Difficulty: Advanced | Prerequisites: Topics 1-9 (all prior exam material, particularly debt and present-value concepts)
Topics 10 through 13 cover the most advanced material in ACC 326. You will learn how companies use derivatives to manage risk and how hedge accounting works, how the new lease standard (ASC 842) requires lessees to recognise right-of-use assets and lease liabilities, how to account for investments in other companies depending on the level of influence, and how acquisitions produce goodwill and pro forma financial statements. These topics build heavily on debt (Topic 7) and present-value mechanics.
Date: Weeks 11-12 | Source: Ch. 19, pgs. 19.1-19.23 | Exercises: P 1, 4, 5
Tags: derivative, forward contract, futures, options, swap, interest rate swap, fair value hedge, cash flow hedge, hedge effectiveness, ASC 815, notional amount, underlying, mark to market, OCI, accumulated other comprehensive income, AOCI
Derivatives are financial instruments whose value depends on an underlying variable (an interest rate, a commodity price, a foreign exchange rate). Companies use them to manage risk, but the accounting can be counterintuitive because derivatives must be reported at fair value on the balance sheet, with changes in fair value flowing through income or OCI depending on whether the derivative qualifies for hedge accounting. This topic draws on your understanding of OCI (Topic 2) and debt (Topic 7).
Derivative
A financial instrument that has an underlying (a price, rate, or index), a notional amount, requires little or no initial net investment, and is settled net or through delivery. Common types: forwards, futures, options, and swaps.
In simple terms, a derivative is a contract whose value moves based on something else. You do not own the thing itself; you own a contract tied to its price.
Fair Value Hedge
A hedge of the exposure to changes in the fair value of a recognised asset or liability (or an unrecognised firm commitment). Both the derivative and the hedged item are marked to fair value through earnings. The offsetting gains and losses reduce earnings volatility.
Example: a company holds a fixed-rate bond and enters an interest rate swap to convert it to a floating rate. Changes in the bond's fair value due to interest rate changes are offset by changes in the swap's fair value.
Cash Flow Hedge
A hedge of the exposure to variability in expected future cash flows. The effective portion of the change in the derivative's fair value is recorded in OCI (not earnings). It is reclassified from OCI to earnings when the hedged transaction affects earnings.
Example: a company expects to purchase inventory in six months and enters a forward contract to lock in the price. Changes in the forward's value go to OCI until the inventory is purchased and sold.
Hedge Effectiveness
The degree to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item. Under ASC 815, a hedge must be highly effective to qualify for special hedge accounting. The ineffective portion of a cash flow hedge is recognised in earnings immediately.
General Rule (No Hedge Designation)
All derivatives are reported at fair value on the balance sheet.
Changes in fair value are recognised in earnings each period.
This can create volatility in reported income if the derivative is hedging a risk whose offsetting effect is not simultaneously recognised.
Fair Value Hedge Accounting
The derivative (hedging instrument) is marked to fair value through earnings.
The hedged item is also adjusted for changes in fair value attributable to the hedged risk, through earnings.
The two adjustments offset each other in earnings (if the hedge is effective), reducing reported volatility.
Cash Flow Hedge Accounting
The effective portion of the derivative's gain or loss goes to OCI.
The ineffective portion goes to earnings immediately.
When the hedged forecasted transaction occurs and affects earnings (e.g., the hedged inventory is sold), the amount in AOCI is reclassified to earnings.
Journal Entries: Interest Rate Swap as Fair Value Hedge
At each reporting date, record the change in fair value of the swap: Debit (or Credit) Swap Asset/Liability, Credit (or Debit) Gain/Loss on Swap (earnings).
Simultaneously adjust the hedged item: Debit (or Credit) Loss/Gain on Hedged Item (earnings), Credit (or Debit) the hedged asset or liability.
Airlines routinely use fuel derivatives (forwards and options on jet fuel or crude oil) to manage exposure to volatile fuel prices. When oil prices spiked, airlines with effective hedging programmes reported lower fuel costs than their unhedged competitors. However, when prices fell sharply, those same hedges locked in above-market prices, demonstrating that hedging reduces variability rather than guaranteeing a better outcome.
Date: Weeks 12-13 | Source: Ch. 13, pgs. 13.1-13.26 | Exercises: E 3-5; P 1, 3, 4
Tags: ASC 842, lease, operating lease, finance lease, right-of-use asset, ROU asset, lease liability, lessee accounting, lessor accounting, implicit rate, incremental borrowing rate, lease term, purchase option, short-term lease, lease classification
ASC 842 fundamentally changed lease accounting by requiring lessees to recognise virtually all leases on the balance sheet. Previously, operating leases were off-balance-sheet. Now, both operating and finance leases produce a right-of-use (ROU) asset and a lease liability. The difference between the two classifications is how expense is recognised over the lease term. This topic uses the same present-value mechanics as debt (Topic 7) and creates deferred tax implications (Topic 6).
Right-of-Use (ROU) Asset
An asset representing the lessee's right to use the underlying asset for the lease term. Initially measured at the present value of lease payments plus any initial direct costs, prepaid lease payments, and less any lease incentives received.
Lease Liability
The lessee's obligation to make lease payments over the lease term. Initially measured at the present value of lease payments, discounted at the rate implicit in the lease (if determinable) or the lessee's incremental borrowing rate.
Finance Lease (Lessee)
A lease that transfers substantially all the risks and rewards of ownership to the lessee. Classified as a finance lease if any one of five criteria is met: transfer of ownership, purchase option reasonably certain to be exercised, lease term is a major part of the asset's economic life, present value of payments is substantially all of the asset's fair value, or the asset is specialised with no alternative use to the lessor.
Expense pattern: interest expense on the lease liability (front-loaded, declining over time) plus amortisation of the ROU asset (typically straight-line). Total expense is higher in early years.
Operating Lease (Lessee)
A lease that does not meet any of the five finance lease criteria. The lessee recognises a single lease expense on a straight-line basis over the lease term.
Expense pattern: a single, level lease expense each period. The ROU asset is adjusted so that total expense (interest on the liability plus ROU amortisation) equals the straight-line amount.
Initial Measurement (Both Types)
Lease liability = Present value of lease payments over the lease term.
ROU asset = Lease liability + Initial direct costs + Prepaid lease payments - Lease incentives received.
Subsequent Measurement: Finance Lease
Interest expense = Beginning lease liability x Discount rate.
Lease payment reduces the lease liability (principal portion = payment - interest).
ROU asset is amortised, typically straight-line over the lease term (or useful life if ownership transfers).
Two expenses hit the income statement: interest expense and amortisation expense.
Subsequent Measurement: Operating Lease
Total lease expense each period = Total lease payments / Lease term (straight-line).
Interest on the lease liability is computed the same way (beginning balance x rate).
The difference between the straight-line expense and the interest is the reduction in the ROU asset.
Only one expense line on the income statement: lease expense (or rent expense).
Short-Term Lease Exception
Leases with a term of 12 months or less (with no purchase option reasonably certain to be exercised) may be excluded from balance sheet recognition.
The lessee simply recognises lease payments as expense on a straight-line basis.
Cash Flow Classification
Finance lease: interest portion of payments is operating; principal portion is financing.
Operating lease: all payments are operating (some companies present the principal portion as financing for comparability).
Lease liability at inception = Sum of [Payment / (1 + r)^t] for each period t
ROU asset at inception = Lease liability + Initial direct costs + Prepayments - Incentives
Finance lease interest expense = Beginning lease liability x Discount rate
Operating lease expense per period = Total lease payments / Number of periods
When ASC 842 took effect, companies with large portfolios of operating leases (airlines, retailers, restaurant chains) saw their balance sheets expand dramatically. Airlines added billions in ROU assets and lease liabilities that had previously been disclosed only in footnotes. This affected leverage ratios and debt covenants, and analysts had to recalibrate their models.
Date: Weeks 13-14 | Source: Ch. 17, pgs. 17.1-17.32 | Exercises: E 1, 2, 4, 6, 10, 12; P 1
Tags: intercorporate investments, trading securities, available-for-sale, AFS, held-to-maturity, HTM, fair value method, equity method, consolidation, significant influence, control, unrealised gains and losses, OCI, investee, investor
When one company invests in another, the accounting depends on the level of influence the investor has over the investee. This topic covers the full spectrum: passive investments (less than 20% ownership) are accounted for at fair value, investments with significant influence (20-50%) use the equity method, and controlling investments (over 50%) require full consolidation. Understanding which method applies and how each works is critical because the choice dramatically affects reported assets, income, and equity.
Trading Securities
Debt and equity securities held for short-term profit. Reported at fair value. Unrealised gains and losses are recognised in earnings.
Available-for-Sale (AFS) Securities
Debt securities not classified as trading or held-to-maturity. Reported at fair value. Unrealised gains and losses are reported in OCI (not earnings) and accumulate in AOCI until the security is sold. (Note: under ASU 2016-01, equity securities are no longer classified as AFS; all equity securities are measured at fair value through earnings.)
Held-to-Maturity (HTM) Securities
Debt securities the investor has the positive intent and ability to hold until maturity. Reported at amortised cost. Unrealised gains and losses are not recognised. Subject to impairment testing.
Equity Method
Used when the investor has significant influence over the investee (generally 20-50% ownership). The investment is initially recorded at cost and adjusted each period for the investor's share of the investee's net income (increases the investment) and dividends received (decreases the investment).
In simple terms, the investor treats the investee's results as partly its own: it picks up its share of the investee's profits and reduces its investment when it receives dividends.
Consolidation
Required when the investor has control over the investee (generally over 50% ownership). The parent and subsidiary's financial statements are combined into a single set of consolidated statements. Intercompany transactions are eliminated.
Decision Framework: Which Method?
Less than 20% ownership (no significant influence): fair value method. Debt securities classified as trading, AFS, or HTM. Equity securities at fair value through earnings.
20-50% ownership (significant influence): equity method.
Over 50% ownership (control): consolidation.
These thresholds are guidelines, not bright lines. Actual influence is assessed based on facts and circumstances.
Fair Value Method: Key Entries
Purchase: Debit Investment, Credit Cash.
Dividend received: Debit Cash, Credit Dividend Revenue.
Fair value adjustment (trading): Debit/Credit Fair Value Adjustment, Credit/Debit Unrealised Gain/Loss (earnings).
Fair value adjustment (AFS debt): Debit/Credit Fair Value Adjustment, Credit/Debit Unrealised Gain/Loss (OCI).
Equity Method: Key Entries
Purchase: Debit Investment, Credit Cash.
Investor's share of investee's net income: Debit Investment, Credit Investment Revenue (or Equity in Earnings of Investee).
Dividends received: Debit Cash, Credit Investment. (Note: dividends reduce the investment balance, not income. This is a key distinction.)
Amortisation of excess purchase price over book value (e.g., if the investor paid more than book value for identifiable assets): Debit Investment Revenue, Credit Investment.
Impairment
HTM and AFS debt securities: tested for credit losses under CECL.
Equity method investments: tested for other-than-temporary impairment. If impaired, the investment is written down to fair value and the loss is recognised in earnings.
Berkshire Hathaway's portfolio illustrates all three methods. Its smaller equity positions (Apple, Coca-Cola when below 20%) are accounted for at fair value. Its larger stakes with board representation may use the equity method. Its wholly owned subsidiaries (GEICO, BNSF) are fully consolidated. Reading Berkshire's financial statements requires understanding how each method affects the numbers.
Date: Week 14 | Source: "Understanding Pro Formas" handout
Tags: business combination, acquisition method, purchase price allocation, goodwill, bargain purchase, identifiable net assets, fair value, pro forma financial statements, pro forma adjustments, consolidated financial statements, non-controlling interest
When one company acquires another, the accounting follows the acquisition method (ASC 805). The acquirer measures all identifiable assets acquired and liabilities assumed at fair value, and any excess of the purchase price over the fair value of identifiable net assets is recorded as goodwill. Pro forma financial statements show what the combined entity would have looked like if the acquisition had occurred at an earlier date. This topic is the natural extension of intercorporate investments (Topic 12) and the final topic in the course.
Acquisition Method
The required method under U.S. GAAP for accounting for business combinations. The acquirer recognises all identifiable assets acquired and liabilities assumed at their acquisition-date fair values.
Purchase Price Allocation (PPA)
The process of assigning the purchase price to the fair values of the identifiable assets acquired and liabilities assumed. Any excess is goodwill. If the fair value of identifiable net assets exceeds the purchase price, the difference is a bargain purchase gain.
Goodwill
The excess of the purchase price over the fair value of identifiable net assets acquired. It represents the value of synergies, reputation, customer relationships, and other intangible factors not separately identifiable. Goodwill is not amortised under U.S. GAAP; it is tested for impairment at least annually.
In simple terms, goodwill is the premium the acquirer paid for things that do not appear as separate line items on the balance sheet.
Bargain Purchase
Occurs when the fair value of identifiable net assets exceeds the purchase price. The acquirer recognises the difference as a gain in earnings. Rare in practice.
Pro Forma Financial Statements
Hypothetical financial statements that show the combined results of the acquirer and target as if the acquisition had occurred at the beginning of the earliest period presented. Required disclosures for material acquisitions.
Non-Controlling Interest (NCI)
The portion of equity in a subsidiary not attributable to the parent. Measured at fair value at the acquisition date and reported as a separate component of equity on the consolidated balance sheet.
Acquisition Method Steps
Identify the acquirer.
Determine the acquisition date.
Measure the consideration transferred (cash, stock, contingent consideration) at fair value.
Recognise and measure the identifiable assets acquired and liabilities assumed at fair value.
Recognise goodwill (or a bargain purchase gain).
Goodwill Calculation
Goodwill = Consideration transferred + Fair value of NCI + Fair value of previously held equity interest - Fair value of identifiable net assets.
If the result is negative, the acquirer has a bargain purchase and recognises a gain.
Pro Forma Adjustments
Adjust revenues and expenses as if the acquisition occurred at the start of the period.
Add the target's pre-acquisition revenue and expenses.
Adjust for fair value step-ups: additional depreciation and amortisation on assets written up to fair value.
Remove transaction costs (these are expensed as incurred under current GAAP, not capitalised).
Adjust interest expense if acquisition debt was issued.
Adjust income tax effects of all pro forma adjustments.
Goodwill Impairment Testing
Performed at the reporting unit level, at least annually.
Compare the fair value of the reporting unit to its carrying amount (including goodwill).
If carrying amount exceeds fair value, goodwill is impaired. The impairment loss is the difference, limited to the carrying amount of goodwill.
Goodwill = Purchase Price - Fair Value of Identifiable Net Assets Acquired
(When NCI is present: Goodwill = Purchase Price + FV of NCI - FV of Identifiable Net Assets)
Pro forma revenue = Acquirer's full-year revenue + Target's pre-acquisition revenue
Pro forma income = Combined income +/- Fair value adjustments (depreciation, amortisation) +/- Tax effects
Major acquisitions such as Microsoft's purchase of LinkedIn or Salesforce's acquisition of Slack involved billions in goodwill because the purchase prices far exceeded the fair value of the targets' identifiable net assets. Understanding how these transactions are accounted for helps analysts assess whether the premium was justified and monitor for potential impairment in future years.
Students often confuse fair value hedges and cash flow hedges. The distinguishing factor is what is being hedged. A fair value hedge protects against changes in the fair value of an existing asset or liability. A cash flow hedge protects against variability in future cash flows. The accounting follows from this distinction: fair value hedges run both sides through earnings; cash flow hedges park the effective portion in OCI.
A common lease error is thinking that operating leases under ASC 842 are still off-balance-sheet. They are not. Both operating and finance leases are now on the balance sheet. The difference is in how expense is recognised (straight-line vs front-loaded), not whether assets and liabilities are recognised.
Under the equity method, students frequently treat dividends received as revenue. They are not. Dividends reduce the carrying amount of the investment. Revenue from the investee is the investor's share of the investee's net income.
For acquisitions, students sometimes try to amortise goodwill. Under U.S. GAAP, goodwill is not amortised. It is tested for impairment at least annually. (IFRS allows amortisation under certain proposals, but U.S. GAAP does not.)
Lease classification (operating vs finance) and the journal entries for both types are heavily tested. Be able to compute the initial ROU asset and lease liability, and record entries for each subsequent period.
Know the three investment accounting methods (fair value, equity, consolidation), when each applies, and the key journal entries for each. The equity method is the most commonly tested.
Derivatives questions will likely require you to identify whether a scenario is a fair value or cash flow hedge and record the journal entries, including the OCI entries for cash flow hedges.
Goodwill calculation (purchase price minus fair value of identifiable net assets) and pro forma adjustments are exam staples for Topic 13.
Cash flow classification for leases is a common multiple-choice question: finance lease splits between operating (interest) and financing (principal); operating lease payments are operating.
True or False: Under a cash flow hedge, the effective portion of the derivative's gain or loss is recognised in earnings immediately.
Answer: False. The effective portion goes to OCI. It is reclassified to earnings when the hedged forecasted transaction affects earnings.
Fill in the blank: Under ASC 842, the initial lease liability equals the ______ of lease payments over the lease term.
Answer: Present value.
True or False: Under the equity method, dividends received from the investee increase the investor's reported investment income.
Answer: False. Dividends reduce the carrying amount of the investment. The investor's share of the investee's net income is recorded as investment income.
Fill in the blank: Goodwill equals the purchase price minus the ______ of identifiable net assets acquired.
Answer: Fair value.
True or False: Under U.S. GAAP, goodwill is amortised over its useful life.
Answer: False. Goodwill is not amortised. It is tested for impairment at least annually.
Q: A company enters a 5-year lease with annual payments of $10,000 due at the end of each year. The lessee's incremental borrowing rate is 6%. The present value factor for an ordinary annuity at 6% for 5 years is 4.2124. The lease does not meet any of the five finance lease criteria. What is the initial ROU asset and lease liability?
A: Both equal $42,124 ($10,000 x 4.2124). There are no initial direct costs, prepayments, or incentives stated, so the ROU asset equals the lease liability.
Q: A company holds 30% of an investee. The investee reports net income of $200,000 and pays dividends of $50,000. What journal entries does the investor record?
A: Share of net income: Debit Investment $60,000 (30% x $200,000), Credit Equity in Earnings of Investee $60,000. Dividends: Debit Cash $15,000 (30% x $50,000), Credit Investment $15,000. The investment balance increases by a net $45,000.
Q: Company A acquires Company B for $800,000 in cash. The fair value of B's identifiable assets is $900,000 and the fair value of its liabilities is $300,000. How much goodwill is recorded?
A: Fair value of identifiable net assets = $900,000 - $300,000 = $600,000. Goodwill = $800,000 - $600,000 = $200,000.
Q: A company uses a forward contract to hedge a forecasted purchase of raw materials (a cash flow hedge). At the reporting date, the forward has increased in fair value by $5,000 and the hedge is fully effective. What is the journal entry?
A: Debit Forward Contract (asset) $5,000, Credit OCI $5,000. The gain is parked in OCI because the hedge is effective and the hedged transaction has not yet occurred.
Q: Under a finance lease, the beginning lease liability is $100,000 and the discount rate is 5%. The annual lease payment is $23,097. What is interest expense and the reduction in lease liability for the first year?
A: Interest expense = $100,000 x 5% = $5,000. Reduction in liability = $23,097 - $5,000 = $18,097. Ending lease liability = $100,000 - $18,097 = $81,903.
Q: A company purchases AFS debt securities for $50,000. At year-end, their fair value is $53,000. What is the journal entry?
A: Debit Fair Value Adjustment $3,000, Credit Unrealised Gain - OCI $3,000. The unrealised gain on AFS debt securities goes to OCI, not earnings.
Leases (Topic 11) use the same present-value amortisation mechanics as debt (Topic 7). Derivatives and hedge accounting (Topic 10) rely on OCI, which was introduced in the income statement topic (Topic 2). Intercorporate investments (Topic 12) and acquisitions (Topic 13) connect to deferred taxes (Topic 6) through fair value step-ups that create temporary differences. The entire course builds toward consolidated financial statements, where everything from revenue recognition to lease accounting appears in a single set of reports.
Derivative, forward contract, futures, options, swap, interest rate swap, fair value hedge, cash flow hedge, hedge effectiveness, ASC 815, OCI, AOCI, mark to market, lease, ASC 842, operating lease, finance lease, right-of-use asset, ROU asset, lease liability, lessee, incremental borrowing rate, implicit rate, short-term lease, intercorporate investments, trading securities, available-for-sale, AFS, held-to-maturity, HTM, equity method, significant influence, consolidation, control, fair value method, investee, investor, unrealised gains losses, business combination, acquisition method, ASC 805, purchase price allocation, goodwill, bargain purchase, identifiable net assets, pro forma financial statements, pro forma adjustments, non-controlling interest, NCI, goodwill impairment, intermediate accounting, ACC 326