FAR SEC 5 Flashcards
What is the most liquid asset?
Cash.
Are securities held as investments the same as cash equivalents?
No, securities held as investments are reported in different classifications on the balance sheet.
What is the standard of value for transactions reported in the financial statements?
As the customary medium of exchange, CASH provides the standard of value (the unit of measurement) of the transactions that are reported in the financial statements.
How important is internal control of cash?
Cash is the most liquid of assets. Because of that liquidity and the ability to transfer it electronically, internal control of cash must be strong.
Is cash always a current asset?
No. Cash is classified as a current asset unless its use is restricted to such purposes as payments to sinking funds.
In this case, cash is reported as a noncurrent asset with an account title such as bond sinking fund.
What condition applies for cash to be reported as a noncurrent asset?
Cash is only reported as a noncurrent asset if its use is restricted to such purposes as payments to sinking funds.
How is cash reported when it is a noncurrent asset?
If cash is a noncurrent asset, the cash is reported as a noncurrent asset with an account title such as bond sinking fund.
Which four forms of cash or cash equivalents should be reported in the cash current asset account?
To be classified as current, cash must be readily available for use. The cash account on the balance sheet should consist of
1) Coin and currency on hand, including petty cash and change funds
2) Demand deposits (checking accounts)
3) Time deposits (savings accounts)
4) Near-cash assets
What are four attributes of near-cash assets?
Near-cash assets
1) They include many negotiable instruments, such as money orders, bank drafts, certified checks, cashiers’ checks, and personal checks.
2) They are usually in the process of being deposited (deposits in transit).
3) They must be depositable. They exclude unsigned and postdated checks.
4) Checks written to creditors but not mailed or delivered at the balance sheet date should be included in the payor’s cash account (not considered cash payments at year end).
Must restricted cash be set aside in special accounts? How should restricted cash be presented?
Restricted cash is not actually set aside in special accounts. However, it is designated for special uses and should be separately presented and disclosed in the notes.
Must restricted cash be set aside in special accounts?
Restricted cash is not actually set aside in special accounts.
How should restricted cash be presented?
Restricted cash is designated for special uses and should be separately presented and disclosed in the notes.
What are examples of restricted cash?
Examples are bond sinking funds, new building funds, and restricted compensating balances.
Is restricted cash always a noncurrent asset?
No. If cash is restricted to pay a current obligation, it is still a current asset. For an example, a bond sinking fund used to redeem noncurrent bond debt is noncurrent, but a fund to be used to redeem bonds currently redeemable is a current asset.
What factor determines if cash is current or noncurrent?
The nature of the use determines whether cash is current or noncurrent.
A bond sinking fund used to redeem noncurrent bond debt is noncurrent, but a fund to be used to redeem bonds currently redeemable is a current asset.
What are compensating balances?
As part of an agreement regarding either an existing loan or the provision of future credit, a borrower may keep an average or minimum amount on deposit with the lender. This compensating balance increases the effective rate of interest paid by the borrower.
-It also creates a disclosure issue because the full amount reported as cash might not be available to meet general obligations.
Why do compensating balances result in a disclosure?
Compensating balances create a disclosure issue because the full amount reported as cash might not be available to meet general obligations.
Do compensating balances require a disclosure?
Yes.
What are the three elements of the definition of cash equivalents?
Cash equivalents are
1) Readily convertible to known amounts of cash and
2) So near maturity that interest rate risk is insignificant.
3) Only investments with an original maturity to the holder of 3 months or less qualify.
What are three examples of cash equivalents?
Cash equivalents are short-term, highly liquid investments. Common examples are Treasury bills, money market funds, and commercial paper.
When would money market mutual funds, commercial paper, treasury bills, or certificates of deposit qualify as cash equivalents (current assets)?
If these are readily convertible to a known amount of cash and have an original maturity to the holder of 3 months or less, they would qualify as cash equivalents.
Can an asset be considered cash equivalent if its current time to maturity is less than 3 months but its original time to maturity was greater than 3 months?
No. However, the asset would become a current non-cash asset once its time to maturity is less than the greater of one year or the length of the operating cycle.
What is a nonsufficient funds (NSF) check?
Nonsufficient funds (NSF) checks and postdated checks should be treated as receivables. These are noncash assets.
How are advances for expenses to employees treated?
Advances for expenses to employees may be classified as receivables (if expected to be paid by employees) or as prepaid expenses. These are noncash assets.
What is an overdraft?
An overdraft is a current liability unless the entity has sufficient funds in another account at the same bank to cover it.
When is an overdraft not a current liability?
Only if entity has sufficient funds in another account at the same bank to cover it.
What are four examples of noncash short-term investments?
Noncash short-term investments are usually substantially restricted and thus not readily available for use by the entity. They should be classified as current or temporary investments, not cash. However, they may qualify as cash equivalents.
1) Money market funds are essentially mutual funds that have portfolios of commercial paper and Treasury bills. However, a money market fund with a usable checking feature might be better classified as cash.
2) Commercial paper (also known as negotiable instruments) consists of short-term (no more than 270 days) corporate obligations.
3) Treasury bills are short-term, guaranteed U.S. government obligations.
4) Certificates of deposit are formal debt instruments issued by a bank or other financial institution and are subject to penalties for withdrawal before maturity.
Are some current or temporary investments considered cash equivalents?
Yes, they may qualify as cash equivalents.
What are four rules for recording cash?
1) Cash may be recorded in a general ledger control account, with a subsidiary ledger for each bank account. An alternative is a series of general ledger accounts.
2) On the balance sheet, one account is presented. It reflects all unrestricted cash.
3) Each transfer of cash from one account to another requires an entry.
4) At the end of each period, a schedule of transfers should be prepared and reviewed to make certain all cash transfers are counted only once.
What is a bank reconciliation?
A bank reconciliation is a schedule comparing the cash balance per books with the balance per bank statement (usually received monthly). The common approach is to reconcile the bank balance to the book balance to reach the true balance.
Why is bank reconciliation necessary?
The bank and book balances usually vary. Thus, the reconciliation permits the entity to determine whether the difference is attributable to normal conditions, error, or fraud. It is also a basis for entries to adjust the books to reflect unrecorded items. The bank and the entity inevitably record many transactions at different times. Both also may make errors.
For bank reconciliation, what are the three items known to entity but not known to bank?
1) Outstanding checks. The books may reflect checks written by the entity that have not yet cleared the bank. These amounts are subtracted from the bank balance to arrive at the true balance.
2) Deposits in transit. A time lag may occur between deposit of receipts and the bank’s recording of the transaction. Thus, receipts placed in a night depository on the last day of the month are reflected only in the next month’s bank statement. These receipts are added to the bank balance to arrive at the true balance.
3) Errors. If the bank has wrongly charged or credited the entity’s account (or failed to record a transaction at all), the error will be detected in the process of preparing the reconciliation.
For bank reconciliation, what are the three items known to bank but not known to entity?
1) Amounts added by the bank. Interest income added to an account may not be included in the book balance. Banks may act as collection agents, for example, for notes on which the depositor is the payee. If the depositor has not learned of a collection, it will not be reflected in its records.
-These amounts are added to the book balance to arrive at the true balance.
-They should be recorded on the entity’s books, after which they are no longer reconciling items.
2) Amounts subtracted (or not added) by the bank. These amounts generally include service charges and customer checks returned for insufficient funds (NSF checks). Service charges cannot be recorded in the books until the bank statement is received. Customer checks returned for insufficient funds are not added to the bank balance but are still included in the book balance.
-These amounts are subtracted from the book balance to get the true balance.
-They should be recorded on the entity’s books, after which they are no longer reconciling items.
3) Errors. Bookkeeping errors made by the entity will likewise be discovered.
What are the four common reconciliation items?
1) Additions to book balance of interest earned, deposits collected, or errors.
2) Additions to bank balance of deposits in transit or errors.
3) Subtractions to book balance of service charges, NSF checks, or errors.
4) Subtractions to bank balance of outstanding checks, errors.
What is the Fair Value Option (FVO)?
The FVO allows entities to measure most recognized financial assets and liabilities at fair value.
An entity may elect the FVO for most recognized financial assets and liabilities.
May an entity elect the fair value option for all recognized financial assets and liabilities.
No. An entity may elect the FVO for most (but not all) recognized financial assets and liabilities. There are FVO exceptions where FVO is unavailable.
What are the 5 cases where the fair value option is not allowed?
The FVO may not be elected for the following:
1) An investment that must be consolidated
-The FVO is not an alternative to consolidation.
-Consolidation is required for subsidiaries and variable interest entities. Study Unit 14 addresses these topics.
2) Postretirement employee benefit obligations, employee stock option and purchase plans, and deferred compensation obligations
3)Most financial assets and liabilities under leases
4) Demand deposit liabilities
5) Financial instruments at least partly classified in equity
Is the decision to elect the fair value option revocable?
No. The decision whether to elect the FVO is made irrevocably at an election date (unless a new election date occurs).
For complex situations, how can the fair value option election be made on a case-by-case basis for each different instrument involved?
1) With certain exceptions, the decision is made instrument by instrument and only for an entire instrument.
2) Thus, the FVO generally need not be applied to all instruments in a single transaction.
-For example, it might be applied only to some of the shares or bonds issued or acquired in a transaction.
What are the four criteria for determining the existence of a fair value option election date?
The election may be made only on the date of one of the following:
1) Initial recognition of an eligible item
2) Making an eligible firm commitment
3) A change in accounting for an investment in another entity because it becomes subject to the equity method
4) Deconsolidation of a subsidiary
How are fair value option financial assets and liabilities presented on the balance sheet? (2 elements)
Balance Sheet
1) Under the FVO, financial assets and liabilities are measured at fair value each balance sheet date.
2) Assets and liabilities measured using the FVO are reported by separating their reported fair values from the carrying amounts of similar items measured using another attribute, such as amortized cost or present value.
How are fair value option financial assets and liabilities presented on the income statement? (2 elements)
Income Statement
1) Transaction costs related to the acquisition of an item for which the FVO was elected must be expensed as incurred. They must not be capitalized at the initial cost of the item.
2) Dividends received from an investment that is accounted for using the FVO are recognized as dividend income.
How are changes in fair value of financial assets reported under the fair value option?
Under the FVO, unrealized holding gains and losses on the remeasurement to fair value of financial assets are recognized in the income statement (net income) at each subsequent reporting date.
How are changes in the fair value of financial liabilities reported under the fair value option? (4 elements)
1) Under the FVO, unrealized gains and losses on the remeasurement to fair value of financial liabilities are recognized in the statement of comprehensive income.
2) The portion of the total change in the fair value attributable to the change in instrument-specific credit risk is recognized as an item of other comprehensive income (OCI).
This amount is the difference between
-The total change in the fair value of the financial liability and
-The amount that results from a change in a base market risk, such as a risk-free interest rate.
3) The remaining change in fair value (total change in fair value – change attributable to instrument-specific credit risk) is recognized directly in the income statement.
4) When the financial liability is derecognized, the accumulated gains or losses due to changes in instrument-specific credit risk are reclassified from OCI to the income statement.
What is an equity security?
An equity security is an ownership interest in an entity (e.g., common stock or preferred stock) or a right to acquire or dispose of such an interest (e.g., warrants or call options).
Are convertible debt securities equity interests in the issuer?
No, convertible debt securities are not equity interests in the issuer.
The topics in section 5.3 apply to all Investments in Equity Securities except for the following: (3 elements)
This subunit applies to all investments in equity securities except for investments
1) Accounted for under the equity method
2) In consolidated subsidiaries
3) For which the entity has elected the FVO
What does the appropriate accounting method for an investment in voting stock depend on? (3 elements)
The accounting method for an investment in voting stock depends on the presumed influence the investor has over the investee. The presumed influence usually is determined based on the ownership interest held.
There are three possible cases:
1) Control (influence level) <=> Ownership Interest > 50% <=> Accounting Method: Consolidation
2) Significant (influence level) <=> 20% <= Ownership Interest <= 50% <=> Accounting Method: Equity Method or Fair Value Option
3) Little or None (influence level) <=> Ownership Interest < 20% <=> Accounting Method: Fair Value Measurement
What are the four steps of the Fair Value Net Income Method?
Fair Value Through Net Income Method
1) When there is little or no influence, the investment in equity securities is measured at fair value at each balance sheet date.
2) Unrealized holding gains and losses on the remeasurement of the investment to fair value are reported in the income statement (net income) at each subsequent reporting date.
3) Dividends received from investments in equity securities are reported as dividend income in the income statement.
4) Cash flows from purchases and sales of equity securities are classified in the statement of cash flows based on the nature and purpose for which the securities were acquired.
What are the four elements of the Measurement Alternative for Investment in Equity Securities without a Readily Determinable Fair Value?
1) Measurement Alternative
2) Impairment Test
3) Observable Price Changes
4) Similar Investments in Same Issuer
What is the measurement alternative for the Measurement Alternative for Investment in Equity Securities without a Readily Determinable Fair Value? (2 elements)
1) An entity may elect a measurement alternative for an investment in equity securities without a readily determinable fair value.
-This alternative is cost minus impairment (if any), plus or minus changes resulting from observable price changes for the identical or a similar investment of the same issuer.
2) If the measurement alternative is selected, it must be applied until the investment has a readily determinable fair value.
-The entity must reassess at each reporting period whether the fair value of an equity investment is readily determinable.
-When the fair value of an equity investment is readily determinable, the investment is measured at fair value through net income.
What is the impairment test for Measurement Alternative for Investment in Equity Securities without a Readily Determinable Fair Value? (2 elements)
Impairment Test
1) A qualitative assessment of whether an investment is impaired must be performed at each reporting date. An investment is impaired if the fair value of the investment is lower than its carrying amount.
-A qualitative assessment may consider many impairment indicators, such as significant deterioration in earnings performance, credit rating, or asset quality.
2) If the qualitative assessment indicates potential impairment, the entity must estimate the fair value of the investment and perform a quantitative impairment test.
-The carrying amount of the investment is compared with its fair value. An impairment loss is recognized in the income statement (net income) for the excess of the carrying amount over the fair value.
Impairment loss = Carrying amount – Fair value
What is the equation for impairment loss?
Impairment loss = Carrying amount – Fair value
What are observable price changes in the Measurement Alternative for Investment in Equity Securities without a Readily Determinable Fair Value? (2 element)
1) To identify observable price changes, a reasonable effort should be made to identify relevant transactions by the same issuer that occurred on or before the balance sheet date.
2) Accordingly, an entity does not need to make an exhaustive search for all observable price changes.
What is similar investment in the same issuer for Measurement Alternative for Investment in Equity Securities without a Readily Determinable Fair Value?
Different rights and obligations of the securities should be considered when identifying whether a security issued by the same issuer is similar to the equity investment.
Classification and Measurement of an Investment in Equity Securities Decision Tree: Does the investment in equity securities result in control or significant influence over the investee? (YES/NO)
YES => Control = Consolidation, Significant Influence = Equity Method or FVO
NO => ASK: Is the fair value of the investment in equity securities readily determinable?
Classification and Measurement of an Investment in Equity Securities Decision Tree: Is the fair value of the investment in equity securities readily determinable? (YES/NO)
NO => The investment is measured at fair value. Changes in fair value are recognized in income statement (net income).
YES => ASK: Was the measurement alternative elected?
Classification and Measurement of an Investment in Equity Securities Decision Tree: Was the measurement alternative elected? (YES/NO)
YES => The investment is measured as follows:
Cost - Impairment +/- Observable Price Changes of the Identical or a Similar Investment of the Same Issuer
NO => The investment is measured at fair value. Changes in fair value are recognized in the income statement (net income).
THIS IS THE LAST STAGE OF THE DECISION TREE
When should the Equity Method be used?
An investment in voting stock that enables the investor to exercise significant influence over the investee should be accounted for by the equity method (assuming no FVO election). Significant influence occurs when the ownership interest is between 20% and 50% of the investee.
What percentage range of ownership of the investee entails significant influence?
An investment of 20% or more (but not more than 50%) in the voting stock of the investee generally results in significant influence over an investee.
How is the Equity Method applied at the acquisition date? (3 elements)
1) An equity method investment is initially recognized at cost. The difference between the cost of the investment and the underlying equity in the investee’s net assets may consist of the following:
2) Equity method goodwill. Goodwill resulting from the acquisition is the difference between the consideration transferred (cost of the investment) and the investor’s equity in the fair value of the investee’s net assets.
-Equity method goodwill is not a separately identifiable asset. Accordingly, it is not recognized and presented separately in the investor’s financial statements. Instead, it is included in the carrying amount of the equity method investment.
-Equity method goodwill is not amortized. The equity method investment (but not the equity method goodwill itself, which is inseparable from the investment) is tested for impairment.
3) The investor’s equity is the difference between the acquisition date fair value and the carrying amount of each identifiable asset or liability of the investee.
How does private companies accounting relate to the topic of the Equity Method?
A private company is any entity that is not (1) a public business entity, (2) a not-for-profit entity, or (3) an employee benefit plan.
In accounting for subsequent measurement of equity method goodwill, a private company may
1) Use the general FASB codification guidance that applies to all entities or
2) May elect to apply the goodwill accounting alternative.
Under the goodwill accounting alternative, goodwill recognized must be amortized on a straight-line basis over 10 years. The amortization expense is recognized in the income statement.
1) A private company may amortize goodwill over a period shorter than 10 years if it can demonstrate that this useful life is more appropriate.
NOTE: Unless specifically stated otherwise, all questions and simulations are based on the FASB codification guidance applied to all entities. The guidance for private companies should be used only when the facts of a question or simulation state that (1) a company has elected the accounting alternative and (2) the company is private.
How are Equity Method journal entries made after the acquisition date? (3 elements)
1) Under the equity method, the investor recognizes in income its share of the investee’s earnings or losses in the periods for which they are reported by the investee. The journal entry is as follows: (see the image)
2) The investor’s share of the investee’s earnings or losses is recognized only for the portion of the year that the investment was held under the equity method.
3) The investor’s share of the investee’s earnings or losses is adjusted to eliminate intraentity profits and losses not realized in third-party transactions.
Under the Equity Method, what is the journal entry for dividends paid from the investee?
Dividends from the investee are treated as a return of an investment. They decrease the investment balance but have no effect on the investor’s income. The journal entry is:
Cash or dividend receivable $XXX
Investment in X Co. $XXX
Under the Equity Method, how is the investor’s share of the investee’s earnings or losses adjusted? (3 elements)
1) The equity method requires the investor’s share of the investee’s earnings or losses to be adjusted for the difference at the acquisition date between the fair value and the carrying amount of the investee’s net assets. This adjustment is made as the assets are sold or consumed in operations (e.g., depreciated).
2) For example, the investee’s depreciable assets may be understated at the acquisition date. Thus, subsequent amortization of the excess of the fair value over the carrying amount decreases equity method income. It is recognized by the following entry:
Equity method loss $XXX
Investment in X Co. $XXX
3) No adjustment is made for assets with an indefinite useful life (e.g., land) because they are not depreciated.
Under the Equity Method, when is the method discontinued without a change to a different method to account for the investment?
Use of the equity method is discontinued when the investment is reduced to zero by investee losses unless the investor has committed to providing additional financial support to the investee.
What are the four disclosures required for the Equity Method?
1) The entity’s accounting policies for the investments;
2) The name of each investee and the entity’s percentage of ownership;
3) The difference, if any, between the carrying amount of the investment and the underlying equity in the net assets of the investee; and
4) The accounting method applied to the difference.
What are the three rules for a change to the Equity Method increasing the level of ownership?
Change to the Equity Method – Increase in Level of Ownership
1) When ownership of the voting stock of an investee rises to the level of significant influence, the investor must adopt the equity method or the FVO. A 20% or greater ownership interest is presumed to permit such influence absent strong contrary evidence.
2) When significant influence is achieved in stages (step-by-step), the investor applies the equity method prospectively from the moment significant influence is achieved.
3) On the date the investment becomes qualified for the equity method, the equity method investment equals (1) the cost of acquiring the additional equity interest in the investee plus (2) the current basis of the previously held equity interest in the investee.
How do changes from the Equity Method to a different method occur? (3 elements)
1) If an investor can no longer be presumed to exercise significant influence (for example, due to a decrease in the level of ownership), it ceases to account for the investment using the equity method.
2) Any retained investment is measured based on the carrying amount of the investment on the date significant influence is lost.
3) The shares retained ordinarily are measured at fair value through net income, unless the measurement alternative was selected because the fair value of shares was not readily determinable.
What are debt securities?
A debt security represents a creditor relationship with the issuer.
What are some other less common forms of debt? (3 elements)
In addition to the common forms of debt, this category includes (a) mandatorily redeemable preferred stock (stock that must be redeemed by the issuer), (b) preferred stock redeemable at the investor’s option, and (c) collateralized mortgage obligations.
What are the three categories of debt securities?
How are debt securities classified?
Debt securities are classified at acquisition into one of three categories. The classification is reassessed at each reporting date.
When are debt securities classified as held-to-maturity? (3 elements)
1) An investment in a debt security is classified as held-to-maturity when the holder has both the positive intent and the ability to hold the security until its maturity date.
2) The investor may intend to hold the security for an indefinite period. Also, the possibility may exist that it will be sold before maturity to supply needed cash, avoid interest rate risk, etc. In these cases, the security cannot be classified as held-to-maturity.
3) If a sale before maturity takes place, the security still can be deemed to have been held-to-maturity if
-Sale is near enough to the maturity or call date (e.g., within 3 months) so that interest rate risk (change in the market rate) does not have a significant effect on fair value, or
-Sale is after collection of 85% or more of the principal.
How are held-to-maturity debt securities measured? (2 elements)
1) Held-to-maturity securities are measured at amortized cost.
Amortized cost is the amount at which an investment in debt securities was recognized, adjusted for accrued interest, collection of cash, and amortization of premium or discount.
2) The purchase of held-to-maturity securities is recorded as follows:
Held-to-maturity debt securities $XXX
Cash $XXX
What is the allowance for credit losses for held-to-maturity debt securities?
1) An allowance for credit losses is a valuation account that is deducted from the amortized cost basis of held-to-maturity debt securities to present the net amount expected to be collected.
2) Initial recognition of the allowance for credit losses and subsequent changes in the allowance balance are recognized immediately in the income statement in the credit loss expense account.
How are held-to-maturity debt securities presented on the balance sheet? (4 elements)
1) On the face of the balance sheet, held-to-maturity securities are presented net of any unamortized premium or discount. (This topic is addressed in Subunit 5.6.)
2) Amortization of any discount (premium) is reported by a debit (credit) to held-to-maturity securities and a credit (debit) to interest income.
3) Individual securities are presented as current or noncurrent.
4) The allowance for credit losses must be separately presented as a deduction from the held-to-maturity securities’ balance. [SEE IMAGE]
How are held-to-maturity debt securities presented on the income statement?
Realized gains and losses and interest income (including amortization of premium or discount) are included in earnings.
How are held-to-maturity debt securities presented on the cash flow statement?
Cash flows are from investing activities.
What is the timeframe for buying and selling trading securities?
Trading securities are bought and held primarily for sale in the near term. They are purchased and sold frequently.
How are trading securities initially recorded?
Each trading security is initially recorded at cost (including brokerage commissions and taxes).
Trading securities $XXX
Cash $XXX
How are trading securities remeasured?
At each balance sheet date, trading securities are remeasured at fair value. (The fair value measurement framework is covered in Study Unit 4, Subunit 7.)
For trading securities, how are holding gains and losses reported? (2 elements)
1) Unrealized holding gains and losses on trading securities are reported in the income statement (net income). A holding gain or loss is the net change in fair value during the period, not including recognized dividends or interest not received.
2) To retain historical cost in the accounts while reporting changes in the carrying amount from changes in fair value, a valuation allowance may be established.
-For example, the entry below debits an allowance for an increase in the fair value of trading securities.
Securities fair value adjustment (trading) $XXX
Unrealized holding gain $XXX
How are trading securities presented on the balance sheet? (2 elements)
1) The balances of the securities and valuation allowances are netted. One amount is displayed for fair value.
2) Trading securities are current assets.
How are trading securities presented on the income statement?
Unrealized and realized holding gains and losses, dividends, and interest income (including premium or discount amortization) are included in earnings (income statement).
How are trading securities presented on the cash flow statement?
Classification of cash flows depends on the nature of the securities and the purpose of their acquisition. They are typically considered to be from operating activities.
How does the treatment of trading securities compare to the treatment of financial assets under the fair value option?
The accounting for (1) trading securities and (2) financial assets under the fair value option is similar. Under both methods, the investment is measured in the balance sheet at fair value. Unrealized holding gains or losses on the remeasurement to fair value then are recognized in earnings (income statement).
What are available-for-sale securities?
An investment in debt securities that are not classified as held-to-maturity or trading is considered available-for-sale.
How are available-for-sale securities initially recorded?
The initial acquisition is recorded at cost by a debit to available-for-sale securities and a credit to cash.
Available-for-sale securities $XXX
Cash $XXX
When and how are available-for-sale debt securities remeasured?
How are unrealized holding gains and losses from available-for-sale debt securities reported? (3 elements)
1) Unrealized holding gains and losses resulting from the remeasurement to fair value are reported in other comprehensive income (OCI).
Unrealized holding loss - OCI $XXX
Securities fair value adjustment (available-for-sale) $XXX
2) Tax effects are debited or credited directly to OCI.
3) Amortization of any discount (premium) is reported by a debit (credit) to available-for-sale securities and a credit (debit) to interest income.
How are available-for-sale debt securities presented on the balance sheet? (3 elements)
1) On the face of the balance sheet, available-for-sale securities are reported at fair value. The amounts of the allowance for credit losses and amortized cost basis should be indicated within the text (presented parenthetically).
2) Individual securities are presented as current or noncurrent.
3) In the equity section, unrealized holding gains and losses are reported in accumulated OCI (the real account to which OCI is closed).
How are available-for-sale debt securities presented on the income statement?
Realized gains and losses, dividends, and interest income (including premium or discount amortization) are included in earnings.
How are available-for-sale debt securities presented on the statement of other comprehensive income? (2 elements)
1) Unrealized holding gains and losses for the period are included in comprehensive income.
2) Reclassification adjustments also must be made for each component of OCI. Their purpose is to avoid double counting when an item included in net income also was included in OCI for the same or a prior period. For example, if a gain on available-for-sale securities is realized in the current period, the prior-period recognition of an unrealized holding gain must be eliminated by debiting OCI and crediting a gain.
How are available-for-sale debt securities presented on the cash flow statement?
Cash flows are from investing activities.
When are available-for-sale debt securities impaired?
An available-for-sale debt security is impaired only if its fair value is less than its amortized cost basis.
What is the central accounting question when dealing with impaired available-for-sale debt securities?
The accounting question is to determine the portion of the impairment that relates to credit losses (recognized in net income) and the noncredit losses portion (unrealized holding loss recognized in OCI).
For available-for-sale debt securities, how could fair value relate to amortized cost in the event of impairment? (2 elements)
1) The debt security’s fair value often may be lower than its amortized cost due to factors that are not related to credit losses (the issuer’s ability to pay). For example, the fair value of the security may decline solely due to an increase in market interest rates.
2) n these cases, the entire decline in the fair value of the security is recognized as an unrealized holding loss in OCI.
For available-for-sale debt securities, when does a credit loss exist? (2 elements)
A credit loss exists if the present value of cash flows expected to be collected from the security is less than its amortized cost basis.
Amortized cost basis > Present value of cash flows = Credit loss exists
The impairment for credit losses recognized is limited by the amount that the fair value of the security is less than the security’s amortized cost basis.
Amortized cost basis – Fair value = Maximum amount of impairment for credit losses
For impairment of available-for-sale debt securities, how is the event recognized?
The impairment for credit losses is recognized in the income statement and recorded through an allowance for credit losses. The following is the journal entry:
Credit loss expense $XXX
Allowance for credit losses $XXX
Available-for-sale Debt Securities Impairment Decision Tree: Is the fair value of an AFS debt security less than its amortized cost basis? (YES/NO)
YES => Does a credit loss exist? Is the present value of cash flows expected to be collected from the security less than its amortized cost basis?
NO => No impairment
Available-for-sale Debt Securities Impairment Decision Tree: Does a credit loss exist? Is the present value of cash flows expected to be collected from the security less than its amortized cost basis?
YES =>The portion of impairment that relates to a credit loss is recognized in the income statement and recorded through allowance for credit losses. The portion of the impairment that does not relate to a credit loss, if any, is recognized as unrealized holding loss in OCI.
NO=> The decline to fair value is recognized as an unrealized holding loss in OCI.
END OF DECISION TREE
For available-for-sale debt securities, how is the allowance for credit losses remeasured over time?
The allowance for credit losses is reassessed each reporting period. Subsequent changes in the allowance for credit losses on available-for-sale debt securities are recognized in the income statement. The previously recorded allowance cannot be reversed below zero.
For debt securities, what 5 rules apply for transfers between categories?
Transfers between categories are accounted for at transfer-date fair value. The following describes the treatment of unrealized holding gains and losses at that date:
1) From trading to any category. Amounts already recognized in earnings are not reversed.
2) To trading from any category. Amounts not already recognized in earnings are recognized in earnings.
3) To available-for-sale from held-to-maturity. Amounts are recognized in OCI.
4) To held-to-maturity from available-for-sale. Amounts recognized in OCI are not reversed but are amortized in the same way as a premium or discount.
5) Transfers from held-to-maturity or into or from trading should be rare.
For debt securities, what 5 rules apply for transfers between categories?
What is the definition and classification of a bond? (3 elements)
1) A bond is a formal contractual agreement by an issuer to pay an amount of money (face amount) at the maturity date plus interest at the stated rate at specific intervals. All terms are stated in a document called an indenture.
2) An investment in a bond is a financial asset. Thus, the investor may elect the FVO.
3) Absent this election (or proper classification as a trading security), a bond is classified as held-to-maturity or available-for-sale.
How is the bond investment recorded on the purchaser’s books? (3 elements)
1) An investment in a bond is recorded on the purchaser’s books at the present value of the bond’s two cash flows, discounted at the interest rate prevailing in the market at the time of the purchase. (Study Unit 11, Subunit 2, has a thorough outline of the time value of money.)
2) The face amount (also called the maturity amount) is received on the bond’s maturity date, e.g., 20 years after the initial purchase.
3) The annual cash interest equals the bond’s face amount times the stated (or coupon) rate, e.g., $1,000 face amount × 4% stated rate = $40 annual cash interest.
In what circumstance would the bond’s coupon rate differ from the market rate at the time of purchase? (4 elements)
1) If the bond’s stated (coupon) rate differs from the market rate at the time of the purchase, the price paid will not equal the face amount.
2) If the bond’s stated rate is greater than the current market rate, the purchase price is higher than the face amount and the bond is purchased at a premium.
3) An investor in bonds rarely uses a separate premium or discount account, instead recording the investment at historical cost.
4) If the bond’s stated rate is less than the current market rate, the purchase price is lower than the face amount and the bond is purchased at a discount.
What happens when a bond is purchased between interest dates? (2 elements)
1) When a bond is purchased between interest dates, the investor generally pays to the issuer the amount of interest that has accrued since the last interest payment. On the next payment date, the investor receives a full interest payment.
2) The purchaser of the bond, in effect, “buys” the amount of interest that has accrued since the last payment.
How is bond premium or discount amortized under the effective-interest method? (4 rules)
Any premium or discount is amortized over the life of the bond using the effective-interest method.
1) The effective rate is the interest rate prevailing in the market at the time of the initial purchase (also called the yield).
2) The essence of the effective rate method is application of a constant interest rate. The total amount of interest revenue recognized changes every period.
3) Amortization results in the carrying amount of the asset (liability) being adjusted over time, reaching the face amount at maturity.
4) The straight-line method is used only if its results are not materially different from those of the effective-interest method.
