Question

Nichols Corporation purchased $100,000 of Holly Inc. 6% bonds at par with the intent and ability to hold the bonds until they matured in 2017, so Nichols classifies its investment as held to maturity. Unfortunately, a combination of problems at Holly and in the debt market caused the fair value of the Holly investment to decline to $70,000 during 2013. Nichols calculates that, of the $30,000 drop in fair value, $10,000 of it relates to credit losses and $20,000 relates to noncredit losses.

Assume that Nichols concludes that the Holly bonds are other-than-temporarily impaired because Nichols claculates that the bonds have incurred credit losses. Before-tax net income for 2013 will be reduced by:

Answer 1

Nichols Corporation will reduce its before-tax net income by $10,000, which is the credit loss amount determined for the other-than-temporarily impaired Holly Inc. bonds.

Step-by-step explanation:

When Nichols Corporation determines that the Holly bonds are other-than-temporarily impaired due to credit losses, the before-tax net income will need to be adjusted accordingly. Only the credit loss portion, that Nichols calculates as $10,000, will affect the net income. The noncredit losses associated with other factors impacting the fair market value do not affect the income statement because the investment is classified as held to maturity.

Since we are dealing with an impairment loss associated with a credit loss, we would recognize this impairment in the income statement, thus reducing the net income. The impairment loss recognized is the amount that Nichols concludes will not be recoverable, which is the $10,000 related to credit losses.