Solution manual intermediate accounting 7th by nelson spiceland ch12

Question 12-5 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” o

Question 12-3

The fair value of an equity security is considered “readily determinable” if its selling price (or

bid-and-asked quotation) is currently available on a securities exchange When its fair value is not

readily determinable, an investment is carried and reported at cost Any dividends received are recognized as investment revenue, and a gain or loss is reported only when actually realized through the sale of the investment

Question 12-4

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 and 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

Question 12-5

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

Question 12-6

Comprehensive income is a more expansive view of the change in shareholders’ equity than

Answers to Questions (continued)

Question 12-7

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 not considered relevant performance measures to be included in earnings

Question 12-9

When acquired, debt and equity securities are assigned to one of the three reporting classifications – held-to-maturity, available-for-sale, or trading 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 as

a separate component of shareholders’ equity, Other comprehensive income

3 Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity

Question 12-10

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 change in net unrealized holding gains and losses, and amortized cost basis by major security type In addition, information about maturities should be reported for

investee 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

Question 12-14

The 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 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 40% x $12 million ÷ 10 years = $480,000 each year for ten years

Question 12-15

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

Answers to Questions (concluded)

Question 12-16

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 market value in the next set of financial statements

Question 12-17

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

Question 12-21

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) 120,000

Cash (price of bonds) 600,000

Gain on sale of investments 2,150

Investment in Disney common shares 54,900

Brief Exercise 12-3

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 The adjusting entry needed to increase the fair value adjustment from $110,000 to $170,000 is:

Brief Exercise 12-4

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 12-5

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

2006 earnings When the fair value rises by $7,000 in 2007, that amount is reported in

2007 earnings S&L’s journal entries for these transactions would be:

Unrealized holding loss 2,000

Investment in Coca Cola shares ([$875,000 - $873,000) 2,000

2007

January 3

Cash (selling price) 880,000

Gain on investments (to balance) 7,000

available-for-sale are not included in earnings S&L reports its $2,000 holding loss in

2006 as Other comprehensive income, a negative component of shareholders’ equity, not earnings When the fair value rises to $880,000 in 2007, the amount is reported in

2007 earnings is the $5,000 gain realized by the sale of the securities S&L’s journal entries for these transactions would be:

Unrealized holding loss (shareholders’ equity) 2,000

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

2007

January 3

Cash (selling price) 880,000

Gain on investments (to balance) 5,000 Investment in Coca Cola shares (cost) 875,000 Assuming no other transactions involving securities available-for-sale, the 2007 adjusting entry would be:

December 31

Fair value adjustment (balance) 2,000

Unrealized holding loss (balance) 2,000

Brief Exercise 12-7

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

Brief Exercise 12-8

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

Brief Exercise 12-9

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

temporary, LED records the impairment as follows:

Impairment loss ($4.50 x $ 100,000 shares) 450,000

Investment 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 - a separate component of shareholders’ equity

Brief Exercise 12-11

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

No If Pioneer 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 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

Exercise 12-1

Investment in bonds (face amount) 240

Discount on bond investment (difference) 40

Cash (price of bonds) 200

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

Cash (proceeds from sale) 190.0

Discount on bond investment (balance, determined above) 39.2

Loss on sale of investments (to balance) 10.8

Investment in bonds (face amount) 240.0

Investment revenue receivable - Facsimile

Enterprises bonds ($30 million x 12% x 1/12) 0.3

Loss on sale of investments 100

Investment in GM common shares 41,200

Exercise 12-4

Requirement 1

Net unrealized holding gains and losses 75

Fair value adjustment ($405 - 480) 75

Fair value adjustment ($480 - 450) 30

Net unrealized holding gains and losses 30

Fair value adjustment ($560 - 480) 80

Net unrealized holding gains and losses 80

Net unrealized holding gains and losses 60

Fair value adjustment ($660 - 720) 60

Requirement 2

None Accumulated net holding gains and losses for securities available-for-sale are reported as a component of shareholders’ equity, and changes in the balance are reported as Other comprehensive income or loss rather than as part of earnings This amount 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

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 This amount

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 Accumulated net holding gains and losses for securities

available-for-sale are reported as a separate component of shareholders’ equity

Requirement 2

December 31, 2006

Net unrealized holding gains and losses (10,000 shares x [$58 - 60]) 20,000

Fair value adjustment 20,000

Available-for-Sale Securities Cost Fair Value Gain (Loss)

Moving from a negative $20 (2006) to a positive $10 requires an increase of $30:

-

+30 ->

Fair value adjustment (10,000 shares x [$61 - 58]) 30,000

Net unrealized holding gains and losses (-$20 less $10) 30,000

Exercise 12-6 (continued)

December 31

Available-for-Sale Securities Cost Fair Value Gain (Loss)

Net unrealized holding gains and losses ($71 – 69) 2

Fair value adjustment ($71 – 69) 2

2007

January 23

Cash ([1 million shares x 1/2] x $32) 16.0

Gain on sale of investments (difference) .5 Investment in Platinum Gauges

shares ($31 million cost x 1/2) 15.5

March 1

Cash ($76 x 500,000 shares) 38

Loss on sale of investments (difference) 2

Investment in LTD preferred (cost) 40

2006 Income Statement

($ in millions)

Investment revenue (from July 18; Oct 15) $3

Gain on sale of investments (from Oct 16) 1

Other comprehensive income:*

Unrealized holding loss 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

Fair value adjustment ($98 - 90 million) 8

Net unrealized holding gains and losses 8

Requirement 2

Investment revenue $3 million

An unrealized holding gain is not included in income for securities

available-for-sale

Investment in Grocers’ Supply preferred shares 50,000

Unrealized holding gain ([$4 x 100,000 shares] - $350,000) 50,000

2007

January 5

Cash (selling price) 395,000

Loss on investments (to balance) 5,000

Investment in Grocers’ Supply preferred

shares (account balance) 400,000

Requirement 2

Balance Sheet (short-term investment):

Trading securities $400,000

Income Statement:

Investment revenue (dividends) $ 2,000 Unrealized holding gain (from adjusting entry) 50,000Note: Unlike for securities available-for-sale, unrealized holding gains and losses for

trading securities are included in income

Accumulated

Available-for-Sale Securities Cost Fair Value Gain (Loss)

IBM shares – Dec 31, 2006 $1,345 $1,175 $(170)

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

Net unrealized holding gains and losses 25,000

Fair value adjustment ($1,175,000 - 1,200,000) 25,000

Requirement 2

Available-for-Sale Securities Cost Fair Value Gain (Loss)

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

Fair value adjustment ($1,275,000 - 1,200,000) 75,000

Net unrealized holding gains and losses 75,000

Exercise 12-10 (concluded)

Requirement 3

Available-for-Sale Securities Cost Fair Value Gain (Loss)

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

Fair value adjustment ($1,375,000 - 1,200,000) 175,000

Net unrealized holding gains and losses 175,000

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 2007 earnings Here are the entries used to record those two transactions:

Loss on sale of investments (difference) 5

Investment in A Corporation shares (cost) 20

September 12, 2007

Exercise 12-11 (concluded)

Requirement 2

Harlon’s securities available-for-sale portfolio should be reported in its 2007

balance sheet at its fair value of $101 million:

-

+11 ->

Fair value adjustment ($5credit to $6debit) 11

Net unrealized holding gains and losses ($5 debit to $6 credit) 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

Exercise 12-12

1 b

2 b

Fair value adjustment ($505,000 - 480,000) 25,000

Net unrealized holding gains and losses 25,000

Cash (30% x 8 million shares x $1.25) 3

Investment in Nursery Supplies shares 3

Retained earnings (investment revenue from the equity method) 17

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 market value in the next set of financial statements There also would be no revision of prior years, but the change

Investments ($100,000 – 80,000) 20,000

Gain on sale of investments 20,000

2 Error not discovered until early 2007

Investments ($100,000 – 80,000) 20,000

Retained earnings 20,000

Cash (4 million shares x $1) 4

Investment in Carne Cosmetics shares 4

Depreciation Adjustment

Investment revenue ($8 million [calculation below‡] ÷ 8 years) 1

Investment in Carne Cosmetics shares 1

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

Investment in Lake Construction shares 6

Adjustment for depreciation

Investment revenue ($10 million [calculation below‡] ÷ 10 years) 1

Investment in Lake Construction shares 1

Exercise 12-18 (concluded)

b As investment revenue in the income statement

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

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 in 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 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

Exercise 12-21

Requirement 1

Insurance expense (difference) 64,000

Cash surrender valueof life insurance ($27,000 – 21,000) 6,000

Cash (2006 premium) 70,000

Requirement 2

Cash (death benefit) 4,000,000

Insurance expense (difference) 22,900

Cash surrender valueof life insurance ($4,600 – 2,500). 2,100

Cash (premium) 25,000

Requirement 2

Cash (death benefit) 250,000

Cash surrender valueof life insurance (account balance) 16,000 Gain on life insurance settlement (to balance) 234,000

* present value of an ordinary annuity of $1: n=2, i=10%

** present value of $1: n=2, i=10%

January 1, 2006

Loss on troubled debt restructuring (to balance) 2,373,510

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

December 31, 2006

Cash (required by new agreement) 1,000,000

Note receivable (to balance) 82,649

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

December 31, 2007

Cash (required by new agreement) 1,000,000

Note receivable (to balance) 90,861

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

Cash (required by new agreement) 11,000,000

Note receivable (balance) 11,000,000

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

Cash Effective Increase in Outstanding

by agreement 10% x Outstanding Balance Discount Reduction

Loss on troubled debt restructuring (to balance) 37,003

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

Note receivable (balance) 274,665

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