Wild / Principles of Financial Accounting IFRS (Chapter 1-17) / 3e / 2022

JOHN J. WILD WINSTON KWOK KEN W. SHAW

PRINCIPLES OF

FINANCIAL ACCOUNTING THIRD EDITON

Wild新版設計理念

本書新版依循 IFRS 國際財務報導準則

( International Financial Reporting Standards ) 編寫，因應最新IFRS標準修改 Ch.15 投資章節。 學習科學研究發現，透過將內容拆解“區塊化”後， 學生能有更好的學習效果，因此，本書新版以更簡 潔的文字敘述、更清晰的版面編排、更視覺化的圖 表設計，讓學生更有效率的閱讀、更有效能的吸收。

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活思考、應用所學、強化教育訓練和職涯發展。

新版特色一 Visual Learning視覺學習 研究分析顯示現代學生比較沒耐心長時間閱讀純文 字，作者特別檢視新版所有文字內容，用更簡明扼 要的語句敘述，用更一目瞭然的視覺圖像表達，減 少文字贅述，去蕪存菁，精簡後更見精華。

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Principles of Financial Accounting 3rd Edition John J.Wild, Winston Kwok, Ken W Shaw ISBN: 9789814923385 / © 2022

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Principles of Financial Accounting, 3rd edition continues to provide leading accounting content that engages and motivates students. With its step-by-step approach, this book streamlines complex accounting processes and helps students build confidence by mastering key concepts and procedures. Suitably written for both introductory and intermediate courses on Financial Accounting, guided by international accounting standards, this edition helps students develop good decisionmaking habits as they prepare, analyze, and apply accounting information. It also includes the latest available financial reports of Nestlé and adidas, both multinational companies that comply with international standards in accounting to further reinforce the real-world relevance of accounting concepts.

Key Features

The recognition, measurement, disclosure, and reporting of revenues, receivables, and investments follow the guiding principles of international accounting standards.

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Chapter-opening stories featuring businesses from diverse sources.

Useful points, hints, and tips strategically placed inside margins.

Comprehensive end-of-chapter questions, exercises, and problems.

Table of Contents 1 Accounting in Business 2 Analyzing and Recording Transactions 3 Adjusting Accounts for Financial Statements 4 Completing the Accounting Cycle 5 Accounting for Merchandising Operations 6 Inventories and Cost of Sales 7 Accounting Information Systems 8 Cash, Fraud, and Internal Control 9 Accounting for Receivables 10 Long-Term Assets 11 Current Liabilities and Payroll Accounting 12 Accounting for Partnerships 13 Accounting for Corporations 14 Long-Term Liabilities 15 Investments 16 Reporting the Statement of Cash Flows 17 Analysis of Financial Statements A Financial Statement Information B Time Value of Money BR Brief Review

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FOURTH PASS

15

Investments

Chapter Preview BASICS OF INVESTMENTS

DEBT INVESTMENTS

EQUITY INVESTMENTS

C1 Short-term vs. long-

Recording debt investments

Recording equity investments

Debt vs. equity

P1 Amortized cost (AC) P2 Fair value through

term

C2 Classification and measurement

C3 Impairment C4 Effective interest rate

other comprehensive income (FVOCI)

P3 Fair value through

REPORTING AND ANALYSIS Summary of debt and equity investments

P4 No control or

Comprehensive income

significant influence

P5 Significant influence C5 Control

A2 Yield to maturity (YTM)

profit or loss (FVTPL)

(EIR)

A1 Calculating EIR with a DCF model.

NTK 15-1

NTK 15-2, 15-3, 15-4

NTK 15-5, 15-6

Learning Objectives CONCEPTUAL

C1

Distinguish between short-term and long-term investments and between debt and equity investments.

C2

Describe different measurement classifications for investments in financial assets.

C3

Describe the general concept of impairment and expected credit loss model.

C4

Describe the concept of effective interest rate (EIR).

C5

Describe the accounting requirements for equity investments with control.

ANALYTICAL

PROCEDURAL

A1

Calculate EIR with a DCF model.

P1

Account for debt investments at AC.

A2

Use yield to maturity to evaluate the returns of debt investments

P2

Account for debt investments at FVOCI.

P3

Account for debt securities at FVTPL.

P4

Account for equity investments with no control or significant influence.

P5

Account for equity securities with significant influence.

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Investing in debt and equity securities “Same debt or equity securities, different accounting treatments under different classifications”— Darren Tan Companies that are reporting their financials under the IFRS framework began to adopt IFRS 9 Financial Instruments globally, in place of IAS 39 Financial Instruments: Recognition and Measurement, on January 1, 2018. Under IFRS 9, all companies that hold debt and equity investments (as part of the wider scope of financial instruments) have to classify them into three broad measurement categories: amortized cost (AC), fair value through other comprehensive income (FVOCI), and fair value through profit or loss (FVTPL). IFRS 9 has a greater impact on the financial reporting of banks and investment funds, compared to non-financial institutions, as they have a higher proportion of financial instruments on their balance sheets.

Since January 1, 2018, OCBC Bank (www.ocbc.com), Southeast Asia’s second largest bank by total assets, has classified and measured its financial assets held according to IFRS 9.1 “In accordance with IFRS 9, we classify loans to our customers, the largest asset on our balance sheet, mainly under amortized cost. For debt and equity securities, we show the total holdings collectively as one item on the balance sheet and disclose the accounting classifications of AC, FVOCI and FVTPL in the accompanying notes to financial statements,” explains

©OCBC Bank

Darren Tan, Chief Financial Officer of OCBC Group, “to provide information that is useful in making economic decisions”.

At the end of 2019, OCBC had loans to customer of S$265,000 million classified under AC. It had debt and equity securities of S$29,000 million, of which it classified S$65 million under AC, S$22,000 million under FVOCI and S$7,000 million under FVTPL. In comparison, non-financial institutions such as adidas and Nestlé had total financial assets of S$9,800 million (EUR6,500 million) and S$34,600 million (CHF25,000 million), respectively, at the end of 2019.

Source: OCBC. https://www.ocbc.com/assets/pdf/annual%20reports/2019/ocbc_ ar2019_english.pdf

BASICS OF INVESTMENTS In prior chapters, we covered the reporting of both equity (ordinary and preference shares) and debt (bonds and notes) from the standpoint of the issuer (also known as investee or seller).

This chapter covers the reporting of investing in financial assets comprising equity and debt securities from the standpoint of the holder (also known as investor or buyer).

Purposes and Types of Investments

C1

Distinguish between debt and equity securities and between short-term and long-term investments.

Investments exclude cash and cash equivalents held for meeting short-term needs, receivables from EXHIBIT 15.1 customers and loans provided to borrowers.2 Companies make investments for at least three rea- Investments of Selected Companies sons: (1) to invest the extra cash (or cash equivalents) to yield more income, (2) to invest for strategic reasons in companies such as suppliers, customers, business partners and even competitors, and (3) for some Coca-Cola ST 5% LT 23% entities, such as investment funds (also known as mutual funds) and penStarbucks ST 1% LT 2% sion funds, to make collective investments on behalf of investors.

Investments can be in either financial assets such as debt and equity LT 13% Pfizer ST 7% securities or non-financial assets such as land and buildings not used LT 1% Microsoft ST 41% in the company’s own operations. On the balance sheets of most companies, investments in financial assets are shown as “financial assets” Percent of total assets without the word “investments”.

This chapter covers investments in financial assets and excludes investments in land Investee’s Investor’s Balance Sheet Balance Sheet and buildings (known as investment property). Exhibit 15.1 shows short-term (ST) and Liabilities Assets long-term (LT) investments as a percentage of total assets for selected companies.

Short-Term Versus Long-Term Investments Short-term investments

comprise securities that are (1) held primarily for the purpose of trading or (2) expected To be precise, OCBC adopts Singapore Financial Reporting Standard (International) 9 (SFRS(I) 9), which is identical to IFRS 9.

2 Banks sometimes structure loans as bonds and they record these as loans to customers but not as investments, based on the economic substance rather than the legal form.

Notes Payable Bonds Payable Equity Ordinary Shares Preference Shares

Debt Investments Equity Investments

1

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to be realized within 12 months from the reporting date. They are presented as current assets. All other investments are regarded as long-term investments and are presented as non-current assets.

Debt Securities versus Equity Securities Investments in securities include both debt and equity securities. Debt securities, such as bonds and notes, reflect a lending arrangement. These are fixed-income securities issued by governments, government agencies and companies. Equity securities, such as investments in shares or units issued by companies, business trusts, real estate investment trusts or unit trusts (also known as mutual funds), reflect an ownership arrangement.

C2

Classification and Measurement

Describe different measurement classifications for investments in financial assets

©Scott Olson/Getty Images

The objective of financial statements is to provide information that is relevant and useful in making economic decisions. To meet this objective, accounting for investments in financial assets considers four factors: (1) type of securities, either debt or equity; (2) for debt securities, the contractual cash flow characteristics of the securities and the investor’s “business model” (explained below) for managing them; (3) for equity securities, the percentage of voting power in the investee company held by the investor; and (4) for debt securities, the maturity date and for equity securities, the company’s expectation of holding over short term or long term.

Debt investments Regardless of whether they are quoted or unquoted, or whether they are held for short term or long term, debt investments are classified under one of the three measurement categories in International Financial Reporting Standard 9 Financial Instruments (IFRS 9).

The classification depends mainly on the contractual cash flow characteristics of the securities and the investor’s “business model” for managing them. Contractual cash flow characteristics refer to whether the cash flows of the securities reflect a basic lending arrangement or are modified by derivatives embedded in the debt securities (called the host). The term “business model” refers to how an investment is managed on its own or within a portfolio; it does not refer to the company’s overall business model. A company can have different “business models” for different investments or for different investment portfolios.

Under IFRS 9, all debt securities are recorded (measured) at the date of purchase at fair value (plus transaction costs where applicable) and subsequently classified under either amortized cost (AC), fair value through other comprehensive income3 (FVOCI) or fair value through profit or loss4 (FVTPL).

The AC classification is for debt securities (like bonds and notes) whose contractual cash flows are solely payments of principal and interest on the principal outstanding (SPPI) and which are managed within a “business model” to collect the contractual cash flows only. For these debt investments, amortized cost provides the most relevant and useful information for reporting the financial position and the performance.

The FVOCI classification is for debt securities whose contractual cash flows are SPPI and which are managed within a “business model” to collect the contractual cash flows and to sell before maturity from time to time. For these debt investments, a combination of fair value for reporting the financial position and amortized cost method for reporting the performance provides the most relevant and useful information.

The FVTPL classification is for debt securities that are managed within a “business model” to sell in the near term (that is, for the purpose of trading) and for any securities not eligible for AC or FVOCI classification – a residual classification. When one or more derivatives are embedded in the host debt securities such that the combined cash flows are not SPPI, the debt securities with the embedded derivative will not be eligible for AC and FVOCI classifications. For these debt investments, fair value is the most relevant and useful information for reporting the financial position and the performance.

Companies may also designate any debt investment for measurement at FVTPL, if this helps to reduce a significant “accounting mismatch” that may arise from different bases of reporting gains and losses from financial assets and financial liabilities. This designation can only be done at the date of purchase and once done is not revocable.

3 In IFRS 9, fair value through other comprehensive income means adjusting a financial asset’s carrying amount to fair value and recording the corresponding fair value gain or loss in other comprehensive income. This balance in the statement of comprehensive income forms part of equity on the balance sheet as a separate line item called fair value reserve.

4 In IFRS 9, fair value through profit or loss means adjusting a financial asset’s carrying amount to fair value and recording the corresponding fair value gain or loss in profit or loss.

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For AC and FVOCI debt investments, a company reports interest income in profit or loss not based on the amount of interest received, but the amount of interest earned (accrued) over time at the effective interest rate (EIR). For FVTPL debt investments, companies are not required to record interest income and may instead record fair value gain/loss inclusive of interest earned over time. However, there is no prohibition from doing so and in practice many companies prefer to record interest income separately before making the fair value adjustment as the additional interest income information is useful.

For all three classifications, companies must report subsequent realized gain/loss on sale in profit or loss.

Equity investments Regardless of whether they are quoted or unquoted, or held for short term or long term, under IFRS 9 the default classification for all equity investments (other than in subsidiaries, joint ventures and associates) is FVTPL. Additionally, companies may elect to classify particular equity investments, only if they are not held for trading, under FVOCI from the date of purchase and report subsequent fair value gain or loss in OCI, instead of profit or loss.

Under this option, companies must also report subsequent realized gain/loss on sale in OCI. In either FVTPL or FVOCI classification, companies report dividends receivable as income in profit or loss unless such dividends are effectively partial recovery of the purchase cost.

Investments in Subsidiaries A company has control over an investee company if it holds a majority (more than 50%) of the voting power in the investee. In some cases, the single largest investor holding a substantial percentage, but not more than 50%, of the voting rights can have control over the investee when all the remaining shares are held by many minority investors. Also, an investor holding not more than 50% of equity shares can have control by way of special arrangements for super-voting power or a special right to appoint directors to the board. Some digital economy giants, such as Alibaba, Alphabet, Facebook etc. have allowed the founders to retain control this way when they no longer hold more than 50% of the equity shares after the company’s initial public offering.

Investments in Associates5 A company is presumed to have significant influence over the investee if it holds 20% to 50% of the voting power in the investee. It is presumed to have no control or significant influence if it holds less than 20% of the voting power.

Exhibit 15.2 identifies six classes of securities using the first three factors mentioned above.

After the classification, the investment is presented as a current or a non-current asset based on the fourth factor.

Debt Investments

AC

Debt securities that are SPPI and held for collecting contractual cash flows only

FVOCI

Debt securities that are SPPI and held for collecting contractual cash flows and for sale from time to time

EXHIBIT 15.2

Equity Investments

FVTPL

Debt securities held for trading or not eligible to be classified under AC or FVOCI (residual classification)

Classifications of Investments in Securities

No control or significant influence

Significant influence

Control

FVTPL or by election, FVOCI

Equity accounting

Consolidation

Equity securities with less than 20% voting power in the investee

Equity securities with 20% to 50% voting power in the investee

Equity securities with more than 50% voting power in the investee

Impairment Investing in debt securities comes with a risk that the issuer may be unable to make payments of interest or principal when due. This is known as the default risk or credit risk. Investing in equity securities comes with the downside risk that the issuer may experience a deterioration in its financial or economic condition. In both cases, the value of the debt or the equity investments may decline and the investor may realize a loss from selling the investments. This decline in value is called impairment.

C3

Describe the general concept of impairment and expected credit loss model.

IAS 28 Investments in Associates and Joint Ventures defines an associate by reference to the concept of significant influence and a joint venture by reference to the concept of sharing of control. Accounting for investments in joint ventures is an advanced topic beyond the scope of this book.

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The value may also fall due to changes in macro-economic or market factors such as interest rates or market liquidity. These may cause declines in fair value which may not be impairment.

For AC and FVOCI debt securities, IFRS 9 requires an investor to recognize the impairment in profit or loss during the investment holding period when it expects the loss to arise in future, not when the issuer fails to pay any interest or principal when due or when the investor sells the investment at a loss. This requirement does not apply to FVTPL debt and equity securities as recording a decline in fair value would automatically include the impairment in profit or loss. It also does not apply to FVOCI equity investments as all related gains (other than dividend income) or losses are recorded in other comprehensive income as a special treatment of IFRS 9.

Impairment can arise due to many reasons and for debt investments, it is due mainly to a deterioration in credit quality. For estimation of a credit loss, IFRS 9 prescribes an expected credit loss model effective from January 1, 2018 to replace the incurred credit loss model under IAS 39. Expected credit loss model uses the probability of default, estimated loss given default and estimated exposure at default to estimate the credit loss before the actual loss occurs.

Impairment in general and expected credit loss model in particular are advanced topics beyond the scope of this book.

Debt Investments C4

Describe the concept of effective interest rate (EIR).

This section cover debt investments (also called debt securities). Exhibit 15.3 summarizes the accounting for debt investments classified under three different measurement categories.

EXHIBIT 15.3

Debt Investments

Accounting for Debt Investments under Three Different Measurement

AC Debt securities that are SPPI and held for collecting contractual cash flows only

FVOCI Debt securities that are SPPI and held for collecting contractual cash flows and for sale from time to time

FVTPL Debt securities held for trading or not eligible to be classified under AC or FVOCI (residual classification)

EFFECTIVE INTEREST RATE The concept of effective interest rate (EIR) is central to accounting for debt investments. The EIR is the rate that will discount all expected future cash flows of a debt instrument to a present value that equals the purchase price (inclusive of commission paid).

The method for calculating the EIR is further explained after this section.

Exhibit 15.4 shows the terms and conditions of a simple coupon-paying bond issued by ABC Ltd that DEF Ltd (the company) has purchased.

EXHIBIT 15.4

Name of issuer Date of issue Original tenor Face value repayable at maturity Coupon rate Frequency of coupon payments Coupon amount Date of purchase Years to maturity from the date of purchase Purchase price (inclusive of commission) Discount on purchase

Terms and Conditions of a Coupon-Paying Bond

ABC Ltd January 1, 2019 7 years $10,000 3% per annum Annually in arrear6 $300 ($10,000 × 3%) January 1, 2021 5 years $9,500 $500 ($10,000 − $9,500)

For simplicity, we use annual payment in arrear this example. In practice, most coupon-paying bonds pay Pre-publication chapters thatcoupon may NOT beinforwarded, shared, or posted. interest semi-annually in arrear.

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We will use this bond to illustrate the application of the effective interest method to derive the amortized cost. Under the effective interest method, the investor accrues interest income for the first interest period at the EIR on the original cost of a coupon-paying bond, through which it adjusts the original cost to the amortized cost (AC). It continues to accrue interest income at the EIR on the amortized cost at the beginning of subsequent interest periods. When the investor receives the coupon, it records the receipt of cash as a partial reduction of the amortized cost instead of interest income.

If the bond is a zero-coupon bond that does not pay any coupon, the investor also accrues interest income at the EIR during the life of the zero-coupon bond, through which it adjusts the original cost to the AC. The investor recovers the amortized cost inclusive of accrued interest either at maturity or through sale before maturity.

It is very important to understand that the amount of interest income is determined by the accrual over time (called “time proportion basis”) under the effective interest method, not by the receipt of coupons from coupon-paying bonds or by the receipt of proceeds (inclusive of interest) upon maturity or sale of zero-coupon bonds.

As the company has purchased the bond at $9,500 and will receive the principal repayment of $10,000 at maturity, it will earn the $500 discount as additional interest income over the 5-year period to maturity. This is equivalent to an additional yield of approximately 1% per annum. We can use the discounted cash flow (DCF) model to calculate the EIR manually. In practice, we usually use a financial calculator with the DCF function to calculate the EIR. Either way, the EIR for this bond works out to be 4.13% per annum.

The purchase cost of $9,500 is inclusive of commission (not separately shown here) that is a transaction cost payable to the brokerage house. The commission forms part of the purchase cost of debt investments classified under AC and FVOCI and is not recorded in profit or loss as an expense when incurred. The commission is expensed over time along with the interest income through the effective interest method. For debt investments classified under FVTPL, the company may expense the commission at the date of purchase.

Exhibit 15.5 shows, starting with the purchase cost of $9,500 (Line A), the interest income at the EIR (Line B), the receipt of coupon (Line C), the amortization of the discount (Line D) and the amortized cost (Line E) from the date of purchase to the date of maturity. At the date of maturity, the amortized cost is $10,000. This is known as the “pull-to-par” effect. As the amortized cost during the life of the bond is inclusive of accrued interest, the comparable fair value (Line G) is the observable market price inclusive of accrued interest (dirty price = clean price + accrued interest) at any reporting date. In this example the accrued interest happens to be zero (for both the amortized cost and the fair value) as the coupon happens to to be received on the last day of the year.

Under the effective interest method, the initial investment is $9,500 (not $10,000) and the company earns interest of $392 for 2021 at 4.13% of $9,500 invested at the beginning of 2021.

Subsequently, the amount invested (amortized cost) (Line A) increases over time through amortization of the discount (Line D) and the company earns interest of $396 for 2022 at 4.13% of Year Beginning amortized cost (A)

2021

2022

2023

2024

2025

9,500

9,592

9,688

9,788

9,892

Interest income accrued (B)

392

396

400

404

408

Coupon received (C)

(300)

(300)

(300)

(300)

(300)

Discount amortized (D = B − C)

92

96

100

104

108

Ending amortized cost (E = A + D)

9,592

9,688

9,788

9,892

10,000

9,500 × 4.13% = 392

9,592 × 4.13% = 396

9,688 × 4.13% = 400

9,788 × 4.13% = 404

9,892 × 4.13% = 408

Ending amortized cost (E)

9,592

9,688

9,788

9,892

10,000

Fair value adjustment (F)

203

114

198

(30)

−

Ending fair value (G)

9,795

9,802

9,986

9,862

10,000

EXHIBIT 15.5 Interest Income at EIR and Amortization of Discount

Additional infomation: Interest income accrued in Line B = A × EIR

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$9,592 invested at the beginning of 2022. The periodic accrual of interest income is higher than the coupon received and the difference is the discount amortized.

If the company had purchased the bond at a premium, the interest income would have been lower than the coupon received and Line D would have shown the premium amortized. We would have seen an opposite pull-to-par effect of reducing the purchase cost progressively to par at maturity. If the company had purchased the bond at par, Line D would have shown no discount or premium amortized. This table format is a very useful “model” for applying the effective interest method.

It is very important to understand that for recording interest income, the effective interest method relies on accrual of interest income at EIR over time and does not rely on the amount and timing of the coupon received.

Debt Investments—Basics We will use the information in Exhibits 15.4 and 15.5 to illustrate the accounting for the purchase, maturity, sale, interest accrual, receipt of coupons and fair value adjustment (where applicable) for the same debt investment under different classifications, AC, FVOCI and FVTPL, respectively.

CALCULATING EFFECTIVE INTEREST RATE FOR A DEBT INSTRUMENT

A1

Calculate EIR with a DCF model.

As explained earlier, the concept of effective interest rate (EIR) is central to accounting for debt investments. The EIR is the rate that will discount all expected future cash flows of a debt instrument to a present value that equals the purchase cost (inclusive of commission if any).

This section explains the concept of EIR by way of a discounted cash flow (DCF) model for a fixed-rate debt instrument, together with a numerical example in Need-to-Know 15-1. n

EQUATION 15.1

PV =

The DCF model

CP ∑ (1+r) t

t =1

PV =

n

+

FV (1+r)n

CP1 CP2 CP3 + + 2 + (1+r) (1+r)3 1+r

...

+

CPn FV n + (1+r) (1+r)n

(Eq 15.1)

where: PV

Present value of the discounted cash flows that equals the purchase cost

FV

Face value receivable in cash at the end of period n, the maturity date

CPt

Coupon receivable in cash at the end of period t

n

Number of periods7

r

EIR of the fixed-rate debt instrument

The EIR above is also known as the internal rate of return (IRR) or the yield to maturity (YTM).

Finding the present value We can use the DCF model to find the PV when all the other inputs are known. We can manually calculate the PV using Equation 15.1, with or without the help of the present value table in Appendix B, to work out the PV. We can also use a financial calculator with a DCF function to find the PV. Finding the effective interest rate More importantly, we have to use the DCF model to find the EIR, r, when all the other inputs are known. It is not possible to re-arrange Most long-term bonds pay coupons semi-annually in arrear. Instead of the number of years, we need to input the number of semi-annual periods (number of years × 2) into the DCF model. The resulting effective interest rate, r, needs to be multiplied by 2 to arrive at an annualized interest rate. Need-to-Know 15.4 shows a semi-annual example.

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Equation 15.1 such that r appears on the left-hand side of the equation and we have to use the equation as it is.

To illustrate the application, we input the information from Exhibit 15.4 into Equation 15.1 to find r.

9,500 =

300 300 300 300 300 10,000 + + + + + (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)5 1+r

As explained earlier, analytically we expect r to be slightly above 4.00%. As our first attempt, we input 4.00% into the equation and obtained a PV of 9,555, slightly higher than 9,500. Next, we input 4.20% into the equation and obtained a PV of 9,469, slightly lower than 9,500. We now know the EIR that will discount the cash flows to a present value of 9,500 should lie between 4.00% and 4.20%. After several trials, we solve the EIR as 4.13%.

Alternatively, using a financial calculator with a DCF model, we can solve r with a few keystrokes.

A bond has a remaining maturity period of 3 years and pays a coupon of 6% per annum on the face value of $10,000 on a semi-annual in arrear basis. Key inputs to the DCF model are as follows: Purchase price = 10,300 Face value = 10,000 Number of semi-annual periods in the remaining maturity period of 3 years = 6 Coupon = 300 (10,000 × 6% × ½)

NEED-TO-KNOW 15-1 Interest earned at EIR on bond investments

A1

We input the above information into Equation 15.1 below.

10,300 =

300 300 300 300 300 300 10,000 + + + + + + (1+r)4 (1+r)5 (1+r)6 (1+r)6 1+r (1+r)2 (1+r)3

Find r with a financial calculator or by trial and error. r = 2.456% on a semi-annual basis Annualize r: rannual = 2.456% × 2 ≈ 4.91% on an annual basis Compute interest earned at the EIR on the initial investment for the first semi-annual interest period: Interest income = 10,300 × 4.91% × ½ = 253

DEBT INVESTMENTS—AMORTIZED COST Debt investments at amortized cost (AC) are presented as current assets if their maturity dates are within one year from the reporting date.8 Otherwise, they are presented as non-current assets.

The purchase cost (inclusive of commission) for debt investments can be either lower (at a discount) or higher (at a premium) than the amount repayable at maturity. The difference between the cost and the maturity value is amortized over the remaining life of the investment through the effective interest method.

P1

Account for debt investments at AC.

Strictly speaking, for any coupon-paying debt investment, the present value of those coupons due within one year should be presented as current assets even if the principal is due for repayment after one year. For simplicity, companies tend to disregard coupons due within one year and present the entire debt investment under non-current assets when the principal is due after one year.

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As shown in Exhibit 15.4, the purchase cost is $9,500 and the maturity value is $10,000. The amortized cost at the end of each of the years increases over time from the difference between accruing interest at 4.13% of amortized cost and receiving the coupon at 3% of $10,000. If the company had purchased the bond at a premium, the amortized cost would have decreased over time from amortization of the premium instead.

Recording Purchase Companies record all AC debt investments at cost (inclusive of commission) at the date of purchase.

Assume that DEF Ltd (the company) has paid-up capital of $9,500 and cash of $9,500. On January 1, 2021, the company purchases ABC Ltd’s bond with 5 years to maturity for cash of $9,500 and records the purchase as follows.

Assets = Liabilities + Equity +9,500 −9,500

Jan. 1, 2021

Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Record purchase of ABC Ltd bond at cost.

Recording Interest Income Companies accrue interest income on a time-proportion basis when earned (not when received). Companies that are not banks usually record the accrual of interest on a monthly basis while banks usually do so on a daily basis. For simplicity, in this example, the company accrues interest income on an annual basis.

Under the effective interest method, interest income is the amount accrued at the EIR on the opening amortized cost and not the coupon of $300 received each year.

For 2021, the company earns interest at the EIR of 4.13% on the original cost of $9,500. At December 31, 2021, the company accrues interest income of $392 as earned.

Dec. 31, 2021

Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 Interest Income (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 Accrue interest at EIR of 4.13% of the original cost.

Recording Coupon Received When the company receives the coupon, it records cash received of $300 as partial recovery of the amortized cost instead of interest income.

Assets = Liabilities + Equity +300 −300

Dec. 31, 2021

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Record receipt of 3% coupon.

If the company receives the coupon later than December 31, 2021, the date of the above journal entry will be later than December 31, 2021 but this delay will not affect the recording of interest income for 2021.

Recording for Next Year For 2022, the company earns interest at the EIR of 4.13% on the amortized cost of $9,592. At December 31, 2022, the company accrues interest income of $396 as earned.

Dec. 31, 2022

Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396 Interest Income (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396 Accrue interest at EIR of 4.13% of the amortized cost.

When the company receives the coupon, it records cash received of $300 as partial recovery of the amortized cost instead of interest income.

Assets = Liabilities + Equity +300 −300

Dec. 31, 2022

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Record receipt of 3% coupon.

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Reporting AC Debt Investments at Amortized Cost Companies reports AC debt investments at amortized cost subsequently. There is no fair value adjustment, regardless of whether the debt investments are current assets or non-current assets.

At the end of 2022, the company reports on its balance sheet this bond at a carrying amount of $9,688, inclusive of a cumulative amortized discount of $188.

Exhibit 15.6 shows the December 31, 2022 balance sheet. The debt investments are presented as either current assets or non-current assets based on the due date of the principal, December 31, 2025 (see footnote 8).

EXHIBIT 15.6

Non-current assets Debt investments (at amortized cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,688 Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 10,288 Equity Paid-up capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Accumulated profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 788 10,288

Balance sheet as at Dec. 31, 2022

Maturity When the bond matures on December 31, 2025, upon receipt of cash repayment in full the company records the proceeds (assuming it records the receipt of the coupon separately) and derecognizes the debt investment.

Dec. 31, 2025

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Derecognize the debt investment upon receipt of cash at maturity.

Assets = Liabilities + Equity +10,000 −10,000

Selling AC Investments Companies are not prohibited from selling debt investments

in the AC portfolio but this should be rare to qualify for AC classification. If sales are frequent and for significant amounts, the portfolio should be classified under FVOCI or FVTPL (see next two sections). In practice, banks usually use FVOCI or FVTPL classifications for debt investments due to the possibility of sale before maturity and use the AC classification only for loans to customers (these are not investments) which are normally held to collect the contractual cash flows and not for sale.

If instead of holding the bond to maturity, the company sells it on January 1, 2023 for $9,780, it records the sale of the AC debt investments with a realized gain of $92, being the sale proceeds of $9,780 less the amortized cost of $9,688 at the date of sale.

Jan. 1, 2023

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,780 Debt Investments – AC . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,688 Gain on Sale of Debt Investments (P/L) . . . . . . . . . . . . . . 92 Derecognize the debt investment sold and record a realized gain on sale.

Debt Investments – AC

Jan. 1 2021

Dec. 31, 9,500 2021

300

Jan. 31 2021

392

Jan. 1 2022

Dec. 31, 9,592 2021

300

Jan. 31 2022

396

Jan. 1 2023

Company XYZ has the following transactions related to a debt investment classified under AC. a. Jan. 15 Pays $10,000 cash to purchase Muni’s newly issued 5-year bond that pays 6% coupons semi-annually in arrear. b. Jun. 30 Accrues interest income at the half-year reporting date. c. Jul. 15 Receives a check for $300 from Muni for semi-annual coupon on the bond. d. Dec. 31 Accrues interest income at the full-year reporting date.

9,688

NEED-TO-KNOW 15-2 AC Debt Investments

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Required

Prepare journal entries to record the transactions.

Solution

a.

$10,000 × 0.06 × 166/365 = $273

b.

c.

$10,000 × 0.06 × 184/365 = $303 The total interest income earned for the year is $576 ($273 + $303) for 350 days (166 + 184) regardless of the timing of the coupons received.

d.

Jan. 15

Jun. 30

Jul. 15

Dec. 31

Debt Investments – AC. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Record purchase of bond at cost.

10,000 10,000

Debt Investments – AC. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Income (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . .

Accrue interest income at 6% of $10,000 for 166 days.

273

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debt Investments – AC. . . . . . . . . . . . . . . . . . . . . . . . .

Record semi-annual coupon received.

300

Debt Investments – AC. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Income (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . .

Accrue interest income at 6% of $10,000 for 184 days.

303

273

300

303

DEBT INVESTMENTS—FVOCI

P2

Account for debt investments at FVOCI.

Debt securities at FVOCI are reported as current assets if their maturity dates are within one year from the reporting date. Otherwise, they are reported as non-current assets (see footnote 8 for explanation).

Recording Purchase and Interest Income The company first records the purchase at cost (inclusive of commission) and accrues for interest income at the EIR in the same way as an AC debt investment.

Recording FVOCI Debt Investments at Fair Value At any financial reporting date, the company adjusts the amortized cost of the FVOCI portfolio to fair value and reports it as the new carrying amount on the balance sheet. The company achieves this by adjusting the carrying amount of the portfolio up or down, with a corresponding entry to record a gain or loss as other comprehensive income. Other comprehensive income does not form part of profit or loss for the year.

On December 31, 2021, the company observes the quoted market price of $9,750 (excluding accrued interest) for the bond and makes the following fair value adjustment.

Assets = Liabilities + Equity +203 +203

a.

Dec. 31, 2021

Debt Investments – FVOCI9 . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Fair Value Reserve (OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Adjust debt investment portfolio to fair value with unrealized gain in OCI.

Recording for Next Year The company continues to accrue interest income ($396 for 2022) normally based on the effective interest method. On December 31, 2022, the company reverses the fair value adjustment of $203 made on December 31, 2021 for the entire FVOCI debt investment portfolio so that the portfolio reverts to amortized cost.

We adjust the “Debt Investments – FVOCI” account directly in this example. Alternatively, we can create a separate account, “Fair Value Adjustment – FVOCI”, for this adjustment.

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Dec. 31, 2022

Fair Value Reserve (OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Debt Investments – FVOCI . . . . . . . . . . . . . . . . . . . . . . . . 203 Reverse previous unrealized fair value gain for debt investment portfolio.

Assets = Liabilities + Equity −203 −203

On December 31, 2022, the observed fair value is $9,802 (excluding accrued interest), reflecting a fair value gain of $114 over the amortized cost (not the previous fair value) of $9,688. The company makes a similar fair value adjustment as follows. c.

Dec. 31, 2022

Debt Investments – FVOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Fair Value Reserve (OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Adjust debt investment portfolio to fair value with unrealized gain in OCI.

Assets = Liabilities + Equity +114 +114

Reporting FVOCI Debt Investments Fair Value Exhibit 15.7 shows the

December 31, 2022 balance sheet. The debt investments are presented as either current assets or non-current assets based on the due date of the principal (see footnote 8).

EXHIBIT 15.7

Non-current assets Debt Investments – FVOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,802 Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

10,402 Equity Paid-up capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Accumulated profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 788 Fair value reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

10,402

Balance Sheet Presentation for Debt Investments at Fair Value Through Other Comprehensive Income

Selling FVOCI Debt Investments The sale of individual FVOCI debt investments

gives rise to a realized gain/loss. A very important accounting step is to reclassify the unrealized fair value gain/loss out of OCI to realized gain/loss in profit or loss. This step is known as “reclassifying from equity to profit or loss as a reclassification adjustment” or loosely as “recycling”.

To illustrate this, assume that on January 1, 2023, the company sells the debt securities for $9,780 (net of commission) when the carrying amount is $9,802 and the related fair value reserve balance is $114. Upon the sale, the company records the sale proceeds and removes the carrying amount and the related fair value reserve, and recognizes the resulting realized gain/ loss in profit or loss.

Exhibit 15.8 shows two methods for working out the realized gain/loss on sale, both of which give the same results.

Method A

EXHIBIT 15.8

Method B

1. Reverse the fair value reserve to revert the carrying amount from fair value to amortized cost, and 2. Compare the sale proceeds with amortized cost.

1. Compare the sale proceeds with the carrying amount, and 2. “Recycle” the fair value reserve to profit or loss.

Sales proceeds

9,780

Sale proceeds

Carrying amount

9,802

Less: Carrying amount

Fair value reserve

(114)

Loss before “recycling”

Less: Amortized cost

(9,688)

“Recycling” fair value reserve

Realized gain

92

Realized gain

Realized Gain/Loss Upon Sale – Two Methods

9,780 (9,802) (22) 114 92

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Exhibit 15.9 shows the journal entries for the two methods.

EXHIBIT 15.9 Journal Entries for Method A and Method B

Method A - Journal entries

a.

b.

Jan. 1, 2023

Fair Value Reserve (OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Debt Investments – FVOCI . . . . . . . . . . . . . . . . . . . . . . . . 114 Reverse previous unrealized fair value gain for debt investment portfolio.

Jan. 1, 2023

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,780 Debt Investments – FVOCI . . . . . . . . . . . . . . . . . . . . . . . . 9,688 Gain on Sale of Debt Investments (P/L) . . . . . . . . . . . . . . 92 Derecognize the debt investment and record a realized gain on sale.

Method B – Journal entries

a.

b.

Jan. 1, 2023

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,780 Gain/Loss on Sale of Debt Investments (P/L) . . . . . . . . . . . . . .

22 Debt Investments – FVOCI . . . . . . . . . . . . . . . . . . . . . . . . 9,802 Derecognize the debt investment and record a realized loss on sale.

Jan. 1, 2023

Fair Value Reserve (OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Gain/Loss on Sale of Debt Investments (P/L) . . . . . . . . . 114 Recycle realized fair value gain to profit or loss.

[Combined realized gain = $114 − $22 = $92]

Both methods give the same realized gain of $92.

NEED-TO-KNOW 15-3 FVOCI Debt Investments

P2

Gard Company has the following transactions related to its debt investments classified under FVOCI. a. May 8 Purchases FedEx bonds as FVOCI debt investments for $12,975. b. Sep. 2 Sells part of the investment in FedEx bonds for $4,475, which had a cost of $4,325. c. Oct. 2 Purchases Ajay bonds for $25,600 as FVOCI debt investments.

Required

1. Prepare journal entries for the transactions. (Ignore accrual of interest income at EIR.) 2. Prepare a year-end adjusting journal entry as at December 31 if the fair values of the debt securities held are $9,600 for FedEx and $22,000 for Ajay respectively. (This year is the first year Gard Company purchased debt investments.)

Solution

1. a. b.

c.

May 8 Debt Investments – FVOCI. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Record purchase of FedEx bonds at cost.

Sep. 2 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debt Investments – FVOCI. . . . . . . . . . . . . . . . . . . . . . . .

Gain on Sale of Debt Investment. . . . . . . . . . . . . . . . . . .

Record sale of a portion of debt investments in FedEx. Oct. 2 Debt Investments – AC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12,975 12,975 4,475 4,325 150 25,600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600

Record purchase of Ajay bonds at cost.

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2.

Calculation of unrealized gain/loss, along with the adjusting entry, follows.

Debt Investments Total Cost FedEx . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,650* Ajay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600

34,250

Total Fair Value 9,600 22,000 31,600

Unrealized Gain/(Loss)

(2,650)

*12,975 − 4,325 = 8,650

Dec. 31

Fair Value Reserve (OCI). . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,650 Debt Investments - FVOCI. . . . . . . . . . . . . . . . . . . . . . 2,650 Adjust debt investment portfolio to fair value with unrealized gain in OCI.

DEBT INVESTMENTS—FVTPL Companies classify debt securities under FVTPL in one of the three situations: (a) they are part of a trading portfolio, (b) they are not eligible for AC or FVOCI, and (c) the company has elected to designate them under FVTPL to reduce an “accounting mismatch” that would otherwise arise from different bases of measuring financial assets or liabilities or recognizing their gains or losses.

Trading securities are those that the company actively buys and sells for profit. They are always classified as current assets. Other FVTPL debt securities that are not part of the trading portfolio are reported under either current or non-current assets depending on whether the principal is due for repayment within or after one year (see the explanation in footnote 8).

Accounting for FVTPL debt securities differs from that for FVOCI in three ways:

P3

Account for debt securities at FVTPL.

1. At the date of purchase, companies expense off the commission payable to the brokerage house immediately instead of recording the purchase cost inclusive of commission.

2. Companies are not required to accrue for interest income at the EIR. 3. At each reporting date, companies adjust the FVTPL securities up or down to fair value and recognize the unrealized fair value gain or loss in profit or loss.

The first two differences are more apparent than real. On the first point, for many bonds, the bond brokerage houses often embed the commission in the purchase price and do not bill it separately. Many companies adopt the practice of recording the purchase of debt securities at the price inclusive of commission, regardless of whether they are classified under AC, FVOCI or FVTPL. On the second point, while IFRS 9 does not require companies to record interest income for FVTPL debt securities, it does not prohibit it. In practice, many banks and financial institutions continue to record interest income for FVTPL debt securities, as the information is useful for determining a key item called net interest income in the statement of profit or loss. If companies do not accrue interest income for FVTPL securities, they will automatically capture it as part of the fair value gain/loss adjustment.

The third difference is the key feature of accounting for FVTPL debt securities. We will illustrate the accounting for the ABC bond assuming that it is not practicable to separate the commission included in the purchase price of $9,500. In this example, the company continues to accrue interest income separately.

Recording Purchase and Interest Income The company first records the purchase at cost (inclusive of brokerage embedded in the purchase price) and then accrues for interest income at the EIR as before.

Recording FVTPL Securities at Fair Value At any financial reporting date, the company adjusts the amortized cost of the FVTPL portfolio to fair value and report the new carPre-publication chapters that may beachieves forwarded, shared, rying amount on the balance sheet at fair value.

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carrying amount of the portfolio up or down, with a corresponding entry to record a gain or loss in profit or loss. In contrast with the FVOCI method, the company records journal entry c as follows.

December 31, 2021 Debt Securities – FVTPL10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Fair Value Gain (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Adjust debt securities portfolio to fair value with unrealized gain in profit or loss.

Recording for Next Year On December 31, 2022, the observed fair value is $9,802, reflecting a fair value gain of $114 over the amortized cost (not the previous fair value) of $9,688. In contrast with the FVOCI method, the company records the reversal and the year-end adjustment both on December 31, 2022 through profit or loss to record a fair value loss of $89 ($114 $203) in the income statement for 2022.

December 31, 2022 Fair Value Gain (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Debt Securities – FVTPL . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Reverse previous unrealized fair value gain for debt securities portfolio.

December 31, 2022 Debt Securities – FVTPL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

Fair Value Gain (P/L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

Adjust debt securities portfolio to fair value with unrealized gain in profit or loss.

Reporting FVTPL Debt Investments at Fair Value Exhibit 15.10 shows the December 31, 2022 balance sheet. The debt securities are presented as current assets if they are held for trading. Debt investments not held for trading but are classified under FVTPL in situations (b) and (c) mentioned in the opening sentence of this section are presented as current assets or non-current assets based on the due date of the principal (see footnote 8).

EXHIBIT 15.10

Current assets Debt securities held for trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,802 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

10,402 Equity Paid-up capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Accumulated profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 902

10,402

Balance Sheet Presentation for Debt Securities at Fair Value Through Profit or Loss

Selling FVTPL Debt Securities The sale of individual FVTPL debt securities gives

rise to a realized gain/loss. The gain/loss on sale is the difference between the sale proceeds and the carrying amount at fair value. In contrast to the FVOCI method, the company records the sale of a FVTPL debt securities without the need for “recycling”, as follows.

January 1, 2023

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,780 Loss on Sale of Debt Securities (P/L) . . . . . . . . . . . . . . . . 22 Debt Securities – FVTPL . . . . . . . . . . . . . . . . . . . . . . . . . . 9,802 Derecognize debt securities and record a realized loss on sale.

Many companies use an account name that does not contain the word “Investments” for a trading portfolio, such as “Debt Securities - Trading”. While not featured here, companies can also have “Debt Investments - FVTPL” for debt investments not held for trading but are classified under FVTPL by default as they are not eligible for AC and FVOCI classifications in situations (b) and (c) mentioned in the opening sentence in this section.

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