Chapter 12: Highlights

Chapter 12: Highlights

1. For a variety of reasons, corporations often acquire the securities (bonds, preferred stock, common stock) of other entities. For example, a business may invest (in the short term) some of its excess cash in income-yielding securities such as bonds or stocks. A business may also invest in securities intending to hold them for a longer period.

2. The accounting for investments in securities depends on the expected holding period and the purpose of the investment.

3. The expected holding period determines where investments in securities appear in the balance sheet. Securities that firms expect to sell within the next year appear as “Marketable Securities” in the Current Asset section of the balance sheet.

4. Generally accepted accounting principles require firms to classify minority, passive investments into three categories: (a) debt securities for which a firm has the intent and ability to hold to maturity; (b) debt and equity securities held as trading securities; and

(c) debt and equity securities held as securities available for sale. This classification scheme is relevant for valuation of securities subsequent to acquisition. This classification scheme is applicable to securities held as current assets (Marketable Securities) and some long-term investments.

5. Firms initially record marketable securities at acquisition cost, which includes the purchase price, plus any commissions, taxes and other costs incurred. Dividends on equity securities become revenue when declared. Interest on debt securities becomes revenue when earned.

6. Debt securities for which a firm has the intent and ability to hold to maturity appear in the balance sheet at amortized acquisition cost. The acquisition cost of debt securities may differ from their maturity value. The difference between acquisition cost and maturity value is amortized over the life of the debt security as an adjustment to interest revenue.

7. Trading securities are securities that firms acquire for their short-term profit potential and imply active and frequent buying and selling. Firms report trading securities on the balance sheet at market value because (a) active securities markets provide objective measures of market values, and (b) market values provide financial statement users with the most relevant information for assessing the success of a firm's trading activities over time.

8. Firms report increases and decreases in the market value of trading securities in the account, Unrealized Holding Gain or Unrealized Holding Loss on Trading Securities, on the income statement.

9. Debt and equity securities held as securities available for sale trade in active securities markets and have easily measurable market values. Securities that a firm intends to sell within one year appear in Marketable Securities in the current assets section of the balance sheet. All others appear as a noncurrent asset, Investment in Securities, on the balance sheet. Securities available for sale appear in the balance sheet at market value. Net income includes dividends or interest earned on securities available for sale each period. Any unrealized holding gain or loss each period does not affect income immediately but instead increases or decreases a separate shareholders' equity account, Unrealized Holding Gain or Unrealized Holding Loss on Securities Available for Sale. These accounts are part of Accumulated Other Comprehensive Income, typically appearing between Additional Paid-In Capital and Retained Earnings. Holding gains and losses on securities available for sale affect net income only when the firm sells the securities and reports a Realized Gain or Realized Loss on Sale of Securities Available for Sale.

10. When firms transfer securities from one of the three categories to another one, the firm transfers the security at its market value at the time of the transfer.

11. Firms can purchase financial instruments to lessen the risks of economic losses from changes in interest rate, foreign exchange rates, and commodity prices. The term used for these financial instruments is a derivative. A derivative is a financial instrument that obtains its value from some other financial item. Changes in the value of the derivative instrument offset changes in the value of an asset or liability or changes in future cash flow, thereby neutralizing, or at least reducing, the economic loss.

12. For example, in accounting and finance, firm frequently purchase (or sell) a derivative contract, such as an interest rate swap. An interest rate swap is a derivative that typically obligates one party and counterparty to exchange the difference between fixed and floating rate interest payments on otherwise similar loans. The term counterparty refers to the opposite party in a legal contract.

13. Some elements of a derivative include: (a) Derivatives have one or more underlyings. An underlying is a variable such as a specified interest rate, commodity price, or foreign exchange rate. (b) A derivative has one or more notional amounts. A notional amount is a number of currency unites, bushels, shares, or other units specified in the contract.

(c) A derivative often requires no initial investments. The firm usually acquires a derivative by exchanging promises with a counterparty (for example, a commercial or investment bank). (d) Derivatives typically require, or permit, net settlement.

14. A firm must recognize derivatives in its balance sheet as assets or liabilities, depending on the rights and obligations under the contract. Firms must revalue the derivatives to market value each period. The revaluation amount, in addition to increasing or decreasing the derivative asset or liability, also affects either (a) net income immediately or (b) other comprehensive income immediately and net income later. Other Comprehensive Income is a temporary shareholders’ equity account that reports changes during an accounting period in the recorded amounts of certain assets and liabilities, such as derivatives.

15. Generally accepted accounting principles classify derivatives as (a) fair value hedges,

(b) cash flow hedges, or (c) not a hedging instrument. Firms must choose to designate a derivative as either a fair value or cash flow hedge (depending on the strategy and purpose of acquiring a particular derivative) or account for the derivative as if it were a trading security which must report changes in the market value as a gain or loss in current

earnings.

16.  When a firm acquires a derivative and attempts to reduce risks involving fluctuations in a market value of a recognized asset or liability, the FASB classifies the transaction as a fair-value hedge. The derivative appears on the balance sheet at its fair value. The FASB requires the firm to show in income each period the change in the fair value of a derivative that qualifies as a fair-value hedge. The firm will also record at fair value the asset or liability it is hedging, so under most circumstances the net effect on both net assets and net income will be zero. If the firm does not acquire a perfect hedge, the firm will report in income the net cost of the unsuccessful hedge or the net benefit of the over-successful hedge.

17.  When a firm acquires a derivative and attempts to reduce the risk in future streams of cash flows (inflows or outflows), the FASB classifies the transaction as a cash-flow hedge. A firm will show the cash-flow hedge at its fair value on the balance sheet, but will not report the matching gain or loss in net earnings of the period. The gain or loss will appear as part of other comprehensive income and will appear on the balance sheet in the separate shareholders’ equity account, Accumulated Other Comprehensive Income. This unrealized gain or loss from changes in the fair value of the cash-flow hedge remains on the balance sheet in a separate shareholders’ equity account to later match against any loss or gain on the cash-flow commitment when the firm settles it.

18. Firms can elect the fair value option for: (a) bonds held to maturity, (b) available for sale securities, or (c) cash flow hedges.

19. Applying the fair value option to investments in debt securities classified as “held to maturity” results in accounting for the investment as if it were a trading security (change in fair value each period).

20. Applying the fair value option to “available for sale” securities and to cash flow hedges results n reporting unrealized gains and losses from remeasuring fair value in net income as fair value changes.