Financial Instruments

According to the IFRS, a financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another.

Financial assets include investments in stocks of other companies or in notes, bonds, or other fixed-income securities issued by other companies or government entities. Financial liabilities, such as notes payable and bonds payable issued by the company, will be covered later.

Certain financial instruments can be categorized as either an asset or a liability based on the contractual terms and current market conditions. For example, derivatives are financial instruments whose value is determined by an underlying factor, such as an interest rate, exchange rate, commodity price, security price, or credit rating, and typically require minimal or no initial investment.

Recognition and Measurement of Financial Instruments

Financial instruments are typically recognized when the entity enters into the contract’s terms. Following the initial acquisition, financial instruments are measured using either fair value or amortized cost.

Recall that fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction. On the other hand, the amortized cost of a financial asset (or liability) is the amount at which it was initially recognized, minus any principal repayments, plus or minus any amortization of discount or premium, and minus any reduction for impairment.

Financial Assets Measurement at Armotized Cost

Under IFRS, financial assets are measured at amortized cost if their cash flows are fixed and occur on specific dates, comprising solely principal and interest payments, and if the business model is to hold the asset until maturity. Under the US GAAP, financial assets measured at amortized cost are described as held-to-maturity assets. An example is a long-term bond investment issued by another company or government; its value may fluctuate with interest rate changes, but if classified as held-to-maturity, it will be recorded at amortized cost on the investor’s balance sheet.

Other financial assets measured at amortized cost are loans to other companies.

Financial Assets Measured at Fair Value

For financial instruments measured at fair value, there are two primary methods for recognizing net changes in fair value:

1.  as profit or loss on the income statement, or
2. (2) as other comprehensive income (loss), which does not affect the income statement.

These alternatives pertain to unrealized changes in fair value, meaning changes in the value of a financial asset that has not been sold and is still held at the end of the period. These unrealized gains and losses are also known as holding period gains and losses. In contrast, realized gains or losses from a sale are reported on the income statement.

1. As Other Comprehensive Income (or Loss)

Under IFRS, financial assets are measured at fair value through other comprehensive income (meaning any unrealized holding gains or losses are recorded on other comprehensive income) if the business model aims to both collect contractual cash flows and sell the financial assets. This IFRS category is relevant to debt investments, which have cash flows on specified dates and consist solely of principal and interest. Additionally, IFRS allows for equity investments to be measured at fair value through other comprehensive income if a company makes an irrevocable choice to measure the asset in this way at the time of acquisition.

Under the US GAAP, financial assets measured at fair value are referred to as available-for-sale. It applies the same concept as IFRS in that any unrealized gains or losses are recognized in other comprehensive income. However, unlike IFRS, the US GAAP category for available-for-sale securities is limited to debt instruments and does not extend to equity investments.

2. As Profit or Loss on the Income Statement

Under IFRS, financial assets that do not fall into the other two measurement categories are measured at fair value through profit or loss, meaning unrealized gains or losses are recognized in the income statement. Additionally, companies can choose to irrevocably classify a financial asset in this category at the time of acquisition.

In contrast, under US GAAP, all equity investments except those that provide significant influence over the investee are measured at fair value, with unrealized gains or losses reported in the income statement. For debt securities, those designated as trading securities are also measured at fair value with unrealized gains or losses recognized in the income statement. Trading securities are those acquired with the intention to sell rather than hold for collecting interest and principal payments.

Summary of Measurement of Financial Assets

$$
\begin{array}{l|l|l}\textbf{ Measurement}&&\\\textbf{at Armotized Cost} & \begin{array}{l}\textbf{ Fair Value through } \\\textbf{ Other Comprehensive } \\\textbf{ Income }\end{array} & \begin{array}{l}\textbf { Fair Value through } \\\textbf{ Profit and Loss }
\end{array} \\\hline \begin{array}{l}\text { – Debt instruments } \\\text { intended for } \\\text { hold-to-maturity. } \\\text { – Receivable loans } \\\text { and notes. } \\\text { – Non-quoted equity } \\\text { instruments (cost used } \\
\text { as an estimate for } \\\text { fair value in certain } \\\text { situations). }\end{array} & \begin{array}{l}\text { – Debt securities } \\\text { categorized as } \\\text { “available-for-sale” } \\\text { (US GAAP); debt } \\
\text { instruments for which } \\\text { the strategy involves } \\\text { both earning from } \\\text { interest and principal } \\\text { and selling the } \\\text { security (IFRS). } \\\text { – Equity investments } \\\text { for which a firm } \\
\text { chooses this } \\\text { measurement method at } \\\text { acquisition (IFRS only). }\end{array} & \begin{array}{l}\text { – All equity } \\\text { securities, except } \\\text { those providing the } \\\text { investor with } \\
\text { significant influence } \\\text { (US GAAP only). } \\\text { – “Trading” debt securities (US GAAP)} \\\text { – Securities not } \\\text { allocated to either } \\\text { of the other two } \\\text { categories, or } \\
\text { investments for which } \\\text { a firm chooses this } \\\text { measurement method at } \\\text { acquisition (IFRS only). }\end{array} \end{array}$$

Question

A financial asset is classified as “available for sale,” and it has unrealized gains. How are these unrealized gains most likely reflected in shareholders’ equity?

1. There is no recognition.
2. They are recognized in the income statement.
3. They are recognized in other comprehensive income statement.

Solution

The correct anwer is C.

Gains for financial assets classified as available for sale a recognized in the other comprehensive income.

A is incorrect. Under both IFRS and US GAAP, unrealized gains on financial assets classified as “available for sale” are recognized. They are not ignored or left unrecognized in the financial statements.

B is incorrect. Unrealized gains on “available for sale” financial assets are not recognized in the income statement. Instead, they are recognized in other comprehensive income, which is a separate component of shareholders’ equity, until they are realized (e.g., when the asset is sold). Only at that point are they transferred from other comprehensive income to the income statement as realized gains.