Financial Accounting Part - Invesments - Equity investments

Firms must fully incorporate current information about: 

• Future cash flows
• Current risk adjusted discount rates
• Investor's private information

It is an estimation of present value of cash for high risk investments/ evaluate present value of risky investment (e.g.investments in real estate). It also represents required rate of returns. 

Market-to-market and Market-to-model.

A measure of the fair value of accounts that can change over time (such as liabilities and assets). 

Aims to provide a realistic appraisal.

It can also be the accounting act of recording the price or value of a security/portfolio/accounting to reflect current market value.

Pricing of specific investment positions based on internal assumptions or financial models. Assets that must be market-to-model either don't have a regular market that provides accurate pricing or valuations refer to complex set of reference variables and time framework.

• What if market is not efficient or liquid?
• More uncertainty in measurement
• More judgement and subjective estimates required by managers (who have incentives to bias information)
• Less reliable --> FV can fluctuate significantly over short time (frequent changes)
• There might be an inability to value assets; business with special assets or investment packages may find it difficult to value these items on the open market
• Reduces book value

• Cash
• Equity investment of another company (e.g. ordinary or preference shares)
• Contractual right to receive cash from another party (e.g. loans, receivables and bonds)

IFRS rules require that companies classidy financial assets into two measurement categories: amortized cost and fair value- depending on the circumstances.

Company's business model for managing its financial assets AND

Contractual cash flow characteristics of the financial asset.

Only debt investments such as receivables, loans and bond investments that meet the two criteria above are recorded at amortized cost. All other debt investments are recorded and reported at fair value.

Debt: 

1. Meets business model (held-for-collection) and contractual cash flow test --> Amortized cost
2. Does not meet the business model test (not held-for-collection) --> Fair value

Equity: 

1. Does not meet the contractual cash flow test --> Fair value (for some equity investments for which the investor exercises some control over the investee, juse the equity method.

Equity investment represents ownership of ordinary, preference or other capital shares/capital stock

• Cost includes price of the security
• Broker's commissions and fees are recorded as expense in the income statement, so not in the cost of shares recognized as an asset on the balance sheet

Depends on the type of ownership --> There are three types of holdings:

• Passive interest- holding of < 20% of all shares
• Significant influence- holding between 20% and 50%
• Control- holding > 50%

The accounting and reporting for equity securities therefore depend on the level of influence and the typ of security involved.

Company values and reports the investment using the fair value method --> this method requires firms to classify equity securities at acquisition as available-for-sale securities or trading securities.

Equity securities have no maturity date and therefore cannot be declared as held to maturity.

For the class of 20% of ownership, the fair value method of accounting results in the following realized income effects:

• Dividends declared by the company of which shares are held
• Gains and losses from the sale of the shares

Yes, we can also accounting for the unrealized gains and losses on the investment by adjusting for changes in the fair value of the investment.

IFRS assumes this is the standard. It records any unrealized gains and losses on the investment in net income (unrealized e.g. if shares are not sold; it is recorded as an expense in the income statement)

Depends on certain circumstances. Records any unrealized gains and losses on the investment in other comprehensive income. 

Fair value changes are directly recorded in the company's equity instead of passing through the income statement and thereby affecting retained earnings.

A debt or equity security that is purchased with the intent of selling before it reaches maturity (therefore not classified as held-for-trading/held-to-maturity). 

Reported at fair value.

Because investee may permanently retain in the business any increased assets resulting from its profitable operation. Therefore, investor earns net income only if investee declares cash dividends.

Investment in shares do not have a maturity date and therefore cannot be classified as held-for-collection.

Under the equity method, the investment is originally recorded at cost, but is adjusted for changes in the investee's net assets. 

The investment account is increased  (decreased) by the investor's proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee.

It is reported in the income statement under other income and expense. The unrealized holding gain or loss-equity account is reported as a part of other comprehensive income and as a component of equity until realized.

The securities fair value adjustment account is added to the cost of the equity investments account to arrive at fair value.

Transfers of securities between categories of investments should be accounted for at fair value, with unrealized holding gains or losses treated in accordance with the nature of the transfer.

Impairments of debt and equity securities are losses in value that are determined to be other than temporary, are based on a fair value test, and are charged to income.

Companies have the option to report most financial instruments at fair value, with all gains and losses related to changes in fair value reported in the income statement.

This option is applied on an instrument-by-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability.

If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.

A company needs a reclassification adjustment when it reports realized gains or losses as part of net income. It also shows the amounts as part of other comprehensive income in the current or in previous periods. Companies should report unrealized holding gains or losses related to available-for-sale securities in other comprehensive income and the aggregate balance as accumulated comprehensive income on the balance sheet.

The degree to which one corporation (investor) acquires an interest in the common stock of another corporation (investee) generally determines the accounting treatment for that investment.

Long-term investments by one corporation in the common stock of another can be classified according to the percentage of the voting stock of the investee held by the investor.

At year-end. 

Carrying value = amount as previously recorded on the balance sheet.

Fair value = market value

The unrealized loss is reflected in the accounts by debiting an income statement account --> net income will be lower.

And: Crediting an asset account on the balance sheet---This asset account (securities fair value adjustment) is subtracted from the (historical) cost amount of the equity investment portfolio to derive the fair value of the investment portfolio.

For example when laws require a minimum level of share ownership. The only difference here is that the unrealized holdings gains and losses are directly incorporated in the company's equity through other comprehensive income. 

Still reported as part of income in the income statement are: 

• Dividends received
• Realized gains and losses