Question 15.1: On 1 January 2007, fictitious company Baxter Inc. invested $...
On 1 January 2007, fictitious company Baxter Inc. invested $300,000 in fictitious company Cartel Co. debt securities (with a 6 percent coupon rate on par value, payable each 31 December). The par value of the securities was $275,000. On 31 December 2007, the fair value of Baxter’s investment in Cartel is $350,000.
Assume that the market interest rate in effect when the bonds were issued was 4.5 percent.^1 If the investment is designated as held-to-maturity, the investment is reported at amortized cost using the effective interest method. A portion of the amortization table is as follows:
How would this investment be reported on the balance sheet, income statement, and statement of shareholder’s equity at 31 December 2007, under both U.S. GAAP and IFRS, if Baxter designated the investment as (1) held-to-maturity, (2) held-for-trading security, (3) available-for-sale, or (4) designated as fair value?
^1The effective interest rate method applies the market rate in effect when the bonds were issued to the current amortized cost (book value) of the bonds to obtain interest expense for the period.
| End of Year | Interest Payment | Interest Income | Amortization | Carrying Value |
| 0 | $300,000 | |||
| 1 | $16,500 | $13,500 | $3,000 | $297,000 |
| 2 | $16,500 | $13,365 | $3,135 | $293,865 |
| 3 | $16,500 | $13,224 | $3,276 | $290,589 |
If the investment is held-to-maturity, the reported amount at amortized cost at the end of year 2 on the balance sheet would be $293,865. Held-for-trading securities and available-for-sale would be measured at the fair value at the end of year 2.
If the debt securities were sold on 1 January 2008 for $352,000, gain recognition would be as follows:
• Held-to-maturity: gain on income statement of $55,000 [$352,000 – ($300,000 – $3,000)]
• Held-for-trading security: gain on income statement of $2,000 ($352,000 – $350,000)
• Available-for-sale: gain on income statement of $52,000 ($352,000 – $300,000); $50,000 removed from other comprehensive income (U.S. GAAP) or income reported directly in equity (IFRS).
If the investment had been in Cartel Co. equity securities rather than debt securities, the analysis would change in the following ways:
1. There would not be a held-to-maturity option.
2. Dividend income (if any) would replace interest income.
| Income Statement | Balance Sheet | Statement of Shareholder’s Equity | |
| Held-to-maturity | Interest income^a $13,500 ($16,500- $3,000) | Reported at amortized cost of $297,000 | No effect |
| Held-for-trading security | Interest income $16,500 and $50,000 unrealized gain is recognized | Reported at fair value $350,000 | No effect |
| Available-for-sale U.S. GAAP | Interest income of $16,500 | Reported at fair value $350,000 | $50,000 unrealized gain is reported as other comprehensive income |
| Available-for-sale IFRS | Interest income of $16,500 | Reported at fair value $350,000 | $50,000 unrealized gain is reported in net income reported directly as equity on the statement of recognized income and expenses |
| Designated fair value | Interest income $16,500 and $50,000 unrealized gain is recognized | Reported at fair value $350,000 | No effect |
^a6\% \times par value of $275,000 = $16,500; 4.5% × carrying value of $300,000 = $13,500.