FA2: Module 8 - PowerPoint Presentation

Slide1

FA2: Module 8Investments and financial instruments

Classification of investments

Amortized cost (Held-to-maturity) investments

Accounting for other investments

The equity method

Investments and the cash flow statementSlide2

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.Slide3

Passive investments: Debt investments

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.

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!Slide4

Passive investments: Equity investments

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).

Fair-value-through-other-comprehensive-income (FVTOCI) investments (also Available-for-sale or AFS)

: irrevocably designated by management at time of acquisition; not acquired primarily for resale

Cost investments

: Investments for which fair value cannot be reliably determinedSlide5

Strategic investments (type of control)

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)

Significant influence investments (associates)

: give influence over investee management but not control (usually > 20%, <50% of voting shares)

Joint ventures

: two or more

venturers

jointly control the entity (one

venturer

cannot decide without consent of other

venturers

)

Example: A11-2Slide6

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 riskSlide7

Key bond data

Face value

(or par value, principal value): amount payable when bond is due

Maturity date

: end of bond term and due date for the face value

Stated interest rate

(or coupon rate, nominal rate): rate that determines periodic interest payments

Interest payment dates

: dates at which periodic interest payments are dueSlide8

Bond characteristics determined by market

Market rate of interest

(or bond yield): return required by investors, function of prevailing interest rates and bond risk

Market value

: present value of cash flows implied by coupon rate and principal repayment, discounted at market rate

Bond discount/premium

: difference between bond face value and market value, at date of issueSlide9

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:

Face value of instrument, payable at maturity date

Stream of interest payments ( = face value x stated interest rate): annuitySlide10

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

.Slide11

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. Slide12

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 lossSlide13

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%.Slide14

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

)Slide15

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.Slide16

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: A11-14Slide17

Cost method: Bookkeeping

Acquisition

Dr. Investment A+B

Cr. Cash A+B

A = cost of shares

B = transactions costsSlide18

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)Slide19

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 soldSlide20

HFT/FVTPL investment: Bookkeeping

Acquisition

Dr. Investment A

Dr. Commissions expense B

Cr. Cash A+B

A = cost of investment

B = transaction costsSlide21

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-PSlide22

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-PSlide23

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 OCISlide24

FVTOCI/AFS: Bookkeeping

Acquisition

Dr. Investment A+B

Cr. Cash A+B

A = cost of shares

B = transaction costsSlide25

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)Slide26

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)-PSlide27

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.Slide28

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: A11-23Slide29

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.Slide30

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.Slide31

5. Investments and the cash flow statement

Cash flows related to acquisition and sale of non-cash-equivalent investments are investing cash flows

Interest and dividends received can be classified as operating or investing cash flows (treatment must be consistent)Slide32

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-to-maturity)

Investor share of investee income (significant influence investments)

Example: A11-26