FA2: Module 8 Investments and financial instruments

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FA2: Module 8
Investments and financial instruments
1. Classification of investments
2. Amortized cost (Held-to-maturity)
investments
3. Accounting for other investments
4. The equity method
5. Investments and the cash flow statement
1. Classification of investments
Accountants distinguish two broad categories of
investments:
Passive investments are made in order to earn a
return, either in the short or the long term, with
no view to control or influence the investee
(entity that issued the instrument). These can
be voting or non-voting instruments.
Strategic investments are made in order to
influence or control the investee company.
Typically, these investments are in voting
instruments.
Passive investments: Debt investments
1. Amortized cost (Held-to-maturity or HTM)
investments: Securities with fixed or
determinable payments and payment dates, and
a maturity date to which management has
positive intent and capability to hold securities.
Objective is to hold investments to collect
contractual cash flows.
2. Fair-value-through-profit-and-loss (FVTPL)
investments: a debt investment that is held for
the purpose of resale
Intention/designation of management is crucial!
Passive investments: Equity investments
1. FVTPL (held- for-trading or HFT)
investments: Held for the purpose of resale (so
market value is important); or subject to certain
accounting rules (e. g., hedges).
2. Fair-value-through-other-comprehensiveincome (FVTOCI) investments (also Availablefor-sale or AFS): irrevocably designated by
management at time of acquisition; not acquired
primarily for resale
3. Cost investments: Investments for which fair
value cannot be reliably determined
Strategic investments (type of control)
1. Controlled investments (subsidiaries): give
“continuing power to determine strategic
operating, investing and financing policies of
investee without cooperation of others.” (usually,
more than 50% of voting shares)
2. Significant influence investments (associates):
give influence over investee management but not
control (usually > 20%, <50% of voting shares)
3. Joint ventures: two or more venturers jointly
control the entity (one venturer cannot decide
without consent of other venturers)
Example: A11-2
2. Amortized cost (HTM) investments
• Usually bonds and money market instruments
• Bonds typically offer interest payments
annually or, more commonly, semi-annually,
and repayment of the principal when the bond
matures
• Bond valuation is a present value exercise,
where the interest payments are an annuity and
the principal repayment is a lump sum; the
discount rate is determined by the market as
function of the risk-free rate and risk
Key bond data
1. Face value (or par value, principal value):
amount payable when bond is due
2. Maturity date: end of bond term and due
date for the face value
3. Stated interest rate (or coupon rate, nominal
rate): rate that determines periodic interest
payments
4. Interest payment dates: dates at which
periodic interest payments are due
Bond characteristics determined by market
1. Market rate of interest (or bond yield):
return required by investors, function of
prevailing interest rates and bond risk
2. Market value: present value of cash flows
implied by coupon rate and principal
repayment, discounted at market rate
3. Bond discount/premium: difference between
bond face value and market value, at date of
issue
Market value of long term debt instruments
The market value of a long term instrument is
the present value of its associated future cash
flows, discounted at the market (or effective) rate
or yield.
Cash flows associated with debt instruments are
generally of two types:
1. Face value of instrument, payable at maturity
date
2. Stream of interest payments ( = face value x
stated interest rate): annuity
Accounting for bond investment
If the bonds are considered held-to-maturity
investments, the amortized cost method is
appropriate. Year-to-year fluctuations in the
market value of the investment are ignored. The
investment is carried at amortized cost.
Investment revenue is (generally) equal to cash
interest received, plus/minus amortization of any
discount/premium, using effective interest
method.
Accounting for initial bond investment
Dr. Investment in bonds
Mkt
Cr. Cash
Mkt +accrued int (if any)
Dr. Interest receivable
Accrued int (if any)
Mkt = market value of bond at date of issue
Discount or premium (difference between face
value and market value of bond) arises if market
interest rate (yield) at date of investment differs
from stated interest rate.
Accounting for AC/HTM bond investment
• Initial cost excludes any accrued interest
• Transaction costs (brokerage fees,
commissions, etc.) are included as part of
initial cost of investment
• Interest income recorded using effective
interest method (ASPE can use straight-line)
• If investment sold before maturity (should be
rare), there can be gain or loss on disposal
• When investment matures, no gain or loss
Bond investment example: Dougherty
Dougherty Ltd. acquires $6,000 of 10% bonds
on June 2, 2005 to be held to maturity. The
bonds pay interest on December 1 and June 1.
The bonds mature on June 1, 2007.
Record the investment in the bonds assuming
that the bonds were priced to yield (1) 10%; (2)
8%; and (3) 12%.
Prepare journal entries related to this investment
through June 1, 2006, assuming the bonds yield
10%.
Amortization of discount/premium
Effective interest method
Interest received (cash) = face value X (stated
interest rate / # of interest payments per year)
Interest revenue = market interest rate at date of
bond issue X opening carrying value of bond
(i. e., after last payment)
Adjustment to bond carrying value = difference
between interest revenue and interest received
(i. e., is a plug)
Dougherty (part 2)
Dougherty Ltd. acquires $6,000 of 10% bonds
on June 2, 2005 to be held to maturity. The
bonds pay interest on December 1 and June 1.
The bonds mature on June 1, 2007.
Prepare an amortization table, assuming that the
bonds are priced to yield (1) 8% and (2) 12%.
Prepare journal entries related to this investment
through June 1, 2006, assuming the bonds yield
(1) 8% and (2) 12%.
In all cases, use effective interest amortization.
3. Accounting for other investments
Cost
• Used for equity investments when fair value
is not available
• Investment recorded at cost; transaction costs
included in cost
• Dividends declared are recorded as income
• Any gain or loss on sale recorded in income
Example: A11-14
Cost method: Bookkeeping
Acquisition
Dr. Investment
Cr. Cash
A = cost of shares
B = transactions costs
A+B
A+B
Cost method: Bookkeeping
Year-end (fair value has changed)
No entry
Sale of investment next year
Dr. Cash (Net proceeds)
P
Cr. Investment
A+B
Dr. Loss on sale
(A+B)-P
Cr. Gain on sale
P-(A+B)
3. Accounting for other investments (A11-14)
Fair-value-through-profit-and-loss (FVTPL)
• Used for held-for-trading (HFT) investments
• Investment recorded at cost; transaction costs
expensed immediately
• Interest income on bonds recorded using
effective interest method; dividend income on
shares recorded when declared
• Investments revalued to fair value at end of
each reporting period
• Holding gains and losses recorded in income
• Realized gains and losses (market less
carrying value) recorded in income when sold
HFT/FVTPL investment: Bookkeeping
Acquisition
Dr. Investment
Dr. Commissions expense
Cr. Cash
A = cost of investment
B = transaction costs
A
B
A+B
FVTPL/HFT investment: Bookkeeping
Year-end (fair value has increased to F)
Dr. Investment
F-A
Cr. Unrealized holding gain (I/S)
F-A
Sale of investment next year
Dr. Cash (Net proceeds)
P
Cr. Investment
F
Cr. Gain on sale
P-F
or Dr. Loss on sale
F-P
FVTPL/HFT: Bookkeeping
Year-end (fair value has decreased to D)
Dr. Unrealized holding loss (I/S)
A-D
Cr. Investment
A-D
Sale of investment next year
Dr. Cash (Net proceeds)
P
Cr. Investment
D
Cr. Gain on sale
P-D
or Dr. Loss on sale
D-P
3. Accounting for other investments (A11-14)
Fair-value-through-OCI (FVTOCI)
• Available-for-sale (AFS); Designated by
management; for equity investments only
• Investment recorded at cost; transaction costs
included in cost of investment
• Dividend income on shares recorded when
declared
• Investments revalued to fair value at end of
each reporting period
• Holding gains and losses recorded in OCI;
may be transferred into RE when realized or
left in Accumulated OCI
FVTOCI/AFS: Bookkeeping
Acquisition
Dr. Investment
Cr. Cash
A = cost of shares
B = transaction costs
A+B
A+B
FVTOCI/AFS: Bookkeeping
Year-end (fair value increases)
Dr. Investment
F-(A+B)
Cr. Unrealized holding gain (OCI)
F-(A+B)
Sale of investment next year (fair value increases)
Dr. Cash (Net proceeds)
P
Cr. Investment
F
Cr. Realized holding gain (OCI)
P-F
Net holding gains transferred to RE (optional)
Dr. OCI: Holding gains
P–(A+B)
Cr. Retained earnings
P-(A+B)
FVTOCI/AFS : Bookkeeping
Year-end (fair value decreases)
Dr. Unrealized holding loss (OCI) A+B-D
Cr. Investment
A+B-D
Sale of investment next year (fair value decreases)
Dr. Cash (Net proceeds)
P
Cr. Investment
D
Dr. Realized holding loss (OCI)
D-P
Net holding losses transferred to RE (optional)
Dr. Retained earnings
(A+B)-P
Cr. OCI: Holding losses
(A+B)-P
4. The equity method (significant influence)
a. Equity method basics
Basics: Investor records its proportionate share
of investee income as its own income (debit to
investment account), and reduces the investment
account by its share of investee dividends
received.
e. g., Big buys 25% of voting shares of Small for
$100 on January 1. At year end, Small reports
net income of $40 and declares and pays a cash
dividend of $20.
4.b. Acquisition cost greater than book value
The purchase discrepancy is the difference
between the cost of investment acquired and the
book value of investor share of investee net
assets on acquisition date. This difference arises
from under- or overstated assets and/or liabilities
on the investee balance sheet; or unrecorded
goodwill. The investor must attribute the
purchase discrepancy to depreciable assets (and
then amortize it), non-depreciable identifiable
assets/liabilities, or goodwill.
Example: A11-23
4.c. Investee discontinued operations
Investor company must record separately its
share of investee income attributable to
discontinued operations. If these items are
material from the investor’s point of view, they
must be presented separately on investor’s
income statement. In practice, this is rare.
4.d. Intercompany transactions
Principle: An economic entity cannot earn a profit
by selling to itself. From an economic point of
view, affiliated companies are (at least partly) a
single entity.
Investor company cannot earn a profit simply by
transferring assets to or from investee. Profits are
earned only by selling to an external party.
Intercompany sales cause no problems as long as
the asset in question is ultimately sold to an
external party. Adjustments must be made if a
“profitable” intercompany sale occurs and the
asset remains “inside” the investor-investee entity.
5. Investments and the cash flow statement
• Cash flows related to acquisition and sale of noncash-equivalent investments are investing cash
flows
• Interest and dividends received can be classified
as operating or investing cash flows (treatment
must be consistent)
5. Investments and the cash flow statement
Non-cash items
Must be removed from income (indirect method) or
excluded from operating activities (direct method)
• Revaluations (not FVTOCI)
• Gains or losses on sale of investments (not
FVTOCI)
• Amortization of discount or premium (held-tomaturity)
• Investor share of investee income (significant
influence investments)
Example: A11-26

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