Chapter 12 Investments 1 Question 12-1 Investment securities are classified as “held-to-maturity,” “available-for-sale,” or “trading securities.” Question 12-2 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. 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 traditional net income. It encompasses all changes in equity from nonowner transactions. So, in addition to net income, comprehensive income includes up to four other changes in equity: Net unrealized holding gains (losses) on investments, Net unrecognized loss on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign currency translation. Chapter 12 Investments QUESTIONS FOR REVIEW OF KEY TOPICS 2 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 12-8 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. 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 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. 3 Answers to Questions (continued) Question 12-11 The equity method is used when an investor can’t control, but can “significantly influence” the 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 12-12 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. Question 12-13 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 12-14 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. 4 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 12-18 These instruments “derive” their values or contractually required cash flows from some other security or index. Question 12-19 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 12-20 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. 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. 5 BRIEF EXERCISES Brief Exercise 12-1 (a) Investment in bonds (face amount) ........................ 720,000 Discount on bond investment (difference) ........ 120,000 Cash (price of bonds) .......................................... 600,000 (b) Cash (1.5% x $720,000) .......................................... 10,800 Discount on bond investment (difference) ............ 1,200 Interest revenue (2% x $600,000) ........................... 12,000 Brief Exercise 12-2 Investment in Disney common shares ........... 54,900 Cash ([2,000 shares x $27] + $900) ................... 54,900 Cash ([2,000 shares x $29] – $950) ....................... 57,050 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: Fair value adjustment ($670,000 – 610,000) ...... 60,000 Accumulated unrealized holding gains and losses 60,000 6 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: 2006 December 27 Investment in Coca Cola shares .......................................... 875,000 Cash ................................................................................. 875,000 December 31 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 Investment in Coca Cola shares (account balance) ............. 873,000 7 Brief Exercise 12-6 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 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: 2006 December 27 Investment in Coca Cola shares .......................................... 875,000 Cash ................................................................................. 875,000 December 31 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 8 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. 9 Brief Exercise 12-10 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) ............ 450,000 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 $12 million. Financial statements would be recast to reflect the equity method for each year reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items. No. If Pioneer changes from the equity method, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note. 10 Exercise 12-1 Requirement 1 ($ in millions) Investment in bonds (face amount) ........................ 240 Discount on bond investment (difference) ........ 40 Cash (price of bonds) .......................................... 200 Requirement 2 Cash (3% x $240 million) ....................................... 7.2 Discount on bond investment (difference) ............ .8 Interest revenue (4% x $200) .................................. 8.0 Requirement 3 Tanner-UNF reports its investment in the December 31, 2006, balance sheet at its amortized cost – that is, its book value: Investment in bonds ............................................ $240.0 Less: Discount on bond investment ($40 - .8 million) 39.2 Amortized cost ................................................ $200.8 If sale before maturity isn’t an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held- to-maturity” and reported at amortized cost rather than fair value in the balance sheet. Requirement 4 ($ in millions) Cash (proceeds from sale) ....................................... 190.0 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 EXERCISES 11 Exercise 12-2 November 1 ($ in millions) Cash ................................................................ 2.4 Investment 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) ....................... 0.8 Investment 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. Exercise 12-3 Investment in GM common shares ................ 41,200 Cash ([800 shares x $50] + $1,200) ................... 41,200 Cash ([800 shares x $53] – $1,300) ....................... 41,100 Loss on sale of investments ............................ 100 Investment in GM common shares ............ 41,200 12 Exercise 12-4 Requirement 1 ($ in 000s) 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. 13 Exercise 12-5 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. 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 [$58 - 60]) 20,000 Fair value adjustment .............................................................. 20,000 14 Exercise 12-5 (concluded) Requirement 3 December 31, 2007 Accumulated ($ in 000s) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2007 $600 $610 $10 Moving from a negative $20 (2006) to a positive $10 requires an increase of $30: -------------------------------------------------------- -20 0 +10 +30 -----------------------------> Fair value adjustment (10,000 shares x [$61 - 58]) ........................... 30,000 Net unrealized holding gains and losses (-$20 less $10) ............ 30,000 15 Exercise 12-6 Requirement 1 2006 March 2 ($ in millions) Investment in Platinum Gauges, Inc. shares ............................... 31 Cash ......................................................................................... 31 April 12 Investment in Zenith bonds ......................................................... 20 Cash ......................................................................................... 20 July 18 Cash ............................................................................................. 2 Investment revenue .................................................................. 2 October 15 Cash ............................................................................................. 1 Investment revenue .................................................................. 1 October 16 Cash ............................................................................................. 21 Investment in Zenith bonds ..................................................... 20 Gain on sale of investments ..................................................... 1 November 1 Investment in LTD preferred shares ........................................... 40 Cash ......................................................................................... 40 16 Exercise 12-6 (continued) December 31 Accumulated ($ in millions) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) Platinum Gauges, Inc. shares $31 $32* $1 LTD 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 ($71 – 69) ...................... 2 Fair value adjustment ($71 – 69) ............................................... 2 2007 January 23 ($ in millions) 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 ($76 x 500,000 shares) ............................................................. 38 Loss on sale of investments (difference) ........................................ 2 Investment in LTD preferred (cost) .......................................... 40 17 Exercise 12-6 (concluded) Requirement 2 2006 Income Statement ($ 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** ........................... $2 * Assuming Construction Forms chooses to report Other comprehensive income as an additional section of the income statement. Alternatively, it can report this (a) as part of the statement of shareholders’ equity or (b) as a separate statement in a disclosure note. Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale. 18 Exercise 12-7 Requirement 1 Purchase ($ in millions) Investment in Jackson Industry shares ........................................ 90 Cash ........................................................................................ 90 Net income No entry Dividends Cash (5% x $60 million) .................................................................. 3 Investment revenue .................................................................. 3 Adjusting entry 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. 19 Exercise 12-8 Requirement 1 2006 December 17 Investment in Grocers’ Supply preferred shares ................ 350,000 Cash ................................................................................. 350,000 December 28 Cash ..................................................................................... 2,000 Investment revenue .......................................................... 2,000 December 31 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) .................... 50,000 Note: Unlike for securities available-for-sale, unrealized holding gains and losses for trading securities are included in income. 20 Exercise 12-9 1. Investments reported as current assets. Security A $ 910,000 Security B 100,000 Security C 780,000 Security E 490,000 Total $2,280,000 2. Investments reported as noncurrent assets. Security D $ 915,000 Security 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 shareholders’ equity. Securities Available-for-Sale: Cost Fair value Unrealized gain (loss) Security C $ 700,000 $ 780,000 $80,000 D 900,000 915,000 15,000 Totals $1,600,000 $1,695,000 $95,000 21 Exercise 12-10 Requirement 1 Accumulated ($ in 000s) Unrealized 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 $25: -------------------------------------------------------- -170 -145 0 Fair value adjustment ($1,275,000 - 1,200,000) .......................... 75,000 Net unrealized holding gains and losses .......................... 75,000 22 Exercise 12-10 (concluded) Requirement 3 Accumulated ($ in 000s) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares – Dec. 31, 2006 $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) .......................... 175,000 Net unrealized holding gains and losses .......................... 175,000 23 Exercise 12-11 Requirement 1 The sale of the A Corporation shares decreased Harlon’s pretax earnings by $5 million. The purchase of the C Corporation shares had no effect on Harlon’s 2007 earnings. Here are the entries used to record those two transactions: June 1, 2007 ($ in millions) Cash 15 Loss on sale of investments (difference) 5 Investment in A Corporation shares (cost) 20 September 12, 2007 Investment in C Corporation shares 15 Cash 15 24 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 $101 million: December 31, 2007 ($ in millions) Cost, Dec. 31 Fair Value, Dec. 31 Securities Available-for-Sale 2006 2007 2006 2007 A Corporation shares $20 na $14 na B Corporation bonds 35 $35 35 $ 37 C Corporation shares na 15 na 14 D Industries shares 45 45 46 50 Totals $100 $95 $95 $101 Moving from a negative $5 (2006) to a positive $6 requires an increase of $11: --------------------------------------------------------- -5 0 +6 +11 -----------------------------> Fair value adjustment ($5 credit to $6 debit) 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 25 Exercise 12-13 Requirement 1 Purchase Investment in AMC common shares ................................... 480,000 Cash ............................................................................... 480,000 Net income No entry Dividends Cash (20% x 400,000 shares x $0.25) ......................................... 20,000 Investment revenue ......................................................... 20,000 Adjusting entry Fair value adjustment ($505,000 - 480,000) ............................ 25,000 Net unrealized holding gains and losses ......................... 25,000 Requirement 2 Purchase Investment in AMC common shares ................................... 480,000 Cash ............................................................................... 480,000 Net income Investment in AMC common shares (20% x $250,000) ........ 50,000 Investment revenue ......................................................... 50,000 Dividends Cash (20% x 400,000 shares x $0.25) ......................................... 20,000 Investment in AMC common shares .............................. 20,000 Adjusting entry No entry 26 Exercise 12-14 Purchase ($ in millions) Investment in Nursery Supplies shares .................................... 56 Cash .................................................................................... 56 Net income Investment in Nursery Supplies shares (30% x $40 million) ...... 12 Investment revenue .............................................................. 12 Dividends Cash (30% x 8 million shares x $1.25) ........................................... 3 Investment in Nursery Supplies shares ................................ 3 Adjusting entry No entry Exercise 12-15 Requirement 1 ($ in millions) Investment in equity securities ($48 million – 31 million) ........... 17 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 should be described in a disclosure note. 27 Exercise 12-16 1. Error discovered before the books are adjusted or closed in 2006. Investments ($100,000 – 80,000) ........................ 20,000 Gain on sale of investments .................... 20,000 2. Error not discovered until early 2007. Investments ($100,000 – 80,000) ........................ 20,000 Retained earnings .................................... 20,000 28 Exercise 12-17 Purchase ($ in millions) Investment in Carne Cosmetics shares ................................ 68 Cash ................................................................................ 68 Net income Investment in Carne Cosmetics shares (25% x $40 million) .. 10 Investment revenue .......................................................... 10 Dividends 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 ‡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] = $224 Adjusting entry No entry 29 Exercise 12-18 Requirement 1 Purchase ($ in millions) Investment in Lake Construction shares .............................. 300 Cash ................................................................................ 300 Net income Investment in Lake Construction shares (20% x $150 million) 30 Investment revenue .......................................................... 30 Dividends Cash (20% x $30 million)......................................................... 6 Investment in Lake Construction shares .......................... 6 Adjustment for depreciation Investment revenue ($10 million [calculation below‡] ÷ 10 years) 1 Investment in Lake Construction shares .......................... 1 ‡ calculation: Investee Net Assets Difference Net Assets Purchased Attributed to: ⇓ ⇓ ⇓ 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 300 Share of income 30 6 Dividends 1 Depreciation adjustment _________________ Balance 323 30 Exercise 12-18 (concluded) 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.] Exercise 12-19 1. b 2. b 3. b 31 Exercise 12-20 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 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 value of life insurance ($27,000 – 21,000) ..... 6,000 Cash (2006 premium) .......................................................... 70,000 Requirement 2 Cash (death benefit) ........................................................ 4,000,000 Cash surrender value of life insurance (account balance) 27,000 Gain on life insurance settlement (to balance) ........... 3,973,000 32 Exercise 12-22 Requirement 1 Insurance expense (difference) ....................................... 22,900 Cash surrender value of life insurance ($4,600 – 2,500) .. 2,100 Cash (premium) .......................................................... 25,000 Requirement 2 Cash (death benefit) ........................................................ 250,000 Cash surrender value of life insurance (account balance) 16,000 Gain on life insurance settlement (to balance) ........... 234,000 33 Exercise 12-23 ANALYSIS Previous Value: Accrued interest (10% x $12,000,000) $ 1,200,000 Principal 12,000,000 Carrying amount of the receivable $13,200,000 New Value: Interest $1 million x 1.73554 * = $1,735,540 Principal $11 million x 0.82645 ** = 9,090,950 Present value of the receivable (10,826,490) Loss: $ 2,373,510 * present value of an ordinary annuity of $1: n=2, i=10% ** present value of $1: n=2, i=10% JOURNAL ENTRIES 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) 34 Exercise 12-23 (concluded) Amortization Schedule – Not required Cash Effective Increase in Outstanding Interest Interest Balance Balance by agreement 10% x Outstanding Balance Discount Reduction 10,826,490 1 1,000,000 .10 (10,826,490) = 1,082,649 82,649 10,909,139 2 1,000,000 .10 (10,909,139) = 1,090,861* 90,861 11,000,000 2,000,000 2,173,510 173,510 * rounded 35 Exercise 12-24 ANALYSIS Previous Value: Accrued interest (10% x $240,000) $ 24,000 Principal 240,000 Carrying amount of the receivable $264,000 New 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% JOURNAL ENTRIES January 1, 2006 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 December 31, 2006 Note receivable (to balance) ........................................... 22,700 Interest revenue (10% x $226,997) .............................. 22,700 December 31, 2007 Note receivable (to balance) ........................................... 24,968 Interest revenue (10% x [$226,997 + 22,700]) .............. 24,968* Cash (required by new agreement) ..................................... 274,665 Note receivable (balance) .......................................... 274,665 * rounded to amortize the note to $274,665 (per schedule below) 36 Exercise 12-24 (concluded) Amortization Schedule – Not required Cash Effective Increase in Outstanding Interest Interest Balance Balance by agreement 10% x Outstanding Balance Discount Reduction 226,997 1 0 .10 (226,997) = 22,700 22,700 249,697 2 0 .10 (249,697) = 24,968* 24,968 274,665 47,668 47,668 * rounded 37 Problem 12-1 Requirement 1 ($ in millions) Investment in bonds (face amount) ........................ 80 Discount on bond investment (difference) ........ 14 Cash (price of bonds) .......................................... 66 Requirement 2 Cash (4% x $80 million) ......................................... 3.20 Discount on bond investment (difference) ............ .10 Interest revenue (5% x $66) .................................... 3.30 Requirement 3 Cash (4% x $80 million) ......................................... 3.20 Discount on bond investment (difference) ............ .11 Interest revenue (5% x [$66 + 0.1]) ........................ 3.31 Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2006, balance sheet at its amortized cost – that is, its book value: Investment in bonds ............................................................ $80.00 Less: Discount on bond investment ($14 –.1 –.11 million) 13.79 Amortized cost ................................................................ $66.21 Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant if sale before maturity isn’t an alternative. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities are classified as “held- to-maturity” and reported at amortized cost rather than fair value in the balance sheet. PROBLEMS 38 Problem 12-2 Requirement 1 ($ in millions) Investment in bonds (face amount) ........................ 80 Discount on bond investment (difference) ........ 14 Cash (price of bonds) .......................................... 66 Requirement 2 Cash (4% x $80 million) ......................................... 3.20 Discount on bond investment (difference) ............ .10 Interest revenue (5% x $66) .................................... 3.30 Requirement 3 Cash (4% x $80 million) ......................................... 3.20 Discount on bond investment (difference) ............ .11 Interest revenue (5% x [$66 + 0.1]) ........................ 3.31 Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2006, 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 ............................................................ $80.00 Less: Discount on bond investment ($14 –.1 –.11 million) 13.79 Amortized cost ................................................................ $66.21 Then, to record it at fair value, we increase the investment by $70 – 66.21 = $3.79 million: Fair value adjustment .............................. ........... 3.79 Net unrealized holding gains and losses ($70 – 66.21) 3.79 39 Problem 12-3 Requirement 1 2006 February 21 Investment in Distribution Transformers shares ........ 400,000 Cash ......................................................................... 400,000 March 18 Cash ............................................................................. 8,000 Investment revenue .................................................. 8,000 September 1 Investment in American Instruments bonds ............... 900,000 Cash ......................................................................... 900,000 October 20 Cash ............................................................................. 425,000 Investment in Distribution Transformers .............. 400,000 Gain on sale of investments ..................................... 25,000 November 1 Investment in M&D Corporation shares .................... 1,400,000 Cash ......................................................................... 1,400,000 40 Problem 12-3 (continued) December 31 Adjusting entries: Investment revenue receivable ..................................... 30,000 Investment revenue ($900,000 x 10% x 4/12) .............. 30,000 Accumulated Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) M & D Corporation shares $1,400,000 $1,460,000 $60,000 American Instruments bonds 900,000 850,000 (50,000) Totals – Dec. 31, 2006 $2,300,000 $2,310,000 $10,000* Fair value adjustment (calculated above) ........................ 10,000 Net unrealized holding gains and losses (change in accumulated balance) 10,000* * The $10,000 credit balance in the Net unrealized holding gains and losses is reported as Accumulated other comprehensive income, a component of Shareholders’ equity in the 2006 balance sheet. The $10,000 change in the accumulated balance is reported as 2006 Other comprehensive income. 41 Problem 12-3 (continued) Requirement 2 Income statement: Investment revenue ($8,000 + 30,000) $ 38,000 Gain 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. Other comprehensive income: Net unrealized holding gain on investments* $ 10,000 Balance sheet: Current Assets Investment revenue receivable $ 30,000 Securities available-for-sale $2,300,000 Plus: Fair value adjustment 10,000 $2,310,000 Shareholders’ Equity Accumulated 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. 42 Problem 12-3 (continued) Requirement 3 2007 January 20 Cash ............................................................................. 1,485,000 Gain on sale of investments (to balance) .................... 85,000 Investment in M&D Corporation shares (cost) ........ 1,400,000 March 1 Cash ............................................................................. 45,000 Investment revenue receivable ................................ 30,000 Investment revenue .................................................. 15,000 August 12 Investment in Vast Communications shares ............... 650,000 Cash ......................................................................... 650,000 September 1 Cash ............................................................................. 45,000 Investment revenue .................................................. 45,000 43 Problem 12-3 (continued) December 31 Adjusting entries: Investment revenue receivable ..................................... 30,000 Investment revenue ($900,000 x 10% x 4/12) .............. 30,000 Accumulated Unrealized Securities Cost Fair Value Gain (Loss) Vast Communication shares $650,000 $670,000 $20,000 American Instruments bonds 900,000 830,000 (70,000) Totals – Dec. 31, 2007 $1,550,000 $1,500,000 $(50,000)* Moving from a positive $10,000 (2006) to a negative $50,000 requires a decrease of $60,000: ------------------------------------------------------------------------------------------- -50,000 0 +10,000 * $42 + 25 (tax) ** at year-end 2003, the gross (pre-tax) accumulated unrealized holding gains were $38 + 23 = $61 million. December 31, 2004 ($ in millions) Fair value adjustment ($61 debit to $67 debit) ................... 6 Net unrealized holding gains and losses ($61 credit to $67 credit) 6 CASES 61 Case 12-1 (concluded) Requirement 3 No, this does not imply that the securities involved had not previously been written up above the original cost. Holding gains and losses from securities available-for- sale are included in earnings when they are realized by selling the securities. When Sprint sold the EarthLink securities, the fair value of the shares had apparently been written up in previous years (securities “primarily made up of EarthLink common stock” had produced unrealized holding gains). Those gains weren’t recognized in prior earnings because they weren’t yet realized by selling the investment. Now, the gain is recognized in 2004 when it is actually realized: ($ in millions) Cash (to balance) ................................................................. 8.59 Gain on sale of investments (given) ............................... 1.50 Investment in securities (determined below) .................... 7.09 Calculation of cost: $134.0 million Cost at 2003 year-end ÷ 18.9 million Shares at 2003 year-end $7.09 Average cost per share 1.0 million Shares sold $7.09 million Cost of shares sold 62 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. They 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. 63 Integrating Case 12-3 SFAS 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. 64 International Case 12-5 As stated in Renault’s disclosure note, France, like the United States, uses the “equity method.” However, unlike in the U.S., changes in the net assets of equity method investees are not reported in net income. Instead, investment revenue consists of dividends received. Another difference relates to non-equity investments. These are valued at the lower of cost or fair market value. In the U.S., they are classified as trading, available-for-sale, or held-to-maturity. Trading and available-for-sale securities are reported at fair value; held-to-maturity at amortized cost. Research Case 12-6 Answers 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. 65 Real World Case 12-7 Requirement 1 The 2004 balance sheet reports the following two current and one noncurrent asset categories ($ in millions): 2004 2003 CURRENT ASSETS: Cash and cash equivalents $2,878.8 $1,201.0 Short-term investments $4,211.1 $2,972.0 NONCURRENT ASSETS: Investments $ 6,727.1 $7,941.2 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. 66 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 and minority interests, 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. 67 Case 12-7 (continued) Requirement 3 Investments accounted for using the equity method are described in the note: 9. Joint Ventures and Other Equity Method Affiliates (in part) In 2000, the Company and Schering-Plough Corporation (Schering-Plough) entered into agreements to create separate equally-owned partnerships to develop and market in the United States new prescription medicines in the cholesterol-management and respiratory therapeutic areas. … The results from the Company’s interest in the Merck/ Schering-Plough partnership are recorded in Equity income from affiliates and were income of $132.0 million in 2004 and losses of $92.5 million and $147.4 million in 2003 and 2002, respectively. In addition, Merck earns certain Partnership returns, which are recorded in Equity income from affiliates. Such returns include a priority return provided for in the Partnership Agreement, variable returns based, in part, upon sales of certain former Astra USA, Inc. products, and a preferential return representing Merck’s share of undistributed AZLP GAAP earnings. These returns aggregated $646.5 million, $391.5 million and $640.2 million in 2004, 2003 and 2002, respectively. The decrease in 2003 is attributable to a reduction in the preferential return, primarily resulting from the impact of generic competition for Prilosec. Investments in affiliates accounted for using the equity method, including the above joint ventures, totaled $2.5 billion at December 31, 2004 and $2.2 billion at December 2003. These amounts are reported in Other assets. Dividends and distributions received from these affiliates were $587.0 million in 2004, $553.4 million in 2003 and $488.6 million in 2002. 68 Case 12-7 (concluded) Requirement 4 Merck reported losses from these investments in 2004, 2003, and 2002 ($ in millions): Equity income from affiliates (1,008.2 ) (474.2 ) (644.7 ) Unrealized holding gains and losses from available-for- sale securities are not reported in the income statement. Requirement 5 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 dissagregation 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. 69 Real World Case 12-8 Requirement 1 The note indicates Unrealized holding losses during 2004 in the amount of $1,846 million. This is not the amount Microsoft would include as a separate component of shareholders’ equity. Actually, the balance sheet amount is the Accumulated net unrealized holding gains. That is, over time, there have been, presumably, both unrealized gains and losses. This is the net, accumulated amount. The 2004 amount in the disclosure note is the 2004 addition to the accumulated amount. Requirement 2 Reclassification adjustment for losses included in net income refers to unrealized holding losses 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 2004, the entire decrease in the fair value of the shares since the investment was acquired was included in earnings. The portion of that decline that occurred prior to 2004, 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 2004 includes the $973 million realized losses. However, $973 million of that amount already has been reported in comprehensive income – as unrealized holding losses in periods when the price decline occurred. To avoid double-counting, Microsoft compensates by increasing comprehensive income by the $973 million of 2004 realized losses that already have been reported. That’s what the reclassification adjustment does; it adjusts this year’s comprehensive income by the amount that was reported previously to keep it from being reported twice. Requirement 3 In addition to net income, comprehensive income includes up to four other changes in equity: Net unrealized holding gains (losses) on investments, Net unrecognized loss on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign currency translation. Three of these – Net gains (losses) on derivative instruments, Net unrealized holding gains (losses) on investments, and Gains (losses) from foreign currency translation – are specifically mentioned in Microsoft’s disclosure note, so “other” refers to Net unrecognized loss on pensions. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
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