Investments in Financial Assets (IFRS 9)
IFRS 9
IASB and FASB have each issued similar new standards for accounting for investment in financial assets (minor differences remain). Consistent with the curriculum, the terminology mentioned here is the International Financial Reporting Standards (IFRS) terminology.
IFRS categorizes financial assets depending on whether they are carried at amortized cost or at fair value. The result is three classifications: amortized cost, fair value through profit or loss, and fair value through OCI. Corresponding classifications under U.S. GAAP are held to maturity, held for trading, and available for sale.
Amortized Cost (for Debt Securities Only)
Debt securities that meet two criteria are accounted for using the amortized cost method.
The criteria for amortized cost accounting include the following:
1. Business model test: Debt securities are being held to collect contractual cash flows.
2. Cash flow characteristic test: The contractual cash flows are either principal, or interest on principal, only.
These debt securities are reported on the balance sheet at amortized cost. Amortized cost is the original cost of the debt security plus any discount, or minus any premium, that has been amortized to date.
Interest income (coupon cash flow adjusted for amortization of premium or discount) is recognized in the income statement, but subsequent changes in fair value are ignored.
Fair Value Through Profit or Loss (for Debt and Equity Securities)
Debt securities may be classified as fair value through profit or loss (FVPL) if held for trading, or if accounting for those securities at amortized cost results in an accounting mismatch. Equity securities that are held for trading must be classified as FVPL. Other equity securities may be classified as either fair value through profit or loss, or fair value through other comprehensive income (FVOCI).
Once classified, the choice is irrevocable. Derivatives that are not used for hedging are always carried at FVPL. If an asset has an embedded derivative (e.g., convertible bonds), the asset as a whole is valued at FVPL.
FVPL securities are reported on the balance sheet at fair value. The changes in fair value, both realized and unrealized, are recognized in the income statement along with any dividend or interest income.
Fair Value Through OCI (for Debt and Equity Securities)
Securities classified as fair value through OCI are carried on the balance sheet at fair value and any unrealized gain or loss is reported in OCI. Dividends and interest income are reported in the income statement.
Figure 7.2 summarizes the effects of the different classifications for financial assets on the balance sheet and income statement.
Figure 7.2: Summary of Classifications of Financial Assets
Let’s look at an example of the different classifications for financial assets.
At the beginning of the year, Midland Corporation purchased a 9% bond with a face value of $100,000 for $96,209 to yield 10%. The coupon payments are made annually at year end. Suppose that the fair value of the bond at the end of the year is $98,500.
Determine the impact on Midland’s balance sheet and income statement if the bond investment is classified as (1) amortized cost, (2) fair value through profit or loss, and (3) fair value through OCI.
Solution
Amortized cost: Balance sheet value is based on amortized cost. At year end, Midland recognizes interest revenue of $9,621 ($96,209 beginning bond investment × 10% yield). The interest revenue includes the coupon payment of $9,000 ($100,000 face value × 9% coupon rate) and the amortized discount of $621 ($9,621 interest revenue − $9,000 coupon payment).
At year end, the bond is reported on the balance sheet at $96,830 ($96,209 beginning bond investment + $621 amortized discount).
Fair value through profit or loss: The balance sheet value is based on fair value of $98,500. Interest revenue of $9,621 ($96,209 beginning bond investment × 10% yield) and an unrealized gain of $1,670 ($98,500 − $96,209 − $621) are recognized in the income statement.
Fair value through OCI: The balance sheet value is based on fair value of $98,500. Interest revenue of $9,621 ($96,209 beginning bond investment × 10% yield) is recognized in the income statement. The unrealized gain of $1,670 ($98,500 − $96,209 − $621) is reported in stockholders’ equity as a component of other comprehensive income.
Reclassification Under IFRS 9
Reclassification of equity securities under the new standards is not permitted as the initial designation (FVPL or FVOCI) is irrevocable. Reclassification of debt securities is permitted only if the business model has changed. For example, unrecognized gains/losses on debt securities carried at amortized cost and reclassified as FVPL are recognized in the income statement.
Debt securities that are reclassified out of FVPL as measured at amortized cost are transferred at fair value on the transfer date, and that fair value will become the carrying amount.
Loan Impairment Under IFRS 9
A key feature of IFRS 9 was that the incurred loss model for loan impairment was replaced by the expected credit loss model. This requires companies to not only evaluate current and historical information about loan (including loan commitments and lease receivables) performance, but to also use forward looking information. The new criteria results in an earlier recognition of impairment (12 month expected losses for performing loans and lifetime expected losses for nonperforming loans).