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The McGraw-Hill Companies, Inc., 2007 Solutions Manual, Vol. 1, Chapter 12 12-1

Question 12-1 Investment securities are classified as held-to-maturity, available-for-sale, or trading

securities.

Question 12-2 Increases and decreases in the market value between the time a debt security is acquired and the

day it matures to a prearranged maturity value are ignored for securities classified as held-to-maturity. These changes arent important if sale before maturity isnt an alternative, which is the case if an investor has the positive intent and ability to hold the securities to maturity.

Question 12-3 The fair value of an equity security is considered readily determinable if its selling price (or

bid-and-asked quotation) is currently available on a securities exchange. When its fair value is not readily determinable, an investment is carried and reported at cost. Any dividends received are recognized as investment revenue, and a gain or loss is reported only when actually realized through the sale of the investment.

Question 12-4 For investments to be held for an unspecified period of time, fair value information is more

relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because sale at that fair value is not an option. The investor receives the same contracted interest payments and principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in fair values indicate managements success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.

Question 12-5 The way unrealized holding gains and losses are reported in the financial statements depends on

whether the investments are classified as securities available-for-sale or as trading securities. Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders equity, as part of Other comprehensive income.

Question 12-6 Comprehensive income is a more expansive view of the change in shareholders equity than

traditional net income. It encompasses all changes in equity from nonowner transactions. So, in addition to net income, comprehensive income includes up to four other changes in equity: Net unrealized holding gains (losses) on investments, Net unrecognized loss on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign currency translation.

Chapter 12 Investments

QUESTIONS FOR REVIEW OF KEY TOPICS

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The McGraw-Hill Companies, Inc., 2007 12-2 Intermediate Accounting, 4e

Answers to Questions (continued) Question 12-7

Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal.

On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are not considered relevant performance measures to be included in earnings.

Question 12-8 Apparently, the drop in the market price of the stock is an other-than-temporary impairment. So,

when the investment is written down to its fair value, the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in income for the period. Subsequent to the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as a separate component of shareholders equity, accumulated other comprehensive income.

Question 12-9 When acquired, debt and equity securities are assigned to one of the three reporting

classifications held-to-maturity, available-for-sale, or trading. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred:

1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period.

2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded as a separate component of shareholders equity, Other comprehensive income.

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

Question 12-10 Yes. Although a company is not required to report individual amounts for the three categories of

investments held-to-maturity, available-for-sale, or trading on the face of the balance sheet, that information should be presented in the disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type. In addition, information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least 4 maturity groupings: (a) within 1 year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.



Answers to Questions (continued) Question 12-11

The equity method is used when an investor cant control, but can significantly influence the investee. If effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.

Question 12-12 The equity method, like consolidation, views the investor and investee as a special type of single

entity. By the equity method, though, the investor doesnt include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.

Question 12-13 The investor should account for dividends from the investee as a reduction in the investment

account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investees net assets, indicating that the investors ownership interest in those net assets declines proportionately.

Question 12-14 The equity method attempts to approximate the effects of accounting for the purchase of the

investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values. Both investment revenue and the investment would be reduced by the negative income effect of the extra depreciation the higher fair value would cause. This would equal 40% x $12 million 10 years = $480,000 each year for ten years.

Question 12-15 The investment account was decreased by $40,000 (40% x $100,000). Cash increased the same

amount. There is no effect on the income statement.



Answers to Questions (concluded) Question 12-16

When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then on. The investment account balance when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to market value in the next set of financial statements.

Question 12-17 A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a

contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.

Question 12-18 These instruments derive their values or contractually required cash flows from some other

security or index.

Question 12-19 Since this fund wont be used within the upcoming operating cycle, it is a noncurrent asset. It

should be reported as part of Investments and funds.

Question 12-20 Part of each premium payment the company makes is not used by the insurance company to pay

for life insurance coverage, but rather is invested on behalf of the insured company in a fixed-income investment. As a result, the periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset cash surrender value.

Question 12-21 When a creditors investment in a receivable becomes impaired, due to a troubled debt

restructuring or for any other reason, the receivable is re-measured based on the discounted present value of currently expected cash flows at the loans original effective rate (regardless of the extent to which expected cash receipts have been reduced). The extent of the impairment is the difference between the carrying amount of the receivable (the present value of the receivables cash flows prior to the restructuring) and the present value of the revised cash flows discounted at the loans original effective rate. This difference is recorded as a loss at the time the receivable is reduced.



BRIEF EXERCISES Brief Exercise 12-1 (a)

Investment in bonds (face amount) ....................... 720,000 Discount on bond investment (difference) ........ 120,000 Cash (price of bonds)......................................... 600,000

(b) Cash (1.5% x $720,000) ........................................ 10,800 Discount on bond investment (difference)............ 1,200 Interest revenue (2% x $600,000) .......................... 12,000

Brief Exercise 12-2

Investment in Disney common shares .......... 54,900 Cash ([2,000 shares x $27] + $900) .................. 54,900 Cash ([2,000 shares x $29] $950) ...................... 57,050

Gain on sale of investments ....................... 2,150 Investment in Disney common shares ....... 54,900

Brief Exercise 12-3

Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders equity, as part of Other comprehensive income. The adjusting entry needed to increase the fair value adjustment from $110,000 to $170,000 is:

Fair value adjustment ($670,000 610,000)...... 60,000 Accumulated unrealized holding gains and losses 60,000



Brief Exercise 12-4 These are securities available-for-sale and are reported at their fair value,

$4,000,000. We know this because securities held-to-maturity are debt securities an investor has the positive intent and ability to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as trading securities. The FedEx shares have been held for over a year. They are classified as available-for-sale since all investments in debt and equity securities that dont fit the definitions of the other reporting categories are classified this way. Of course, the equity method isnt appropriate either because 40,000 shares of FedEx certainly dont constitute significant influence. Investments in securities available-for-sale are reported at fair value.

Brief Exercise 12-5 Unlike for securities available-for-sale, unrealized holding gains and losses for

trading securities are included in earnings. S&L reports its $2,000 holding loss in 2006 earnings. When the fair value rises by $7,000 in 2007, that amount is reported in 2007 earnings. S&Ls journal entries for these transactions would be:

2006 December 27

Investment in Coca Cola shares ......................................... 875,000 Cash ............................................................................... 875,000

December 31 Unrealized holding loss ...................................................... 2,000 Investment in Coca Cola shares ([$875,000 - $873,000)...... 2,000

2007 January 3

Cash (selling price)................................................................ 880,000 Gain on investments (to balance) ...................................... 7,000 Investment in Coca Cola shares (account balance) ............. 873,000



Brief Exercise 12-6 Unlike for trading securities, unrealized holding gains and losses for securities

available-for-sale are not included in earnings. S&L reports its $2,000 holding loss in 2006 as Other comprehensive income, a negative component of shareholders equity, not earnings. When the fair value rises to $880,000 in 2007, the amount is reported in 2007 earnings is the $5,000 gain realized by the sale of the securities. S&Ls journal entries for these transactions would be:

2006 December 27

Investment in Coca Cola shares ......................................... 875,000 Cash ............................................................................... 875,000

December 31 Unrealized holding loss (shareholders equity) ..................... 2,000 Fair value adjustment ($875,000 - $873,000) ...................... 2,000

2007 January 3

Cash (selling price)................................................................ 880,000 Gain on investments (to balance) ...................................... 5,000 Investment in Coca Cola shares (cost) ............................. 875,000

Assuming no other transactions involving securities available-for-sale, the 2007 adjusting entry would be:

December 31 Fair value adjustment (balance) ........................................... 2,000 Unrealized holding loss (balance).................................... 2,000



Brief Exercise 12-7 An investor should account for dividends from an equity method investee as a

reduction in its investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Instead, the dividend distribution is considered to be a reduction of the investees net assets, reflecting the fact that the investors ownership interest in those net assets declined proportionately. Turners cash increased by $2 million (40% x $5 million). Its investment account declined by the same amount. There is no effect on the income statement.

Brief Exercise 12-8 An investor should account for dividends from an investment not accounted for by

the equity method as investment revenue. Since Turner holds only 10% of ICA stock, its assumed that it does not have significant influence over the company. Turners cash increased by $500,000 (10% x $5 million). It also reports $500,000 as investment revenue in the income statement.

Brief Exercise 12-9 With the equity method we attempt to approximate the effects of accounting for the

purchase of the investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values. Both investment revenue and the investment would be reduced by the negative income effect of the extra depreciation the higher fair value would cause. This would equal 30% x $50 million 15 years = $1 million each year for fifteen years.



Brief Exercise 12-10 Because the drop in the market price of stock is considered to be other-than-

temporary, LED records the impairment as follows: Impairment loss ($4.50 x $ 100,000 shares) ........... 450,000 Investment in Branch Pharmaceuticals .......... 450,000

The investment is written down to its fair value, and the amount of the write-down

should be treated as if it were a realized loss, meaning the loss is included in LEDs earnings for the period. Following the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as Other comprehensive income or loss - a separate component of shareholders equity.

Brief Exercise 12-11 The investment would be increased by $12 million. Financial statements would

be recast to reflect the equity method for each year reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items.

No. If Pioneer changes from the equity method, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.



Exercise 12-1 Requirement 1 ($ in millions)

Investment in bonds (face amount) ....................... 240 Discount on bond investment (difference) ........ 40 Cash (price of bonds)......................................... 200

Requirement 2 Cash (3% x $240 million) ...................................... 7.2 Discount on bond investment (difference)............ .8 Interest revenue (4% x $200) ................................ 8.0

Requirement 3 Tanner-UNF reports its investment in the December 31, 2006, balance sheet at its amortized cost that is, its book value: Investment in bonds .......................................... $240.0 Less: Discount on bond investment ($40 - .8 million) 39.2 Amortized cost............................................... $200.8

If sale before maturity isnt an alternative, increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant. For this reason, if an investor has the positive intent and ability to hold the securities to maturity, investments in debt securities are classified as held-to-maturity and reported at amortized cost rather than fair value in the balance sheet.

Requirement 4 ($ in millions) Cash (proceeds from sale)...................................... 190.0 Discount on bond investment (balance, determined above) 39.2 Loss on sale of investments (to balance) .............. 10.8 Investment in bonds (face amount) ................... 240.0

EXERCISES



Exercise 12-2 November 1

($ in millions) Cash .............................................................. 2.4 Investment revenue .................................... 2.4

December 1 Investment in Facsimile Enterprises bonds .... 30 Cash........................................................... 30

December 31 Investment in U.S. Treasury bills ................. 8.9 Cash........................................................... 8.9

December 31 Investment revenue receivable - Convenience bonds ($48 million x 10% x 2/12) ...................... 0.8 Investment revenue receivable - Facsimile Enterprises bonds ($30 million x 12% x 1/12) .... 0.3 Investment revenue .................................... 1.1 Note: Securities held-to-maturity are not adjusted to fair value.

Exercise 12-3 Investment in GM common shares ............... 41,200 Cash ([800 shares x $50] + $1,200) .................. 41,200 Cash ([800 shares x $53] $1,300) ...................... 41,100 Loss on sale of investments ........................... 100 Investment in GM common shares ............ 41,200



Exercise 12-4 Requirement 1

($ in 000s) Net unrealized holding gains and losses ................................ 75 Fair value adjustment ($405 - 480) ....................................... 75 Fair value adjustment ($480 - 450)........................................... 30 Net unrealized holding gains and losses............................. 30 Fair value adjustment ($560 - 480)........................................... 80 Net unrealized holding gains and losses............................. 80 Net unrealized holding gains and losses ................................ 60 Fair value adjustment ($660 - 720) ....................................... 60

Requirement 2 None. Accumulated net holding gains and losses for securities available-for-

sale are reported as a component of shareholders equity, and changes in the balance are reported as Other comprehensive income or loss rather than as part of earnings. This amount can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders equity, or (c) as a separate statement in a disclosure note.




Securities held-to-maturity are debt securities an investor has the positive intent and ability to hold to maturity. Actively traded investments in debt or equity securities acquired principally for the purpose of selling them in the near term are classified as trading securities. The IBM shares are neither. They are classified as available-for-sale since all investments in debt and equity securities that dont fit the definitions of the other reporting categories are classified this way. Of course, the equity method isnt appropriate either because 10,000 shares of IBM certainly dont constitute significant influence.

Investments in securities available-for-sale are reported at fair value, and holding gains or losses are not included in the determination of income for the period. Instead, they are reported as Other comprehensive income or loss. This amount can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders equity, or (c) as a separate statement in a disclosure note. Accumulated net holding gains and losses for securities available-for-sale are reported as a separate component of shareholders equity.

Requirement 2

December 31, 2006 Net unrealized holding gains and losses (10,000 shares x [$58 - 60]) 20,000 Fair value adjustment ........................................................... 20,000



Exercise 12-5 (concluded) Requirement 3

December 31, 2007 Accumulated ($ in 000s) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares Dec. 31, 2007 $600 $610 $10

Moving from a negative $20 (2006) to a positive $10 requires an increase of $30: -------------------------------------------------------- -20 0 +10 +30 -----------------------------> Fair value adjustment (10,000 shares x [$61 - 58]) .......................... 30,000 Net unrealized holding gains and losses (-$20 less $10) ........... 30,000



Exercise 12-6 Requirement 1 2006 March 2

($ in millions) Investment in Platinum Gauges, Inc. shares ............................. 31 Cash ...................................................................................... 31

April 12 Investment in Zenith bonds ....................................................... 20 Cash ...................................................................................... 20

July 18 Cash .......................................................................................... 2 Investment revenue ............................................................... 2

October 15 Cash .......................................................................................... 1 Investment revenue ............................................................... 1

October 16 Cash .......................................................................................... 21 Investment in Zenith bonds ................................................... 20 Gain on sale of investments................................................... 1

November 1 Investment in LTD preferred shares ......................................... 40 Cash ...................................................................................... 40



Exercise 12-6 (continued) December 31

Accumulated ($ in millions) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) Platinum Gauges, Inc. shares $31 $32* $1 LTD preferred shares 40 37** (3) Totals $71 $69 $(2)

* $32 x 1 million shares ** $74 x 500,000 shares Adjusting entry: Net unrealized holding gains and losses ($71 69)..................... 2 Fair value adjustment ($71 69).............................................. 2

2007 January 23

($ in millions) Cash ([1 million shares x 1/2] x $32)............................................... 16.0 Gain on sale of investments (difference) .................................. .5 Investment in Platinum Gauges shares ($31 million cost x 1/2) ................................................. 15.5

March 1 Cash ($76 x 500,000 shares)........................................................... 38 Loss on sale of investments (difference) ...................................... 2 Investment in LTD preferred (cost) ........................................ 40




2006 Income Statement ($ in millions) Investment revenue (from July 18; Oct. 15).................................... $3 Gain on sale of investments (from Oct. 16) .................................. 1 Other comprehensive income:* Unrealized holding loss on investments**........................... $2 * Assuming Construction Forms chooses to report Other comprehensive income as an

additional section of the income statement. Alternatively, it can report this (a) as part of the statement of shareholders equity or (b) as a separate statement in a disclosure note.

Note: Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale.




Purchase ($ in millions) Investment in Jackson Industry shares....................................... 90 Cash ..................................................................................... 90 Net income No entry Dividends Cash (5% x $60 million)................................................................ 3 Investment revenue ............................................................... 3 Adjusting entry Fair value adjustment ($98 - 90 million) ....................................... 8 Net unrealized holding gains and losses ................................ 8

Requirement 2

Investment revenue ......................... $3 million An unrealized holding gain is not included in income for securities available-for-sale.




2006 December 17

Investment in Grocers Supply preferred shares ................ 350,000 Cash ............................................................................... 350,000

December 28 Cash ................................................................................... 2,000 Investment revenue ........................................................ 2,000

December 31 Investment in Grocers Supply preferred shares ................. 50,000 Unrealized holding gain ([$4 x 100,000 shares] - $350,000) .. 50,000

2007 January 5

Cash (selling price)................................................................ 395,000 Loss on investments (to balance) .......................................... 5,000 Investment in Grocers Supply preferred

shares (account balance)................................................ 400,000 Requirement 2

Balance Sheet (short-term investment):

Trading securities .................................................. $400,000 Income Statement:

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

trading securities are included in income.



Exercise 12-9 1. Investments reported as current assets.

Security A $ 910,000 Security B 100,000 Security C 780,000 Security E 490,000 Total $2,280,000

2. Investments reported as noncurrent assets. Security D $ 915,000 Security F 615,000 $1,530,000

3. Unrealized gain (or loss) component of income before taxes. Trading Securities:

Cost Fair value Unrealized gain (loss)

Security A $ 900,000 $ 910,000 $10,000 B 105,000 100,000 (5,000) Totals $1,005,000 $1,010,000 $ 5,000 4. Unrealized gain (or loss) component of shareholders equity. Securities Available-for-Sale:

Cost Fair value Unrealized gain (loss)

Security C $ 700,000 $ 780,000 $80,000 D 900,000 915,000 15,000 Totals $1,600,000 $1,695,000 $95,000




Accumulated ($ in 000s) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares Dec. 31, 2006 $1,345 $1,175 $(170)

Moving from a negative $145 (Jan.1) to a negative $170 requires a reduction of $25: -------------------------------------------------------- -170 -145 0 Fair value adjustment ($1,275,000 - 1,200,000)......................... 75,000 Net unrealized holding gains and losses ......................... 75,000




Accumulated ($ in 000s) Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) IBM shares Dec. 31, 2006 $1,345 $1,375 $30

Moving from a negative $145 (Jan.1) to a positive $30 requires an increase of $175: ------------------------------------------------------------------------------------------- -145 -70 0 +30 +175 --------------------------------------------------------> Fair value adjustment ($1,375,000 - 1,200,000)......................... 175,000 Net unrealized holding gains and losses ......................... 175,000



Exercise 12-11 Requirement 1 The sale of the A Corporation shares decreased Harlons pretax earnings by $5 million. The purchase of the C Corporation shares had no effect on Harlons 2007 earnings. Here are the entries used to record those two transactions:

June 1, 2007 ($ in millions) Cash 15 Loss on sale of investments (difference) 5 Investment in A Corporation shares (cost) 20 September 12, 2007 Investment in C Corporation shares 15 Cash 15




Harlons securities available-for-sale portfolio should be reported in its 2007 balance sheet at its fair value of $101 million:

December 31, 2007 ($ in millions) Cost, Dec. 31 Fair Value, Dec. 31 Securities Available-for-Sale 2006 2007 2006 2007

A Corporation shares $20 na $14 na B Corporation bonds 35 $35 35 $ 37 C Corporation shares na 15 na 14 D Industries shares 45 45 46 50 Totals $100 $95 $95 $101

Moving from a negative $5 (2006) to a positive $6 requires an increase of $11: ---------------------------------------------------------

-5 0 +6 +11 ----------------------------->

Fair value adjustment ($5 credit to $6 debit) 11 Net unrealized holding gains and losses ($5 debit to $6 credit) 11

The adjustment has no effect on earnings. Unlike for trading securities, unrealized holding gains and losses are not included in income for securities available-for-sale.

Exercise 12-12 1. b 2. b




Purchase Investment in AMC common shares .................................. 480,000 Cash ............................................................................. 480,000 Net income No entry Dividends Cash (20% x 400,000 shares x $0.25)........................................ 20,000 Investment revenue ....................................................... 20,000 Adjusting entry Fair value adjustment ($505,000 - 480,000)............................ 25,000 Net unrealized holding gains and losses ........................ 25,000

Requirement 2

Purchase Investment in AMC common shares .................................. 480,000 Cash ............................................................................. 480,000 Net income Investment in AMC common shares (20% x $250,000) ........ 50,000 Investment revenue ....................................................... 50,000 Dividends Cash (20% x 400,000 shares x $0.25)........................................ 20,000 Investment in AMC common shares ............................. 20,000 Adjusting entry No entry



Exercise 12-14

Purchase ($ in millions) Investment in Nursery Supplies shares .................................. 56 Cash ................................................................................. 56 Net income Investment in Nursery Supplies shares (30% x $40 million) ..... 12 Investment revenue ........................................................... 12 Dividends Cash (30% x 8 million shares x $1.25) ......................................... 3 Investment in Nursery Supplies shares .............................. 3 Adjusting entry No entry


($ in millions) Investment in equity securities ($48 million 31 million) .......... 17 Retained earnings (investment revenue from the equity method). 17

Requirement 2 Financial statements would be recast to reflect the equity method for each year

reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items.

Requirement 3 When a company changes from the equity method, no adjustment is made to the

carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note.



Exercise 12-16 1. Error discovered before the books are adjusted or closed in 2006.

Investments ($100,000 80,000) ...................... 20,000 Gain on sale of investments.................... 20,000

2. Error not discovered until early 2007.

Investments ($100,000 80,000) ...................... 20,000 Retained earnings ................................... 20,000



Exercise 12-17 Purchase ($ in millions) Investment in Carne Cosmetics shares ............................... 68 Cash .............................................................................. 68 Net income Investment in Carne Cosmetics shares (25% x $40 million) ... 10 Investment revenue ........................................................ 10 Dividends Cash (4 million shares x $1) .................................................... 4 Investment in Carne Cosmetics shares............................ 4 Depreciation Adjustment Investment revenue ($8 million [calculation below] 8 years). 1 Investment in Carne Cosmetics shares............................ 1 Calculations: Investee Net Assets Difference Net Assets Purchased Attributed to: Cost $68 Goodwill:$12 Fair value: $224* x 25% = $56 Undervaluation Book value: $192 x 25% = $48 of assets: $8 *[$192 + 32] = $224 Adjusting entry No entry




Purchase ($ in millions) Investment in Lake Construction shares ............................. 300 Cash .............................................................................. 300 Net income Investment in Lake Construction shares (20% x $150 million) 30 Investment revenue ........................................................ 30 Dividends Cash (20% x $30 million) ....................................................... 6 Investment in Lake Construction shares ......................... 6 Adjustment for depreciation Investment revenue ($10 million [calculation below] 10 years) 1 Investment in Lake Construction shares ......................... 1 calculation: Investee Net Assets Difference Net Assets Purchased Attributed to: Cost $300 Goodwill: $120 Fair value: $900 x 20% = $180

Undervaluation Book value: $800 x 20% = $160 of buildings($10) and land ($10): $20

Requirement 2 a. Investment in Lake Construction shares

_________________________________________ ($ in millions) Cost 300 Share of income 30 6 Dividends 1 Depreciation adjustment _________________ Balance 323



Exercise 12-18 (concluded) b. As investment revenue in the income statement. $30 million (share of income) $1 million (depreciation adjustment) = $29 million c. Among investing activities in the statement of cash flows. $300 million [Cash dividends received ($6 million) also are reported - as part of operating activities.]

Exercise 12-19 1. b 2. b 3. b



Exercise 12-20 1. c. According to SFAS 115, available-for-sale securities are investments in debt

securities that are not classified as held-to-maturity or trading securities and in equity securities with readily determinable fair values that are not classified as trading securities. They are measured at fair value in the balance sheet.

2. b. Available-for-sale securities include (1) equity securities with readily determinable fair values that are not classified as trading securities and (2) debt securities that are not classified as held-to-maturity or trading securities. Unrealized holding gains and losses are measured by the difference between the amortized cost and fair value, excluded from earnings, and reported in other comprehensive income. The balance is reported net of the tax effect (ignored in this question). Thus, the difference at May 31, year 3 is $8,005 ($643,500 fair value $635,495 amortized cost). This unrealized gain is reported as a credit to accumulated other comprehensive income.

3. d. Debt securities that the company has the positive intent and ability to hold to maturity are classified as held-to-maturity. Held-to-maturity securities are reported at amortized cost. Under the provisions of SFAS 115, any unrealized gains or losses are not recognized.


Insurance expense (difference).............................................. 64,000 Cash surrender value of life insurance ($27,000 21,000)...... 6,000 Cash (2006 premium)......................................................... 70,000

Requirement 2 Cash (death benefit)....................................................... 4,000,000 Cash surrender value of life insurance (account balance) 27,000 Gain on life insurance settlement (to balance)........... 3,973,000




Insurance expense (difference)...................................... 22,900 Cash surrender value of life insurance ($4,600 2,500). 2,100 Cash (premium) ........................................................ 25,000

Requirement 2

Cash (death benefit)....................................................... 250,000 Cash surrender value of life insurance (account balance) 16,000 Gain on life insurance settlement (to balance)........... 234,000



Exercise 12-23 ANALYSIS

Previous Value: Accrued interest (10% x $12,000,000) $ 1,200,000 Principal 12,000,000 Carrying amount of the receivable $13,200,000 New Value: Interest $1 million x 1.73554 * = $1,735,540 Principal $11 million x 0.82645 ** = 9,090,950 Present value of the receivable (10,826,490) Loss: $ 2,373,510 * present value of an ordinary annuity of $1: n=2, i=10% ** present value of $1: n=2, i=10%

JOURNAL ENTRIES

January 1, 2006 Loss on troubled debt restructuring (to balance) ........... 2,373,510 Accrued interest receivable (account balance) ............ 1,200,000 Note receivable ($12,000,000 - 10,826,490)................. 1,173,510 December 31, 2006 Cash (required by new agreement).................................... 1,000,000 Note receivable (to balance).......................................... 82,649 Interest revenue (10% x $10,826,490)......................... 1,082,649 December 31, 2007 Cash (required by new agreement).................................... 1,000,000 Note receivable (to balance).......................................... 90,861 Interest revenue (10% x [$10,826,490 + 82,649]).......... 1,090,861* Cash (required by new agreement).................................... 11,000,000 Note receivable (balance) ......................................... 11,000,000 * rounded to amortize the note to $11,000,000 (per schedule below)



Exercise 12-23 (concluded) Amortization Schedule Not required

Cash Effective Increase in Outstanding Interest Interest Balance Balance by agreement 10% x Outstanding Balance Discount Reduction 10,826,490 1 1,000,000 .10 (10,826,490) = 1,082,649 82,649 10,909,139 2 1,000,000 .10 (10,909,139) = 1,090,861* 90,861 11,000,000 2,000,000 2,173,510 173,510

* rounded



Exercise 12-24 ANALYSIS

Previous Value: Accrued interest (10% x $240,000) $ 24,000 Principal 240,000 Carrying amount of the receivable $264,000 New Value: $11,555 + 11,555 + 11,555 + 240,000 = $274,665 $274,665 x 0.82645 * = (226,997) Loss: $ 37,003 * present value of $1: n=2, i=10%

JOURNAL ENTRIES

January 1, 2006 Loss on troubled debt restructuring (to balance) ........... 37,003 Accrued interest receivable (10% x $240,000) ........... 24,000 Note receivable ($240,000 - $226,997)........................ 13,003 December 31, 2006 Note receivable (to balance).......................................... 22,700 Interest revenue (10% x $226,997) ............................. 22,700 December 31, 2007 Note receivable (to balance).......................................... 24,968 Interest revenue (10% x [$226,997 + 22,700]) .............. 24,968* Cash (required by new agreement).................................... 274,665 Note receivable (balance) ......................................... 274,665 * rounded to amortize the note to $274,665 (per schedule below)



Exercise 12-24 (concluded) Amortization Schedule Not required

Cash Effective Increase in Outstanding Interest Interest Balance Balance by agreement 10% x Outstanding Balance Discount Reduction 226,997 1 0 .10 (226,997) = 22,700 22,700 249,697 2 0 .10 (249,697) = 24,968* 24,968 274,665

47,668 47,668 * rounded



Problem 12-1 Requirement 1 ($ in millions)


Requirement 2 Cash (4% x $80 million) ........................................ 3.20 Discount on bond investment (difference)............ .10 Interest revenue (5% x $66) .................................. 3.30

Requirement 3 Cash (4% x $80 million) ........................................ 3.20 Discount on bond investment (difference)............ .11 Interest revenue (5% x [$66 + 0.1])....................... 3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2006, balance sheet at its amortized cost that is, its book value: Investment in bonds ......................................................... $80.00 Less: Discount on bond investment ($14 .1 .11 million) 13.79 Amortized cost.............................................................. $66.21

Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are relatively unimportant if sale before maturity isnt an alternative. For this reason, if an investor has the positive intent and ability to hold the securities to maturity, investments in debt securities are classified as held-to-maturity and reported at amortized cost rather than fair value in the balance sheet.

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Problem 12-2 Requirement 1 ($ in millions)


Requirement 2 Cash (4% x $80 million) ........................................ 3.20 Discount on bond investment (difference)............ .10 Interest revenue (5% x $66)................................... 3.30

Requirement 3 Cash (4% x $80 million) ........................................ 3.20 Discount on bond investment (difference)............ .11 Interest revenue (5% x [$66 + 0.1]) ....................... 3.31

Requirement 4 Fuzzy Monkey reports its investment in the December 31, 2006, balance sheet at its fair value, $70 million in this case. For investments in securities available-for-sale, changes in market values, and thus market returns, provide an indication of managements success in deciding when to acquire the investment, when to sell it, whether to invest in fixed-rate or variable-rate securities, and whether to invest in long-term or short-term securities.

To do this, we first need to determine the investments amortized cost (or book value) at the end of the year:

Investment in bonds ......................................................... $80.00 Less: Discount on bond investment ($14 .1 .11 million) 13.79 Amortized cost.............................................................. $66.21

Then, to record it at fair value, we increase the investment by $70 66.21 = $3.79 million:

Fair value adjustment ............................. .......... 3.79 Net unrealized holding gains and losses ($70 66.21) 3.79



Problem 12-3 Requirement 1 2006 February 21

Investment in Distribution Transformers shares ........ 400,000 Cash ....................................................................... 400,000

March 18 Cash ........................................................................... 8,000 Investment revenue ................................................ 8,000

September 1 Investment in American Instruments bonds ............... 900,000 Cash ....................................................................... 900,000

October 20 Cash ........................................................................... 425,000 Investment in Distribution Transformers .............. 400,000 Gain on sale of investments.................................... 25,000

November 1 Investment in M&D Corporation shares .................... 1,400,000 Cash ....................................................................... 1,400,000



Problem 12-3 (continued) December 31

Adjusting entries: Investment revenue receivable.................................... 30,000 Investment revenue ($900,000 x 10% x 4/12) .............. 30,000 Accumulated Unrealized Available-for-Sale Securities Cost Fair Value Gain (Loss) M & D Corporation shares $1,400,000 $1,460,000 $60,000 American Instruments bonds 900,000 850,000 (50,000) Totals Dec. 31, 2006 $2,300,000 $2,310,000 $10,000*

Fair value adjustment (calculated above)........................ 10,000

Net unrealized holding gains and losses (change in accumulated balance) 10,000* * The $10,000 credit balance in the Net unrealized holding gains and losses is reported as

Accumulated other comprehensive income, a component of Shareholders equity in the 2006 balance sheet. The $10,000 change in the accumulated balance is reported as 2006 Other comprehensive income.



Problem 12-3 (continued) Requirement 2

Income statement: Investment revenue ($8,000 + 30,000) $ 38,000 Gain on sale of investments 25,000

Note: Unlike for trading securities, unrealized holding gains and losses are not

included in income for securities available-for-sale. Other comprehensive income: Net unrealized holding gain on investments* $ 10,000 Balance sheet: Current Assets Investment revenue receivable $ 30,000 Securities available-for-sale $2,300,000 Plus: Fair value adjustment 10,000 $2,310,000 Shareholders Equity Accumulated other comprehensive income Net unrealized holding gain (loss) ($60,000 - 50,000) $ 10,000 * Can be reported either (a) as an additional section of the income statement, (b) as part of the

statement of shareholders equity, or (c) as a separate statement in a disclosure note.



Problem 12-3 (continued) Requirement 3 2007 January 20

Cash ........................................................................... 1,485,000 Gain on sale of investments (to balance) ................... 85,000 Investment in M&D Corporation shares (cost) ........ 1,400,000

March 1 Cash ........................................................................... 45,000 Investment revenue receivable................................ 30,000 Investment revenue ................................................ 15,000

August 12 Investment in Vast Communications shares .............. 650,000 Cash ....................................................................... 650,000

September 1 Cash ........................................................................... 45,000 Investment revenue ................................................ 45,000



Problem 12-3 (continued) December 31

Adjusting entries: Investment revenue receivable.................................... 30,000 Investment revenue ($900,000 x 10% x 4/12) .............. 30,000 Accumulated Unrealized Securities Cost Fair Value Gain (Loss) Vast Communication shares $650,000 $670,000 $20,000 American Instruments bonds 900,000 830,000 (70,000) Totals Dec. 31, 2007 $1,550,000 $1,500,000 $(50,000)* Moving from a positive $10,000 (2006) to a negative $50,000 requires a decrease of $60,000: ------------------------------------------------------------------------------------------- -50,000 0 +10,000



Income statement: Investment revenue ($15,000 + 45,000 + 30,000) $ 90,000 Gain on sale of investments 85,000

Note: Unlike for trading securities, unrealized holding gains and losses are not

included in income for securities available-for-sale. Other comprehensive income: Net unrealized holding loss on investments* $ (60,000) Balance sheet: Current Assets Investment revenue receivable $ 30,000 Securities available-for-sale $1,550,000 Less: Fair value adjustment (50,000) $1,500,000 Shareholders Equity Accumulated other comprehensive income Net unrealized holding gain (loss) ($20,000 - 70,000) $ (50,000) * Can be reported either (a) as an additional section of the income statement, (b) as part of the

statement of shareholders equity, or (c) as a separate statement in a disclosure note.



Problem 12-4 Requirement 1

2006 December 12 ($ in millions)

Investment in FF&G Corporation bonds ................................... 12 Cash ....................................................................................... 12

December 13 Investment in Ferry common shares .......................................... 22 Cash ....................................................................................... 22

December 15 Cash ........................................................................................... 12.1 Investment in FF&G Corporation bonds ................................ 12.0 Gain on sale of investments ($12.1 12)................................... 0.1

December 22 Investment in U.S. Treasury bills .............................................. 56 Investment in U.S. Treasury bonds ............................................ 65 Cash ....................................................................................... 121

December 23 Cash ........................................................................................... 10 Loss on sale of investments ($10 11) ......................................... 1 Investment in Ferry common shares ($22 x 1/2) ....................... 11

December 26 Cash (selling price)........................................................................ 57 Gain on sale of investments ($57 56) ..................................... 1 Investment in U.S. Treasury bills (balance) .............................. 56

December 27 Cash (selling price)........................................................................ 63 Loss on sale of investments ($63 65) ......................................... 2 Investment in U.S. Treasury bonds (balance) ........................... 65



December 28 Cash ........................................................................................... 0.2 Investment revenue ................................................................ 0.2



Problem 12-4 (concluded) December 31

($ in millions) Adjusting entry: Unrealized holding loss on investments ($10 million - [$22 million x 1/2]) 1.0 Investment in Ferry common shares ...................................... 1.0 Closing entry: Income summary (to balance) ....................................................... .7 Investment revenue ($5 + 0.2 million)............................................ 5.2 Gain on sale of investments ($8 + 0.1 + 1 million).......................... 9.1 Loss on sale of investments ($11 + 1 + 2 million) ....................... 14.0 Unrealized holding loss on investments (adjusting entry)........... 1.0 Note: Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities.

Requirement 2 ($ in millions) Balance sheet (short-term investment): Investment in Ferry common shares (balance after adjusting entry) 10.0 Income statement: Investment revenue (closing entry) 5.2 Gain on sale of investments (closing entry) 9.1 Loss on sale of investments (closing entry) (14.0) Unrealized holding loss on investments (closing entry) (1.0)

Requirement 3 2007

January 2 ($ in millions) Cash (selling price)........................................................................ 10.2 Investment in Ferry common (balance after adjusting entry)......... 10.0 Gain on sale of investments (difference) ................................... .2

January 5 Investment in Warehouse Designs bonds .................................. 34 Cash ....................................................................................... 34



Problem 12-5 ($ in millions)

October 18 Investment in Millwork Ventures preferred shares .................... 58 Cash ....................................................................................... 58

October 31 Cash ........................................................................................... 1.5 Investment revenue ................................................................ 1.5

November 1 Investment in Holistic Entertainment bonds ............................... 18 Cash ....................................................................................... 18

November 1 Cash ........................................................................................... 28 Loss on sale of investments ($28 30) ......................................... 2 Investment in Kansas Abstractors bonds ............................... 30

December 1 Investment in Household Plastics bonds..................................... 60 Cash ....................................................................................... 60

December 20 Investment in U.S. Treasury bonds ............................................ 5.6 Cash ....................................................................................... 5.6

December 21 Investment in NXS common shares ........................................... 44 Cash ....................................................................................... 44

December 23 Cash ........................................................................................... 5.7 Investment in U.S. Treasury bonds ........................................ 5.6 Gain on sale of investments ($5.7 5.6) ................................... .1



Problem 12-5 (continued) ($ in millions)

December 29 Cash ........................................................................................... 3 Investment revenue .............................................................. 3

December 31 Accrued interest: Investment revenue receivable - Holistic Entertainment ($18 million x 10% x 2/12)...................................... 0.3 Investment revenue receivable - Household Plastics ($60 million x 12% x 1/12)................................................ 0.6 Investment revenue ............................................................. 0.9 Revaluations: Net unrealized holding loss on investments ([2 million shares x $27.50] - $58 million) .................... 3 Fair value adjustment .......................................................... 3 Investment in NXS common shares ........................................... 2 Unrealized holding gain on investments ([4 million shares x $11.50] - $44 million).............. 2 Note: Securities held-to-maturity are not adjusted to fair value. Closing entry: Unrealized holding gain on investments (NXS) ........................... 2.0 Investment revenue ($3.0 + 1.5 + .9).............................................. 5.4 Gain on sale of investments (U.S. Treasury bonds) ......................... .1 Loss on sale of investments (Kansas Abstractors) .................... 2.0 Income summary (to balance)................................................. 5.5 Note: Unlike for securities available-for-sale, unrealized holding gains and losses are included in income for trading securities.

2007 January 7

Cash ........................................................................................... 43 Loss on sale of investments (to balance) ....................................... 3 Investment in NXS common shares (after adjusting entry).......... 46




Beale should report its securities available-for-sale in its December 31, 2007, balance sheet at their fair value, $54 million.

Requirement 2

The journal entry needed to enable the investment to be reported at fair value is:

($ in millions) Fair value adjustment ($4 debit to $5 debit) 1 Net unrealized holding gains and losses ($4 credit to $5 credit) 1

Requirement 3

The reclassification adjustment to 2007 other comprehensive income is $2 million. Beales statement of comprehensive income can be provided as (a) an extension of its income statement, (b) as part of its statement of shareholders equity, or (c) in a disclosure note in a manner similar to this:

OTHER COMPREHENSIVE INCOME

($ in millions)

Unrealized holding gains (losses) on investments $ 3 Reclassification adjustment of prior years unrealized gain included in 2007 net income (2) Net unrealized holding gains (losses) $ 1

Comprehensive income includes both net income and other comprehensive

income. Net income in 2007 includes the $3 million gain realized from selling the Schwab shares. However, $2 million of that gain already has been reported in comprehensive income as an unrealized holding gain in a prior year or years when the shares value increased from $25 million to $27 million. To avoid double-counting, Beale must compensate by reducing comprehensive income by the $2 million portion of the 2007 realized gain that already has been reported. Thats what the reclassification adjustment does; it reduces this years comprehensive income by the amount that was reported previously to keep it from being reported twice.




Purchase ($ in millions) Investment in Lavery Labeling shares ........................................ 324 Cash ...................................................................................... 324 Net income Investment in Lavery Labeling shares (30% x $160 million) ......... 48 Investment revenue ................................................................ 48 Dividends Cash (10 million shares x $2) .......................................................... 20 Investment in Lavery Labeling shares .................................... 20 Depreciation adjustment Investment revenue ([$80 million x 30%] 6 years) ..................... 4 Investment in Lavery Labeling shares .................................... 4

Calculations: Investee Net Assets Difference Net Assets Purchased Attributed to: Cost $324 Goodwill: $60 Fair value: $880* x 30% = $264 Undervaluation Book value: $800 x 30% = $240 of depr. assets: $24 *[$800 + 80] = $880 Adjusting entry No entry



Problem 12-7 (concluded) Requirement 2

Purchase ($ in millions) Investment in Lavery Labeling shares ........................................ 324 Cash ...................................................................................... 324 Net income No entry Dividends Cash (10 million shares x $2) .......................................................... 20 Investment revenue ................................................................ 20 Adjusting entry Net unrealized holding loss on investments ([10 million shares x $31] $324 million) .............................................. 14 Fair value adjustment ............................................................. 14




Purchase ($ in millions) Investment in Vancouver T&M shares ....................................... 400.0 Cash ...................................................................................... 400.0 Net income Investment in Vancouver T&M shares (40% x $140 million) ........ 56.0 Investment revenue ................................................................ 56.0 Dividends Cash (40% x $30 million) ............................................................... 12.0 Investment in Vancouver T&M shares ................................... 12.0 Inventory adjustment Investment revenue ($5 million x 40%: all sold in 2006) ................... 2.0 Investment in Vancouver T&M shares ................................... 2.0 Depreciation adjustment Investment revenue ([$20 million x 40%] 16 years) .................... .5 Investment in Vancouver T&M shares ................................... .5 Calculations: Investee Net Assets Difference Net Assets Purchased Attributed to: Cost $400 Goodwill: $80 [plug] Fair value: $800* x 40% = $320 inventory (5) x 40% Undervaluation of inventory: $2 plant facilities (20) x 40% Undervaluation of plant: $8 Book value: $775 x 40% = $310

* $775 +5 +20



Problem 12-8 (concluded) Requirement 2

Investment Revenue ($ in millions)

56.0 Share of income Inventory 2.0 Depreciation .5

_________________ Balance 53.5

Requirement 3 Investment in Vancouver T&M shares ($ in millions) Cost 400.0 Share of income 56.0 12.0 Dividends 2.0 Inventory .5 Depreciation _________________ Balance 441.5

Requirement 4 $400 million cash outflow from investing activities $12 million cash inflow (dividends) among operating activities




Millers management should decide whether it has the ability to exercise significant influence over operating and financial policies of the Marlon Company. Ability to exercise significant influence is presumed for investments of 20 percent or more of voting stock and presumed not to exist for investments of less than 20 percent, other things being equal. Evidence to the contrary should be considered, including participation on the board of directors, technological dependency, material intercompany transactions, or interchange of managerial personnel. Requirement 2 a. Income statement: ($ in millions) Investment revenue ($12 million x 1/6) $2.0 Patent amortization adjustment ($4 million* 10) (.4) *([$24 million] x 1/6]) $1.6 b. Balance sheet: Investment in Marlon Company ($19 million + 2 million - 1 million - .4 million) $19.6* *Investment in Marlon Company ($ in millions) Cost 19.0 Share of income 2.0 1.0 Dividends ($6 million x 1/6) .4 Amortization adjustment _________________ Balance 19.6

c. Statement of cash flows: $19 million cash outflow from investing activities $1 million cash inflow (dividends) among operating activities



Problem 12-10 Item Reporting Category __A_ 1. 35% of the nonvoting preferred stock T. Trading securities of American Aircraft Company M. Securities held-to-maturity __M_ 2. Treasury bills to be held-to-maturity A. Securities available-for-sale __M_ 3. Two-year note receivable from affiliate E. Equity method __N_ 4. Accounts receivable C. Consolidation __M_ 5. Treasury bond maturing in one week N. None of these __T_ 6. Common stock held in trading account for immediate resale. __T_ 7. Bonds acquired to profit from short-term differences in price. __E_ 8. 35% of the voting common stock of Computer Storage Devices Company. __C_ 9. 90% of the voting common stock of Affiliated Peripherals, Inc. __A_10. Corporate bonds of Primary Smelting Company to be sold if interest rates

fall 1/2%. __A_11. 25% of the voting common stock of Smith Foundries Corporation: 51%

family-owned by Smith family; fair value determinable. __E_ 12. 17% of the voting common stock of Shipping Barrels Corporation:

Investors CEO on the board of directors of Shipping Barrels Corporation.




($ in millions) Land........................................................................................... 16 Loss on debt restructuring .......................................................... 6 Note receivable ...................................................................... 20 Accrued interest receivable .................................................... 2

Requirement 2

ANALYSIS Previous Value: Accrued interest (10% x $20,000,000) $ 2,000,000 Principal 20,000,000 Carrying amount of the receivable $22,000,000 New Value: Interest $1 million x 3.16987 * = $ 3,169,870 Principal $15 million x 0.68301 ** = 10,245,150 Present value of the receivable (13,415,020) Loss: $ 8,584,980 * present value of an ordinary annuity of $1: n=4, i=10% ** present value of $1: n=4, i=10%

JOURNAL ENTRIES

January 1, 2006 Loss on troubled debt restructuring (to balance) ................ 8,584,980 Accrued interest receivable (10% x $20,000,000) ............ 2,000,000 Note receivable ($20,000,000 - $13,415,020) ................... 6,584,980 December 31, 2006 Cash (required by new agreement)......................................... 1,000,000 Note receivable (to balance)............................................... 341,502 Interest revenue (10% x $13,415,020).............................. 1,341,502



December 31, 2007 Cash (required by new agreement)......................................... 1,000,000 Note receivable (to balance)............................................... 375,652 Interest revenue (10% x $13,756,522).............................. 1,375,652



Problem 12-11 (continued) December 31, 2008 Cash (required by new agreement)......................................... 1,000,000 Note receivable (to balance)............................................... 413,217 Interest revenue (10% x $14,132,174).............................. 1,413,217 December 31, 2009 Cash (required by new agreement)......................................... 1,000,000 Note receivable (to balance)............................................... 454,609 Interest revenue (10% x $14,545,391).............................. 1,454,609* Cash (required by new agreement)......................................... 15,000,000 Note receivable (balance) .............................................. 15,000,000 * rounded to amortize the note to $15,000,000 (per schedule below)

Amortization Schedule Not required

Cash Effective Increase in Outstanding Interest Interest Balance Balance by agreement 10% x Outstanding Balance Discount Reduction

13,415,020 1 1,000,000 .10(13,415,020) = 1,341,502 341,502 13,756,522 2 1,000,000 .10(13,756,522) = 1,375,652 375,652 14,132,174 3 1,000,000 .10(14,132,174) = 1,413,217 413,217 14,545,391 4 1,000,000 .10(14,545,391) = 1,454,609* 454,609 15,000,000 4,000,000 5,584,980 1,584,980

* rounded




ANALYSIS Previous Value: Accrued interest (10% x $20,000,000) $ 2,000,000 Principal 20,000,000 Carrying amount of the receivable $22,000,000 New Value: $27,775,000 x 0.68301 * = (18,970,603) Loss: $ 3,029,397 * present value of $1: n=4, i=10%

JOURNAL ENTRIES

January 1, 2006 .. Loss on troubled debt restructuring (to balance) ................... 3,029,397 Accrued interest receivable (10% x $20,000,000) ............ 2,000,000 Note receivable ($20,000,000 - 18,970,603)...................... 1,029,397 December 31, 2006 .. Note receivable (to balance)............................................... 1,897,060 Interest revenue (10% x $18,970,603).............................. 1,897,060 December 31, 2007 .. Note receivable (to balance)............................................... 2,086,766 Interest revenue (10% x [$18,970,603 + 1,897,060])........... 2,086,766 December 31, 2008 .. Note receivable (to balance)............................................... 2,295,443 Interest revenue (10% x balance [see schedule]) ................ 2,295,443 December 31, 2009 .. Note receivable (to balance)............................................... 2,525,128 Interest revenue (10% x balance [see schedule]) ................ 2,525,128* Cash (required by new agreement)......................................... 27,775,000 Note receivable (balance) .............................................. 27,775,000 * rounded to amortize the note to $27,775,000 (per schedule below)



Problem 12-11 (concluded) Amortization Schedule Not required

Cash Effective Increase in Outstanding Interest Interest Balance Balance by agreement 10% x Outstanding Balance Discount Reduction 18,970,603 1 0 .10 (18,970,603) = 1,897,060 1,897,060 20,867,663 2 0 .10 (20,867,663) = 2,086,766 2,086,766 22,954,429 3 0 .10 (22,954,429) = 2,295,443 2,295,443 25,249,872 4 0 .10 (25,249,872) = 2,525,128* 2,525,128 27,775,000 8,804,397 8,804,397

* rounded



Real World Case 12-1 Requirement 1

December 31, 2004 ($ in millions) Securities available-for-sale $90 Fair value adjustment ($42 + 25) 67 Investment (fair value) $157

Requirement 2 ($ in millions) Unrealized Securities Available-for-Sale Cost Fair Value Gain (Loss)

EarthLink shares $90 $157 $ 67 Moving from a positive $61** (2003) to a positive $67 requires an increase of $6:

--------------------------------------------------------- 0 + 61 +67* + 6 --------->

* $42 + 25 (tax) ** at year-end 2003, the gross (pre-tax) accumulated unrealized holding gains

were $38 + 23 = $61 million. December 31, 2004 ($ in millions) Fair value adjustment ($61 debit to $67 debit) ................... 6 Net unrealized holding gains and losses ($61 credit to $67 credit) 6

CASES



Case 12-1 (concluded) Requirement 3 No, this does not imply that the securities involved had not previously been written up above the original cost. Holding gains and losses from securities available-for-sale are included in earnings when they are realized by selling the securities. When Sprint sold the EarthLink securities, the fair value of the shares had apparently been written up in previous years (securities primarily made up of EarthLink common stock had produced unrealized holding gains). Those gains werent recognized in prior earnings because they werent yet realized by selling the investment. Now, the gain is recognized in 2004 when it is actually realized:

($ in millions) Cash (to balance) ............................................................... 8.59

Gain on sale of investments (given) .............................. 1.50 Investment in securities (determined below).................... 7.09

Calculation of cost:

$134.0 million Cost at 2003 year-end 18.9 million Shares at 2003 year-end $7.09 Average cost per share 1.0 million Shares sold $7.09 million Cost of shares sold



Research Case 12-2 [Note: This case encourages the student to reference actual annual reports.]

The footnote that describes an investment in securities available-for-sale may be headed by any one of a variety of captions or subsumed within another disclosure note. Likewise, the caption by which the investments are reported in the balance sheet can be reported separately as one of several asset titles or included within another asset caption.

They will be reported as current or noncurrent assets depending on the intent of management regarding the timing of their eventual sale. Realized gains or losses are reported in the income statement if any of these securities were sold during any year reported.

Investments in securities available-for-sale are reported at fair value. Unrealized holding gains and losses from retaining securities during periods of price change are not included in the determination of income for the period. Rather, they are accumulated and reported as accumulated other comprehensive income, a separate component of shareholders equity. This means an unrealized holding gain would increase shareholders equity and an unrealized holding loss would decrease shareholders equity. Because unrealized gains or losses cause changes in shareholders equity, those changes are reported in the statement of shareholders equity. [Some companies may not provide a statement of shareholders equity and may provide a statement of retained earnings instead. Unrealized gains or losses have no effect on retained earnings

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