ACCOUNTING THEORY: INVESTMENTS SET 2 [SPRING 2017]

FAS 157-4 AND 115-2/124-2

GENERAL COMMENTS

1. The questions on this handout are based on the article “Recent Developments in Fair Value
Accounting,” by Avinash Arya and Alan Reinstein from the August 2010 issue of the CPA Journal.

2. Note that on page 21 of the article, last column, 2nd last paragraph, 2nd sentence, a word is
missing. The last clause of the sentence states: "unobservable, relevant inputs are preferred over
observable inputs." It should read: "unobservable, relevant inputs are preferred over irrelevant
observable inputs."

QUESTIONS based on 157-4 (and a little bit of 157-3 and 115-2/124-2)

1. Assume Company needs to determine the fair value of a bond investment as of December 31, Year 1.
Assume that no current quotes or other observable inputs for similar or identical bonds are available.
However, transaction prices for similar bonds sold in July and August are available. Is the market for the
type of bond held by Company active or inactive? Should the transaction prices from the July and
August sales be used by Company to determine the fair value of its bond investment?

2. Company holds a mortgage-backed bond. The fair value of the bond depends on whether or not
homeowners will repay principal and interest (the holder of a mortgage-backed bond only receive their
investment back, plus interest, to the extent the borrowers make their loan payments; unless some type
of guarantee is provided). Is the risk that the underlying mortgages are not repaid liquidity risk or
nonperformance risk?

3. Company holds a mortgage-backed bond. Company has identified nearly identical bonds that are
for sale. The asking price for the identical bonds is 90% of par value ($900 for a $1,000 bond). The only
bids (to purchase the bonds for sale) are between 70% and 75% of par value. According to 157-4, what
does this wide bid-ask spread indicate? Do you think Company should use either the ask or bid price on
the bond for sale as a measure of the current fair value for its bond?

4. According to 157-4, what (4) indicators suggest a disorderly transaction?

5. Company ABC holds a mortgage-backed bond. Not much activity exists in the market for identical or
similar securities. However, management of Company ABC becomes aware of four recent transactions
in similar bonds. Transaction 1 was not orderly, as the seller was under regulatory orders to sell the
position. Transaction 2 was known to be orderly, as Company ABC participated in the bidding process,
which allowed a customary marketing period, but another buyer outbid Company ABC. Transactions 3
and 4 were reported; but, after making inquiries, Company ABC could not determine whether those
transactions were orderly or not. How should Company ABC use the information for the four
transactions to determine the fair value of its mortgage-backed bond? Could Company ABC use a
discounted cash-flows model to determine the fair value of its bond? What, if any, additional
information would you want?

6. Company holds a bond with a BBB+ credit rating and needs to determine the fair value of this
investment. No transactions of identical bonds are identified. However, Company has identified
several (sales) transactions for similar bonds. These similar bonds have a lower credit rating (BB) than
Company’s bond. Nevertheless, Company has determined that the identified transactions were not
forced sales and believes these transactions prices can be used as inputs in the determination of the fair
value of its security. Company computes the effective yield (discount rate) implied by the sales price of
the similar bonds. Company will use a model incorporating this implied discount rate; however, the
discount rate should be adjusted because a BBB+ credit rating implies a different risk premium than a BB
credit rating. Should Company increase or decrease the observed discount rate in the valuation of its
investment? Why?

QUESTIONS ON 115-2/124-2 (OTHER-THAN-TEMPORARY IMPAIRMENT)

7. When is a debt security impaired?

8. When is an impairment on a debt security considered other-than-temporary?

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FOCUS ON OTHER-THAN-TEMPORARY IMPAIRMENT

(1) EQUITY SECURITIES (available-for-sale securities)

The OTTI is included in net income. OTTI exist if an investor does not have the intent or ability to hold
the investment until fair value recovers. [Note that this is based on current GAAP. Eventually,
impairments of equity securities will become irrelevant].
PROBLEM 1 [we will work during class—no need to work this problem ahead of time]

Company holds as an investment stock in First Motors. The cost of the First Motors stock was $100,000
and the current fair value is $1,000.

(a) Is the $99,000 unrealized loss included in net income if Company intends to hold the First
Motors stock and it is expected that the First Motors stock price will recover?
(b) Is the $99,000 unrealized loss included in net income if First Motors has filed for bankruptcy?

PROBLEM 2 [we will work during class—no need to work this problem ahead of time].

During Year 1, Company purchased stock in Second Motors Company for $10,000. Company classified
this investment as an available-for-sale security. On December 31, Year 1, the fair value of the
investment in Second Motors was $9,000 and Company recorded the $1,000 decline in value as an
unrealized holding loss in other comprehensive income. On March 31, Year 2, Company determined the
fair value of this investment was $100. Furthermore, Company determined the investment in Second
Motors had an other-than-temporary impairment. For the three month period ending March 31, Year 2,
Company's income before considering the OTTI is $80,000. Ignoring income taxes, determine
Company's net income and comprehensive income for the three-month period ending March 31, Year 2.

(2) DEBT SECURITIES (available-for-sale and held-to-maturity securities)

OTTI exists if the security is impaired and (1) investor intends to sell before recovery of fair value
or (2) investor will be required to sell before recovery of fair value or (3) investor intends and
has the ability to hold the investment but recovery of fair value is not expected. In case 3, the
OTTI is divided into credit losses and other losses. The credit losses go to net income. The other
losses go to OCI.

PROBLEM 3

Company holds an asset-backed bond as an AFS investment. Company’s amortized cost basis is $100. At
12/31/Year 2, the fair value of the security is $60. Company intends to sell the investment early in Year
3. How should the $40 decline in value be reported in the Year 2 financial statements?

PROBLEM 4

Company holds an asset backed bond as an available-for-sale investment. Company’s amortized cost
basis for this security is $100. At 12/31/Year 2, the fair value of the security is $60. Company intends to
hold the investment and has the ability to hold the investment. Management of Company estimates
that the future cash flows to be generated from this investment is $74. The present value of these
future cash flows is estimated at $70. How should the $40 decline in value be reported for Year 2?