Financial Instruments Flashcards
What are financial instruments?
they include financial assets and liabilities
financial assets include: cash, evidence of an ownership interest in an entity, a contract that convey to one entity a right to receive cash or another financial instrument from a second entity or exchange other financial instruments on potentially favorable terms with the second entity
financial liabilities are: a contract that imposes on one entity an obligation to deliver cash or another financial instrument to a second entity or exchange other financial instruments on potentially unfavorable terms with the second entity
What is the fair value option?
on specified election dates, entities may choose to measure at fair value eligible financial instruments that are not typically measured at fair value; under the fair value option, unrealized gains and losses are reported in earnings; the fair value option is irrevocable and is applied to individual financial instruments
the fair value option may only be applied on certain dates, including the date that an entity first recognizes an eligible financial instrument, the date that an investment becomes subject to equity method accounting, or the date that an entity ceases to consolidate an investment in a subsidiary or VIE
What is a debt security?
a debt security is any security representing a creditor relationship with an entity and includes corporate bonds, redeemable preferred stock, government securities, convertible debt, commercial paper
debt securities should be classified into 1 of 3 categories, based on the intent of the company
trade securities: debt securities that are bought an held principally for the purpose of selling them in the near term; trading securities generally reflect active and frequent buying and selling with the objective of generating profits on short-term differences in price; debt securities classified as trading securities are generally reported as current assets, although they can be reported as non-current, if appropriate
available-for-sale debt securities: debt securities that do not meet the definitions of the other two classifications; they are reported as either current or non-current assets, depending on the intent of the corporation
held-to-maturity debt securities: debt securities that the corporation has the positive intent and ability to hold these securities to maturity; if the intent is to hold the security for an indefinite period of time, but not necessarily to maturity, then the security is classified as available-for-sale; if a security can be paid or otherwise settled in a manner that the holder may not recover substantially all of its investment, the held-to-maturity classification may not be used; securities classified as held-to-maturity are reported as current or non-current assets, based on their time to maturity
Valuation of debt securities
debt securities classified as trading and available-for-sale must be reported at fair value; fair value is the market price of the security or what a willing buyer and seller would pay and accept to exchange the security; changes in the fair value of trading and available-for-sale debt securities result in unrealized holdings gains and losses; the reporting of these gains/losses in the financial statements depends on the classification of the securities; although two general ledger accounts are normally maintained (i.e. one for the original cost of the security and the other for the valuation account), the presentation on the balance sheet is one net amount
unrealized gains/losses (trading securities) - these are included in earnings; therefore, the unrealized gain/loss on trading securities is recognized in net income
unrealized gains/losses (available-for-sale debt securities) - these are recognized in other comprehensive income
realized gains/losses - these are recognized when a debt security is sold and when an available-for-sale debt security is deemed to be impaired; all realized gains/losses are recognized in net income
held-to-maturity debt securities are reported at amortized cost; unrealized gains/losses are not recognized in the financial statements, as these securities are not marked-to-market at period end
Reclassification of debt securities
transfers between categories should occur only when justified; any transfer of a particular security from one group to another is accounted for at fair value; any unrealized holding gain/loss on that security is accounted for as follows:
from trading category - the unrealized holding gain/loss at the date of transfer is already recognized in earnings and shall not be reversed
to trading category - the unrealized holding gain/loss at the date of transfer shall be recognized in earnings immediately
HTM to AFS - the unrealized holding gain/loss at the date of transfer shall be reported in other comprehensive income; remember that this debt security was valued at amortized cost as a HTM security and is being transferred to a category valued at fair value
AFS to HTM - the unrealized holding gain/loss at the date of transfer is already reported in other comprehensive income; the unrealized holding gain/loss shall be amortized over the remaining life of the security as an adjustment of yield in a manner consistent with the amortization of any premium or discount
as a side note, any interest income from an investment in debt securities classified as trading or AFS is recorded on the income statement
Impairment of debt securities
impairment of HTM securities - if it is determined that all amounts due (principal and interest) will not be collected on a debt investment reported at amortized cost, the investment should be reported at the present value of the principal and interest that is expected to be collected; the credit loss is the difference between the repent value and the amortized cost
impairment of AFS securities - impairment on AFS securities is accounted for differently from HTM securities because the investor has the option to sell an AFS security is the loss on the sale will be less than the expected credit loss as a result, the credit loss reported in net income on an AFS security is limited to the amount by which fair value is below amortized cost; any additional loss is reported as an unrealized loss in other comprehensive income
Sale of debt securities
a sale of a debt security from any category results in a realized gain or loss and is recognized in net income for the period; the valuation account, if used, also would have to be removed on the sale of a security
trading securities - the realized gain/loss reported when a trading debt security is sold is the difference between the adjusted cost (original cost plus or minus unrealized gains and losses previously recognized in net income) and the selling price
AFS securities - the realized gain/loss reported when an AFS debt security is sold is the difference between the selling price and the original cost of the security; any unrealized gains/losses in accumulated other comprehensive income must be reversed at the time the security is sold
What is an equity security?
it is a security that represents an ownership interest in an enterprise or the right to acquire or dispose of an ownership interest in an enterprise at fixed or determinable prices; equity securities include ownership shares (common, preferred, and other forms of capital stock), rights to acquire ownership shares (stock warrants, rights, and call options), and rights to dispose of ownership shares (put options)
What is the practicability exception?
it allows an entity to measure an equity investment at cost less impairment, plus/minus observable price changes (in orderly transactions) of identical or similar investments from the same issuer; this exception is applicable for equity investments that do no have a readily determinable fair value; reporting entities that are broker-dealers in securities, investment companies, or postretirement benefit plans cannot use this exception
Valuation of equity securities
they are generally reported at fair value through net income; unrealized holding gains/losses on equity securities are included in earnings as they occur
Income from investments in equity securities
dividend income from an equity security investment is recognized in net income, unless the dividend is a liquidating dividend; a liquidating dividend is a distribution that exceeds the investor’s share of the investee’s retained earnings and is a return of capital that decreases the investor’s basis in the investment
Impairment for equity securities
equity investments that do not have readily determinable fair values are measured at cost minus impairment (the practicability exception); when a qualitative assessment indicates that impairment exists, the cost basis of the security is written down to fair value and the amount of the write-down is accounted for as a realized loss and included in earnings
Sale of an equity security
the sale of an equity security does not give rise to a gain/loss if all changes in the equity’s fair value have been reported in earnings as unrealized gains/losses as they occurred; if an entity has not recorded an equity security’s change in fair value up to the point of sale, a gain/loss is recorded at the time of the sale equal to the difference between adjusted cost (original cost plus or minus unrealized gains and losses previously recognized in earnings) and the selling price; note that any valuation account would also have to be removed when the security is sold
