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Financial Assets

Contractual agreements on future cash flows

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.

 

Financial Assets

 

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 market price at that time would be 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., day 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 the most appropriate method. 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 InstrumentBusiness ModelAccounting ClassificationAccounting Treatment
EquityControlSubsidiaryConsolidation
EquityJoint control of assets and liabilitiesJoint operationsProportionate consolidation
EquityJoint control of net assetsJoint ventureEquity method
EquitySignificant influenceAssociateEquity method
Equity/DebtRealize changes in valueFair value through profit or loss (FVPL)Fair value, changes recorded through net income
DebtCollect contractual cash flowsAmortized 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) 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). The Equity method either increases or decreases the investment account based on income earnings and dividend payments. It 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 Cash1,000
DR Transaction Expense40
CR Cash40

 

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.

 

Additional Resources

Thank you for reading CFI’s guide to financial assets. CFI is the official provider of the FMVA Financial Modeling Certification, designed to transform anyone into a world-class financial analyst. To develop your career, these additional resources will be helpful:

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