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Chapter 9

MGAC01H3 Chapter Notes - Chapter 9: Comprehensive Income, Net Income, Financial Instrument

Financial Accounting
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Chapter 9 Investments Notes
Accounting Models
Financial Assets and Investments
companies that invest in debt instruments of another entity are creditors of the issuing company
debt instruments include debt securities, whose prices are normally quoted in an active market, such as investments in government
and corporate bonds, convertible debt, and commercial paper; on the other hand, equity instruments represent ownership interests
typical examples are common, preferred, or other capital stock or shares and also include rights to acquire or dispose of ownership
interests at an agreed-upon or determinable price, such as warrants, rights, and call or put options
an equity instrument is any contract that is evidence of a residual interest in the assets of an entity after deducting all of its liabilities
Prices and Fair Values
it is logical to capitalize the transaction costs associated with an investment that is accounted for using a cost-based model because
transaction costs are a necessary cost of acquiring the asset
alternatively, for assets accounted for using a fair value model, it makes more sense to expense the transaction costs
regardless of how transaction costs are accounted for at acquisition, they are not included in fair value at later balance sheet dates
when a financial instrument is measured at fair value, changes in fair value carrying amount are unrealized holding gains or losses
the change in value is unrealized because it has not been converted to cash or a claim to cash—the asset is still held by the entity
such gains or losses are only realized when the asset is disposed of
Cost/Amortized Cost Model Fair Value Through NI Model Fair Value Through OCI Model
At acquisition, measure
Cost (equal to fair value +
transaction costs) Fair value Fair value
At each reporting date,
measure at: Cost or amortized cost Fair value Fair value
Report unrealized
holding gains and
losses (changes in FV):
Not applicable In net income In OCI
Report realized
holdings gains and
In net income In net income
Transfer total realized gains/losses
to net income (recycling) or
directly to retained earnings
Cost/Amortized Cost Model
the amortized cost model applies only to investments in debt instruments and long-term notes and loans receivable, while the cost
model may be applied to investments in equity instruments (shares) of other companies
Investments in Shares of Other Entities
application of the cost model to the investment one company makes in another entity’s shares is straightforward:
1) Recognize the cost of the investment at the fair value of the shares acquired (or the fair value of what was given up to acquire
them, if more reliable). Add to this any direct transaction costs (such as commissions) incurred to acquire the shares.
2) Unless impaired, report the investment at its cost at each balance sheet date.
3) Recognize dividend income when the entity has a claim to the dividend.
4) When the shares are disposed of, derecognize them and report a gain or loss on disposal in net income. The gain or loss is the
difference between the investment’s carrying amount and the proceeds on disposal.
Investments in Debt Securities of Other Entities
when cost model is applied to investment in debt securities (and long-term notes and loans receivable), it is referred to as amortized
cost model because any difference between acquisition cost recognized and FV of security is amortized over period to maturity
amortized cost is amount recognized at acquisition reduced by principal repayments, where applicable, plus or minus the cumulative
amortization of any discount or premium; i.e., the difference between the initial amount recognized and the maturity value
the following statements describe this method:
1) Recognize cost of investment at the fair value of the debt instrument acquired (or the fair value of what was given up to acquire
it, if more reliable a measure). Add to this any direct transaction costs, such as commissions, incurred to acquire the investment.
2) Unless impaired, report investment at amortized cost as well as any outstanding interest receivable at each balance sheet date.
3) Recognize interest income as it is earned, amortizing any discount or premium at the same time by adjusting the carrying
amount of the investment.
4) When the investment is disposed of, first bring the accrued interest and discount or premium amortization up to date.
Derecognize the investment, reporting any gain or loss on disposal in net income. The gain or loss is the difference between the
proceeds received for the security and the investment’s amortized cost at the date of disposal.
Fair Value through Other Comprehensive Income (FV – OCI) Model
comprehensive income is the change in equity (or the net assets) of an entity during a period from non-owner source transactions and
events; it is the total of net income and other comprehensive income
other comprehensive income (OCI) is made up of revenues, gains, expenses, and losses that accounting standards say are included in
comprehensive income, but excluded from net income
accumulated other comprehensive income (AOCI) is the balance of all past charges and credits to OCI to the balance sheet date
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Income Statement Statement of Comprehensive
Statement of Changes in
Shareholders’ Equity
Shareholders’ Equity End of
Share capital
Revenues, gains
– Expenses, losses
Opening balance,
Retained earnings
Net income Net income + Net income
– Dividends
Ending balance,
Retained earnings Retained earnings
± Other comprehensive income
for period
Opening balance, AOCI
± Other comprehensive income
for period
Comprehensive income Ending balance, AOCI AOCI
Shareholders’ equity
GAAP Classifications
under ASPE, the cost-based model is generally applied for equity investments except when active market prices are available
because investment portfolios are usually made up of a mix of debt and equity instruments that are managed on a fair value basis, PE
GAAP allows entities to choose the FV-NI model for any financial instrument
regardless of which method is used, all interest earned and dividends received are recognized in net income
the IASB’s underlying philosophy is that the amortized cost classification decision should be based on an entity’s business model for
managing its financial assets as well as on the contractual cash flow characteristics of the instrument
1) Business model for managing the instrument: The amortized cost classification does not depend on management’s intent for
a specific instrument, but instead, is based first on how it, or more likely, a portfolio of such instruments, is managed. If
investments are managed on a contractual yield basis, changes in its fair value are not relevant. If the prospects for future cash
flows are best assessed by reference to the contractual cash flows specified by the instrument, the amortized cost method is the
more appropriate method of accounting for and reporting the asset.
2) Contractual cash flow characteristics: The instrument should have only basic loan features. This means that the financial
asset has contractual terms that give rise to cash flows on specified dates that are solely payments of principal and interest on
the principal outstanding.
if an investment does not meet both of these conditions, it is accounted for at fair value through income
while the two main IFRS classifications are amortized cost and FV-NI, two other options have been included in the draft standard
Incurred Loss Model
under the incurred loss model, investments are recognized as impaired when there is no longer reasonable assurance that the future
cash flows associated with them will be entire collected in their entirety or when due; entities look for evidence that there has been a
significant adverse change in the period in the expected amount of future cash flows or in the timing of those cash flows
the next step is to measure the investment’s estimated realizable amounts
this is calculated as the PV of the revised amounts and timing of the future cash flows, discounted (a) at the interest rate originally
used to measure the instrument when it was first recognized or (b) at a current market rate
for this reason, this method is sometimes referred to as a discounted cash flow (DCF) model
alternatively, if revised amount and timing of CFs cannot be reasonably determined, realizable amount can be calculated as current
market price for the instrument, or fair value of net proceeds entity would get on liquidating any collateral it is entitled to
impairment loss is the difference between this revised present value calculation and the instrument’s carrying amount
after the impairment is recorded, interest income is recognized based on the revised cash flows estimates and the discount rate that
was used to determine the present value of those flows
Expected Loss Model
under an expected loss impairment model, estimates of future cash flows used to determine the present value of the investment are
made on a continuous basis and do not rely on a triggering event to occur
the expected impairment loss is the difference between the revised present value calculation and the instrument’s carrying amount
after impairment is recognized, interest income continues to be recognized based on the continuously revised cash flow estimates and
the original discount rate; changes in the investment’s realizable value are recognized as adjustments of the impairment loss
Fair Value Loss Model
under the fair value loss impairment model, the impairment loss is the difference between the asset’s fair value and its current
carrying amount assuming the fair value is less than the carrying amount
its fair value is based on discounted cash flows, but in this case, the discount rate is a current interest rate
because impairment is usually restricted to instruments carried at cost or amortized amount, the current carrying amount is the
investment’s amortized cost less any accumulated impairment losses previously recognized
interest income recognized after the impairment is calculated using the revised discount rate that determined the instrument’s fair
value or by using the original historical cost; to be consistent with the cost/amortized cost approach, the original rate is used, and the
new reduced impaired value becomes the instrument’s new “cost” for accounting purposes
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