WEEK 2

• Debt investments


  Loans, bonds
• Equity investments


  Ordinary shares, preference shares
• Main motivations for investing in other entities' securities

  • Earn a return (e.g., interest, dividends, capital gains)
  • Strategic investment to secure certain operating or financing arrangements with another company (e.g., control a supplier)
• IFRS 9 requirements for classifying financial assets

  • Amortized cost
  • Fair value

  
• Classification/Measurement of Financial Assets

  1. Business model test

  2. Cash flow characteristics test (SPPI test)
• Business model test


  Is the company's business model to hold the specific financial asset to collect contractual cash flows rather than to sell the asset before its maturity to realize its fair value changes?
• Amortized (historical) cost


  Assets/liabilities reported at original value (adjusted for depreciation/amortization)
• Fair value


  Amount for which an asset could be exchanged between knowledgeable willing parties in an arm's length transaction (i.e., in an open market)
• Mark-to-market


  Measuring fair value using the market price for actively traded assets on a liquid market
• Mark-to-model


  Measuring fair value using a valuation model (e.g., Black-Scholes model for the estimation of the fair value of employee stock options)
• Downsides of fair value accounting include uncertainty in measurement, more judgment and subjective estimates required by managers, and potential bias in information
• Fair value accounting and the accounting for financial assets were heavily debated around the globe after the banking crisis
• Most research suggests that fair value accounting was not the main cause of the financial crisis, but rather a "just shooting the messenger" situation
• Held-for-collection (Held-until-Maturity)


  One of the three categories for debt investments based on the business model test in IFRS 9

  
• Accounting for debt investments at amortized cost

  1. Compute interest revenue by amortizing premiums or discounts using the effective interest method

  2. Record interest payments and amortization of discounts/premiums

  
• Held-for-collection and selling (HFCS)


  Debt investments that are held both to collect contractual cash flows and to sell before maturity
• Accounting for HFCS debt investments

  1. Record interest revenue and amortization of premiums/discounts during the reporting period

  2. At the end of the year, adjust the amortized cost to fair value with the unrealized holding gains/losses reported in other comprehensive income (OCI)
• Accounting for debt investments

  1. As soon as cash is paid the company credits Interest Receivable and debits Cash

  2. Held-for-Collection and Selling (HFCS) debt investments are reported at fair value, with unrealized holding gains and losses reported in other comprehensive income

  3. Debt investments held for trading are reported at fair value, with unrealized holding gains and losses reported in net income

  4. Companies can choose the fair value option to account for debt investments, reporting all gains and losses in net income

  5. Impairment of debt investments measured at amortized cost is recognized using the expected credit loss approach, with write-downs included in net income

  6. Reversal of impairment losses on debt investments measured at amortized cost are recorded by debiting the Allowance for Impaired Debt Investments account and crediting Recovery of Impairment Loss

  7. Impairment of debt investments classified as Held-for-Collection and Selling (HFCS) uses a different model, with details not required

  
• IFRS 9 requires credit losses on financial assets to be measured and recognized using the "expected credit loss (ECL)" approach
• Credit losses are the difference between the present value (PV) of the contractual cash flows and the PV of expected future cash flows
• Every individual debt investment accounted for at amortized cost must be evaluated at each reporting date for a potential credit loss
• If an investment is impaired, that is, there is "objective evidence" (e.g., financial difficulties) that the PV is below the carrying value, the carrying value has to be written down
• The write-down is a realized loss, included in net income
• If the impairment loss subsequently decreases, some or all of the previously recognized impairment loss shall be reversed, with a debit to the Allowance for Impaired Debt Investments account and a credit to Recovery of Impairment Loss
• Reversal of impairment losses should not result in a carrying amount of the investment that exceeds the amortized cost that would have been reported had the impairment not been recognized
• Derivatives


  Financial instruments that derive their value from values of other assets (e.g., ordinary shares, bonds, or commodities)
• Who uses derivatives and why

  • Producers and consumers (e.g., for hedging)
  • Speculators and arbitrageurs
• Basic principles in accounting for derivatives

  • Recognize derivatives in the financial statements as assets and liabilities
  • Report derivatives at fair value
  • Recognize gains and losses resulting from speculation in derivatives immediately in income
  • Report gains and losses resulting from hedge transactions differently, depending on the type of hedge