Chapter 7 Student

Lo/Fisher, Intermediate Accounting Vol.
Administrative Matters
Second Quiz on Nov 4
Covers selected sections of Chapters 5-7 (TBA)
Dr. Ds OH: Tuesdays 4-5:30pm (Room 331)
Robert and Jonathans OH: Mondays 5:30-6:30pm
(Room 232)
Case Assignment
Groups of 2-3
Will be released on the week of Nov 4
Due at the end of the semester Dec 4
Copyright 2014 Pearson Education Canada Inc.
7-1
7-
7-2
Chapter 7
Financial Assets
7-3
Lo/Fisher, Intermediate Accounting Vol.1
LEARNING OBJECTIVES
L.O. 7-1. Explain what financial assets are, how they differ
from other types of assets, and why there is a variety of
measurement standards for different categories of financial
assets.
L.O. 7-2. Evaluate the nature of a financial asset to classify
it into one of eight categories: subsidiaries, joint operations,
joint ventures, associates, held for trading, available for
sale, held to maturity, and loans and receivables.
L.O. 7-3. Identify the measurement approach appropriate to
the eight categories of financial assets and explain the
general nature of the various measurement approaches.
7-2
LEARNING OBJECTIVES
L.O. 7-4. Analyze historical cost and fair value information
to determine the appropriate post-purchase balance sheet
measurement and income recognition for three categories
of financial assets: held for trading, available for sale, and
held to maturity.
L.O. 7-5. Apply present value techniques to account for
investments in debt instruments.
7-3
A. INTRODUCTION (L.O. 7-1)
Financial assets assets arising from

contractual agreements on future cash flows
Not equipment, land, buildings, inventory,
which are real assets
7-6
Measurement Basis for Reporting Values
Most important issue for financial assets

No single measurement basis for all
financial assets
Depend on managements intent for the
investment
Standards specify criteria and accounting
treatment for different classifications
7-7
B. OVERVIEW OF FINANCIAL ASSET

CLASSIFICATION (L.O. 7-2)
Three general groupings based on nature:

Equity instrument
A derivative
A debt instrument
Under ASPE, investments are

classified by nature
Under IFRS, investments are not
classified by the nature!
7-8
Defining the Instruments

Equity instrument contract that gives the holder residual
interest in an entity after deducting its liabilities
Derivative a financial instrument with
(i) its value changes according to a specified variable
(ii) it requires no initial net investment or a small
investment relative to non-derivative contracts with similar
exposure to the specified variable; and
(iii) it is settled at a future date
Debt instrument any financial instrument that is not an
equity instrument or a derivative
7-9
Financial Asset Categories
1.
2.
3.
4.
5.
6.
7.
8.
Subsidiaries Control
Investment in joint operations Joint control
Strategi
Investment in joint ventures Joint control
c
Investment in associated companies Significant
influence
Held-for-trading To trade over short-term
Available-for-sale No specific trading intention NonStrategic
Held-to-maturity To hold until maturity
Loans and receivables No active market
7 - 10
Accounting Classification and Treatment of Financial

Assets
Strategi
c
No longer allowed
NonStrategic
7 - 11
C. STRATEGIC EQUITY INVESTMENTS

(L.O. 7-3)
Strategic reasons to
access resources
extend their market reach
increase operational efficiency
Investor can direct or influence management
decisions
Degree of influence determines category
Voting power often the determining factor
Could only be equity (not debt or derivative)
7- 12
1. Subsidiaries
Parent entity that controls another entity

Subsidiary entity that is controlled by another
entity (known as the parent)
Control power to govern the financial and
operating policies
Presume control if investor holds > 50% of voting
power
Accounting treatment consolidation
Consolidation is covered in advanced financial
accounting AFA
The basic idea is to add the two companies together
7 - 13
Relationship Example: Control
7 - 14
Real Life Example: LVMH

LVMH is the parent company of over 60 subsidiaries
(imagine you are doing the consolidation!):
15
2. Joint operations
Joint arrangement contractual arrangement whereby two
or more parties undertake an economic activity subject to
joint control
Joint control
contractually agreed sharing of control over an
economic activity
strategic decisions require unanimous consent
Usually has limited life on a project-basis
Accounting treatment proportionate consolidation
The basic idea is to add the parent company plus % of the JO

7 - 16
3. Joint ventures
Joint venture Rights and responsibilities of the

parties are limited to the net assets of the investee
Do not have direct control over the assets nor
direct exposure to the liabilities of the venture
Not easy distinction between JO and JV: Professional judgment
required!
Accounting treatment equity method
Will be taught later
7 - 17
Distinguishing JO and JV (IFRS 11)
7 - 18
Relationship Example: JO or JV
David & Victorias

son, Brooklyn,
could be thought
of as JV:
They make this
company
together but it is
a separate entity,
the parents share
the profit of the
company but
none have direct
control on the
company!
It is a JO not a JV because they do

not have a separate entity!
7 - 19
Real Life Example of JV

Sony Ericsson: 50-50 JV in 2001
Miller Coors: started 2008
Groupon LiveNation: 2012
20
4. Associates
Significant influence power to participate in

financial and operating policy decisions of
investee
not to the extent of control or joint control
Associate entity over which investor has
significant influence
Not a subsidiary nor an interest in a joint
venture
7 - 21
4. Associates
Presume significant influence if holding 2050%

of the voting power
Consider evidence to the contrary
Accounting treatment equity method
Balance sheet value = cost + investors share of
post-acquisition in net assets
Income = investors share of associates income
7 - 22
What is Equity Method?

Initial investment is recorded at cost
The respective share of the investee net income
for the year increases the investment
Dr.
Investment in Associates
Cr. Investment Revenue/Income
Dividends represents return to investments and
reduces the investment
Moreover, the carrying (book) value of the
investment cannot be higher than the market
price!
+ Income
23
- Dividend
Exercise: Equity Method

Jonathan loves fancy party too much
that he decided on January 2, 2012,
purchased 20% of the Big in Japan
Bar (BiJB) with 48,000 shares @
$10/share
BiJB reported a net income of
$200,000 for the year
On December 31, BiJB declared and
paid $100,000 cash dividend
On December 31, BiJB shares were
traded for $12/share
Prepare all journal entries, using the
equity method
24

January 2
(48,000 shares * $10)

December 31
($200,000 net income * 20%)
($100,000 dividends * 20%)

25

Question: Does Jonathan care about the market price of
BiJB @ $12/share?
Answer:
Book value =
Market value =
Hence, no impairment!
26
Let say now it is 2013

For the year 2013, BiJB reported a net loss of $50,000
No dividend was paid in 2013
On December 31, 2013, BiJB shares were traded for
$9/share
Prepare all journal entries, using the equity method
December 31
($50,000 net loss * 20%)

27

Question: Does Jonathan care about the market price of
BiJB now @ $9/share?
Answer:
Book value =
Market value =
Hence, impairment if carrying amount is less than
recoverable amount (in this case, the fair market values
of the shares)
December 31, 2013
($490,000-432,000)
28
Premium Paid in Equity Method

What if you have to pay a premium to
acquire the shares of the associates?
29
Exercise: Premium in Equity Method

What if Robert is also fancy and wants to own a part of
BiJB as well?
So he would use his money earned from his tutoring to
pay a premium to beat out Jonathan
The premium would be attributed to goodwill and
tangible assets (e.g., land and buildings)
Premium allocated to depreciable assets (e.g.,
buildings) must be amortized
30
Assume Robert now paid $500,000 for the 48,000 shares

with book values of $480,000
The extra $20,000 represents $8,000 goodwill and
$12,000 increase in the value in buildings (with useful
life of 10 years)
Prepare the journal entries for 2012
31

January 2
Investment in BiJB
Cash
500,000
500,000
December 31
Investment in BiJB
40,000
Investment Income
40,000
(same as before)
Cash
20,000
Investment in BiJB
20,000
(same as before)
(additional depreciation! Note goodwill is NOT depreciated!)

32
D. NON-STRATEGIC INVESTMENTS (L.O. 7-4)
Four categories of financial assets that are

non-strategic investment
1. Held for trading (HFT)
They are
2. Available for sale (AFS) your old
3. Held to maturity (HTM) friends!
4. Loans and receivables
Classification depends on management intention: Two
companies can have the same investment (e.g., Google
stock) but different accounting treatments!
7 - 33
1. Held for trading (HFT)
A category of financial assets

(i) acquired for purpose of selling in the near
term
(ii) part of a portfolio of identified financial
investments (debt or equity) that show evidence
of short-term profit taking or
(iii) a derivative
Management intends to trade and make profit
Derivatives can only be HFT because they are
high risk and speculative
7 - 34
1. Held for trading
Report at fair value on the balance sheet
Accounting treatment fair value through profit

or loss (FVPL)
Unrealized gain and losses show up in net
income (i.e., not OCI)
Trading activity part of regular activities
Fair value is the relevant measure
An active market supports fair value
7 - 35
Relationship Example: HFT

http://www.zimbio.com/Kim+Kardashian/dating
No one expects it to be held for long time!
7 - 36
Exercise: HFT
On January 2, Dr.D purchased 1,000

shares of The Honest Co. (assume
publicly traded) @ $20/share
On December 31, the company
declared and paid $0.50 dividends
per share
On December 31, shares of the
company were traded for $19/share
Prepare all journal entries (including
closing entries), assume the
investments are held-for-trading
37
Exercise: HFT
January 2
(1,000 shares * $20)

December 31
($0.5 * 1,000 shares)
(recognize unrealized gains)
(closing entry to RE on balance sheet)

38
Example: HFT
On February 15 of the following year, Dr.D sold

the shares at $22/share
Disposal is easy for HFT:
February 15
39
2. Available for sale (AFS)
A category of financial investments usually held

for medium term
Entity has designated as available for sale
Active intention to trade does not apply
Investment accounted for as AFS if:
Not classified as one of the other categories of
financial assets (catch-all category)
New IFRS 9: Available only for equity
investment
ASPE has no such category!
7 - 40
2. Available for sale
Report at fair value on the balance sheet

Accounting treatmentfair value through other
comprehensive income (OCI)
Unrealized amounts shown in OCI
New IFRS 9: There is no recycling of gain/loss to

net income upon disposal
Disposal gain/loss goes to retained earnings directly
7 - 41
Relationship Example: AFS
Looking nice now but

dont know how long it
will last!
7 - 42
Exercise: AFS
On January 2, Dr.D purchased 1,000 shares of LAMB

(assume publicly traded) @ $20/share
On December 31, the company declared and paid $0.50
dividends per share
On December 31, shares of the company were traded for
$19/share
Prepare all journal entries (including closing entries),
assume the investments are available for sale
43
Exercise: AFS
January 2
Investment in AFS
Cash
(same as HFT)
December 31
Cash
Dividend Income
(same as HFT)
20,000
20,000
500
500
(recognize OCI)
(closing entry to AOCI on balance sheet)

44
Exercise: AFS
On February 15 of the following year, Dr.D sold

the shares at $22/share
Disposal has three steps for AFS:
Update the investment:
February 15
(update the investment amount)
(closing entry to AOCI on balance sheet)

45
Exercise: AFS
Record the sales:

February 15
II
(the investment is sold)
No Recycling of G/L in net income (goes to RE directly):

February 15
III
(no gain or loss would show up on net income)
46
3. Held to maturity (HTM)
A category of financial investments, excluding

derivatives and equity
Could only be in bond
Fixed or determinable payments & fixed maturity
Entity intends and is able to hold to maturity
7 - 47
3. Held to maturity
Are not reported at fair value on balance sheet

Accounting treatment amortized cost
the purchase cost of the investment adjusted for
amortization of any premium or discount on the
investment
IFRS: valuation using the effective interest
method
ASPE: effective interest or straight line method
Same as notes receivable!
7 - 48
Relationship Example: HTM
Think of all the bromance and

bff in your life: You do not own
each other, but you intend to
hold onto it for a long time!
7 - 49
4. Loans and receivables
Applies to investments in debt instruments only

Fixed or determinable payments
No active market
no readily obtainable price
Doesnt include loans and receivables the entity
(i) intends to sell in the near term, which should be
classified as held for trading
(ii) has designated as available for sale when first
acquired
Accounting treatment amortized cost
7 - 50
Example: Amortized Costs
On January 2, Dr.D purchased a bond from Justin, Inc. with

face value $1,000 and annual coupon of $60. Time to maturity
is 2 years
Assume a market interest rate is 5%
Premium bond
The price of the bond for now is:
$60/ (1.05) + $60/(1.05)2 + $1,000/(1.05)2 = $1,018.59
Prepare journal entries, assume investments are held to maturity
51
Example: Amortized Costs

January 2
Investment in HTM
1,018.59
Cash
1,018.59
December 31
Cash
60
Investment in HTM
9.07
Interest Income
50.93
December 31
Cash
60
Investment in HTM
9.52
Interest Income
50.48
January 2
Cash
1,000
Investment in HTM
1,000
52
Summary on non-strategic investments

Amortized Cost
model
Investment
Types
HTM
FV Profit &
Loss
FV OCI
(only under IFRS)
HFT
AFS
Loans &
Receivables
Measureme
nt after
acquisition
Amortized Cost
Fair value
Fair value
Unrealized
holding
gains and
losses
Not recognized
Recognize in
net income
Recognize in
OCI
Disposal
gains and
losses
No gain or loss if
held to maturity
Recognize in
net income
Recognize in
OCI, AOCI close
directly to RE
5. Reclassifications from one category to another

Classification depends on management intentions vs.
characteristics
Changes in management intention can result in change in
reclassification
IAS 39
Restricts the ability to reclassify financial assets into or
out of HFT
Prevents reporting of gains and deferral of losses by
reclassifying from HTM to HFT
New IFRS 9
Prevent the reclassification of any AFS investment
7 - 54
Reclassification: Earnings Management Implications

Why IFRS 9 is so mean?
Without restrictions, managers can
cherry pick and:
Reclassify investments with unrealized gains
from AFS to HFT
Reclassify investments with unrealized
losses from HFT to AFS
Balance sheet management

Reclassify HTM winners to AFS, and keep
the losers in HTM
55
G. SUBSTANTIVE DIFFERENCES BETWEEN

RELEVANT IFRS AND ASPE
Strategic investments (joint arrangements)

distinguish joint operations from joint ventures
(IFRS) vs. joint venture for both types (ASPE)
Non-strategic investments classify according
to trading intention (IFRS) vs. nature as to
equity, debt and derivative (ASPE)
Non-strategic investments AFS unrealized
gains in losses in OCI (IFRS) vs. no OCI/no
unrealized amounts (ASPE)
7- 56
G. SUBSTANTIVE DIFFERENCES BETWEEN

RELEVANT IFRS AND ASPE
Non-strategic equity investments measurement

fair value (IFRS) vs. fair value if active market,
if not at cost subject to impairment (ASPE)
Non-strategic debt investments measurement
HFT at fair value or HTM at effective interest
method (IFRS) vs. amortized cost at effective
interest or straight-line method (ASPE)
7 - 57
Hints for Quiz 2 (Exclusively Available in Class)
7 - 58

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Lo/Fisher, Intermediate Accounting Vol.

Copyright 2014 Pearson Education Canada Inc.

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

A. INTRODUCTION (L.O. 7-1)

Financial assets assets arising from

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Measurement Basis for Reporting Values

Most important issue for financial assets

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

B. OVERVIEW OF FINANCIAL ASSET

Three general groupings based on nature:

Under ASPE, investments are

Lo/Fisher, Intermediate Accounting Vol.1

Defining the Instruments

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Financial Asset Categories

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Accounting Classification and Treatment of Financial

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

C. STRATEGIC EQUITY INVESTMENTS

Lo/Fisher, Intermediate Accounting Vol.1

Parent entity that controls another entity

The basic idea is to add the two companies together

Lo/Fisher, Intermediate Accounting Vol.1

Relationship Example: Control

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Real Life Example: LVMH

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2014 Pearson Education Canada Inc.

The basic idea is to add the parent company plus % of the JO

Lo/Fisher, Intermediate Accounting Vol.1

Joint venture Rights and responsibilities of the

Accounting treatment equity method

Will be taught later

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Distinguishing JO and JV (IFRS 11)

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

David & Victorias

It is a JO not a JV because they do

Lo/Fisher, Intermediate Accounting Vol.1

Real Life Example of JV

Lo/Fisher, Intermediate Accounting Vol.1

Significant influence power to participate in

Lo/Fisher, Intermediate Accounting Vol.1

Presume significant influence if holding 2050%

Copyright 2014 Pearson Education Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

What is Equity Method?

Lo/Fisher, Intermediate Accounting Vol.1

Exercise: Equity Method