Week 4 - Debt investments

Question 1

Enron fraud case study - Use of SPEs and Partnerships to manipulate financial results

Answer 1

1. Enron gave their investment/stock to a partnership (Special Purpose Entity).
2. SPE sets up contract & pays Enron money if investment declines in value (if Enron perform poorly).
3. Essentially still Enron’s money but recorded as large profits on investment

Question 2

Replacing IAS 39 by IFRS 9 (Investments) features a single model that has fewer exceptions than IAS 39, but this comes at a price…

> > simplified by less acct. rules but more DISCRETION

Answer 2

1. Introduces more IS volatility
2. More disclosure requirements
3. Timelier effects on IS and BS (sometimes undesirable)

Question 3

OCI vs Net income

Clean circle of accounting

Answer 3

1. OCI to separate unrelated activities (eg. Snapchat’s investing activities) from CORE business activities (Snapchat is a social media company after all)
   - we don’t want Net income to be too VOLATILE
2. Unrealised gains and losses
   eg. if we have not sold the marketable securities and they are thus NOT REALISED, but we still want the BALANCE SHEET to reflect the ECONOMIC REALITY of price increases/decreases
   eg. like cryptocurrencies
3. Clean circle of acct. = Equity increases with Net income
   ie. difference in equity is only from changes in Net income
   - however, when we add Accumulated OCI as part of Equity, these changes in AOCI (fluctuations) are now part of the differences in Equity from period to period
   » hence, dirty circle of acct.

Question 4

IFRS 9 ~ Debt investments
1. Held-for-collection securities - AMORTISED COSTS

Business model test + Cash flow characteristics test

Answer 4

Steps
1. Recognise investment @ purchase price (+ transaction costs)
2. Recognise INTEREST REVENUE
3. Adjust investment at amortised cost

Why?
- Investment is held for CASH COLLECTION at MATURITY, so FV is not important
- No FV adjustment!!! although value changes before maturity

4. Only recognise Gain on sale of Investments when SELLING after held until maturity and only materialised

Question 5

IFRS 9 ~ Debt investments
2. Held-for-collection and SELLING securities - FVTOCI

Business model test + Cash flow characteristics test

Answer 5

Steps
1. Recognise investment @ purchase price (+ transaction costs)
2. Recognise INTEREST REVENUE
3. Adjust investment at FAIR VALUE (mark-to-market)
4. Unrealised Holding Gain/Loss (UGL) is reported as part of OCI

Why?
- Investment MAY be sold in the near future, so FV is important
» investors want to know what these are worth & how much to expect
- BUT investment may also be HELD TO MATURITY w/o recognition of trading profit, so premature to record in Net income (P&L)
-> therefore, report UGL in OCI in BALANCE SHEET

Fair Value Adjustment can be used as one account for the journal entries

Question 6

IFRS 9 ~ Debt investments
2. Held-for-collection and SELLING securities - FVTOCI // 3 levels of FV measurement

Answer 6

1. Level 1
   - quoted market prices in ACTIVE MARKETS, eg. stocks, bonds
2. Level 2
   - observable market-based inputs OR no direct observable prices but corroborated by market data
   eg. options, Black-Scholes
3. Level 3
   - unobservable inputs reflecting entity’s own assumptions; NO ACTIVE MARKET
   - gives management a lot of DISCRETION b/c no one can check
   eg. The Big Short’s Michael Burry going to banks to get price quotes for exotic Credit Default Swaps

Question 7

IFRS 9 ~ Debt investments
3. Held-for-TRADING securities - FVTPL

Business model test + Fair value option

Answer 7

Steps
1. Recognise investment @ purchase price (+ transaction costs)
2. Recognise INTEREST REVENUE
3. Adjust investment at FAIR VALUE (mark-to-market)
4. Unrealised Holding Gain/Loss (UGL) is reported as part of P&L

Why?
- Investment may be SOLD AT ANY TIME, so FV is important
- Investment is held to generate short-term trading profits, can be REALISED any time
-> therefore, record FV ADJUSTMENT + charge UGL to NET INCOME
» applying FV option to eliminate an ACCOUNTING MISMATCH (= measurement/recognition inconsistency)

^this intention has the most effect

Question 8

Reporting issue - Impairment of value in IFRS 9 (impairment model)

Another is the Reclassification between categories. Management has a lot of discretion over what their intention of reporting is -> leads to differences in BS and/or IS effects.

Answer 8

1. Companies have to provide for EXPECTED losses
   - significant judgment required; management has to anticipate changes in fair value, sometimes not even substantiated yet {no proof yet}
2. Management technically has DISCRETION over their view of CURRENT conditions & forecasts of FUTURE ECONOMIC conditions when measuring expected credit losses
3. Banks with less capital tend to provision substantially less than other banks {can probably generalise to all companies}