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17-1
PREVIEW OF CHAPTER
Intermediate Accounting
15th Edition
Kieso Weygandt Warfield
17
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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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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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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.
Investment Accounting Approaches
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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
Investment Accounting Approaches
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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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Debt Investment Classifications
Investment in Debt Securities
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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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
Investment Accounting Approaches
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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
Investment in Debt Securities
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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Held-to-Maturity Securities
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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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
Held-to-Maturity Securities
LO 2
*Journal entry to record purchase.
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Illustration 17-3
Schedule ofInterest
Revenue and
Bond
Discount
AmortizationEffective-Interest
Method
Held-to-Maturity Securities
LO 2
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Held-to-Maturity Securities
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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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
Interest Revenue 4,645
Held-to-Maturity Securities
LO 2*Adjusting journal entry to recognize interest revenue.
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Held-to-Maturity Securities
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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Held-to-Maturity Securities
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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Held-to-Maturity Securities
LO 2
Computation of Gain on Sale of Bonds
Cash 102,417Interest Revenue (4/6 x $4,000) 2,667
Debt Investments 99,683
Gain on Sale of Securities 67
Illustration 17-5
*Journal entry to record sale of HTM.
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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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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
Available-for-Sale Securities DebtSecurities
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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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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.
Debt Investments 108,111
Cash 108,111
Available-for-Sale Securities DebtSecurities
LO 2
*Journal entry to record purchase.
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Illustration 17-6
Schedule of
Interest
Revenue and
Bond
Premium
AmortizationEffective-Interest
Method
Available-for-Sale Securities DebtSecurities
LO 2
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Available-for-Sale Securities DebtSecurities
Illustration 17-6
Illustration (Single Security): The entry to record interest
revenue on July 1, 2013, is as follows.
Cash 5,000Debt Investments 676
Interest Revenue 4,324
LO 2*Journal entry to record interest revenue.
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Available-for-Sale Securities DebtSecurities
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 4,297
Interest
Revenue for
2013 = $8,621
LO 2
*Adjusting journal entry to record interest revenue.
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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
Available-for-Sale Securities DebtSecurities
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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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
Available-for-Sale Securities DebtSecurities
LO 2
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Prepare the adjusting entry Herringshaw would make on December
31, 2014 to record the loss.
Unrealized Holding Gain or LossEquity 9,537
Fair Value Adjustment (AFS) 9,537
Available-for-Sale Securities DebtSecurities
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.
Available-for-Sale Securities DebtSecurities
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Sale of Available-for-Sale Securities
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.)
Available-for-Sale Securities DebtSecurities
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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
Debt Investments 94,214
Illustration 17-8
Available-for-Sale Securities DebtSecurities
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
Available-for-Sale Securities DebtSecurities
LO 2
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Illustration (Sale of Available-for-Sale Securities): Herringshawrecords the following at December 31, 2015. (Please note the
illustration below should read 12/31/15.)
Fair Value Adjustment (AFS) 4,537
Unrealized Holding Gain or LossEquity 4,537
Available-for-Sale Securities DebtSecurities
LO 2
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Financial Statement Presentation Illustration 17-10Reporting of Available-for-Sale Securities
Available-for-Sale Securities DebtSecurities
LO 2
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Sale of Available-for-Sale Securities
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.
Available-for-Sale Securities DebtSecurities
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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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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.
Trading Securities DebtSecurities
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.
Trading Securities DebtSecurities
(a) Debt investments 50,000
Cash 50,000
LO 2
(b) Cash 2,000
Interest Revenue 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