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Lecture 22

BUS 320 Lecture Notes - Lecture 22: Cash Flow, Retained Earnings, Accrued Interest


Department
Business Administration
Course Code
BUS 320
Professor
Dennis Chung
Lecture
22

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BUS320
Assignment #8
QUESTION ONE
Flamingo Financial Incorporated
Possible scenarios and conditions that have to be satisfied to justify and support the following
accounting treatment:
(i) Flamingo accounting for its investment in the Nighthawk bonds as “a financial asset measured
at amortised cost”
- Having made this investment does not give Flamingo significant influence or control
over Nighthawk. This is a factor to consider because if there is significant influence or
control, then IFRS9 does not apply (with an exception which we will cover in Lecture
9); for example, IAS28 applies if there is significant influence, and IFRS3 and IFRS10
apply if there is control (and we will cover IAS28, IFRS3 and IFRS10 in Lecture 9 too).
In this particular case, it is unlikely that Flamingo has significant influence or control
over Nighthawk because investments in bonds typically do not give the investor such
power. Aside from this question, notice that significant influence or control may be
possible in some special situations for investment in bonds, e.g., bonds can come with
convertible features or detachable warrants (i.e., embedded equity options) giving the
investor potential voting rights over the investee that may lead to significant influence
or, in the rare and extreme case, perhaps even control.
- Next, we have to consider the two basic requirements for the use of the amortised cost
model and apply these requirements to this particular case: (1) Flamingo’s objective of
investing in the Nighthawk bonds must fit the business model that the investment is held
“in order to collect contractual cash flows”, this is something we have to check with
management of Flamingo to make sure that management did in fact make the
investment with the intention to collect contractual cash flows, and (2) “the contractual
terms give rise on specified dates to cash flows that are solely payments of principal and
interest on the principal amount outstanding” (which likely is the case for most bonds
such as the Nighthawk bonds). In this particular case, these two basic requirements are
likely met for Flamingo’s investment in the Nighthawk bonds if the intended holding
period for the investment is long-term and the investment is not expected to be sold
quickly or frequently.
- We also need to make sure that the selling of financial assets is not an integral part of
Flamingo’s business model in making all its investments such as the investment in the
Nighthawk bonds. We have to rule out this possibility because if selling of financial
assets is an integral part of Flamingo’s business model, then Flamingo should be using
the FV-OCI model instead of the amortised cost model to account for its investment in
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the Nighthawk bonds, assuming all other requirements for FV-OCI (such as non-
strategic nature of investment, cash flow characteristics, etc.) are met.
- The investment was not designated by management of Flamingo as FV-NI under the
irrevocable “fair value option” at the time of acquisition. We have to rule out this
possibility because if the conditions for the use of the “fair value option” did exist (i.e.,
use of FV-NI could eliminate or significantly reduce an accounting mismatch) and
management of Flamingo had chosen at the date of acquisition to make the irrevocable
election to use the “fair value option”, then Flamingo would have been using FV-NI and
not amortised cost to account for its investment in the Nighthawk bonds based on our
discussion so far before this point in this particular case.
(ii) Flamingo accounting for its investment in the Nighthawk bonds as “a financial asset measured
at fair value through profit and loss”
- Having made this investment does not give Flamingo significant influence or control
over Nighthawk. This is a factor to consider because if there is significant influence or
control, then IFRS9 does not apply (with an exception which we will cover in Lecture
9); for example, IAS28 applies if there is significant influence, and IFRS3 and IFRS10
apply if there is control (and we will cover IAS28, IFRS3 and IFRS10 in Lecture 9 too).
The exception, nevertheless, does provide one possibility that an investment with
significant influence under certain conditions can be accounted for as investment
measured at FV-NI. In this particular case, it is unlikely that Flamingo has significant
influence or control over Nighthawk because investments in bonds typically do not give
the investor such power. Also see the relevant discussions in part (i) above.
- Flamingo’s objective of investing in the Nighthawk bonds does not fit the business
model that the investment is held “in order to collect contractual cash flows”, or it is not
the case that “the contractual terms give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount outstanding”. If one
(or both) of these two conditions for the use of the amortised cost model is not met, then
Flamingo has no choice but to account for the Nighthawk bonds as a FV-NI investment.
In this particular case, FV-NI is likely appropriate if Flamingo’s intended holding
period for the Nighthawk bonds is short-term (e.g., investment is held for trading) and
the investment is expected to be sold quickly whenever necessary.
- The investment could meet all the requirements to be classified as an investment
measured at amortised cost (i.e., met all conditions in the “business model” test and the
“contractual cash flow characteristics” test), but was designated by management of
Flamingo as FV-NI under the irrevocable election of the “fair value option” at the time
of acquisition.
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(iii) Flamingo accounting for its investment in the Nighthawk bonds as “a financial asset measured
at fair value through other comprehensive income”
- Having made this investment does not give Flamingo significant influence or control
over Nighthawk. In this particular case, it is unlikely that Flamingo has significant
influence or control over Nighthawk because investments in bonds typically do not give
the investor such power. Also see the relevant discussions in part (i) above.
- Next, there are two specific requirements that have to be met in this particular case for
the use of the FV-OCI model: (1) Flamingo’s objective of investing in the Nighthawk
bonds must fit the business model that the investment is held “in order to collect
contractual cash flows”, and the selling of financial assets is an integral part of
Flamingo’s business model for making such investments, and (2) “the contractual terms
give rise on specified dates to cash flows that are solely payments of principal and
interest on the principal amount outstanding” (which likely is the case for the
Nighthawk bonds). In this particular case, both of these requirements are likely met for
Flamingo’s investment in the Nighthawk bonds if it is Flamingo’s intention to hold the
bonds and collect the interest payments (i.e., contractual cash flows) and Flamingo is
also in the business of selling financial assets like the Nighthawk bonds.
- The investment was not designated by management of Flamingo as FV-NI under the
irrevocable “fair value option” at the time of acquisition. We have to rule out this
possibility because if the conditions for the use of the “fair value option” did exist (i.e.,
use of FV-NI could eliminate or significantly reduce an accounting mismatch) and
management of Flamingo had chosen at the date of acquisition to make the irrevocable
election to use the “fair value option”, then Flamingo would have been using FV-NI and
not FV-OCI to account for its investment in the Nighthawk bonds based on our
discussion so far before this point in this particular case.
(iv) Flamingo accounting for its investment in the Pelican shares as “a financial asset measured at
amortised cost”
- Likely no possible scenario for an investment in a typical equity instrument like the
Pelican shares.
- To be eligible for the use of the amortised model, Flamingo’s objective of investing in
the Pelican shares has to fit the business model that the investment is held “in order to
collect contractual cash flows”, and “the contractual terms give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal amount
outstanding”. These conditions are likely not met in the case of an investment in a
typical equity instrument; not possible to expect receiving contractual cash flows on
specified dates, etc. from an investment like the Pelican shares.
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