Essentials of FA_Chapter 11

8/13/2019 Essentials of FA_Chapter 11

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Essent ia l s o f F inanc ia l Accoun t ing , Second Edi t ion ASISH K. BHATTACHARYYA

ESSENTIALS OF FINANCIALACCOUNTING

BY ASISH K BHATTACHARYYASecond Edition

Chapter 11


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NATURE OF INVESTMENTS

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Nature of Investments

Investment activities refer to activities related to theacquisition of long-term assets and otherinvestments.Entities invest in long-term assets (e.g. property,plant and equipment and intangible assets) tocreate capacity to produce goods and services.Other investment refers to investment in assetswhich do not augment or maintain the capacity ofproducing goods and services.Investments in other assets are classified asinvestments in the balance sheet.

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Nature of Investments

Categor ies of Inv estm ents

Investments

Financial assets Investment property

Equityissued byotherentities

Sovereign bond andTreasury

bill

Corporate bond andloan tootherentities

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Objectives

Entities invest in other investments earn a regularreturn (e.g. rent, interest and dividend income) andcapital appreciation.

Entities, as a part of treasury function, invest short- termfunds in treasury bills and other money marketinstruments.Temporary surplus is also invested in units of mutualfunds.

A long-term surplus (e.g. fund which is planned to be usedin business over a long period) is invested in equityinstruments and long-term debt instruments issued byother non-government entities and governments.

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Trade Investments

Entities often invest outside the business to earntrade benefits.

For example, entities invest in major suppliers andmajor customers to earn trade benefits.

If investment in the equity of another entity is 20% or more of the equity of that other entity, that otherentity (investee) is considered to be the associate of the investor.

It is assumed that the investor can significantly influence the financial and operating decisions of the investee,although it cannot control that entity.

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Group

Control is defined as The power to govern thefinancial and operating policies of an entity so as toobtain benefits from its activities.If an entity holds more than 5% of the equity of anentity or controls the composition of the Board ofDirectors, it is assumed that the investor controlsthe investee.

The investor company is called the holding company

and the investee company the subsidiary of the investor.

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Group (cont.)

The parent and its subsidiaries form a group.Usually, an internal banking system operates in agroup.

Companies invest their surplus fund in other companieswithin the group.

Those investments are usually in the form of inter-corporate investments in equity and debt capital.

The Companies Act, 1956 imposes certain restrictionson inter-company investments to protect the interest ofnon-controlling shareholders in those companies.

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INVESTMENT IN F INANCIAL A SSETS

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Investment in Financial Statements

Classification1

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Investment in financial assets

Held to maturity (Deb tinstruments notclassified asavailable for

sale)

Held for trading (Debt and equityinstruments heldfor trading)

Loans andreceivables

Available forsale (Debt andequityinstruments notheld for

trading); anddebt instrumentsnot classified asheld to maturity



Measurement

Investments in financial instruments are initiallymeasured at fair value.But subsequent measurement is not uniform for alltypes of investments.

Held-to-maturity investments and loans and receivablesare carried in the balance sheet at amortised cost usingthe effective interest rate method .Held-for-trading investments and available-for-sale

investments are carried in the balance sheet at the fairvalue at the balance sheet date.

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HELD -TO -MATURITY INVESTMENTS

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Definition

Held-to-maturity investments are financial assetswith fixed or determinable payments and fixedmaturity that an entity has the positive intention andability to hold to maturity other than those that theentity designates as available for sale .If an entity has sold or reclassified not aninsignificant amount of held-to-maturity investmentsin the current year, it is not allowed to classify any

investment as held-to-maturity in the current yearand in two subsequent years.

This provision is called tainting provision .

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Initial Measurement

At the date of acquisition, held-to-maturity investmentsare measured at fair value plus transaction costs thatare directly attributable to the acquisition of theinvestment.

Fair value at the acquisition date is the exit price at themeasurement date.

Therefore, in normal circumstances, the cost of investmentshould be higher than the fair value, because the exit price islower than the purchase price.

However, as the bid-ask spread is considered atransaction cost, practically, held-to-maturity investmentsare initially recorded at the transaction price plus directlyattributable transaction costs.

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Bid-ask Spread

Dealers in financial markets follow the principle ofbuying low and selling high .The price they quote to buy is called bid price, and theprice that they quote to sell is called ask price .

The difference between the bid price and the ask price,which is called the bid-ask spread , is their margin.For example, a market maker quotes Rs. 98 Rs. 100 forshares of a listed company.

The bid-ask spread is Rs. 2.The fair value is Rs. 98.The bid-ask spread of Rs. 2 is considered as transaction cost.

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Bid-ask Spread (cont.)

In stock market, which operates under the quote-driven mechanism , market makers give two-wayquotes.

They quote the bid and ask prices at the same time.

Indian stock exchanges order-driven mechanism isprevalent.

In order-driven trading mechanism, any marketparticipant can enter an order which is visible over themarket screen.

Other participants view the same and enter a counterorder at same price or price suitable for them.Trade occurs when orders match.Bid-ask spread is irrelevant.

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Subsequent Measurement

Held-to-maturity, investments are carried in thebalance sheet at amortised cost using the effectiveinterest rate method.Effective interest rate is the rate that exactlydiscounts estimated future cash receipts throughthe expected life of the financial instrument to thenet carrying amount of the financial asset.

Effective interest rate is determined at the time of

acquisition of the financial asset.Effective interest rate is also called yield to maturity andinternal rate of return (IRR).

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Illustration 1

On 1 January, 2010, Satyiki Limited (SL) acquired abond with face value of Rs. 100,000 and couponrate of 7% at Rs. 110,000.

The remaining period to maturity is four years.Interest is payable by the issuer of the bond at the endof each year (31 December) and the principal will berefunded at the end of the fourth year.The transaction cost was 0.4% of the purchase price.

Required Calculate the effective interest rate.

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Illustration 1: SolutionThe acquisition cost is Rs. 110,440 (110,000 1.004).Cash inflow at the end of each of the first three years isRs. 7,000.

At the end of the fourth year, cash inflow will be Rs.107,000.

Therefore, IRR should be calculated taking cash flow of (minus) Rs. 110,440 at the beginning of the first year(1 January, 2010), which is referred as year 0.Cash flow at the end of each of year: years 1, 2 and 3 isRs. 7,000, and at the end of year 4 Rs. 107,000.IRR is the discount rate at which the present value ofthe cash flow stream is zero.Using the IRR function in the Microsoft Excel, we getthe IRR of 4.1160%.

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Illustration 2

Consider the facts presented in the Illustration 1and present how the investment should beaccounted for initially and at each balance sheetdate. Also present how interest income should beaccounted for in profit and loss account for each ofthe four years.

Assume that SL closes its financial year on31 December.

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Illustration 2: Solution

Table showing calculations1

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Year (1)

Opening balanceof investment (Rs.) (2)

Cash flow (Rs.) (3)

Effectiveinterest (Rs.) (20.0412) (4)

Closing balanceof investment(Rs.) (2 +4 3) (5)

2010 110,440 .00 7,000 .00 4,550.13 107,990.13 2011 107.990.13 7,000 . 00 4,449.19 105,439.32 2012 105,439.32 7,000.00 4,344.10 102,783.42 2013 102,783.42 107,000.00 4,234.68 18.10


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Illustration 2: Solution (cont.)

Initially measurement at Rs. 110,440.In the year 2010, interest income Rs. 4,550.13 andthe investment at Rs. 107,990.13.

In the year 2011, interest income at Rs. 4,449.19,and the investment at Rs. 105,439.32.In the year 2012, interest income at Rs. 4,344.10,and the investment at Rs. 102,783.42.

In the year 2013, interest income at Rs. 4,216.58(4,234.68 18.10). The investment will not appear inthe balance sheet as on 31 December, 2013.

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Impairment

An entity assesses at each balance sheet datewhether there is any objective evidence that afinancial asset or group of financial assets isimpaired.The impairment loss is recognised in profit or losswhen the financial asset is impaired and throughthe amortisation process . Impairment loss is the difference between thecarrying amount and the present value of estimatedcash inflows discounted using the effective interestrate determined at the time of initial recognition.

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Illustration 3

Consider the facts in the Illustrations 1 and 2.While assessing the impairment of the investment, SLestimates that the issuer of the bond will be able torepay only Rs. 95,000.

Estimate the impairment loss and explain theaccounting for interest income for all the four years.

Also calculate the amount at which the investment willbe presented in the balance sheet at the end of each ofthe four years.

Assume that the issuer negotiated with the bond holderson maturity and settled the obligation by repaying Rs.95,000 against each bond with the face value of Rs.100,000.

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The closing balance at the end of the second year,before adjustment for impairment loss was Rs.105,439.32.The present value of the future expected cash flowscalculated using the effective interest rate of 4.12%is Rs. 100,810.50 [7,000/1.0412+102,000/(1.0412) 2].The impairment loss is Rs. 4,628.82 (105,439.32 100,810.50).

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Table showing calculations1

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Year (1)

Opening balance ofInvestment

(Rs.) (2)

Cash flow(Rs.) (3)

Effectiveinterest(Rs.)

(2.0412) (4)

Closin g balance ofinvestment

(Rs.) (2 +4 3) (5)

Impairmentloss (Rs.) (6)

Closing balance,adjusted for

impairmentloss (Rs.) ( 5 - 6 ) (7)

2010 110,440.00 7,000.00 4,550.13 107,990.13 0 107,990.13 2011 107.990.13 7,000.00 4,449.19 105,439.32 4,628.82 100,810.50 2012 100,810.50 7,000.00 4153.39 97,963.89 0 97,963.89 2013 97,963.89 10 2 ,000.00 4,036.11 0 0 0


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Initial measurement at Rs. 110,440.In the year 2010, interest income at Rs. 4,550.13,and the investment at Rs. 107,990.13.In the year 2011, interest income at Rs. 4,449.19,impairment loss of Rs. 4,628.82, and theinvestment at Rs. 100,810.50.In the year 2012, interest income at Rs. 4153.39and the investment at Rs. 97,963.89.In the year 2013, interest income at Rs. 4,036.11.

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Loss Events

Significant financial difficulty of the issuer or obligor A breach of contractThe lender (investor), for economic or legal reasonsrelating to the borrowers financial difficulty, granting to

the borrower a concession that the lender would nototherwise considerIt becoming probable that the borrower will enterbankruptcy or other financial reorganisationThe disappearance of an active market for that financialasset because of financial difficulties; orObservable data indicating that there is a measurabledecrease in the estimated future cash flows from agroup of financial assets since the initial recognition ofthose assets

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Reversal of Impairment Loss

If, in a subsequent period, the amount of theimpairment loss decreases and the decrease canbe related objectively to an event occurring after theimpairment was recognised, the previouslyrecognised impairment loss is reversed.The reversal shall not result in a carrying amount ofthe financial asset that exceeds what the amortisedcost would have been had the impairment not been

recognised at the date the impairment is reversed.The amount of the reversal is recognised in profit orloss.

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LOANS AND R ECEIVABLES

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Definition

Loans and receivables are financial assets withfixed or determinable payments that are not quotedin an active market .Examples of loan and receivables are amount duefrom customers and other debtors, loans toemployees and vendors, and loans and advancesby a bank to its constituents.

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Initial Measurement

Loans and receivables are initially measured at fairvalue plus transaction costs that are directlyattributable to the acquisition of the investment.Short-term receivables are measured at the originalinvoice amount if the effect of discounting isimmaterial.

If the impact of discounting is material, the receivable ismeasured at the present value.

The difference between the transaction price and thepresent value is recognised as interest income over theexpected settlement period.

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Initial Measurement (cont.)

Loans are recognised at the transaction price .However, loans granted at concessional rates ofinterest are measured at the present value of thecontracted or estimated cash inflows.The present value is calculated by discounting cashinflows by the market interest rate.

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Loans and receivables are carried in the balancesheet at amortised cost using the effective interestrate method.The principles and methods are the same as thosewhich are applied for accounting for held-to-maturity investments.

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Impairment

An entity assesses at each balance sheet datewhether there is any objective evidence that afinancial asset or group of financial assets isimpaired.The impairment loss is recognised in profit or losswhen the financial asset is impaired and throughthe amortisation process . The principles and methods are the same as thosewhich are applied for accounting for held-to-maturity investments.

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Reversal of Impairment

If, in a subsequent period, the amount of theimpairment loss decreases and the decrease canbe related objectively to an event occurring after theimpairment was recognised, the previouslyrecognised impairment loss is reversed.The reversal shall not result in a carrying amount ofthe financial asset that exceeds what the amortisedcost would have been had the impairment not been

recognised at the date the impairment is reversed.The amount of the reversal is recognised in profit orloss.

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HELD-FOR-TRADING

INVESTMENTS

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Definition

A financial asset that is acquired principally for thepurpose of selling or repurchasing it in the near termor that is part of a portfolio of identified financialinstruments that are managed together and for which

there is evidence of a recent actual pattern of short-term profit-taking.

Held-for-trading investment can be a debt instrument oran equity instrument issued by another entity.

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Initial Measurement

At the date of acquisition, held-for-tradinginvestments are measured at fair value.

Transaction costs are recognised in the profit or loss asexpenses for the period in which the investment is

acquired.Fair value at the acquisition date is the exit price atthe measurement date.Therefore, if the investor purchases a financial

asset in a stock market which operates under aquote-driven mechanism and classifies it as held-for-trading investment, it has to recognise the bid-ask spread a loss immediately .

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Initial Measurement (cont.)

In India, stock markets operate under order- drivenmechanism .

There are no two-way quotes.

Therefore, held for trading investment acquired inan Indian stock exchange is recorded at thetransaction price.If the transaction price is cum-dividend the amountof dividend that is receivable is considered recoveryof the part of the purchase price.

Therefore, the investment is measured at thetransaction price reduced by the amount of dividend.

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Cum-dividend and Ex-dividend

Dividend is paid to holders who are on the registerof shareholders maintained by the company on therecord date .The name of the buyer of shares of the company isentered in the register on the settlement date .There is a gap between the transaction date andthe settlement date.

India follows T + 3 settlement process.

Therefore, if the transaction occurs on Monday (say 1February, 2010), the settlement day is the nextThursday (4 February, 2010).

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Cum-dividend and Ex-dividend (cont.)

On the declaration date , the Board announcesdividend.The market price captures that information.

A buyer of shares of the company will receive thedividend if it purchases the shares adequately inadvance of the record date to ensure that thesettlement occurs on or before the record date.For example, if the record date is 6 February, 2010,an investor should purchase the shares latest by 3February, 2010 to be entitled to the dividendannounced by the company.

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If, the investor purchases shares on or after 4 February4, 2010, it will not be entitled to dividend.Therefore, 4 February, 2010 is called the ex-dividenddate .

In general, a stocks price drops the day (ex -dividend date)the ex-dividend period starts, since the buyer will not receivethe benefit of a dividend payout until the next dividend date.

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Although, theoretically, a share is said to be tradingcum-dividend when payment of the dividend is duein the near future and those who buy the sharesnow will receive the dividend.

However, for accounting for investments, we mayconsider that shares are traded cum-dividend onlyduring the period from the declaration date to theex-dividend date.

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Held-for-trading investments are measured at fairvalue at each balance sheet date. The change inthe fair value is recognised in profit or loss for theperiod ended on the balance sheet date.

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Subsequent Measurement (cont.)

An entity (investor) is not required to assessimpairment of held-for-trading investments as thoseare carried in the balance sheet at fair value.

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AVAILABLE -F OR -S ALE INVESTMENTS

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Definition

Available-for-sale financial assets are thosefinancial assets that are designated as available forsale or are not classified as (a) loans andreceivables, (b) held-to-maturity investments, or (c)

financial assets held for trading.Thus, available-for-sale investments is the residualcategory.

Available-for-sale investment can be a debt

instrument or an equity instrument issued byanother entity.

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Initial Measurement

At the date of acquisition, available-for-saleinvestments are measured at fair value plustransaction costs which are directly attributable tothe acquisition of the asset.

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Generally, available-for-sale investments aremeasured at fair value at each balance sheet.Gain or loss on account of the change in fair value arerecognised as other comprehensive income andpresented as a separate component of equity in the

balance sheet.On sale of an available-for-sale investment, thecumulative gain or loss recognised in othercomprehensive income is reclassified from equity toprofit or loss.Interest accrued, and dividend receivable is recognisedin the profit and loss account for the period in which theinterest is accrued and right to dividend is established.

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Illustration 4

Kasturi Limited (KL) acquired a zero coupon bondon 31 December, 2010 for Rs. 750, which was thefair value at the date of acquisition.

The bond would mature on 1 January, 2014 at

Rs. 1,000.KL closes its financial year on 31 December.Fair value of the investment as at end of 2011, 2012,and 2013 is Rs. 850, Rs. 950 and Rs. 1,000,respectively.

RequiredExplain the accounting for the investment and relatedinterest income in financial statements for the years2010 2013.

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The effective interest rate calculated using the IRRfunction of Microsoft Excel is 10.06%.Table showing calculations:

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Year (1)

Amortisedcost at thebeginning(Rs.) ( 2+3) (2)

Effectiveinterest(Rs.) (2 0.006) (3)

Change in fair value (Rs.) (7 2)

(4)

Gain or loss to equity (Rs.) (4 3) (5)

Cash flow (Rs.) (6)

Fair valueat balance

sheet date (Rs.) (7)

2010 750.00 2011 750.00 75.45 100.00 24.55 850.00 2012 825.45 83.04 100.00 17.96 950.00 2013 908.49 91.59 50.00 (4 1.51 ) 1,000.00 2014 1,000.00 1,000


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Interest income of Rs. 75.45 for the year 2011 anda gain of Rs. 24.55.Interest income of Rs. 83.04 for the year 2012 anda gain of Rs. 17.96.Interest income of Rs. 91.59 for the year 2013 anda loss of Rs. 41.51.In the balance sheet as at 31 December 2010,investment should be carried at Rs. 750.Investment should be carried in the balance sheet2011, at Rs. 850; 2012, at Rs. 950; 2013, at Rs.1,000.

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Zero-coupon Bond

A zero-coupon bond is a debt security that does notpay interest (a coupon).

It is traded at a discount over face value.It results in profit (compounded interest) at maturity

when the bond is redeemed for its full face value.Some zero-coupon bonds are issued as such by theissuer.Financial institutions often strip regular bonds oftheir coupons and then repackage them as zero-couponbonds.Zero-coupon bonds tend to fluctuate in price much morethan regular bonds because they offer the entirepayment (interest plus principal) at maturity.

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Impairment

An entity (investor) is required to assessimpairment of available-for-sale investments.When a decline in the fair value of an available- for-sale asset has been recognised in othercomprehensive income and there is objectiveevidence that the asset is impaired, the cumulativeloss within equity should be reclassified to profit orloss even though it has not been derecognised.

Assets are usually derecognised on sale or onmaturity of a debt instrument.

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OTHER ISSUES : F INANCIAL A SSETS

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Derivatives

Derivative instruments are often used for hedgingfinancial risks.They are also used for arbitrage and speculation.Derivative instruments designated as hedginginstruments are accounted for using hedgeaccounting principles and methods.Other derivative instruments are designated asheld-for-trading instruments.

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Reclassification

Reclassifications between held-to-maturityinvestments and available-for-sale assets arepermitted.Reclassification from held-for-trading investments isgenerally prohibited.Under certain circumstances, available-for-saleinvestments are reclassified as loans andreceivables, provided those investments meet the

definition of loans and receivables at the date ofreclassification.

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Investments in Subsidiaries, Associatesand Joint Ventures

In addition to consolidated financial statements, anentity, which is a parent, may present separatefinancial statements.When an entity prepares separate financialstatements, it accounts for investments insubsidiaries, jointly controlled entities andassociates either:

(a) At cost, or

(b) Applying the accounting principles and methodswhich are applied for accounting for available-for-saleinvestments.

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INVESTMENT P ROPERTY

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Definition

Investment property is property (land or abuilding or part of a building or both) held toearn rentals or for capital appreciation or both,rather than for:

(a) Use in the production or supply of goods or services orfor administrative purposes; or

(b) Sale in the ordinary course of business.

Owner-occupied property , which is property held for

use in the production or supply of goods or servicesor for administrative purposes, is accounted for asproperty, plant and equipment.

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Initial Measurement

An investment property is measured initially at itscost.

Transaction costs are included in the initialmeasurement.

Principles and methods for accumulating cost ofinvestment property are the same as those foraccumulating costs of owner occupied property.

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An entity can choose either the cost model or thefair value model for the measurement of investmentproperty.

IFRS prefer use of the fair value model for subsequent

measurement of investment properties.Cost model

Principles and methods used to account for investmentproperty using the cost model are the same as thoseused to account for owner-occupied property.

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END

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Essentials of FA_Chapter 11

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