FAR · Select balance sheet accounts · 9 practice questions
Investment Classification: AFS, HTM, ASC 321, and Equity Method
Debt classification and significant influence determine how an investment is measured and where its gains and losses go. Below: sort Lark Co.'s independent investment facts by model, then test the rule with free practice questions.
Try one first
Hint
Separate the measurement rules for AFS debt and for equity securities with readily determinable fair values, decide which type places non-credit unrealized changes in OCI versus in earnings.
Answer D. AFS debt securities are measured at fair value on the balance sheet, and non-credit-related unrealized gains and losses are reported in OCI; therefore the bonds are $193,000 with a $4,500 unrealized loss in OCI. Equity securities with readily determinable fair values are measured at fair value with changes recognized in net income, so the stock is $51,500 with the $3,500 gain in earnings. (Credit losses on AFS debt are recognized through an allowance, and OCI amounts are typically presented net of tax.)
Why not A: Tempting if a student overgeneralizes OCI treatment for unrealized changes. The bond portion is correct, but equity securities with readily determinable fair values recognize unrealized gains and losses in net income under current GAAP, not in OCI.
Why not B: Tempting because some candidates mistakenly think only credit-related declines affect income and that AFS debt stays at amortized cost unless credit-impaired. It is wrong: AFS debt is reported at fair value and non-credit unrealized losses are recorded in OCI, so the bonds should be $193,000 with the loss in OCI.
Why not C: Tempting because it mixes two common errors (treating AFS like trading and treating equity as historical-cost until sale). It fails because AFS unrealized non-credit losses go to OCI (not earnings), and publicly traded equity with a readily determinable fair value must be measured at fair value with changes in earnings.
Sort it
No significant influence or control: fair value through earnings, or an elected measurement alternative when fair value is not readily determinable.
Debt is neither trading nor HTM: fair value, with noncredit changes in OCI and credit losses in earnings.
Debt has positive intent and ability to hold to maturity: amortized cost less the CECL allowance.
Significant influence without control, with no fair value option: cost plus share of earnings minus dividends received.
| Item | Goes to |
|---|---|
| Public common shares cost $120,000 and have year-end fair value of $108,000. Lark has no significant influence or control. | ASC 321 equityCarry at $108,000 and recognize the $12,000 loss in earnings, even though the shares remain unsold. |
| Bonds cost $520,000. Effective-interest premium amortization is $3,000; fair value is $511,000. Lark has positive intent and ability to hold to maturity. No credit-loss allowance is required. | HTM debtCarry at $517,000: $520,000 minus $3,000. Neither original cost nor fair value is the correct carrying amount. |
| A 30% voting interest costs $240,000 and gives significant influence, not control. The investee earns $80,000 and pays total dividends of $20,000. No impairment, basis differences, or intercompany adjustments exist. | Equity methodCarry at $258,000: $240,000 plus $24,000 of earnings minus $6,000 of dividends. |
| AFS bonds have amortized cost of $500 and fair value of $460. Credit loss is $15. Lark neither intends to sell nor is more likely than not required to sell before recovery. | AFS debtCarry at $460. Recognize a $15 credit-loss allowance through earnings and the remaining $25 loss in OCI. |
| Private common shares cost $300,000. Lark has no significant influence and elected the measurement alternative. An orderly sale of identical issuer shares implies a value of $330,000. No impairment exists. | ASC 321 equityAdjust the investment to $330,000 and recognize the $30,000 increase in earnings. The measurement alternative does not freeze cost. |
| An appropriately classified HTM bond has amortized cost of $180,000 and a recorded CECL allowance of $8,000. | HTM debtCarry at $172,000. HTM uses amortized cost net of the credit-loss allowance. |
| AFS bonds cost $620,000. After premium amortization, amortized cost is $610,000 and fair value is $585,000. No credit loss exists; no sale is intended or likely required before recovery. | AFS debtCarry at $585,000 with a $25,000 loss in OCI. Using purchase price would incorrectly produce a $35,000 loss. |
| An 18% voting interest gives Lark significant influence through participation in financial and operating policy decisions. Lark does not control the investee and has not elected the fair value option. | Equity methodSignificant influence establishes the model. Ownership below 20% does not prevent equity-method accounting. |
| An 18% public common-stock interest gives no significant influence or control. Cost is $300,000, year-end fair value is $330,000, and ordinary dividends received are $12,000. | ASC 321 equityCarry at $330,000. Earnings include the $30,000 fair-value gain and $12,000 dividend income, totaling $42,000. |
| Bonds were purchased at par for $500,000. Fair value is $480,000. Lark has positive intent and ability to hold to maturity. No credit-loss allowance is required. | HTM debtCarry at $500,000. The market-value decline does not create an OCI loss for HTM debt. |
| Bonds may be sold for cash needs but were not purchased for near-term trading. Amortized cost is $194,000 and fair value is $198,000. No credit-loss allowance is required. | AFS debtCarry at $198,000 with a $4,000 gain in OCI. Possible sale for cash needs prevents HTM classification here. |
| An 8% private common-stock interest gives no significant influence. Fair value is not readily determinable, and Lark elected the measurement alternative. No observable price changes or impairment exist. | ASC 321 equityKeep the cost basis because no adjustment trigger exists. This is the measurement alternative, not HTM amortized cost. |
Key points
- Remember: Classify each holding first; investments in the same portfolio can use different measurement models.
- Effective-interest amortization changes debt's cost basis before you compare it with fair value.
- Ownership percentage is a clue; actual rights determine significant influence.
- Add carrying amounts for the balance sheet, but keep earnings and OCI separate.
How the exam traps you
- Put every unrealized gain or loss in OCI. ASC 321 equity changes go to earnings. AFS debt's noncredit changes go to OCI.
- Measure an AFS bond's unrealized change from its purchase price. Compare fair value with amortized cost after effective-interest amortization.
- Subtract an AFS credit-loss allowance from fair value. AFS debt's final carrying amount is fair value. Subtracting the allowance again double counts the credit loss.
Question 2
Hint
Identify what events the measurement alternative permits to change carrying amount and where those changes are reported under current GAAP.
Answer B. Under ASC 321's measurement alternative, the carrying amount is not frozen at historical cost. It must be adjusted for impairment and for observable price changes from orderly transactions in identical or similar shares of the same issuer, and those adjustments are recognized in net income. Because Vale observed an orderly transaction implying $330,000 and there are no impairment indicators, the investment should be reported at $330,000 with the increase in earnings.
Why not A: This is tempting because the measurement alternative is often remembered as a cost-based approach for private-company shares. It is wrong because it ignores the rule that observable price changes from orderly transactions in identical or similar shares of the same issuer require carrying‑amount adjustments even when fair value is not readily determinable.
Why not C: This choice appeals to the common belief that upward adjustments are blocked until a public quoted price exists. It fails because ASC 321 allows upward adjustments when supported by observable price changes from orderly transactions for identical or similar investments of the same issuer.
Why not D: This distractor mixes older available‑for‑sale/OCI concepts with current guidance. Under ASC 321, changes in fair value of equity securities with readily determinable fair values are recognized in net income (not OCI), and the measurement alternative's observable-price adjustments are also recognized in earnings.
Question 3
Hint
Focus first on the type of security and whether fair value is readily determinable before thinking about management intent.
Answer B. Under current U.S. GAAP (ASC 321), equity securities with readily determinable fair values are measured at fair value each reporting date, and changes in fair value are recognized in net income. The stem excludes equity-method or consolidation accounting and states the fair value is readily determinable, so the fair-value-through-net-income model applies.
Why not A: This distractor confuses the historical available-for-sale concept (mainly for certain debt securities) with current equity treatment. For publicly traded equity securities with readily determinable fair values, unrealized gains and losses are generally reported in net income, not OCI.
Why not C: A cost-based approach is only an alternative for equity investments that do not have a readily determinable fair value. Because the stem specifies a publicly traded security with a readily determinable fair value, the cost/impairment model is not appropriate here.
Why not D: Amortized cost is a measurement for certain debt securities (e.g., held-to-maturity), not for equity securities. Management's intent to hold does not change an equity security's measurement to amortized cost.
Question 4
Hint
Separate equity securities from debt securities first, then ask which debt investment satisfies the specific condition required for held-to-maturity classification.
Answer B. Only debt securities that qualify as held-to-maturity (both positive intent and ability to hold to maturity) are measured at amortized cost under ASC 320. Investment 3 is a debt security and the facts state Alder has the positive intent and ability to hold it to maturity, so it may be reported at amortized cost. Investments 1 and 2 are equity securities (investment 2 uses ASC 321's measurement alternative, which is cost-based but not amortized cost), and Investment 4 is debt but Alder may sell it before maturity, so it cannot be classified as held-to-maturity.
Why not A: Tempting because the shares are held long term, but public common shares typically have a readily determinable fair value and are measured at fair value (changes recognized in net income) under ASC 321 rather than at amortized cost.
Why not C: Attractive because ASC 321's measurement alternative starts from cost, but that alternative results in cost less impairment and certain observable price adjustments, it is not amortized cost for debt HTM classification.
Why not D: Both are debt securities, but Investment 4 fails the held-to-maturity limiting condition because Alder 'may sell' it to realize gains; that indicates a lack of the required positive intent and ability to hold to maturity.
Question 5
Hint
First decide the accounting model based on the level of influence. Then separately think about how the ending balance sheet amount is measured and whether dividends affect earnings, carrying amount, or both.
Answer D. River lacks significant influence, so the investment is measured at fair value with changes in fair value recognized in net income (ASC 321). The ending balance is the fair value of $330,000. Year 1 earnings include the $30,000 unrealized gain (330,000 − 300,000) plus the $12,000 dividend income, totaling $42,000.
Why not A: This mixes correct recognition of the $42,000 total earnings (unrealized gain plus dividend) with an incorrect ending carrying amount that appears to reduce the fair value by the dividend. For a fair-value-measured investment, ordinary dividends are recognized in income but do not reduce the reported fair value.
Why not B: Tempting because it applies the equity method (300,000 + 18% of 100,000 − 12,000 = 306,000 and 18,000 income). It's wrong because the facts rule out significant influence, so the equity method does not apply.
Why not C: This correctly uses fair value for the balance sheet and recognizes the $30,000 unrealized gain, but it omits the $12,000 ordinary dividend income, which is also recognized in earnings for a fair-value-through-net-income equity security.
Question 6
Hint
Focus first on the measurement basis for an equity security with a readily determinable fair value, then decide whether the dividend changes the carrying amount.
Answer C. Because Pine lacks significant influence and the shares have a readily determinable fair value, the investment is measured at fair value at the reporting date. Pine should report the investment at its December 31 fair value of $46,000 (any $4,000 unrealized loss is recognized in earnings). The $1,200 cash dividend is recognized in income and does not reduce the carrying amount of the investment unless it were a return of capital.
Why not A: This reflects subtracting the $1,200 dividend from the year-end fair value (46,000 − 1,200). That treats the dividend as a reduction of the investment; however, dividends are recognized as income for this type of equity security and do not reduce the carrying amount.
Why not B: This comes from starting with historical cost ($50,000) and subtracting the dividend ($1,200 → 50,000 − 1,200 = 48,800). For equity securities with a readily determinable fair value, the correct approach is to remeasure to fair value at year-end, not carry an adjusted cost basis.
Why not D: Leaving the investment at original cost ignores the requirement to measure equity securities with readily determinable fair values at fair value (with changes recognized in earnings) under current U.S. GAAP.
Question 7
Hint
Identify the type of investment first: this is common stock with a readily determinable fair value, and the investor does not have significant influence.
Answer A. Equity securities with readily determinable fair values are measured at fair value each reporting date under current U.S. GAAP when the investor does not have significant influence. Rook reports 1,000 × $28 = $28,000 at December 31, and the $3,000 increase from cost is recognized in net income.
Why not B: This confuses treatment for certain debt securities (and older available-for-sale terminology) with current equity accounting. For equity securities with a readily determinable fair value, unrealized gains and losses are reported in net income, not OCI.
Why not C: That reflects a historical-cost or sale-only recognition approach, which is incorrect here because the security has a readily determinable fair value and must be remeasured at each reporting date.
Why not D: This echoes older impairment-based thinking for equities. Current guidance requires fair-value measurement for equity securities with a readily determinable fair value, with changes recognized in earnings rather than waiting for an other-than-temporary threshold.
Question 8
Hint
First determine whether this investment is accounted for under the equity method. If not, focus on the default measurement rule for equity securities with readily determinable fair values.
Answer B. Under U.S. GAAP (ASC 321), equity securities with a readily determinable fair value are measured at fair value, with unrealized gains and losses recognized in net income. Park owns only 2% and lacks significant influence, so the investment is measured at the fair value of $46,000 at December 31, 20X5. The $4,000 unrealized loss is therefore reported in net income.
Why not A: This confuses the accounting for certain debt securities (historically available-for-sale) with equity securities. For equity securities with a readily determinable fair value, unrealized gains and losses are recognized in net income, not OCI.
Why not C: This reflects the incorrect assumption that investments remain at historical cost until disposal. Current guidance requires remeasurement of equity securities with a readily determinable fair value, with changes reported in earnings.
Why not D: This mixes up optional fair-value elections used elsewhere. For equity securities with a readily determinable fair value, fair value measurement with earnings recognition is the default and no separate fair-value election is required.
Question 9
Hint
Focus first on two things: whether the investment is an equity security and whether the investor has significant influence.
Answer A. Under ASC 321, equity securities with a readily determinable fair value are measured at fair value, with changes in fair value recognized in net income. Alder's 2% publicly traded holding, with no indication of significant influence, meets that description. Therefore the $18,000 unrealized gain is reported in earnings at December 31, 20X5.
Why not B: This distractor plays on the older available-for-sale model where unrealized gains flowed to OCI. Current GAAP (ASC 321) requires equity securities with readily determinable fair values to flow through net income, so OCI is not the general treatment here.
Why not C: This reflects the common 'realization' intuition, but for equity securities with readily determinable fair values GAAP requires periodic remeasurement to fair value and recognition of unrealized gains and losses in net income.
Why not D: The equity method is used when the investor can exercise significant influence (often indicated by ~20% ownership or other influence factors). With a 2% holding and no influence, the equity method does not apply.
Common questions
What is the difference between AFS and HTM measurement?
AFS debt is reported at fair value; its noncredit unrealized changes go to OCI. HTM debt is reported at amortized cost less its CECL allowance, not marked to market.
Do ASC 321 equity gains and losses go to net income?
Yes, when fair value is readily determinable and neither significant influence nor control exists. Under an elected measurement alternative for shares without readily determinable fair value, observable price changes and impairment adjustments also go to net income.
How do dividends affect equity-method and passive equity investments?
Under the equity method, add your share of earnings and subtract dividends received from the investment. Ordinary dividends on ASC 321 equity are income when declared, not adjustments to the investment balance.
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