Chapter 12 Solutions

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise and problem in Intermediate Accounting, 5e with the following AACSB learning skills:

Questions AACSB Tags Exercises (cont.)

AACSB Tags

12-1 Reflective thinking 12-8 Analytic12-2 Reflective thinking 12-9 Analytic12-3 Reflective thinking 12-10 Analytic12-4 Reflective thinking 12-11 Analytic12-5 Reflective thinking 12-12 Analytic12-6 Reflective thinking 12-13 Analytic12-7 Reflective thinking 12-14 Analytic, Reflective thinking12-8 Reflective thinking 12-15 Analytic12-9 Reflective thinking 12-16 Analytic12-10 Reflective thinking 12-17 Analytic12-11 Reflective thinking 12-18 Analytic12-12 Reflective thinking 12-19 Analytic12-13 Reflective thinking 12-20 Analytic12-14 Reflective thinking 12-21 Analytic12-15 Reflective thinking 12-22 Analytic12-16 Analytic 12-23 Analytic12-17 Analytic 12-24 Analytic12-18 Reflective thinking 12-25 Analytic12-19 Diversity CPA/CMA12-20 Reflective thinking 12-1 Analytic12-21 Reflective thinking 12-2 Analytic12-22 Reflective thinking 12-3 Analytic12-23 Reflective thinking 12-4 Analytic12-24 Reflective thinking 12-5 Analytic12-25 Reflective thinking 12-6 Analytic

Brief Exercises

12-7 Analytic

12-1 Analytic 12-8 Analytic12-2 Analytic 12-1 Reflective thinking12-3 Analytic 12-2 Analytic12-4 Analytic 12-3 Analytic12-5 Analytic Problems12-6 Analytic 12-1 Analytic12-7 Analytic, Communications 12-2 Analytic12-8 Analytic, Communications 12-3 Analytic12-9 Analytic 12-4 Analytic12-10 Analytic 12-5 Analytic12-11 Analytic 12-6 Analytic12-12 Analytic 12-7 Analytic12-13 Analytic, Communications 12-8 Analytic

Exercises 12-9 Analytic

12-1 Analytic 12-10 Analytic© The McGraw-Hill Companies, Inc., 2009

Solutions Manual, Vol. 1, Chapter 12 12-1

Chapter 12 Investments

12-2 Analytic 12-11 Analytic12-3 Analytic 12-12 Analytic12-4 Analytic 12-13 Communications12-5 Reflective thinking, Analytic 12-14 Reflective thinking12-6 Analytic 12-15 Analytic12-7 Analytic 12-16 Analytic

Investment securities are classified as “held-to-maturity,” “trading,” or “available-for-sale” securities.”

Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are ignored for securities classified as “held-to-maturity.” These changes aren’t important if sale

before maturity isn’t an alternative, which is the case if an investor has the “positive intent and ability” to hold the securities to maturity.

SFAS No. 157 governs determination of fair value. That Standard distinguishes between three levels of inputs to fair value determination, with level 1 being readily observable fair values (for example, from a securities exchange),

level 2 inputs are other observable amounts (for example, quoted values for similar items, or important inputs like interest rates), and level 3 inputs are unobservable, like the company’s own assumptions. SFAS No. 157 requires disclosure of the amount of fair values based on each of these three classes of inputs.

For investments to be held for an unspecified period of time, fair value information is more relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because

sale at that fair value is not an option. The investor receives the same contracted interest payments for the period held to maturity and the stated principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in fair values indicate management’s success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.

The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as “securities available-for-sale” or as “trading securities.” Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders’ equity, as part of Other comprehensive income. (Available-for-sale securities for which the investor has chosen the fair value option are reclassified as trading securities.)

© The McGraw-Hill Companies, Inc., 200912-2 Intermediate Accounting, 5e

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 12-1

Question 12-2

Question 12-3

Question 12-4

Answers to Questions (continued)

Question 12-5

Comprehensive income is a more expansive view of the change in shareholders’ equity than traditional net income. It encompasses all changes in equity from nonowner transactions. The non-income part of comprehensive income

is called “Other comprehensive income.” Other comprehensive income includes net unrealized holding gains (losses) on investments.

Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from

short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal.

On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are less relevant performance measures to be included in earnings.

Apparently, the drop in the market price of the stock is an other-than-temporary impairment. So, when the investment is written down to its fair value, the amount of the write-down should be treated as if it were a realized loss, meaning the loss is

included in income for the period. Subsequent to the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as a separate component of shareholders’ equity, accumulated other comprehensive income.

When acquired, debt and equity securities are assigned to one of the three reporting classifications – held-to-maturity, trading, or available-for-sale. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred:

1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period.

2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded in Other Comprehensive Income, which will then increase Accumulated Other Comprehensive Income in shareholders’ equity.

3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity. This would be the case for Western Die-Casting’s investment in the LGB Heating Equipment bonds.

Yes. Although a company is not required to report individual amounts for the three categories of investments – held-to-maturity, available-for-sale, or trading – on the face of the balance sheet, that information should be presented in the

disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the

© The McGraw-Hill Companies, Inc., 2009Solutions Manual, Vol. 1, Chapter 12 12-3

Question 12-6

Question 12-7

Question 12-8


Question 12-9

Question 12-10

change in net unrealized holding gains and losses, and amortized cost basis by major security type. Information about the level of the fair value hierarchy upon which fair values are based should be provided, and more disclosure is necessary with respect to amounts based on level 3 of the fair value hierarchy. In addition, information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least 4 maturity groupings: (a) within 1 year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.

When a company elects the fair value option for held-to-maturity or available-for-sale investments, it simply reclassifies those investments as trading securities and accounts for them in that fashion.

U.S. GAAP allows companies complete discretion in electing the fair value option when an investment is made. The only constraint is that the election is irrevocable. IFRS only allows companies to elect the fair value option in specific

circumstances, e.g., when a group of financial assets or liabilities are managed on a fair value basis, or to allow more consistent accounting of a hedging arrangement.

The equity method is used when an investor can’t control but can “significantly influence” the investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.

The equity method, like consolidation, views the investor and investee as a special type of single entity. By the equity method, though, the investor doesn’t

include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.

The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are

distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investee’s net assets, indicating that the investor’s ownership interest in those net assets declines proportionately.

Question 12-16The equity method attempts to approximate the effects of accounting for the purchase of the

investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values as of the date the investor acquired the investee. The accounting in the consolidated financial statements subsequent to the acquisition date is based on those fair values. So, if Finest had consolidated its acquisition of Penner, Penner’s depreciable assets would have been put on Finest’s


Question 12-11

Question 12-12


Question 12-13

Question 12-14

Question 12-15

balance sheet in their respective asset accounts at their fair value on the date of acquisition and then depreciated over 10 years. Under the equity method, Finest’s investment in Penner is shown in a single investment account. Therefore, for the equity method to approximate consolidation, it would reduce both investment revenue (as if depreciation expense were being recognized) and the investment (as if the book value of the asset were being reduced) by the negative income effect of the “extra depreciation” the higher fair value would cause. This would equal 40% x $12 million ÷ 10 years = $480,000 each year for ten years.

The investment account was decreased by $40,000 (40% x $100,000). Cash increased by the same amount. There is no effect on the income statement.

When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then

on. The investment account balance when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value in the next set of financial statements.

IFRS require that accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Also, IFRS allow investors to account for a joint venture using

either the equity method or “proportionate consolidation,” whereby the investor combines its proportionate share of the investee’s accounts with its own accounts on an item-by-item basis. U.S. GAAP generally requires that the equity method be used to account for joint ventures.

When a company elects the fair value option for a significant-influence investment, that investment is not reclassified as a trading security. Rather, the investment still appears on the balance sheet as a significant-influence investment,

but the amount that is accounted for at fair value is indicated on the balance sheet either parenthetically on a single line that includes the total amount of significant-influence investment or on a separate line. As with trading securities, unrealized gains and losses are included in earnings in the period in which they occur.

A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to

receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.

These instruments “derive” their values or contractually required cash flows from some other security or index.

Since this fund won’t be used within the upcoming operating cycle, it is a noncurrent asset. It should be reported as part of “Investments and funds.”



Question 12-17

Question 12-18

Question 12-19

Question 12-20

Question 12-21

Question 12-22

Question 12-23

Part of each premium payment the company makes is not used by the insurance company to pay for life insurance coverage, but rather is “invested” on behalf of the insured company in a fixed-income investment. As a result, the periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset – cash surrender value.

When a creditor’s investment in a receivable becomes impaired, due to a troubled debt restructuring or for any other reason, the receivable is re-measured based on the discounted present value of currently expected cash flows at the

loan’s original effective rate (regardless of the extent to which expected cash receipts have been reduced). The extent of the impairment is the difference between the carrying amount of the receivable (the present value of the receivable’s cash flows prior to the restructuring) and the present value of the revised cash flows discounted at the loan’s original effective rate. This difference is recorded as a loss at the time the receivable is reduced.

(a) Investment in bonds (face amount)....................... 720,000

Discount on bond investment (difference)........ 120,000Cash (price of bonds)......................................... 600,000

(b)Cash (1.5% x $720,000)......................................... 10,800Discount on bond investment (difference)............ 1,200

Interest revenue (2% x $600,000)....................... 12,000

Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in earnings. S&L reports its $2,000 holding loss in 2009 earnings. When the fair value rises by $7,000 in 2010, that amount is reported in 2010 earnings ($5000 as a realized gain, and $2000 as the reversal of the unrealized loss that was recognized in 2009). S&L’s journal entries for these transactions would be:

2009


Answers to Questions (concluded)

Question 12-24

Question 12-25

BRIEF EXERCISES

Brief Exercise 12-1

Brief Exercise 12-2

December 27Investment in Coca Cola shares ......................................... 875,000

Cash............................................................................... 875,000

December 31Net unrealized holding gains and losses—I/S..................... 2,000

Fair value adjustment ($875,000 - 873,000)........................ 2,000

2010

January 3Cash (selling price)................................................................ 880,000

Gain on investments (to balance)...................................... 5,000Investment in Coca Cola shares (account balance)............. 875,000

Assuming no other trading securities, the 2010 adjusting entry to remove the fair value adjustment associated with the sold securities would be:

December 31Fair value adjustment (account balance)................................. 2,000

Net unrealized holding gains and losses—I/S (to balance) 2,000

Unlike for trading securities, unrealized holding gains and losses for securities available-for-sale are not included

in earnings. S&L reports its $2,000 holding loss in 2009 as Other comprehensive income in the statement of comprehensive income. When the fair value rises to $880,000 in 2010, the amount is reported in 2010 earnings is the $5,000 gain realized by the sale of the securities. S&L’s journal entries for these transactions would be:

2009


Cash............................................................................... 875,000

December 31Net unrealized holding gains and losses–OCI..................... 2,000

Fair value adjustment ($875,000 - 873,000)........................ 2,000

2010


Brief Exercise 12-2 (concluded)

Brief Exercise 12-3


Gain on investments (to balance)...................................... 5,000Investment in Coca Cola shares (cost)............................. 875,000

Assuming no other transactions involving securities available-for-sale, the 2010 adjusting entry to remove the fair value adjustment associated with the sold securities would be:


Net unrealized holding gains and losses–OCI............................... 2,000

Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of net income for the period. Rather, they are reported as “other comprehensive income” in the statement of comprehensive income. The accumulated balance of net holding gains and losses is reported as a separate component of shareholders’ equity, as part of accumulated other comprehensive income. The adjusting entry needed to increase the fair value adjustment from $110,000 to $170,000 is:

Fair value adjustment ($670,000 – 610,000)........... 60,000Net unrealized holding gains and losses–OCI. 60,000

These are securities available-for-sale and are reported at their fair value, $4,000,000. We know this because

securities “held-to-maturity” are debt securities an investor has the “positive intent and ability” to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The FedEx shares have been held for over a year. They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn’t appropriate either because 40,000 shares of FedEx certainly don’t constitute “significant influence.” Investments in securities available-for-sale are reported at fair value.


Brief Exercise 12-4

Brief Exercise 12-5

Because S&L elected the fair value option, it would classify this investment as a trading security and account for

it in that fashion. Therefore, S&L reports its $2,000 holding loss in 2009 earnings. When the fair value rises by $7,000 in 2010, that amount is reported in 2010 earnings ($5000 as a realized gain, and $2000 as the reversal of the unrealized loss that was recognized in 2009). S&L’s journal entries for these transactions would be:

2009


Cash............................................................................... 875,000


Fair value adjustment ($875,000 - 873,000)................... 2,000

2010


Gain on investments (to balance)...................................... 5,000Investment in Coca Cola shares (account balance)............. 875,000



Net unrealized holding gains and losses—I/S (to balance) 2,000

An investor should account for dividends from an equity method investee as a reduction in its investment account.

Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investee’s net assets, reflecting the fact that the investor’s ownership interest in those net assets declined proportionately. Turner’s cash increased by $2 million (40% x $5 million).


Brief Exercise 12-6

Brief Exercise 12-7

Its investment account declined by the same amount. There is no effect on the income statement.

An investor should account for dividends from an investment not accounted for by the equity method as

investment revenue. Since Turner holds only 10% of ICA stock, it’s assumed that it does not have significant influence over the company. Turner’s cash increased by $500,000 (10% x $5 million). It also reports $500,000 as investment revenue in the income statement.

Given Turner’s election of the fair value option, it would account for this investment similar to a trading security, while still preserving its classification as a significant-

influence investment and showing it as a non-current asset on the balance sheet.

2009

January 2Investment in ICA Company .............................................10,000,000

Cash............................................................................... 10,000,000

December 30Cash (40% x $500,000) ......................................................... 200,000

Investment revenue ........................................................ 200,000

December 31Fair value adjustment ($11.5M - 10M)................................... 1,500,000

Net unrealized holding gains and losses—I/S (may also labeled “Investment revenue”)....................... 1,500,000

Note: A different approach to reach the same outcome would be for Turner to use equity-method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Turner would recognize 40% of ICA’s $750,000 income ($300,000) as investment income, it would not recognize investment income associated with ICA’s dividend, and it would end up with an Investment account containing $10,100,000 ($10,000,000 + $300,000 - $200,000). Turner then would need to make a fair value adjustment of $1,400,000


Brief Exercise 12-8

Brief Exercise 12-9

($11,500,000 - $10,100,000) to their ICA investment. So the total amount of income recognized would be $1,700,000 ($300,000 investment income + $1,400,000 unrealized gain). Note that this alternative produces the same total amount of investment income as is produced above, $1,700,000 ($200,000 investment revenue + $1,500,000 unrealized gain).

With the equity method we attempt to approximate the effects of accounting for the purchase of the investee as a

consolidation. Consolidated financial statements report acquired net assets at their fair values. Both investment revenue and the investment would be reduced by the negative income effect of the “extra depreciation” the higher fair value would cause. This would equal 30% x $50 million ÷ 15 years = $1 million each year for fifteen years.

Under proportionate consolidation, Park would have included its portion of Wallis’s depreciable assets in the Park depreciable asset accounts on its consolidated balance sheet. Those depreciable asset accounts would be reduced by the “extra depreciation” the higher fair value would cause. This would equal 50% x $50 million ÷ 15 years = $1.67 million each year for fifteen years.

Because the drop in the market price of stock is considered to be other-than-temporary, LED records the

impairment as follows:

Impairment loss ($4.50 x $ 100,000 shares)............ 450,000Investment in Branch Pharmaceuticals .......... 450,000

The investment is written down to its fair value, and the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in LED’s earnings for the period. Following the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as other comprehensive income or loss in the statement of comprehensive income.


Brief Exercise 12-10



The investment would be increased by $12 million. Financial statements would be recast to reflect the equity

method for each year reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items.

The answer would not be the same if Pioneer changes from the equity method. Rather, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.

Requirement 1 ($ in millions)

Investment in bonds (face amount)....................... 240Discount on bond investment (difference)........ 40Cash (price of bonds)......................................... 200

Requirement 2 Cash (3% x $240 million)....................................... 7.2Discount on bond investment (difference)............ .8

Interest revenue (4% x $200)............................ 8.0

Requirement 3 Tanner-UNF reports its investment in the December 31, 2009, balance sheet at its amortized cost – that is, its book value:

Investment in bonds........................................... $240.0Less: Discount on bond investment ($40 - .8 million) 39 .2

Amortized cost............................................... $200.8



EXERCISES

Exercise 12-1

If sale before maturity isn’t an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet.

Requirement 4 ($ in millions)Cash (proceeds from sale)...................................... 190.0Discount on bond investment (balance, determined above) 39.2Loss on sale of investments (to balance)............... 10.8

Investment in bonds (face amount).................... 240.0

November 1 ($ in millions)

Cash............................................................... 2.4Investment revenue..................................... 2.4

December 1 Investment in Facsimile Enterprises bonds..... 30

Cash........................................................... 30

December 31 Investment in U.S. Treasury bills .................. 8.9

Cash........................................................... 8.9

December 31 Investment revenue receivable - Convenience bonds ($48 million x 10% x 2/12)....................... 0.8Investment revenue receivable - Facsimile Enterprises bonds ($30 million x 12% x 1/12).. . . 0.3

Investment revenue .................................. 1.1

Note: Securities held-to-maturity are not adjusted to fair value.

Investment in GM common shares 41,200Cash ([800 shares x $50] + $1,200)...............................41,200


Exercise 12-2

Exercise 12-3

Cash ([800 shares x $53] – $1,300)...................... 41,100Loss on sale of investments............................ 100

Investment in GM common shares ............ 41,200

Requirement 1 .

Net unrealized holding gains and losses–OCI 25,000Fair value adjustment ($45,000 – 20,000) 25,000

Requirement 2

None. Accumulated net holding gains and losses for securities available-for-sale are reported as a component of shareholders’ equity (in accumulated other comprehensive income), and changes in the balance are reported as other comprehensive income or loss in the statement of comprehensive income rather than as part of earnings. This statement can be reported either (a) as an extension of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note.

Requirement 1

Securities “held-to-maturity” are debt securities an investor has the “positive intent and ability” to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as “trading securities.” The IBM shares are neither. They are classified as “available-for-sale” since all investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified this way. Of course, the equity method isn’t appropriate either because 10,000 shares of IBM certainly don’t constitute “significant influence.”

Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as other comprehensive income or loss in the statement of comprehensive income. This statement can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note.


Exercise 12-4

Exercise 12-5

Accumulated net holding gains and losses for securities available-for-sale are reported as a separate component of shareholders’ equity in the balance sheet.

Requirement 2

December 31, 2009Net unrealized holding gains and losses–OCI

(10,000 shares x [$58 - 60]) ........................................................ 20,000 Fair value adjustment.......................................................... 20,000

Requirement 3

December 31, 2010Accumulated

($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2010 $600 $610 $10

Moving from a negative $20 (2009) to a positive $10 (2010) requires an increase of $30:

---------------------------------------------------------20 0 +10

+30 ----------------------------->

Fair value adjustment 10,000 shares x [$61 - 58])............................ 30,000Net unrealized holding gains and losses–OCI (-$20 less $10). . . 30,000

Requirement 1

2009


Exercise 12-5 (concluded)

Fair Value Adjustment

Balance needed in fair value adjustment $10Existing balance in fair value adjustment: ($20)

Increase (decrease) needed in fair value adjustment: $30

Exercise 12-6

March 2($ in millions)

Investment in Platinum Gauges, Inc. shares .............................. 31Cash....................................................................................... 31

April 12Investment in Zenith bonds........................................................ 20

Cash....................................................................................... 20

July 18Cash........................................................................................... 2

Investment revenue................................................................ 2

October 15Cash........................................................................................... 1


October 16 Cash........................................................................................... 21

Investment in Zenith bonds.................................................... 20Gain on sale of investments................................................... 1

November 1Investment in LTD preferred shares .......................................... 40

Cash....................................................................................... 40

December 31Accumulated

($ in millions) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) Platinum Gauges, Inc. shares $31 $32* $1LTD preferred shares 40 37** (3 ) Totals $71 $69 $(2)

* $32 x 1 million shares ** $74 x 500,000 shares

Adjusting entry: Net unrealized holding gains and losses–OCI ($71 – 69)............ 2

Fair value adjustment ($71 – 69).............................................. 2

2010© The McGraw-Hill Companies, Inc., 200912-16 Intermediate Accounting, 5e

Exercise 12-6 (continued)

January 23($ in millions)

Cash ([1 million shares x 1/2] x $32)............................................... 16.0Gain on sale of investments (difference)................................... 0.5Investment in Platinum Gauges shares ($31 million cost x 1/2)................................................. 15.5

March 1Cash ($76 x 500,000 shares)........................................................... 38Loss on sale of investments (difference)....................................... 2

Investment in LTD preferred (cost)......................................... 40

Note: As part of the process of recording the normal, period-end fair value adjusting entry at 12/31/2010, Construction would debit Fair value adjustment and credit Net unrealized gains and losses—OCI for the $2 million associated with the sold investments to remove their effects from the financial statements.

Requirement 2 2009 Income Statement

($ in millions)Investment revenue (from July 18; Oct. 15).................................... $3Gain on sale of investments (from Oct. 16)................................... 1

Other comprehensive income:*Net unrealized holding gains and losses on investments**. . $2

* Assuming Construction Forms chooses to report Other comprehensive income as an additional section of the income statement. Alternatively, it can report this (a) as part of the statement of shareholders’ equity or (b) as a separate statement in a disclosure note.

Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Rather, they are included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.



Requirement 1

Purchase ($ in millions)Investment in Jackson Industry shares....................................... 90

Cash ...................................................................................... 90

Net incomeNo entry

DividendsCash (5% x $60 million)................................................................ 3


Adjusting entryFair value adjustment ($98 - 90 million)........................................ 8

Net unrealized holding gains and losses–OCI........................ 8

Requirement 2

Investment revenue......................... $3 million

Note: An unrealized holding gain is not included in income for securities available-for-sale. Rather, it is included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.

Requirement 1

2009


Exercise 12-7

Exercise 12-8

December 17Investment in Grocers’ Supply preferred shares ................ 350,000

Cash............................................................................... 350,000

December 28Cash................................................................................... 2,000

Investment revenue......................................................... 2,000

December 31Fair value adjustment......................................................... 50,000

Net unrealized holding gains and losses—I/S ([$4 x 100,000 shares] - $350,000)........................................ 50,000

2010


Gain on investments (to balance)...................................... 45,000Investment in Grocers’ Supply preferred shares (account balance)............................................... 350,000



Fair value adjustment (account balance)............................. 50,000


Requirement 2 Balance Sheet

(short-term investment):Trading securities.................................................. $400,000

Income Statement:Investment revenue (dividends)......................................... $ 2,000Net unrealized holding gains and losses (from adjusting entry) 50,000

Note: Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in income.

1. Investments reported as current assets.

Security A $ 910,000Security B 100,000Security C 780,000Security E 490,000 Total $2,280,000

2. Investments reported as noncurrent assets.Security D $ 915,000Security F 615,000

$1,530,000

3. Unrealized gain (or loss) component of income before taxes.

Trading Securities:Cost Fair value Unrealized

gain (loss)Security A $ 900,000 $ 910,000 $10,000

B 105,000 100,000 (5,000 ) Totals $1,005,000 $1,010,000 $ 5,000

4. Unrealized gain (or loss) component of AOCI in shareholders’ equity.

Securities Available-for-Sale:



Exercise 12-9

Cost Fair value Unrealized gain (loss)

Security C $ 700,000 $ 780,000 $80,000D 900,000 915,000 15,000

Totals $1,600,000 $1,695,000 $95,000

Requirement 1

Accumulated ($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2009 $1,345 $1,175 $(170)

Moving from a negative $145 (Jan.1) to a negative $170 requires a reduction of $25:

---------------------------------------------------------170 -145 0

<---------------- - 25

Net unrealized holding gains and losses–OCI....................... 25,000Fair value adjustment ($1,175,000 - 1,200,000)................... 25,000

Requirement 2 Accumulated

($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2009 $1,345 $1,275 $(70)

Moving from a negative $145 (Jan.1) to a negative $70 requires an increase of $75:


Exercise 12-10


Balance needed in fair value adjustment ($170)Existing balance in fair value adjustment: ($145)

Increase (decrease) needed in fair value adjustment: ($ 25)

Exercise 12-10 (continued)

--------------------------------------------------------------------------------------------145 -70 0

+75 ---------------------->

Fair value adjustment ($1,275,000 - 1,200,000) ....................... 75,000Net unrealized holding gains and losses–OCI................. 75,000

Requirement 3 Accumulated

($ in 000s) UnrealizedAvailable-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2009 $1,345 $1,375 $30

Moving from a negative $145 (Jan.1) to a positive $30 requires an increase of $175:

--------------------------------------------------------------------------------------------145 -70 0 +30

+175 -------------------------------------------------------->

Fair value adjustment ($1,375,000 - 1,200,000) ....................... 175,000Net unrealized holding gains and losses–OCI................. 175,000

Requirement 1



Balance needed in fair value adjustment ($ 70)Existing balance in fair value adjustment: ($145)

Increase (decrease) needed in fair value adjustment: $ 75



Balance needed in fair value adjustment $ 30Existing balance in fair value adjustment: ($145)


Exercise 12-11

The sale of the A Corporation shares decreased Harlon’s pretax earnings by $5 million. The purchase of the C Corporation shares had no effect on Harlon’s 2010 earnings (because the shares are classified as available-for-sale investments, any unrealized gains or losses occurring after purchase during 2010 would not affect 2010 earnings). Here are the entries used to record those two transactions:

June 1, 2010 ($ in millions)Cash 15 Loss on sale of investments (difference) 5

Investment in A Corporation shares (cost) 20

September 12, 2010Investment in C Corporation shares 15

Cash 15

Requirement 2

Harlon’s securities available-for-sale portfolio should be reported in its 2010 balance sheet at its fair value of $101 million:

December 31, 2010

($ in millions) Cost, Dec. 31 Fair Value, Dec. 31 Securities Available-for-Sale 2009 2010 2009 2010

A Corporation shares $20 na $14 naB Corporation bonds 35 $35 35 $ 37C Corporation shares na 15 na 14D Industries shares 45 45 46 50 Totals $100 $95 $95 $101

In 2009, Harlon would have had a net unrealized loss of $5 (cost of $100 – fair value of $95). Moving from a negative $5 (2009) to a positive $6 requires an increase of $11:



Fair Value Adjustment Allowance

Balance needed in fair value adjustment $ 6Existing balance in fair value adjustment: (5)


----------------------------------------------------------5 0 +6

+11 ----------------------------->

Fair value adjustment ($5 credit to $6 debit) 11Net unrealized holding gains and losses–OCI 11

The adjustment has no effect on earnings. Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. Rather, they are included in other comprehensive income, and accumulated in shareholders’ equity in accumulated other comprehensive income.

Requirement 1

The investment would be accounted for as an available-for-sale investment:

PurchaseInvestment in AMC common shares................................... 480,000

Cash ............................................................................. 480,000

Net incomeNo entry

DividendsCash (20% x 400,000 shares x $0.25)....................................... 20,000

Investment revenue....................................................... 20,000

Adjusting entryFair value adjustment ($505,000 - 480,000)............................ 25,000

Net unrealized holding gains and losses–OCI................ 25,000

Requirement 2

The investment would be accounted for using the equity method:


Exercise 12-12

PurchaseInvestment in AMC common shares................................... 480,000

Cash ............................................................................. 480,000

Net incomeInvestment in AMC common shares (20% x $250,000) ........ 50,000

Investment revenue....................................................... 50,000

DividendsCash (20% x 400,000 shares x $0.25)....................................... 20,000

Investment in AMC common shares.............................. 20,000

Adjusting entryNo entry

Purchase ($ in millions)Investment in Nursery Supplies shares................................... 56

Cash .................................................................................. 56

Net incomeInvestment in Nursery Supplies shares (30% x $40 million) ...... 12

Investment revenue............................................................ 12

DividendsCash (30% x 8 million shares x $1.25).......................................... 3

Investment in Nursery Supplies shares............................... 3

Adjusting entryNo entry


Investment in equity securities ($48 million – 31 million)........... 17Retained earnings (investment revenue from the equity method). 17


Exercise 12-13

Exercise 12-14

Requirement 2 Financial statements would be recast to reflect the equity method for each year

reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items.

Requirement 3 When a company changes from the equity method, no adjustment is made to the

carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to fair value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.

Requirement 1: Error discovered before the books are adjusted or closed in 2009.

The journal entry the company made is:

Cash........................................................... 100,000Investments............................................ 100,000

The journal entry the company should have made is:

Cash........................................................... 100,000Investments............................................ 80,000Gain on sale of investments ($100,000 – 80,000) 20,000

Therefore, to get from what was done to what should have been done, the following entry is needed:

Investments ($100,000 – 80,000).................... 20,000Gain on sale of investments.................... 20,000

Requirement 2: Error not discovered until early 2010.


Exercise 12-15

Investments ($100,000 – 80,000).................... 20,000Retained earnings................................... 20,000

Purchase ($ in millions)Investment in Carne Cosmetics shares............................... 68

Cash .............................................................................. 68

Net incomeInvestment in Carne Cosmetics shares (25% x $40 million) . . 10

Investment revenue......................................................... 10

DividendsCash (4 million shares x $1).................................................... 4

Investment in Carne Cosmetics shares............................ 4

Depreciation Adjustment

Investment revenue ($8 million [calculation below‡] ÷ 8 years). 1Investment in Carne Cosmetics shares............................ 1

‡Calculations:Investee Net Assets Difference

Net Assets Purchased Attributed to:

Cost $68 Goodwill:$12

Fair value: $224* x 25% = $56 Undervaluation

Book value: $192 x 25% = $48 of assets: $8

*[$192 + 32] = $224

Adjusting entryNo entry to adjust for changes in fair value as this investment is accounted for under the equity method.

Requirement 1


Exercise 12-16

Exercise 12-17

Purchase ($ in millions)Investment in Lake Construction shares............................. 300

Cash .............................................................................. 300

Net incomeInvestment in Lake Construction shares (20% x $150 million) 30

Investment revenue......................................................... 30

DividendsCash (20% x $30 million)....................................................... 6

Investment in Lake Construction shares......................... 6

Adjustment for depreciation

Investment revenue ($10 million [calculation below‡] ÷ 10 years) 1Investment in Lake Construction shares......................... 1

‡ calculation:Investee Net Assets Difference


Cost $300 Goodwill: $120

Fair value: $900 x 20% = $180

Undervaluation

Book value: $800 x 20% = $160 of buildings ($10) and land ($10): $20

Requirement 2 a. Investment in Lake Construction shares__________________________________________

($ in millions)Cost 300Share of income 30

6 Dividends1 Depreciation adjustment

_________________Balance 323

b. As investment revenue in the income statement.

$30 million (share of income) – $1 million (depreciation adjustment) = $29 million



c. Among investing activities in the statement of cash flows.

$300 million [Cash dividends received ($6 million) also are reported - as part of operating activities. If Cameron reports cash flows using the indirect method, the operations section of its statement of cash flows would include an adjustment of ($23 million) to get from the net income figure that includes $29 million of revenue to a cash flow number that should only include $6 million of cash flow.]

Requirement 1

Investee Net Assets DifferenceNet Assets Purchased Attributed to:

Cost $750

Goodwill: $300 Fair value: $900 x 50% = $450

Undervaluation

Book value: $800 x 50% = $400 of buildings ($25) and land ($25): $50

a. January 1, 2009 effect on Buildings

b. January 1, 2009 effect on Land

c. January 1, 2009 effect on Goodwill


Exercise 12-18

First we need to identify the amount of difference between book value and fair value associated with goodwill, buildings and land:

Because half of the fair value of Lake’s individual net assets are buildings, and Lake would be consolidated with Cameron, Cameron’s Buildings account would increase by 1/2 x $450 = $225 million.

Because half of the fair value of Lake’s individual net assets is land, and Lake would be consolidated with Cameron, Cameron’s Land account would increase by 1/2 x $450 = $225 million.

Because Lake would be consolidated with Cameron, Cameron’s Goodwill account would increase by $300 million.

d. January 1, 2009 effect on Equity method investments

Requirement 2 a. December 31, 2009 effect on Buildings

b. December 31, 2009 effect on Land

c. December 31, 2009 effect on Goodwill

d. December 31, 2009 effect on Equity method investments

Requirement 3


Because Lake would be consolidated with Cameron, there would be no effect of this investment on Cameron’s Equity method investment account.


Because half of the fair value of Lake’s individual net assets are buildings, and Lake would be consolidated with Cameron, Cameron’s Buildings account would increase by 1/2 x $450 = $225 million. Cameron would depreciate those buildings over their remaining 10 year life, so Lake would recognize $22.5 million of depreciation expense per year ($225 million ÷ 10 years). Therefore, at December 31, 2009, the buildings associated with the Lake investment would have a carrying value of $202.5 million ($225 million cost - $22.5 million accumulated depreciation).

Land is not amortized, so its carrying value would not change from its value on January 1, 2009.

Goodwill is not amortized, so its carrying value would not change from its value on January 1, 2009.

Because Lake would be consolidated with Cameron, there would be no effect of this investment on Cameron’s Equity method investment account at December 31, 2009.

Requirement 1

Electing the fair value option for held-to-maturity securities simply requires reclassifying those securities as trading securities. Therefore, this investment would be classified as a trading security on Tanner-UNF’s balance sheet.

Requirement 2 ($ in millions)Investment in bonds (face amount)....................... 240

Discount on bond investment (difference)........ 40Cash (price of bonds)......................................... 200

Requirement 3 Cash (3% x $240 million)....................................... 7.2Discount on bond investment (difference)............ .8

Interest revenue (4% x $200)................................. 8.0

Requirement 4

The carrying value of the bonds is $240 – ($40 – $0.8) = $200.8. Therefore, to adjust to fair value of $210, Tanner-UNF would need the following journal entry:

Fair value adjustment......................................... 9.2Net unrealized holding gains and losses—I/S ($210 – 200.8) 9.2

Requirement 5

Tanner-UNF reports its investment in the December 31, 2009, balance sheet at fair value of $210 million.



The effect of the investment on Cameron’s December 31, 2009 retained earnings would not differ between the equity method and proportionate consolidation treatments. Under the equity method, Cameron would recognize investment revenue based on its share of Lake’s net income, while under proportionate consolidation, Cameron would include its share of Lake’s revenue and expenses on those lines of the consolidated income statement. Regardless, the same total amount would be included in Cameron’s net income and closed to Cameron’s retained earnings.

Exercise 12-19

Cash (proceeds from sale)...................................... 190.0Loss on sale of investments (to balance)............... 10.8Discount on bond investment (account balance). . . . 39.2

Investment in bonds (account balance)............... 240.0

Assuming no other trading securities, the 2010 adjusting entry would be:Net unrealized holding gains and losses—I/S..... 9.2 Fair value adjustment (account balance) ............ 9.2

Requirement 1

Electing the fair value option for available-for-sale securities simply requires reclassifying those securities as trading securities. Therefore, this investment would be classified as a trading security on Sanborn’s balance sheet.

Requirement 2

Purchase ($ in millions)Investment in Jackson Industry shares....................................... 90

Cash ...................................................................................... 90

Net incomeNo entry

DividendsCash (5% x $60 million)................................................................ 3


Adjusting entryFair value adjustment ($98 - 90 million)........................................ 8

Net unrealized holding gains and losses—I/S......................... 8


Exercise 12-20

Requirement 3

Investment revenue (dividends)......................................... $ 3,000Net unrealized holding gains and losses (from adjusting entry) 8,000 Total effect on 2009 net income before taxes 11,000

Requirement 1

Electing the fair value option for significant-influence investments requires use of the same basic accounting approach that is used for trading securities. However, the investments will still be classified as significant-influence investments and shown either on the same line of the balance sheet as equity-method investments (but with the amount at fair value indicated parenthetically) or on a separate line of the balance sheet.

Requirement 2

Purchase ($ in millions)Investment in Nursery Supplies shares................................... 56

Cash .................................................................................. 56

Net incomeNo entry.

DividendsCash (30% x 8 million shares x $1.25).......................................... 3

Investment revenue............................................................ 3

Adjusting entry....................................................................................Net unrealized holding gains and losses—I/S ($56 - 52 million) 4

Fair value adjustment......................................................... 4

Note: A different approach to reach the same outcome would be for Florists to use equity-method accounting throughout the year, and then at the end of the year make whatever adjustment to fair value is necessary to adjust the investment account to fair value. Under that approach, Florists would recognize 30% of Nursery’s $40 million of income ($12 million) as investment income, it would not recognize investment income associated with Nursery’s dividend, and would end


Exercise 12-21

up with an Investment account containing $65 ($56 million + $12 million – $3 million). The company would need to make a fair value adjustment of $13 million ($65 million – 52 million). So the total amount of loss recognized would be $1 million ($12 million investment income – $13 million unrealized loss). Note that this alternative produces the same total amount of investment loss as is produced above: $1 million ($3 million investment revenue – $4 million unrealized loss).

Requirement 1

Insurance expense (difference).............................................. 64,000Cash surrender value of life insurance ($27,000 – 21,000)..... 6,000

Cash (2009 premium)........................................................ 70,000

Requirement 2 Cash (death benefit)....................................................... 4,000,000

Cash surrender value of life insurance (account balance) 27,000Gain on life insurance settlement (to balance)........... 3,973,000

Requirement 1

Insurance expense (difference)...................................... 22,900Cash surrender value of life insurance ($4,600 – 2,500).. 2,100

Cash (premium)......................................................... 25,000

Requirement 2

Cash (death benefit)....................................................... 250,000Cash surrender value of life insurance (account balance) 16,000Gain on life insurance settlement (to balance)........... 234,000

ANALYSIS

Previous Value:

Accrued 2008 interest (10% x $12,000,000) $ 1,200,000Principal 12,000,000 Carrying amount of the receivable $13,200,000New Value:

Interest $1 million x 1.73554 * = $1,735,540Principal $11 million x 0.82645 ** = 9,090,950


Exercise 12-22

Exercise 12-23

Exercise 12-24

Present value of the receivable (10,826,490 ) Loss: $ 2,373,510 * present value of an ordinary annuity of $1: n=2, i=10% (from Table 4)** present value of $1: n=2, i=10% (from Table 2)

JOURNAL ENTRIES

January 1, 2009 Loss on troubled debt restructuring (to balance)............ 2,373,510

Accrued interest receivable (account balance)............ 1,200,000Note receivable ($12,000,000 - 10,826,490)................. 1,173,510

December 31, 2009Cash (required by new agreement).................................... 1,000,000Note receivable (to balance).......................................... 82,649

Interest revenue (10% x $10,826,490)......................... 1,082,649

December 31, 2010Cash (required by new agreement).................................... 1,000,000Note receivable (to balance).......................................... 90,861

Interest revenue (10% x [$10,826,490 + 82,649]).......... 1,090,861*

Cash (required by new agreement).................................... 11,000,000Note receivable (balance).......................................... 11,000,000

* rounded to amortize the note to $11,000,000 (per schedule below)

Amortization Schedule – Not required

Cash Effective Increase in OutstandingInterest Interest Balance Balance

by agreement 10% x Outstanding Balance Discount Reduction

10,826,4901 1,000,000 .10 (10,826,490) = 1,082,649 82,649 10,909,1392 1,000,000 .10 (10,909,139) = 1,090,861* 90,861 11,000,000

2,000,000 2,173,510 173,510* rounded

ANALYSIS



Exercise 12-25

Previous Value:

Accrued 2008 interest (10% x $240,000) $ 24,000Principal 240,000 Carrying amount of the receivable $264,000New Value:

$11,555 + 11,555 + 11,555 + 240,000 = $274,665$274,665 x 0.82645 * = (226,997 )

Loss: $ 37,003 * present value of $1: n=2, i=10% (from Table 2)

JOURNAL ENTRIES

January 1, 2009Loss on troubled debt restructuring (to balance)............ 37,003

Accrued interest receivable (10% x $240,000)............ 24,000Note receivable ($240,000 - 226,997).......................... 13,003

December 31, 2009Note receivable (to balance).......................................... 22,700

Interest revenue (10% x $226,997)............................. 22,700

December 31, 2010Note receivable (to balance).......................................... 24,968

Interest revenue (10% x [$226,997 + 22,700]).............. 24,968*

Cash (required by new agreement).................................... 274,665Note receivable (balance).......................................... 274,665

* rounded to amortize the note to $274,665 (per schedule below)





226,9971 0 .10 (226,997) = 22,700 22,700 249,6972 0 .10 (249,697) = 24,968* 24,968 274,665

47,668 47,668* rounded

1. d. Sales price (2,000 shares x $14) $28,000Less: Brokerage commission (1,400) Net Proceeds $26,600Less: Cost of investment (31,500)Realized loss on trading security $(4,900)

If these securities had been categorized as available-for-sale, the total loss of $4,900 would have been recognized in net income. The prior year's unrealized holding loss would not have been included (recognized) in earnings (net income), but rather would have been reported as an element of other comprehensive income. A reclassification adjustment for the unrealized holding loss ($2,000) would also be included in other comprehensive income to remove it from the balance sheet and report it in income.

Note: The question asks for realized loss. This is defined as the net cash proceeds from sale minus the original cost of the investment. That realized loss was recognized over two accounting periods: Year 4 (unrealized loss) and Year 5 (realized, due to sale). Be careful when answering these questions: watch for the difference between loss realized and loss recognized.



CPA / CMA REVIEW QUESTIONS

CPA Exam Questions


CPA Review Questions (continued)

2. a. Marketable equity securities (equity securities with readily determinable fair values) are categorized as either trading securities (which are classified as current assets) or available-for-sale securities (which are classified as current or noncurrent assets), as appropriate. Because Lark’s investments are long-term, they are categorized as available-for-sale securities.

Available-for-sale securities are reported at fair value with unrealized holding gains and losses reported in other comprehensive income and included in the balance of accumulated other comprehensive income reported in equity. The unrealized holding gain included in other comprehensive income for 2009 would be $60,000 ($240,000 current fair value vs. $180,000 prior period fair value). The net unrealized holding gain, included in the accumulated other comprehensive income as of December 31, 2009 is $40,000 ($60,000 current period unrealized holding gain less $20,000 prior period unrealized holding loss). Alternative calculation shown below.

Net unrealized holding gains at December 31, 2009: Fair value at December 31, 2009 $240,000 Cost (200,000 ) Net unrealized holding gain $ 40,000

3. d. $116,250.

LT investments in marketable equity securities at fair value $ 96,450Plus: Net unrealized holding gains and losses on

long-term marketable equity securities 19,800Cost of LT investments in marketable equity securities $116,250

Unrealized holding gains and losses on the non-current portfolio of investments in marketable equity securities (categorized as available-for-sale securities) are reported in other comprehensive income and included in the balance of accumulated other comprehensive income reported in stockholders' equity.


CPA Review Questions (continued)

4. d. Since the decline in value occurred in 2008, the available-for-sale security was reduced to fair value with a related unrealized holding loss reported in other comprehensive income in 2008. In 2009, the asset continues to be carried at the same net value but the unrealized holding loss in accumulated other comprehensive income is removed and recognized as a loss in the determination of net income since the decline is considered to be permanent. The recognition of the loss (write-down to fair value) establishes a new cost basis which will not be changed for subsequent recoveries in fair value. However, subsequent unrealized holding gains and losses will be reported in other comprehensive income.

5. d. Neither a change in fair value of investee's common stock nor cash dividends from investee affect the investor's reported investment income (equity in earnings of investee) under the equity method. Under the equity method, cash dividends would be charged against (reduce) the investment account and have no effect on income. A change in the fair value of the investee's common stock would not be recorded under the equity method unless the change were judged a permanent and substantial decline, and then the decline would be charged to a loss account rather than investment income. FAS #115 does not apply to investments accounted for under the equity method.

6. c. The entries should have been:

Investment in affiliate (40% x 20,000) 8,000Equity in earnings of affiliate 8,000

Cash (40% x $5,000) 2,000Investment in affiliate 2,000

By erroneously recognizing the $2000 dividend as revenue, retained earnings are overstated. The dividends should have been booked as a reduction of the investment; thus the investment is overstated.


CPA Review Questions (concluded)

7. b. Under the equity method, the investor should reflect adjustments which would be made in consolidation, based on the investor's percentage ownership, if such adjustment (eliminations) can be recorded between investment income and the investment account. The fair value of the FIFO inventory in excess of the carrying value would reduce net income of the investee, therefore, the investor would charge investment income and credit the investment account to reflect the decrease in income. The fair value of the land in excess of its carrying value would not affect income as it is not a depreciable asset. No adjustment would be made relative to the land.

8. a. $435,000. The equity method of accounting for investments in common stock should be used if the investor has significant influence over the operating and financial policies of the investee. Well Company's significant influence is demonstrated by its officers being a majority of the investees' board of directors.

Original cost of investment $400,000Add: Share of income subsequent to acquisition 10% x $500,000 50,000Less: Dividend of investee 10% x $150,000 (15,000)

$435,000

1. c. According to SFAS 115, available-for-sale securities are investments in debt securities that are not classified as held-to-maturity or trading securities and in equity securities with readily determinable fair values that are not classified as trading securities. They are measured at fair value on the balance sheet.

2. b. Available-for-sale securities include (1) equity securities with readily determinable fair values that are not classified as trading securities and (2) debt securities that are not classified as held-to-maturity or trading securities. Unrealized holding gains and losses are measured by the difference between the amortized cost and fair value, excluded from earnings, and reported in other comprehensive income. The balance is reported net of the tax effect (ignored in


CMA Exam Questions

this question). Thus, the difference at May 31, year 3 is $8,005 ($643,500 fair value – $635,495 amortized cost). This unrealized gain is reported as a credit to accumulated other comprehensive income.

3. d. Debt securities that the company has the positive intent and ability to hold to maturity are classified as held-to-maturity. Held-to-maturity securities are reported at amortized cost. Under the provisions of SFAS 115, any unrealized gains or losses are not recognized.


Investment in bonds (face amount)....................... 80Discount on bond investment (difference)........ 14Cash (price of bonds)......................................... 66

Requirement 2 Cash (4% x $80 million)........................................ 3.20Discount on bond investment (difference)............ .10

Interest revenue (5% x $66)................................... 3.30


Interest revenue (5% x [$66 + 0.1])....................... 3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2009, balance sheet at its amortized cost – that is, its book value:

Investment in bonds.......................................................... $80.00Less: Discount on bond investment ($14 –.1 –.11 million) 13 .79

Amortized cost.............................................................. $66.21


PROBLEMS

Problem 12-1

Increases and decreases in the fair value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant if sale before maturity isn’t an alternative. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held-to-maturity” and reported at amortized cost rather than fair value in the balance sheet.

Requirement 5

Fuzzy Monkey’s 2009 statement of cash flows would be affected as follows:

Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – $6.61 = ($0.21) to get from net income to cash from operations.)

Investing cash flows: Cash outflow from purchasing investments of $66.

Requirement 1 ($ in millions)Investment in bonds (face amount)........................ 80






Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2009, balance sheet at its fair value, $70 million in this case. For investments in trading securities, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.


Problem 12-1 (concluded)

Problem 12-2

To do this, we first need to determine the investment’s amortized cost (or book value) at the end of the year:


Amortized cost.............................................................. $66.21

Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million:


Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2009 income statement.

Requirement 5


Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 and an unrealized holding gain of $3.79 included in net income, totaling $10.4, so would have to include an adjustment of $6.4 – $10.4 = ($4.0) to get from net income to cash from operations.)








Problem 12-3



Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2009, balance sheet at its fair value, $70 million in this case. For investments in securities available-for-sale, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.

To do this, we first need to determine the investment’s amortized cost (or book value) at the end of the year:

Investment in bonds.......................................................... $80.00Less: Discount on bond investment ($14 –.1 –.11 million)13 .79

Amortized cost.............................................................. $66.21


Fair value adjustment......................................... 3.79Net unrealized holding gains and losses–OCI ($70 – 66.21) 3.79

Because these are available-for-sale securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2009 other comprehensive income, and serve to increase the accumulated other comprehensive income shown in shareholders’ equity.

Requirement 5


Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have interest revenue of $3.30 + $3.31 = $6.61 included in net income, so would have to include an adjustment of $6.4 – $6.61 = ($0.21) to get from net income to cash from operations.)




Note: Because Fuzzy Monkey elected the fair value option, these investments will be reclassified as trading securities and accounted for under that approach. Therefore, the answers to Requirements 1-5 are the same as those to Problem 12-2.







Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2009, balance sheet at its fair value, $70 million in this case. For investments in trading securities, changes in market values, and thus market returns, provide an indication of management’s success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.

To determine the journal entry that Fuzzy Monkey must make, we first need to determine the investment’s amortized cost (or book value) at the end of the year:


Amortized cost.............................................................. $66.21




Problem 12-4


Because these are trading securities, the unrealized holding gain of $3.79 would be recognized in Fuzzy Monkey’s 2009 income statement.

Requirement 5


Operating cash flows: Cash inflow from interest of $3.2 + $3.2 = $6.4. (Note: if Fuzzy Monkey prepares an indirect method statement of cash flows, it would have included in net income interest revenue of $3.30 + $3.31 = $6.61 and an unrealized holding gain of $3.79, totaling $10.4, so would have to include an adjustment of $6.4 – $10.4 = ($4.0) to get from net income to the correct operating cash flow.)


Requirement 6

The answers to requirements 1-5 would not differ if the investment qualified for treatment as a held-to-maturity investment, because Fuzzy Monkey’s choice of the fair value option still requires reclassification of the investment as trading securities.

Requirement 1

2009February 21

Investment in Distribution Transformers shares ......... 400,000Cash........................................................................ 400,000

March 18Cash............................................................................ 8,000

Investment revenue................................................. 8,000

September 1Investment in American Instruments bonds ............... 900,000

Cash........................................................................ 900,000


Problem 12-5

October 20Cash............................................................................ 425,000

Investment in Distribution Transformers ............... 400,000Gain on sale of investments.................................... 25,000

November 1Investment in M&D Corporation shares ..................... 1,400,000

Cash........................................................................ 1,400,000

December 31Adjusting entries:

Investment revenue receivable.................................... 30,000Investment revenue ($900,000 x 10% x 4/12).............. 30,000

AccumulatedUnrealized

Available-for-Sale Securities Cost Fair Value Gain (Loss) M & D Corporation shares $1,400,000 $1,460,000 $60,000American Instruments bonds 900,000 850,000 (50,000 ) Totals – Dec. 31, 2009 $2,300,000 $2,310,000 $10,000*

Fair value adjustment (calculated above)........................ 10,000Net unrealized holding gains and losses–OCI......... 10,000*

* The $10,000 credit balance in the net unrealized holding gain is reported as 2009 Other comprehensive income in the statement of comprehensive income. It serves to increase Accumulated other comprehensive income, a component of Shareholders’ equity in the 2009 balance sheet.

Requirement 2 Income statement:

Investment revenue ($8,000 + 30,000) $ 38,000Gain on sale of investments 25,000

Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale.


Problem 12-5 (continued)


Statement of comprehensive income*:Net unrealized holding gains and losses on investments $ 10,000

Balance sheet:Current AssetsInvestment revenue receivable $ 30,000

Securities available-for-sale $2,300,000Plus: Fair value adjustment 10,000 $2,310,000

Shareholders’ EquityAccumulated other comprehensive income

Net unrealized holding gain (loss) ($60,000 - 50,000) $ 10,000

* Can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note.

Requirement 3 2010January 20

Cash............................................................................ 1,485,000Gain on sale of investments (to balance).................... 85,000Investment in M&D Corporation shares (cost)......... 1,400,000

March 1Cash............................................................................ 45,000

Investment revenue receivable................................ 30,000Investment revenue................................................. 15,000

August 12Investment in Vast Communications shares ............... 650,000

Cash........................................................................ 650,000

September 1Cash............................................................................ 45,000

Investment revenue................................................. 45,000



December 31Adjusting entries:Investment revenue receivable.................................... 30,000

Investment revenue ($900,000 x 10% x 4/12).............. 30,000

AccumulatedUnrealized

Securities Cost Fair Value Gain (Loss) Vast Communication shares $650,000 $670,000 $20,000American Instruments bonds 900,000 830,000 (70,000 ) Totals – Dec. 31, 2010 $1,550,000 $1,500,000 $(50,000)*

Moving from a positive $10,000 (2009) to a negative $50,000 requires a decrease of $60,000:

--------------------------------------------------------------------------------------------50,000 0 +10,000 <-------------------------------------------- $60,000

Net unrealized holding gains and losses—OCI........... 60,000* Fair value adjustment (calculated above).................. 60,000

* The $60,000 debit balance in the net unrealized holding gains and losses is reported as 2010 Other comprehensive income in the statement of comprehensive income. It serves to decrease Accumulated other comprehensive income, a component of Shareholders’ equity in the 2010 balance sheet, from the $10,000 credit balance it showed on the 2009 balance sheet to the $50,000 debit balance it shows in the 2010 balance sheet.

Requirement 4 Income statement:

Investment revenue ($15,000 + 45,000 + 30,000) $ 90,000Gain on sale of investments 85,000




Balance needed in fair value adjustment ($50)Existing balance in fair value adjustment: $10

Increase (decrease) needed in fair value adjustment: ($60)


Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale.

Statement of comprehensive income*:Net unrealized holding gains and losses on investments $ (60,000)

Balance sheet:Current AssetsInvestment revenue receivable $ 30,000

Securities available-for-sale $1,550,000Less: Fair value adjustment (50,000 ) $1,500,000

Shareholders’ EquityAccumulated other comprehensive income

Net unrealized holding gain (loss) ($20,000 - 70,000) $ (50,000)

* Can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note.

Requirement 1

2009December 12 ($ in millions)

Investment in FF&G Corporation bonds .................................... 12Cash........................................................................................ 12

December 13Investment in Ferry common shares ........................................... 22

Cash........................................................................................ 22

December 15Cash............................................................................................ 12.1

Investment in FF&G Corporation bonds ................................ 12.0Gain on sale of investments ($12.1 – 12)................................... 0.1


Problem 12-6

December 22Investment in U.S. Treasury bills ............................................... 56Investment in U.S. Treasury bonds ............................................ 65

Cash........................................................................................ 121

December 23Cash............................................................................................ 10 Loss on sale of investments ($10 – 11).......................................... 1

Investment in Ferry common shares ($22 x 1/2)........................ 11

December 26Cash (selling price)........................................................................ 57

Gain on sale of investments ($57 – 56)...................................... 1Investment in U.S. Treasury bills (account balance)................... 56

December 27Cash (selling price)........................................................................ 63 Loss on sale of investments ($63 – 65).......................................... 2

Investment in U.S. Treasury bonds (account balance)................. 65

December 28Cash............................................................................................ 0.2

Investment revenue................................................................. 0.2

December 31($ in millions)

Adjusting entry:Net unrealized holding gains and losses—I/S

($10 million - [$22 million x 1/2])................................................. 1.0Fair value adjustment.............................................................. 1.0

Closing entry:Income summary (to balance)........................................................ .7Investment revenue ($5 + 0.2 million)............................................ 5.2Gain on sale of investments ($8 + 0.1 + 1 million).......................... 9.1

Loss on sale of investments ($11 + 1 + 2 million)....................... 14.0Net unrealized holding gains and losses—I/S (adjusting entry)... 1.0



Note: Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities.


Balance sheet (short-term investment):Trading Securities.............................. 11Less: Fair value adjustment................. (1 ) total..................................................... 10

Income statement:Investment revenue (closing entry) 5.2Gain on sale of investments (closing entry) 9.1Loss on sale of investments (closing entry) (14.0)Net unrealized holding gains and losses on investments (closing entry) (1.0)


Requirement 3

2010January 2

($ in millions)Cash (selling price)........................................................................ 10.2Loss on sale of investments (to balance) ....................................... 0.8

Investment in Ferry common (account balance).......................... 11.0

Assuming no other transactions involving trading securities, the 2010 adjusting entry to remove the fair value adjustment associated with the sold securities would be:

December 31Fair value adjustment (account balance)..................................... 1.0

Net unrealized holding gains and losses—I/S.......................... 1.0

January 5Investment in Warehouse Designs bonds ................................... 34

Cash........................................................................................ 34

2009($ in millions)

October 18Investment in Millwork Ventures preferred shares ..................... 58

Cash........................................................................................ 58

October 31Cash............................................................................................ 1.5

Investment revenue................................................................. 1.5

November 1Investment in Holistic Entertainment bonds................................ 18

Cash........................................................................................ 18

November 1Cash............................................................................................ 28 Loss on sale of investments ($28 – 30).......................................... 2

Investment in Kansas Abstractors bonds ................................ 30© The McGraw-Hill Companies, Inc., 200912-54 Intermediate Accounting, 5e

Problem 12-7

December 1Investment in Household Plastics bonds..................................... 60

Cash........................................................................................ 60

December 20Investment in U.S. Treasury bonds ............................................ 5.6

Cash........................................................................................ 5.6

December 21Investment in NXS common shares ........................................... 44

Cash........................................................................................ 44

December 23Cash............................................................................................ 5.7

Investment in U.S. Treasury bonds ........................................ 5.6Gain on sale of investments ($5.7 – 5.6).................................... .1

($ in millions)December 29

Cash............................................................................................ 3Investment revenue............................................................... 3

December 31Accrued interest:Investment revenue receivable - Holistic Entertainment ($18 million x 10% x 2/12)...................................... 0.3Investment revenue receivable - Household Plastics ($60 million x 12% x 1/12)................................................ 0.6

Investment revenue .............................................................. 0.9

Revaluations:Net unrealized holding gains and losses—OCI ([2 million shares of Millwork Ventures x $27.50] - $58 million)......... 3

Fair value adjustment ........................................................... 3

Fair value adjustment ................................................................. 2Net unrealized holding gains and losses—I/S

([4 million shares of NXS x $11.50] - $44 million)....................... 2



Note: Securities held-to-maturity are not adjusted to fair value.

Closing entry:Net unrealized holding gains and losses—I/S (NXS).................... 2.0Investment revenue ($3.0 + 1.5 + .9).............................................. 5.4Gain on sale of investments (U.S. Treasury bonds).......................... .1

Loss on sale of investments (Kansas Abstractors)..................... 2.0Income summary (to balance)................................................. 5.5

Note: Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities.

2010January 7

Cash............................................................................................ 43 Loss on sale of investments (to balance)........................................ 1

Investment in NXS common shares (account balance)................ 44

Assuming no other transactions involving trading securities, the 2010 adjusting entry to remove the fair value adjustment associated with the sold securities would be:

December 31Net unrealized holding gains and losses—I/S.............................. 2.0

Fair value adjustment (account balance).................................. 2.0

Requirement 1

Beale should report its securities available-for-sale in its December 31, 2010, balance sheet at their fair value, $54 million.

Requirement 2

The journal entry needed to enable the investment to be reported at fair value is:

($ in millions)Fair value adjustment ($4 debit to $5 debit) 1

Net unrealized holding gains and losses–OCI ($4 credit to $5 credit) 1

Requirement 3



Problem 12-8

As of December 31, 2009, the cost of the Schwab Pharmaceuticals investment was $25 million and its fair value was $27 million. Therefore, in the year-end 2009 adjustment process, Beale must have made whatever adjustment was necessary to produce a debit balance of $2 in the fair value adjustment valuation allowance for Schwab Pharmaceuticals and a credit balance of that amount in accumulated other comprehensive income. Because the Schwab Pharmaceuticals investment was sold during 2010, the reclassification adjustment would have to remove that amount in 2010. Beale’s statement of comprehensive income can be provided as (a) an extension of its income statement, (b) as part of its statement of shareholders’ equity, or (c) in a disclosure note in a manner similar to this:

STATEMENT OF COMPREHENSIVE INCOME($ in millions)Net income............................................. $xxxOther comprehensive income:

Unrealized holding gains (losses) on investments $ 3Reclassification adjustment of prior years’ unrealized gain included in 2010 net income (2 )

Net unrealized holding gains (losses) 1Comprehensive income $xxx

Comprehensive income includes both net income and other comprehensive income. Net income in 2010 includes the $3 million gain realized from selling the Schwab shares. However, $2 million of that gain already has been reported in comprehensive income – as an unrealized holding gain in a prior year or years when the shares’ value increased from $25 million to $27 million. To avoid double-counting, Beale must compensate by reducing comprehensive income by the $2 million portion of the 2010 realized gain that already has been reported. That’s what the reclassification adjustment does; it reduces this year’s comprehensive income by the amount that was reported previously to keep it from being reported twice. For there to be a total increase in AOCI of $1 million (from $4 million to $5 million), and the reclassification serving to reduce AOCI by $2 million, $3 million of unrealized holding gains must have occurred during 2010.

Requirement 1



Problem 12-9

Purchase ($ in millions)Investment in Lavery Labeling shares......................................... 324

Cash ....................................................................................... 324

Net incomeInvestment in Lavery Labeling shares (30% x $160 million) .......... 48

Investment revenue................................................................. 48

DividendsCash (10 million shares x $2)........................................................... 20

Investment in Lavery Labeling shares..................................... 20

Depreciation adjustmentInvestment revenue ([$80 million x 30%] ÷ 6 years) ‡..................... 4


‡Calculations:


Cost $324

Goodwill: $60

Fair value: $880* x 30% =$264 Undervaluation

Book value: $800 x 30% =$240 of depr. assets: $24

*[$800 + 80] = $880

Adjusting entryNo entry to recognize changes in the fair value of the Lavery investment, as Runyan is accounting for its investment under the equity method.

Requirement 2


Cash ....................................................................................... 324



Net incomeNo entry



Adjusting entryNet unrealized holding gains and losses–OCI ([10 million shares x $31] – $324 million)............................................... 14

Fair value adjustment.............................................................. 14

Requirement 1


Cash ....................................................................................... 324

Net incomeNo entry



Adjusting entryNet unrealized holding gains and losses—I/S ([10 million shares x $31] – $324 million)................................................ 14


Requirement 2

Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2009 net income. Therefore, total effect on net income would be $20 million – 14 million, or $6 million.


Problem 12-10

Requirement 1 (note: requirement 1 has the same answer as does P 12-10)


Cash ....................................................................................... 324

Net incomeNo entry



Adjusting entryNet unrealized holding gains and losses—I/S ([10 million shares x $31] – $324 million)............................................... 14


Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2009 net income. Therefore, total effect on net income would be $20 of dividend – $14 of unrealized holding loss, or $6. The investment would be shown on the balance sheet at its fair value of $310.


Problem 12-11

Requirement 2


Cash ....................................................................................... 324

Net incomeInvestment in Lavery Labeling shares (30% x $160 million) .......... 48




Depreciation adjustmentInvestment revenue ([$80 million x 30%] ÷ 6 years) ‡...................... 4


‡Calculations:


Cost $324

Goodwill: $60

Fair value: $880* x 30% =$264 Undervaluation

Book value: $800 x 30% =$240 of depr. assets: $24

*[$800 + 80] = $880


Note: After the preceding journal entries are recorded, the balance in the Lavery Labeling investment account would be:

Investment in Lavery Labeling shares__________________________________________

($ in millions)Cost 324Share of income 48

20 Dividends4 Depreciation adjustment

_________________Balance 348

At December 31, 2009, the fair value of that investment is $310 (= 10 million shares x $31/share), implying need for the following adjusting entry to adjust the carrying value of the investment to fair value:

Net unrealized holding gains and losses—I/S ([10 million shares x $31] – $348 million)............................................... 38


Because Runyan is accounting for the Lavery investment under the fair value option, the unrealized holding loss would be included in 2009 net income. Therefore, total effect on net income would be $48 million for Runyan’s share of Lavery income minus $4 million of depreciation adjustment and minus the $38 million unrealized holding loss, yielding a total of $6 of income. The investment would be shown on the balance sheet at its fair value of $310 million.

Note that the income effect and the carrying value on the balance sheet are the same in requirements 1 and 2.

Requirement 1

Purchase ($ in millions)Investment in Vancouver T&M shares........................................ 400.0

Cash ....................................................................................... 400.0

Net incomeInvestment in Vancouver T&M shares (40% x $140 million) ......... 56.0

Investment revenue................................................................. 56.0© The McGraw-Hill Companies, Inc., 200912-62 Intermediate Accounting, 5e

Problem 12-12

DividendsCash (40% x $30 million)................................................................ 12.0

Investment in Vancouver T&M shares.................................... 12.0

Inventory adjustmentInvestment revenue ($5 million x 40%: all sold in 2009).................... 2.0

Investment in Vancouver T&M shares.................................... 2.0

Depreciation adjustmentInvestment revenue ([$20 million x 40%] ÷ 16 years) ‡..................... .5

Investment in Vancouver T&M shares.................................... .5

‡Calculations:Investee Net Assets Difference


Cost $400 Goodwill: $80 [plug]

Fair value: $800* x 40% =$320 inventory (5) x 40% Undervaluation

of inventory: $2 plant facilities (20 ) x 40% Undervaluation

of plant: $8 Book value: $775 x 40% = $310

* $775 +5 +20

Requirement 2

Investment Revenue ($ in millions)

56.0 Share of incomeInventory 2.0Depreciation .5

_________________Balance 53 .5

Requirement 3



Investment in Vancouver T&M shares ($ in millions)

Cost 400.0Share of income 56.0

12.0 Dividends2.0 Inventory

.5 Depreciation_________________

Balance 441 .5

Requirement 4 $400 million cash outflow from investing activities $12 million cash inflow (dividends) among operating activities (Note: if Northwest uses the indirect method to report its operating cash flows, it would need an adjustment of ($41.5) to get from the $53.5 included as investment revenue in net income to the $12 of cash actually received in dividends and needing to be shown in cash from operations.)

Requirement 1

Miller’s management should decide whether it has the ability to exercise significant influence over operating and financial policies of the Marlon Company. Ability to exercise significant influence is presumed for investments of 20 percent or more of voting stock and presumed not to exist for investments of less than 20 percent, other things being equal. Evidence to the contrary should be considered, including participation on the board of directors, technological dependency, material intercompany transactions, or interchange of managerial personnel.

Requirement 2

a. Income statement: ($ in millions)

Investment revenue ($12 million x 1/6) $2.0

Patent amortization adjustment ($4 million* ÷ 10) ( .4) *([$24 million] x 1/6])


Problem 12-13

$1 .6

b. Balance sheet:Investment in Marlon Company ($19 million + 2 million - 1 million - 0.4 million) $19 .6*

*Investment in Marlon Company ($ in millions)

Cost 19.0Share of income 2.0

1.0 Dividends ($6 million x 1/6).4 Amortization adjustment

_________________Balance 19 .6

c. Statement of cash flows: $19 million cash outflow from investing activities $1 million cash inflow (dividends) among operating activities (Note: if Marlon uses the indirect method to report its operating cash flows, it would need an adjustment of ($0.6) to get from the $1.6 included as investment revenue in net income to the $1 of cash actually received in dividends and needing to be shown in cash from operations.)



Item Reporting Category

__A_ 1. 35% of the nonvoting preferred stock T. Trading securities of American Aircraft Company M. Securities held-to-maturity

__M_ 2. Treasury bills to be held-to-maturity A. Securities available-for-sale __M_ 3. Two-year note receivable from affiliate E. Equity method __N_ 4. Accounts receivable C. Consolidation__M_ 5. Treasury bond maturing in one week N. None of these

__T_ 6. Common stock held in trading account for immediate resale.

__T_ 7. Bonds acquired to profit from short-term differences in price.__E_ 8. 35% of the voting common stock of Computer Storage Devices Company.__C_ 9. 90% of the voting common stock of Affiliated Peripherals, Inc.__A_10. Corporate bonds of Primary Smelting Company to be sold if interest rates

fall 1/2%.__A_11. 25% of the voting common stock of Smith Foundries Corporation: 51%

family-owned by Smith family; fair value determinable.__E_ 12. 17% of the voting common stock of Shipping Barrels Corporation:

Investor’s CEO on the board of directors of Shipping Barrels Corporation.


Land............................................................................................ 16Loss on debt restructuring........................................................... 6

Note receivable....................................................................... 20Accrued interest receivable..................................................... 2

Requirement 2 ANALYSIS

Previous Value:Accrued 2008 interest (10% x $20,000,000) $ 2,000,000Principal 20,000,000 Carrying amount of the receivable $22,000,000


Problem 12-14

Problem 12-15

New Value:Interest $1 million x 3.16987 * = $ 3,169,870Principal $15 million x 0.68301 ** = 10,245,150 Present value of the receivable (13,415,020 ) Loss: $ 8,584,980 * present value of an ordinary annuity of $1: n=4, i=10% (from Table 4)** present value of $1: n=4, i=10% (from Table 2)

JOURNAL ENTRIES

January 1, 2009Loss on troubled debt restructuring (to balance)................. 8,584,980

Accrued interest receivable (10% x $20,000,000)............. 2,000,000Note receivable ($20,000,000 - $13,415,020).................... 6,584,980

December 31, 2009 Cash (required by new agreement)......................................... 1,000,000Note receivable (to balance)............................................... 341,502

Interest revenue (10% x $13,415,020).............................. 1,341,502





December 31, 2012Cash (required by new agreement)......................................... 1,000,000Note receivable (to balance)............................................... 454,609

Interest revenue (10% x $14,545,391).............................. 1,454,609*

Cash (required by new agreement)......................................... 15,000,000Note receivable (balance)............................................... 15,000,000






by agreement 10% x Outstanding Balance Discount Reduction13,415,020

1 1,000,000 .10(13,415,020) = 1,341,502 341,502 13,756,5222 1,000,000 .10(13,756,522) = 1,375,652 375,652 14,132,1743 1,000,000 .10(14,132,174) = 1,413,217 413,217 14,545,3914 1,000,000 .10(14,545,391) = 1,454,609* 454,609 15,000,000

4,000,000 5,584,980 1,584,980* rounded

Requirement 3 ANALYSIS

Previous Value:Accrued interest (10% x $20,000,000) $ 2,000,000Principal 20,000,000 Carrying amount of the receivable $22,000,000New Value:

$27,775,000 x 0.68301 * = (18,970,603 ) Loss: $ 3,029,397 * present value of $1: n=4, i=10% (from Table 2)

JOURNAL ENTRIES

January 1, 2009 .. Loss on troubled debt restructuring (to balance).................... 3,029,397

Accrued interest receivable (10% x $20,000,000)............. 2,000,000Note receivable ($20,000,000 - 18,970,603)...................... 1,029,397

December 31, 2009 .. Note receivable (to balance)............................................... 1,897,060





Interest revenue (10% x [$18,970,603 + 1,897,060])........... 2,086,766


Interest revenue (10% x balance [see schedule])................. 2,295,443


Interest revenue (10% x balance [see schedule])................. 2,525,128*

Cash (required by new agreement)......................................... 27,775,000Note receivable (balance)............................................... 27,775,000





18,970,6031 0 .10 (18,970,603) = 1,897,060 1,897,060 20,867,6632 0 .10 (20,867,663) = 2,086,766 2,086,766 22,954,4293 0 .10 (22,954,429) = 2,295,443 2,295,443 25,249,8724 0 .10 (25,249,872) = 2,525,128* 2,525,128 27,775,000

8,804,397 8,804,397* rounded

Requirement 1

Bond Fair Value at 1/1/09:Interest $150,000 x (6%/2) x 14.21240 * = $ 63,956Principal $150,000 x 0.50257 ** = 75,386 Present value of the receivable 139,342



Problem 12-16

* present value of an ordinary annuity of $1: n=20, i=3.5% (=7%/2) (from Table 4)** present value of $1: n=20, i=3.5% (=7%/2) (from Table 2)

January 1, 2009Investment in bonds (face amount)....................... 150,000


Requirement 2



June 30, 2009Cash (6%/2 x $150,000)......................................... 4,500Discount on bond investment (difference)............ 377

Interest revenue (7%/2 x [$150,000 - 10,658])....... 4,877

December 31, 2009Cash (6%/2 x $150,000)......................................... 4,500Discount on bond investment (difference)............ 390

Interest revenue (7%/2 x [$150,000 – {$10,658 - 377}]) 4,890

Note: For held-to-maturity investments, there are no adjustments to fair value.

Requirement 3



June 30, 2009Cash (6%/2 x $150,000)......................................... 4,500Discount on bond investment (difference)............ 377

Interest revenue (7%/2 x [$150,000 - 10,658])....... 4,877



Bond Fair Value at June 30, 2009:Interest $150,000 x (6%/2) x 13.13394 * = $ 59,103Principal $150,000 x 0.47464 ** = 71,196 Present value of the receivable 130,299

*present value of an ordinary annuity of $1: n=19, i=4% (=8%/2) (from Table 4)**present value of $1: n=19, i=4% (=8%/2) (from Table 2)

January 1 initial cost $139,342 Increase from discount amortization 377June 30 amortized initial cost $139,719

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value.

June 30 amortized initial cost $139,719June 30 fair value 130,299

Fair value adjustment needed $ 9,420

Net unrealized holding gains and losses—I/S ........................... 9,420 Fair value adjustment......................................................... 9,420

December 31, 2009Cash (6%/2 x $150,000)......................................... 4,500Discount on bond investment (difference)............ 390

Interest revenue (7%/2 x [$150,000 – {$10,658 - 377}]) 4,890

Bond Fair Value at December 31, 2009:Interest $150,000 x (6%/2) x 12.15999 * = $ 54,720Principal $150,000 x 0.45280 ** = 67,920 Present value of the receivable $122,640

* present value of an ordinary annuity of $1: n=18, i=4.5% (=9%/2) (from Table 4)** present value of $1: n=18, i=4.5% (=9%/2) (from Table 2)



June 30 amortized initial cost $139,719 Increase from discount amortization 390Dec. 31 amortized initial cost $140,109

Comparing the amortized initial cost with the fair value of the bonds on that date provides the amount needed to adjust the investment to its fair value.

Dec. 31 amortized initial cost $140,109 Dec. 31 fair value 122,640Fair value adjustment balance needed: debit/(credit) $ 17,469

Less: Current fair value adjustment debit/(credit) (9,420 ) Change in fair value adjustment needed $ 8,049

Net unrealized holding gains and losses—I/S ........................... 8,049 Fair value adjustment......................................................... 8,049

Real World Case 12-1

Requirement 1

Fair value adjustment ([$178-$1] – [$164-$5])................... 18Net unrealized holding gains and losses–OCI.............. 18

Requirement 2

Loss on impairment of available-for-sale securities......... 105Micron investment....................................................... 105

Per Intel’s 2006 10K, “The impairment was principally based on our assessment during the second quarter of 2005 of Micron’s financial results and the fact that the market price of Micron’s stock had been below our cost basis for an extended period of time, as well as the competitive pricing environment for DRAM products.” (p. 39)


CASES

Requirement 3

Cash............................................................................................ 275 Gain on sale of investments.................................................... 103Micron investment (to balance)................................................. 172

Additionally, as part of its normal period-end valuation adjustment, Intel would remove any fair value adjustment and related AOCI associated with the Micron investment.

Requirement 4

It is odd that the Micron investment was written down to recognize an other-than-temporary decline in fair value in one year and then sold at a gain of roughly the same amount in the next year. One possible explanation is that some of the Micron investment was purchased for a higher amount than the rest of the Micron investment, such that the shares purchased for a high amount were written down and the shares purchased at a low amount were sold at a loss. Another possibility is that Micron’s shares recovered value during the latter half of 2005 and in 2006, such that a decline in fair value that Intel had thought to be other than temporary was in fact temporary. It is unlikely that this was an intentional shifting of profit from 2005 to 2006 on the part of Intel, since this pattern of effects is disclosed so clearly.


Case 12-1 (concluded)

Research Case 12-2[Note: This case encourages the student to reference actual annual reports.]

The footnote that describes an investment in securities “available-for-sale” may be headed by any one of a variety of captions or subsumed within another disclosure note. Likewise, the caption by which the investments are reported in the balance sheet can be reported separately as one of several asset titles or included within another asset caption.

Investments in securities available-for-sale will be reported as current or noncurrent assets depending on the intent of management regarding the timing of their eventual sale. Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported.

Investments in securities available-for-sale are reported at fair value. Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period. Rather, they are accumulated and reported as accumulated other comprehensive income, a separate component of shareholders’ equity. This means an unrealized holding gain would increase shareholders’ equity and an unrealized holding loss would decrease shareholders’ equity. Because unrealized gains or losses cause changes in shareholders’ equity, those changes are reported in the statement of shareholders’ equity. [Some companies may not provide a statement of shareholders’ equity and may provide a statement of retained earnings instead. Unrealized gains or losses have no effect on retained earnings.] By definition, securities available-for-sale are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings.

Cash outflows from acquiring these investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows. Whether they are specifically identifiable depends on the degree of detail the company uses in reporting its cash flows. Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds.

A disclosure note may provide information not available in the financial statements, in part dependent on how much information the financial statements provide. Often the footnote will indicate the cost of the securities.


Integrating Case 12-3SFAS 115, “Accounting For Certain Investments in Debt and Equity Securities,”

follows a “mixed” approach to transition to the new standard. It calls for either a current approach or a prospective approach. Certain investments that previously were reported at lower of cost or market were required by the new Standard to be reported instead at their fair values. Fair values were not to be reported retrospectively, but only from the effective date of the Standard forward. However, the cumulative income effect of holding gains and losses created in years before the change are reported by either a current approach or a prospective approach. For securities classified as “available-for-sale,” unrealized holding gains and losses are reported as part of Accumulated other comprehensive income within shareholders’ equity as of the beginning of the year of adoption. Unrealized holding gains and losses for securities classified as “trading securities” were reported in earnings of the year of adoption as the cumulative effect of a change in accounting principle. Pro forma effects are not reported.

Trueblood Accounting Case 12-4

A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. These are available to instructors at: www.deloitte.com/more/DTF/cases_subj.htm.


International Case 12-5

Requirement 1

Satisfied by going to http://www.iasplus.com/standard/ias28.htm.

Requirement 2

Renault’s decision appears appropriate, as the company has significant influence, but not control. Significant influence is indicated by a greater-than 20% equity stake and seats on the Nissan board. Lack of control is indicated by Renault not owning a majority of voting rights or board seats, and not having full rights to use assets or the obligations with respect to liabilities.

Requirement 3

It is not surprising that Renault makes adjustments that take into account the fair value of Nissan’s assets and liabilities at the time Renault invested in Nissan. For example, if the fair value of Nissan’s fixed assets was greater than the book value of those assets on the date of Renault’s purchase, Renault would have to recognize additional depreciation over the life of those assets when applying the equity method. This is consistent with IFRS, and also with US GAAP.

Requirement 4

Renault’s harmonization adjustments are required by IFRS, which requires that, “if the associate uses accounting policies that differ from those of the investor, the associate's financial statements should be adjusted to reflect the investor's accounting policies for the purpose of applying the equity method. [IAS 28.27].” U.S. GAAP has no such requirement.


http://www.iasplus.com/standard/ias28.htm

Research Case 12-6Answers to the questions will, of course, vary because students will research

financial statements of different companies. The responses should identify securities held that are classified as trading

securities, available-for-sale, or held-to-maturity. Although a company is not required to report individual amounts for the three categories of investments – held-to-maturity, available-for-sale, or trading – on the face of the balance sheet, that information should be presented in the disclosure notes. If securities available-for-sale are held, there may be unrealized gains or losses reported in the shareholders’ equity section of the balance sheet. Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as a separate component of shareholders’ equity.

Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities. There may also be gains or losses from the sale of investments during the year. There also will likely be investment revenue (dividends or interest) in the income statement.

The statement of cash flows will report acquisitions or disposals of investments as investing activities. Investment revenue is an operating activity.



Requirement 1

The 2006 balance sheet reports the following two current and one noncurrent asset categories ($ in millions):

2006 2005CURRENT ASSETS:

Cash and cash equivalents $5,914.7 $9,585.3

Short-term investments $2,798.3 $6,052.3

NONCURRENT ASSETS:

Investments $ 7,788.2 $1,107.9

In the summary of significant accounting policies (Note 2), Merck describes its policy regarding investments classified as "cash equivalents." It is consistent with the way most companies classify "cash equivalents."

CASH AND CASH EQUIVALENTS -- Cash equivalents are comprised of certain highly liquid investments with original maturities of less than three months.


Case 12-7 (continued)

Requirement 2

Merck (in the summary of significant accounting policies) describes its policy regarding its available-for-sale securities in keeping with SFAS 115:

INVESTMENTS - Investments classified as available-for-sale are reported at fair value, with unrealized gains or losses, to the extent not hedged, reported net of tax in Accumulated other comprehensive income. Investments in debt securities classified as held-to-maturity, consistent with management’s intent, are reported at cost. Impairment losses are charged to Other (income) expense, net, for other-than-temporary declines in fair value. The Company considers available evidence in evaluating potential impairment of its investments, including the duration and extent to which fair value is less than cost and the Company’s ability and intent to hold the investment.

Investments in securities available-for-sale are reported at fair value. Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period. Rather, they are accumulated and reported as a separate component of shareholders’ equity. This means an unrealized holding gain would increase shareholders’ equity and an unrealized holding loss would decrease shareholders’ equity. Because unrealized gains or losses cause changes in shareholders’ equity, those changes are reported in the statement of shareholders’ equity.

In the balance sheet, unrealized gains or losses may be reported under that title, as "other" shareholders’ equity, or some different caption.

Gross unrealized holding gains and losses of Merck are reflected as adjustments to "accumulated other comprehensive income," net of related income taxes. Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported.

Requirement 3


Case 12-7 (continued)

Investments accounted for using the equity method are described in note 9. The company has ongoing joint ventures and other equity-method investments with Merck/Schering-Plough, AstraZeneca LP, Merial Limited, Sanofi Pasteur, and Johnson & Johnson.

Requirement 4

As indicated on the income statement and in note 9, equity income recognized by Merck during 2006 was $2,294.4.

Requirement 5

Operating section: Cash inflows from dividends are shown in operations on the statement of cash flows, and equal $1,931.9 million for 2006. Cash flows from interest income are included in net income, and given that Merck prepares an indirect-method statement of cash flows that starts the operations section with net income, interest income is included in operations via that number.

Investing section: Cash outflows from acquiring investments or inflows from selling them are reported as investing activities in the company’s comparative statements of cash flows. Whether they are specifically identifiable depends on the degree of dissagregation the company uses in reporting its cash flows. Merck shows 2006 cash spent on “purchases of securities, subsidiaries and other investments” of ($20,044.3) million, and cash received from “proceeds from sales of securities, subsidiaries and other investments” of $16,143.8 million. Information on investing activities assists investors and creditors by indicating the direction the company is directing its funds.



Requirement 1 The note indicates Unrealized holding gains during 2007 in the amount of $123 million. This amount is included in comprehensive income. It is not the amount Microsoft would include as a separate component of shareholders’ equity -- that amount is Accumulated other comprehensive income. The 2007 amount in the disclosure note is the 2007 addition to the accumulated amount, not the accumulated amount.

Requirement 2 Reclassification adjustment for gains included in net income refers to unrealized holding gains that occurred in periods prior to the period in which the securities are sold. Holding gains and losses from securities available-for-sale are included in earnings when they are realized by selling the securities. When Microsoft sold securities in 2007, the entire increase in the fair value of the shares since the investment was acquired was included in earnings. The portion of that increase that occurred prior to 2007, but wasn’t recognized in prior earnings because it wasn’t yet realized by selling the investment, is what Microsoft refers to as its reclassification adjustment.

Net income in 2007 includes the $109 million of realized losses on an after tax basis (or $109 + $59 = $168 of realized losses on a before-tax basis). However, that $109 gain already has been reported in comprehensive income – as unrealized holding gains that were included in other comprehensive income in periods when price increases occurred. To avoid double-counting when those same gains are realized and included in comprehensive income via net income when the securities are actually sold, Microsoft compensates by decreasing other comprehensive income by the $109 million in that period. The basic idea is that the company only gets to report the gain in comprehensive income one time, so if the company includes it later in income, it must offset that by reducing other comprehensive income by the same amount. That’s what the reclassification adjustment does; it adjusts this year’s other comprehensive income by the amount that was reported previously to keep it from being reported twice.


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