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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
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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
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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
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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.
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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
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(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.
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