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Derivatives

This chapter discusses financial instruments, specifically investment securities and derivatives, detailing their definitions and accounting methods. It explains the differences in accounting for passive investments, such as held-to-maturity (HTM), trading (T), and available-for-sale (AFS) securities, including how unrealized gains or losses are recognized. The chapter emphasizes the fair value option for financial instruments and provides examples to illustrate the accounting implications of different classifications.

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0% found this document useful (0 votes)

15 views46 pages

Derivatives

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Available Formats

Download as PDF, TXT or read online on Scribd

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BEP172

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July 20th, 2012

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CHAPTER SEVEN

Financial Instruments: Investment Securities

and Derivatives
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From Financial Reporting Standards: A Decision-Making
Perspective for Non-Accountants
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By David T. Doran
(A Business Expert Press Book)
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© 2012 Business Expert Press

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Permissions@[Link] or 617.783.7860
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This document is authorized for educator review use only by Van Japheth Ancla, HE OTHER until September 2017. Copying or posting is an infringement of copyright.
Permissions@[Link] or 617.783.7860
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CHAPTER 7

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Financial Instruments:
Investment Securities
and Derivatives

yo Introduction
Financial instruments are defined as: cash, ownership interests in other
entities and contractual rights/obligations to receive/deliver financial
op
instruments in the future. We will discuss two forms of financial instru-
ments in this chapter. We first address accounting by investors who hold
debt and equity securities of other entities, followed by a discussion of
derivatives. Derivatives are financial instruments that “derive” their
value from some other item. For example, an option to purchase shares
of Ford Motor Co. stock at a set price derives its value from the mar-
tC

ket value of Ford’s stock, while credit default swaps derive their value
from the likelihood of borrower default (because they provide contractual
rights/obligations in such instances). The required accounting for invest-
ment securities and derivatives differs depending upon management
intent and/or circumstances. However, firms can elect the “fair value
option” in accounting for many financial instruments. The fair value
No

option allows balance sheet presentation at “fair value” while recognizing

fair value changes as gain or loss in net income.1 Although some invest-
ment securities and derivatives are already required to be accounted for
in that manner under GAAP, others are not. The fair value option is dis-
cussed after we present the otherwise required financial statement presen-
tation of investment securities and derivatives under GAAP.
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1
FASB ASC 825-10-35-4; Original pronouncement: Statement of Financial
Accounting Standard No. 159, “Fair Value Option for Financial Assets and Financial
Liabilities,” FASB, 2007.

Investment Securities
Firms commonly hold debt and equity securities of other entities as

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investments. Debt securities include bonds and other notes, commercial
paper, etc. Equity securities are stocks and other instruments representing
ownership interest in other entities. Debt securities are generally consid-
ered “passive” investments in that the investor is only seeking to earn a
return on invested funds, not gain the ability to influence the investee
firm. Debt security investments are consistently accounted for under the

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effective interest method with amortization of discount/premium increas-
ing/decreasing the carrying value of the investment to its maturity value
at the maturity date. The effective interest method was discussed primar-
ily from the borrower’s perspective in chapter 5. Since the investor’s appli-
cation of the effective interest method is the mirror image of that for the
borrower, it will not be repeated here. Equity holders may be considered
op
to be passive or “active” investors. Active investors are those with the abil-
ity to significantly influence the investee firm. Generally under GAAP,
ownership of less than 20% of a firm’s voting stock is considered a passive
investment, while ownership of 20% or more is considered active. Active
investments are accounted for under the equity method or through con-
tC

solidation, depending upon the degree of investor influence. If the equity

security investor can effectively control the investee firm, consolidation
is required. The equity method is applied when the investor can signifi-
cantly influence, but not control the investee firm. Accounting for passive
investments will be discussed first.
No

Passive Investments: Debt and Equity Securities2

The accounting for passive investments depends upon management
intent. “Trading” (T) securities are those intended to be held for a
very short period of time (typically hours or days, but not longer than
3 months). A good example of trading securities is an investment bank
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2
The discussion of accounting for passive investments is based upon FASB ASC 320;
Original Pronouncement: Statement of Financial Accounting Standard No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” FASB, 1993.

that holds debt and equity securities as inventory with the full intention
of imminent sale. “Held-to-Maturity” (HTM) securities are those where

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management has the intent and can demonstrate the ability (financial
wherewithal) to hold an investment until its maturity. Since equity secu-
rities have no maturity date, HTM securities include only debt instru-
ments. The default, catchall category for passive investment securities is
“Available-for-Sale” (AFS). All passive investments that are not classified
as T or HTM are accounted for as AFS securities.

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Held-to-Maturity (HTM) Securities

HTM securities are presented in the balance sheet at their amortized cost
based carrying value (CV) under the effective interest method. Exclusive
of default, the market and maturity value of debt securities will be equal
at the maturity date. So, if held to maturity, changes in market value
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are relatively less important. Disposal of HTM securities before maturity
should be rare, but if it occurs, gain or loss is recognized in net income as
the difference between net proceeds and CV at time of sale.
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Trading (T) and Available-for-Sale (AFS) Securities

Contrary to HTM securities, T securities and AFS securities are both

presented in the balance sheet at fair value (they are “marked to market”).
Publicly traded stocks and bonds that are widely held (called market-
able securities) have determinable fair value measures available through
quoted market prices.3 The securities are kept on the books at their cost
No

based CV and are written up or down to fair value (FV) using a “fair
value adjustment” (FVA) account. The FVA account relates to the entire
portfolio of T or AFS securities, serving as a negative/contra asset account
if portfolio’s FV < CV or a positive/adjunct asset account if the portfolio’s
FV > CV. On the balance sheet date, the FVA account is adjusted to its

3
Nonmarketable equity securities are outside the scope of ASC Topic 320, and are
generally not marked to market, but instead presented in the balance sheet at cost.
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Under ASC Topic 320, nonmarketable debt instruments are considered to have
determinable fair values computed by discounting the future cash flows using esti-
mated effective interest rates at the date of the financial statements.

appropriate amount and offset in the accounting equation through “unre-

alized” holding gain or loss recognition.

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The key distinction between T and AFS securities is how unrealized
gain or loss is recognized in the financial statements. Recall from previous
discussion that there are two components of comprehensive income (CI):
net income (NI) and other comprehensive income (OCI). Recall also that
most U.S. GAAP firms choose to present OCI in the statement of owners’
equity—not in combination with the income statement.4 For T securities

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unrealized holding gain/loss is recognized in NI (and subsequently closed
to retained earnings), whereas unrealized holding gain/loss on AFS securi-
ties is recognized in OCI (and subsequently closed to accumulated other
comprehensive income (AOCI).
Gain or loss is not considered “realized” until the security is sold or
otherwise disposed of. Realized gain or loss from the sale of T and AFS
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securities is recognized in NI in full, and computed as the difference
between sale proceeds and the individual security’s cost-based CV. To
avoid double counting, previously recognized unrealized holding gain
or loss must be reversed in the period of sale. The income reversal is
consistent with the original treatment of unrealized gain/loss recogni-
tion when the securities were marked to market (i.e., T securities in
tC

NI and AFS securities in OCI). Although the reversal entry can be

made at the time of sale, it is typically done when the entire portfolio
is marked to market through an adjusting entry made at the end of
the period.
Interest and dividends from both T and AFS securities are recognized
as investment revenue and included in NI. The effective interest method
No

is applied to determine investment revenue from debt securities5 whereas

dividends from equity securities are recognized in investment revenue
upon declaration by the investee firm.

4
As indicated in chapter 1, for fiscal years beginning after December 15, 2011, U.S.
GAAP will no longer allow presentation of OCI in the statement of stockholders’
equity (Accounting Standards Update No. 2011-05, June 2011 “Comprehensive in-
come (Topic 220) Presentation of Comprehensive Income).”
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5
Since trading securities are held for a very short period of time, and unrealized hold-
ing gain or loss is recognized in NI, many firms do not amortize discount or premium
on trading debt securities under the materiality constraint.

Example

The following example is used to illustrate the accounting differences

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due to HTM, T, and AFS classification. On 1/01/12 Behrend Corp.
purchased debt and equity securities of Gannon Corp. Behrend paid
$100,000 in exchange for 100 of Gannon’s $1,000 bonds that pay
10% interest annually on 12/31, and mature on 12/31/13.6 Behrend
also buys 1,000 shares of Gannon Corp stock for $100/share. Behrend
held no other investments on 1/01/12, therefore its total portfolio CV

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at 1/01/12 = $200,000 ($100,000 in debt securities and $100,000 in
equity securities). Assume that on 12/31/12 Gannon’s bonds are trad-
ing at 947 and their stock is trading at $120/share (total portfolio
FV = $214,000). In addition to paying interest due on 12/31/12
Gannon also declares and distributes a dividend of $5/share (interest
and dividends earned and received = $15,000). On 12/31/13 Gannon
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pays both maturity value ($100,000) and interest on its bonds, and also
declares and pays a $6/share dividend on its stock (interest and divi-
dends earned and received = $16,000). The Gannon stock is trading at
$99/share on 12/31/13 (portfolio FV = $99,000 versus CV = $100,000).
Behrend sells its entire investment in Gannon Corp. stock on 7/22/14
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for $102/share ($102,000).

Held-to-maturity (HTM) accounting—Debt securities only

This example will initially assume that Behrend’s debt security invest-
ment is classified as HTM. Since HTM securities include only debt
No

instruments, the illustration exclusively depicts Behrend’s accounting for

its investment in Gannon bonds. With HTM classification, we assume
Behrend’s management has the intent and can demonstrate the ability
to hold the Gannon Corp. bonds until their maturity on 12/31/13. We

6
Note that since Behrend buys the bonds at their face value, the effective rate is equal
to the stated rate of 10% so that no discount or premium amortization issues exist.
Do

7
Bond prices are frequently quoted as a percentage of par so that a $1,000 bond trad-
ing at 94 has a market value of $940 ($1,000 × 94%), and a $1,000 bond trading at
105 has a market value of $1,050 ($1,000 × 105%).

illustrate the financial statement implications of HTM classification using

the accounting equation format (in 000s):

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ASSETS = LIABILITIES + SE

2012
HTM Debt Security (Bond) purchase on 1/01/2012
+ HTM Sec. + 100
– Cash – 100

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The statement of cash flows will include an investing cash outflow of
$100,000.

HTM Security—Record 2012 interest received 12/31/2012

+ Cash + 10 + Invest. Rev. (NI) + 108
Note that HTM securities are not marked to market. HTM securi-
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ties appear on the balance sheet at carrying value with no recognition of
unrealized gain or loss. Since the maturity date is one year from 12/31/12,
the HTM investment would be included among current assets. To illus-
trate how stockholders’ equity is affected in the balance sheet, temporary
account closing is also presented:
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HTM Security—Close related temporary accounts on 12/31/2012

– Invest. Rev. (NI) – 10
+ Retained Earnings + 10

2013
HTM Security—Record 2013 interest received 12/31/2013
+ Cash + 10 + Invest. Rev. (NI) + 10
No

HTM Security—Record Bond maturity on 12/31/2013

– HTM Sec. – 100
+ Cash + 100

Consistent with the accounting by the borrower in chapter 5,

no gain or loss is recognized by the investor when a debt security’s

8
Note that if the bond investment was purchased at a discount or premium, inter-
Do

est revenue would have been increased or decreased for amortization and the HTM
security investment account balance increased or decreased, respectively to the matu-
rity value at the maturity date.

maturity value is collected at the maturity date. Recording the receipt

of debt’s maturity value simply involves recording an increase in cash

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and removing the security from the books. Note that cumulative net
income recognized equals the $20,000 total net cash flow from the
bond investment.

HTM Security—Close related temporary accounts on 12/31/2013

– Invest. Rev. (NI) – 10
+ Retained Earnings + 10

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Trading (T) and Available-for-Sale (AFS) Accounting—Debt
or Equity Securities

We now use the same example information to compare and contrast

the accounting assuming T or AFS security classification. Financial state-
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ment effects are first presented assuming T security classification and then
presented assuming AFS classification. Since T securities are bought and
sold within a very short period of time, assuming a 2-year holding period
is unreasonable from a technical perspective, and is only provided for
illustrative purposes. The financial statement implications of applying
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T versus AFS classification are presented using the accounting equation

format (in 000s):

ASSETS = LIABILITIES + SE

2012
T Securities purchased on 1/01/2012
No

+ T Debt Sec. + 100

+ T Equity Sec. + 100
– Cash – 200

AFS Securities purchased on 1/01/2012

+ AFS Debt Sec. + 100
+ AFS Equity Sec. + 100
– Cash – 200
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Note that financial statement effects are identical except for security
portfolio classification as T or AFS.

T Securities—Record 2012 interest of $10,000 and dividends of

$5,000 received on 12/31/12

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+ Cash + 15 + Invest. Rev. (NI) + 15

AFS Securities—Record 2012 interest of $10,000 and dividends of

$5,000 received on 12/31/12
+ Cash + 15 + Invest. Rev. (NI) + 15

Financial statement effects are identical. Dividends from both T

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and AFS equity securities are recognized as investment revenue when
declared. Investment revenue is consistently recognized under the effec-
tive interest method whether debt securities are classified as T, AFS,
or HTM.

T Securities—Mark to market on 12/31/2012 and recognize

unrealized holding gain/loss in NI
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+ FVA (T) Sec. + 14 + Unreal. Gain (NI) + 14

AFS Securities—Mark to market on 12/31/2012 and recognize

unrealized holding gain/loss in OCI
+ FVA (AFS) Sec. + 14 + Unreal. Gain (OCI) + 14
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The fair value adjustment (FVA) account is increased from 0 to $14,000

and represents the difference between the portfolio’s CV ($100,000 +
$100,000 = $200,000) and its FV ($94,000 (bonds) + $120,000
(stock) = $214,000). Since FV > CV, the FVA account will serve as a
positive/adjunct asset account and be added to the portfolio’s CV of
$200,000 for balance sheet presentation at $214,000 (FV). Although T
No

and AFS securities are both presented on the balance sheet at FV, the
offsetting recognition of unrealized holding gain or loss is different. NI
for 2012 will be $14,000 less under AFS classification because the net
unrealized gain is only recognized in OCI—not in NI.

T Security—Close related temporary accounts on 12/31/2012

– Invest. Rev. (NI) – 15
+ Retained Earnings + 15
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– Unreal. Gain (NI) – 14

+ Retained Earnings + 14

AFS Security—Close related temporary accounts on 12/31/2012

– Invest. Rev. (NI) – 15

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+ Retained Earnings + 15
– Unreal. Gain (OCI) – 14
+ AOCI:AFS Sec. + 14
Since retained earnings and AOCI are both stockholders’ equity
accounts, total stockholders’ equity is consistently increased by
$29,000 in 2012 regardless of T or AFS classification. The difference

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relates to the entire amount being included in retained earnings under
T security classification, whereas retained earnings and AOCI are
increased by $15,000 and $14,000 respectively under AFS security
classification.

2013
T Securities—Record 2013 interest of $10,000 and dividends of
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$6,000 received on 12/31/13
+ Cash +16 + Invest. Rev. (NI) + 16

AFS Securities—Record 2013 interest of $10,000 and dividends of

$6,000 received on 12/31/13
+ Cash + 16 + Invest. Rev. (NI) + 16
tC

The financial statement effects are identical and similar to those from
recognizing 2012 investment revenue except dividends increased from
$5/share = $5,000 to $6/share = $6,000 in 2013.

T Securities—Record cash receipt from bond maturity on 12/31/2013

– T Debt Sec. – 100

+ Cash + 100

AFS Security—Record cash receipt from bond maturity on 12/31/2013

– AFS Debt Sec. – 100
+ Cash + 100

Consistently applying the effective interest method (regardless of

T, AFS, or HTM classification) causes the debt security’s CV to equal
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its maturity value at the maturity date, and no gain or loss is recognized.

T Securities—Mark to market on 12/31/2013 and recognize

unrealized holding gain/loss in NI

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– FVA (T) Sec. – 15 + Unreal. Loss (NI) – 15

AFS Securities—Mark to market on 12/31/2013 and recognize

unrealized holding gain/loss in OCI
– FVA (AFS) Sec. – 15 + Unreal. Loss (OCI) – 15

The FVA account only relates to the remaining security—the Gannon

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Corp. stock. The FVA account has a positive/adjunct balance before adjust-
ment of $14,000 (see the 12/31/12 mark to market adjustment). Since
the FV of the Gannon stock is $99,000 at 12/31/13 ($99/share) and has a
cost-based CV of $100,000, the FVA account should have a negative/contra
balance of $1,000 after adjustment. We must reduce it by $15,000.

T Security—Close related temporary accounts on 12/31/2013

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– Invest. Rev. (NI) – 16
+ Retained Earnings + 16
– Unreal. Loss (NI) + 15
– Retained Earnings – 15

AFS Security—Close related temporary accounts on 12/31/2013

– Invest. Rev. (NI) – 16

+ Retained Earnings + 16
– Unreal. Loss (OCI) + 15
– AOCI: AFS Sec. – 15

Total stockholders’ equity is consistently increased in 2013 by $1,000

regardless of T or AFS classification. The entire increase is included in
No

retained earnings under T classification, whereas under AFS classifica-

tion, retained earnings is increased by $16,000 and AOCI is decreased by
$15,000. Note that after closing, the AOCI:AFS securities account has a
negative $1,000 balance (consistent with the negative balance in the FVA
account) and will appear in the 12/31/2013 balance sheet as a contra
stockholders’ equity account.
When securities are sold, realized gain or loss is determined based
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upon sale proceeds versus the cost based CV of the investment without
regard to any existing balance in the FVA account. This is the case across
all investment classifications.

2014
T Equity Securities sold on 7/22/2014

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– T Equity Sec. – 100 + Real. Gain (NI) +2
+ Cash + 102

AFS Equity Securities sold on 7/22/2014

– AFS Equity Sec. – 100 + Real. Gain (NI) +2
+ Cash + 102

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Assuming no further passive investment activity during 2014, Behrend
has no investment securities at 12/31/2014 (CV = FV = $0). The FVA
account needs to be brought to a zero balance, and since all gain or loss is
now realized (and recognized), unrealized gain or loss is reversed to avoid
double counting. The cumulative unrealized loss of $1,000 ($14,000
gain recognized in 2012 and $15,000 loss recognized in 2013) is reversed
consistent with initial recognition (NI for T securities versus OCI for
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AFS securities). A year-end adjustment is necessary to remove the FVA
account balance and reverse cumulative unrealized loss as follows:

T Securities—Adjustment at 12/31/14
+ FVA (T) Sec. +1 + Unreal. Gain (NI) +1
tC

AFS Securities—Adjustment at 12/31/2014

+ FVA (AFS) Sec. +1 + Unreal. Gain (OCI) +1

Closing the related temporary accounts has the following effects on

stockholders’ equity:
T Securities—Close related temporary accounts on 12/31/2014
No

– Real Gain (NI) –2

– Unreal. Gain (NI) –1
+ Retained Earnings +3
AFS Securities—Close related temporary accounts on 12/31/2014
– Real Gain (NI) –2
+ Retained Earnings +2
– Unreal. Gain (OCI) – 1
+ AOCI:AFS Sec. +1
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Before closing, the AOCI:AFS securities had a negative balance of

$1,000. After the closing, there is no balance in the AOCI related to the

AFS securities. Note also that upon entire investment portfolio liquida-
tion, cumulative net income of $33,000 is reflected in retained earnings

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regardless of T or AFS classification.
Net cash flow of $33,000 (2012 = <$185,000>, 2013 = $116,000,
2014 = $102,000) is equal to cumulative net income over the entire
investment period. Net income amounts differ between T and AFS
classification each period but in total equal the $33,000 net cash flow
(T: 2012 = $29,000, 2013 = $1,000 and 2014 = $3,000 versus AFS: 2012

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= $15,000, 2013 = $16,000 and 2014 = $2,000).

Additional Issues Regarding Passive Investments

We next discuss how changes in passive investment securities classifica-

tion are accounted for with related discussion of earnings management
opportunity. We then describe financial statement presentation issues
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related to passive investment securities.
As indicated previously, classification of passive investment securities
is based upon financial circumstances and management intent. Classifica-
tions need to be reassessed when financial statements are issued, which
may result in reclassification of investment securities. For example, finan-
tC

cial conditions may indicate that debt securities previously classified as

HTM must be reclassified as AFS or T because the firm can no longer
demonstrate the ability to hold them to maturity. When reclassification
occurs, the security is marked to market when transferred to the new cat-
egory. Depending upon the type of transfer, the accounting differs with
regard to the treatment of related unrealized gain or loss. All transfers into
No

or out of the T category require recognition in NI.9 All transfers between

HTM and AFS require recognition in OCI.10

9
Transfers to the T security classification will result in NI recognition of the full
amount of unrealized gain or loss since acquisition. Transfers from the T classification
will affect NI only to the extent that value has changed since previously being marked
to market (since previous changes in FV will have already been recognized in NI).
10
A complicating issue relates to transfers of debt securities from AFS to HTM. The
fair value at time of transfer becomes the CV of the debt and a new effective rate is
Do

determined. Over the remaining term of the debt interest revenue is recognized using
the new effective rate but is adjusted for amortization of any unrealized gain or loss
recognized in OCI at the time of transfer.

Firms with AFS securities have the capability of increasing or decreas-

ing NI11 by selling particular securities from their AFS and HTM port-

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folios or reclassifying them as T. Holding gain or loss on AFS and HTM
securities impacts NI in the period realized through their sale or reclas-
sification as T securities. Since the period of sale or reclassification can
be a matter of management discretion, accounting for AFS and HTM
securities provides an earnings management opportunity. In our previous
example, management can increase 2012 income by as much as $20,000

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(by selling or reclassifying as T its entire investment in Gannon stock) or
decrease income by as much as $6,000 (by selling or reclassifying as T its
entire investment in Gannon bonds). Choosing to sell or reclassify partic-
ular AFS and HTM securities in order to manage earnings is sometimes
referred to as “cherry picking.” This opportunity doesn’t exist for securi-
ties initially classified as T because market valuation—not management
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discretion, determines the holding gain or loss included in NI.
Passive investments in T securities appear among current assets on the
balance sheet. HTM securities are presented as long-term assets unless
maturity is within one year of the balance sheet date. AFS securities
should be presented as current assets if management holds them as a ready
source of cash should the need arise. If management intends to hold AFS
tC

securities for more than one year they should be included among long-
term assets. For purposes of the statement of cash flows, all dividends
and interest received are considered operating under U.S. GAAP, but are
classified as either operating or investing under IFRS. Cash flows from
purchase and sale of passive investments should be included in investing
cash flows. The only exception may relate to T securities. If purchase and
No

sale of T securities is considered part of normal operations (e.g., an invest-

ment banking firm), all related cash flows should be considered operating.

Active Investments
Investment in equity securities may enable the investor to influence the
operating and financing decisions of the investee firm. Depending upon
Do

the degree of influence, the investor may be required to either apply the

11
Recall that only items included in NI affect reported earnings-per-share amounts.

equity method or issue consolidated financial statements. Consolidated

financial statements are required when the investor controls the investee

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firm. The equity method is applied when the investor has the ability to
significantly influence (but not control) the investee firm. We initially dis-
cuss the equity method of accounting and subsequently address issuance
of consolidated financial statements.

Equity Method of Accounting

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Since dividends are included in NI under AFS accounting, its use is
inappropriate in cases where the investor holds a sufficient voting inter-
est to influence the dividend making decisions of the investee firm.
Dividends are declared at the discretion of a firm’s board of directors. If
the investor can influence the dividend making decisions of the investee
firm, they can indirectly control the timing and amount of investment
op
revenue reported in its own income statement under AFS accounting.
Unlike AFS accounting, the equity method does not treat dividends
as investment revenue, but instead treats dividends as reductions of
CV (dividends are treated as a return of capital, not return on capital).
Equity method investment income or loss is recognized as a proportion-
tC

ate share of the investee’s reported income or loss for the period, and
is offset in the accounting equation with an increase or decrease in the
investment’s CV. Equity method investments are not marked to market
so there is no recognition of unrealized gain or loss, and realized gain or
loss recognition is the difference between sale proceeds and CV of the
investment sold.
No

The equity method is deemed appropriate in instances where the

investor has the ability to exercise “significant influence” over the inves-
tee firm. Unless there is evidence to the contrary, GAAP assumes that
owning a voting interest between 20 and 50% indicates that significant
influence exists and the equity method is appropriate. The equity method
can be applied in situations where voting interest is less than 20% and
not applied in situations where voting interest is 20–50%; however, the
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burden of proof is on the investor firm to show that significant influence

does or does not exist, respectively. Consider these situations: 1) if an

investor holds 18% of a firm’s voting stock, but the remaining 82% is
widely held with the next largest holder owning only .01%, the equity

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method may be appropriate; and 2) if an investor holds 30% of a firm’s
voting stock, but the remaining 70% is owned by another entity that acts
without regard to the 30% investor’s interests, the equity method may
not be appropriate.
To illustrate the equity method, consider the case of Behrend Corp.
purchasing 25% of the stock of FWC Corp. on 1/01/12 for $50,000.

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The balance sheet of FWC Corp. on 1/01/12 is illustrated in Exhibit 7.1.
Note that FWC’s total book value (or net assets = assets – liabilities) at
1/01/12 is $200,000 ($1,000,000 – $800,000), and Behrend pays an
amount equal to the book value acquired ($200,000 × 25% = $50,000).
Also, we initially assume that all assets and liabilities of FWC have fair
values equal to their book values. During 2012 FWC reports income of
op
$100,000 and pays dividends of $40,000 as reported in the combined
statement of income and retained earnings illustrated in Exhibit 7.2.
The fair value of Behrend’s investment in FWC Corp. stock on 12/31/12
is $70,000.
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Exhibit 7.1. FWC Corp. Condensed Balance Sheet

1/01/2012 (All Amounts in 000s)
Assets:
Cash $100
Accounts Rec. (net) 100
Inventory 300 $500
Operational assets (net) 500
No

Total Assets $1,000

Liabilities:
Accounts Payable $300
Long-Term Debt 500 $800
Stockholders’ Equity:
Paid in Capital $100
Retained Earnings 100 200
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Total Liabilities and $1,000

Stockholders’ Equity

Exhibit 7.2. FWC Corp. Combined Statement of Income and

Retained Earnings Year Ended 12/31/2012 (All Amounts in 000s)

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Revenue $700
Cost of Goods Sold –400
Gross Proﬁt $300
Operating Expenses (Including Depreciation) –150
Income from Continuing Operations Before Tax $150
Income Tax –50
Net Income $100

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Retained Earnings 1/01/2012 100
Less Dividends 2012 – 40
Retained Earnings 12/31/2012 $160

The financial statement implications of applying the equity method

are presented using the accounting equation format (in 000s):
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ASSETS = LIABILITIES + SE

Behrend records its equity method investment in FWC Corp.

purchased on 1/01/2012
+ Invest. in FWC + 50
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– Cash – 50

Note that FWC makes no entry related to sales/purchases of its stock

in the secondary market.12
FWC dividends declared and received by Behrend during 2012
+ Cash + 10
– Invest. in FWC – 10
No

Although dividends received under the equity method are not recog-
nized in NI, consistent with T and AFS securities, dividends are considered
operating for purposes of presentation in the statement of cash flows.13

12
Trading of stocks and bonds between investors is referred to as the “secondary
market.” Initial issuance of stocks and bonds by a corporation is referred to as the
“primary market.” With the exception of the fair value option for a firm’s debt, trading
Do

by investors in the secondary market is not reflected in the issuing firm’s financial
statements.
13
FASB ASC 230-15-55-10; Original pronouncement: Statement of Financial
Accounting Standard No. 95, “Statement of Cash Flows,” FASB, 1987, par. 131.

FWC reports income of $100,000 for 2012

+ Invest. in FWC + 25 + Invest. Rev. (NI) + 25

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Under the equity method, investment revenue is recognized in the
amount of the proportionate reported income of the investee firm (25%).
Since investments are not marked to market under the equity method,
FWC’s market value of $70,000 at 12/31/12 is ignored. Note that the
book value of FWC increased by $60,000 during 2011 (Income of
$100,000 – dividends of $40,000), and the investment in FWC account

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increased proportionately ($60,000 × 25% = $15,000) under the equity
method ($25,000 – $10,000).
Investee firms usually have a fair value greater than their book value,
requiring the investor to pay an amount in excess of the proportionate
share of net assets reported in the investee firm’s balance sheet at the time
of acquisition. The excess payment should be explained to the extent pos-
op
sible by identifying differences in book value and fair value of the inves-
tee’s assets and liabilities at the time of acquisition, with any remaining
excess attributed to goodwill. Subsequently, investment revenue recog-
nized under the equity method will require adjustment for related income
statement effects (e.g., a difference in book and fair value associated with
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inventory would impact cost of goods sold in the period of sale, any dif-
ference associated with operational assets would impact depreciation or
amortization expense over its remaining service life, any difference associ-
ated with long-term debt would impact interest expense over the remain-
ing term of the debt, etc.).
We continue the FWC equity method example with a simple intro-
No

duced complication. Although FWC presents the same balance sheet on

1/01/12 (Exhibit 7.1), we now assume that Behrend pays $80,000 for
its 25% voting stock interest, and that FWC has equipment included in
operational assets that is undervalued by $40,000 (fair value = $140,000
and book value = $100,000) with remaining service life of 5 years. We
continue to assume all other FWC assets and liabilities have fair values
equal to their book values. The payment in excess of book value is first
identified with specific assets and liabilities that are under/overvalued,
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and any remaining unidentified excess payment attributed to goodwill.

Recall from chapter 4 that goodwill is determined as the residual amount
paid over the fair value of a business’s net identifiable assets acquired.

In chapter 4 we assumed the entire business (100%) was acquired. Here

we adapt that procedure since only 25% of FWC is purchased.

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Amount paid: $80,000
Book value acquired 50,000 ($200,000 × 25%)
Excess payment $30,000
Undervalued equipment −10,000 ($40,000 × 25%)
Goodwill $20,000

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Since FWC uses its assets’ book values to determine income state-
ment expense amounts, an adjustment for FWC’s understated deprecia-
tion is needed. The equipment’s annual depreciation expense (included in
operating expenses) recognized by FWC = $20,000 ($100,000/5 years),
whereas from Behrend’s perspective (since it paid fair value—not book
value) depreciation should be $28,000 ($140,000/5 years). Behrend will
reduce investment revenue by $2,000/year for 5 years with offsetting
op
reduction of the investment account’s carrying value. The underlying
logic for the adjustment is that from the investor’s perspective, FWC’s
income each year 2012–2016 is overstated by $8,000 and Behrend’s
share is 25% (8,000 × 25% = $2,000). Recall from chapter 4 that the
intangible asset goodwill is not amortized because it has “indefinite life.”
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Therefore no goodwill related adjustment to investment revenue is made

under the equity method.14 The following adjustment to investment rev-
enue and the investment account for each year 2012–2016 (in 000s) is
as follows:

ASSETS = LIABILITIES + SE
No

Behrend adjusts 2012, 2013, 2014, 2015 and 2016 investment

revenue for understatement of FWC’s depreciation expense
– Invest. in FWC – 2 – Invest. Rev. (NI) – 2

The amount of investment revenue recognized in 2012 is $23,000,

and is equal to FWC’s adjusted income of $92,000 ($100,000 – $8,000) ×
25%. Note that after five years, the balance in the investment account
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14
Unlike goodwill that appears as an intangible asset in the balance sheet, the implied
goodwill amount included in the investment account under the equity method is not
annually tested for impairment.

will be equal to 25% of FWC’s book value plus the $20,000 originally
attributed to goodwill. With the possible exceptions of recognizing

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“impairment loss” or electing the “fair value option” (discussed later),
postacquisition changes in fair values are ignored under the equity method.
The equity method of accounting is referred to as a “one line consoli-
dation.” The reason for this terminology will become apparent after we
next address consolidated financial statements.

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Consolidated Financial Statements

In chapter 4 we discussed how one firm gains control of another through

direct purchase of its assets and assumption of its liabilities. In such
instances, the form and the substance of the business acquisition are one
and the same. The acquired firm ceases to exist as a going concern, and
op
the acquiring firm records the acquired firm’s assets and liabilities directly
on its books. Consolidated financial statements are required when one
firm controls another firm indirectly, usually through a majority owner-
ship interest in another firm’s voting stock. Holding a majority interest in
a firm’s voting stock enables the investor to select the investee firm’s board
of directors who hires and fires the managers who make the day-to-day
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operating decisions of the investee firm. In form, two separate legal enti-
ties continue to exist (and maintain their own self balancing set of books);
however, in substance there is one economic entity. In majority voting
interest situations, the investor firm is referred to as the “parent” (P) and
the investee firm is called a “subsidiary” (S). The objective of consolida-
tion is to issue one complete set of financial statements for the P and its
No

one or more S(s) as if there was just one set of books maintained by the
one economic entity (as was the case in chapter 4 with direct purchase of
assets and assumption of liabilities).
There are many reasons why a corporation may want to indirectly
control another firm rather than hold a direct ownership interest. One
reason may involve minimizing legal liability. For example, assume that
“FWC” stands for FireWorks Complete and FWC is a manufacturer
Do

and distributor of fireworks. By holding stock of FWC rather than

owning it outright, if FWC is sued, Behrend may be able to protect
its own assets and limit potential loss to the amount of its investment.

Also, a firm can gain control of 100% of a firm’s operations by acquir-

ing less than 100% of its stock, and in doing so leverage its investment

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dollar.
Although the P does not record the assets and liabilities of the
S directly in its own accounts, it must somehow keep track of its invest-
ment in the S for record keeping purposes. GAAP dictates financial
reporting requirements but recordkeeping is at the discretion of the
firm.15 For purposes of illustration we will assume that the P applies

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the equity method of accounting for internal record keeping purposes
and subsequently applies procedures that result in consolidated finan-
cial statements.16
We continue using FWC Corp. as our example based upon its
1/01/2012 balance sheet presented in Exhibit 7.1. We initially assume
that Behrend acquires 100% of FWC’s stock for its book value of
op
$200,000, and all FWC assets and liabilities have fair values equal to
their book values. Behrend records the investment in FWC as follows
(amounts in 000s):

ASSETS = LIABILITIES + SE

Behrend records its equity method investment in FWC Corp.

purchased on 1/01/2012
+ Invest. in FWC + 200
– Cash – 200

Exhibit 7.3 illustrates a consolidation worksheet immediately after

acquisition. The consolidation worksheet is a tool used in transform-
ing the individual account balances on the books of the P and its S(s)
No

to the appropriate consolidated amounts as if there were just one set of

books maintained by the one economic entity. We assume the books are
closed on 12/31/2011 and the FWC stock acquisition is Behrend’s first
transaction in 2012. As such, only balance sheet information is included.

15
Recall from chapter 1 discussion that there are no “Generally Accepted Recording
Principles” (GARP).
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16
Consolidation accounting is covered extensively in the advanced financial account-
ing course. Most advanced accounting texts primarily assume the P’s use of the equity
method for internal recordkeeping purposes.

Exhibit 7.3. Consolidation Worksheet At 1/01/2012 Purchase 100%

of FWC Stock at BV (In 000s)

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P S
Behrend FWC Consolidation Consolidated
Corp. Corp. adjustments amounts
Assets:
Cash 1,800 100 1,900
Accounts Receivable 500 100 600
(net)

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Inventory 500 300 800
Investment in FWC 200 – <200> –
Operational assets 2,000 500 2,500
(net)
Total Assets 5,000 1,000 <200> 5,800
Liabilities:
Accounts Payable 500 300 800
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Long-Term Debt 500 500 1,000
Stockholders’ Equity:
Paid In Capital 1,000 100 <100> 1,000
Retained Earnings 3,000 100 <100> 3,000
Total Liabilities and SE 5,000 1,000 <200> 5,800
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Behrend’s amounts are assumed except for the “investment in FWC”

account balance of $200,000 resulting from the FWC stock acquisi-
tion illustrated above. Note again that FWC makes no entry related
to the acquisition of its stock by Behrend, so its amounts are consist-
ent with those presented in Exhibit 7.1. A consolidated balance sheet
No

should include the combined assets and liabilities of the P and its S(s)
(Behrend and FWC in our example). The worksheet sums across from
left to right, where the far right column is usually a summation of the
P and S amounts (e.g., consolidated cash of $1,900,000 includes the P’s
cash of $1,800,000 and the S’s cash of $100,000), which appears in the
consolidated balance sheet. If the summation is not the appropriate con-
solidated amount, a worksheet “adjustment” is made. Since the S’s assets
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and liabilities are included in the consolidated balance sheet amounts,

also including the P’s investment in S (FWC) account would be double
counting; so a worksheet “adjustment” eliminates “Investment in FWC”

so that it does not appear in the consolidated balance sheet. Also, since
the P’s stockholders are the owners of the economic entity, the equity

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accounts of the S are eliminated so that consolidated owners’ equity is
that of the P.
Before proceeding to the other consolidated statements, we rein-
troduce the complication of Behrend paying more than the book value
acquired because FWC has equipment on its books that is undervalued by
$40,000. Any remaining excess payment is again attributed to goodwill. In

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our equity method example, we assumed that Behrend paid $80,000 for a
25% interest. We now assume that on 1/01/2012 Behrend pays $320,000
for 100% of FWC’s stock.17 We again assume FWC has equipment with
undervalued book value of $40,000 that has a remaining service life of
5 years. Similar to our equity method example, we determine the amount
of goodwill at acquisition as the unidentifiable excess amount paid:
op
Amount paid $320,000
Book value acquired 200,000 ($200,000 × 100%)
Excess payment $120,000
Undervalued equipment –40,000 ($40,000 × 100%)
Goodwill $80,000
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Behrend records the investment in FWC as follows (amounts in 000s):

ASSETS = LIABILITIES + SE

Behrend records its equity method investment in FWC Corp.

purchased on 1/01/2012
+ Invest. in FWC + 320
No

– Cash – 320

Exhibit 7.4 illustrates a consolidation worksheet immediately after

acquisition with the excess payment of $40,000 specifically assigned
to undervalued equipment and $80,000 attributed to goodwill. Note
that the consolidated balance sheet includes the S’s identifiable assets

17
Investors may need to pay a higher amount (a premium) to gain control of another
Do

firm. Such “control premium” generally results in higher amounts of goodwill report-
ed in the consolidated balance sheet. For purposes of simplification, control premium
is ignored in this example.

Exhibit 7.4. Consolidation Worksheet on 1/01/2012 Purchase 100%

of FWC Stock at $120,000 More Than BV (In 000s)

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P S
Behrend FWC Consolidation Consolidated
Corp. Corp. adjustments amounts
Assets:
Cash 1,680 100 1,780
Accounts Receivable 500 100 600
(net)

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Inventory 500 300 800
Investment in FWC 320 –320 –
Operational assets 2,000 500 +40 2,540
(net)
Goodwill – – +80 80
Total Assets 5,000 1,000 –200 5,800
Liabilities:
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Accounts Payable 500 300 800
Long Term Debt 500 500 1,000
Stockholders’ Equity:
Paid In Capital 1,000 100 –100 1,000
Retained Earnings 3,000 100 –100 3,000
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Total Liabilities and SE 5,000 1,000 –200 5,800

and liabilities at FV (operational assets are increased by $40,000 for the

undervalued equipment) and goodwill of $80,000 is also included. Note
also that consistent with Exhibit 7.3, consolidated stockholders’ equity is
that of the P and the investment in FWC account is eliminated.
No

Assuming the equity method is used for recordkeeping purposes

Behrend’s accounts would be affected as follows in 2012 (in 000s):

Dividends declared and received from FWC during 2012

+ Cash + 40
– Invest. in FWC – 40

FWC reports income of $100,000 for 2012

+ Invest. in FWC +100 + Invest. Rev. (NI) + 100
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Again under the equity method, since FWC uses its assets’ book
values to determine NI, we recognize an annual adjustment associated

with the understatement of depreciation expense on the undervalued

equipment. As discussed previously, the equipment’s annual depreciation

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expense (included in operating expenses) recognized by FWC = $20,000
($100,000/5 years); whereas from Behrend’s perspective (since it paid fair
value—not book value) depreciation should be $28,000 ($140,000/5
years). Since Behrend owns 100% of FWC it reduces investment rev-
enue by the full $8,000 per year for 5 years with offsetting reduction
of the investment account’s carrying value. Again, the intangible asset

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goodwill is not amortized because it has “indefinite life,” so no good-
will related adjustment to investment revenue would be made under the
equity method. Assuming the equity method is used for recordkeeping
purposes Behrend’s accounts would be affected each year 2012–2016 as
follows (in 000s):
ASSETS = LIABILITIES + SE
op
Behrend adjusts 2012 (2013, 2014, 2015 and 2016) investment
revenue for understatement of FWC’s depreciation expense
– Invest. in FWC – 8 – Invest. Rev. (NI) – 8
Note that the investment in FWC account balance is now $372,000
(320,000 + 100,000 – 40,000 – 8,000) and investment revenue is $92,000
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(100,000 – 8,000).
The consolidation worksheet in Exhibit 7.5 includes the income
statement accounts of P and S for the year 2012 and the individual
balance sheet accounts of the P and S on 12/31/2012. FWC’s income
statement and retained earnings related accounts were taken from
Exhibit 7.2. All remaining FWC account balances are assumed. All of
No

Behrend’s account balances are assumed with the exception of investment

in FWC = $372,000 and investment revenue = $92,000.
Concentrating on the income statement, note that the revenues and
expenses of FWC are included in the consolidated income statement with
one adjustment that increases operating expenses by $8,000. This is the
adjustment necessary to report the appropriate amount of depreciation
expense on the undervalued equipment. This same adjustment will be
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made for the consolidated income statements of 2013, 2014, 2015, and
2016. The equipment will be fully depreciated by the end of 2016 and
no longer require adjustment (FWC’s book value based depreciation will

Exhibit 7.5. Consolidation Worksheet Year Ending 12/31/2012

Purchase 100% of FWC Stock at $120,000 More Than BV (In 000s)

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Statement of income P S
and retained Behrend FWC Consolidation Consolidated
earnings—2012 Corp. Corp. adjustments amounts
Revenue 2,908 700 3,608
Cost of Goods Sold 1,000 400 1,400
Gross Proﬁt 1,908 300 2,208
Operating Exp. 800 150 +8 958

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(Incl. Depr.)
Operating Income 1,108 150 1,250
Investment Revenue– 92 – –92 –
FWC
Income Before Tax 1,200 150 1,250
Income Tax 400 50 450
Net Income 800 100 800
op
Retained Earnings 3,000 100 –100 3,000
1/1/2012
Less Dividends 2012 500 40 –40 500
Retained Earnings 3,300 160 –160 3,300
12/31/2012
Balance Sheet at
tC

12/31/2012
Assets:
Cash 2,000 150 2,150
Accounts Receivable 450 350 800
(net)
Inventory 550 100 650
Investment in FWC 372 – –372 –
No

Operational assets (net) 1,900 450 +32 2,382

Goodwill – – +80 80
Total Assets 5,272 1,050 –260 6,062
Liabilities:
Accounts Payable 472 290 762
Long-Term Debt 500 500 1,000
Stockholders’ Equity:
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Paid In Capital 1,000 100 –100 1,000

Retained Earnings 3,300 160 –160 3,300
Total Liabilities and SE 5,272 1,050 –260 6,062

thereafter equal depreciation expense from the perspective of the economic

entity). Notice also that the investment revenue account ($92,000) does

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not appear in the consolidated income statement. This prevents double
counting of the S’s 2012 income in consolidated net income. The follow-
ing FWC income items will appear in the consolidated income statement:

Revenue $ 700,000
Cost of Goods Sold – 400,000
Operating Expense – 158,000 (150,000 + 8,000

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(including depreciation) depreciation adjustment)
Income Tax – 50,000
S’s Consolidated Net Income Effect $92,000

This is why the equity method is referred to as a “one line consoli-

dation” in reporting investment revenue. Under the equity method,
$92,000 of investment revenue is included in the investor’s income state-
op
ment; whereas the S’s detailed income statement elements are included in
a consolidated income statement.
Regarding the statement of retained earnings, note that consolidated
amounts relate exclusively to the P. In cases of 100% ownership interest,
the P’s stockholders are the owners of the economic entity.18 S dividends
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paid to the parent are nonevents from the viewpoint of the economic
entity and they do not appear in the statement of cash flows because no
cash has left the consolidated entity. Consolidated stockholders’ equity is
that of Behrend (the P), the S’s stockholders’ equity accounts are elimi-
nated through consolidation adjustment.
The consolidated balance sheet excludes the investment in FWC
No

account. Instead, the individual assets and liabilities of the S are included.
As we discussed in chapter 4, goodwill needs to be tested for impairment
annually. We assume no goodwill impairment exists at 12/31/2012 and
therefore it continues to be included in the consolidated balance sheet
at $80,000. Consolidation adjustment increased operational assets by
$40,000 on 1/01/2012, but only by $32,000 at 12/31/2012. The origi-
nal $40,000 undervaluation of equipment has been recognized to the
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extent of 2012’s consolidation adjustment that increased depreciation

18
Less than 100% ownership complications will be discussed later.

by $8,000. As discussed above, the remaining $32,000 undervalua-

tion will be recognized by increasing depreciation expense over the next

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4 years at $8,000/year. The adjustment to increase operational assets
will be $24,000, $16,000, and $8,000 at 12/31/2013, 12/31/2014, and
12/31/2015, respectively. No consolidation adjustment to operational
assets will occur at 12/31/2016 and beyond because the original $40,000
undervaluation will have been fully recognized. The 12/31/2012 con-
solidated balance sheet includes the following assets and liabilities related

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to FWC:

Cash $150,000
Accts. Rec. (net) 350,000
Inventory 100,000
Operational Assets (net) 482,000 (450,000 + 32,000 consolidation adj.
for undervalued equipment)
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Goodwill 80,000 (entirely through consolidation adj.)
Accounts Payable – 290,000
Long-Term Debt – 500,000
Net Assets Included $372,000

Note that $372,000 is the balance in the investment in FWC

account that would be presented in the investor’s balance sheet under

the equity method of accounting. This is the rationale for terming the
equity method a “one line consolidation” as it relates to the balance
sheet.
No

Additional Issues Related to Consolidation

In this section we first discuss the required accounting when the P Corp.
owns less than 100% of the S’s stock. We then discuss the consolidation
issues related to transactions between separate legal entities of the consoli-
dated economic entity. Specifically we discuss “intercompany” sales and
“intercompany” payables/receivables.
Consolidated financial statements are usually required when a P owns
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more than 50% of another firm’s voting stock. When a P controls the S
with less than 100% ownership, the consolidated income statement still
includes all revenues and expenses of the S, and the consolidated balance

sheet still includes all of the S’s assets and liabilities.19 Therefore the por-
tion of the S not owned by the parent, termed “noncontrolling interest”

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needs to be presented in the consolidated balance sheet and the “non-
controlling interest’s share of S income” must be deducted to arrive at
the consolidated net income to the “controlling interests.” We again use
Behrend’s acquisition of FWC on 1/01/2012 to illustrate. Previously, we
assumed that Behrend purchased 100% of FWC’s stock for $320,000.
Let’s now assume that Behrend purchased 75% of FWC’s stock for

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$240,000 ($320,000 × 75% = $240,000). The consolidated balance
sheet on 12/31/2012 will include the same asset and liability amounts
as presented in Exhibit 7.5. However, consolidated stockholders’ equity
will include “noncontrolling interest” in the amount of $93,000. This
equals the noncontrolling interest’s share in S net assets that are included
in the consolidated balance sheet ($372,000 × 25%). The consolidated
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income statement will include the S’s revenues and expenses as depicted
in Exhibit 7.5. Recall that the S’s contribution to consolidated net
income was $92,000. Noncontrolling interest’s share of S income in the
amount of $23,000 ($92,000 × 25%) will appear as a deduction (similar
to an expense) in determining consolidated net income to the “control-
ling interest.” Also, even though consolidated dividends are those of the
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parent (as depicted in Exhibit 7.5), the dividends paid by the S to the
noncontrolling interest are included in the statement of cash flows as
a financing cash outflow. The P’s stockholders constitute the “control-
ling interest,” and consolidated financial statements are intended to meet
their decision making needs. The separate financial statements of the S
are better suited to meet the decision making needs of noncontrolling
No

shareholders.
Frequently the P and S engage in “intercompany sales.” Intercom-
pany sales are those between the separate legal entities that make up the
one economic entity. From the viewpoint of the economic entity, the

19
Including only the P’s portion (e.g., 75%) is referred to as “proportionate consoli-
dation.” Proportionate consolidation is not permitted under U.S. GAAP. Previously,
Do

proportionate consolidation was an allowed alternative to the equity method for firms
under IFRS. However, consistent with U.S. GAAP firms with significant influence
must now apply the equity method under IFRS.

consolidated income statement should not include any sales revenue

or cost of goods sold (gross profit or loss) from intercompany “sales”

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until it is legitimately realized through sale to an unrelated third party,
and inventory should be included in the consolidated balance sheet at
its true cost to the economic entity. If the P and S record intercom-
pany transfers in their separately maintained books, adjustments will be
required in the consolidation worksheet to assure that the consolidated
financial statements report the correct (realized) amounts. For example,

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assume that Behrend records an intercompany cash “sale” of inventory
with a cost of $100,000 to FWC for $140,000 on 11/30/2012. The
intercompany sale would affect the accounts of Behrend and FWC as
follows (in 000s):

ASSETS = LIABILITIES + SE
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Behrend records intercompany sale of inventory costing
$100,000 to FWC for $140,000 on 11/30/2012
+ Cash + 140 + Sales Revenue + 140
– Inventory – 100 + Cost Goods Sold – 100

FWC records the intercompany purchase of inventory

from Behrend for $140,000

+ Inventory + 140
– Cash – 140

If FWC continues to hold the inventory on 12/31/2012, a legitimate

sale has not occurred because the inventory continues to be held within
the economic entity. A worksheet adjustment must be made reducing
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sales revenue by $140,000 and cost of goods sold by $100,000. Without

adjustment consolidated gross profit would be overstated by $40,000.
Also, since FWC carries the inventory on its books at its cost of $140,000,
a worksheet adjustment must be made to reduce inventory by $40,000.
After adjustment, the inventory would be included in the consolidated
balance sheet at its true cost to the economic entity of $100,000. Note
that cash would not require a worksheet adjustment because it is retained
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within the economic entity.

The worksheet adjustment would be different if the inventory is sold
by year-end to an unrelated firm. Let’s now assume that FWC sells the

inventory for cash to ABC Corp. on 12/30/2012 for $160,000. The fol-
lowing additional effects on the books of FWC to record the sale are

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(in 000s):
ASSETS = LIABILITIES + SE
FWC records sale of inventory to unrelated third party for $160,000
on 12/30/2012
+ Cash + 160 + Sales Revenue + 160
– Inventory – 140 + Cost Goods Sold – 140

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The revenue is realized through sale to an outsider, but to avoid over-
statement of both sales and cost of goods sold an adjustment is required.
Without adjustment sales would be $300,000 ($140,000 recorded by
Behrend, and $160,000 recorded by FWC) and cost of goods sold would
be $240,000 ($100,000 recorded by Behrend, and $140,000 recorded
op
by FWC). The legitimate related amounts of consolidated sales revenue
and cost of goods sold are $160,000 and $100,000, respectively; there-
fore, adjustments reducing both sales and cost of goods sold by $140,000
would be made on the consolidation worksheet. Note that no consoli-
dation worksheet adjustment of inventory would be necessary because
neither Behrend nor FWC carries it on their books at year-end.
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Sales by the P to the S are termed “downstream,” and “sales” by the

S to the P are termed “upstream.” In cases where the P controls multiple
Ss, sales by one S to another S are termed “horizontal.” Regardless of
intercompany sale direction, the consolidation worksheet adjusts related
income statement and balance sheet accounts to present the appropriate
amounts in the consolidated financial statements. However, unrealized
No

profit or loss adjustments on intercompany sales are “attributed to” the

shareholders of the transferor firm (i.e., the P in the case of downstream
transfers and the S in cases of upstream and horizontal transfers). There-
fore noncontrolling interest’s share of S income that appears in the con-
solidated income statement and non-controlling interest that appears in
the consolidated balance sheet must be adjusted to reflect the S’s realized
profit (or loss) from upstream and horizontal transfers.
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Another intercompany issue relates to amounts owed to/from entities

within the consolidated entity. The related payable/receivable should not
appear in the consolidated balance sheet because from the viewpoint of the

economic entity, a firm cannot owe itself money. For example, if instead of
paying cash, assume that FWC purchased the inventory on account from

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Behrend on 11/30/2012 and the amount remained unpaid at year-end.
FWC would have $140,000 in accounts payable on its books and Behrend
would have $140,000 in accounts receivable on its books on 12/31/2012.
The consolidation worksheet would include an adjustment decreasing
both accounts payable and receivable in the amount of $140,000. In
cases where intercompany amounts owed to/from involve interest bearing

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instruments (e.g., a note payable/receivable) the worksheet adjustments
would also eliminate related interest expense and interest revenue.

Variable Interest Entities

Firms sometime want to avoid consolidation of firms they effectively

control in order to achieve off-balance sheet financing and accommo-
op
date earnings management. Consider Behrend’s acquisition of FWC on
1/01/2012 illustrated in the consolidation worksheet in Exhibit 7.3. Note
that Behrend’s D/E ratio without consolidation of FWC (far left column)
is .25 to 1 ($1,000,000 of debt/$4,000,000 of SE). Since FWC is highly
leveraged, with consolidation (far right column) the D/E ratio increases
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to .45 to 1 ($1,800,000 of debt/$4,000,000 SE). If Behrend were to

apply any of the other methods of accounting for its investment (T, AFS,
or equity) it would report its FWC investment in one asset account and
in doing so, keep the investee’s debt off its balance sheet. Also, if they
applied AFS (or T) classification accounting, they could report profit
from “sales” of goods or services to the “passive” investee firm.
No

Traditionally, consolidated financial statements have been required

when there is a parent–subsidiary relationship. Under ARB 51 consoli-
dated statements are required given the financial control the P has over
the S through an ownership of the majority (greater than 50%) of its vot-
ing stock.20 In most situations, this is appropriate because the degree of
relative stock ownership is indicative of the relative degree of control held
by the equity holder. The relative amount of equity held also generally
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20
FASB ASC 810-10-25; Original pronouncement: ARB No. 51, “Consolidated
Financial Statements,” AICPA, 1959, par. 5.

indicates the extent of risk and reward of ownership. If the investee cor-
poration does well, the equity holder benefits through an increase in the

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worth of its investment, whereas if the investee does poorly, the equity
holder’s investment correspondingly decreases in value.
Firms like Enron were establishing entities in which they had effective
control and the accompanying risks and rewards of ownership, but they
structured the entities such that they had little, if any equity ownership.
Under strict compliance with ARB 51, since they did not have a majority

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equity ownership in the created entity, they did not consolidate the financial
statements of the created entity with their own. This provided the investor
firm (that had effective control in substance) with the opportunity for off-
balance-sheet financing (by having the created entity purchase and finance
assets on the controlling company’s behalf), and the opportunity to report
fictitious earnings (by making sales to the controlled entity at a profit). Recall
op
from our previous discussions of consolidated financial statements that this
would not be possible with consolidation because debt of all affiliates would
appear in the consolidated balance sheet, and “intercompany profit” would
be eliminated for purposes of the consolidated income statement.
In response to these types of financial reporting abuses, the FASB
issued Interpretation No. 46 (FIN 46) in January 2003 and revised it
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December 2003 (FIN 46R)21 and again in 200922. The objective of these
ARB 51 interpretations is to identify instances where majority equity
interest is not indicative of the true underlying control and the risks and
rewards of ownership. This is determined to be so in the case of “Variable
Interest Entities” (VIEs). For VIEs, equity ownership is deemed to not be
indicative of relative control, and therefore majority stock ownership is
No

not used to determine if consolidation is appropriate. Once an entity has

been identified as a VIE, other factors are used to determine if there is a
“primary beneficiary” of the VIE. If so, the primary beneficiary consoli-
dates the VIE and issues consolidated financial statements.

21
Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities,”
FASB, 2003.
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22
Statement of Financial Accounting Standards No. 167, “Amendments to FASB
Interpretation 46(R),” FASB, 2009.

Two fundamental issues are addressed. The first involves identifica-

tion of an entity as a VIE. If an entity exists under certain conditions,

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it is determined to be a VIE. A VIE is one “in which equity investors
do not have the characteristics of a controlling financial interest or do
not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support or, as a group, the
holders of the equity investment at risk lack any one of the following
three characteristics: (a) The power, through voting rights or similar

yo
rights, to direct the activities of an entity that most significantly impact
the entity’s economic performance (b) The obligation to absorb the
expected losses of the entity (c) The right to receive the expected resid-
ual returns of the entity.”23 If an entity has been identified as a VIE, the
second issue addressed is determining if there a “primary beneficiary”
of the VIE. All those with a “variable interest” in the VIE are con-
op
sidered as a potential “primary beneficiary” of the VIE. An enterprise
must consolidate a VIE if it has both of the following characteristics:
“1) The power to direct the activities of a variable interest entity that
most significantly impact the entity’s economic performance, and 2)
The obligation to absorb losses of the entity that could potentially be
significant to the variable interest entity or the right to receive benefits
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from the entity that could potentially be significant to the variable

interest entity.”24
In the case of VIEs, intercompany profit and loss is consistently
“attributed to” the primary beneficiary—not to the noncontrolling inter-
ests, so unrealized profit or loss on intercompany transactions affects con-
solidated net income in full. The primary beneficiary is precluded from
No

manipulating reported income by entering into transactions with the

VIE. Also, inclusion of all VIE debt on the consolidated balance sheet
precludes the primary beneficiary from achieving off balance sheet financ-
ing by having the VIE incur debt on its behalf.

23
FASB ASC 810-10-05-8; Original pronouncement: Statement of financial
Accounting Standard No. 167, par. 3a.
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24
FASB ASC 810-10-25-38; Original pronouncement: Statement of financial
Accounting Standard No. 167, par. 3b.

Accounting for Investment Securities Under IFRS

U.S. GAAP and IFRS have been very similar in their required accounting

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for investment securities.25 However, the IASB recently issued IFRS No. 9,
which must be applied for fiscal years beginning on or after January 1,
2015.26 Accounting for active type investments will continue to require
using the equity method in instances where the investor has “significant
influence” and also continue to require consolidated financial statements
when the investor has “control” over the investee firm. However, the

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accounting for passive type investments will significantly change under
IFRS No. 9. Rather than “available for sale” constituting the default cat-
egory, the default category will instead be “trading” with changes in mar-
ket value recognized in net income (termed “fair value through profit or
loss” (FVTPL) under IFRS).
In the case of debt security investments, available for sale account-
op
ing treatment is not permitted at all under IFRS No. 9. Under IFRS
No. 9, debt investments must be accounted for as trading securities
(FVTPL) unless specific criteria are met, which will allow “held for col-
lection” accounting treatment.27 Held for collection debt securities are
accounted for the same way as “held to maturity” securities discussed
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previously. Held for collection debt securities are not marked to market
but are accounted for under the effective interest method, with balance
sheet presentation at amortized cost. Investment revenue continues to be
recognized in net income each period using the effective interest method
for all debt investment securities under IFRS No. 9.
Dividends received from all passive equity investments continue to be
No

recognized in net income under IFRS No. 9. However, FVTPL treatment

25
FASB ASC 320; Original Pronouncement: Statement of Financial Accounting
Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securi-
ties,” FASB, 1993; and International Accounting Standard No. 39, “Financial Instru-
ments: Recognition and Measurement,” IASB.
26
Early adoption of IFRS No. 9 is permitted. International Financial Reporting
Standard No. 9 “Financial Instruments,” IASB.
27
There are two criteria that require that: 1) the instrument will provide exclusive-
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ly interest and principal payments in the future, and 2) the firm’s business model
indicates the objective is to hold the debt security in order to collect contractual cash
flows.

is required for all passive equity security investments under IFRS No. 9
unless management makes an irrevocable election at the time of acqui-

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sition to account for them as “fair value through other comprehensive
income” (FVTOCI). If the election is made, the securities are accounted
for similar to “available for sale” securities discussed previously—they
are marked to market with unrealized gain and loss recognized in other
comprehensive income. However, a significant difference involves the
accounting for sales of FVTOCI securities. No gain or loss is recognized

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in net income as a result of sales of FVTOCI securities under IFRS No. 9.
In the period of sale, cumulative unrealized gain or loss related to security
being sold is transferred directly from accumulated other comprehensive
income to retained earnings, without recognition in net income. Recall
that earnings-per-share is computed based exclusively upon amounts
reported in net income—not amounts reported in “other comprehensive
op
income.” This required treatment that disallows income statement rec-
ognition of realized gain or loss from sales of FVTOCI securities under
IFRS No. 9 will effectively eliminate the earnings management opportu-
nity previously accessible through sales of “cherry picked” available for
sale securities.
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Derivative Securities28
As described at the beginning of this chapter, derivatives are financial
instruments that derive their value from some other measure of worth
(called the “underlying”). The value of a derivative is a function of the
underlying and the contracted amounts (called the “notional amounts”).
No

Derivatives are consistently presented on the balance sheet at fair value,

and those with positive value are presented as assets and those with nega-
tive value are presented as liabilities. If a firm presents a derivative on its
balance sheet as an asset, the other party involved in the derivative con-
tract (called the “counterparty”) should be presenting an equal amount

28
The discussion of derivative accounting is based upon FASB ASC 815; Original pro-
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nouncement: Statement of Financial Accounting Standards No. 133, “Accounting for

Derivative Instruments and Hedging Activity,” FASB, 1998; and International Account-
ing Standard No. 39, Financial Instruments: Recognition and Measurement,” IASB.

on its balance sheet as a liability. Common types of derivatives include

options, swaps, and forward/futures contracts.

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Forward and futures contracts require the holder to buy or sell some
“notional amounts” of an underlying (e.g., commodities such as crude oil
or wheat, or units of a foreign currency like Japanese yen or Euros) in the
future at a predetermined price.29 The most common type of derivative is
an interest rate swap. Issuers of fixed rate debt may want to “swap” their
fixed interest payments for interest payment amounts that would other-

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wise have been required had they carried variable rate debt, and vice versa.
In the case of interest rate swaps, the “underlying” is interest rate changes
and the “notional amounts” include the debt principal and time until
maturity. If the variable interest rate increases (decreases), the party swap-
ping from a variable to a fixed rate experiences an increase (decrease) in
worth, whereas the “counterparty” that swapped from a fixed to a variable
op
rate experiences a decrease (increase) in worth. Depending upon whether
interest rates have increased or decreased since inception, the swap instru-
ment will have a positive or negative value. The swap instrument’s worth
is a function of interest rate change, the principal amount involved and
the time until maturity.
Options allow, but do not require the holder to sell (called a “put”
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option) or to buy (called a “call” option) something in the future at a

predetermined “strike” price. Options will only be exercised if they are
“in the money”; that is, if the strike price exceeds the market price of
a put option, or if the market price exceeds the strike price of a call
option. Options that are “out of the money” will expire unexercised
because the holder is not required to buy for more or sell for less than
No

market value of the underlying. Therefore, although the maximum

value of an option to its holder is unlimited, it cannot have a negative
value and will never appear in the holder’s balance sheet as a liability.
The option holder’s loss is limited to the option’s cost. Contrary to the
option holder, the option writer is exposed to the risk of unlimited

29
Two key distinctions between futures and forward contracts are: 1) forwards specify
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a certain date for the future sale or purchase whereas futures are exercisable over a span
of time, and 2) futures are traded on organized market exchanges whereas forwards are
privately negotiated contracts.

negative value, whereas their gain is limited to the proceeds from the
option’s issuance.

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Derivatives differ from other investment securities in that they gener-
ally have little if any initial investment cost but can subsequently have
substantial market value (positive or negative) depending upon changes
in the underlying and the notional amounts involved. Also, derivatives are
typically settled at net amounts rather than directly exercising/fulfilling
the rights/obligations otherwise provided per the derivative security. For

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example, assume that Behrend Corp. holds a forward contract to purchase
100 ounces of gold on 12/31/2012 at $1,000 an ounce and the market
price of gold is $1,100 on 12/31/2012. Rather than buying the 100
ounces of gold for $100,000 and then immediately selling it at the market
price of $110,000, Behrend receives a net settlement where the counter-
party simply pays them $10,000. The net settlement feature significantly
op
reduces transaction costs.
Although the balance sheet presentation of derivatives at market
value is consistent, the offsetting effects in double entry accounting dif-
fer depending upon the circumstances. Changes in fair value of deriva-
tives that are held for speculation are recognized as gain or loss in net
income (NI) (similar to the accounting for trading securities discussed
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previously). Frequently, firms enter into derivative arrangements in an

attempt to reduce risk. For example a firm with variable rate debt may
want to eliminate or reduce the risk associated with increases in inter-
est rates by entering into a swap arrangement whereby it converts to
fixed rate interest payments. The process of trying to eliminate or reduce
risk by taking an offsetting position is called “hedging.” In account-
No

ing for derivatives under GAAP there are two types of hedges: “cash
flow” hedges, and “fair value” hedges. Interest rate swaps provide a good
example to distinguish cash flow from fair value hedges. The example
just discussed where a firm with variable rate debt swaps for fixed rate
debt payments is termed a cash flow hedge if it is intended to eliminate
the risk of fluctuating cash flows (interest payments) due to changes in
interest rates. The counterparty to the swap arrangement that exchanges
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their fixed rate debt to get variable rate debt may be doing so as a fair
value hedge. The fair value of a debt instrument is the present value of
future payments discounted using the market interest rate. Whereas the

fair value of fixed rate debt changes with changes interest rates,30 the
fair value of variable rate debt does not fluctuate as widely. Therefore

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swapping fixed rate debt for variable rate debt in order to reduce the
risk associated with changes in the debt’s fair value is referred to as a fair
value hedge.
Fair value hedge accounting is available in hedging risk associated
with recognized assets and liabilities, and “firm commitments.” Cash flow
hedge accounting is available in hedging risk associated with recognized

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assets and liabilities, and “forecasted transactions.” Fair value hedges are
accounted for similar to the accounting for trading securities, with change
in a derivative’s fair value recognized in net income (NI). The hedged item
in a fair value hedge must also be marked to market and presented as an
asset or liability on the balance sheet, with change in fair value recognized
in NI regardless of how the hedged item would otherwise be accounted
op
for under GAAP. For example, in the case of interest rate swaps, although
debt is normally presented on the balance sheet at amortized cost, if a
swap is designated as a fair value hedge, both the derivative (swap) and
the fixed rate debt (the hedged item) will be presented on the balance
sheet at fair value with changes in each recognized in NI. The intention
of this special treatment is that gains on the derivative instrument should
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offset losses in the hedged item, and in the case of perfect hedges the effect
on NI should be zero. Cash flow hedges are accounted for similar to the
accounting for available-for-sale securities, with change in a derivative’s
fair value recognized in other comprehensive income (OCI). Unlike fair
value hedges, cash flow hedges account for the hedged item consistent
with general GAAP, and defer recognition in NI to the period(s) income
No

is otherwise effected by the hedged item. In order to qualify for special

hedge accounting treatment, management must identify (and document)
their cash flow or fair value hedge intention when the derivative arrange-
ment is entered into, and the derivative must be judged “highly effective”
in reducing risk consistent with management’s intent. The hedge instru-
ment is considered highly effective if the correlation between the change
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30
There is a negative relationship between changes in interest rates and the fair
value of debt instruments. If interest rates increase, the fair value of debt instruments
decreases, and vice versa.

in value of the hedged item and the change in value of the derivative
instrument is at or near –1.

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Example

To illustrate hedge accounting we provide as an example a firm entering

into a forward contract to hedge the risk due to changes in commodity
prices of a “firm commitment” (fair value hedge), and of a “forecasted trans-

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action” (cash flow hedge). Assume that Behrend mines and sells gold. On
12/15/12 Behrend’s salesman indicates that a customer (a jewelry manu-
facturer) intends to purchase 1,000 ounces of gold on 1/01/13 at its mar-
ket price on that date. The market price of gold on 12/15/12 is $1,000
per ounce and because Behrend believes that the market price of gold will
decline before 1/01/13 it enters into a forward contract requiring the sale of
op
1,000 ounces of gold on 1/01/13 for $1,000 per ounce. If a formal contract
documenting the exchange is signed, it is considered a “firm commitment”
and accounted for as a fair value hedge, whereas if there is no such con-
tract, it is considered a “forecasted transaction” and accounted for as cash
flow hedge. Since the forward contract price agreed to equals the market
price of gold on 12/15/12, we assume its market value (and cost) is zero.
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We assume further that the price of gold actually increases to $1,050 per
ounce on 12/31/12, and remains at that value on 1/01/13, so that Behrend
receives $1,050,000 from the customer for the cash sale of the gold. Also on
1/01/13, Behrend pays the counterparty $50,000 (1,000 ounces at $50 per
ounce ($1,050–$1,000)) in net settlement of the forward contract.
No

Fair Value Hedge Accounting

We initially provide the accounting as a fair value hedge where both the
derivative instrument (forward contract) and the hedged item (firm com-
mitment) are marked to market with change in value recognized in NI.
The financial statement implications of fair value hedge treatment are
presented using the accounting equation format (in 000s):
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ASSETS = LIABILITIES + SE

Fair value hedge—Behrend enters into forward contract on 12/15/12

Since there is no cost or fair value of the forward contract, Behrend’s

accounts are unaffected.

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Fair value hedge—Behrend marks both the forward contract and the
firm commitment to market on 12/31/12, and recognizes change in
value of each in net income (NI)
+ Fwd. con. + 50 + Loss on fwd. con. (NI) – 50
+ Firm com. + 50 + Gain on firm com. (NI) + 50
Recall that all derivative instruments (e.g., the forward contract) are

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consistently presented on the balance sheet at fair value, and in the case of
fair value hedge accounting: 1) the hedged item (the firm commitment)
must also appear on the balance sheet at fair value regardless of how it
would otherwise be accounted for under GAAP, and 2) changes in fair value
of both the derivative instrument and the hedged item are recognized in net
income. Although firm commitments are “executory contracts” and not
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normally recognized in the financial statements, fair value hedge accounting
requires recognition of the hedged item at fair value regardless of how it is
otherwise accounted for under GAAP. Since the price of gold has increased,
the firm commitment has positive value and is included on the year-end
balance sheet as an asset. Because the forward contract requires Behrend to
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sell gold at less than its market price, it has negative value and is presented
in the year-end balance sheet as a liability. Note that this is an example
of a “perfect” hedge and in such cases the overall effect on net income is
zero because any gain (loss) that otherwise would have occurred due to the
increase (decrease) in value of the firm commitment is precisely offset by
the loss (gain) on the derivative instrument. Note that if the hedge was not
No

perfect, the “ineffective” portion would affect reported net income.31

Fair value hedge—Close related temporary accounts on
12/31/2012
– Loss on fwd. con. (NI) + 50
– Gain on firm com. (NI) – 50
Retained Earnings 0
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31
If the forward contract required Behrend to sell 1,500 ounces of gold, the com-
mitment to sell the additional 500 ounces of gold for $1,000 per ounce would be
considered “ineffective” and treated as a derivative held for speculation resulting in
recognition of a net loss of $25,000 in net income.

Note that since our example involves a perfect hedge, there is no

impact upon year-end stockholders’ equity when accounted for as a fair

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value hedge.

Fair value hedge—Behrend records the sale, net settlement of the

forward contract on 1/01/13
+ Cash + 1,050 + Sales (NI) + 1,050
– Cash – 50 – Fwd. con. – 50
– Firm com. – 50 – Sales (NI) – 50

yo
Initially the 1/01/13 sale of 1,000 ounces of gold at its market price
of $1,050 per ounce is recorded. The second item records net settlement
of the forward contract liability by paying the counterparty $50,000.
The third item removes the firm commitment asset from the books and
reduces sales revenue.32 The amount of sales reported in the income state-
op
ment is $1 million, which is equal to the amount Behrend locked in
when they entered into the forward contract requiring them to sell 1,000
ounces of gold for $1,000 per ounce.

Fair value hedge—Close related temporary accounts on 12/31/2013

– Sales (NI) – 1,000
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+ RE + 1,000

After closing the overall effect on the financial statements is an increase

in both cash and retained earnings (RE) in the amount of $1 million.

Cash Flow Hedge Accounting

We next illustrate the accounting for a cash flow hedge by assuming

there was no formal agreement entered into by Behrend, and the antici-
pated sale was merely a forecasted transaction.33 Under cash flow hedge
accounting, only the derivative instrument (forward contract) is marked
to market, and change in its value is recognized in OCI. The financial
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32
Rather than reducing sales, Behrend could include the $50,000 loss elsewhere in the
operating section of the 2013 income statement.
33
To qualify for cash flow hedge accounting treatment a forecasted transaction must
be deemed “likely to occur.”

statement implications of cash flow hedge treatment are presented using

the accounting equation format (in 000s):

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ASSETS = LIABILITIES + SE

Cash flow hedge—Behrend enters into forward contract

on 12/15/12

Since there is no cost or fair value of the forward contract, Behrend’s

accounts are unaffected.

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Cash flow hedge—Behrend marks the forward contract to market
on 12/31/12 and recognizes change in value in other comprehensive
income (OCI)
+ Fwd. con. + 50 + Loss on fwd. con. (OCI) – 50

Again, the derivative instrument (e.g., the forward contract) is pre-

op
sented on the balance sheet at fair value, but under cash flow hedge
accounting, changes in its fair value are recognized in OCI. Also under
cash flow hedge accounting, the hedged item appears in the financial
statements consistent with how it is accounted for under GAAP. Fore-
casted transactions are not recognized in the financial statements under
GAAP. Note again that this example involves a “perfect” hedge and in
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such cases the full change in the derivative’s value is recognized in OCI.
If the hedge was not perfect, the change in fair value of the derivative not
effectively hedging the forecasted transaction would be considered held
for speculation and recognized in NI, not OCI.34
Cash flow hedge—Close related temporary accounts on 12/31/2012
No

– Loss on fwd. con. (OCI) + 50

– AOCI: Cash flow hedge – 50

Recall that OCI is closed to accumulated comprehensive income

(AOCI), not retained earnings (RE). As such, AOCI: Cash flow hedge

34
Assuming again that the forward contract required Behrend to sell 1,500 ounces of
gold at $1,000 per ounce, the effective portion of the hedge would reflect the require-
ment to sell 1,000 ounces of gold, and the ineffective portion would be the require-
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ment to sell 500 ounces of gold. If that was the case, a $50,000 loss would still be
recognized in OCI, but an additional loss of $25,000 loss would be recognized in NI.

will appear as a contra stockholders’ equity account in the year-end

balance sheet.

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Cash flow hedge—Behrend records the sale and net settlement of the
forward contract on 1/01/13
+ Cash + 1,050 + Sales (NI) + 1,050
– Cash – 50 – Fwd. con. – 50
+ Gain on fwd. con. (OCI) + 50
– Sales (NI) – 50

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The first two financial statement effects are the same as those for the
fair value hedge accounting. The first recognizes the sale of 1,000 ounces
of gold at its market price of $1,050 per ounce, and the second records
the forward contract liability’s net settlement by paying the counterparty
$50,000. The third recording does two things: 1) It reverses the loss rec-
op
ognized in 2012’s OCI by recognizing a gain in 2013’s OCI, and 2) it
reclassifies the loss previously recognized in 2012’s OCI to NI by reduc-
ing 2013’s sales revenue.35 Note that consistent with fair value hedge
accounting, sales revenue of $1 million appears in the 2013 income state-
ment that reflects the amount locked in when Behrend entered into the
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forward contract on 12/15/12.

Cash flow hedge—Close related temporary accounts on 12/31/2013

– Sales (NI) – 1,000
+ RE + 1,000
– Gain on fwd. con. (OCI) – 50
+ AOCI: Cash flow hedge + 50
No

After the 2013 related temporary accounts are closed, again the
overall effect on the financial statements is an increase in both cash
and retained earnings in the amount of $1 million. Note that the
balance sheet account “AOCI: cash flow hedge” is brought to a zero
balance.
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35
Again, rather than adjusting sales, Behrend could include the $50,000 loss else-
where in the operating section of the 2013 income statement.

The Fair Value Option36

GAAP allows firms the option to report certain investment securities

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and derivative instruments on the balance sheet at fair market value with
changes in fair value recognized in net income. As discussed previously
in this chapter, that accounting treatment is already required in the case
of 1) trading securities, 2) derivatives held for speculation, and 3) deriva-
tives held as fair value hedges. The fair value option is not available for
investments that are accounted for as consolidations. Therefore, if elected,

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the fair value option affects financial statement presentation of: 1) held to
maturity securities, 2) available for sale securities, 3) equity method secu-
rities, and 4) derivatives held as cash flow hedges. The fair value option
must be elected (and specifically documented) at the time of acquisition.
The option is available for election on a security-by-security basis, but
once made, it is binding and irrevocable.
op
In the case of held to maturity and available for sale securities, if the
fair value option is elected the investor accounts for the investment as
trading securities and also classifies them as trading securities in the bal-
ance sheet. If the fair value option is elected for what otherwise would
be accounted for as equity method securities, the investor accounts for
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the securities as if they were trading, but includes them on the balance
sheet among equity method (long-term) investments. If the fair value
option is elected for derivatives that would otherwise be accounted for as
cash flow hedges, the investor accounts for the derivative as a speculative
investment.
In the previous chapter we discussed bonds and other forms of notes
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payable. The fair value option is also available in the case of these forms
of financial instruments. If the fair value option is elected for liabilities,
increases in their value results in loss recognition in the net income,
whereas decreases in their value results in gain recognition in net income.

36
The discussion of the fair value option is based upon FASB ASC 825-10-35-4;
Original pronouncement: Statement of Financial Accounting Standards No. 159,
Do

“Fair Value Option for Financial Assets and Financial Liabilities,” FASB, 2007; and
International Accounting Standard No. 39, Financial Instruments: Recognition and
Measurement,” IASB.

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