CHAPTER 36 FINANCIAL INSTRUMENTS Measurement of financial asset PFRS 9 TECHNICAL KNOWLEDGE To identify the financial assets that can be measured at fair value through profit or loss. To understand the measurement of equity investments at fair value through other comprehensive income. To understand the. measurement of debt investments at amortized cost. To understand the measurement of debt investments at fair value through other comprehensive income. 724 ovaimieu wiur vamSJnitial measurement of financial asset PERS 8 paxagraph 8.12, ea that at initial recognition, an entity sho sure a financial asset at fair value plus, i th case of financial asset not at fair y eh profit oF i value through profit or loss, transaction costs that are direct! i we acquisition of the financial asset. etly attributable fo:#he As a rule, transaction costs that are di i alee rectly attributable to the acquisition of the financial asset sk itali as cost of the financial asset. shall be capitalized However, if the financial asset is held for trading or if the financial asset is measured at fair value through profit or loss, transaction costs are expensed outright. Subsequent measurement PERS 9, paragraph 5.2.1, provides that after initial recognition, an entity shall measure a financial asset at: a. Fair value through profit or loss (FVPL) b. Fair value through other comprehensive income (FVOCI) c. Amortized cost The measurement depends on the business model of managing financial asset which may be to realize fair value changes and to collect contractual cash flows. Financial assets at fair value through profit or loss The following financial assets shall be measured at fair value through profit or loss: 1. Financial assets held for trading or popularly known as “trading securities” 2. All other investments in quoted equity instruments 3. Debt investments that are irrevocably designated on initial recognition as at fair value through profit or loss 4. All debt investments that do not satisfy the requirements for measurement at amortized cost and at fair value through other comprehensive income 725 ovaimeu wiur camSFinancial asset held for trading Appendix A of PFRS 9 provides that a financial asset in holg for trading ift a, It is acquired principally for the purpose of selling or repurchasing it in the near term. b. On initial recognition, it is part of a portfolio of identified financial assets that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking. c. Itis a derivative, except for a derivative that is a financial guarantee contract or a designated and an effective hedging instrument. In other words, trading securities are debt and equity securities that are purchased with the intent of selling them in the "near term" or very soon. Trading securities are normally classified as current assets. What is an equity security? The term. equity security encompasses any instrument representing ownership shares and right, warrants or options to acquire or dispose of ownership shares at a fixed or determinable price. In simple language, equity securities represent an ownership interest in an entity. Ownership shares include ordinary shares, preference shares and rights or options to acquire ownership shares. What is a debt security? A debt security is any security that represents a creditor relationship with an entity. A debt security has a maturity date and a maturity value. Examples of debt securities include corporate bonds, BSP treasury bills, commerical papers and other debt instruments with maturity. 726 ovaimeu wiur vamSIllustration ~ Trading securities (TS) During 2020, an entity purchased marketable equity securities ata total cost of P5,000,000, The equity securities qualify a9 financial asset held for trading. The entity also paid P50,000 a8 commission to the broker. jf Trading securities 5,000,000 Commission expense 50,000 — 5,050,000 Observe that the commission paid to the broker is not capitalized as cost of the investment but treated as outright expense. On December 31, 2020, the trading securities have a total fair value of P6,000,000. The increase in value is recorded as follows: Trading securities 1,000,000 Unrealized gain-TS 1,000,000 The unrealized gain is classified in the income statement as other income. On December 31, 2020, the statement of financial position will report the trading securities at fair value of P6,000,000 with a disclosure of the cost of P5,000,000. On December 31, 2021 the trading securities have a fair value of P4,500,000. The decrease in fair value is recorded as follows: Unrealized loss ~ TS 1,500,000 Trading securities 1,500,000 The unrealized loss is reported in the income statement as other expense. On December 31, 2021, the trading securities will be carried at 4,500,000, with disclosure of the cost of P5,000,000. ocaimeu wiur vamSSale of trading securities On December 31, 2022, the trading securities are sold fo, P5,200,000. The sale is simply recorded as follows: Cash | 5,200,000 Trading securities 4,500,000 Gain on sale of trading securities 700,000 PFRS 9, paragraph 3.2.12, provides that on disposal of a financial asset the difference between the carrying amount and the consideration received is recognized as gain or loss on disposal to be reported in the income statement. Financial asset at FVOCI At initial recognition, PFRS 9, paragraph 5.7.5, provides that an entity may make an irrevocable election to present inother comprehensive income or OCI subsequent changes in fair value of an investment in equity instrument that is not held for trading. This irrevocable approach is designed to impose discipline in accounting for nontrading equity investment. The amount recognized in other comprehensive income is not reclassified to profit or loss under.any circumstances. ‘ However, on derecognition, the amount may be transferred to retained earnings. If the investment in equity instrument is held for trading, the election to present gain and loss in other comprehensive income is not allowed. If the investment in’ equity instrument is held for trading, ‘subsequent changes in fair value are always included in profit or loss or reported in the income statement. 728 ovaimeu wiur camSIllustration During 2020, an entity purchased ng marketabl i securities at a total cost of P1,000,000. Defer commission’ and taxes of P100,000. a The equity securities do not qualify as financial asset held for trading. The entity made an irrevocable election to present unrealized gain and loss in other comprehensive income. . The journal entry to record the acquisition is: Financial asset - FVOCI 1,100,000 , ash 1,100,000 FVOCI means the financial asset is measured at fair value through other comprehensive income. Under PFRS 9, paragraph:5.1.1, a financial asset measured. at fair value through other comprehensive income shall be recognized intially at fair value plus transaction cost directly attributable to the acquisition. Thus, the commission and taxes of P100,000 are capitalized as cost of the investment. On December 31, 2020, the securities have a total market value of P1,800,000. The increase in market value is: Financial asset - FVOCI 200,000 Unrealized gain — OcI 200,000 sented as component of other The unrealized gain is pr 2020 statement of comprehensive comprehensive income in the income. “4, FVOCI on December 31, 2020 is carried * The financial asset — f P1,300,000, with disclosure of the cost of at the market value o! P1,100,000. The financial asset - FVOCI i noncurrent asset. s normally classified as 729 ocaimeu wiur camSSale of equity investment - FVOCI On July 1, 2021, the securities are sold for P2,000,000. The journal entry to record the sale is: Cash 2,000,000 Financial asset- FVOCI 1,300,000 Retained earnings 700,000 Gain or loss on disposal of equity investment measured at fair value through other comprhensive income is recognized directly in retained earnings in accordance with PFRS 9, paragraph 5.7.1b. Moreover, the cumulative gain or loss previously recognized in other comprehensive income is also transferred to retained earnings in accordance PFRS 9 Application Guidance, paragraph 5.7.1. Accordingly, the cumulative unrealized gain of P200,000 is transferred to retained earnings. Unrealized gain- OCI 200,000 Retained earnings 200,000 The amount recognized in other comprehensive income is not reclassified to profit or loss under any circumstances. Sale price "2,000,000 Historical cost 1,100,000 Actual gain on disposal , 900,000 The actual gain of P900,000 is directly credited to retained .earnings as shown in the two entries. - 730° ovaimeu wiur vamSDebt investment at amortized cost PFRS 9, paragraph 4.1.2, provides that i PF gcured at amortized aaee pita financial asst shal conditions are met: following a. The business model is to hold the financial i to collect contractual cash flows on specified date, order b. The contractual cash flows are solely payments of 5 principal and interest on the principal amount In other words, the business model is to collect contractual cash flows if the contractual cash flows are solely payments of principal and interest. In‘such a case, the financial asset shall be measured at amortized cost. Debt investment at fair value through OCI PFRS 9, paragraph 4.1.2A, provides that a financial asset shall be measured at fair value through other comprehensive income if both of the following conditions are met: a. The business model is achieved both by collecting contractual cash flows and by selling the financial asset. b. The contractual cash flows are solély payments of principal and interest on the principal outstanding. Note that the business model includes selling the financial asset in addition to collecting contractual cash flows. In this case, interest income is recognized using the effective interest method as in amortized cost measurement. On derecognition, the cumulative gain and loss recognized in other comprehensive income shall be reclassified to profit or loss. The measurement of debt investment at amortized cost or at fair value through other comprehensive income is discussed extensively in an intermediate accounting course: 731 ovaimieu wiur vamSSUMMARY OF MEASUREMENT RULES Measurement of equity investments 1. Held for trading — at fair value through profit or loss 2. Not held for trading — as a rule, at fair value through profit or loss 3. Not held for trading — at fair value through other comprehensive income by irrevocable election 4, All other investments in quoted equity instruments - at fair value through profit or loss 5. Investments in unquoted equity instruments — at cost 6. Investments of 20% to 50% — equity method of accounting 7. Investments of more than 50% — consolidation method to be taken up in an advanced accounting course. Measurement of debt investments 1. Held for trading — at fair value through profit or loss 2. Held for collection of contractual cash flows - at amortized cost . 3. Held for collection of contractual cash flows — at fair value through profit or loss by irrevocable designation or fair value option 4. Held for collection of contractual cash flows and for sale of the financial asset — at fair value through other comprehensive income 5. Held for collection of contractual cash flows and for sale of the financial asset — at fair value through profit or loss by irrevocable designation or fair value option 732 ovaimeu wiur camSQUESTIONS 1. Explain the initial measurement of financial asset. 2. Explain the subsequent measurement of financial asset. 3. What are the financial assets measured at fair value through profit or loss? “ 4, Explain financial asset held for trading. 5. Explain measurement of equity investment at fair value through other comprehensive income. 6, Explain measurement of debt investment at amortized cost. 7, Explain measurement of debt investment at fair value through other comprehensive income. 8. Explain the treatment of unrealized gain and loss on financial asset at fair value. 9. Explain the derecognition of financial asset at fair value through profit or loss. 10. Explain derecognition of equity investment at fair value through other comprehensive income. 733 ocameu wiur CamSPROBLEMS Problem 36-1 (IFRS) At the beginning of current year, Alexis Company purchased marketable equity securities to be held as “trading” for P5,000,000. The entity. also paid transaction cost amounting to P200,000. The securities had a market value of P5,500,000 at year-end and the transaction cost that would be incurred on sale is estimated at P100,000. No securities were sold during the current year. What amount of unrealized gain or loss on these securities should be reported in the income statement for the current year? a. 500,000 gain b. 500,000 loss c. 300,000 gain d. 400,000 gain Problem 36-2 (AICPA Adapted) During 2020, Latvia Company purchased trading securities with the following cost and market value on December 31, 2020: Security Cost Market value A- 1,000 shares 200,000 B- 10,000 shares 1,700,000 C— 20,000 shares 3,100,000 5,000,000 The entity sold 10,000 shares of Security B on January 15, 2021 for P150 per share. 1. What amount of unrealized gain or loss should be reported in the income statement for 2020? a. 200,000 loss b. 200,000 gain c. 300,000 loss d. 300,000 gain 2. What amount should be reported as loss on sale of trading investment in 2021? a. 200,000 gain b. 200,000 loss ec. 100,000 gain d. 100,000 loss 734 . - ovammeu wiur CamSproblem 36-3 (IFRS) Carmela Company acquired nontrading equity instrument for P4,000,000 during the current year. The equity instrument is classified as financial asset at fair value through other comprehensive income. The transaction cost incurred amounted to P700,000. At year-end, the fair value of the instrument was P5,500,000 ‘rand the transaction cost that’ would be incurred on the sale of the investment is estimated at P600,000. What amount of unrealized gain should be recognized in other comprehensive income for the current year? a. 200,000 b. 900,000 c. 800,000 d. 0 Problem 36-4 (IAA) On January 1, 2020, Lebanon Company purchased equity securities to be held at fair value through other comprehensive income. On December 31, 2020, the cost and market value were: : Cost Market Security X 2,000,000 2,400,000 Security Y 3,000,000 3,500,000 Security Z 5,000,000 4,900,000 On July 1, 2021, the entity sold Security X for P2,500,000. What amount should be recognized directly in retained earnings as a result of the sale of financial asset in 2021? 500,000 100,000 400,000 0 Bo Dp 135 OULAIINICU WILT vamSProblem 36-5 Multiple choice (PFRS 9) 1. Depending on the business model for managing financin} assets, an entity shall classify financial assets subsequent, to initial recognition at a. Fair value through profit or loss b. Amortized cost‘ _ ec: Fair value through other comprehensive income d. All of these are used in measuring financial assets 2. Which of the following is a characteristic of a financial asset held for trading? ‘ a. It is acquired principally for the purpose of selling or repurchasing it in the near term. b. It is part of a portfolio of financial assets that are managed together and for which there is actual pattern of short-term profit taking. c. - It is a derivative that is not designated as an effective hedging instrument. : d. All of these are correct. 3. Under IFRS, the presumption is that equity investments are: Held for trading Held to profit from price changes Held for trading and held to profit from price changes Held as financial assets at fair value through other comprehensive income . Be op 4. All of the following shall be measured at FVPL, except a. Financial asset held for trading b. Debt investment irrevocably designated at FVPL c. Investment in quoted equity instrument d. Debt investment at amortized cost 5. Equity investments irrevocably accounted for at fair value through other comprehensive income are. a. Nontrading investments of less than 20%. b. Trading investments of less than 20%. c. Investments of between 20% and 50%. d. Investments of more than 50%. 736 ovaimeu wiur camS10. . Entities are required to measure financial asset. based on all of the following, except a, The business model for managing financial asset. b. Whether the financial asset is a debt or an equity investment. c. The contractual cash flow characteristics of the financial asset. d. All of the choices are required. . Debt investments that meet the business model and contractual cash flow tests are reported at a. Net realizable value b. Fair value c. Amortized cost d. The lower of amortizéd cost and fair value . Debt investments not held for collection are reported at a. Amortized cost b. Fair value c. The lower of amortized cost and fair value d. Net realizable value . Debt investments reported at amortized cost are a. Managed and evaluated based on a documented risk management strategy : b. Trading debt investments, c. Held for collection debt investments d. All of these are correct A debt investment shall be measured af fnir value through other comprehensive income When the debt investment is held for trading. When the debt investment is not held for trading. By irrevocable designation When the business model is to collect contractual cash flows that are solely payments of principal and interest and also to sell the financial asset Be op 737, ovaimeu wiur vamS