Accounting for Investments
Investments are financial assets which represent a company’s right to receive cash from its stake in bonds, shares, real estate, etc. The intent behind making such investments is to generate investment income (interest and dividend) and to benefit from expected capital gain.
Classification of investments
Investments are reported by the investor on its balance sheet and classified into current and non-current portions. Current investments (i.e. those expected to mature within 12 months) are called short-term investments while non-current investments are called long-term investments. Some investments which are can be easily converted to cash with negligible fluctuation in its value are classified as cash equivalents.
Major categories of investments include debt securities, equity securities and derivative instruments.
- Debt securities are financial instruments that represent a right to a determined stream of cash flows for a definite period of time, such as bonds.
- Equity securities are financial instruments that represent residual (ownership) interest in a company, for example, shares of common stock, etc.
- Derivative securities are financial instruments which ‘derive’ their value from other financial instruments, such as forward contracts, futures contacts, options, etc.
Accounting classification of debt securities
IAS 32 and IAS 39, the previous IFRS financial instruments accounting standards, classified debt securities into held to maturity, available for sale, and held for trading categories. IFRS 9, the new standard, requires debt securities to be classified mainly into those carried at (a) amortized cost, (b) fair value through profit or loss (FVTPL), and (c) fair value through other comprehensive income (FVOCI).
Under US GAAP, the classification is dictated by the legal form of the instruments. The US GAAP retains the legacy classification categories for many debt securities.
Under IFRS, classification depends on (a) the business model and (b) cash flow characteristics of the instrument. An investor first determines whether its business model is to hold the asset to collect cash flows or to sell it to realize capital gain. Second, it assesses whether the cash flows of the asset are solely payments of principal and interest (called the SPPI test). Categories of debt securities under IFRS include:
- Amortized cost: Debt securities are classified at amortized cost if the company’s business model is to hold the asset to collect cash flows, and those cash flows are solely payments of principal and interest.
- Fair value through other comprehensive income (FVTOCI): Debt securities are classified at FVOCI if the investor’s business model is both to collect cash flows and sell the asset, and the cash flows are solely payments of principal and interest.
- Fair value through profit or loss (FVTPL): Debt securities which do not qualify for classification at either amortized cost or FVTOCI are classified at FVTPL.
Accounting for equity securities
Accounting for equity investments depends on the extent of ownership:
- Controlling interest: where Company A owns more than 50% equity of Company B, it has control over Company B and is required to prepare consolidated financial statements.
- Significant influence: where Company A owns anywhere between 20% and 50% of equity of Company B, it has significant influence over Company B and is required to account for investments in Company B using the equity method.
- No controlling interest and no significant influence: if Company A owns less than 20% of Company B’s equity, neither consolidation nor equity method is required.
Previous investment accounting standards, such as IAS 39 and its US GAAP equivalent, allowed equity instruments to be classified as (a) held for trading, (b) designated at fair value through profit and loss, and (c) available for sale.
Under the new accounting standard, IFRS 9, fair value through profit or loss (FVTPL) is the go-to category for all equity securities. It means that equity securities would typically be carried at their fair value with any changes reflected in profit or loss.
However, under IFRS a company can irrevocably categorize equity investments (on instrument-by-instrument basis) at fair value through other comprehensive income (FVOCI). It means that the securities are carried at fair value, but the changes are reflected in other comprehensive income. In case of such categorization, no reclassification to FVTPL category is allowed in future for such investments.
Similarly, under US GAAP there are some exceptions to the default fair value category. For example, if fair value cannot be determined, an equity investment is allowed to be carried at cost less impairment losses.
You are an Accountant at Flow, Inc., a futuristic technology-enabled financial services company. Its cash and cash equivalents at 1 January 20X9 stood at $2.2 billion. A newly appointed Investment Manager embarked on an aggressive investment spree. During the year, the company entered into the following transactions:
- 1 January 20X9: obtained 60% holding in Dots, Inc. for $300 million.
- 1 February 20X9: purchased 18% of common stock of Air, Inc., a cutting-edge communication company for $450 million with intent to hold them for indefinite period.
- 1 March 20X9: invested $55 million in an equity mutual fund with intent to sell it in near future.
- 30 June 20X9: sold the equity mutual fund investment made on 1 March 20X9 for $60 million.
- 1 July 20X9: invested in plain-vanilla government bonds with face value of $350 million due by the end of 5th year carrying interest rate of 8% at par. The company intends to hold them to maturity.
- 1 September 20X9: obtained 35% holding for $320 in Fiber, Inc.
At the year end, i.e. 31 December 20X9, investment in Dots, Inc. dropped to $290 million, investment in Air, Inc. rose to $500 million while investment in Fiber, Inc. was valued at $350 million. The company earned dividends of $2 million from Dots, Inc., nothing from Air, Inc., nothing from the equity mutual fund and nothing from Fiber, Inc. Fiber, Inc. net income for financial year 20X9 amounted to $15 million.
Classify the above investments into different investment categories and outline the accounting treatment of related gains or losses.
- The 60% holding in Dots, Inc. should be consolidated in financial statements of Flow, Inc. because it represents control.
- The 18% stake in Air, Inc. should be classified at FVTPL and a gain of $50 million ($500 million - $450 million) should be reported in income statement.
- The $55 million investment in equity mutual fund should be classified at FVTPL and the realized gain of $5 million ($60 million - $55 million) should be included in income statement.
- The investment in government securities should be carried at amortized cost recognizing interest income in income statement. It is because the company’s business model to ‘hold the asset to collect’ cash flows which meet SPPI test. Any fair value changes in government securities are not recognized.
- The 35% holding in Fiber, Inc. should be accounted for using equity method since the investment resulted in significant influence.
- The company has an option to designate the investments in Air, Inc. and the equity mutual fund at FVOCI on initial recognition in which case the unrealized gains will be reported in other comprehensive income.