Lecture notes Intermediate Financial Accounting - Part 2

Intermediate financial accounting – College 9
Financial instruments – Relevant IFRS
IAS 32 & IFRS 9 ‘Financial instruments’
- Financial instruments (focus on financial assets)
- Classification of financial assets
- Other Comprehensive Income (OCI)

- Financial assets: Equity financial instruments
- Financial assets: Debt financial instruments

Financial instruments: definition
IAS 32 defines a financial instrument as any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity.

- Financial markets have created a variety of financial instruments, ranging from
traditional equity and loans to different types of derivates. The above definition
covers them all.
- Note how, for accounting purposes, the perspective matters:
o A share always results in an equity position (for the issuing firm) and an asset
position (for the investor).
o Similarly, a loan always results in a liability (for the borrower) and an asset
(for the lender)

Definitions and some examples:




Financial assets:
- Companies can generate extra returns by investing in financial assets  we
concentrate on 2 types:
o Equity investments (receive capital gains from revaluations)
o Debt investments (receive interests from buying debt)
o Derivates (out of scope)

- Plus, strategic component of investments
o E.g.,: Google Ventures taking positions on Al start-ups.

Financial assets classification
Financial assets (FA) are classified according to 2 criteria:

, - Business model test: Why is the asset held?
o Hold the asset (i.e., collect contractual CF) or sell it?
- Contractual terms test: What are the contractual terms of the assets?
o Solely payments of principal + interests on the amount outstanding or
something else?
Based on the satisfaction of these criteria, the financial assets will be measured at:




Other Comprehensive Income
- Financial assets (A) and liabilities (L) are recognized as A or L, but gains/losses on
these instruments are generally accounted in I/S (realized) or OCI (unrealized)

- In turn, I/S or OCI are part of Shareholders’ Equity:
o Common stock & share premium
o Retained earnings (accumulated net income  I/S)
o Other comprehensive income (OCI)
- OCI includes transactions that bypass the Income Statement but affect assets and
liabilities.
- Comprehensive income = net income + OCI
o One-statement approach (comprehensive income is part of the income
statement)
o Two-statement approach (separate comprehensive I/S)

Nike – Other Comprehensive income
- Transactions that bypass the Income Statement
o Gains/losses on, e.g., cash flows hedges, some financial instruments
o Currency translations (unrealized differences in exchange rates)

Financial assets: Equity financial instruments
Equity financial instruments
- Ownership interest in other companies
- Degree of percentage of acquisition determines
the accounting treatment.




I. Equity holdings <20%
a. IFRS presumes equity FA are held for trading
- Initial recognition: Fair value (FV) = exit price (transaction price)
- Subsequent measurement: All unrealized changes in FV are recognized in the Profit
& Loss account (Fair value through profit & loss  FVTPL).
o Dividends (+NI) and realized gains/losses (+/- NI).

, b. If equity FA are held to maturity (i.e., for long period of time) or are available for sale
(in the middle: no trading but no maturity either).
- Initial recognition: Fair value (FV) = exit price (transaction price)
- Subsequent measurement: All unrealized changes in FV are recognized in the OCI
(FV through OCI  FVTOCI)
o Dividends (+NI) and realized gains/losses (+/- NI).

Example A – FVTPL




Losses March 2011
DR. Unr. loss 10,768
CR. FA at FVTPL 10,768

Gains March 2012
DR. FA at FVTPL 21,216
CR. Unr. Gain 21,216

Example B – FVTOCI
December 2019
DR. FA at FVTOCI 20,750
CR. Cash 20,750

Cash dividend
DR. Cash 450
CR. Dividend revenue 450

II. Equity holdings between 20% - 50%
- Investor does not possess legal control (achieved with >50%), but has significant
influence, as for example:
o Representation at the board/technological dependency
o Intercompany relationship/exchange of management, etc.
- These equity financial assets are accounted for using the equity method
o Initial recognition: Acquisition price (cost of the shares acquired)
o Subsequent measurement: Adjustments (each period) for changes in the
investee’s net assets.
- The investor’s proportionate share of the earnings (or losses) of the investee
periodically increases (decreases) the investment’s carrying amount.
- All dividends received by the investor from the investee also decrease the
investments carrying amount.
- The equity method recognizes that the investee’s earnings increase the investee’s
net assets, and that the investee’s losses and dividends decrease these net assets.

III. Equity holdings > 50%
- Investor is said to have a controlling interest (50% or more)