Investments C hapter 15 An electronic presentation by Norman Sunderman Angelo State University An...

Investments

Chapter15

An electronic presentation by Norman Sunderman Angelo State University

An electronic presentation by Norman Sunderman Angelo State University

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Intermediate AccountingIntermediate Accounting 10th edition 10th edition

Nikolai Bazley JonesNikolai Bazley Jones

2

1. Explain the classification and valuation of investments.

2. Account for investments in debt and equity trading securities.

3. Account for investments in available-for-sale debt and equity securities.

4. Account for investments in held-to-maturity debt securities, including amortization of bond premiums and discounts.

Objectives

3

5. Understand transfers and impairments.

6. Understand disclosures of investments.

7. Explain the conceptual issues regarding investments in marketable securities.

8. Account for investments using the equity method.

9. Describe additional issues for investments.

10. Account for derivatives of financial instruments. (Appendix)

Objectives

4

1. Additional revenues from idle cash.

2. Control over another company.

3. Beneficial relationship with another company.

Why Companies Invest in Other Companies

5

Classification of Investments

1. Trading securities

2. Available-for-sale securities

3. Held-to-maturity debt securities

6

Trading securities are investments in debt and equity securities that are

purchased and held principally for the purpose of selling them in the near

term.

Trading securities are investments in debt and equity securities that are

purchased and held principally for the purpose of selling them in the near

term.

Classification of Investments

7

Trading securities are investments in debt and equity securities that are purchased and held principally for the purpose of

selling them in the near term.

Trading securities are investments in debt and equity securities that are purchased and held principally for the purpose of

selling them in the near term.

These securities are reported at their fair market value on the balance sheet date, and unrealized holding gains and losses are included in net income of the

period.

These securities are reported at their fair market value on the balance sheet date, and unrealized holding gains and losses are included in net income of the

period.

Trading Securities

8

Investments in available-for-sale securities are (a)

debt securities that are not classified as being held to

maturity, and...

Investments in available-for-sale securities are (a)

debt securities that are not classified as being held to

maturity, and...

Available-for-Sale Securities

9

…(b) debt and equity securities that are not

classified as trading securities.

…(b) debt and equity securities that are not

classified as trading securities.


10

Investments in available-for-sale securities are reported at their fair value on the balance sheet date. The unrealized holding gains or losses are included in other comprehensive income.

Investments in available-for-sale securities are reported at their fair value on the balance sheet date. The unrealized holding gains or losses are included in other comprehensive income.


11

Therefore, the unrealized holding gains and losses for

available-for-sale securities are not included in net income.

Therefore, the unrealized holding gains and losses for

available-for-sale securities are not included in net income.


12

Investments in held-to-maturity debt securities are debt securities for which the

company has the positive intent and ability to hold until

they mature.

Investments in held-to-maturity debt securities are debt securities for which the

company has the positive intent and ability to hold until

they mature.

Held-to-Maturity Securities

13

Investments in held-to-maturity debt securities are reported at

their amortized cost on the balance sheet…not their fair

value.

Investments in held-to-maturity debt securities are reported at

their amortized cost on the balance sheet…not their fair

value.

Held to Maturity Securities

14

Accounting for Investments Reporting of

Unrealized Holding Method Gains and Losses

Investment in Equity Securities1. No significant influence

a. Trading Fair value Net Incomeb. Available for sale Fair value Other comprehen-

sive income2. Significant influence Equity method Not recognized3. Control Consolidation Not recognized

15

Accounting for Investments Reporting of

Unrealized Holding Method Gains and Losses

Investment in Debt Securities1. Trading Fair value Net Income2. Available for sale Fair value Other comprehen-

sive income3. Held to maturity Amortized cost Not recognized

16

Investments in Available-for-Sale

Debt and Equity Securities1. The investment is initially recorded at cost.

2. It is subsequently reported at fair value.

3. Unrealized holding gains and losses are reported as a component of other comprehensive income.

4. Interest and dividend revenue, as well as realized gains and losses on sales, are included in net income for the current period.

17

• 100 shares of A Company common stock at $50 per share

• 300 shares of B Company common stock at $80 per share

• 200 shares of Company C preferred stock at $120 per share.

• $15,000 Company D 10% bonds

• 100 shares of A Company common stock at $50 per share

• 300 shares of B Company common stock at $80 per share

• 200 shares of Company C preferred stock at $120 per share.

• $15,000 Company D 10% bonds

$ 5,000

24,000

24,00015,000

$ 5,000

24,000

24,00015,000

Kent Company purchases the following securities on May 1, 2006, as an investment in

available-for-sale securities:

Total $68,000


Debt and Equity Securities

18

Investment in Available-for-Sale Securities 68,000Interest Revenue 625 Cash 68,625

See Page 709



19

Accrued interest on the D Company bond from November 30, 2005, to May 31, 2006

Accrued interest on the D Company bond from November 30, 2005, to May 31, 2006

May 31, 2006

Interest Revenue 750

$15,000 x 0.10 x 6/12$15,000 x 0.10 x 6/12



Cash 750

20

December 31, 2006Interest Receivable 125 Interest Revenue 125

Cash 3,000 Dividend Revenue 3,000

$15,000 x 0.10 x 1/12$15,000 x 0.10 x 1/12$15,000 x 0.10 x 1/12$15,000 x 0.10 x 1/12

During 2006 Kent Company receives dividends of $3,000 from its investment in

the stocks of A, B, and C Companies.

During 2006 Kent Company receives dividends of $3,000 from its investment in

the stocks of A, B, and C Companies.



21

The cost and fair value of the available-for-sale securities held by the Kent Company is as follows:


CumulativeChange

Fair in FairSecurity Cost Value Value

100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000 300 shares of B Co. common stock 24,000 23,500 (500)200 shares of C Co. preferred stock 24,000 26,000 2,000 D Company 10% bonds 15,000 15,500 500 Totals $68,000 $71,000 $3,000



12/31/06

22



CumulativeChange

Fair in FairSecurity Cost Value Value

100 shares of A Co. common stock $ 5,000 $ 6,000 $1,000 300 shares of B Co. common stock 24,000 23,500 (500)200 shares of C Co. preferred stock 24,000 26,000 2,000 D Company 10% bonds 15,000 15,500 500 Totals $68,000 $71,000 $3,000



12/31/06Allowance for Change in ValueAllowance for Change in Value of Investmentof Investment 3,0003,000 Unrealized Increase/DecreaseUnrealized Increase/Decrease in Value of Available-for-in Value of Available-for- Sale SecuritiesSale Securities 3,0003,000

Allowance for Change in ValueAllowance for Change in Value of Investmentof Investment 3,0003,000 Unrealized Increase/DecreaseUnrealized Increase/Decrease in Value of Available-for-in Value of Available-for- Sale SecuritiesSale Securities 3,0003,000

23

The same securities are held on December 31, 2007.The same securities are held on December 31, 2007.

Cumulative Change Fair in FairSecurity Cost Value Value

100 shares of A Co. common stock $ 5,000 $ 6,100 $1,100 300 shares of B Co. common stock 24,000 22,700 (1,300)200 shares of C Co. preferred stock 24,000 23,200 (800)D Company 10% bonds 15,000 14,000 (1,000) Totals $68,000 $66,000 $(2,000)



12/31/07

24

12/31/06 3,000 5,000 adjusting entry

2,000 12/31/07

Allowance for Change in Value of Investment

Unrealized Increase/Decrease in Unrealized Increase/Decrease in Value of Available-for-Sale SecuritiesValue of Available-for-Sale Securities 5,0005,000 Allowance for Change in Value ofAllowance for Change in Value of InvestmentInvestment 5,0005,000

Unrealized Increase/Decrease in Unrealized Increase/Decrease in Value of Available-for-Sale SecuritiesValue of Available-for-Sale Securities 5,0005,000 Allowance for Change in Value ofAllowance for Change in Value of InvestmentInvestment 5,0005,000

25

Sale of Available-for-Sale Securities

On March 1, 2008, the Kent Company sold 100 shares of A Company stock for $6,000. The stock

had a fair value on Dec. 31, 2007, of $6,100.

On March 1, 2008, the Kent Company sold 100 shares of A Company stock for $6,000. The stock

had a fair value on Dec. 31, 2007, of $6,100.

Cash 6,000 Investment in Available-for- Sale Securities 5,000 Gain on Sale of Available-for- Sale Securities 1,000

The Unrealized Increase/Decrease in Value (DR) and the allowance (CR) account are reduced by $1,100.

The Unrealized Increase/Decrease in Value (DR) and the allowance (CR) account are reduced by $1,100.

26

Cumulative 12/31/08 Change Fair in FairSecurity Cost Value Value

300 shares of B Co. common stock $24,000 $23,500 $(500)200 shares of C Co. preferred stock 24,000 24,100 100 D Company 10 bonds 15,000 14,700 (300) Totals $63,000 $62,300 $(700)

Available-for-Sale SecuritiesDecember 2008

27

700 12/31/08

2,400 adjusting entry2,000 12/31/07 1,100 3/1/08

Allowance for Change in Value of Investments

Allowance for Change in Value of InvestmentAllowance for Change in Value of Investment 2,4002,400 Unrealized Increase/Decrease in Unrealized Increase/Decrease in Value of Available-for-Sale SecuritiesValue of Available-for-Sale Securities 2,4002,400

Allowance for Change in Value of InvestmentAllowance for Change in Value of Investment 2,4002,400 Unrealized Increase/Decrease in Unrealized Increase/Decrease in Value of Available-for-Sale SecuritiesValue of Available-for-Sale Securities 2,4002,400

28

Classify Recognize Recognize Compute According to Interest and Realized Realized Management Dividend Gain or Gain or Intent as: Revenue in: Loss in: Loss as:

Trading Net Income Net Income Selling Price minus

Fair Value at Most

Recent BalanceSheet Date

Available- Net Income Net Income Selling price minus

for-Sale (Amortized) Cost Held-to- Net Income Net Income Selling Price minus

Maturity (Amortized) Cost

Accounting for Investments

29

Investments in Held-to-Maturity Debt Securities

1. The investment is initially recorded at cost.

2. It is subsequently reported at amortized cost.

3. Unrealized holding gains and losses are not recorded.

4. Interest revenue and realized gains and losses on sales (if any) are all included in net income.

30

A company purchases 9% bonds with a face value of $100,000 on August 1, 2006, at 99 plus

accrued interest, which is payable semiannually.

A company purchases 9% bonds with a face value of $100,000 on August 1, 2006, at 99 plus

accrued interest, which is payable semiannually.

Investment in Held-to-Maturity Debt Securities 99,000Interest Revenue 1,500 Cash 100,500

$100,000 x 0.99$100,000 x 0.99

$100,000 x 0.09 x 2/12$100,000 x 0.09 x 2/12

Investments in Held-to-Maturity Debt Securities

31

Accounting for Bond Premiums

On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a face value of $100,000, paying $102,458.71. The stated rate is

13% and the effective interest rate is 12%.

On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a face value of $100,000, paying $102,458.71. The stated rate is

13% and the effective interest rate is 12%.

Investment in Held-to- Maturity Debt Securities 102,458.71 Cash 102,458.71

32

Colburn Company records the first interest receipt on June 30, 2006, using the effective interest method.

Colburn Company records the first interest receipt on June 30, 2006, using the effective interest method.

Cash 6,500.00 Investment in Held-to- Maturity Debt Securities 352.48 Interest Revenue 6,147.52

$100,000 x 0.13 x 1/2$100,000 x 0.13 x 1/2

$102,458.71 x .12 x 1/2$102,458.71 x .12 x 1/2$102,458.71 x .12 x 1/2$102,458.71 x .12 x 1/2

Accounting for Bond Premiums

33

Accounting for Bond Discounts

On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a

face value of $100,000, paying $97,616.71. The stated rate is 13% and the effective interest rate

is 14%.

On January 1, 2006, Colburn Company invests in bonds that will be held to maturity, with a

face value of $100,000, paying $97,616.71. The stated rate is 13% and the effective interest rate

is 14%.

Investment in Held-to- Maturity Debt Securities 97,616.71 Cash 97,616.71

34

Colburn Company records the first interest receipt on June 30, 2006,

using the effective interest method.

Colburn Company records the first interest receipt on June 30, 2006,

using the effective interest method.

Cash 6,500.00Investment in Held-to- Maturity Debt Securities 333.17 Interest Revenue 6,833.17

$97,616.71 x .14 x 1/2$97,616.71 x .14 x 1/2$97,616.71 x .14 x 1/2$97,616.71 x .14 x 1/2

Accounting for Bond Discounts

35

Trading Cost Fair Value Net Income

Available- Cost Fair Value Other Compre-for-Sale hensive Income

Held-to- Cost Amortized ---Maturity Cost

Classify Subsequently Recognize According to Report on the Unrealized Management Initially Balance Holding Gains Intent as: Record as: Sheet at: and Losses in:

Investment in Securities

36

Tallen Company purchased 13% bonds with a face value of $200,000 for $204,575.07 on April 3, 2006.

Interest on these bonds is payable June 30 and December 31, and the bonds mature on December 31,

2008.

Tallen Company purchased 13% bonds with a face value of $200,000 for $204,575.07 on April 3, 2006.

Interest on these bonds is payable June 30 and December 31, and the bonds mature on December 31,

2008.

Investment in Held-to-MaturityDebt Securities 204,575.07

Interest Revenue 6,500.00Cash 211,075.07

ContinuedContinuedContinuedContinued

Amortization of Bonds Acquired Between Interest Dates

$200,000 x $200,000 x 0.13 x 3/120.13 x 3/12$200,000 x $200,000 x 0.13 x 3/120.13 x 3/12

37

June 30, 2006

Cash 13,000.00Interest Revenue 12,637.25Investment in Held-to-Maturity Debt Securities 362.75

$13,000 $13,000 –– $12,637.25$12,637.25$13,000 $13,000 ––

$12,637.25$12,637.25ContinuedContinued


($204,575.07 ($204,575.07 x 0.12 x ¼) x 0.12 x ¼)

+ $6,500+ $6,500

($204,575.07 ($204,575.07 x 0.12 x ¼) x 0.12 x ¼)

+ $6,500+ $6,500

38

December 31, 2006

Cash 13,000.00Interest Revenue 12,252.74Investment in Held-to-Maturity Debt Securities 747.26

$13,000 – $12,252.74$13,000 –

$12,252.74


($204,575.07 ($204,575.07 - $362.75) X - $362.75) X 0.12 X 1/20.12 X 1/2

($204,575.07 ($204,575.07 - $362.75) X - $362.75) X 0.12 X 1/20.12 X 1/2

39

The $100,000 of 13% bonds purchased by the Colburn Company for $97,616.71 were sold on

March 31, 2007, for $102,000 plus accrued interest.

The $100,000 of 13% bonds purchased by the Colburn Company for $97,616.71 were sold on

March 31, 2007, for $102,000 plus accrued interest.

Investment in Held-to-MaturityDebt Securities 198.61

Interest Revenue 198.61

($2,383.29 ($2,383.29 ÷ ÷ 6) x ½6) x ½

($2,383.29 ($2,383.29 ÷ ÷ 6) x ½6) x ½

ContinuedContinued

Sale of Investment in Bonds Before Maturity

40


41

Cash 105,250.00Interest Revenue 3,250.00Gain on Sale of Debt Securities 3,390.24Investment in Held-to-Maturity

Debt Securities 98,609.76

$98,411.15 + $98,411.15 + $198.61$198.61

$98,411.15 + $98,411.15 + $198.61$198.61


$100,000$100,000 x 0.13 x ¼x 0.13 x ¼$100,000$100,000

x 0.13 x ¼x 0.13 x ¼

$102,000 $102,000 + $3,250+ $3,250

$102,000 $102,000 + $3,250+ $3,250

42

1. A transfer from the trading category.

2. A transfer into the trading category.

3. A transfer into the available for sale category.

4. A transfer of a debt security into the held to maturity category from the available for sale category.

Transfers of Investments Between Categories

43

In 2007, Kent transfers the Company A securities into the trading category when the fair value is $6,300.

In 2007, Kent transfers the Company A securities into the trading category when the fair value is $6,300.

Investment in Trading Securities 6,300 Investment in Available-for- Sale Securities 5,000 Gain on Transfer of Securities 1,300

Unrealized Increase/Decrease in Value of Available-for-Sale Securities1,100 Allowance for Change in Value of Investment 1,100

Transfer from Available-for-Sale to Trading Securities

44

Devon Company has $10,000 in bonds that were purchased at par. When the fair value is $9,500,

Devon transfers them to the available-for-sale category.

Devon Company has $10,000 in bonds that were purchased at par. When the fair value is $9,500,

Devon transfers them to the available-for-sale category.

Investment in Available-for-Sale Securities 10,000 Investment in Held-to- Maturity Debt Securities 10,000Unrealized Increase/Decrease in Value of Available-for-Sale Securities 500 Allowance for Change in Value of Investment 500

Transfers from Held-to-Maturity to Available-for-Sale

45

Disclosures1. Trading Securities--A company must disclose the

change in the net unrealized holding gain or loss that is included in each income statement.

2. Available-for-Sale Securities--For each balance sheet date, a company must disclose the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses and (amortized cost) by major types.

3. Held-to-Maturity Debt Securities--For each balance sheet date, a company must disclose the aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost by major security types.

46

Devon Company classifies its bond investment as available for sale with a previous fair vale of $9,700,

and transfers them into the held-to-maturity category when the current market value of the debt securities

is $9,500.

Devon Company classifies its bond investment as available for sale with a previous fair vale of $9,700,

and transfers them into the held-to-maturity category when the current market value of the debt securities

is $9,500.

Investment in Held-to-Maturity Debt Securities 9,500Unrealized Increase/Decrease from Transfer of Securities 500 Investment in Available-for- Sale Securities 10,000


Transfer from Available-for-Sale to Held to Maturity

47

An entry is needed to eliminate the previous $300 ($9,700 – $10,000) amount in the allowance and

unrealized increase/decrease accounts.

An entry is needed to eliminate the previous $300 ($9,700 – $10,000) amount in the allowance and

unrealized increase/decrease accounts.

Allowance for Change in Value of Investment 300 Unrealized Increase/Decrease in Value of Available-for-Sale Securities 300

Transfer from Available-for-Sale to Held to Maturity

48

Impairments may be an “other than temporary” decline below the

amortized cost of an investment in a debt security classified as available

for sale or held to maturity.

Impairments may be an “other than temporary” decline below the

amortized cost of an investment in a debt security classified as available

for sale or held to maturity.

Impairments

49

Tracy Company has a bond investment categorized as held to maturity, which has an unamortized carrying amount of $21,500 and a fair value of

$6,500. The investment is considered to be “impaired.”

Tracy Company has a bond investment categorized as held to maturity, which has an unamortized carrying amount of $21,500 and a fair value of

$6,500. The investment is considered to be “impaired.”

Realized Loss on Decline in Value 15,000 Investment in Held-to-Maturity Debt Securities 15,000

Impairments

50

Current AssetsTemporary investment in available-for-sale securities (at cost)

$29,000Plus: Allowance for change in value of investment

500Temporary investment in available-for-sale securities (at fair value)

$29,500

Noncurrent AssetsInvestment in available-for-sale securities (at cost) $39,000Plus: Allowance for change in value of investment 2,500Investment in available-for-sale securities (at fair value) $41,500

Financial Statement Classification

51

1. Fair value is required in the balance sheet for trading securities and available-for-sale securities, whereas amortized cost is required for held-to-maturity securities.

2. Fair value is not required for certain liabilities.

3. Unrealized holding gains and losses are reported in net income for trading securities, but in other comprehensive income for available-for-sale securities.

4. The classification of securities is based on management intent.

FASB 115: A Conceptual Evaluation

52

Equity Method

When an investor corporation owns a significantly large

percentage of common stock, it is able to exert

significant influence over the policies of the investee corporation. The equity

method is used to account for this investment.

When an investor corporation owns a significantly large

percentage of common stock, it is able to exert

significant influence over the policies of the investee corporation. The equity

method is used to account for this investment.

53

Acknowledges the existence of a material economic relationship between the investor and the investee.

Is based upon the requirements of accrual accounting.

Reflects the change in stockholders’ equity of the investee company.

Equity Method

54

According to FASB Interpretation No. 35, what are the facts and

circumstances that indicate that investors

with 20% or more in the investee’s stock should not

use the equity method?

According to FASB Interpretation No. 35, what are the facts and

circumstances that indicate that investors

with 20% or more in the investee’s stock should not

use the equity method?

Equity Method

In the absence of evidence to the contrary, an

investment of 20% or more in the outstanding

common stock of the investee leads to the

presumption of significant influence.

In the absence of evidence to the contrary, an

investment of 20% or more in the outstanding

common stock of the investee leads to the

presumption of significant influence.

55

Opposition by the investee which challenges the investor’s ability to exercise significant influence.

The investor and investee sign an agreement under which the investor surrenders significant stockholder’s rights.

Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to views of the investor.

Inability to gather information not available to other shareholders.

Failure to obtain representation on investee’s board of directors.

Equity Method Not Used

56

Cliborn Company purchases 4,200 shares of the S company’s outstanding stock (25%) on January 1,

2007, for $125,000 (significant influence).

Cliborn Company purchases 4,200 shares of the S company’s outstanding stock (25%) on January 1,

2007, for $125,000 (significant influence).

Investment in Stock: S Company 125,000 Cash 125,000

S Company pays a $20,000 dividend.S Company pays a $20,000 dividend.

Cash 5,000 Investment in Stock: S Company 5,000

See Page 731

Equity Method

57

S Company reported net income for 2007 of $81,000, consisting of ordinary income of $73,000

and an extraordinary gain of $8,000.

S Company reported net income for 2007 of $81,000, consisting of ordinary income of $73,000

and an extraordinary gain of $8,000.

Investment in Stock: S Company 20,250 Investment Income: Ordinary 18,250 Investment Income: Extraordinary 2,000

25% of $81,00025% of $81,00025% of $73,00025% of $73,000

25% of 8,00025% of 8,00025% of 8,00025% of 8,000

Equity Method

58

Balance Sheet Book Value Fair Value

Depreciable assets $400,000 $450,000 (remaining life, 10 yrs)Other nondepreciable assets 190,000 246,000 (e.g., land) Total $590,000$696,000

Liabilities $200,000 $220,000Common Stock 250,000 Retained earnings 140,000Total $590,000

Equity MethodInvestment Book Value Difference X

% of Investment

50,000 X 25% = 12,500

59

When acquired by S Company, the investee’s depreciable assets had a fair market value that exceeded book value by $50,000 (10-year life). Cliborn’s share of the depreciable asset value is $12,500 (25%). Additional depreciation is

needed on December 31.

When acquired by S Company, the investee’s depreciable assets had a fair market value that exceeded book value by $50,000 (10-year life). Cliborn’s share of the depreciable asset value is $12,500 (25%). Additional depreciation is

needed on December 31.

Investment Income: Ordinary 1,250 Investment in Stock: S Company 1,250

Note that this entry results in a deduction from ordinary income.

Note that this entry results in a deduction from ordinary income.

Equity Method

$12,500 / $12,500 / 10 years10 years

60

Investment 125,000Ordinary income 18,250 Extraordinary income 2,000

5,000 Dividends received

1,250 Excess depreciation

Ending balance 139,000

Disclosure-Carrying Value

61

Disclosure-Equity Income

Share of 2007 ordinary income $18,250

Less: excess depreciation 1,250

Ordinary investment income $17,000

Plus: investee extraordinary income 2,000

Net investment income $19,000

62

Stock Dividends

Smith Corporation purchased 2,000 shares of Kell Company common stock for $30 per share. Two months later, Kell issued a 50% stock dividend.

Smith Corporation purchased 2,000 shares of Kell Company common stock for $30 per share. Two months later, Kell issued a 50% stock dividend.

Memo: Received 1,000 shares of Kell Company common stock as a stock dividend. The cost of the shares is now $20 per share, computed as follows:

$60,000 ÷ 3,000 (2,000 + 1,000) shares.

63

Subsequently, Smith Corporation sold 500 of the shares for $25 per share, and the fair value at the most recent balance sheet date was $23 per share.

Subsequently, Smith Corporation sold 500 of the shares for $25 per share, and the fair value at the most recent balance sheet date was $23 per share.

Cash 12,500 Investment in Available-for-Sale Securities 10,000 Gain on Sale of Investment 2,500Unrealized Increase/Decrease in Value of Available-for Sale Securities 1,500 Allowance for Change in Value of Investment 1,500

Stock Dividends

64

Merle Corporation paid an annual insurance premium of $5,500 at the

beginning of the year to cover the lives of its officers.

Merle Corporation paid an annual insurance premium of $5,500 at the

beginning of the year to cover the lives of its officers.

Prepaid Insurance 5,500 Cash 5,500


Cash Surrender Value of Life Insurance

65

Insurance Expense 4,400Cash Surrender Value of Life Insurance 1,100 Prepaid Insurance 5,500

$8,300 $8,300 –– $7,200 $7,200$8,300 $8,300 –– $7,200 $7,200

Cash Surrender Value of Life Insurance

According to the terms of the insurance contract, the cash surrender value

increases from $7,200 to $8,300 during the year.

According to the terms of the insurance contract, the cash surrender value

increases from $7,200 to $8,300 during the year.

66

Appendix-DerivativesDerivatives are financial instruments, such as forwards and options whose value depends upon the value of an underlying instrument such as a security, commodity, currency or interest rate. Hence, they are "derived" from these underlying instruments. Derivatives are used to transfer risk, and companies often use them to reduce the risk of adverse changes in interest rates, commodity prices, and foreign currency exchange rates.The fair value of a derivative fluctuates with movements in the underlying instrument (for example, if interest rates increase, the value of a swap to pay a fixed interest rate increases).

67

Derivatives

The two basic types of derivatives are:–Forward contracts

•Forwards

•Futures

•Swaps

–Option contracts•Puts

•Calls

68

Forward or Future ContractsContracts to purchase or sell a commodity or

stock, such as grain, oil, or livestock, at a given price in the future. The purpose is to lock in a price. A seller wants to guarantee a current price for future delivery and a buyer wants to assure a steady supply of raw materials at a given price.– A forward is a privately-negotiated contract to be satisfied in the

future.– A future is a standardized forward contract, that can be traded on

an exchange, like the Chicago Board of Trade.– A swap is a bundle of forward contracts, often used by companies

to switch floating-rate debt to fixed-rate debt.• Each interest payment would, in effect, be covered by an

individual forward contract.• A swap combines all these small forward contracts into one

instrument.

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HedgesFair value hedge – protects against the

risk from changes in value caused by fixed terms, rates or prices.– For example, a company with debt that has a

fixed interest rate that enters into an interest rate swap to pay a variable rate of interest and receive a fixed rate.

– This protects the company against paying more interest than necessary if interest rates decline.

– Gains or losses on the market value of these hedges flow through net income.

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HedgesCash flow hedge – protects against the

risk caused by variable prices, costs, rates, or terms that cause future cash flows to be uncertain– For example, a company with variable rate debt that

enters into a swap to pay a fixed rate of interest and receive a variable rate.

– This guarantees that the company will pay a fixed rate, no matter what happens to interest rates in the market.

– Gains or losses of “effective” cash flow hedges flow through other comprehensive income.

– “Effectiveness” is determined by how well the terms of the hedge, such as time period and notional value, match the terms of the underlying debt.

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Hedges

Foreign currency hedge -to reduce the risk of currency fluctuation for transactions and investments in foreign currencies. –Foreign currency hedges can be structured so that they behave like fair value hedges OR cash flow hedges.

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Options

A call enables the owner to purchase a commodity, security, or currency at a set price in the future, but is under no obligation to do so. Any gain or loss is included in net income.

A put enables the owner to sell a commodity, security, or currency at a set price in the future, but again is under no obligation to do so. Any gain or loss is included in net income.

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Chapter15

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