Chapter 3 - Investments in Debt & Equity Securities

Impairments

FV is lower than its amortized cost basis on the F/S date, the asset is impaired. Declines in the values of financial assets had previously all be recognized as impairment losses. Although they are not determined or measured in the same manner, credit losses are essentially the same as those impairment losses that result from inability to pay, rather than those resulting from changed in market conditions.

Investments under IFRS - Marketable Securities

Financial assets are generally measured at fair value through profit or loss (FVTPL). When measured at FVTPL, increases or decreases in FV are reported as gains/losses on the statement of operations (income statement) Under certain circumstances, financial assets are measured at amortized cost. This is only the cases if 2 conditions are met: - The entity's business model is to hold the asset to collect scheduled cash flows. - the terms of the instrument call for cash flows that are exclusively payments of principal and interest on specified date

Adjusted Cost Method

Cost - Impairment losses *the original investment is recorded at cost *when the investee earns money, NO JE is recorded *when a dividend is received it is recorded as dividend income on the income statemnt (NOT a reduction of investment) *in rare cases, if the dividend received is greater than the investor's proportionate share of the investee's income since acquisition, then it is recorded as a reduction of the investment (these usually are distributions of an investee's earnings that occurred BEFORE the investor made their purchase of the investee Cash Investment

Credit loss JE

Credit loss expense Allowance for credit losses *Adjustments increasing the allowance create a credit loss expense in the period, and adjustments decreasing the allowance create a recovery of previously recognized credit losses, causing an increase in income. The allowance will not be reduced below zero, however, and recoveries of credit losses cannot exceed amounts previously recognized.

Changes to debt securities when using FV Option

*HTM: Securities continue to be accounted for at amortized cost, recognizing interest income under the effective interest method. In addition, the carrying value is adjusted to FV on each balance sheet date with the increase or decrease recognized as a component of net income *AFS: Reported at FV on each balance sheet date, which is already required. Unrealized g/l are reported as a component of net income, however, instead of OCI *Trading: not affected

Example of credit loss indicators

*The difference between the security's amortized cost basis and its lower fair value *Adverse conditions affecting the security, the industry of the issuer, or a relevant geographic area *The payment structure, along with the issuer's ability to make payments that increase in later periods *The issuer's failure to make scheduled payments *Changes in the issuer's security rating determined by a rating agency

Equity method

*the investment is originally recorded at cost *as the investee reports earnings, it is reported on the investor's income statement as "equity in earnings" equal to the investors % owned multiplied by the investee's earnings, as a component of continuing operations *"equity in losses" -in general, losses cannot be recognized that reduce the carrying value of the investment below zero unless the investor has guaranteed investee obligations or is committed to provide additional financial support -if the investee subsequently becomes profitable again, unrecognized equity method losses will be offset against the investor's share of profits until they ahve been absorbed

Two types of assets that are subject to the recognition of credit losses include:

1) Assets measured at amortized cost 2) Available-for-sale debt securities *Allowance for credit losses would never be greater than the amount by which the amortized cost exceeds the fair value.

Investments in debt securities are reported on an investor's balance sheet in one of 3 categories:

1) Trading Securities - Held for Trading 2) Available-for-Sale (AFS) Securities 3) Held-to-Maturity Securities

Fair Value Option

ASC 825 allows an entity to value various eligible items at FV at certain dates, referred to as election dates. Once the FV option is elected, it is irrevocable until a subsequent election date. Eligible items include most financial instruments except: -HTM debt securities -Subs or VIEs required to be consolidated -Deferred compensation arrangements including pension or other postretirement or post-employment obligations and stock options or stock purchase plans -Assets or liab recognized under leases -Deposit liabs or depository institutions -Financial instruments classified as a component of SE

Equity method JEs

Acquisition of investment at cost: Investment Cash Investor records % of earnigns Investment Equity in earnings % of Cash dividend Cash Investment Amortization/Depreciation/Impairment excess: Equity in earnings Investment

Equity method - when purchase price is not equal to the investor's % owned of book value

Adjustments to equity in earnings will result in order to reflect the investor's true share of the investee's income *Fair vale write up of assets -PPE -Inventory -Land -Goodwill

Under IFRS, can switch from amortized cost to FVTPL

An entity may also elect to report financial assets at FVPL that would otherwise be measured at amortized cost. -the election must be made when the financial asset is first recognized -the election is irrevocable -FV measurement must eliminate or reduce an inconsistency that would result from recognizing gains or losses on a different basis

Selling an asset with associated credit losses

Any allowance for credit losses associated with these securities is to be eliminated and the security is to be written down to its fair value. the difference is incremental impairment, is recognized in the period's earnings.

Investments in Equity Securities of Other Entites

Balance Sheet: -Investments in equity securities are originally recorded at cost, but are adjusted to FV each balance sheet date (ie the FV approach). If FV is not readily determinable, then we use the "adjusted cost method", which is cost minus any impairment losses. Income Statement: -Unrealized gains and losses (temp) are reported in income as a component of income from continuing operations. (same treatment as trading securities) -Realized gains/losses -interest and dividend income Stmt of Cash Flows: -Classification of the cash flows related to the acquisition (outflows) or disposal (inflows) related to these investments will be based on the nature and purpose for which they are acquired, either operating or investing.

Reclassifications of debt securities

Between Trading and AFS: -Reclassify at fair value -The difference is treated as a realized gain/loss on the income statement -Eliminate any related valuation allowance accounts Between HTM and AFS: -Reclassify at fair value -If HTM to AFS: then record unrealized gain/loss in OCI -If AFS to HTM: then any unrealized holding gain/loss is recognized in OCI, transferred to the B/S in AOCI and amortized over the remaining life of the security

Amortized cost

HTM securities are initially recorded at cost and then carried at amortized cost (ie face amount), net of unamortized discount or premium. -the difference between the cost and the face/maturity is amortized over the life of the security, using the effective rate method; however, the straight-line method may be used if it doesn't materially differ.

Accounting for Held-to-Maturity Securities

INTENT and ABILITY to hold until maturity. Securities are considered held to maturity if sale occurs after at least 85% of principal has been collected. In rare cases where these securities are not held to maturity, an ordinary gain or loss on disposal results.

Held-to-Maturity (HTM) Securities

Investments in bonds and other debt instruments that the investor has the ability and intent to hold until the due date for repayment. -Classified as noncurrent assets until the maturity date is less than 1 year from the balance sheet date - When principal is paid in installments, whether annually at the end of the term, or in some other pattern, the principal that will be paid within the next year is classified as a current asset - If an entity has an operating cycle that exceeds a year, the current amount will be the principal amount to be paid within the next operating cycle

Trading Securities / Held for Trading

Investments in debt instruments (eg bonds) which the investor has acquired in an attempt to make profits by buying and selling within a short period of time Normally classified as current assets

Available-for-Sale Securities

Investments in marketable debt instruments that do not fit the definition of HTM or trading securities These may be classified as current or noncurrent assets, depending on the expected date of sale. If the holding period of the securities is indefinite, they should be classified as noncurrent assets

Available-for-Sale JEs

Purchase: Investment in AFS security Cash Increase in FV: Market Adjustment - AFS Security (B/S) Unrealized gain (Stmt of comp inc) Decrease in FV: Unrealized loss (stmt of comp inc) Market adjustment - AFS Security (B/S) *Unrealized gain/loss are reported in OCI in each period's statement of comprehensive income. The amount is accumulated in a stockholder's equity account (Accum OCI) on the balance sheet.

Trading securities JEs

Purchase: Investment in trading securities Cash Increase in FV: Market Adjustment - Trading Security (B/S) Unrealized gain (I/S) Decrease in FV: Unrealized loss (I/S) Market Adjustment - Trading Security (B/S)

Market risk (in bond section)

The risk that a receivable will diminish in value due to: -A rise in market interest rates, making the lower rate less desirable or -other investments will become available that offer a greater return

Credit risk (in bond section)

The risk that the debtor will not perform, which could mean that some or all payments will be missed or late

Impact on balance sheet for debt securities

Trading (HFT): Usually current, FAIR VALUE Available-for-sale (AFS): Current/noncurrent, FAIR VALUE Amortized cost & allowance for credit losses Unrealized gains/losses (other than credit losses) in OCI (Statement of Comprehensive Income) & accumulated OCI in Stockholders' Equity (separately) Held to maturity (HTM): noncurrent/current Amortized cost Allowance for credit losses (separately)

Impact to Income Statement for debt securities

Trading: Unrealized gains/losses realized gains/losses interest income AFS: Credit loss expense/reversal Realized gain/loss Interest Income HTM: Credit loss expense/reversal realized gain/loss Interest income

Impact to Statement of Cash Flows for debt securities

Trading: Usually operating activity (purchase or sale) AFS: Investing activity HTM: Investing activity

Investment in the Stock of Other Entities

When a company acquires equity securities of another entity, they are generally reported on the balance sheet at their FV as of the balance sheet date, with both realized and unrealized gains and losses being reported in income. However, there are 3 circumstances that either require or allow a different accounting treatment. *0-20% adjusted cost method* -Investment does not provide investor with ability to exercise significance influence over trustee -used when FV is not readily determinable -requires election *20-50% equity method (one-line consolidation) -the investor has the ability to exercise significant influence over the entity. -investor does not have a controlling financial interest in the entity *50% + consolidation -the investor has controlling financial interest in the investee -may result from equity ownership or other factors, such as representation on the board of directors making the investor the primary beneficiary of a variable interest entity (VIE)

Initial recording of credit losses

When a debt security classified as available for sale is purchased with deteriorated credit and indicators of a credit loss have been met, the initial allowance for credit losses is added to the purchase price of the security (instead of being expensed) to get the initial amortized cost basis. Subsequent changes in the allowance will be recorded as credit loss expense

Sales of AFS Debt Securities

When the investment in AFS is sold, the difference between the cost and the proceeds is treated as a realized gain/loss. Ignore the allowance account and adjust to the new target balance without the security that was just sold, unless it is the last investment, then the allowance and the unrealized gain/loss must both be eliminated.