Kế toán, kiểm toán - Chương 17: Investments

PREVIEW OF CHAPTERIntermediate AccountingIFRS 2nd EditionKieso, Weygandt, and Warfield 17Understand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. ACCOUNTING FOR FINANCIAL ASSETSFinancial Asset Cash.Equity investment of another company (e.g., ordinary or preference shares). Contractual right to receive cash from another party (e.g., loans, receivables, and bonds).IASB requires that companies classify financial assets into two measurement categories—amortized cost and fair value—depending on the circumstances.LO 1Measurement Basis—A Closer LookIFRS requires that companies measure their financial assets based on two criteria:Company’s business model for managing its financial assets; andContractual cash flow characteristics of the financial asset.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.ACCOUNTING FOR FINANCIAL ASSETSLO 1Measurement Basis—A Closer LookEquity investments are generally recorded and reported at fair value.ACCOUNTING FOR FINANCIAL ASSETSLO 1ILLUSTRATION 17-1Summary of Investment Accounting ApproachesUnderstand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. DEBT INVESTMENTSDebt investments are characterized by contractual payments on specified dates of principal and interest on the principal amount outstanding. Companies measure debt investments at amortized cost orfair value.LO 2Illustration: Robinson Company purchased €100,000 of 8% bonds of Evermaster Corporation on January 1, 2015, at a discount, paying €92,278. The bonds mature January 1, 2020 and yield 10%; interest is payable each July 1 and January 1. Robinson records the investment as follows:January 1, 2015 Debt Investments 92,278 Cash 92,278Debt Investments—Amortized CostLO 2LO 2Debt Investments—Amortized CostILLUSTRATION 17-2Cash 4,000Debt Investments 614 Interest Revenue 4,614Debt Investments—Amortized CostLO 2ILLUSTRATION 17-2Robinson Company records the receipt of the first semiannual interest payment on July 1, 2015, as follows:Interest Receivable 4,000Debt Investments 645 Interest Revenue 4,645Debt Investments—Amortized CostLO 2ILLUSTRATION 17-2Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2015, as follows:Reporting of Bond Investment at Amortized CostILLUSTRATION 17-3Debt Investments—Amortized CostLO 2ILLUSTRATION 17-2Assume that Robinson Company sells its investment on November 1, 2017, at 99¾ plus accrued interest. Robinson records this discount amortization as follows:(€783 x 4/6 = €522) LO 2Debt Investments 522 Interest Revenue 522Computation Gain on Sale of BondsCash 102,417 Interest Revenue (4/6 x €4,000) 2,667 Debt Investments 96,193 Gain on Sale of Debt Investments 3,557ILLUSTRATION 17-4Debt Investments—Amortized CostLO 2Understand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. 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. Any unrealized holding gain or loss reported as part of net income (fair value method). Debt Investments—Fair ValueLO 3Illustration: Robinson Company purchased €100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2015, at a discount, paying €92,278. The bonds mature January 1, 2020, and yield 10 percent; interest is payable each July 1 and January 1.The journal entries in 2015 are exactly the same as those for amortized cost.Debt Investments—Fair ValueLO 3Entries are the same as those for amortized cost.Debt Investments—Fair ValueLO 3To 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, 2015.Fair Value Adjustment 1,463 Unrealized Holding Gain or Loss—Income 1,463Debt Investments—Fair ValueLO 3ILLUSTRATION 17-5Computation of Unrealized Gain on FairValue Debt Investment (2015)Debt Investments—Fair ValueLO 3ILLUSTRATION 17-6Financial Statement Presentation of Debt Investments at Fair ValueAt December 31, 2016, assume that the fair value of the Evermaster debt investment is €94,000.Unrealized Holding Gain or Loss—Income 2,388 Fair Value Adjustment 2,388Debt Investments—Fair ValueLO 3ILLUSTRATION 17-7Computation of Unrealized Gain onDebt Investment (2016)Debt Investments—Fair ValueLO 3ILLUSTRATION 17-8Financial Statement Presentation of Debt Investments at Fair Value (2016)Assume now that Robinson sells its investment in Evermaster bonds on November 1, 2017, at 99 ¾ plus accrued interest. The only difference occurs on December 31, 2017. Since the bonds are no longer owned by Robinson, the Fair Value Adjustment account should now be reported at zero. Robinson makes the following entry to record the elimination of the valuation account.Fair Value Adjustment 925 Unrealized Holding Gain or Loss—Income 925Debt Investments—Fair ValueLO 3Income Effects on Debt Investment (2015-2017)Illustration 17-9Debt Investments—Fair ValueLO 3Illustration (Portfolio): Wang Corporation has two debt investments accounted for at fair value. The following illustration identifies the amortized cost, fair value, and the amount of the unrealized gain or loss.Debt Investments—Fair ValueLO 3ILLUSTRATION 17-10Computation of Fair Value Adjustment (2015)Illustration (Portfolio): Wang makes an adjusting entry at December 31, 2015 to record the decrease in value and to record the loss as follows.Unrealized Holding Gain or Loss—Income 9,537 Fair Value Adjustment 9,537Debt Investments—Fair ValueLO 3Illustration (Sale of Debt Investments): Wang Corporation sold the Watson bonds (from Illustration 17-10) on July 1, 2016, for ¥90,000, at which time it had an amortized cost of ¥94,214. Cash 90,000Loss on Sale of Debt Investments 4,214 Debt Investments 94,214Debt Investments—Fair ValueLO 3ILLUSTRATION 17-11Computation of Loss onSale of BondsWang reports this realized loss in the “Other income and expense” section of the income statement. Assuming no other purchases and sales of bonds in 2016, Wang on December 31, 2016, prepares the information:Debt Investments—Fair ValueLO 3ILLUSTRATION 17-12Computation of FairValue Adjustment (2016)Wang records the following at December 31, 2016.Fair Value Adjustment 4,537 Unrealized Holding Gain or Loss—Income 4,537ILLUSTRATION 17-12Debt Investments—Fair ValueLO 3Financial Statement PresentationDebt Investments—Fair ValueLO 3ILLUSTRATION 17-13Reporting of DebtInvestments at Fair ValueUnderstand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. Companies have the option to report most financial assets at fair value. This option is applied on an instrument-by-instrument basis and is generally available only at the time a company first purchases the financial asset or incurs a financial liability. Fair Value OptionIf a company chooses to use the fair value option, it measures this instrument at fair value until the company no longer has ownership. LO 4Illustration: Hardy Company purchases bonds issued by the German Central Bank. Hardy plans to hold the debt investment until it matures in five years. At December 31, 2015, the amortized cost of this investment is €100,000; its fair value at December 31, 2015, is €113,000. If Hardy chooses the fair value option to account for this investment, it makes the following entry at December 31, 2015.Debt Investment (German bonds) 4,537 Unrealized Holding Gain or Loss—Income 4,537Fair Value OptionLO 4Summary of Debt Investment AccountingLO 4ILLUSTRATION 17-14Summary of DebtInvestment AccountingUnderstand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. EQUITY INVESTMENTSEquity investment represents ownership of ordinary, preference, or other capital shares. Cost includes price of the security.Broker’s commissions and fees are recorded as expense.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.LO 5ILLUSTRATION 17-15Levels of InfluenceDetermine Accounting MethodsEQUITY INVESTMENTSLO 5Illustration 17-16Accounting and Reporting for Equity Investments by CategoryEQUITY INVESTMENTSLO 5Under IFRS, the presumption is that equity investments are held-for-trading. General accounting and reporting rule: Investments valued at fair value. Record unrealized gains and losses in net income.EQUITY INVESTMENTSLO 5Holdings of Less Than 20%EQUITY INVESTMENTSLO 5Holdings of Less Than 20%IFRS allows companies to classify some equity investments as non-trading.General accounting and reporting rule: Investments valued at fair value. Record unrealized gains and losses in other comprehensive income.Illustration: November 3, 2015, Republic Corporation purchased ordinary shares of three companies, each investment representing less than a 20 percent interest. These shares are held-for-trading.Republic records these investments as follows:Equity Investments—Trading (Income)LO 5Equity Investments —TradingRepublic records these investments as follows:Equity Investments 718,550 Cash 718,550On December 6, 2015, Republic receives a cash dividend of €4,200 on its investment in the ordinary shares of Nestlé.Cash 4,200 Dividend Revenue 4,200LO 5At December 31, 2015, Republic’s equity investment portfolio has the carrying value and fair value shown.Equity Investments—Trading (Income)LO 5ILLUSTRATION 17-17Computation of Fair Value Adjustment—Equity Investment Portfolio (2015)Equity Investments—Trading (Income)LO 5ILLUSTRATION 17-17Unrealized Holding Gain or Loss—Income 35,550 Fair Value Adjustment 35,550On January 23, 2016, Republic sold all of its Burberry ordinary shares, receiving €287,220.Cash 287,220 Equity Investments 259,700 Gain on Sale of Equity Investment 27,520Equity Investments—Trading (Income)LO 5ILLUSTRATION 17-18Computation of Gain on Sale of Burberry SharesIn addition, assume that on February 10, 2016, Republic purchased €255,000 of Continental Trucking ordinary shares (20,000 shares €12.75 per share), plus brokerage commissions of €1,850. Republic’s equity investment portfolio as of December 31, 2016.Equity Investments—Trading (Income)ILLUSTRATION 17-19Computation of FairValue Adjustment—Equity InvestmentPortfolio (2016)Fair Value Adjustment 101,650 Unrealized Holding Gain or Loss—Income 101,650LO 5ILLUSTRATION 17-19Republic records this adjustment as follows.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. Report the unrealized holding gain or loss as other comprehensive income. Equity Investments—Non-Trading (OCI)LO 5Illustration: On December 10, 2015, Republic Corporation purchased 1,000 ordinary shares of Hawthorne Company for €20.75 per share (total cost €20,750). The investment 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 requirement. Republic accounts for this investment at fair value.Equity Investments 20,750 Cash 20,750Equity Investments—Non-Trading (OCI)LO 5On December 27, 2015, Republic receives a cash dividend of €450 on its investment in the ordinary shares of Hawthorne Company. It records the cash dividend as follows.Cash 450 Dividend Revenue 450Equity Investments—Non-Trading (OCI)LO 5At December 31, 2015, Republic’s investment in Hawthorne has the carrying value and fair value shown.Fair Value Adjustment 3,250 Unrealized Holding Gain or Loss—Equity 3,250Equity Investments—Non-Trading (OCI)LO 5ILLUSTRATION 17-20Computation of Fair Value Adjustment—Non-Trading EquityInvestment (2015)Republic records this adjustment as follows.ILLUSTRATION 17-21Financial Statement PresentationEquity Investments—Non-Trading (OCI)LO 5On December 20, 2016, Republic sold all of its Hawthorne Company ordinary shares receiving net proceeds of €22,500.Unrealized Holding Gain or Loss—Equity 1,500 Fair Value Adjustment 1,500Equity Investments—Non-Trading (OCI)LO 5ILLUSTRATION 17-22Adjustment to Carrying Value of InvestmentEntry to adjust the carrying value of the non-trading investment.On December 20, 2016, Republic sold all of its Hawthorne Company ordinary shares receiving net proceeds of €22,500.Cash 22,500 Equity Investments 20,750 Fair Value Adjustment 1,750Equity Investments—Non-Trading (OCI)LO 5ILLUSTRATION 17-22Adjustment to Carrying Value of InvestmentEntry to record the sale of the investment.Understand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. An investment (direct or indirect) of 20 percent or more of the voting shares 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.Holdings Between 20% and 50%LO 6Equity MethodRecord the investment at cost and subsequently adjust the amount each period for the investor’s proportionate share of the earnings (losses) anddividends 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.Holdings Between 20% and 50%LO 6LO 6ILLUSTRATION 17-23Comparison of Fair Value Method and Equity MethodControlling 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.Holdings of More Than 50%LO 6Understand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. 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.” 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.Impairment of ValueOTHER REPORTING ISSUESLO 7Illustration: At December 31, 2014, Mayhew Company has a debt investment in Bao Group, purchased at par for ¥200,000 (amounts in thousands). 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.Using the following information record the loss on impairment.Impairment of ValueLO 7Loss on Impairment 12,680 Debt Investments 12,680Impairment of ValueLO 7ILLUSTRATION 17-24Investment Cash FlowsILLUSTRATION 17-25Computation of Impairment LossIf subsequently the impairment loss decreases, some or all of the previously recognized impairment loss shall be reversed with a debit to the Debt Investments account and crediting Recovery of Impairment Loss.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.Recovery of Impairment LossLO 7Understand the accounting for equity investments at fair value.Explain the equity method of accounting and compare it to the fair value method for equity investments.Discuss the accounting for impairments of debt investments.Describe the accounting for transfer of investments between categories.After studying this chapter, you should be able to:Investments17LEARNING OBJECTIVESDescribe the accounting framework for financial assets.Understand the accounting for debt investments at amortized cost.Understand the accounting for debt investments at fair value.Describe the accounting for the fair value option. Transferring an investment from one classification to another Should occur only when the business model for managing the investment changes. IASB expects such changes to be rare. Companies account for transfers between classifications prospectively, at the beginning of the accounting period after the change in the business model.Transfers Between CategoriesLO 8Illustration: British Sky Broadcasting Group plc (GBR) has a portfolio of debt investments that are classified as trading; that is, the debt investments are not held-for-collection but managed to profit from interest rate changes. As a result, it accounts for these investments at fair value. At December 31, 2014, British Sky has the following balances related to these securities.Transfers Between CategoriesLO 8Illustration: As part of its strategic planning process, completed in the fourth quarter of 2014, British Sky management decides to move from its prior strategy—which requires active management—to a held-for-collection strategy for these debt investments. British Sky makes the following entry to transfer these securities to the held-for-collection classification.Debt Investments 125,000 Fair Value Adjustment 125,000Transfers Between CategoriesLO 8Reporting Treatment of InvestmentsLO 8ILLUSTRATION 17-26Summary of Investment Accounting ApproachesINVESTMENTSBefore the IASB issued IFRS 9, the accounting and reporting for investments under IFRS and U.S. 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.GLOBAL ACCOUNTING INSIGHTSRelevant FactsFollowing are the key similarities and differences between U.S. GAAP and IFRS related to investments.SimilaritiesU.S. GAAP and IFRS use similar classifications for trading investments. The accounting for trading investments is the same between U.S. GAAP and IFRS. Held-to-maturity (U.S. GAAP) and held-for-collection investments are accounted for at amortized cost. Gains and losses on some investments are reported in other comprehensive income. U.S. GAAP and IFRS use the same test to determine whether the equity method of accounting should be used, that is, significant influence with a general guide of over 20 percent ownership.GLOBAL ACCOUNTING INSIGHTSRelevant FactsSimilaritiesU.S. 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 U.S. GAAP and IFRS.GLOBAL ACCOUNTING INSIGHTSRelevant FactsDifferencesWhile U.S. GAAP classifies 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 classifications. Under U.S. GAAP, a bipolar approach is used to determine consolidation, which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting-interest approach. The basis for consolidation under IFRS is control. However, under both systems, for consolidation to occur, the investor company must generally own 50 percent of another company.GLOBAL ACCOUNTING INSIGHTSRelevant FactsDifferencesWhile the measurement of impairments is similar under U.S. GAAP and IFRS, U.S. 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 U.S. GAAP and IFRS are similar in the accounting for the fair value option, one difference is that U.S. GAAP permits the fair value option for equity method investments; IFRS does not.GLOBAL ACCOUNTING INSIGHTSOn the HorizonAt one time, both the FASB and IASB indicated that they believed 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, IFRS 9 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, earlier than the FASB has completed its deliberations on financial instrument accounting, could create obstacles for the Boards in converging the accounting in this area.GLOBAL ACCOUNTING INSIGHTSFinancial instruments that derive their value from values of other assets (e.g., ordinary shares, bonds, or commodities). Three types of derivatives:Financial forwards or financial futures.Options.Swaps.DEFINING DERIVATIVESAPPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 9 Explain who uses derivative and why.WHO USES DERIVATIVES, AND WHY?Producers and ConsumersSpeculators and ArbitrageursAPPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 9BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVESRecognize 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 10 Understand the basic guidelines for accounting for derivatives.LO 11 Describe the accounting for derivative financial instruments.Derivative Financial Instrument (Speculation)Illustration: Assume that the company purchases a call option contract on January 2, 2015, 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 shares at an option price of €100 per share. The option expires on April 30, 2015. The company purchases the call option for €400 and makes the following entry.Call Option 400 Cash 400Option PremiumJan. 2, 2015APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSThe option premium consists of two amounts.ILLUSTRATION 17A-1Option Premium FormulaIntrinsic 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, 2015, the intrinsic value is zero because the market price equals the preset strike price.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSDerivative Financial Instrument (Speculation)LO 11Time 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSDerivative Financial Instrument (Speculation)The option premium consists of two amounts.ILLUSTRATION 17A-1Option Premium FormulaLO 11Additional data available with respect to the call option:On March 31, 2015, 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 company a gain on the option contract of ____________.€20,000(€120,000 - €100,000)APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11On March 31, 2015, it records the increase in the intrinsic value of the option as follows.Call Option 20,000 Unrealized Holding Gain or Loss—Income 20,000A market appraisal indicates that the time value of the option at March 31, 2015, is €100. The company records this change in value of the option as follows.Unrealized Holding Gain or Loss—Income 300 Call Option (€400 - €100) 300APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11At March 31, 2015, the company reports the call option in its statement of financial position 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11On April 16, 2015, 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 5,000The decrease in the time value of the option of €40 (€100 - €60) is recorded as follows.Unrealized Holding Gain or Loss—Income 40 Call Option 40APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11At the time of the settlement, the call option’s carrying value is as follows.Settlement of the option contract is recorded as follows.Cash 15,000Loss on Settlement of Call Option 60 Call Option 15,060APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11Summary effects of the call option contract on net income.The company records the call option in the statement of financial position on March 31, 2015. Furthermore, it reports the call option at fair value, with any gains or losses reported in income.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSILLUSTRATION 17A-2Effect on Income Derivative Financial InstrumentLO 11Differences between Traditional and Derivative Financial InstrumentsA derivative financial instrument has the following three basic characteristics. Instrument has (1) one or more underlyings and (2) an identified payment provision.Instrument requires little or no investment at the inception of the contract. Instrument requires or permits net settlement.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11Features of Traditional and Derivative Financial InstrumentsAPPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSILLUSTRATION 17A-3LO 11DERIVATIVES USED FOR HEDGINGHedging: The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates. IFRS allows special accounting for two types of hedges—fair value and cash flow hedges.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 11Fair Value HedgeA 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 optionsLO 12 Explain how to account for a fair value hedge.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSIllustration: On April 1, 2015, Hayward Co. purchases 100 ordinary shares of Sonoma Company at a market price of €100 per share. Due to a legal requirement, Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as a non-trading equity investment. Hayward records this investment as follows.Equity investments 10,000 Cash 10,000APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 12Fair Value Adjustment 2,500 Unrealized Holding Gain or Loss—Equity 2,500Illustration: Fortunately for Hayward, the value of the Sonoma shares increases to €125 per share during 2015. On December 31, 2015, Hayward records the gain on this investment as follows.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 12Hayward reports the Sonoma investment in its statement of financial position.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSILLUSTRATION 17A-4LO 12Hayward is exposed to the risk that the price of the Sonoma shares 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 shares.Illustration: Hayward enters into the put option contract on January 2, 2016, 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 12Illustration: At December 31, 2016, 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 500 Fair Value Adjustment 500APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 12Illustration: The following journal entry records the increase in value of the put option on Sonoma shares on December 31, 2016.Put Option 500 Unrealized Holding Gain or Loss—Income 500APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 12Financial Statement Presentation of Fair Value HedgeAPPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSILLUSTRATION 17B-5ILLUSTRATION 17B-6LO 12Cash Flow HedgeUsed to hedge exposures to cash flow risk, which results from the variability in cash flows.Reporting:Fair value on the statement of financial position.Gains or losses in equity, as part of other comprehensive income.LO 13 Explain how to account for a cash flow hedge.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSIllustration: In September 2015 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2016. 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 (amounts in thousands). This contract price is good until the contract expires in January 2016. The underlying for this derivative is the price of aluminum. Allied enters into the futures contract on September 1, 2015. 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 13Illustration: At December 31, 2015, 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 statement of financial position as a current asset and the gain as part of other comprehensive income.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 13Illustration: In January 2016, 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) 1,575,000At 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) 25,000APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 13Effect of Hedge on Cash FlowsILLUSTRATION 17B-7There 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 13Illustration: Assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2016) is ¥1,700,000. Allied sells the cans in July 2016 for ¥2,000,000, and records this sale as follows.Cash 2,000,000 Sales Revenue 2,000,000Cost of Goods Sold 1,700,000 Inventory (Cans) 1,700,000APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 13Illustration: 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 25,000 Cost of Goods Sold 25,000The 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 13OTHER REPORTING ISSUESLO 14 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems.Embedded DerivativesA convertible bond is a hybrid instrument. Two parts: a debt security, referred to as the host security, andan option to convert the bond to shares of common stock, the embedded derivative.The IASB requires that the embedded derivative and host security be accounted for as a single unit.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSQualifying Hedge CriteriaCriteria that hedging transactions must meet before requiring the special accounting for hedges.Documentation, risk management, and designation.Effectiveness of the hedging relationship.Effect on reported earnings of changes in fair values or cash flows.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 14Summary of Derivative AccountingILLUSTRATION 17B-8APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 14DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTSLO 15 Describe required fair value disclosures.Both cost andfair valueof all financial instruments must be reported in the notes to the financial statements.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSDISCLOSURE OF FAIR VALUEThree broad levels related to the measurement of fair values. 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.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 15DISCLOSURE OF FAIR VALUECompanies must provide the following (with special emphasis on Level 3 measurements):Quantitative information about significant unobservable inputs used for all Level 3 measurements.A qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed, including interrelationships between inputs.A description of the company’s valuation process.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 15DISCLOSURE OF FAIR VALUECompanies must provide the following (with special emphasis on Level 3 measurements):Any transfers between Levels 1 and 2 of the fair value hierarchy.Information about non-financial assets measured at fair value at amounts that differ from the assets’ highest and best use.The proper hierarchy classification for items that are not recognized on the statement of financial position but are disclosed in the notes to the financial statements.APPENDIX 17AACCOUNTING FOR DERIVATIVE INSTRUMENTSLO 15Copyright © 2015 John Wiley & Sons, Inc. 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