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 concluded that the Holly bonds are other-than temporarily impaired because Nichols believes it is more likely than not that it will have to sell the Holly bonds before the bonds have a chance to recover their fair value. Before-tax net income for 2013 will be reduced by:

Answer 1

Nichols Corporation will need to reduce its before-tax net income for 2013 by the total impairment loss of $30,000 due to classifying the Holly Inc. bonds as other-than-temporarily impaired.

Step-by-step explanation:

The student asks how the before-tax net income for 2013 will be reduced if Nichols Corporation classifies its investment in Holly Inc.'s bonds as other-than-temporarily impaired. When a company classifies an investment as held to maturity but concludes that the investment is other-than-temporarily impaired due to a likelihood of selling it before recovery, it must recognize an impairment loss. For this scenario, Nichols Corporation purchased the bonds at $100,000 with no intention to sell until maturity. Due to problems, the fair value declined to $70,000, attributing $10,000 to credit losses, which are recognized in earnings, and $20,000 to noncredit losses, which are recognized in other comprehensive income (OCI) if the company has the intent and ability to hold the bonds. However, if Nichols concludes they'll likely sell the bonds before a recovery, they must recognize the total impairment loss of $30,000 in earnings, which reduces the 2013 before-tax net income by $30,000.