978-0324651140 Chapter 12 Lecture Note

12–

1

Notes

CHAPTER 12

MARKETABLE SECURITIES AND DERIVATIVES

I. Learning Objectives

1. Understand why firms acquire securities of other firms and how the

purpose of the investment governs the accounting for that investment.

2. Develop skills to account for short-term and long-term investments in

marketable securities at fair value.

3. Understand why firms use derivative contracts to hedge the risk of

changes in interest rates, exchange rates, commodity prices, and other

factors and for other purposes.

4. Develop skills to apply hedge accounting to derivative contracts.

5. Develop the ability to apply the fair value option to marketable securities

and hedging contracts.

II. Organization of Class Sessions

We generally find that students are gasping for breath by the time we

reach this chapter. As a minimum, we want students to grasp why underlying

economics requires half a dozen methods of accounting for the holding by one

firm of securities of another. Exhibit 12.1 provides the illustration of asset

measurement and income recognition as per U.S. GAAP and IFRS. The

classification of marketable securities required as per the U.S. GAAP and IFRS is

to be explained

(1) Debt securities held to maturity,

(2) Debt and equity securities held as trading securities,

(3) Debt and equity securities held as securities available for sale (U.S GAAP) or

as available for-sale financial assets (IFRS).

The accounting for all these should be explained with the relevant question

in the text. The accounting of derivatives, treatment of hedging gains and losses

and its disclosure in the statements are to be explained in detail.

III. Lecture Outline

Notes 12–

2

1. Understand why firms acquire securities of other firms and how the

purpose of the investment governs the accounting for that

investment.

We provide examples of each categories of intercorporate investment

by firms and ask students to find the purpose of investment by these firms.

Firms generally make minority, passive investments for their interest,

dividends, and capital gain potential or, in the case of derivatives, either to

manage risks or to speculate. The ownership percentage is typically so

small that the investor cannot control or significantly influence the

activities of the investee. Firms may acquire such securities as a

temporary investment of excess cash or for long-term expected returns.

The market value method reflects the purpose of such investments.

Income includes interest and dividends each period. The balance sheet

reports the securities at their market value and the unrealized capital gain

or loss appears in a separate shareholders’ equity account.

Firms generally make minority, active investments with a long-term

investment horizon in mind and with the intention of exerting significant

influence over the investee. The minority ownership position, however,

does not usually permit the investor to control the activities of the

investee. The equity method reflects the purpose of these investments.

Accruing the investor’s share of the investee’s earnings each period

recognizes the influence of the investor over the investee. However,

showing the investment on one line in the investor’s balance sheet instead

of all of the assets and liabilities of the investee reflects the investor’s

minority ownership position. Also, showing the investor’s equity in the

earnings of the investee on one line in the income statement instead of the

individual revenues and expenses of the investee reflects the investor’s

minority ownership position.

Firms generally make majority, active investments in order to control

the activities of the investee on both a broad strategy level and a day–to–

day operational level. Full consolidation of the assets, liabilities, revenues,

and expenses of the investee reflects this active control.

2. Develop skills to account for short–term and long-term investments

in marketable securities at fair value.

We proceed with our discussion to account for short-term and long-

A. Begin by asking why current market value of minority, passive

12–

3

Notes

should see that firms acquire minority, passive investments classified

as a current asset (securities available for sale and trading securities)

with the intention of selling them when they need cash. The current

market value provides a better indication of the amount of cash the

firm is likely to receive when it sells the marketable securities than

its acquisition cost. The rationale for using market value (rather than

historical cost) for minority, passive investments classified as

noncurrent assets is less because selling them within the next year is

not the firm’s intention. We then ask: Would you think that

acquisition cost or current market value for such investments is more

informative to the user of the financial statements? Students then

begin to understand the market value gives a better indication of how

well the investee is performing and the amount of cash the investor

would receive if it sold the investment.

B. Next, ask why GAAP does not require the use of current market

values for inventories or fixed assets. This is a tougher question for

students. The justification for using market values for marketable

securities applies to inventories as well (that is, both assets are held

for subsequent sale). The only difference that might justify current

GAAP is that current market values for inventories are more difficult

to ascertain, particularly for semi-finished items. Firms typically hold

fixed assets for use in operations rather than for sale, so current

market values might be less relevant for such assets. Measuring

current market values for fixed assets is probably more subjective as

well.

C. Next, ask students to indicate the type of account that the firm might

debit or credit when it revalues marketable securities to market value

each period. The candidates are an income statement account or a

separate shareholder’s equity account. The principal argument for

using an income statement account, at least for marketable securities

classified as a current asset, is the high probability of realizing the

holding gain or loss soon after the end of the accounting period. The

principal argument for using a separate shareholders’ equity account

is that the holding gain or loss is unrealized as of the end of the

accounting period and that the fluctuations in income might distort

analysis of operating activities. Students should see that total

shareholders’ equity will not differ between these two approaches.

The argument for including the unrealized holding gain or loss in

income for trading securities is persuasive because of their short-term

holding period and the acquisition of such securities principally for

their market value changes. These arguments also apply but to a

lesser extent to marketable securities held as available for sale. The

holding period for the latter securities is longer than for trading

Notes 12–

4

securities and firms look to interest and dividends as well as market

value changes for their return. Students observe in GAAP’s

treatment of unrealized holding gains and losses for minority, passive

investments the compromises sometimes needed to achieve consensus

within standard-setting bodies.

D. We then work several problems that illustrate the application of

GAAP for minority, passive investments. We tend not to spend class

time on trading securities because financial institutions are the

principal firms with such securities. (Questions 12.13, 12.14, 12.15,

12.16 and Problems 12.26, )

3. Understand why firms use derivative contracts to hedge the risk of

changes in interest rates, exchange rates, commodity prices, and

other factors and for other purposes.

We confess that we often run out of time for this and skip it. We have

attempted to give the basics here, so that you can do something useful for

the students with this complex but important material.

Most instructors have probably struggled as we have with both

understanding the mechanics of derivative transactions and the most

effective approach to teaching the appropriate accounting. Fortunately,

the economics of what firms attempt to accomplish when engaging in

derivative transactions is sufficiently clear to students, so we tend to start

with that understanding and then move to the accounting. In general, we

find that students more easily understand the accounting for a transaction

if they understand the economics motivating the transaction.

We have found that making the journal entries for financial

instruments and related derivatives aids in understanding this complex

topic. But this material complicates the text and most instructors, who

report on this, have not used this material, so we have placed it on the web

site.

12–

5

Notes

4. Develop skills to apply hedge accounting to derivative contracts.

Provide an insight on classification of derivatives (i.e., fair value

hedges, cash flow hedges & not a hedging instrument) as per U.S. GAAP

and IFRS.

Consider the Examples 12-19 provided in the text and ask students to

identify which of these relates to fair value hedges and cash flow hedges.

Later clear on the concept that

(1) The fair value hedges are either hedges of a recognized asset or liability

(or an identified portion of a recognized asset or liability),

(2) Hedges of an unrecognized firm commitment (or an identified portion of

that commitment).

Also bring about the general types of cash flow hedges,

(1) Hedges on some or all of the cash flows of a recognized asset or liability,

and

(2) Hedges on some or all of the cash flows of forecasted transactions. Note

that the use of the Examples 12-19 is considered for this purpose.

The firms are allowed to choose whether to designate a particular

derivative as a hedge. For this, firms remeasures derivatives not

designated as a hedge to fair value at every balance sheet date and include

changes in fair value in net income. Bring out that the accounting for fair

value hedges and cash flows hedges is similar under U.S.GAAP and IFRS.

Consider the Examples 13 and 17 to explain the accounting for an

interest rate swap deputed as a fair value hedge. Bring out the various

journal entries required starting from entering the contract till the close of

the swap contract to provide a fair idea on the accounting of fair value

hedge.

Similarly, Examples 14 and 18 could be considered to explain the

accounting under Cash Flow hedge, starting with the initial journal entry

of the note payable until the firm pays back the note.

5. Develop the ability to apply the fair value option to marketable

securities and hedging contracts.

Start of by stating that a firm can report selected financial assets and

financial liabilities at fair value and recognizing gains and losses in net

income as fair values changes. Hence, firms can elect the fair value option

for the following items as discussed earlier

(1) Trading securities

Notes 12–

6

(2) Fair value hedges

(3) Derivatives not designated as hedges.

Applying the fair value option to investments in debt securities

classified as held to maturity results in accounting for the investments as

if they were a trading security, with changes in fair value recognized in

income each period. Applying the fair value option to available for sale

securities and to cash flow hedges results in reporting unrealized gains and

losses from remeasurement to fair value in net income as fair value

changes, instead of initially in other comprehensive income. Provide a copy

of Exhibit 12.7 to the students and advice them to go through the exhibit

along with the notes provided. Explain the effect if the company follows the

fair value option and its effect on net income.

12–

7

Notes

This page is intentionally left blank