Contractual agreements on future cash flows
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What are Financial Assets?
Financial assets refer to assets that arise from contractual agreements on future cash flows or from owning equity instruments of another entity. Financial instruments refer to a contract that generates a financial asset to one of the parties involved, and an equity instrument or financial liability to the other entity.
A key difference between financial assets and PP&E assets – which typically include land, buildings, and machinery – is the existence of a counterparty. Financial assets can be categorized as either current or non-current assets on a company’s balance sheet.
Measurement of Financial Assets
The most important accounting issue for financial assets involves how to report the values on the balance sheet. Considering all financial assets, there is no single measurement technique that is suitable for all assets. When investments are relatively small, the current market price is a relevant measure. However, for a company that owns a majority of shares in another company, the market price is not particularly relevant because the investor doesn’t intend to sell its shares.
In fact, a key factor in the presentation of financial statements is the management’s intent for the investment. For example, the value of a company’s investment in another company’s shares would be shown differently if they were purchased with the intention to hold them for a while and then sell them (e.g., trading) vs. owning a significant percentage (75%) of the company.
The flexibility and uniqueness of different financial assets, however, do not mean that companies can choose any method they want to. Accounting standards specify general guidelines to account for different financial assets. A few guidelines set out by the IFRS are shown below.
Accounting Classification of Financial Assets under IFRS
| Type of Financial Instrument | Business Model | Accounting Classification | Accounting Treatment |
|---|---|---|---|
| Equity | Control | Subsidiary | Consolidation |
| Equity | Joint control of assets and liabilities | Joint operations | Proportionate consolidation |
| Equity | Joint control of net assets | Joint venture | Equity method |
| Equity | Significant influence | Associate | Equity method |
| Equity/Debt | Realize changes in value | Fair value through profit or loss (FVPL) | Fair value, changes recorded through net income |
| Debt | Collect contractual cash flows | Amortized cost | Amortized cost method |
Equity investments in the first four rows refer to strategic investments. The first row refers to investments wherein a company exercises control (i.e., normally owns >50% of the voting interest) of another company. The proper accounting treatment is to consolidate the financial statements of the investor and the subsidiary into a single set of financials.
In addition, joint control in rows 2 and 3 refer to any contractual arrangement between two or more companies. For joint operations, the appropriate treatment is proportionate consolidation wherein the financial statements are compiled depending on the percentage of ownership. Joint venture classifications and significant influence investments, on the other hand, follow the equity method.
The Equity Method
The Equity method is used for either joint ventures or significant influence investments (i.e., owning 20%-50% voting interest). It either increases or decreases the investment account based on income earnings and dividend payments. This is best illustrated through an example.
On January 1, 2017, XYZ Company acquired 10,000 shares of ABC Company, representing 30% of the shares of ABC, for $100,000. For the year ended December 31, 2017, ABC earns $300,000 of net income. On January 1, 2018, ABC declares and pays a dividend to XYZ company of $20,000.
January 1, 2017
| DR Investment in ABC (significant influence) | 100,000 |
| CR Cash | 100,000 |
December 31, 2017
| DR Investment in ABC (significant influence) | 90,000 |
| CR Investment income | 90,000 |
Because ABC is an associate of XYZ, XYZ can include its portion of the net income (300,000 * 30%) to its ledger.
January 1, 2018
| DR Cash | 20,000 |
| CR Investment in ABC (significant influence) | 20,000 |
When dividend payments are received, the investment account is reduced.
Fair Value through Profit or Loss
The FVPL accounting treatment is used for all financial instruments that are intended to be held for sale and NOT to maintain ownership. When these assets are being held, they are always recorded at fair value on the balance sheet, and any changes in the fair value are recorded through the income statement, eventually affecting net income and not other comprehensive income (OCI). All transaction costs associated with the investment are expensed immediately.
Example: XYZ Company purchased an investment on November 1, 2016 for $1,000. At December 31, 2016, the fair value of the investment is $3,000. Transaction costs are 4% of purchases. What are the journal entries?
November 1, 2016
| DR Investment (FVPL) | 1,000 |
| CR Cash | 1,000 |
| DR Transaction Expense | 40 |
| CR Cash | 40 |
December 31, 2016
| DR Investment (FVPL) | 2,000 |
| CR Unrealized Gain | 2,000 |
Amortized Cost Method
Finally, the amortized cost method is used to account for debt instruments. These financial assets are intended for collecting contractual cash flows until maturity. Debt instruments are different from FVPL investments because FVPL is intended to be held for a certain period and then sold.
The debt instrument is recorded at its acquisition cost; any premium or discount is amortized over the life of the investment using the effective interest rate method, and transaction costs, if any, are capitalized.
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Additional Resources
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