17 Investments

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the accounting 5. Understand the accounting for equity

framework for financial assets. investments at fair value.

2. Understand the accounting for debt 6. Explain the equity method of

investments at amortized cost. accounting and compare it to the fair
value method for equity investments.
3. Understand the accounting for debt
investments at fair value. 7. Discuss the accounting for impairments
of debt investments.
4. Describe the accounting for the fair
value option. 8. Describe the accounting for transfer of
investments between categories.

17-1
 ACCOUNTING FOR FINANCIAL ASSETS

Financial 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.

17-2 LO 1
 ACCOUNTING FOR FINANCIAL ASSETS

Measurement Basis—A Closer Look

IFRS requires that companies measure their financial
assets based on two criteria:
 Company’s business model for managing its financial
assets; and
 Contractual 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.

17-3 LO 1
 ACCOUNTING FOR FINANCIAL ASSETS

Measurement Basis—A Closer Look

Equity investments are generally recorded and reported at
fair value.

ILLUSTRATION 17-1
Summary of Investment Accounting Approaches

17-4 LO 1
 DEBT INVESTMENTS

Debt 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 or
 fair value.

17-5 LO 2
 Debt Investments—Amortized Cost

Illustration: 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 92,278

17-6 LO 2
 Debt Investments—Amortized Cost
ILLUSTRATION 17-2

17-7 LO 2
 Debt Investments—Amortized Cost
ILLUSTRATION 17-2

Robinson Company records the receipt of the first semiannual

interest payment on July 1, 2015, as follows:

Cash 4,000
Debt Investments 614
Interest Revenue 4,614

17-8 LO 2
 Debt Investments—Amortized Cost
ILLUSTRATION 17-2

Because Robinson is on a calendar-year basis, it accrues

interest and amortizes the discount at December 31, 2015, as
follows:
Interest Receivable 4,000
Debt Investments 645
Interest Revenue 4,645
17-9 LO 2
 Debt Investments—Amortized Cost

Reporting of Bond Investment at Amortized Cost

ILLUSTRATION 17-3

17-10 LO 2
 ILLUSTRATION 17-2

Assume that Robinson Company sells its investment on

November 1, 2017, at 99¾ plus accrued interest. Robinson
records this discount amortization as follows:

Debt Investments 522

Interest Revenue 522
(€783 x 4/6 = €522)
17-11 LO 2
 Debt Investments—Amortized Cost

Computation Gain on Sale of Bonds

ILLUSTRATION 17-4

Cash 102,417
Interest Revenue (4/6 x €4,000) 2,667
Debt Investments 96,193
Gain on Sale of Debt Investments 3,557

17-12 LO 2
 Debt Investments—Fair Value

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).

17-13 LO 3
 Debt Investments—Fair Value

Illustration: 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.

17-14 LO 3
 Debt Investments—Fair Value

Entries are the same as those for amortized cost.

17-15 LO 3
 Debt Investments—Fair Value

To apply the fair value approach, Robinson determines that,

due to a decrease in interest rates, the fair value of the debt
investment increased to €95,000 at December 31, 2015.
ILLUSTRATION 17-5
Computation of Unrealized Gain on Fair
Value Debt Investment (2015)

Fair Value Adjustment 1,463

Unrealized Holding Gain or Loss—Income 1,463

17-16 LO 3
 Debt Investments—Fair Value

ILLUSTRATION 17-6
Financial Statement Presentation
of Debt Investments at Fair Value

17-17 LO 3
 Debt Investments—Fair Value

At December 31, 2016, assume that the fair value ILLUSTRATION 17-7
Computation of
of the Evermaster debt investment is €94,000. Unrealized Gain on
Debt Investment (2016)

Unrealized Holding Gain or Loss—Income 2,388

Fair Value Adjustment 2,388

17-18 LO 3
 Debt Investments—Fair Value

ILLUSTRATION 17-8
Financial Statement Presentation
of Debt Investments at Fair Value (2016)

17-19 LO 3
 Debt Investments—Fair Value

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 925

17-20 LO 3
 Debt Investments—Fair Value
Income
Effects on
Debt
Investment
(2015-2017)
Illustration 17-9

17-21 LO 3
 Debt Investments—Fair Value

Illustration (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. ILLUSTRATION 17-10
Computation of Fair Value Adjustment (2015)

17-22 LO 3
 Debt Investments—Fair Value

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 9,537

17-23 LO 3
 Debt Investments—Fair Value

Illustration (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.
ILLUSTRATION 17-11
Computation of Loss
on
Sale of Bonds

Cash 90,000
Loss on Sale of Debt Investments 4,214
Debt Investments 94,214

17-24 LO 3
 Debt Investments—Fair Value

Wang 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:

ILLUSTRATION 17-12
Computation of Fair
17-25 Value Adjustment (2016) LO 3
 Debt Investments—Fair Value

Wang records the following at December 31, 2016.

ILLUSTRATION 17-12

Fair Value Adjustment 4,537

Unrealized Holding Gain or Loss—Income 4,537

17-26 LO 3
 Debt Investments—Fair Value

Financial Statement Presentation

ILLUSTRATION 17-13
Reporting of Debt
Investments at Fair Value
17-27 LO 3
 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.

If a company chooses to use the fair value option, it

measures this instrument at fair value until the company no
longer has ownership.

17-28 LO 4
 Fair Value Option

Illustration: 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 4,537

17-29 LO 4
 Summary of Debt Investment Accounting

ILLUSTRATION 17-14
Summary of Debt
Investment Accounting

17-30 LO 4
 EQUITY INVESTMENTS

Equity 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.

17-31 LO 5
 EQUITY INVESTMENTS

ILLUSTRATION 17-15
Levels of Influence
Determine Accounting Methods

17-32 LO 5
 EQUITY INVESTMENTS

Illustration 17-16
Accounting and Reporting for Equity
Investments by Category

17-33 LO 5
 EQUITY INVESTMENTS

Holdings of Less Than 20%

Under 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.

17-34 LO 5
 EQUITY INVESTMENTS

Holdings 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.

17-35 LO 5
 Equity Investments—Trading (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:

17-36 LO 5
 Equity
Investments
—Trading

Republic records these investments as follows:

Equity Investments 718,550
Cash 718,550

On 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 4,200
17-37 LO 5
 Equity Investments—Trading (Income)

At December 31, 2015, Republic’s equity investment portfolio has

the carrying value and fair value shown.

ILLUSTRATION 17-17
Computation of Fair Value Adjustment—
Equity Investment Portfolio (2015)

17-38 LO 5
 Equity Investments—Trading (Income)

ILLUSTRATION 17-17

Unrealized Holding Gain or Loss—Income 35,550

Fair Value Adjustment 35,550
17-39 LO 5
 Equity Investments—Trading (Income)

On January 23, 2016, Republic sold all of its Burberry ordinary

shares, receiving €287,220. ILLUSTRATION 17-18
Computation of Gain on Sale of Burberry Shares

Cash 287,220
Equity Investments 259,700
Gain on Sale of Equity Investment 27,520

17-40 LO 5
 Equity Investments—Trading (Income)

In 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.

ILLUSTRATION 17-19
Computation of Fair
Value Adjustment—
Equity Investment
Portfolio (2016)

17-41
 ILLUSTRATION 17-19

Republic records this adjustment as follows.

Fair Value Adjustment 101,650

Unrealized Holding Gain or Loss—Income 101,650

17-42 LO 5
 Equity Investments—Non-Trading (OCI)

The accounting entries to record non-trading equity

investments are the same as for trading equity investments,
except for recording the unrealized holding gain or loss.

Report the unrealized holding gain or loss as other

comprehensive income.

17-43 LO 5
 Equity Investments—Non-Trading (OCI)

Illustration: 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 20,750

17-44 LO 5
 Equity Investments—Non-Trading (OCI)

On 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 450

17-45 LO 5
 Equity Investments—Non-Trading (OCI)

At December 31, 2015, Republic’s investment

in Hawthorne has the carrying value and fair ILLUSTRATION 17-20
Computation of Fair Value
value shown. Adjustment—Non-Trading Equity
Investment (2015)

Republic records this adjustment as follows.

Fair Value Adjustment 3,250

Unrealized Holding Gain or Loss—Equity 3,250

17-46 LO 5
 Equity Investments—Non-Trading (OCI)

ILLUSTRATION 17-21
Financial Statement Presentation

17-47 LO 5
 Equity Investments—Non-Trading (OCI)

On December 20, 2016, Republic sold all of its Hawthorne

Company ordinary shares receiving net proceeds of €22,500.

ILLUSTRATION 17-22
Adjustment to Carrying Value of Investment

Entry to adjust the carrying value of the non-trading investment.

Unrealized Holding Gain or Loss—Equity 1,500
Fair Value Adjustment 1,500

17-48 LO 5
 Equity Investments—Non-Trading (OCI)

On December 20, 2016, Republic sold all of its Hawthorne

Company ordinary shares receiving net proceeds of €22,500.

ILLUSTRATION 17-22
Adjustment to Carrying Value of Investment

Entry to record the sale of the investment.

Cash 22,500
Equity Investments 20,750
Fair Value Adjustment 1,750
17-49 LO 5
 Holdings Between 20% and 50%

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.

17-50 LO 6
 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.

17-51 LO 6
 ILLUSTRATION 17-23
Comparison of Fair Value Method and Equity Method
17-52 LO 6
 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.

17-53 LO 6
 OTHER REPORTING ISSUES

Impairment of Value
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.

17-54 LO 7
 Impairment of Value

Illustration: 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.

17-55 LO 7
 Impairment of Value ILLUSTRATION 17-24
Investment Cash Flows

ILLUSTRATION 17-25
Computation of
Impairment Loss

Loss on Impairment 12,680

Debt Investments 12,680
17-56 LO 7
 Recovery of Impairment Loss

If 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.

17-57 LO 7
 Transfers Between Categories

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.

17-58 LO 8
 Transfers Between Categories

Illustration: 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.

17-59 LO 8
 Transfers Between Categories

Illustration: 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 125,000

17-60 LO 8
 Reporting Treatment of Investments

ILLUSTRATION 17-26
Summary of Investment Accounting Approaches
17-61 LO 8
 GLOBAL ACCOUNTING INSIGHTS

INVESTMENTS
Before 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.

17-62
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Following are the key similarities and differences between U.S. GAAP and
IFRS related to investments.
Similarities
• U.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.

17-63
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Similarities
• U.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.

17-64
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• While 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.

17-65
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• While 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.

17-66
 GLOBAL ACCOUNTING INSIGHTS

On the Horizon
At 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.

17-67
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

DEFINING DERIVATIVES
Financial instruments that derive their value from values of
other assets (e.g., ordinary shares, bonds, or commodities).

Three types of derivatives:

1. Financial forwards or financial futures.

2. Options.

3. Swaps.

17-68 LO 9 Explain who uses derivative and why.

 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

WHO USES DERIVATIVES, AND WHY?

 Producers and Consumers
 Speculators and Arbitrageurs

17-69 LO 9
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

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.

17-70 LO 10 Understand the basic guidelines for accounting for derivatives.

 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
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.

Jan. 2, Call Option 400 Option

2015 Cash 400 Premium

17-71 LO 11 Describe the accounting for derivative financial instruments.

 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Derivative Financial Instrument (Speculation)

The option premium consists of two amounts. ILLUSTRATION 17A-1
Option Premium
Formula

Intrinsic value is the difference between the market price and the preset
strike price at any point in time. It represents the amount realized by the
option holder, if exercising the option immediately. On January 2, 2015, the
intrinsic value is zero because the market price equals the preset strike
price.

17-72 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Derivative Financial Instrument (Speculation)

The option premium consists of two amounts. ILLUSTRATION 17A-1
Option Premium
Formula

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.

17-73 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Additional 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
€20,000
on the option contract of ____________. (€120,000 - €100,000)

17-74 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

On 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 20,000

A 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) 300
17-75 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

At 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.

17-76 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

On 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 5,000

The 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 40
17-77 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
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 60
Call Option 15,060
17-78 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Summary effects of the call option contract

ILLUSTRATION 17A-2
on net income. Effect on Income Derivative
Financial Instrument

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.
17-79 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Differences between Traditional and Derivative

Financial Instruments
A derivative financial instrument has the following three basic
characteristics.
1. Instrument has (1) one or more underlyings and (2) an identified
payment provision.
2. Instrument requires little or no investment at the inception of the
contract.
3. Instrument requires or permits net settlement.

17-80 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Features of Traditional and Derivative Financial Instruments

ILLUSTRATION 17A-3

17-81 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
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.

IFRS allows special accounting for two types of hedges—

 fair value and
 cash flow hedges.

17-82 LO 11
 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
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

17-83 LO 12 Explain how to account for a fair value hedge.

 ACCOUNTING FOR DERIVATIVE
APPENDIX 17A
INSTRUMENTS

Illustration: 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 10,000

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Illustration: 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.

Fair Value Adjustment 2,500

Unrealized Holding Gain or Loss—Equity 2,500

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Hayward reports the Sonoma investment in its statement of

financial position.
ILLUSTRATION 17A-4

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Hayward 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.
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Illustration: 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 500

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Illustration: 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 500

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Financial Statement Presentation of Fair Value Hedge

ILLUSTRATION 17B-5

ILLUSTRATION 17B-6

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Cash Flow Hedge

Used 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.

17-91 LO 13 Explain how to account for a cash flow hedge.

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Illustration: 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.

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Illustration: 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.

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Illustration: 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) 1,575,000

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) 25,000

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Effect of Hedge on Cash Flows

ILLUSTRATION 17B-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.

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Illustration: 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 2,000,000

Cost of Goods Sold 1,700,000

Inventory (Cans) 1,700,000

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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 25,000

Cost of Goods Sold 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.

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OTHER REPORTING ISSUES

Embedded Derivatives
A 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.

The IASB requires that the embedded derivative and host security
be accounted for as a single unit.

LO 14 Identify special reporting issues related to derivative financial

17-98 instruments that cause unique accounting problems.
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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.

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Summary of Derivative Accounting ILLUSTRATION 17B-8

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DISCLOSURE OF FAIR VALUE INFORMATION:

FINANCIAL INSTRUMENTS
Both
 cost and
 fair value

of all financial instruments must be reported in the notes to the

financial statements.

17-101 LO 15 Describe required fair value disclosures.

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DISCLOSURE OF FAIR VALUE

Three 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.
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DISCLOSURE OF FAIR VALUE

Companies must provide the following (with special emphasis
on Level 3 measurements):

1. Quantitative information about significant unobservable

inputs used for all Level 3 measurements.

2. A qualitative discussion about the sensitivity of recurring

Level 3 measurements to changes in the unobservable
inputs disclosed, including interrelationships between inputs.

3. A description of the company’s valuation process.

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DISCLOSURE OF FAIR VALUE

Companies must provide the following (with special emphasis
on Level 3 measurements):

4. Any transfers between Levels 1 and 2 of the fair value

hierarchy.

5. Information about non-financial assets measured at fair value

at amounts that differ from the assets’ highest and best use.

6. 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.

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17-105