Income Statements Traditional by snj62624

VIEWS: 72 PAGES: 19

Income Statements Traditional document sample

More Info
									               _______________________________________________________

                       Strategic Accounting
               _______________________________________________________
               This reading is based primarily on current international accounting standards as
               promulgated by the International Accounting Standards Board. These standards will
               change. The IASB and FASB are coordinating closely and plan to reach a new
               converged standard later this year. The two boards have been taking different
               approaches with revising their standards for financial instruments. The two boards plan
               to take into account the public comments they receive to reach the converged standard.

                     ACCOUNTING FOR FINANCIAL ASSETS AND LIABILITIES

               Investments and Comprehensive Income
               OVERVIEW
               Investments are accounted for differently depending on the nature of the
               investment relationship and the preferences of the investor. Before we discuss
               the approaches in detail, see this quick overview.
REPORTING      Equity Investments
METHODS USED                                                           Financial assets at fair value through
BY THE         Default reporting method                                profit or loss (FVTPL)—investment
INVESTOR1                                                              reported at fair value (with unrealized
                                                                       holding gains and losses included in net
                                                                       income)
               Optional (irrevocable) choice by the investor at        Financial assets at fair value through
               acquisition.                                            other comprehensive income
                                                                       (FVTOCI)—investment reported at fair
               Not permitted if the equity investment is held for      value (with unrealized holding gains and
               trading.                                                losses included in OCI)

               Debt Investments
                                                                       Financial assets at fair value through
               Default reporting method                                profit or loss (FVTPL)—investment
                                                                       reported at fair value (with unrealized
                                                                       holding gains and losses included in net
                                                                       income)

               Investment meets both:                                  Amortized Cost—investment reported at
               (a) the “cash flow characteristics” test (which         amortized cost
                   requires that the debt instrument consist of only
                   principal and interest payments) and
               (b) the “business model test” (which requires that
                   the objective of the company’s business model
                   is to hold the investment to collect the
                   contractual cash flows rather than to sell the
                   investment at a gain).

               1
                Financial Instruments‖ International Financial Reporting Standard No. 9 (IASCF), November
               12, 2009.
             U.S. GAAP DIFFERENCE
        IFRS No. 9 will be required after January 1, 2013, and earlier
    adoption is allowed, so in the time period between 2010 and 2012 either
    IAS No. 39 or IAS No. 9 might be in effect for a particular company. IAS
    No. 39 is essentially equivalent to U.S. GAAP which classifies
    investments as:
       1. trading securities (FVTPL under IFRS),
       2. securities available for sale, or
       3. held to maturity securities.


   The reporting approaches we use for investments differ according to how the
approaches account for one or more of the four critical events that an investor
experiences in the life of an investment:
       (1) purchasing the investment,
       (2) recognizing investment revenue (interest in the case of debt,
           dividends in the case of equity),
       (3) holding the investment during periods in which the investment’s fair
           value changes (and thus incurring unrealized holding gains and
           losses, since the security has not yet been sold), and
       (4) selling the investment (and thus incurring realized gains and losses,
           since the security has been sold and the gains or losses actually are
           incurred).

    Regardless of the investment type, investors can elect the ―fair value option‖
and classify amortized cost securities as FVTPL if the investment meets specific
conditions we discuss later. The key difference among the reporting approaches
is how we account for unrealized gains and losses (critical event #3 above), as
shown below.

                                             Treatment of              Investment
                                          Unrealized Holding          Reported in the
     Reporting Approach:                   Gains and Losses:         Balance Sheet at:
FVTPL                                Recognized in net income,
                                     and therefore in retained           Fair Value
                                     earnings as part of
                                     shareholders' equity
FVTOCI                               Recognized in other
                                     comprehensive income, and           Fair Value
                                     therefore in accumulated
                                     other comprehensive income
                                     in shareholders' equity
Amortized Cost                       Not recognized                   Amortized Cost


    Let's examine the three reporting classifications, one by one.
                  Securities at Fair Value Through Profit and Loss
                 To see how we account for FVTPL securities, let’s consider the following
             illustration.

Accounting for      United Intergroup, Inc. buys and sells both debt and equity securities
Securities at FVTPL of other companies as investments. United’s fiscal year-end is
                    December 31. The following events during 2011 and 2012 pertain to
                    the investment portfolio.

                       Purchase Investments      Purchased Masterwear Industries’ 12%, 3-
                       July 1, 2011                year bonds for $666,633 to yield an
                                                   effective interest rate of 14%.
                                                 Purchased $1,500,000 of Arjent, Inc.
                                                   common stock.
                                                 Purchased $1,000,000 of Bendac common
                                                   stock.

                       Receive Investment        Received a semi-annual cash interest
                       Revenue                     payment of $42,000 from Masterwear.
                       December 31, 2011         Received a cash dividend of $75,000 from
                                                   Arjent. (Bendac does not pay dividends)

                       Adjust Investments        Valued the Masterwear bonds at $714,943.
                       to Fair Value             Valued the Arjent stock at $1,450,000.
                       December 31, 2011         Valued the Bendac stock at $990,000.

                       Sell Investments          Sold the Masterwear bonds for $725,000.
                       January 15, 2012          Sold the Arjent stock for $1,446,000.

                       Adjust Remaining          Valued the Bendac stock at $985,000.
                       Investments to Fair
                       Value
                       December 31, 2012


                Assuming all investments are classified as securities at FVTPL, the
             accounting would be as follows.
                         Purchase Investments. The journal entry to record the purchase of the bond
                         investment is to exchange one asset (cash) for another (investment):

                         July 1, 2011
  All investment
                         Investment in Masterwear bonds………………                   666,633
  securities are            Cash…………………………………………                                              666,633
  recorded initially
  at cost.
                         Investment in Arjent stock………………… 1,500,000
                            Cash……………………………………………….                                         1,500,000

                         Investment in Bendac stock………………                     1,000,000
                            Cash…………………………………………                                            1,000,000

                         Recognize Investment Revenue. To record the receipt of bond interest we
                         recognize the revenue earned, the cash interest received, and the increase in the
                         investment for the interest earned but not yet received ($4,664). The journal
                         entry to record the receipt of dividends related to the Arjent equity investment is
                         straightforward. There is no entry for the Bendac equity investment, because
                         Bendac doesn’t pay dividends.

                         December 31, 2011
  Dividend and           Cash (6% x $700,000)……………………………                         42,000
  interest income is     Bond investment                                          4,664
  included in net
  income.
                           Investment revenue (interest: 7% x $666,633)…                   46,664

                         Cash……………………………………………                                   75,000
                           Investment revenue (dividends)……………                             75,000

                         Adjust FVTPL Security Investments to Fair Value (2011). The carrying
FVTPL securities are     value of FVTPL securities in the balance sheet is adjusted to fair value at the
adjusted to their fair   end of every reporting period. Rather than increasing or decreasing the
value at each
reporting date.
                         investment account itself, we use a valuation allowance, Fair value adjustment,
                         to increase or decrease the carrying value of the investment. At the same time,
                         we record an unrealized holding gain or loss that is included in net income in the
                         period in which fair value changes (the gain or loss is unrealized because the
                         securities haven’t actually been sold). The following table summarizes the
                         relevant facts for United’s investments:

                         December 31, 2011
                                                                                              Fair Value
                          Security         Amortized Cost              Fair Value             Adjustment
                         Masterwear         $ 671,297                  $ 714,943               $ 43,646
                         Arjent              1,500,000                  1,450,000               (50,000)
                         Bendac              1,000,000                    990,000               (10,000)
                            Total           $3,171,297                 $3,154,943              $(16,354)
                                             Existing balance in fair value adjustment:              -0-
                                    Increase (decrease) needed in fair value adjustment:       ($16,354)
                                 Note that, to determine the amount of unrealized holding gain or loss on the
                             Masterwear bonds, United first identifies the bonds’ amortized cost and then
                             determine the amount necessary to adjust that amount to fair value:

                                          Amortized cost of the bonds:                              $671,297
                                          +/- Fair value adjustment (plug)                           +43,646
                                          Fair value of the bond at 12/31/09:                       $714,943

                                 There is no discount to amortize for the equity investments, so for the Arjent
                             and Bendac investments, their amortized cost is simply their initial cost. The
                             journal entry to record the fair value adjustment is:

                             December 31, 2011 2
                             Net unrealized holding gains and losses—I/S3                              16,354
                               Fair value adjustment ……….…………..                                                   16,354


                             Sell FVTPL Security Investments. To record the gain or loss realized on the
                             sale of the Masterwear and Arjent investments, United records the receipt of
                             cash ($725,000 for Masterwear and $1,446,000 for Arjent), removes all balance
                             sheet accounts that are directly associated with the investments, and plugs to
                             determine realized gain or loss.4

                             January 15, 2012
Realized gain or loss for
the difference between
                             Cash (amount received)……………………………………… 725,000
carrying value and the           Investment in Masterwear bonds (account balance) …                             671,297
cash received from selling       Gain on sale of investments (to balance)………                                     53,703
a FVTPL security are
included in net income.
                             Cash (amount received)………                                      1,446,000
                             Loss on sale of investments (to balance) ……                       54,000
                                 Investment in Arjent stock (account balance)                                   1,500,000




                             2
                               Sometimes companies don’t bother with a separate fair value adjustment account and simply
                             adjust the investment account to fair value. Also, sometimes companies set up separate fair
                             value adjustment accounts for each investment.
                             3
                               We title this account ―Net unrealized holding gains and losses—I/S‖ to highlight that, for
                             FVTPL securities, unrealized holding gains and losses are included in the income statement (I/S)
                             in the period in which they occur.
                             4
                               For purposes of this example, we ignore any unpaid interest associated with the bonds. In
                             practice, that amount would be added to the sales price of the bonds and included in investment
                             revenue.
                                  For the Masterwear bonds, United needs to remove the fair value adjustment
When FVTPL securities are
sold, unrealized gains or
                              associated with them, but typically companies accomplish that step when they
losses and any changes in     adjust their investment portfolios to fair value at the end of the accounting
the fair value adjustment     period.
account that were recorded
previously are removed as
part of the next fair value   Adjust FVTPL Security Investments to Fair Value (2012). The following
adjustment.                   table summarizes the situation at the end of 2012:

                   December 31, 2012
                                                                                                         Fair Value
                        Security                   Amortized Cost             Fair Value                 Adjustment
                   Masterwear                           (sold)                    -0-                        -0-
                   Arjent                               (sold)                    -0-                        -0-
                   Bendac                            $1,000,000                $985,000                   ($15,000)
                     Total                           $1,000,000                $985,000                   ($15,000)
                                                  Existing balance in fair value adjustment:              ($16,354)
                                        Increase (decrease) needed in fair value adjustment:               $ 1,354

                                  The journal entry necessary to show the appropriate balance in the fair value
                              adjustment at the end of 2012 is:

                              December 31, 2012
                              Fair value adjustment …………..……………………. 1,354
                                 Net unrealized holding gains and losses—I/S                                1,354

                                  This journal entry serves two purposes: (a) accounts for changes in the fair
                              value of investments that have not been sold (in this case, Bendac), and (b)
                              removes from the fair value adjustment any amounts associated with sold
                              investments (in this case, Masterwear and Arjent).

                                Don’t Shoot the Messenger
                                Or, as written in The Economist, ―Messenger, Shot: Accounting rules are
                              under attack. Standard-setters should defend them. Politicians and banks should
                              back off.‖ Using fair values that are hard to estimate is controversial. For
                              example, during the recent financial crisis many financial-services companies
                              had to recognize huge unrealized losses associated with their investments. Some
                              blamed their losses on GAAP for requiring estimates of fair value that were
                              driven by depressed current market prices, argued that those losses worsened the
                              financial crisis, and lobbied for a move away from fair-value accounting. Others
                              countered that these companies were using GAAP’s requirement for fair value
                              accounting as a ―scapegoat‖ for their bad investment decisions. ―Fair value
                              accounting . . . does not create losses but rather reflects a firm’s present
                              condition,‖ says Georgene Palacky, director of the CFA’s financial reporting
                              group.‖5


                              5
                                  Sarah Johnson, ―The Fair Value Blame Game,‖ CFO.com, March 19, 2008.
                                                           Securities at FVTOCI
                                When an investor buys shares of another company, it can elect to classify the
                               investment as at FVTOCI. The choice is irrevocable. The choice is not
                               permitted if the equity investment is held for trading; that is, if the objective is to
                               achieve short term gains from buying and selling such investments.
                                   When securities are reported at FVTOCI, gains and losses from changes in
                               fair value are reported, not in net income, but in other comprehensive income
                               (OCI). In all other respects, the investment is accounted for precisely the same
                               as for investments at FVTPL as described and illustrated in the previous section.
                               For example, the journal entry to adjust the investment to fair value would be:

                               December 31
                               Fair value adjustment …………..……………………. xxx
    Unrealized holding gains      Net unrealized holding gains and losses—OCI                                   xxx
    and losses on FVTOCI
    securities affect
    comprehensive income,          rather than:
    but not net income.
                               December 31
                               Fair value adjustment …………..……………………. xxx
                                  Net unrealized holding gains and losses—NI                                    xxx

                                   All other entries would be the same.

                                   Like securities at FVTPL, we report investments in securities at FVTOCI in
                               the balance sheet at fair value. Unlike securities at FVTPL, though, unrealized
                               holding gains and losses on AFS securities are not included in net income.
                               Instead, they are reported in the statement of comprehensive income as other
                               comprehensive income (OCI).

                               Comprehensive Income. Recall that comprehensive income is a more all-
                               encompassing view of changes in shareholders’ equity than net income,
Comprehensive income
includes not only net          including not only net income but also all other changes in equity that do not
income, but also other
changes in equity that
                               arise from transactions with owners.6 Comprehensive income therefore includes
don’t arise from               net income and other comprehensive income (OCI). Both net income and OCI
transactions with owners.
                               accumulate in shareholders’ equity in the balance sheet, but in different
                               accounts. While net income accumulates in retained earnings, OCI accumulates
                               in accumulated other comprehensive income (“AOCI”).
                                   As part of a joint project with the FASB, the International Accounting
                               Standards Board (IASB) in 2007 issued a revised version of IAS No.1,
                               ―Presentation of Financial Statements‖ that revised the standard to bring
                               international reporting of comprehensive income largely in line with U.S.
                               standards. It provides the option of presenting revenue and expense items and
                               6
                                Transactions with owners primarily include dividends and the sale or purchase of shares of the
                               company’s stock.
components of other comprehensive income either in (a) a single statement of
comprehensive income or (b) in a separate income statement followed by a
statement of comprehensive income.

  Observation: A proposed Accounting Standards Update, Comprehensive Income
    (Topic 220): Statement of Comprehensive Income would require an entity to
    present a continuous statement of comprehensive income. That is, other
    comprehensive income would be presented immediately following the income
    statement in a single statement of comprehensive income. Just one presentation
    option – no more choices.

    Comprehensive income encompasses all changes in equity other than from
transactions with owners. Transactions between the corporation and its
shareholders primarily include dividends and the sale or purchase of shares of
the company’s stock. Most nonowner changes are reported in the income
statement. So, the changes other than those that are part of traditional net income
are the ones reported as ―other comprehensive income.‖
    Comprehensive income extends our view of income beyond conventional
net income to include four types of gains and losses that traditionally haven’t
been included in income statements:
   1. Net holding gains (losses) on FVTOCI investments.
   2. Gains (losses) from and amendments to postretirement benefit plans.
   3. Deferred gains (losses) on derivatives.
   4. Gains (losses) from foreign currency translation.

    The first of these are the gains and losses on securities reported at FVTOCI
that occur when the fair values of these investments increase or decrease. 7
These gains and losses aren’t included in earnings until they are realized through
the sale of the securities but are considered a component of other comprehensive
income in the meantime. Similarly, net gains and losses as well as ―prior service
cost‖ on pensions sometimes affect other comprehensive income but not net
income. When a derivative designated as a ―cash flow hedge‖ is adjusted to fair
value, the gain or loss is deferred as a component of other comprehensive
income and included in earnings later, at the same time as earnings are affected
by the hedged transaction. Gains and losses from changes in foreign currency
exchange rates are discussed elsewhere in your accounting curriculum, but also
are included in other comprehensive income (OCI) but not net income.
                              OCI shares another trait with net income. Just as net income is reported
      OCI is reported    periodically in the income statement and also on a cumulative basis as part of
      in the statement
      of                 retained earnings, OCI too, is reported periodically in the statement of
      comprehensive      comprehensive income and also as accumulated other comprehensive income
      income.            in the balance sheet along with retained earnings. In other words, we report two
                         attributes of OCI: (1) components of comprehensive income created during the
      AOCI is reported
      in the balance     reporting period and (2) the comprehensive income accumulated over the
      sheet.             current and prior periods.
                              The first attribute—components of comprehensive income created during
                         the reporting period—can be reported either as (a) an expanded version of the
                         income statement, (b) part of the statement of shareholders’ equity, or (c) a
                         separate statement. Regardless of the placement a company chooses, the
                         presentation is similar. It will report net income, other components of
                         comprehensive income, and total comprehensive income, similar to the
                         presentation below. Note that each component is reported net of its related
                         income tax expense or income tax benefit.

                                                                                                                          ($ in millions)
Comprehensive
Income                   Revenues                                                                                                    $xxx
                         Expenses                                                                                                    (xxx)
                         Net income                                                                                                  $xxx
                         Other comprehensive income:
                           Net unrealized holding gains (losses) on investments (net of tax)*      $x
                           Gains (losses) from and amendments to postretirement benefit plans (net
                              of tax)†                                                             (x)
                                                                               ‡
                           Deferred gains (losses) on derivatives (net of tax)                      (x)
                                                                                         §
                           Gains (losses) from foreign currency translation (net of tax)             x                                 xx
                         Comprehensive income                                                                                        $xxx

                         *Changes in the market value of FVTOCI securities
                         †
                           Gains and losses due to revising assumptions or market returns differing from expectations and prior
                         service cost from amending the plan
                         ‡
                           When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as
                         a component of comprehensive income and included in earnings later, at the same time as earnings are
                         affected by the hedged transaction
                         §
                           Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or
                         reduction in shareholders’ equity.


                             The second measure—the comprehensive income accumulated over the
                         current and prior periods—is reported as a separate component of shareholders’
                         equity following retained earnings. Note that amounts reported here—
                         accumulated other comprehensive income (AOCI)—represent the cumulative
sum of the changes in each component created during each reporting period
throughout all prior years.


         U.S. GAAP DIFFERENCE
Comprehensive Income. The International Accounting Standards Board (IASB) in 2007
issued a revised version of IAS No.1, “Presentation of Financial Statements,” as part of
a joint project with the FASB. It revised the standard to bring international reporting
of comprehensive income largely in line with U.S. standards.8 With regard to the
presentation of comprehensive income, both sets of standards permit alternative
formats, but IFRS provides one fewer choice. Here are options for reporting revenue
and expense items and components of other comprehensive income:

                  IFRS                                          U.S. GAAP
1. single statement of comprehensive income   1. single statement of comprehensive income
2. a separate ‘income statement’              2. a separate ‘income statement’
   and ‘statement of comprehensive income         and ‘statement of comprehensive income
                                              3. in the statement of shareholders’ equity

    The rationale behind the decision under IFRS not to allow the third presentation
option is to clearly segregate changes in equity arising from transactions with owners
in their capacity as owners (statement of shareholders’ equity) from non-owner
changes in equity (statement of comprehensive income).
    As mentioned above, the FASB already has issued an Exposure Draft eliminating all
but the first choice. The IASB likely will follow suit.
                                 SECURITIES AT AMORTIZED COST
                      On July 1, 2011, Masterwear Industries issued $700,000 of 12% bonds, dated
                      January 1. The investment meets both (a) the ―cash flow characteristics‖ test
                      (because the debt instrument consists of only principal and interest payments)
                      and (b) the ―business model test‖ (because the objective of the company’s
                      business model is to hold the investment to collect the contractual cash flows
                      rather than to sell the investment at a gain).
                          Interest of $42,000 is payable semiannually on June 30 and December 31.
                      The bonds mature in three years. The market yield for bonds of similar risk and
                      maturity is 14%. The entire bond issue was purchased by United Intergroup,
                      Inc.

Because interest is   Calculation of the price of the bonds:
paid semiannually,                                                               Present Values
the present value     Interest              $42,000 x 4.76654       * =               $200,195
calculations use:                                                   ** =
 (a) one-half the     Principal            $700,000 x 0.66634                          466,438
    stated rate         Present value (price) of the bonds                            $666,633
    (6%),
(b) one-half the      *       present value of an ordinary annuity of $1: n=6, i=7%
    market rate       **
    (7%), and                 present value of $1: n=6, i=7%
(c) 6 (3 x 2) semi-
    annual periods.
                      Journal Entries at Issuance – Bonds Purchased at Discount July 1
                       Investment in bonds                    666,633
                            Cash (price calculated above)                   666,633



                      Recognize Investment Revenue
                          The Masterwear bonds pay cash interest at a rate of 12%, but were issued at
                      a time when the market rate of interest was 14%. As a result, the bonds were
                      sold at a discount that was large enough to provide bond purchasers with the
                      same effective rate of return on their investment (14%) that they could get
                      elsewhere in the market. Think of it this way: a little piece of that initial
                      discount serves each period to make up the difference between the relatively low
                      rate of interest that the bond pays (12%) and the higher rate of interest that the
                      market demands (14%).
                         Determining Interest – Effective Interest Method
                         Interest accrues on an outstanding debt at a constant percentage of the debt each
                         period. Of course, under the concept of accrual accounting, the periodic
The effective interest
on debt is the market    effective interest is unaffected by when the cash interest actually is paid.
rate of interest         Recording interest each period as the effective market rate of interest multiplied
multiplied by the        by the outstanding balance of the debt (during the interest period) is referred to
outstanding balance of   as the effective interest method. Although giving this a label – the ―effective
the debt.                interest method‖ – implies some specialized procedure, this simply is an
                         application of the accrual concept, consistent with accruing all expenses as they
                         are incurred.
                            Continuing our example, we determined that the amount of debt when the
                         bonds are issued is $666,633. Since the effective interest rate is 14%, interest
                         recorded (as expense to the issuer and revenue to the investor) for the first six-
                         month interest period is $46,664:

                                      $666,633       x       [14% ÷ 2]        =       $46,664
                                 Outstanding Balance       Effective Rate         Effective Interest

                           However, the bond indenture calls for semiannual interest payments of only
                         $42,000 – the stated rate (6%) times the face amount ($700,000). As always,
                         when only a portion of the revenue is received, the remainder becomes an asset
                         – in this case an addition to the outstanding investment. So the difference,
                         $4,664, increases the investment.
                            Journal Entry – The Interest Method
The effective interest is
calculated each period as        At the First Interest Date
the market rate times the        December 31
amount of the debt               Cash (stated rate x face amount) ........................... 42,000
outstanding during the           Bond investment (difference) ..............................   4,664
interest period.                   Interest revenue (market rate x outstanding balance)              46,664

                                Because the balance of the debt changes each period, the dollar amount of
                            interest (balance x rate) also will change each period. To keep up with the
                            changing amounts, it usually is convenient to prepare a schedule that reflects the
                            changes in the debt over its term to maturity.
                                An amortization schedule for the situation under discussion is shown here:

                                   Cash                 Effective                 Increase in   Outstanding
                                  Interest              Interest                   Balance       Balance
                                   6% x                  7% x
                                 Face Amount      Outstanding Balance
                                                                                                 666,633
Since less cash is           1       42,000       .07   (666,633)   =   46,664     4,664         671,297
received each period         2       42,000       .07   (671,297)   =   46,991     4,991         676,288
than the effective           3       42,000       .07   (676,288)   =   47,340     5,340         681,628
interest, the unpaid
difference increases the
                             4       42,000       .07   (681,628)   =   47,714     5,714         687,342
outstanding balance of       5       42,000       .07   (687,342)   =   48,114     6,114         693,456
the investment.              6       42,000       .07   (693,456)   =   48,544*    6,544         700,000
                                    252,000                             285,367    33,367
                             * rounded


                                This demonstrates interest being recorded at the effective rate over the life of
                            this investment. As you can see, the amortization of discount gradually
                            increases the carrying value of the investment, until the investment reaches its
                            face amount of $700,000 at the time when the debt matures.


                            Do Not Recognize Unrealized Holding Gains and Losses for Investments at
 For securities at          Amortized Cost. Suppose that, as of the end of the first reporting period, the
 amortized cost,            market interest rate for similar securities has fallen to 11%. A market
 unrealized holding         participant valuing the Masterwear bonds at that time would do so at the current
 gains and losses from
 fair value changes are     market interest rate (11%) because that’s the rate of return she or he could get
 ignored.                   from similar bonds. Calculating the present value of the bonds using a lower
                            discount rate results in a higher present value. Let’s say that checking market
                            prices in the Wall Street Journal indicates that the fair value of the Masterwear
                            bonds on that date is $714,943. How will United account for this increase in fair
                            value? If United views the bonds as an investment at amortized cost, that
                            change in fair value will be ignored. The investment simply will be recorded at
                            amortized cost (the amounts in the right-hand column of the amortization
                            schedule above). United will disclose the fair value of its investments in a
                                footnote, but will not recognize fair value in the income statement or balance
                                sheet.

                                                                Additional Consideration
                                 Suppose the bonds are not traded on an active exchange. How would you determine
                                the fair value of the Masterwear bonds on December 31, 2011? If the Masterwear
                                bonds were publicly traded, United could find the fair value by looking up the current
                                market price (this way of obtaining fair value is consistent with ―level one‖ of the fair
                                value hierarchy). On the other hand, since the bonds were not publicly traded, United
                                can calculate the fair value by using present value techniques (this way of obtaining fair
                                value is consistent with ―level two‖ of the fair value hierarchy). With five interest
                                periods remaining, and a current market rate of 11% (5.5% semi-annually), the present
                                value would be $714,943:
                                                                                       Present Values
                                                                                *
                                         Interest        $ 42,000 x 4.27028 =              $179,352
U                                        Principal        $700,000 x 0.76513† =             535,591
         Using excel, enter:                 Present value of the bonds                    $714,943
PV   (.055, 5, 42000, 700000)
     Output: 714,943
                                        *Present value of an ordinary annuity of $1: n = 5, i = 5.5%.
     Using a calculator,                †Present value of $1: n = 5, i = 5.5%.
     enter: N 5 I 5.5
     PMT -42000 FV -700000
     Output: PV 714,943         Sell Investments. Typically, investment at amortized cost are held to maturity.
                                However, suppose that due to unforeseen circumstances the company decided to
                                sell its debt investment for $740,000 on January 15, 2012. United would record
                                the sale as follows (for simplicity we ignore any interest earned during 2012):

                                January 15, 2012
                                Cash……………………………………                                    725,000
                                   Investment in Masterwear bonds (account balance)..         671,297
                                   Gain on sale of investments (to balance)..……………             53,703


                                    In other words, United would record this sale just like any other asset sale,
                                with a gain or loss determined by comparing the cash received with the carrying
                                value (in this case, the amortized cost) of the asset given up.

                                                      Debt Investment at FVTPL
                                Suppose United’s investment meets (a) the ―cash flow characteristics‖ test
                                (because the debt instrument consists of only principal and interest payments)
                                but not (b) the ―business model test‖ (because the objective of the company’s
                                business model is to try to sell the investment at a gain). In that case, United
                                would account for the investment at FVTPL and the accounting would be the
                                same as in the previous section describing equity investments at FVTPL.
                                    This also is the way we account for investments for which the fair value
                                option is elected.
Fair Value Option

When an investment in debt securities meets both conditions for reporting at
amortized cost, the invest still can elect to report the investment at FVTPL if
that designation eliminates or significantly reduces an ―accounting mismatch‖ as
discussed in connection with the fair value option for reporting liabilities in a
previous module. The FVO must be elected on initial recognition and is
irrevocable.

Fair Value Option for Non-Financial Assets
IAS 16 allows a company to value property, plant and equipment (PP&E)
subsequent to initial valuation at (1) cost less accumulated depreciation or (2)
fair value (revaluation). If revaluation is chosen, all assets within a class of
PP&E must be revalued on a regular basis. U.S. GAAP prohibits revaluation.
          British Airways, Plc., a U.K. company, prepares its financial
      statements according to IFRS. The following disclosure note illustrates
      the company’s choice to value PP&E at cost:

              Property, plant and equipment (in part)
              Property, plant and equipment is held at cost. The Group has a policy
              of not revaluing tangible fixed assets.




    A company also is permitted to value an intangible asset subsequent to initial
valuation at fair value if fair value can be determined by reference to an active
market.9 Because very few intangible assets are traded on an active exchange,
very few intangible assets are accounted for under the revaluation option. If
revaluation is used, all assets within that class of intangibles must be revalued on
a regular basis.


                U.S. GAAP DIFFERENCE
          International standards allow the revaluation of property, plant and
       equipment and for some intangible assets. U.S. GAAP does not permit
       revaluation.


9
    IAS 38.
                       DECISION MAKERS’ PERSPECTIVE

                       The various approaches used to account for investments can have very different
                       effects on an investor’s income statement and balance sheet. Consequently, it’s
                       critical that both managers and external decision makers clearly understand
                       those effects and make decisions accordingly. 10
                            Of particular concern is the potential for inaccurate fair value estimates.
A concern with fair    Even if management is trying to provide the most accurate fair value estimate
value accounting is
that management has    possible, there is much potential for error. Also, a company conceivably could
much discretion over
fair values, and may
                       use the discretion inherent in fair value estimation to manage earnings with
not be able to         respect to FVTPL securities. Given this potential for error and bias, it’s not
estimate fair values
accurately.
                       surprising that investors are nervous about the accuracy of fair value estimates.
                       For example, in the third quarter of 2007 E-Trade recognized $198 million of
                       impairments for overvalued investments, and saw its share price plunge 59% on
                       analyst warnings of the potential for further impairments.11 To address these
                       sorts of concerns, the FASB has required extensive footnote disclosure about the
                       quality of inputs associated with estimates of fair value, but financial statement
                       users need to know to look for those disclosures and still must understand that
                       they cannot assess fully the accuracy of fair value estimates.
                          It’s important, therefore, to understand what is meant by fair value and how it
                       is determined. The fair value of a financial asset or liability as defined by IAS
                       39 is the ―amount for which the financial asset could be exchanged, or the
                       financial liability settled, between knowledgeable, willing parties in an arm’s
                       length transaction.‖ Underlying this definition is the presumption that the
                       company is a going concern without any need to undertake a transaction on
                       adverse terms.

                       Fair Value and the Financial Crisis
                       When the financial crisis hit the global economy in 2008 and the stock market
                       plummeted, one cry heard far and wide was that the crisis could be blamed
                       largely on fair value accounting rules. A common theme of the claim was that
                       fair value accounting produced unintended consequences that fed back to
                       worsen the economy, making banks unwilling to lend and therefore increasing
                       foreclosures, and making investors unwilling to invest and therefore worsening
                       the economics of banks. The argument was that when insurance companies,




                       11
                         Craig, S. ―Mortgage Crisis Extends its Reach: E*Trade Plunges 59% on Analyst’s Warnings;
                       Bank Unit Goes Awry,‖ Wall Street Journal, Nov 13, 2007, p. A.1.
banks, and other financial institutions were required to write down financial
assets to their fair values at a time when those values were seriously impaired
led to a self-fueled downward spiral.12
    Others countered that the real culprits in the financial crisis were the bankers
who issued bad mortgage loans and engineered and invested in risky mortgage-
backed securities. And, if fair values were actually understating true values of
those investments as alleged, we would expect smart market participants to be
snapping them up, but that wasn’t happening. The reasoning followed that fair
values provide simpler and more transparent information to investors and thus
should increase investor confidence when confidence is justified.13
    At the pinnacle of the crisis' beginnings, the arguments against fair value, or
mark-to-market accounting, garnered sufficient support that as Congress was
negotiating the terms of its infamous $700 billion bail-out bill, the SEC and the
FASB offered clarification on how to apply FAS 157, the controversial fair
value standard. That was followed quickly by an amendment to FAS 157 that
reinterpreted how to determine the fair value of financial assets in ―inactive
markets.‖ That guidance tried to assure companies that they can use their
internal models and assumptions to make their valuations for inactive markets.
Stated differently, companies were given permission to use more judgment in
their determination of fair values, to reclassify some financial assets out of the
fair-value-through-profit-or-loss category (FVTPL), and to do so retrospectively
to prior to the financial collapse.
    Not surprisingly, the guidance from the SEC and FASB motivated many
European companies — in a financial crisis of their own — to reconsider their
competitive positions globally. As a result, in October of 2008, the IASB issued
amendments to IAS 39, ―Financial Instruments: Recognition and Measurement‖
and IFRS 7, ―Financial Instruments: Disclosures.‖ The amendments are a
response to demands from constituents, particularly within the European Union,
to create a 'level playing field' with US GAAP regarding companies’ ability to
reclassify financial assets. The amendments permit similar reclassification of
some financial instruments out of the FVTPL and the AFS categories, the same
possibility of reclassifications that is permitted under US GAAP. In the event of
reclassification, additional disclosures are required under IFRS 7.




12
   See, for example, "Two Biggest Things to Do," (Steve Forbes, Forbes 10/13/08) and "Mark to
Mayhem? What Would Happen If We Changed the Rules? Let’s Find Out," (Jenkins, Jr.,
10/1/08).
1313
     See, for example, "How to Restore Trust in Wall Street," (Arthur Levitt, Jr. and Lynn
Turner, WSJ 9/26/08) and "Bankers Persist in Scapegoating 'Fair Value'," (Rapoport, Dow Jones
9/30/08).
                      Where We’re Headed
                      Accounting for financial instruments will change. The nature of the changes is
                      uncertain. The FASB is offering a competing alternative.14 Each Board is
                      asking the constituents of the other to comment on its approach. The objective
                      is to weigh world opinion on both proposals and arrive at a single approach that
                      represents that consensus. Here is the FASB’s alternative plan.


                             FASB: Report Most Financial Instruments at Fair Value

The FASB proposes     Most financial instruments (for example, borrowings and investments in stock)
to report most
                      would be reported each period at fair value with all changes in fair value
financial
instruments at fair   reported in net income (FVTNI).
value with all
changes in fair         Observation: This does not represent a change for investments classified
value reported in
net income.
                          under the existing accounting approach as ―trading securities‖ or
                          derivatives, since these financial instruments currently are reported at fair
                          value with changes reported in net income. This is a new approach for
                          investments classified as ―available for sale,‖ though, because these
                          financial instruments currently are reported at fair value with changes
                          reported in other comprehensive income (OCI).


                      Exception for financial instruments for which a company’s business strategy is to
                      hold for collection or payment of contractual cash flows. When a company buys
When a company
                      bonds from another company, it actually is lending the bond issuer the cash paid
holds a financial     for the bonds. At maturity, the face amount will be repaid to the investing
instrument for the    company. In the meantime, the investor receives periodic cash interest
collection or         payments. Both companies – the bond investor and the bond issuer – would
payment of the
contractual cash
                      report the financial instruments (investment in bonds and bonds payable) using a
flows, the            variation of the method described above. When a company’s business strategy
instruments would     is to hold a financial instrument for the collection (like this investment in a debt
be reported at fair   security) or payment of the contractual cash flows (like this issuer of the bond
value with changes
                      payable), the instruments would be reported in the balance sheet at fair value
reported in OCI.
                      with changes reported in other comprehensive income (OCI). Reasoning that
                      financial statement users benefit from both fair value and amortized cost
                      information, both amounts would be reported on the face of the balance sheet.




                         FASB proposed ASU, Accounting for Financial Instruments and Revisions to the Accounting for
                         Derivative Instruments and Hedging Activities, May 26, 2010.
  Observation: Investments in this category are similar to those presently
    classified as ―held-to-maturity,‖ but there need not be positive intent to
    hold the investments to maturity. Reporting changes in fair value in other
    comprehensive income is the manner used presently for investments
    classified as ―available for sale.‖


    For these financial instruments, net income is affected only by any interest
on the instruments, impairment losses if any, and gains or losses from selling the
instruments.
    The proposed update would have companies report in the balance sheet both
amortized cost and fair value information on the face of financial statements for
instruments that are being held for collection or payment of contractual cash
flows. Reporting both fair value and amortized cost information would allow
investors to more easily incorporate either or both in their analyses of a
company. Fair value information provides users with up-to-date information
about the market’s assessment of future net cash flows, taking into account both
risk and current interest rates. Amortized cost would provide investors with
information about the contractual cash flows.
    The balance sheet presentation for investments in this category would be:

Balance Sheet:

Assets:
Investment in bonds payable, at amortized cost                    $xxx,xxx
Fair value adjustment                                               xx,xxx
Investment in bonds payable, at fair value                         xxx,xxx

Shareholders’ Equity:
Ordinary shares                                                 $xxx,xxx
Retained earnings                                                xxx,xxx
Other comprehensive income:
 Unrealized gain or loss due to change in FV of financial assets xx,xxx
Total Shareholders’ Equity                                      $xxx,xxx

								
To top