Chapter 7 Investments

Investments – assets not directly identified with the central revenue producing activities of the enterprise but are acquired for any of the following:

1) Earn a return on idle cash balance 2) Establish long-term relationship with suppliers and customers3) Exercise significant influence/ control over another entity4) Accumulate funds for future use5) Capital appreciation6) Future protection

Investments include:- Investment in securities (equity / debt securities)- Fund for long term use (plant expansion fund, equipment acquisition fund,

stock redemption fund and sinking fund)- Investment property and cash surrender value of life insurance policies

INVESTMENTS in SECURITIESSecurity – interest/share in a debt/equity of another entity that is represented in a financial instrument and is one that is being dealt in capital markets.

Equity Securities – represent ownership in company/rights to acquire ownership interest at an agreed –upon/determinable price.

- Preference shares (Preferred stock)- Ordinary shares (Common stock)- Share warrants/Stock rights- Call options- Put options

Debt Securities – instruments representing a creditor relationship with an enterpriseTypically have the following characteristics:

1. Maturity value2. Periodic interest payments at fixed/variable interest rate3. Maturity date- Government securities (Philippine treasury bills and warrants)- Corporate bonds- Convertible debt and commercial paper

Substance rather than its legal form govern whether an instrument is an equity or debt security

INVESTMENTS in EQUITY SECURITIES

20% 50%

Less than 20% 20% - 50% More than 50%

Share capital (capital stock) of other companies may be purchased by an enterprise for no. of reasons:

1. Temporary placements of excess cash and held primarily for sale in the near term to generate income on short-term price fluctuations.

2. Obtain long –term customer/supplier/ creditor relationship to secure operating/financing arrangements with these companies.

3. Exercise significant influence or even control over the operating policies of another entity

Convertible debt and redeemable preference shares ≠ equity securities The extent of ownership in common stock by an investor in an investee

determines the accounting treatment for equity securities

Classification of Equity Securities

Financial Assets @ FVPL (Trading Securities)

AFS-Investor does not have significant influence over the investee co.

Investment in Associate-- - Power to participate- - Investor has significant

influence over the investee co.

Investment in Subsidiaries

- Power to govern- Investor has control

over the investee co.

Available for Sale Securities

Initial recognition:

purchase price + transaction cost

Transaction subsequent to initial recognition:

Share split – reduction in the par/stated value of share capital accompanied by a proportionate increase in the no. of shares outstanding

- Does not affect equity of shareholder in the issuing corporation nor its total SHE

- No formal entry needed (memo entry only indicating change in no. of shares)

Dividends – corporate distributions to its shareholders proportionate to the nos. of shares held by the latter

a) Cash dividends

- Recognized as income/receivable3 significant dates: 1. Declaration date – BOD declares distribution of dividends2. Record date – Co. draw a list naming the shareholders who are entitled to

dividends3. Payment date – dividends are distributed to shareholders

Declaration date Record date- Shares sell dividends-on- Market price of a share includes amount of dividend

After Record date- Shares sell ex-dividend- Market price does not include the amount of dividend

b) Bonus Issue/Share Dividend- Increases no. of shares held by each shareholder without any change in the

total SHE/net assets of distributing corporation- Memo entry only- Merely adjust the carrying value/ share held by the investor If the bonus issue is in the form of another class of share capital, a part of the

carrying value of the original investment will be transferred to the new shares received in another class. The allocation based on the relative FMV.

c) Property Dividends- Dividends distributable in the form of the investee’s NCA- Recorded as Dividend revenue at the asset’s FMV

Stock rightsPre-emptive right – right of shareholder to maintain his proportionate ownership

in the co.Share warrant - certificate that evidence a shareholder’s pre-emptive right

3 significant dates: 1. Declaration/Announcement of warrants Date2. Issuance Date3. Expiration Date

Declaration date Issuance date- Share and right cannot be separately bought/sold (selling rights-on)Issuance Declaration date Expiration- Shares and rights may be bought/sold separately (selling ex-rights) Share warrant received by the investor qualifies as a derivate as

defined by PAS 39:1. The value of the warrant depends on the movement of the value of

the issuing corporation’s share capital.2. It requires no investment for the holder, as the same is received as

a result of the original shares held by the investor.3. The warrant is settled at a future date through exercise by the

holder or through expiration.

o Rule on measurement of derivates shall apply to stock rights measured at Fair Value except for those derivates that are linked to equity securities whose fair value cannot be reliably measured.

o Derivates are classified as Financial Assets at FVPL.Theoretical Market Value of Stock Rights

- May be use as initial measurement basis in the absence of an actual market value of the stock right at the ___ of distribution

Ex -rights

TMV = Market value of stock ex−rig h t−subscription priceNo .of rig hts needed ¿buy one share ¿

Rights-on

TMV = Market value of stock rightson−subscription priceNo .of rights needed¿buy one share+1¿

Presentation and Measurement in SFP:

- Non-current asset measured at Fair Market Value - Only charge in Market Value recognized as other comprehensive income

outside of P/L in SCI- Market adjustment – AFS if debit – addition to AFS balance

if credit – deduction- Net Unrealized Gain/Loss on AFS – cumulative bal part of SHE forming part of

reserves credit – addition, debit – deduction

Disposal of AFS:

Net selling price – recorded cost of securities - amount of Realized Gain/Loss

-Balance in both market adjustment and net unrealized gain and losses account pertaining to the securities sold are eliminated

-SP > Cost of AFSCash (Net SP)

Gain on Sale of AFSAFS

-Prior to sale CV (FMV as of end of last b/s date) > Cost (entry for elimination of Unrealized G/L)

Net Unrealized G/L on AFSMarket Adjustment – AFS

Exception to the rule on measurement at Fair Value:

AFS without active market are measured, after initial recognition at cost.

Impairment of AFS: Entity shall asses at each reporting date whether there is any objective evidence that a financial asset is impaired. Objective evidence that there is impairment in AFS includes observable data that come to the attention of the holder of the securities about the following events:

a) Significant financial difficulty of the issuer.b) Disappearance of an active market for the securities because of financial

difficulties of the issuer of the securities.c) Significant changes that adversely affect the technological, economic or legal

environment in which the issuer operates.d) Prolonged decline in the fair value of the securities.

Amount of any previous decline in market value of the securities that has been recognized directly in equity (balance of Net Unrealized G/L on AFS) shall be removed from equity and shall be recognized in P/L/

Market Adjustment – AFSNet Unrealized G/L on AFS

original cost – current fair value – any impairment loss previously recognized

Reversal of Impairment: Market Adjustment – AFS

Unrealized Gain/Loss on AFS

Trading Securities

Initial recognition:

purchase price = FMV at date of acquisition

transaction cost directly attributable to acquisition = expense

Dividends, Share Split and Stock rights on Trading Securities

Similar procedures applied when dividends and share splits relate too TS.

However when stock rights are received on shares classified as Financial Assets at FVPL, there is no need to value the stock rights separately.

Presentation and Measurement in SFP:

- Current asset measured at Fair Value- “Financial Asset at FVPL”- Any change in the Fair value reported as Gain/Loss in P/L section of SCI

- Unrealized Gains/Losses on TS if credit balance part of income from continuing operation in P/L section of SCI

Disposal of TS:

Net SP – CV of securities

Purchased in prior period CV = Market value at the end of most recent b/s datePurchased in same year of disposal CV = Initial amount recorded

Investment in Associate

- Shares of stock give the investor significant influence over the investee, the investee is called associate

Existence of significant influence evidenced in 1 or more of the following ways:a) Representation in BOD/ equivalent governing body of the investeeb) Participation in policy making processes, including participation in decision

about dividends/other distributionsc) Material transactions between the investor and investeed) Interchange of managerial personnele) Provision of essential technical info. Judgment is frequently required in determining whether an investment of 20% or

more results in significance influence.- Accounted for using equity method when not held exclusively for disposal within

12 mos. from acquisition date Initially recorded at cost Investment’s CV increased by investor’s proportionate share of earnings Investment’s CV decreased by investor’s proportionate share of losses and

dividends declared by investee

Presentation in FS:

Investment in Associate- Non-current Asset- Separate line item

Share in Profit in Associate- Separate line item on SCI in P/L section

Other Issues: Difference in Reporting Dates

- Maximum difference for the 2 entities reporting date is 3 mos. Difference in Accounting Policies

- Investor’s FS shall be prepared using uniform accounting policies for like transactions and events in similar circumstances

Associate has Preference shares- When the associate has Outstanding P/S, the measurement of the investor’s

share of profit from associate shall be based on the associate’s profit after making adjustments for the dividends on preference shares.

- If it has outstanding cumulative P/S, the profit shall be adjusted by deducting the required current preference dividends whether/ or not declared.

- If it has an outstanding non-cumulative P/S, the associate’s profit shall be reduced by the amount of preference dividends declared during the period.

INVESTMENTS in DEBT SECURITIES

Financial instruments issued by a company and typically have the following characteristics:

a) Maturity Value (MV)b) Interest rate that specifies the periodic interest payments c) Maturity Date

Ex. Bond certificates – certificates of indebtedness issued by a corporation/government agency guaranteeing payment of a principal amount at a specified future date plus periodic interest.

- May sell at a price different from the face value of the instruments

Bond’s Market Value- Result of an interaction of variety of forces such as the current interest rates,

expected future interest rates and stated rate of interest on the investment.

Rate of interestStated on bond

= Rate of return desired by investors(effective, yield/market rate)

will sell at face value

Stated rate > Market rate will pay more than face value (bond premium)

Stated rate < Market rate purchaser will pay less than face value (bond discount)

Bond Price Computation/Present Value1)

Present Value of Maturity Value (Face Value x PVF ) + Present Value of Interest Payment (Interest per period x PVAF) Total Present Value/ Bond Price

PVF = [1+r ]−n

PVAF = [ 1− (1+r )r

¿¿−n]¿

2) Bond Price = Face Value – Discount/+PremiumDiscount/Premium = Difference in interest rates x Face Value x PVAF

Classification of Debt Securities

1) Trading Securities (Financial Assets at FVPL)2) AFS3) HTM

Held to Maturity- Non derivative financial assets with fixed/determinable payments and fixed

maturity that the entity has positive intention and ability to hold to maturity other than those that the entity upon initial recognition designates as at Fair Value through P/L or as AFS.

- Positive intent to hold the securities until maturity date- Ability to hold the until maturity dateEntity shall not classify an investment as HTM if the entity has during the current financial year, sold/reclassified more than an insignificant amount of HTM investments before maturity except: a) The sale/reclassification is so close to maturity that changes in market interest

rate would not have significant effects on the instrument’s fair value. b) The sale occurs after the entity has collected substantially all of the financial

asset’s original principal through scheduled payments, or the sale is attributable to an isolated event that is beyond the entity’s control, is non-recurring and could not have been reasonably anticipated by the entity.

Initial recognition:

purchase price + transaction cost

- Periodically amortize the difference between COI and its face value over the term of debt instrumentsAmortization gradually adjust the original cost of the instrument, such that on maturity date, its carrying value equals its face value

PAS 39 requires the use of effective interest method for the amortization of discount/premium on HTM

Interest income during interest period

= CV of instrument x Actual interest rate/ Effective interest rate/ Yield

- Bonds purchased at more/less than face value premium/discount not shown separately but included as part of COI/netted against investment cost

If the bond year does not coincide with accounting period, the amortization of premium/discount must be updated at each reporting date.

If bond investment is purchased between interest payment dates, buyer should pay, in addition to the purchase price of the bonds, amount of accrued interest from the last interest payment date.

Disposal of HTMSold before maturity, investor shall update the amount of premium/discount amortization. Amortization should be taken up until date of sale up to date the CV of investment sold.Gain/Loss sale of investment

- P/L (other operating income/expense) When an enterprise sells more than an insignificant amount of HTM before

maturity date, the ability of the company to hold any securities until maturity is tainted. Any remaining HTM shall be reclassified as AFS. In addition, the enterprise cannot designate during the current financial year and the next 2 years, any acquired debt securities as HTM.

However the following sale of HTM will not taint the enterprise’s ability to hold the securities as HTM. a) Sale of HTM that is so close to maturity or financial asset’s call date (for

example, less than 3 mos. before maturity date) that changes in the market rate of interest would not have a significant effect on the financial asset’s fair value

b) Sale that occurs after the entity has collected substantially all of the financial asset’s original principal through scheduled payments/prepayments.

c) Sale that is attributable to an isolated event that is beyond the entity’s control is non-recurring and could not have been reasonably anticipated.

Impairment of HTM- Recorded either directly crediting HTM or using allowance account

Asset CV (amortized cost)- PV of estimated future cash flows

discounted at the financial assets original effective interest rate at initial recognition

Impairment Loss

- Amount of loss shall be recognized in P/L If in subsequent period, the amount of impairment loss is recovered and the

recovery can be related objectively to an event occurring after the impairment

was recognized, the previously recovered impairment loss shall be reserved either directly or by adjusting the allowance method.

The reversal shall not result in a carrying amount that exceeds what the amortized cost could have been had the impairment loss not been recognized at the date the impairment is reversed. HTM (Allowance)

Recovery in Market Value of HTM

Financial Assets at FVPL

Initial recognition:

purchase price = FMV at date of acquisition

transaction cost directly attributable to acquisition = expense

Interest income instrument’s stated interest rate- Adjusted to market value at b/s date- Change in Market Value taken to P/L

Available For Sale

Initial recognition:

purchase price + transaction cost

- Similar to HTM any discount (net of transaction cost) or premium (inclusive of transaction cost incurred upon initial recognition) are amortized using effective interest method

At each reporting date, debt securities classified as AFS are measured at Fair value, with change in faire value taken to comprehensive income.

Cumulative credit balance in Unrealized Gains/Losses on AFS account is presented as component of SHE

Disposal of AFS:

- Any premium/discount shall be updated up to date of sale

selling price – amortized cost = gain/loss on sale

- Same with derecognition of AFS equity security the accounts market adjustment (if used) and unrealized gain/loss on AFS carried in the equity shall be cancelled.

Impairment of AFS:

- Cumulative loss that had been recognized directly in equity shall be removed from equity and recognized in P/L

- Market value after impairment shall be replaced cost of the securities

- The accounting procedures same as its equity securities. If in a subsequent period, the fair value increases and the increase can be

objectives related to an event occurring after the impairment loss was recognized in profit/loss, the impairment loss shall be reversed with the amount of reversal recognized in P/L

The amount of reversal taken to profit/loss shall not bring the amortized cost of the securities to that amount had no impairment loss been previously recorded.

BIFURCATING A COMPUND FINANCIAL INSTRUMENT

Compound Financial Instrument – one that possesses a debt and equity characteristics

Ex. Bonds with non-detachable share warrants Convertible bonds

- Those that would be exchanged with the issuing entity’s O/S at the option of the bondholders

Bifurcation – the process of splitting the purchase price of a compound financial instrument into equity and debt component

Equity component (share warrant/____) - derivative recognized at fair valueDebt component – purchase price fair value of derivative