Question

You are enjoying a very rewarding internship position with Luke and Levi Brother, Inc.   You were assigned to work in the accounting department, specifically on the team that is responsible for the preparation of financial statement at year-end.  Today, you encountered a very interesting situation.

Your immediate supervisor, Johnny hamhock, and the CFO, Jerome adams, are disagreeing about the accounting for the portfolio of equity and debt securities included in the company’s investment portfolio.  

For the past several years, the company has built a rather large investment portfolio of debt and equity securities.  It has been determined that at year end, January 31, 2019, the cost of the total portfolio is greater than its fair value.   As expected, some securities have increased in value above their original cost while others have decreased in value below their original cost.    It is now time to resolve the disagreement between Reed and Page and determine how the portfolio should be reported on the December 31, 2018 balance sheet.

Your supervisor, Johnny hamhock, indicates that those securities that have increased in value above cost should be classified as trading securities.   Alternative, she wants to classify the securities that have decreased in value as long-term available-for-sale securities.

The CFO, Jerome adams, says that classifying the securities that have decreased in value as trading securities and those that have increased in value as long-term available-for-sale securities is the correct approach.   adams argument is that since Luke and Levi Brothers is having a very good year, recognizing losses now will make income look less volatile Moreover, built-in gains will be there in the future if the company is not so profitable.  

You are asked to express your opinion/recommendation as to how the portfolio should be reported on the balance sheet.     Both hamhock and adams agree that since you are up-to-date on the latest accounting rules, you are the best person to resolve their conflict.

Write a letter addressed to both  individuals, Jerome adams Johnny hamhock and .   Your letter should recommend the proper approach for reporting the portfolio on the balance sheet.  

From an ethical standpoint, you should also express what is good and what is not good about the argument of both parties.  

From an accounting standpoint, you should express what I good and what is not good about the argument of both parties.  

Answer 1

According to IFRS, a company’s investments in stocks issued by another company or its investments in the notes, bonds, or other fixed-income instruments issued by another company come under the heading Financial assets.

All financial instruments are recognised when the entity becomes a party to the contractual provisions of the instrument. In general, there are two basic alternative ways that financial instruments are measured: fair value or amortised cost.

Fair value is the arm’s length transaction price at which an asset could be exchanged. The amortised cost of a financial asset (or liability) is the amount at which it was initially recognised, minus any principal repayments, plus or minus any amortisation of discount or premium, and minus any reduction for impairment.

Companies should classify the investments as Held-to-maturity (HTM) if the intention of the company is to hold the assets till maturity. Financial assets classified as HTM are measured at amortised cost if the asset’s cash flows occur on specified dates and consist solely of principal and interest.

Financial assets not measured at amortised cost are measured at fair value. For financial instruments measured at fair value, there are two basic alternatives in how net changes (which are unrealised) in fair value are recognised: as profit or loss on the income statement, or as other comprehensive income (loss) which bypasses the income statement.

If a financial asset is sold within the period, a gain is realised if the selling price is greater than the carrying value and a loss is realised if the selling price is less than the carrying value. When a financial asset is sold, any realised gain or loss is reported on the income statement.

Other category of financial assets is Held-for-trading (HFT), a category of financial assets that is acquired primarily for the purpose of selling in the near term. These assets are likely to be held only for a short period of time. These trading assets are measured at fair value, and any unrealised holding gains or losses are recognised as profit or loss on the income statement.

Some financial assets are not classified as held for trading, even though they are available to be sold. They are called Available-for-sale assets, measured at fair value, with any unrealised holding gains or losses recognised in other comprehensive income. However, the “available-for-sale” classification is no longer in effect under IFRS with the release of IFRS 9 (Financial Instruments). IFRS 9 is based on the concept that financial assets should be classified and measured at either amortised cost or at fair value, and subsequently recognised in either the income statement or other comprehensive income when they arise. Although the available-for-sale category no longer exists, IFRS still permit certain equity investments to be measured at fair value with any unrealised holding gains or losses recognised in other comprehensive income. Specifically, at the time a company buys an equity investment that is not held for trading, the company is permitted to make an irrevocable election to measure the asset in this manner. These assets are referred to as “financial assets measured at fair value through other comprehensive income.”¹⁷

As per the standards, in the given situation, the company must classify the investments based on the intention to hold them till maturity or to trade. The measures of Accounting should be adopted accordingly. Considering the fact of increase of investments above the fair value, the accounting treatment cannot be determined.