FAR · Select balance sheet accounts · 7 practice questions
AFS Debt: Effective Interest, Fair Value, and OCI
For AFS debt, measure the noncredit unrealized gain or loss from updated amortized cost, not the purchase price. Below: a worked effective-interest calculation and free practice on fair value and OCI.
Try one first
Hint
Compute the bond's amortized cost first, then compare that amount with fair value and recall where unrealized gains on available-for-sale debt securities are reported.
Answer B. Amortized cost at year-end is $483,000 ($480,000 purchase price + $3,000 discount amortization). Available-for-sale debt securities are reported at fair value, so the balance sheet amount is $490,000. The $7,000 difference between fair value and amortized cost is an unrealized holding gain and, absent any credit-loss allowance, is reported in other comprehensive income (OCI).
Why not A: This treats the unrealized gain as the difference between fair value and the original purchase price ($490,000 − $480,000 = $10,000). After amortizing $3,000 of discount, unrealized gains are measured from amortized cost ($483,000), giving $7,000, not $10,000.
Why not C: That reflects held-to-maturity accounting (amortized cost) rather than available-for-sale. Because Hall classified the bonds as available-for-sale, they must be reported at fair value each reporting date with unrealized gains reported currently in OCI (subject to the credit-loss exception, which this fact pattern excludes).
Why not D: This has the correct amounts but records the unrealized gain in net income. For available-for-sale debt securities, unrealized holding gains and losses are reported in OCI (unless a credit loss is recognized in earnings).
Worked example
On January 1, Vale Co. buys an AFS bond for $240,000. Face amount is $250,000, annual coupon is 4%, and effective yield is 5%. Interest is paid December 31. Year-end fair value is $245,000. No credit loss exists. Vale neither intends nor is more likely than not required to sell before recovery of amortized cost. Ignore income taxes.
| 1 | Effective-interest income$240,000 × 5% | $12,000 |
| 2 | Cash interest$250,000 × 4% | $10,000 |
| 3 | Discount amortization$12,000 - $10,000 | $2,000 |
| 4 | Year-end amortized cost$240,000 + $2,000 | $242,000 |
| 5 | Unrealized gain in OCI$245,000 - $242,000 | $3,000 |
| 6 | Balance sheet carrying amount$242,000 + $3,000 | $245,000 |
Vale reports the bond at $245,000 and recognizes a $3,000 unrealized gain in OCI.
Check: Shortcut: $240,000 + $12,000 - $10,000 = $242,000 amortized cost; $245,000 - $242,000 = $3,000 in OCI.
Key points
- Interest income uses beginning amortized cost and effective yield; cash interest uses face amount and coupon rate.
- Discount amortization raises amortized cost; premium amortization lowers it.
- OCI reports the period's unrealized change; AOCI holds the accumulated balance in equity.
How the exam traps you
- Compare fair value with the original purchase price. Amortize the discount or premium first. Compare fair value with updated amortized cost.
- Put the noncredit unrealized gain or loss in net income. Use OCI when there is no credit loss, intended sale, or more-likely-than-not required sale before recovery.
- Report the AFS investment at amortized cost. Use amortized cost to measure the OCI amount, but report the investment at fair value.
Question 2
Hint
Focus first on the type of instrument, then ask whether management has both the intent and ability to hold it to maturity.
Answer C. Held-to-maturity requires both the positive intent and the ability to hold the debt security to maturity. Management's statement that the bonds could be sold if interest rates change indicates Reed lacks the required intent for held-to-maturity. The bonds also were not purchased for short-term profit (so not trading), making available-for-sale the most appropriate classification.
Why not A: Tempting because the bonds have a stated maturity, but HTM requires positive intent and ability to hold to maturity; management's willingness to sell disqualifies HTM.
Why not B: Trading classification is for securities acquired principally for sale in the near term to profit from short-term price changes; the facts state Reed is not buying for short-term profit.
Why not D: The equity method applies to certain equity investments when the investor has significant influence; these are debt securities and the stem says Reed does not have significant influence.
Question 3
Hint
First decide which debt security classification fits the facts, then ask where a noncredit fair value change goes for that classification.
Answer C. Harlan neither acquired the bond for trading nor asserted the positive intent and ability to hold it to maturity, so the debt security is classified as available-for-sale. Available-for-sale debt securities are carried at fair value on the balance sheet. Because the decline in fair value is due solely to market interest rates (not credit deterioration), the unrealized loss is recorded in other comprehensive income rather than in current earnings.
Why not A: This describes trading securities, which flow fair-value changes through earnings. The facts state Harlan did not acquire the bond for near-term trading profits, so trading classification (and earnings recognition of unrealized losses) is not appropriate.
Why not B: Tempting because the bond is not trading, but held-to-maturity (amortized cost) classification requires an assertion of positive intent and ability to hold to maturity, which the stem says Harlan has not made. Without HTM status, amortized-cost-only reporting is incorrect.
Why not D: Noncredit losses are not reported in earnings for available-for-sale debt securities, but that does not permit carrying the security at amortized cost. Available-for-sale debt securities must be reported at fair value with noncredit unrealized losses in OCI.
Question 4
Hint
Focus first on what kind of investment instrument this is, then ask whether the facts support both intent and ability to hold it to maturity.
Answer C. Under ASC 320, a debt security is classified as available-for-sale when it is not purchased for near-term resale and the investor does not have the positive intent and ability to hold it to maturity. The facts here explicitly rule out trading (not bought for near-term resale) and held-to-maturity (management does not assert positive intent and ability). Therefore, available-for-sale is the appropriate classification at acquisition.
Why not A: Tempting because the bond has a fixed maturity, but held-to-maturity requires a positive intent and ability to hold to maturity; the stem states management does not assert that intent.
Why not B: This might look plausible since the bonds could be sold, but trading classification applies only to securities purchased and held primarily for near-term resale, which the stem denies.
Why not D: This distractor confuses debt and equity rules: the instrument is a corporate bond (a debt security), so the equity classification model does not apply.
Question 5
Hint
Classify each investment first: debt or equity, then determine which current GAAP category, if any, sends unrealized holding gains to OCI.
Answer C. Under current U.S. GAAP (ASC 320/ASC 321), unrealized gains and losses for debt securities classified as available-for-sale are reported in OCI, while held-to-maturity debt is carried at amortized cost (no unrealized gains in OCI) and equity securities with a readily determinable fair value report fair value changes in net income. The first bond is not a trading position and may be sold before maturity, so it fits the available-for-sale treatment. The second bond is held-to-maturity (amortized cost), and the quoted common stock (3% ownership, no significant influence) has its fair value changes recognized in net income.
Why not A: This is tempting because students often associate OCI with long-term investments, but OCI is not determined simply by management's subjective 'long-term' view. For debt securities the classification (trading, available-for-sale, held-to-maturity) controls whether unrealized gains flow to OCI; HTM securities remain at amortized cost, not OCI.
Why not B: This distractor appeals to memory of older rules where nontrading securities affected OCI, but under current U.S. GAAP equity securities with readily determinable fair values (like quoted common stock) recognize fair value changes in net income (ASC 321). Only available-for-sale debt securities route unrealized gains to OCI.
Why not D: This lures students who conflate HTM intent with OCI. Positive intent and ability to hold to maturity classifies debt as held-to-maturity, which is measured at amortized cost, unrealized fair value changes are not recorded in OCI for HTM securities.
Question 6
Hint
For debt securities, do not stop at management's preference. Ask whether the facts support the required condition for a held-to-maturity classification.
Answer A. A debt security can be classified as held-to-maturity only if the investor has the positive intent and the ability to hold it to maturity. Here, the expected need to sell the bond to finance the planned plant expansion shows that the positive intent/ability condition is not supportable. The bond was not acquired principally for sale, so trading is inappropriate; available-for-sale is therefore the correct classification.
Why not B: This is tempting because candidates often remember 'intent' and stop there. Held-to-maturity requires both positive intent and the ability to hold to maturity; an expected liquidity-driven sale is a limiting condition that prevents HTM classification.
Why not C: This distractor relies on an oversimplification. Trading classification applies when a security is acquired principally for sale in the near term; the stem expressly rules out that acquisition purpose, so trading is not appropriate here.
Why not D: The equity method applies to certain stock (equity) investments when the investor has significant influence over the investee, not to a corporate bond. The expected holding period alone does not trigger equity-method accounting for debt securities.
Question 7
Hint
First evaluate whether facts support the affirmative positive intent to hold to maturity (ASC 320). If positive intent is defeated, consider whether the security was acquired for near-term sale (trading) or should be AFS and measured at fair value with unrealized amounts in OCI.
Answer A. Classification as held-to-maturity requires both the ability and the affirmative positive intent to hold the debt security to maturity. A board policy that expressly permits and contemplates sales to realize interest-rate gains undermines the required positive intent (ASC 320), so the bond should not be HTM. Because it was not acquired for near-term trading, available-for-sale is appropriate; AFS debt securities are measured at fair value with unrealized gains and losses reported in other comprehensive income (assuming no credit loss).
Why not B: Tempting because management says it expects to hold and the company has ability to hold, but ASC 320 requires affirmative positive intent to hold to maturity; a treasury policy that permits and contemplates selling to capture interest-rate gains is inconsistent with that positive intent.
Why not C: This is attractive if one focuses on the permission to sell, but trading classification is for securities acquired principally for near-term sale or active trading. Harbor purchased the bond for a long-term cash management portfolio and does not trade frequently, so trading is not the best classification.
Why not D: The fair-value option is a valid measurement election under ASC 825, but it must be irrevocably elected in accordance with the guidance (typically at initial recognition or permitted election points). The fact pattern gives no indication Harbor elected the fair-value option, so this assumption is not supportable.
Common questions
How do you calculate an unrealized gain or loss on AFS debt?
First update amortized cost for effective-interest amortization. With no credit loss, fair value minus updated amortized cost gives the unrealized gain or loss: positive means a gain; negative means a loss.
Does AFS interest income use the coupon rate or effective yield?
Interest income equals beginning amortized cost multiplied by the effective yield for the period. The coupon rate determines cash interest, not interest income.
Do unrealized losses on AFS debt go to OCI or net income?
With no credit loss and no intended or more-likely-than-not required sale before amortized cost recovery, the unrealized loss goes to OCI. Credit losses go to earnings.
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