Investment Risk and Portfolio Management Paper 7

(b) A company may elect the fair value option for reporting available-for-sale securities. If the fair value option is elected, realized and unrealized gains and losses from availablefor- sale securities are included in earnings of the period. Therefore, the net gain of $18,000 ($14,000 unrealized gains + $30,000 realized gains – $26,000 unrealized losses) is reported on the income statement for the period.

(c) The requirement is to determine how the losses on the securities classified as available-for-sale should be reported. A decline in fair value of a security which is considered to be otherthan- temporary should be reported on the income statement in the current period. A decline in fair value which is considered to be temporary would be recorded as an unrealized loss, and recognized as other comprehensive income. Therefore, answer (c) is correct as the loss on the Knox stock is considered to be otherthan- temporary and it would be reported on the income statement. Answer (a) is incorrect because the unrealized loss on the Scot stock would be reported as other comprehensive income. Answer (b) is incorrect because the loss on the Knox stock is considered to be a realized loss as it is other-than-temporary. Answer (d) is incorrect because the other-than-temporary decline in Knox stock results in a realized loss that is reported on the income statement.

(b) The carrying amount of a marketable equity security classified as available-for-sale shall be the fair value and the unrealized holding gain or loss should be reported as other comprehensive income. In year 1 when the value declined, the portfolio was reported at fair value with an unrealized holding loss recorded as other comprehensive income. In year 2, the decline is considered to be other than temporary. Thus, the security must be written down to fair value and a realized loss recognized. However, since there is no actual change in value, in year 2 the security will be reported at the same amount (Cost – Write-down of asset) as in year 1. Therefore, there is no effect on net noncurrent assets in year 2. However, net income will be affected because a realized loss is recorded on the income statement. Note that the unrealized loss account charged to other comprehensive income in year 1 would be credited and the realized loss account would be debited for the same amount. The allowance accounts will be closed against each other because the new basis after the write-down will equal the lower FV amount. Answer (a) is incorrect because net income is affected. Note that if the decline was merely temporary, there would be no net income effect because temporary declines in value of noncurrent portfolios are reported as other comprehensive income, rather than net income. Answer (c) is incorrect because there is no net decrease in noncurrent assets, but there is a net income effect. Answer (d) is incorrect because only net income decreases.

(d) Dividends in arrears are not a receivable to the cumulative preferred stockholder until the issuing corporation’s board of directors formally declares the dividend. In this case, Hadley, Inc. did not declare the year 1 dividends in arrears until year 2. At the year 2 dividend declaration date, Woody Co. records dividends receivable and dividend income. Dividend income is included in income from continuing operations.

(a) A nonmonetary asset (the merchandise in this case) received in a nonreciprocal transfer should be recorded at the fair value of the asset received. Additionally, the transfer of a nonmonetary asset to a stockholder or other entity (Deed’s employees in this case) should be recorded at the fair value of the asset received.

(d) Noncash transactions should be excluded from the statement of cash flows to better achieve the statement’s objectives. However, information about noncash investing and financing transactions be must reported in related disclosures.

(a) An investor carries an investment in the stock of an investee at fair value, and recognizes as income dividends received that are distributed from the net accumulated earnings of the investee since the date of acquisition by the investor. Dividends received in excess of earnings subsequent to the date of investment are considered to be return of investment or a liquidating dividend and are recorded as reductions of the cost of the investment. Therefore, Pal Corp.’s accounting treatment of the dividend it received from Ima Corp. indicates that Pal is accounting for the securities as an available-for-sale investment in Ima. Answer (b) is incorrect because Ima’s fair value does not impact Pal’s treatment of dividends received. Answers (c) and (d) are incorrect because all dividends received are treated as reductions in an investee’s carrying value under the equity method.

(d) Noncash transactions should be excluded from the statement of cash flows to better achieve the statement’s objectives. However, information about noncash investing and financing transactions be must reported in related disclosures.

(d) The requirement is to determine the amount of loss on investments to be reported in Sun’s year 2 income statement. This transfer is accounted for at fair value and any holding gains or losses on securities that are transferred to held-to-maturity from available-for-sale be reported as accumulated other comprehensive income. This amount is then amortized over the remaining life of the security as an adjustment to yield. Since cost is greater than fair value by $75,000 at 12/31/Y1 ($650,000 cost – $575,000 fair value), the following entry would be recorded: Unrealized loss 75,000 Marketable debt securities 75,000 Then on June 30, year 2, when Sun decides to hold the investments to maturity, an additional $45,000 will be recorded in the valuation account ($575,000 value on books – $530,000 FV) to reflect the change in FV. The following entry would be recorded: Unrealized loss 45,000 Marketable debt securities 45,000 Each year the unrealized loss would be reported as other comprehensive income that would be closed to “accumulated other comprehensive income.”

(d) When a security is transferred to held-to-maturity from available-for-sale the unrealized holding gain or loss continues to be reported as a separate component of stockholders’ equity. Held-to-maturity securities are carried at amortized cost, and any unrealized holding gains or losses are not reported. Thus, the balance in the “accumulated other comprehensive income” in stockholders’ equity on the year 2 statement of stockholders’ equity would be $120,000 ($75,000 amount reported at 12/31/Y1 plus the $45,000 amount reported at June 30, year 2). The $120,000 will be amortized over the remaining life of the security as an adjustment to yield. The additional decline in value from 6/30/Y2 to 12/31/Y2 would not be reported, as heldto- maturity securities do not report unrealized losses.