INVESTMENTS ZOE REGINA CASTRO Financial instruments • Financial instrument is “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.” (PAS 32) • Financial instruments include both financial assets and financial liabilities. • Financial instruments include equity instruments of another entity but exclude an entity’s own equity instruments. An entity’s own equity instruments are neither assets nor liabilities, but rather equity. Financial assets A financial asset is any asset that is: a. Cash; b. Equity instrument of another entity; or c. Contractual right to receive cash or another financial asset or to exchange financial instruments with another entity under conditions that are potentially favorable. Financial liabilities A financial liability is any liability that is: a. a contractual obligation to deliver cash or another financial asset to another entity; or b. a contractual obligation to exchange financial instruments with another entity under conditions that are potentially unfavorable. Initial recognition and Classification • Financial assets are recognized only when the entity becomes a party to the contractual provisions of the instrument. Basis of classification Financial assets are classified based on: 1. the entity’s business model for managing the financial assets; and 2. the contractual cash flow characteristics of the financial asset. Equity vs. Debt instruments • Only debt instruments can be classified under the Amortized Cost or FVOCI (mandatory) measurement categories. • Equity instruments are measured at FVPL, unless the entity makes an irrevocable election on initial recognition to measure them at FVOCI. • A debt instrument that is not measured at amortized cost or at FVOCI is measured at FVPL. Business models Business models Business models Business models Fair Value Measurement • Fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (PFRS 13) • Fair value is based on the market price of the asset in a: a. principal market; or b. the most advantageous market (in the absence of a principal market) • The market price used in measuring fair value is not adjusted for any transaction costs, but is adjusted for any transport costs. Formula Market price (in ‘principal’ or ‘most advantageous’ market) Less: Transport costs Fair value INTERMEDIATE ACCTG 1A (by: MILLAN) xx (xx) xx Fair value hierarchy Level 1 Observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3 Unobservable inputs (for example, entity’s own data or assumptions). INTERMEDIATE ACCTG 1A (by: MILLAN) an Most reliable Least reliable INVESTMENT IN DEBTS SECURITIES Account for financial assets measured at amortized cost. Explain the accounting for discounts and premiums. Account for financial assets measured at FVOCI (mandatory). Bonds • Bonds are long-term debt instruments similar to term loans except that they are usually offered to the public and sold to many investors. • Bond indenture is the contractual arrangement between the issuer and the bondholders. It contains restrictive covenants intended to prevent the issuer from taking actions contrary to the interests of the bondholders. A trustee, often a bank, is appointed to ensure compliance. INTERMEDIATE ACCTG 1A (by: MILLAN) Types of bonds • Term bonds – bonds that mature on a single date. • Serial bonds – bonds that mature in a series of maturity dates. • Registered bonds – bonds issued in the name of the holder (owner). Interest payments are sent directly to the holder. • Coupon (bearer) bonds – bonds that can be freely transferred and have a detachable coupon for each interest payment. • Zero-coupon bonds (strip bonds) – bonds that do not pay periodic interests. Principal and compounded interest are due only at maturity date. • Callable bonds – bonds containing call provisions giving the issuer thereof the right to redeem the bonds prior to their maturity date. • Convertible bonds – bonds giving the holder thereof the option of exchanging the bonds for shares of stocks of the issuer. INTERMEDIATE ACCTG 1A (by: MILLAN) Accounting for investments measured at amortized cost • The accounting for investments in bonds that are measured at amortized cost is similar to the accounting for notes and loans receivables, in the sense that it also involves the following: a. Present value computations b. Preparation of amortization table (Effective interest method) INTERMEDIATE ACCTG 1A (by: MILLAN) Discount vs. Premium • If the carrying amount is less than the face amount, the difference represents a discount. • If the carrying amount is more than the face amount, the difference represents a premium. • If there is a discount, the EIR is higher than the NIR. • If there is a premium, the EIR is lower than the NIR. • Discount or premium is amortized using the effective interest method. INTERMEDIATE ACCTG 1A (by: MILLAN) Effect of discount amortization You have acquired a bond with face amount of ₱5,000 for ₱4,000. ➢ Would this be favorable or an unfavorable on your part? ➢ Favorable. Why? --- You will be collecting ₱5,000 (excldg. interest) while your cash outflow is only ₱4,000. ➢ On acquisition date, it seems you have earned a “gain” of ₱1,000 right? ➢ Yes; however, the PFRSs prohibit you from recognizing this “gain” outright. You need to amortize it over the term of the bond. ➢ The “gain” represents the discount (Carrying amt. less than Face amt.). ➢ The effect of the amortization is an increase in interest income. ➢ Over the term of the bonds, total interest income will be greater than total collections of interests by ₱1,000. INTERMEDIATE ACCTG 1A (by: MILLAN) Transaction costs • Transaction costs incurred in the acquisition of bonds to be measured at amortized cost are included as part of the cost of the investment. INTERMEDIATE ACCTG 1A (by: MILLAN) Sale of bonds prior to maturity • When bonds are sold prior to maturity, the difference between the net disposal proceeds and the carrying amount of the bonds, adjusted for any discount or premium amortization up to date of disposal, is recognized as gain or loss in profit or loss. INTERMEDIATE ACCTG 1A (by: MILLAN) Serial bonds • Serial bonds are bonds with series of maturity dates. Serial bonds are accounted for similar to term bonds. However, the periodic collections on serial bonds include not only collections for interests but also collections for principal. INTERMEDIATE ACCTG 1A (by: MILLAN) Zero-coupon bonds • Zero-coupon bonds are bonds that do not pay periodic interests. Both principal and interest are due only at maturity date. INTERMEDIATE ACCTG 1A (by: MILLAN) Financial assets measured at FVOCI (mandatory) • Initial measurement: Fair value + Transaction costs. • Subsequent measurement: Fair value • Changes in fair value are recognized in OCI. • Impairment losses and gains are recognized in profit or loss. • Interest revenue is computed using the effective interest method and is recognized in profit or loss. • Derecognition: When the asset is derecognized, the cumulative balance of gains and losses in equity are transferred to profit or loss as a reclassification adjustment. • The amounts recognized in profit or loss for a debt instrument measured at FVOCI are the same as the amounts that would have been recognized in profit or loss if the debt instrument had been measured at amortized cost. INTERMEDIATE ACCTG 1A (by: MILLAN) INVESTMENT – OTHER CONCEPTS Account for regular way purchase or sale of financial assets. Account for the reclassification of financial assets. Account for the impairment of financial assets measured at FVOCI (mandatory). Account for dividends received from investments. Account for stock rights. State the types of risks that are disclosed in the financial statements. Regular way purchase or sale of financial assets • A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned. • Trade date accounting vs. Settlement date accounting a. Under trade date accounting, the financial asset purchased (s0ld) is recognized (derecognized) at the trade date (i.e., the date the entity commits to purchase or sell the financial asset). b. Under settlement date accounting, the financial asset purchased (s0ld) is recognized (derecognized) at the settlement date (i.e., the date the ownership of the financial asset is transferred). Fair value change between trade date & settlement date • For purchases of FVPL and FVOCI assets (but not amortized cost), the buyer recognizes the change in fair value between the trade date and the settlement date. • For sale transactions, the seller does not recognize the change in fair value between the trade date and the settlement date. Reclassification • After initial recognition, financial assets are reclassified only when the entity changes its business model for managing financial assets. • Reclassification date is the first day of the first reporting period following the change in business model that results in an entity reclassifying financial assets. Reclassification of debt-type financial assets Reclassification of debt-type financial assets Notes on reclassification • Only debt instruments can be reclassified. Equity instruments (e.g., investments in shares of stocks) cannot be reclassified. • Financial assets cannot be reclassified into or out of the “designated at FVPL” and “FVOCI - election” classifications. • The initial measurement is fair value at reclassification date, except for a reclassification from FVOCI to Amortized cost where the fair value on reclassification date is adjusted for the cumulative balance of gains and losses previously recognized in OCI. Impairment • The impairment requirements of PFRS 9 apply equally to debt-type financial assets that are measured either at amortized cost or at FVOCI. • Impairment gains or losses on debt instruments measured at FVOCI are recognized in profit or loss. However, the loss allowance is recognized in OCI and does not reduce the carrying amount of the financial asset in the statement of financial position. Dividends • Only cash and property dividends received from equity securities may be recognized as dividend revenue. Stock rights • Stock rights, being equity instruments, are measured at fair value. Disclosure of Risks on financial instruments 1. Credit risk - The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. 2. Liquidity risk - The risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities that are settled by delivering cash or another financial asset. 3. Market risk - The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises the following. a) Interest rate risk b) Currency risk c) Other price risk OTHER LONG TERM INVESTMENTS Give examples of other long-term investments. Account for cash surrender value. Other long-term investments Other long-term investments include investments in funds set aside for specific and long-term purpose and cash surrender value. Examples of other long-term investments a. Sinking fund b. Preference share redemption fund c. Asset replacement fund d. Expansion fund e. Contingency fund f. Insurance fund g. Cash surrender value Cash surrender value • A cash surrender value accumulates when premiums and interest paid on a whole life insurance exceed the cost of insurance. Accounting for cash surrender value INITIAL RECOGNITION: • On initial recognition, the cash surrender value is allocated over the required holding period necessary for it to accumulate (e.g., 3 years). The amount allocated to the current year is recognized as a deduction from insurance expense while the amount allocated to prior years is credited to retained earnings. The cash surrender value is classified as noncurrent investment. • Pro-forma entry: Cash surrender value xx Retained earnings xx Insurance expense xx INTERMEDIATE ACCTG 1A (by: MILLAN) Accounting for cash surrender value SUBSEQUENT PERIODS: • Subsequent to initial recognition, increases in cash surrender value are treated as deduction from the insurance expense recognized during the period. • Pro-forma entry: Cash surrender value xx Insurance expense xx • Cash dividends received from the insurance are not recognized as income but rather as deduction from the insurance expense recognized during the period. • Pro-forma entry: Cash xx Insurance expense xx Accounting for cash surrender value SETTLEMENT: • When the insured key employee dies during the year, the increase in cash surrender value is recognized up to the date of death. The difference between (a) the insurance proceeds received or receivable and (b) the sum of cash surrender value and any unexpired portion of prepaid insurance is recognized as gain on life insurance settlement. • Pro-forma entry: Cash xx Cash surrender value xx Insurance expense/ Prepaid insurance xx Gain on settlement xx BASIC DERIVATIVES Definition of a derivative A derivative is a financial instrument or other contract that derives its value from the changes in value of some other underlying asset or other instrument. Characteristics of a derivative 1. Its value changes in response to the change in an underlying; 2. It requires no initial net investment or only a very minimal initial net investment; and 3. It is settled at a future date. Common types of derivatives 1. Forward contract – is an agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future at a preagreed price. 2. Futures contract – is a contract traded on an exchange that allows an entity to buy or sell a specified quantity of commodity or a financial security at a specified price on a specified future date. Common types of derivatives (Continuation) 3. Option – is a contract giving the holder the right, but not the obligation, to buy or sell an asset at a specified price any time during a specified period in the future. When the holder exercises his right, the writer of the option is obligated to perform his obligation on the option contract. • Types of options as to right of holder: 1. Call option – an option to buy 2. Put option – and option to sell ➢ At the money – holder may or may not exercise option; no gain or loss in exercising ➢ In the money – holder should exercise; gain in exercising ➢ Out of the money – holder should not exercise; loss in exercising Common types of derivatives (Continuation) 4. Swap – is a contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate. Common examples include: • Interest rate swap – is a contract between two parties who agree to exchange future interest payments on a given loan amount. Usually, one set of interest payments in based on a fixed interest rate and the other is based on a variable interest rate. • Foreign currency swap – is a contract between two parties who agree to exchange sum of money in one currency for another currency. Common types of derivatives (Continuation) 5. Caps, floors and collars – are essentially options designed to shift the risk of an upward and/or downward movement in variables, such as interest rates. These are normally linked to a notional amount and a reference rate. 6. Swaption – is an option on a swap. The option provides the holder with the right to enter into a swap at a specified future date at specified terms. This derivative has characteristics of an option and a swap. 7. Weather derivative – a contract that requires payment based on climatic, geological or other physical variables. Purpose of derivatives 1. to speculate (incur risk); or 2. to hedge (avoid or manage risk). Measurement of derivatives • All derivatives are measured at fair value. The accounting for fair value changes depends on whether the derivative is: 1. Not designated as a hedging instrument; 2. Designated as fair value hedge; or 3. Designated as cash flow hedge. No hedging designation (held for speculation) • Derivatives that are not designated as hedging instruments are accounted for as held for trading securities. Accordingly, fair value changes are recognized in profit or loss (i.e., FVPL). INVESTMENT IN ASSOCIATES Definition of terms • Associate – an entity, including an unincorporated entity such as a partnership, over which the investor has significant influence. • Significant influence – the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. (PAS 28) Significant influence • Significant influence is presumed to exist if the investor holds, directly or indirectly (e.g. through subsidiaries), 20% or more of the voting power of the investee, unless it can be clearly demonstrated that this is not the case. • For significant influence to exist, the investment should provide the investor voting rights. Thus, investment in preference shares, regardless of the percentage of ownership, is not accounted for under PAS 28 because preference shares do not give the investor voting rights. Evidence of existence of significant influence by an investor The following may provide evidence of significant influence even if the percentage of ownership interest is less than 20%. a) Representation on the board of directors or equivalent governing body of the investee; b) Participation in policy-making processes, including participation in decisions about dividends or other distributions; c) Material transactions between the investor and the investee; d) Interchange of managerial personnel; or e) Provision of essential technical information. Equity method • Investments in associates or joint ventures are accounted for using the equity method. Under this method, the investment is initially recognized at cost and subsequently adjusted for the investor’s share in the changes in the EQUITY of the investee. T-accounts Investment in associate beg. xx Sh. in profit xx xx Sh. in loss Sh. in (Cr.) OCI xx xx Sh. in (Dr.) OCI xx Sh. in dividends Undervaluation xx of asset xx end. Sh. In P/L of associate Sh. in loss xx Undervaluation of asset xx xx xx Sh. in profit Preference shares issued by an associate If an associate has outstanding preference shares that are held by parties other than the investor, the investor computes its share of profits or losses after making the following adjustments. Preference share is cumulative Preference share is noncumulative Preference share is redeemable Deduct one Deduct dividends No dividend is year dividend, only when deducted when whether declared before computing share declared or not computing share in in associate’s before associate’s profit or profit or loss. computing loss. share in associate’s profit or loss. Discontinuance of the use of equity method • An investor starts to apply the equity method on the date it obtains significant influence and ceases to apply the equity method on the date it loses significant influence. • On the loss of significant influence, the investor shall measure at fair value any investment the investor retains in the former associate. The investor shall recognize in profit or loss any difference between: a. b. The fair value of any retained investment and any proceeds from disposing of the part interest in the associate; and The carrying amount of the investment at the date when significant influence is lost. Classification of retained interest Following the discontinuance of equity method, the retained interest shall be classified as follows: Loss of significant influence due to Accounting treatment • Decrease of ownership interest below 20%. ➢ Financial asset at fair value under PFRS 9 • Increase of ownership above 50% ➢ Investment in subsidiary under PFRS 3 and PFRS 10 Reclassification of cumulative OCI • If an investor loses significant influence over an associate, all amounts recognized in other comprehensive income in relation to the associate shall be accounted on the same basis as would be required if the associate had directly disposed of the related assets or liabilities. Change to equity method - Gain of significant influence • Significant influence may be achieved from additional purchase of shares resulting to an increase in ownership interest. Although, not specifically addressed in PAS 28, this type of acquisition may be accounted for by reference to PFRS 3 Business Combinations particularly on the accounting for business combination achieved in stages. • “In a business combination achieved in stages, the acquirer shall remeasure its previously held equity interest in the acquiree at its acquisition-date fair value and recognize the resulting gain or loss, if any, in profit or loss or other comprehensive income, as appropriate.” (PFRS 3.42 ) Share in losses of associate If an investor’s share of losses of an associate equals or exceeds its interest in the associate, the investor discontinues recognizing its share of further losses. Interest in the associate includes the following: 1. Investment in associate measured under equity method 2. Investment in preference shares of the associate 3. Unsecured long-term receivables or loans Interest in the associate does not include the following: 1. Trade receivables and payables 2. Secured long-term receivables or loans Share in losses of associate - continuation After the investor’s interest in the associate is reduced to zero, additional losses are provided for, and a liability is recognized, only to the extent that the investor has incurred a. Legal or constructive obligations or b. Made payments on behalf of the associate. • Any other losses are not recognized. • If the associate subsequently reports profits, the investor resumes recognizing its share of those profits only after its share of the profits equals the share of losses not recognized. INTERMEDIATE ACCTG 1B (by: MILLAN) THANK YOU!!!!
