter
17-39
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Illustration: Republic records these investments on
November 3, 2010, as follows.
Available-for-Sale Securities
718,550
Cash
718,550
On December 6, 2010, Republic receives a cash dividend of
$4,200 from Campbell Soup Co.
Cash
4,200
Dividend revenue
Chapter
17-40
4,200
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Illustration: Republic’s available-for-sale equity security
portfolio on December 31, 2010:
Illustration 17-14
Chapter
17-41
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Illustration: On December 31, 2010, 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.
Unrealized Holding Gain or Loss—Equity
Securities Fair Value Adjustment (AFS)
Chapter
17-42
35,550
35,550
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Illustration: On January 23, 2011, Republic sold all of its
Northwest Industries, Inc. common stock receiving net
Illustration 17-15
proceeds of $287,220.
Cash
287,220
Available-for-Sale Securities
Gain on Sale of Stock
Chapter
17-43
259,700
27,520
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Illustration: On February 10, 2011, Republic purchased
20,000 shares of Continental Trucking at a price of $12.75
per share plus brokerage commissions of $1,850 (total cost,
$256,850).
Illustration 17-16
Chapter
17-44
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
Available-for-Sale Securities
Illustration:
Securities Fair Value Adjustment (AFS)
Unrealized Holding Gain or Loss—Equity
Chapter
17-45
Illustration 17-16
99,800
99,800
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
P17-6: McElroy Company has the following portfolio of
securities at September 30, 2010, its last reporting date.
Trading Securities
Horton, Inc. common (5,000 shares)
Monty, Inc. preferred (3,500 shares)
Oakwood Corp. common (1,000 shares)
Cost
$ 215,000
133,000
180,000
Fair Value
$ 200,000
140,000
179,000
On Oct. 10, 2010, 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 Nov. 2, 2010. The
Dec. 31, 2010, fair values were: Monty $106,000, Patriot
$132,000, and the Oakwood common $193,000.
Chapter
17-46
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
P17-6: Prepare the journal entries to record the sale,
purchase, and adjusting entries related to the trading
securities in the last quarter of 2010.
Portfolio at September 30, 2010
Chapter
17-47
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
P17-6: Prepare the journal entries to record the sale,
purchase, and adjusting entries related to the trading
securities in the last quarter of 2010.
October 10, 2010 (Horton):
Cash (5,000 x $54)
270,000
Trading securities
215,000
Gain on sale
55,000
November 2, 2010 (Monty):
Trading securities (3,000 x $54.50)
Cash
Chapter
17-48
163,500
163,500
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
P17-6: Portfolio at December 31, 2010
December 31, 2010:
Unrealized holding loss - Income
Securities fair value adj. - Trading
Chapter
17-49
36,500
36,500
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings of Less Than 20%
P17-6: How would the entries change if the securities
were classified as available-for-sale?
The entries would be the same except that the
Unrealized Holding Gain or Loss—Equity account is used
instead of Unrealized Holding Gain or Loss—Income.
The unrealized holding loss would be deducted from the
stockholders’ equity section rather than charged to the
income statement.
Chapter
17-50
LO 3 Identify the categories of equity securities and describe the
accounting and reporting treatment for each category.
Holdings Between 20% and 50%
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.
In instances of “significant influence,” the investor
must account for the investment using the equity
method.
Chapter
17-51
LO 4 Explain the equity method of accounting and compare
it to the fair value method for equity securities.
Holdings Between 20% and 50%
Equity Method
Record the investment at cost and subsequently
adjust the amount each period for
 the investor’s proportionate share of the
earnings (losses) and
 dividends received by the investor.
If investor’s share of investee’s losses exceeds the carrying
amount of the investment, the investor ordinarily should
discontinue applying the equity method.
Chapter
17-52
LO 4 Explain the equity method of accounting and compare
it to the fair value method for equity securities.
Holdings Between 20% and 50%
E17-17: (Equity Method) On January 1, 2010, Meredith
Corporation purchased 25% of the common shares of Pirates
Company for $200,000. During the year, Pirates earned net
income of $80,000 and paid dividends of $20,000.
Instructions: Prepare the entries for Meredith to record
the purchase and any additional entries related to this
investment in Pirates Company in 2010.
Chapter
17-53
LO 4 Explain the equity method of accounting and compare
it to the fair value method for equity securities.
Holdings Between 20% and 50%
E17-17: Prepare the entries for Meredith to record the
purchase and any additional entries related to this investment
in Pirates Company in 2010.
Investment in Stock
200,000
Cash
200,000
Investment in Stock
Investment Revenue
20,000
Cash
5,000
Investment in Stock
Chapter
17-54
20,000
($80,000 x 25%)
($20,000 x 25%)
5,000
LO 4 Explain the equity method of accounting and compare
it to the fair value method for equity securities.
Holdings of More Than 50%
Controlling Interest - When one corporation acquires a
voting interest of more than 50 percent in another
corporation
 Investor is referred to as the parent.
 Investee is referred to as the subsidiary.
 Investment in the subsidiary is reported on the
parent’s books as a long-term investment.
 Parent generally prepares consolidated financial
statements.
Chapter
17-55
LO 4 Explain the equity method of accounting and compare
it to the fair value method for equity securities.
Fair Value Option
Companies have the option to report most financial
instruments at fair value, with all gains and losses related
to changes in fair value reported in the income statement.
 Applied on an instrument-by-instrument basis.
 Fair value option is generally available only at the time
a company first purchases the financial asset or incurs
a financial liability.
 Company must measure this instrument at fair value
until the company no longer has ownership.
Chapter
17-56
LO 5 Describe the accounting for the fair value option.
Fair Value Option
Available-for-Sale Securities
Illustration: Hardy Company purchases stock in Fielder Company
during 2010 that it classifies as available-for-sale. At December
31, 2010, the cost of this security is $100,000; its fair value at
December 31, 2010, 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, 2010.
Investment in Fielder Stock
Unrealized Holding Gain or Loss—Income
Chapter
17-57
25,000
25,000
LO 5 Describe the accounting for the fair value option.
Fair Value Option
Equity Method
Illustration: Durham Company holds a 28 percent stake in
Suppan Inc. Durham purchased the investment in 2010 for
$930,000. At December 31, 2010, the fair value of the
investment is $900,000. Durham elects to report the investment
in Suppan using the fair value option. The entry to record this
investment is as follows.
Unrealized Holding Gain or Loss—Income
Investment in Suppan Stock
Chapter
17-58
30,000
30,000
LO 5 Describe the accounting for the fair value option.
Fair Value Option
Financial Liabilities
Illustration: Edmonds Company has issued $500,000 of 6%
bonds at face value on May 1, 2010. Edmonds chooses the fair
value option for these bonds. At December 31, 2010, the value of
the bonds is now $480,000 because interest rates in the market
have increased to 8 percent. The value of the debt securities
falls because the bond is paying less than market rate for similar
securities. Under the fair value option, Edmonds makes the
following entry.
Bond payable
20,000
Unrealized holding gain or loss-Income
Chapter
17-59
20,000
LO 5 Describe the accounting for the fair value option.
Other Reporting Issues
Impairment of Value
Impairments of debt and equity securities are
 losses in value that are determined to be other
than temporary,
 based on a fair value test, and
 are charged to income.
Chapter
17-60
LO 6 Discuss the accounting for impairments of debt and equity investments.
Other Reporting Issues
Reclassification Adjustments
The reporting of changes in unrealized gains or losses in
comprehensive income 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 reclassification adjustment is necessary.
Chapter
17-61
LO 7 Explain why companies report reclassification adjustments.
Other Reporting Issues
Reclassification Adjustments
Illustration: Open Company has the following two available-for-
sale securities in its portfolio at the end of 2009 (its first year
of operations).
Illustration 17-19
Chapter
17-62
LO 7 Explain why companies report reclassification adjustments.
Other Reporting Issues
Reclassification Adjustments
Illustration: If Open Company reports net income in 2009 of
$350,000, it presents a statement of comprehensive income as
follows.
Chapter
17-63
Illustration 17-20
LO 7 Explain why companies report reclassification adjustments.
Other Reporting Issues
Reclassification Adjustments
Illustration: During 2010, Open Company sold the Lehman Inc.
common stock for $105,000 and realized a gain on the sale of
$25,000 ($105,000 – $80,000). At the end of 2010, the fair
value of the Woods Co. common stock increased an additional
$20,000, to $155,000.
Illustration 17-21
Chapter
17-64
LO 7 Explain why companies report reclassification adjustments.
Other Reporting Issues
Reclassification Adjustments
Illustration: In addition, Open realized a gain of $25,000 on the
sale of the Lehman common stock. Comprehensive income includes
both realized and unrealized components. Therefore, Open
recognizes a total holding gain (loss) in 2010 of $20,000,
computed as follows.
Illustration 17-22
Chapter
17-65
LO 7 Explain why companies report reclassification adjustments.
Other Reporting Issues
Reclassification Adjustments
Illustration: Open reports net income of $720,000 in 2010,
which includes the realized gain on sale of the Lehman securities.
Illustration 17-23
Chapter
17-66
LO 7 Explain why companies report reclassification adjustments.
Other Reporting Issues
Transfers Between Categories
Illustration 17-30
* Assumes that adjusting entries to report changes in fair value for the current period are not
yet recorded.
Chapter
17-67
LO 8 Describe the accounting for transfer of
investment securities between categories.
Other Reporting Issues
Transfers Between Categories
Illustration 17-30
Chapter
17-68
**According to GAAP, these types of
transfers should be rare.
LO 8 Describe the accounting for transfer of
investment securities between categories.
Other Reporting Issues
Fair Value Controversy
Measurement Based on Intent
Gains Trading
Liabilities Not Fairly Valued
Subjectivity of Fair Values
Chapter
17-69
LO 8 Describe the accounting for transfer of
investment securities between categories.

The accounting for trading, available-for-sale, and held-to-maturity
securities is essentially the same between iGAAP and U.S. GAAP.

Gains and losses related to available-for-sale securities are
reported in other comprehensive income under U.S. GAAP. Under
iGAAP, these gains and losses are reported directly in equity.

Both iGAAP and U.S. GAAP use the same test to determine whether
the equity method of accounting should be used.

Reclassification in and out of trading securities is prohibited under
iGAAP. It is not prohibited under U.S. GAAP, but this type of
reclassification should be rare.
Chapter
17-70

Under iGAAP, both the investor and an associate company should
follow the same accounting policies.

The basis for consolidation under iGAAP is control. Under both
systems, for consolidation to occur, the investor company must
generally own 50 percent of another company.

iGAAP and U.S. GAAP are similar in the accounting for the fair
value option.

U.S. GAAP does not permit the reversal of an impairment charge
related to available-for-sale debt and equity investments. iGAAP
permits reversal for available-for-sale debt securities and held-tomaturity securities.
Chapter
17-71
Defining Derivatives
Financial instruments that derive their value from values
of other assets (e.g., stocks, bonds, or commodities).
Three different types of derivatives:
1. Financial forwards or financial futures.
2. Options.
3. Swaps.
Chapter
17-72
Who Uses Derivatives, and Why?
 Producers and Consumers
 Speculators and Arbitrageurs
Chapter
17-73
LO 9 Explain who uses derivative and why.
Basic Principles in Accounting for Derivatives
 Recognize derivatives in the financial statements as
assets and liabilities.
 Report derivatives at fair value.
 Recognize gains and losses resulting from
speculation in derivatives immediately in income.
 Report gains and losses resulting from hedge
transactions differently, depending on the type of
hedge.
Chapter
17-74
LO 10 Understand the basic guidelines for accounting for derivatives.
Example of Derivative Financial Instrument-Speculation
Illustration: Assume that a company purchases a call option
contract from Baird Investment Co.,on January 2, 2010, 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, 2010. The company
purchases the call option for $400 and makes the following entry
on January 2, 2010.
Call Option
Cash
Chapter
17-75
400
400
Option
Premium
LO 11 Describe the accounting for derivative financial instruments.
Example of Derivative Financial Instrument-Speculation
The option premium consists of two amounts.
Illustration 17A-1
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, 2010, the intrinsic value is zero because the market price
equals the preset strike price.
Chapter
17-76
LO 11 Describe the accounting for derivative financial instruments.
Example of Derivative Financial Instrument-Speculation
The option premium consists of two amounts.
Illustration 17A-1
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.
Chapter
17-77
LO 11 Describe the accounting for derivative financial instruments.
Additional data available with respect to the call option:
On March 31, 2010, 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
$20,000
gives the company a gain on the option contract of ____________.
($120,000 - $100,000)
Chapter
17-78
LO 11 Describe the accounting for derivative financial instruments.
On March 31, 2010, it records the increase in the intrinsic
value of the option as follows.
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, 2010, is $100. The company records this
change in value of the option as follows.
Unrealized Holding Gain or Loss—Income
Call Option ($400 - $100)
Chapter
17-79
300
300
LO 11 Describe the accounting for derivative financial instruments.
At March 31, 2010, the company reports the
 call option in its balance sheet at fair value of
$20,100.
 unrealized holding gain which increases net income.
 loss on the time value of the option which decreases
net income.
Chapter
17-80
LO 11 Describe the accounting for derivative financial instruments.
On April 16, 2010, the company settles the option before
it expires. To properly record the settlement, it updates
the value of the option for the decrease in the intrinsic
value of $5,000 ([$20 - $15]) x 1,000) as follows.
Unrealized Holding Gain or Loss—Income
5,000
Call option
5,000
The decrease in the time value of the option of $40 ($100 $60) is recorded as follows.
Unrealized Holding Gain or Loss—Income
Call Option
Chapter
17-81
40
40
LO 11 Describe the accounting for derivative financial instruments.
At the time of the settlement, the call option’s carrying
value is as follows.
Settlement of the option contract is recorded as follows.
Cash
15,000
Loss on Settlement of Call Option
Call Option
Chapter
17-82
60
15,060
LO 11 Describe the accounting for derivative financial instruments.
Summary effects of the call option contract on net income.
Illustration 17A-2
Because the call option meets the definition of an asset, the
company records it in the balance sheet on March 31, 2010. It
also reports the call option at fair value, with any gains or losses
reported in income.
Chapter
17-83
LO 11 Describe the accounting for derivative financial instruments.
Differences between Traditional and Derivative
Financial Instruments
A derivative financial instrument has the following three basic
characteristics.
1.
The instrument has (1) one or more underlyings and (2) an
identified payment provision.
2. The instrument requires little or no investment at the
inception of the contract.
3. The instrument requires or permits net settlement.
Chapter
17-84
LO 11 Describe the accounting for derivative financial instruments.
Features of Traditional and Derivative Financial
Instruments
Illustration 17A-3
Chapter
17-85
LO 11 Describe the accounting for derivative financial instruments.
Derivatives Used for Hedging
Hedging: The use of derivatives to offset the negative
impacts of changes in interest rates or foreign currency
exchange rates.
FASB allows special accounting for two types of hedges—
 fair value and
 cash flow hedges.
Chapter
17-86
LO 11 Describe the accounting for derivative financial instruments.
Fair Value Hedge
A company uses a derivative to hedge (offset) the exposure
to changes in the fair value of a recognized asset or liability
or of an unrecognized commitment.
Companies commonly use several types of fair value hedges.
 Interest rate swaps
 put options
Chapter
17-87
LO 12 Explain how to account for a fair value hedge.
Illustration: On April 1, 2010, 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.
Available-for-Sale Securities
Cash
Chapter
17-88
10,000
10,000
LO 12 Explain how to account for a fair value hedge.
Illustration: Fortunately for Hayward, the value of the
Sonoma shares increases to $125 per share during 2010.
On December 31, 2010, Hayward records the gain on this
investment as follows.
Security Fair Value Adjustment (AFS)
Unrealized Holding Gain or Loss—Equity
Chapter
17-89
2,500
2,500
LO 12 Explain how to account for a fair value hedge.
Hayward reports the Sonoma investment in its balance
sheet.
Illustration 17A-4
Chapter
17-90
LO 12 Explain how to account for a fair value hedge.
Hayward 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.
Illustration: Hayward enters into the put option contract
on January 2, 2011, and designates the option 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.
Chapter
17-91
LO 12 Explain how to account for a fair value hedge.
Illustration: At December 31, 2011, the price of the
Sonoma shares has declined to $120 per share. Hayward
records the following entry for the Sonoma investment.
Unrealized Holding Gain or Loss—Income
Security Fair Value Adjustment (AFS)
Chapter
17-92
500
500
LO 12 Explain how to account for a fair value hedge.
Illustration: The following journal entry records the
increase in value of the put option on Sonoma shares on
December 31, 2011.
Put Option
500
Unrealized Holding Gain or Loss—Income
Chapter
17-93
500
LO 12 Explain how to account for a fair value hedge.
Balance Sheet Presentation of Fair Value Hedge
Illustration 17A-5
Income Statement Presentation of Fair Value Hedge
Illustration 17A-6
Chapter
17-94
LO 12 Explain how to account for a fair value hedge.
Cash Flow Hedge
Used to hedge exposures to cash flow risk, which results
from the variability in cash flows.
Reporting:
 Fair value on the balance sheet
 Gains or losses in equity, as part of other
comprehensive income.
Chapter
17-95
LO 13 Explain how to account for a cash flow hedge.
Illustration: In September 2010 Allied Can Co. anticipates
purchasing 1,000 metric tons of aluminum in January 2011. As a
result, Allied enters into an aluminum futures contract. In this
case, the aluminum futures contract gives Allied the right and
the obligation to purchase 1,000 metric tons of aluminum for
$1,550 per ton. This contract price is good until the contract
expires in January 2011. The underlying for this derivative is
the price of aluminum.
Allied enters into the futures contract on September 1, 2010.
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.
Chapter
17-96
LO 13 Explain how to account for a cash flow hedge.
Illustration: At December 31, 2010, 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.
Futures Contract
25,000
Unrealized Holding Gain or Loss—Equity
25,000
([$1,575 - $1,550] x 1,000 tons)
Allied reports the futures contract in the balance sheet as a current
asset and the gain as part of other comprehensive income.
Chapter
17-97
LO 13 Explain how to account for a cash flow hedge.
Illustration: In January 2011, Allied purchases 1,000
metric tons of aluminum for $1,575 and makes the
following entry.
Aluminum Inventory
1,575,000
Cash ($1,575 x 1,000 tons)
1,575,000
At the same time, Allied makes final settlement on the
futures contract. It records the following entry.
Cash
25,000
Futures Contract ($1,575,000 - $1,550,000)
Chapter
17-98
25,000
LO 13 Explain how to account for a cash flow hedge.
Effect of Hedge on Cash Flows
Illustration 17A-7
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.
Chapter
17-99
LO 13 Explain how to account for a cash flow hedge.
Illustration: Assume that Allied processes the aluminum
into finished goods (cans). The total cost of the cans
(including the aluminum purchases in January 2011) is
$1,700,000. Allied sells the cans in July 2011 for
$2,000,000, and records this sale as follows.
Cash
2,000,000
Sales Revenue
2,000,000
Cost of Goods Sold
1,700,000
Inventory (Cans)
Chapter
17-100
1,700,000
LO 13 Explain how to account for a cash flow hedge.
Illustration: Since the effect of the anticipated
transaction has now affected earnings, Allied makes the
following entry related to the hedging transaction.
Unrealized Holding Gain or Loss—Equity
Cost of Goods Sold
25,000
25,000
The gain on the futures contract, which Allied reported as part of other
comprehensive 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.
Chapter
17-101
LO 13 Explain how to account for a cash flow hedge.
Other Reporting Issues
Embedded Derivatives
Convertible bond is a hybrid instrument. Two parts:
1. a debt security, referred to as the host security, and
2. an option to convert the bond to shares of common
stock, the embedded derivative.
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.
Chapter
17-102
LO 14
Identify special reporting issues related to derivative
financial instruments that cause unique accounting problems.
Qualifying Hedge Criteria
Criteria that hedging transactions must meet before
requiring the special accounting for hedges.
1. Documentation, risk management, and designation.
2. Effectiveness of the hedging relationship.
3. Effect on reported earnings of changes in fair values
or cash flows.
Chapter
17-103
LO 14
Identify special reporting issues related to derivative
financial instruments that cause unique accounting problems.
Summary of Derivative Accounting under GAAP
Illustration 17A-8
Chapter
17-104
LO 14
Identify special reporting issues related to derivative
financial instruments that cause unique accounting problems.
What About GAAP?
Two models for consolidation:
1. Voting-interest model—If a company owns more
than 50 percent of another company, then
consolidate in most cases.
2. Risk-and-reward model—If a company is involved
substantially in the economics of another company,
then consolidate.
Chapter
17-105
LO 15
Describe the accounting for the variable-interest entitles.
Consolidation of Variable-Interest Entities
A variable-interest entity (VIE) is an entity that has
one of the following characteristics:
1. Insufficient equity investment at risk.
2. Stockholders lack decision-making rights.
3. Stockholders do not absorb the losses or receive
the benefits of a normal stockholder.
Chapter
17-106
LO 15
Describe the accounting for the variable-interest entitles.
Illustration 17B-1
VIE
Consolidation
Model
Chapter
17-107
LO 15
Describe the accounting for the variable-interest entitles.
What Is Happening in Practice?
One study of 509 companies with
total market values over $500
million found that just 17 percent
of the companies reviewed have a
material impact.
Chapter
17-108
LO 15
Describe the accounting for the variable-interest entitles.
FASB believes that fair value information is relevant
for making effective business decisions. Others
express concern about fair value measurements for
two reasons:
1. the lack of reliability related to the fair value
measurement in certain cases, and
2. the ability to manipulate fair value measurements.
Chapter
17-109
Disclosure of Fair Value Information:
Financial Instruments—No Fair Value Option
Both the cost and the fair value of all financial instruments
are to be reported in the notes to the financial statements.
FASB 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.
Chapter
17-110
Disclosure of Fair Value Information:
Financial Instruments—No Fair Value Option
Two reasons for additional disclosure beyond the simple
itemization of fair values are:
1. Differing levels of reliability exist in the measurement
of fair value information.
2. Changes in the fair value of financial instruments are
reported differently in the financial statements,
depending upon the type of financial instrument
Chapter
17-111
involved and whether the fair value option is employed.
Levels of reliability fair value hierarchy.

Level 1 is the most reliable measurement because fair value
is based on quoted prices in active markets for identical
assets or liabilities.

Level 2 is less reliable; it is not based on quoted market
prices for identical assets and liabilities but instead may be
based on similar assets or liabilities.

Level 3 is least reliable; it uses unobservable inputs that
reflect the company’s assumption as to the value of the
financial instrument.
Chapter
17-112
Example of Fair Value Hierarchy
Illustration 17C-1
Chapter
17-113
Reconciliation
of Level 3
Inputs
Chapter
17-114
Illustration 17C-2
Disclosure of Fair Value Information:
Financial Instruments—Fair Value Option
Illustration 17C-3
Disclosure of Fair
Value Option
Chapter
17-115
Disclosure of Fair Values: Impaired Assets
or Liabilities
Illustration 17C-4
Disclosure of
Fair Value with
Impairment
Chapter
17-116
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Chapter
17-117