DE LA SALLE UNIVERSITY MANILA

RVR – COB DEPARTMENT OF ACCOUNTANCY

ACCCOB2 2nd Term AY 20 - 21

ACCCOB2 Lecture 4 Prof. Francis H. Villamin

INVESTMENTS IN DEBT AND EQUITY INSTRUMENT

Definition of investments

The International Accounting Standards Board defines investments as follows:

Investments are assets held by an entity for the accretion of wealth through distribution such as
interest, royalties, dividends and rentals, for capital appreciation or for other benefits to the
investing entity such as those obtained through trading relationships.

Actually, investments are assets not directly identified with the operating activities of an entity
and occupy only an auxiliary relationship to the central revenue producing activities of the entity.

Purposes of investments

Investments are held for diverse reasons such as:

a. For accretion of wealth or regular income through interest, dividends, royalties and rentals.

b. For capital appreciation as in the case of investments in land and real estate held for
appreciation and direct investments in gold, diamonds and other precious commodities.

c. For ownership control as in the case of investments in subsidiaries and associates.

d. For meeting business requirements as in the case of sinking fund, preference share
redemption fund, plant expansion fund and other noncurrent fund.

e. For protection as in the case of interest in life insurance contract in the form of cash
surrender value.

Examples of investments

Specifically, investments include the following:

1. Trading securities or financial asset at fair value through profit or loss

2. Financial asset at fair value through other comprehensive income
3. Investment in nontrading equity securities
4. Investment in bonds or financial asset at amortized cost
5. Investment in associate
6. Investment in subsidiary
7. Investment property
8. Investment in fund
9. Investment in joint venture
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Statement classification

Investments are classified either as current or noncurrent assets.

Current investments are investments that are by their very nature readily realizable and are
intended to be held for not more than one year.

For example, trading securities are normally classified as current assets because these
investments are expected to be realized within twelve months after the end of reporting period.

Noncurrent or long-term investments are investments other than current investments.

This residual definition means that the noncurrent investments are intended to be held for more
than one year or are not expected to be realized within twelve months after the end of the
reporting period.

Definition of financial asset

A financial asset is any asset that is:

a. Cash
b. A contractual right to receive cash or another financial asset from another entity
c. A contractual right to exchange financial instrument with another entity under conditions that
are potentially favorable
d. An equity instrument of another entity

Examples of financial assets

Cash or currency is a financial asset because it represents the medium or exchange and is
therefore the basis on which all transactions are measured and recognized in financial
statements.

A deposit of cash with a bank or similar financial institution is a financial asset because it
represents the contractual right of the depositor to obtain cash from the bank or to draw a check
against the balance in favor of a creditor in payment of a financial liability.

But a gold bullion deposited in bank is not a financial asset because although it is very precious
the gold is a commodity.

Financial assets representing a contractual right to receive cash in the future include trade
accounts receivable, notes receivable and loans receivable.

In case of exchanges of financial instruments with another entity, conditions are potentially
favorable when such exchanges will result to gain or additional cash inflow to the entity.

An example of a favorable condition is an option held by the holder to purchase shares of

another entity at less than market price.

Investments in shares or other equity instruments such as trading securities can be classified
as financial assets.

Not considered financial assets

Intangible assets are not financial assets.

Physical assets, such as inventory and property, plant and equipment are not also financial
assets.
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Control of such physical and intangible assets creates an opportunity to generate an inflow of
cash or another financial asset but it does not give rise to a present right to receive cash or
another financial asset.

Prepaid expenses for which the future economic benefit is the receipt of goods or services
rather than the right to receive cash or another financial asset are not also financial assets.

Leased assets are not also financial assets because control of such assets does not give rise to
a present right to receive cash or another financial asset.

Classification of financial assets

1. Financial assets at fair value through profit or loss – include both equity securities and debt
securities.
2. Financial assets at fair value through other comprehensive income – include both equity
securities and debt securities.
3. Financial assets at amortized cost – include only debt securities.

The classification depends on the business model for managing financial assets which may
be:

a. To hold investments in order to realize fair value changes.

b. To hold investments in order to collect contractual cash flows.

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.

The owners of equity securities are legally known as shareholders.

A share is the ownership interest or right of a shareholder in an entity. The share is evidenced
by an instrument called share certificate.

This right pertains to the share in earnings, election of directors, subscription for additional
shares and share in net assets upon liquidation.

Equity securities do not include redeemable preference shares, treasury shares and convertible
debt.

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 dare and a maturity value.

Examples of debt securities include the following:

a. Corporate bonds
b. BSP treasury bills
c. Government securities
d. Commercial papers
e. Preference shares with mandatory redemption date or are redeemable at the option of the
holder
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Initial measurement of financial asset

At initial recognition, an entity shall measure a financial asset at fair value plus, in the case of
financial asset not at fair value through profit or loss, transaction costs that are directly
attributable to the acquisition of the financial asset.

The fair value of a financial asset at initial recognition is normally the transaction price,
meaning, the fair value of the consideration given.

In other words, a financial asset is recognized initially at fair value.

As a rule, transaction costs that are directly attributable to the acquisition of the financial asset
shall be capitalized as cost of the financial asset.

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.

Transaction costs include fees and commissions paid to agents, advisers, brokers and dealers,
levies by regulatory agencies and securities exchanges and transfer taxes and duties.

Transaction costs do not include debt premiums or discounts, financing costs and internal
administrative or holding costs.

Subsequent measurement

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

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”

These financial assets are measured at fair value through profit or loss “by requirement,”
meaning, required by the standard.

2. All other investments in quoted equity instruments.

These financial assets are measured at fair value through profit or loss “by consequence”.

3. Financial assets that are irrevocably designated on initial recognition as at fair value
through profit or loss.
These financial assets are measured at fair value through profit or loss “by irrevocable
designation” or “by option”.

This fair value option is applicable to investments in bonds and other debt instruments which
can be irrevocably designated as at fair value through profit or loss even if the financial
assets satisfy the amortized cost or fair value through other comprehensive income
measurement.

This irrevocable designation is the fair value option allowed.

4. All debt investments that do not satisfy the requirements for measurement at amortized
cost and at fair value through other comprehensive income.
These financial assets are measured at fair value through profit or loss “by default”.
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Financial asset held for trading

A financial asset is held for trading if:

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. It is 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.

Equity investment at fair value through OCI

At initial recognition, an entity may make an irrevocable election to present in other

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 equity or retained earnings.

If the investment in equity instrument is held for trading, subsequent changes in fair value are
always included in profit or loss.

Debt investment at amortized cost

A financial asset shall be measured at amortized cost if both of the following conditions are
met:

a. The business model is to hold the financial asset in order to collect contractual cash flows
on specified date.
b. The contractual cash flows are solely payments of principal and interest on the principal
amount outstanding.

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

A financial asset shall be measured at fair value through other comprehensive income if both of
the following conditions are met:
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a. The business model is achieved both by collecting contractual cash flows and by selling
the financial asset.

b. The contractual cash flows are solely 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.

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

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 at fair value option

FINANCIAL ASSET AT AMORTIZED COST

Bond Investment

Definition of a bond

A bond is a formal unconditional promise made under seal to pay a specified sum of money at a
determinable future date, and to make periodic interest payments at a stated rate until the
principal sum is paid.
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In simple language, a bond is a contract of debt whereby one party called the issuer borrows
fund from another party called the investor.

Thus, a bond is a debt security because the bondholder is a creditor and the issuer is a debtor.

A bond is evidenced by a certificate and the contractual agreement between the issuer and
investor is contained in another document known as “bond indenture”.

A bond is issued in small denomination of P100, P1,000 or P10,000 to enable more investors to
purchase the bond issue.

For example, a P50,000,000 bond issue may be issued in denomination of P1,000. Thus, there
shall be 50,000 bonds with face of P1,000 each.

An investor acquires a bond either as a temporary or permanent investment and derives regular
income in the form of interest.

Interest payment date

The interest on the bond investment is usually paid semiannually or every six months as follows:

a. January 1 and July 1

b. February 1 and August 1
c. March 1 and September 1
d. April 1 and October 1
e. May 1 and November 1
f. June 1 and December 1

Of course, there are certain bonds that pay interest annually or at the end of the bond year.

Classification of bond investments

Bonds may be acquired as current or noncurrent investment depending on the business model
of managing financial assets.

Accordingly, bond investments are classified and accounted for as follows:

a. Financial asset held for trading

b. Financial asset at amortized cost
c. Financial asset at fair value through other comprehensive income
d. Financial asset at fair value through profit or loss by irrevocable designation or by fair value
option

Initial measurement

Bond investments are recognized initially at fair value plus transaction costs that are directly
attributable to the acquisition.

However, transaction costs attributable to the acquisition of bond investments held for trading or
at fair value through profit or loss are expensed immediately.

Subsequent measurement

Subsequent to initial recognition, bond investments are measured and accounted for as follows:
a. At fair value through profit or loss
b. At amortized cost
c. At fair value through other comprehensive income

Acquisition of bond investments

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Bonds may be acquired on interest date or between interest dates. When bonds are
acquired on interest date, there is no accounting problem because the purchase price is initially
recognized as the acquisition cost.

When bonds are acquired between interest dates, meaning the date of acquisition is not any
one of the interest dates, the purchase price normally includes the accrued interest.

That portion of the purchase price representing accrued interest should not be reported as part
of the cost of investment but should be accounted for separately.

In effect, in this case, two assets are acquired, namely the bonds and the accrued interest.
On the date of acquisition, the accrued interest is charged either to accrued interest receivable
or interest income.

When accrued interest receivable is debited, upon receipt of the first semiannual interest, the
accrued interest receivable account is closed and interest income is credited for the excess.
When interest income is debited, the receipt of the first semiannual interest is credited entirely
to interest income.

Investment in bonds at amortized cost

A financial asset shall be measured at amortized cost if both of the following conditions are
met:
a. The business model is to hold the financial asset in order to collect contractual cash flows
on specified dates.
b. The contractual cash flows are solely payments of principal and interest on the principal
amount outstanding.

Amortized cost is the initial recognition amount of the investment minus repayments, plus
amortization of discount, minus amortization of premium, and minus reduction for impairment
or uncollectibility.

When bonds are acquired and classified as financial asset at amortized cost, the bond
investments are classified as noncurrent investments.

Amortization of premium or discount

Investment in bonds shall be measured subsequently at amortized cost.

This means that any premium or discount on the acquisition of long-term investment in bonds
must be amortized.

Bond premium or discount is amortized over the life of the bonds. On the part of the
bondholder, the life of the bonds is from the date of acquisition to the date of maturity.

Amortization is done through the interest income account.

a. Amortization of bond discount:

Investment in bonds xx
Interest Income xx

b. Amortization of bond premium:

Interest income xx
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Investment in bonds xx

Amortization may be made on interest dates or at the end of the reporting period. It is more
convenient to record amortization at the end of the reporting period.

Rationalization on amortization

The reason for amortization of bond premium or discount is to bring the carrying amount of the
investment to face amount on the date of maturity.

When the bonds are redeemed on the date of maturity, the entry will simply be a debit to cash
and a credit to investment in bonds at face value.

The bondholder is a creditor and will collect on the date of maturity an amount equal only to the
face amount of the bonds no more and no less.

Conceptually, bond premium is a loss on the part of the bondholder because the bondholder
paid more than what can be collected on the date of maturity.

Such loss is not recognized outright but allocated over the life of the bonds to be offset against
the interest income to be derived from the bond investment.

On the other hand, bond discount is a gain on the part of the bondholder because the
bondholder paid less than what can be collected on the date of maturity.

Such gain is not recognized outright but allocated over the life of the bonds to be added to the
interest income derived from the bond investment.

Such process of allocating the bond premium as deduction from the interest income and the
bond discount as addition to interest income is what traditionally called amortization.

INVESTMENT IN ASSOCIATE

BASIC PRINCIPLES

Intercorporate share investment

An intercorporate share investment is the purchase of the equity shares of one entity by another
entity.

In other words, it is a case of one entity investing in another entity through the acquisition of
share capital.

An entity may purchase enough shares of another entity in order to exert significant influence
over the financial and operating policies of the investee entity.

Significant influence

The assessment of significant influence is a matter of judgment.

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Significant influence is the power to participate in the financial and operating policy decisions of
the investee but not control or joint control over those policies.

If the investor holds, directly or indirectly through subsidiaries, 20% or more of the voting power
of the investee, it is presumed that the investor has significant influence, unless it can be
clearly demonstrated that this is not the case.

Conversely, if the investor holds, directly or indirectly through subsidiaries, less than 20% of the
voting power of the investee, it is presumed that the investor does not have significant
influence, unless such influence can be clearly demonstrated.

A substantial or majority ownership by another investor does not necessarily preclude an

investor from having significant influence.

Beyond the mere 20% threshold of ownership, the significant influence is usually evidenced by
the following factors:

a. Representation in the board of directors

b. Participation in the policy making process
c. Material transactions between the investor and the investee
d. Interchange of managerial personnel
e. Provision of essential technical information

Potential voting rights

An entity may own share warrants, debt or equity instruments that are convertible into ordinary
shares that have the potential, if exercised or converted, to give the entity additional voting
power over the financial and operating policies of another entity.

The existence of such potential voting rights is considered in assessing whether an entity has
significant influence.

The potential voting rights should be currently exercisable or convertible.

Potential voting rights are not currently exercisable or convertible when the rights cannot be
exercised or converted until a future date or until the occurrence of a future event.

However, when potential voting rights exist, the investor’s share of profit or loss of the investee
and of changes in the investee’s equity is determined on the basis of “present ownership of
interest” and does not reflect the possible exercise or conversion of potential voting rights.

Loss of significant influence

An entity loses significant influence over an investee when it loses the power to participate in the
financial and operating policy decisions of the investee.’

The loss of significant influence can occur with or without change in the absolute or relative
ownership interest.

For example, the loss of significant influence could occur when an associate becomes subject
to control of a government, court, administrator or regulator.

The loss of significant influence could also occur as a result of a contractual agreement.

Equity method
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The equity method is based on the economic relationship between the investor and the
investee.

The investor and the investee are viewed as a single economic unit. The investor and the
investee are one and the same.

The equity method is applicable when the investor has a significant influence over the investee.

Accounting procedures

a. The investment is initially recognized at cost.

b. The carrying amount is increased by the investor’s share of the profit of the investee and
decreased by the investor’s share of the investee.

The investor’s share of the profit or loss of the investee is recognized as investment income.

c. Distributions or dividends received from an equity investee reduce the carrying amount of
the investment.

d. Note that the investment must be in ordinary shares.

If the investment is in preference shares, the equity method is not appropriate regardless of
the percentage because the preference share is a nonvoting equity.

The investment in preference shares may be accounted for as at fair value through profit or
loss or at fair value through other comprehensive income or at cost.

e. Technically, if the investor has significant influence over the investee, the investee is said to
be an associate.

Accordingly, under the equity method, the investment in ordinary shares should be
appropriately described as investment in associate.

f. The investment in associate accounted for using the equity method shall be classified as
noncurrent asset.

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