USCPA (FAR) – (23) Financial Instruments

I would like to record about the key points of the US CPA exam content.

<Create and note the points based on mainly Becker’s workbook>

Differences Between Fair Value Option in US GAAP and IFRS

<Scope of Application>

• US GAAP: The fair value option can be applied to specific financial instruments and certain non-financial items. It must be elected for entire financial instruments and cannot be applied to specific risks (e.g., interest rate risk).
• IFRS: Under IFRS 9 “Financial Instruments,” the fair value option can be applied to financial liabilities under certain conditions, particularly when aligned with risk management strategies or to avoid accounting mismatches.

<Criteria for Fair Value Application>

• US GAAP: Companies can elect the fair value option for entire financial instruments at the beginning of each reporting period. Once chosen, this election is irrevocable.
• IFRS: The fair value option under IFRS requires meeting specific conditions, especially to avoid accounting mismatches or to align with risk management practices.

<Revaluation and Measurement>

• US GAAP: Financial instruments for which the fair value option has been elected are continuously measured at fair value, with changes in fair value reflected in the income statement.
• IFRS: Similarly, under IFRS 9, financial instruments elected for the fair value option are continuously measured at fair value. However, the guidance on how these changes are reflected may differ.

<Disclosure Requirements>

• US GAAP: Detailed disclosures are required for the reasons behind selecting the fair value option and its impacts.
• IFRS: IFRS 7 “Financial Instruments: Disclosures” requires detailed disclosures about the fair value of financial instruments for which the fair value option has been chosen, including the reasons for this choice.

Processing Under the Fair Value Option

• Expected Credit Loss: Amortized Cost > Present Value of Expected Cash Flows: (DR) Expected Credit loss XX (CR) Allowance for Credit Losses. Expected credit loss is an internal estimate used to evaluate the credit risk of assets held by the company. This estimate serves as the basis for allowances and loss recognition in the financial statements.
• Other Comprehensive Income: Fair Value > Amortized Cost: In this case, the expected credit loss is not directly recorded in the income statement, and the valuation gain is recorded in OCI. Fair value evaluation is based on the market price of the asset, and therefore does not include the company’s internal expected credit loss.
• (Example): Amortized cost (250) > PV of expected cash flows (230) > Fair Value (200) : the credit loss is 20, and the unrealized loss (OCI) is 30.
• (Example 2): Amortized cost (250) > Fair Value (230) > PV of expected cash flows (200) : the credit loss is 50, and no OCI. An adjustment from the amortized cost of 250 to the present value of expected cash flows at 200 results in recognizing a credit loss of 50. Since the fair value of 230 is higher than this adjusted value (200), there are no additional losses recognized in OCI.
• “When a credit loss is recognized, impacts on OCI (Other Comprehensive Income) are limited to cases where the fair value is lower than the amortized cost.
• In the scenario where the fair value is higher than the present value of expected cash flows (with a fair value of 230 and an adjusted amortized cost of 200), the excess of fair value is not typically recorded as a gain in OCI. Under US GAAP, when financial assets are written down due to credit losses, any subsequent recovery in value (increase in fair value) is often processed through the income statement rather than OCI.“

Available-for-Sale Securities (AFS)

• Definition: Financial assets that are neither held to maturity nor intended for trading but may be sold in the future.
• Accounting Treatment: Measured at fair value, with unrealized gains or losses recorded in Other Comprehensive Income (OCI). These are transferred to the income statement upon realization.
• AFS (Available-for-Sale) securities as well, expected credit losses should be independently assessed and properly accounted for. Even if the fair value exceeds the amortized cost, this fact does not exempt the recognition of credit losses.
• Per the current expected credit loss (CECL) model, the expected credit loss is equal to the difference between amortized cost ($1,000,000) and the present value of expected cash flows ($978,000) = $22,000. However, the loss will not be recorded on the income statement because the fair value ($1,015,000) is higher than amortized cost. Because fair value exceeds amortized cost, the security actually produces a gain of $15,000 (the difference between $1,015,000 and $1,000,000). This gain will be recorded in other comprehensive income (OCI).

Trading debt securities

• The trading securities are valued at fair value in the statement of financial position.
• The unrealized gain and losses that result from making the investments to fair value are recorded in earnings.
• Interest income received during the year does not impact the value of the investments in the statement of financial position.

Held-to-maturity securities

• HTM securities are measured based on acquisition cost, using amortized cost.
• Unrealized gains or losses due to market value fluctuations are not recognized in the financial statements.
• If there is an impairment due to credit risk, the impairment loss is recognized in the income statement. (DR) Credit loss XX (CR) Allowance for credit loss
• The present value of expected future cash flow: Present value of face value at maturity + Present value of interest payments. For held-to-maturity securities, the current expected credit losses (CECL) model requires recording a loss when the amortized cost exceeds the present value of expected future cash flows. 
• Concentration of credit risk is required disclosure in the notes to the financial statements.

Marketable Equity Securities under US GAAP

• Marketable equity securities are measured at fair value, and any unrealized gains or losses are reflected in the financial statements. This accounting treatment applies when equity securities are measured at fair value. (DR) Valuation account XX (CR) Unrealized gain on equity securities.
•  Equity securities are generally valued on the balance sheet at fair value, with the unrealized holding gain (loss) impacting the income statement. This requirement does not apply to investments accounted for under the equity method, consolidated investees, or when the practicability exception is applied. 
• Equity securities are generally valued on the balance sheet at fair value, with the unrealized holding gain (loss) impacting the income statement. This requirement does not apply to investments accounted for under the equity method, consolidated investees, or when the practicability exception is applied. Though management’s intended holding period for the two equity securities differs, intent only matters for the classification of investments in debt securities. Both securities, when marked to fair value at the end of the year, result in an income statement impact. Marking Security A to fair value results in a $200 unrealized gain ($4,200 – $4,000). Marking Security B to fair value results in a $500 unrealized loss ($1,500 – $2,000). When combined, these securities result in an overall unrealized holding loss of $300 on the income statement and a reduction in the investment account for the same amount.
• Equity Securities: The duration for which management intends to hold the two equity securities does not affect their classification. Equity securities are classified based on their nature (e.g., trading, available-for-sale, or at fair value through profit or loss), so the intended holding period is not important.
• Debt Securities: For debt securities, the duration for which management intends to hold them is crucial for their classification. Debt securities are classified as held-to-maturity, available-for-sale, or trading based on management’s intent.
• Any dividends paid in excess of retained earnings are treated as a return of capital. (DR) cash 100, (CR) Dividend income 60, Investment in the security 40.

From an available-for-sale security to a held-to-maturity security

• Removal of the loss from OCI is necessary. The unrealized loss will be amortized over the remaining life of the security as an adjustment of yield similar to the amortization of a premium/discount when interest revenue is recorded.

Investments in Affiliates and Subsidiaries

<Affiliates & Subsidiaries>

• When using the fair value method, unrealized gains and losses are recognized in net income.
• When using the cost method, the investment is held at acquisition cost, and gains and losses are not recognized.

Equity Investments in Standalone Financial Statements

• Under US GAAP, equity investments other than those in affiliates and subsidiaries are typically measured using the fair value method. Unless these equity investments are held for trading purposes, the unrealized gains and losses from these investments are recorded in the income statement.

Sinking Fund

• The classification of the restricted cash in the balance sheet depends on the restricted purpose. As the restriction is associated with noncurrent bonds, the restricted cash is classified as noncurrent.

Concentration of credit risk

• Concentration of credit risk is required disclosure in the notes to the Financial Statements.