11/02/2021 CFA Exam Review - Level 2 - Lesson 1: Investments in Financial Assets

Overview
Lesson 1: Investments in Financial Assets

This lecture was recorded by Mr. Peter Olinto. He teaches straight from the Study Guide so there are no
handouts for this lesson.

Upon completion of this lesson, candidates should be able to:

LOS 13a: Describe the classification, measurement, and disclosure under International Financial
Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint
ventures, 4) business combinations, and 5) special purpose and variable interest entities.

LOS 13b: Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of
investments in financial assets, investments in associates, joint ventures, business combinations, and
special purpose and variable interest entities.

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11/02/2021 CFA Exam Review - Level 2 - Lesson 1: Investments in Financial Assets

Study Guide
Lesson 1: Investments in Financial Assets

1.1  Investments in Financial Assets

Intercorporate investments (investments in other companies) can have a significant impact on the
investing company's financial performance (income statement) and financial position (balance sheet). A
company may invest in debt and equity instruments issued by other companies to diversify its asset base,
enter new markets, or improve profitability.
Over the last few years, IFRS and U.S. GAAP have worked to reduce differences in accounting standards that
apply to the classification, measurement, and disclosure of intercorporate investments. The resulting
standards have improved the relevance, transparency, and comparability of information provided in
financial statements, However, some differences remain. The terminology used in this reading is IFRS-
oriented. U.S. GAAP may not use identical terminology, but in most cases the terminology is similar.

LOS 13a: Describe the classification, measurement, and disclosure under International Financial
Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint
ventures, 4) business combinations, and 5) special purpose and variable interest entities. Vol 2, pp 8–45
LOS 13b: Distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of
investments in financial assets, investments in associates, joint ventures, business combinations, and
special purpose and variable interest entities. Vol 2, pp 8–45

Investments in marketable debt and equity securities can be categorized as:

Investments in financial assets, in which the investor has no significant influence or control over
operations of the investee. Generally speaking, there is a lack of significant influence if the investor
holds less than 20% equity interest in the investee.
Investments in associates, in which the investor can exert significant influence, but not control, over
the investee. Generally speaking, there is significant influence (but not control) if the investor holds
between a 20% and 50% equity interest in the investee.
Business combinations (including investments in subsidiaries), in which the investor has control over
the investee. Generally speaking, an equity interest exceeding 50% indicates control over the
investee.
Joint ventures, in which control is shared by two or more entities.

Note that the classification of an investment is based on the degree of influence or control, not purely on
the percentage holdings listed above.
Table 1.1 summarizes the accounting treatments for various types of corporate investments under IFRS.
Table 1.1  Summary of Accounting Treatment for Investments
In Business In Joint
  In Financial Assets Associates Combinations Ventures
Influence Not significant Significant Controlling Shared
Control

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11/02/2021 CFA Exam Review - Level 2 - Lesson 1: Investments in Financial Assets

In Business In Joint
  In Financial Assets Associates Combinations Ventures
Typical percentage Usually <20% Usually Usually >50% Varies
interest 20%−50%
Financial Reporting Classified as Equity Consolidation IFRS: Equity
Treatment method method
Fair value through profit or
loss
Fair value through other
comprehensive income
Amortized cost

U.S. GAAP categorizes intercorporate investments similarly, but not identically.

1.2  Investments in Financial Assets: IFRS 9

Both IASB and FASB have developed new standards for financial investments.

The IASB issued the first phase of their project dealing with classification and measurement of
financial instruments by including relevant chapters in IFRS 9, Financial Instruments. IFRS 9, which
replaced IAS 39, became effective on January 1, 2018.
The FASB issued ASC 825 in January 2016, with the standard being effective for periods after
December 15, 2017. The new ASC has resulted in significant (but not total) convergence with IFRS
with respect to financial instruments.

In this section, we lay out the differences between the current standard (IAS 39) and the new standard (IFRS
9). The new standard is based on an approach that considers (1) the contractual characteristic of cash flows
and (2) the management of the financial assets. The terms available-for-sale and held-to-maturity no
longer appear in IFRS 9.

Another key change in IFRS 9, compared with the old standard IAS 39, relates to the approach to
provisioning models for financial assets, financial guarantees, loan commitments, and lease receivables.
Specifically, companies are required to migrate from an (actual) incurred loss model to an expected credit
loss model. This results in companies evaluating not only historical and current information about loan
performance, but also forward-looking information.

The criteria to use amortized cost are similar. In order to be measured at amortized cost, financial assets
must meet two criteria:

1. A business model test: The financial assets are being held to collect contractual cash flows.
2. A cash flow characteristic test: The contractual cash flows are solely payments of principal and
interest on principal.

1.3  Classification and Measurement of Financial Assets under IFRS 9

IFRS 9 divides all financial assets into two classifications—those measured at amortized cost and those
measured at fair value. All financial assets are measured at fair value when initially acquired. Subsequently,
financial assets are measured at either fair value or amortized cost.
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Financial assets that meet the two criteria listed previously are generally measured at amortized cost.
If the financial asset meets the two criteria but may be sold (a “hold to collect and sell” business
model), it may be measured at fair value through other comprehensive income (FVOCI).
However, management may choose the fair value through profit or loss (FVPL) option to avoid an
accounting mismatch.
An accounting mismatch refers to an inconsistency resulting from different measurement bases
for assets and liabilities.

Debt instruments are measured at amortized cost, fair value through other comprehensive income (FVOCI),
or fair value through profit or loss (FVPL), depending upon the business model.
Equity instruments are measured at FVPL or at FVOCI.
Equity investments held for trading must be measured at FVPL.

Other equity investments can be measured at either FVPL or FVOCI, but the choice is irreversible. If the
entity uses the FVOCI option, only the dividend income is recognized in profit or loss. Further, the
requirements for reclassifying gains or losses recognized in other comprehensive income are different for
debt and equity instruments.

Financial assets that are derivatives are measured at fair value through profit or loss (except for hedging
instruments). (See Figure 1.1.) Embedded derivatives are not separated from the hybrid contract if the asset
falls within the scope of this standard and the asset as a whole is measured at FVPL.

Figure 1.1  Financial Assets Classification and Measurement Model, IFRS 91 Exhibit 2, Volume 2, CFA
Program Curriculum 2020

1.4  Reclassification of Investments
Under the new standards:

Reclassification of equity instruments is not permitted (the initial classification as FVPL and FVOCI is
irrevocable).

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Reclassification of debt instruments from FVPL to amortized cost (or vice versa) is only permitted if
the objective for holding the assets (business model) has changed in a way that significantly affects
operations.
When reclassification is deemed appropriate, there is no restatement of prior periods at the
reclassification date.
If the financial asset is reclassified from amortized cost to FVPL, the asset is measured at fair
value with gain or loss recognized in profit or loss.
If the financial asset is reclassified from FVPL to amortized cost, the fair value at the
reclassification date becomes the carrying amount.

1.5  Analysis of Investments in Financial Assets

Convergence between IFRS and U.S. GAAP standards for the classification, measurement, and reporting of
investments in financial assets has made it easier for analysts to make comparisons across companies.
Analysts typically assess the performance of a company's operating and investing activities separately.

Analysis of operating performance should exclude items related to investing activities (e.g., interest
income, dividends, realized and unrealized gains/losses).
Nonoperating assets should be excluded from the calculation of return on operating assets.
Use of market values of financial assets is encouraged when assessing performance ratios. Both IFRS
and U.S. GAAP require disclosure of the fair value of all classes of financial assets.

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11/02/2021 CFA Exam Review - Level 2 - Lesson 1: Investments in Financial Assets

Flashcards
Lesson 1: Investments in Financial Assets

1
fc.L2R14L02.0001_1812

Investments in financial assets – No

significant influence or control over
operations of the investee (usually <20%).
Categorize investments in marketable debt
and equity securities. Investments in associates – Significant
influence, but not control, over the investee
(20%–50%).

Business combinations (including

investments in subsidiaries) – Control over
the investee (>50%).

Joint ventures, in which control is shared by

two or more entities.

2
fc.L2R14L02.0002_1812

How may financial assets be classified under

Held-to-maturity.
IFRS?
Available-for-sale.

Fair value through profit or loss.

Loans and receivables.

3
fc.L2R14L02.0003_1812

Investments in financial assets with fixed or

Explain held-to-maturity (HTM) investments.
determinable payments and fixed maturities
(debt securities). Investor has positive intent
and ability to hold till maturity. Cannot
reclassify or sell prior to maturity except in
unusual circumstances or investor may be
precluded from classifying investments under
the HTM category going forward.

4
fc.L2R14L02.0004_1812

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List the types of investments classified as fair

value through profit or loss. Securities held for trading

Those designated by management as carried

at fair value

5
fc.L2R14L02.0005_1812

Describe available-for-sale (AFS) investments. AFS investments are debt and equity
securities not classified as held-to-maturity or
at fair value through profit or loss.

6
fc.L2R14L02.0006_1812

AFS investments are initially recognized at fair

value and remeasured at each reporting date
to reflect fair value.

All unrealized gains/losses (except for

Explain AFS investments under IFRS. gains/losses on AFS debt securities arising
from exchange rate movements) are
recognized (net of taxes) in equity under other
comprehensive income.

Unrealized gains/losses on AFS debt securities

resulting from exchange rate movements are
recognized on the income statement.

Realized gains/losses, interest income, and

dividend income, are also recognized on the
income statement.

7
fc.L2R14L02.0007_1812

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Items that meet the definition are carried at

Differentiate between loans and receivables amortized cost unless they are designated as
under IFRS and U.S. GAAP. (1) fair value through profit or loss or (2)
available-for-sale.

Loans and receivables that meet the

definition of debt securities are classified as
HFT, AFS, or HTM, with HFT and AFS securities
being measured at fair value.

8
fc.L2R14L02.0008_1812

How can HTM (debt) securities be reclassified HTM securities reclassified as AFS securities
as AFS securities? are remeasured at fair value and any
differences between fair value and carrying
amount (amortized cost) are recognized in
other comprehensive income.

9
fc.L2R14L02.0009_1812

How are AFS debt securities reclassified as AFS debt securities are reclassified as HTM
HTM securities? securities at fair value, which becomes their
(new) amortized cost and any unrealized
gains/losses previously recognized in other
comprehensive income are amortized to
profit or loss over the security's remaining life
using the effective interest method.

10
fc.L2R14L02.0010_1812

There has been a substantial and extended

Under IFRS, when is an equity security decline in the fair value of the security below
considered impaired? its cost.

There have been significant changes in the

technology, market, and/or legal
environment that have had an adverse impact
on the investee and indicate that the initial
cost of the investment may not be recovered.

11
fc.L2R14L02.0011_1812

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When is a debt security considered impaired? If at least one loss event (which has an impact
on its estimated future cash flows that can be
reliably estimated) has occurred.

12
fc.L2R14L02.0012_1812

Describe debt security impairment under U.S. Impairment means that the investor will be
GAAP. unable to collect all amounts owed according
to contractual terms at acquisition.

13
fc.L2R14L02.0013_1812

Describe the approach used by IFRS 9. (1) The contractual characteristic of cash
flows and (2) the management of the financial
assets. The classifications available-for-sale
and held-to-maturity are replaced by fair
value through profit or loss, fair value through
other comprehensive income, and amortized
cost.

14
fc.L2R14L02.0014_1812

How are debt instruments measured? At amortized cost, fair value through other
comprehensive income (FVOCI), or fair value
through profit or loss (FVPL), depending on
the business model.

15
fc.L2R14L02.0015_1812

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Reclassification of equity instruments is not

Describe reclassification for equity and debt permitted (the initial classification as FVPL
instruments under the new standards. and FVOCI is irrevocable).

Reclassification of debt instruments from

FVPL to amortized cost (or vice versa) is only
permitted if the objective for holding the
assets (business model) has changed in a way
that significantly affects operations.

16
fc.L2R14L02.0016_1812

Analysis of operating performance should

exclude items related to investing activities.
With the convergence between IFRS and U.S.
GAAP, describe the analysis of investments in Nonoperating assets should be excluded from
financial assets. the calculation of return on operating assets.

Use of market values of financial assets is

encouraged when assessing performance
ratios. Both IFRS and U.S. GAAP require
disclosure of the fair value of all classes of
financial assets.

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