Accy 432 Ch 17 Day 1

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17-1

PREVIEW OF CHAPTER

Intermediate Accounting

15th Edition

Kieso Weygandt Warfield

17

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17-2

Lets say that Company B purchases 1,000 of

Company Zs common stock.

In this chapter, we are concerned with Company Bs

accounting for the investment.

Investment Accounting Approaches

Different motivations for investing:To earn a high rate of return.

To secure certain operating or financingarrangements with another company.

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17-3

Companies account for investments based on

the type of security (debt or equity) and

their intent with respect to the investment.

Illustration 17-1Summary of Investment

Accounting Approaches

Investment in Debt Securities

LO 1

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17-4

Fair Value Definition

Fair value is the price that would be received to sell an

asset or paid to transfer a liability in an orderly

transaction between market participants at the

measurement date.


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17-5

Is it a debt or equity security (from the investors

perspective)?

Important question because equity securities cannot be

held-to-maturity.

Convertible debt (think convertible bonds)

Debt

Mandatory redeemable preferred stock

Debt


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17-6

Three classifications of debt securities

Held to maturitycompany (creditor) has the ability and

intent to hold the security until it matures (amortized cost)

Tradinggoal is to profit from short-term price differences(fair market value)

General ruleHeld for 3 months or less

Available for saleeverything not classified as trading or

held to maturity (fair market value)

For all three classificationsrecord original purchase at

cost.

Classifying Debt Securities

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17-7

Debt Investment Classifications


ILLUSTRATION 17-2Accounting for DebtSecurities by Category

Amortized cost is the acquisition cost adjusted for the amortization of

discount or premium, if appropriate.

LO 1

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17-8

Interest and Gains/Losses

Interest income on debt securities

Treat the same for all three classesrecognizein income as earned (this is different than as

received).

Gains/Losses from selling debt securities

Recognize in income as earned


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17-9

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.

LO 2


Held-to-Maturity Securities

Amortize premium or discountusing the effective-interest

methodunless the straight-line

method yields a similar result.

See BE 17-1

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17-10


LO 2 Understand the procedu res for discoun t andpremium amort izat ion on bond investm ents.

Held-to-maturityIgnore holding gains /losses (unless impaired)

Presented on balance sheet at amortized cost(means we amortize premium or discount)

Impairments are discussed later in this chapter

Accounting for Investment in Bonds

We will not use a bond premium or discountaccountAny premium or discount will simply be included in the

amortized cost included in the Investment Account.

This means the Investment Account balance might changeover the life of the debt security

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17-11

Illustration: Z-Smith Company purchased $100,000 of 8 percentbonds of Bush Corporation on January 1, 2013, at a discount,

paying $92,278. The bonds mature January 1, 2018 and yield

10%; interest is payable each July 1 and January 1. Z-Smith

records the investment as follows:

January 1, 2013

Debt Investments 92,278

Cash 92,278


LO 2

*Journal entry to record purchase.

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Illustration 17-3

Schedule ofInterest

Revenue and

Bond

Discount

AmortizationEffective-Interest

Method


LO 2

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17-13


Illustration 17-3

Illustration: Z-Smith Company records the receipt of the first

semiannual interest payment on July 1, 2013, as follows:

Cash 4,000Debt Investments 614

Interest Revenue 4,614

LO 2*Journal entry to record interest revenue.

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17-14

Illustration 17-3

Illustration: Z-Smith is on a calendar-year basis, it accrues

interest and amortizes the discount at December 31, 2013, as

follows:

Interest Receivable 4,000

Debt Investments 645



LO 2*Adjusting journal entry to recognize interest revenue.

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17-15


Reporting of Held-to-Maturity SecuritiesIllustration 17-4

LO 2

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Saleof Held-to-Maturity Securities

Record interest and amortization of premiumor discount up to sale date

After amortizing premium or discount,compute gain or loss and record income

statement effect

NOTE: Sale of a held-to-maturity securitycould bring into doubt the classification of any

remaining H-T-M securitieswhy?

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17-17


Illustration 17-3

Illustration:Assume Z-Smith

sells its

investment in

Bush bonds onNovember 1,

2017, at 99

plus accrued

interest. Z-Smithrecords discount

amortization as

follows:

Debt Investments 635

Interest Revenue 635

Calculation of amortization = $952 x 4/6 = $635

LO 2*Journal entry to amortize discount up to the sale date.

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17-18


LO 2

Computation of Gain on Sale of Bonds

Cash 102,417Interest Revenue (4/6 x $4,000) 2,667


Gain on Sale of Securities 67

Illustration 17-5

*Journal entry to record sale of HTM.

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17-19

Companies report available-for-sale securities at

fair value, with

unrealized holding gains and losses reported as part

of other comprehensive income (OCI) (equity).

Note 1: OCI flows to AOCI (like NI flows to RE)

Note 2: OCI + NI = Comprehensive Income

Book value = Investment Account + Securities Fair

Value Adjustment Account (VAA is a valuation

account)

Any discount or premium is amortized.

Available-for-Sale Securities DebtSecurities

BE 17-2

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17-20

Accounting for changes in FV of AFS debt securities

Use investment account to record amortized cost

i.e. continue to record interest income based

on amortization schedule

Use Securities Fair Value Adjustment account to

record holding gains and losses

Balance in this account should = Differencebetween Investment Account balance and FV


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Three levels for identifying fair value of a security:

Level 1

Quoted prices in active markets for identical

assets or liabilities

Level 2

Quoted prices in active markets for similar

assets or liabilities

Level 3

Unobservable inputs reflecting companys

assumptions (e.g. project cash flows)

Fair Value Hierarchy DebtSecurities

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17-22

Illustration (Single Security): Graffeo Corporation purchases$100,000, 10 percent, five-year bonds on January 1, 2013, 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. Graffeo records the purchase of

the bonds on January 1, 2013, as follows.


Cash 108,111


LO 2

*Journal entry to record purchase.

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Illustration 17-6

Schedule of

Interest

Revenue and

Bond

Premium

AmortizationEffective-Interest

Method


LO 2

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17-24


Illustration 17-6

Illustration (Single Security): The entry to record interest

revenue on July 1, 2013, is as follows.

Cash 5,000Debt Investments 676


LO 2*Journal entry to record interest revenue.

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17-25


Illustration 17-6

Illustration (Single Security):At December 31, 2013, Graffeo

makes the following entry to recognize interest revenue.

Interest Receivable 5,000Debt Investments 703


Interest

Revenue for

2013 = $8,621

LO 2

*Adjusting journal entry to record interest revenue.

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17-26

Illustration (Single Security): To apply the fair value method to

these debt securities, assume that at December 31, 2013 the fair

value of the bonds is $105,000. Graffeo makes the following entry.

Unrealized Holding Gain or LossEquity 1,732

Fair Value Adjustment (AFS) 1,732


Illustration 17-6

LO 2Valuation account, permanent account so carry balance forward

*CV FV = Loss (106,732-105,000 = 1,732)

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17-27

Illustration (Portfolio of Securities): Herringshaw Corporationhas 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


LO 2

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17-28

Prepare the adjusting entry Herringshaw would make on December

31, 2014 to record the loss.




Illustration 17-7

LO 2*Adjusting journal entry to record change in fair value.

Herringshaw reports the unrealized holding loss of $9,537 as other

comprehensive income and a reduction of stockholders equity.

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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 theOther expenses and losses section of the income

statement.


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17-30


Record interest and amortization of premium or discount

up to sale date

1. After amortizing premium or discount, compute gain or

loss and record realized gain or loss

2. Comprehensive income account and FV adjustment

account are adjusted at the end of the reporting period

Think of this as a 2-step approach (1. record realized

gain or loss; 2. adjust unrealized gains or loss acct.)


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17-31

Illustration (Sale of Available-for-Sale Securities):HerringshawCorporation 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.

Cash 90,000

Loss on Sale of Investments 4,214


Illustration 17-8


LO 2

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Illustration (Sale of Available-for-Sale Securities): Herringshawreports this realized loss in the Other expenses and losses

section of the income statement. Assuming no other purchases and

sales of bonds in 2015, Herringshaw on December 31, 2015,

prepares the information:Illustration 17-9


LO 2

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17-33

Illustration (Sale of Available-for-Sale Securities): Herringshawrecords the following at December 31, 2015. (Please note the

illustration below should read 12/31/15.)




LO 2

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17-34

Financial Statement Presentation Illustration 17-10Reporting of Available-for-Sale Securities


LO 2

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17-35


Remember: Unrealized gains/losses on AFS securities

hit comprehensive income (not the income statement)

Key point: Gains or losses on AFS securities do not

affect net income until the AFS securities are sold.


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17-36 LO 2

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Trading Securities

Companies report trading securities at

fair value on balance sheet,

use a valuation account to record balance sheet

effects of holding gains and losses

continue to use effective interest method to amortize

discount or premium

recognize unrealized holding gains and losses

reported in net income.

DebtSecurities

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Illustration: On December 31, 2012, Koopmans PublishingCorporation determined its trading securities portfolio to be as follows:

At December 31, Koopmans Publishing makes an adjusting entry:

Fair Value Adjustment (Trading) 3,750

Unrealized Holding Gain or LossIncome 3,750

Trading Securities DebtSecurities

LO 2

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17-39

Illustration:(Trading Securities) Hendricks Corporationpurchased 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.


LO 2

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Illustration:(Trading Securities) Hendricks Corporationpurchased 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.


(a) Debt investments 50,000

Cash 50,000

LO 2

(b) Cash 2,000


(c) Unrealized Holding LossIncome 2,600

Fair Value Adjustment (Trading) 2,600

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Trading Securities

Sale of debt classified as Trading Securities

Record interest and amortization of premium or

discount up to sale date

After amortizing premium or discount, compute gain orloss and record income statement effect (realized gain

or loss)

Unrealized holding gain or loss and FV adjustment

account are adjusted at the end of the reporting period

Net effect on income statement during period

of sale = Realized gain or lossUnrealized

holding gain or loss recorded to date

DebtSecurities

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Trading Securities

Why do we continue to amortize the bond premium ordiscount on AFS and trading securities? Wouldnt a

single adjustment to FMV be just as good?

Answer: No.

There are two sources of changes in the FV of debtsecurities held as investments.

Change in discount or premium

We want this component of the change to be partof interest income

Change in FV due to market conditions

We want this to be part of unrealized gain/loss

DebtSecurities

Accy 432 Ch 17 Day 1

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