Financial Accounting Part - Invesments - Debt investments

(1) Contractual payments

(2) Specified dates of payment of principal amount and interest on principal

Only debt investment can be measured at amortized cost. E.g. if company makes investmenti n another company, it will receive contractual cash flows of interest over the life of the bonds and repayment of the principal at maturity.

Investment in a firm or projet through purchase of bonds or debentures, instead of the purchase of common or preferred stock (e.g. ordinary/preference stock).

Usually generates returns in slightly different manner

This approach carries some risk although less volatile than other strategies --> The Investor is essentially making a loan to the company with the expectation that the loan will eventually be repaid with interest. If bond is fully mature, investor not only receives the investment but also a little more --> generating returns less risky for investors --> at least original price is insured.

Held for trading/ not-held-for-collection --> fair value

The effective interest rate method. 

It is a strategy to hold an investment in order to receive Cash Flows --> investment is measured at amortized cost.

Companies must amortize premiums or discounts using the effective interest method. 

Applied to bond investments.

Method to calculate the actual interest rate in a period based on the book value at the beginning of the period --> when book value decreases of bond, then amount of interest decreases too (and vice versa)

Purchase of bonds with the intention of selling them in a short period of time.

During the accounting period: Use amortized cost - same as for held-to-maturity investments.

At the end of the accounting period: Adjust amortized cost to fair value. 

Report any unrealized holding gain or loss as part of net income (e.g. record in the income statement)

Unrealized holding gain/loss: net change in fair value of the debt instrument from one period to another.

Steps are the same as for amortized cost method! 

Realized gain on sale of the debt investment is computed aas the difference between the amount received (=fair value) and the carrying amount based on amortized cost. So the securities fair value adjustment is not used here. 

Only difference is the elimination (reverse) the valuation account (gains and losses are allocated to different time periods)

Write down the amortized cost basis of the investment and recognize a realized loss in net income.

text-decorationFor debt investments:  use impairment test to determine whather it is probable that the investor will not be able to collect all contractual amounts.

It would be impractical to test all assets for impairment at the end of the year. 

• Correcting the value of an asset that has an overstated book value
• Identifying assets that currently carry a higher book value than their actual worth.

Determining whether this is the case typically involves:

• Deciding if that current book value is higher than future net cash flows that can be expected
• If book value is higher --> use of impairment losses helps to reduce that book value back to a level that is considered as realistic

Impairment loss decreases or disappears.

Held-to-maturity --> amortized cost

Held-for-trading --> fair value

At the end of each year (or:reporting period), a fair value adjustment is made to account for the difference between the carrying value and fair value of the debt investment. The fair value adjustment account is eliminated (reversed) when the bonds are sold.

When it is probable that the investor will be unable to collect all amounts due according to the contractual terms.

When an impairment has occurred, the investment is written down to its fair value, which is also the security's new cost basis. The amount of the writedown is accounted for as realized loss.

It is the initial recognition amount of the investment minus repayments plus or minus cumulative amortization and net of any reduction for uncollectibility.

Only debt investments such as loans and bond investment are valued at amortized cost. A company should use amortized cost if it has a business model whose objective is to hold assets in order to collect contractual cash flows. The contractual terms of the financial asset gives specific dates to cash flows.

(1) Carry and report held-to-maturity debt securities at amortized cost. 

(2) Value trading debt securities for reporting purposes at fair value, with unrealized holding gains or losses included in net income.

(3) Value available-for-sale debt securities for reporting purposes at fair value, with unrealized holding gains or losses reported as other comprehensive income and as a separate component of stockholders' equity.

The assets or liabilites should be reported separately from other financial instruments that use a different valuation basis.