Financial assets at FVOCI

As explained in our chapter “classification of financial assets”, any investment in debt instrument will be classified as financial asset at fair value through other comprehensive income (FVOCI) if the following conditions are met:

  • the entity’s business model is to hold the financial asset to obtain benefits by collecting the contractual cash flows associated with the financial asset and selling the financial asset.
  • the contractual cash flows arising from the financial asset are solely payments of principal and interest (SPPI).

In addition, an entity can irrevocably opt to classify any investment in equity instrument not held for trading purposes as financial asset at FVOCI.

Now, let’s study the accounting of financial assets classified as “financial assets at fair value through other comprehensive income (FVOCI)”.

Initial recognition

An entity will recognize a financial asset when it becomes party to a contract of the financial instrument. Initially, a financial asset at FVOCI is recognized at its fair value. Any transaction costs incurred to acquire the financial asset are added to the cost of the financial asset. Formula for initial recognition of a financial asset at FVOCI is as follows:

Initial recognition of FVOCI financial asset = Fair value + Transaction costs

What are transaction costs? Transaction costs are incremental costs incurred to acquire or issue a financial instrument. The word incremental means that such costs would not have been incurred if the financial instrument were not acquired or issued. Some examples of transaction costs are given below:

  • instrument issuance or registration fee
  • commission of brokers and dealers
  • taxes and levies on sale/purchase of financial instruments etc.

Subsequent measurement

We’ll separately discuss the subsequent measurement of equity instruments and debt instruments at FVOCI.

Financial assets at FVOCI – Equity instruments

Investment in equity instrument is subsequently measured at fair value. Gains and losses on fair valuation are recorded as other comprehensive income or loss and are accumulated as a separate reserve in equity. Gains and losses of FVOCI investments in equity instruments cannot be transferred to the statement of profit or loss, however, on derecognition of the investment, the reserve can be transferred to retained earnings.

Any dividend income from the investment in equity instrument is recorded in statement of profit or loss. Only the fair valuation gains and losses are recorded as other comprehensive income or loss.

Let’s take a look at the following example to clarify our concepts related to the accounting of financial assets at FVOCI (equity instruments).

Example – FVOCI investment in equity instrument

On 1 January 20X1, XYZ Company invested $300,000 in shares of a multinational company. Commission of $6,000 was paid to the broker. As the company has no intention to trade these shares, it opts to classify this investment as fair value through other comprehensive income (FVOCI). The company received dividend of $5,000 and $7,000 in years 20×1 and 20×2. Information regarding fair values of the investment is as follows:

  • Fair value on 31 December 20×1: $302,000
  • Fair value on 31 December 20×2: $315,000

How will this financial asset be accounted for by XYZ Company in the financial statement for the years ended 31 December 20×1 and 20×2?

Answer

On 1 January 20×1, financial asset will be recognized at its fair value plus transaction costs.

Financial asset = $300,000 + $6,000 = $306,000

Following are the journal entries related to financial year 20×1:

Bank A/C – Dr. $5,000

Dividend income (recorded in profit or loss) – Cr. $5,000

Revaluation loss (OCI) – Dr. $4,000

Financial asset – Cr. $4,000

(Revaluation loss is calculated by comparing the fair value of investment at year end with its carrying amount i.e. $302,000 – $306,000)

Financial asset will be presented at $302,000 whereas negative fair value reserve of $4,000 will be presented in the balance sheet of the company as at 31 December 20×1.

Following are the journal entries related to financial year 20×2:

Bank A/C – Dr. $7,000

Dividend income (recorded in profit or loss) – Cr. $7,000

Financial asset – Dr. $13,000

Revaluation gain (OCI) – Cr. $13,000

(Revaluation gain is calculated by comparing the fair value of investment at year end with its carrying amount i.e. $315,000 – $302,000)

Financial asset will be presented at $315,000 whereas fair value reserve of $9,000 will be presented in the balance sheet of the company as at 31 December 20×2.

Financial assets at FVOCI – Debt instruments

Do you remember the amortized cost table from our previous chapter “financial assets at amortized cost”? At first, investments in debt instruments carried at FVOCI are measured in the same way as financial assets at amortized cost. Interest income is recorded in statement of profit or loss using the effective interest rate.

After doing so, fair value of the FVOCI investment is measured and is compared with its carrying amount. Gains and losses on fair valuation are recorded as other comprehensive income or loss and are accumulated as a separate reserve in equity. On derecognition of the financial asset, this reserve of cumulative fair value gains and losses is eventually transferred to the statement of profit or loss.

Let’s take a look at the following example to clarify our concepts related to the accounting of financial assets at FVOCI (debt instruments).

Example – FVOCI investment in debt instrument

On 1 January 20X1, XYZ Company invested $200,000 in debentures carrying interest rate of 6% per annum. Interest is receivable annually in arrears. Commission of $4,000 was paid to a dealer who arranged this investment. As per contractual terms, the debentures will be redeemed at a premium of $10,000 over their nominal value. Term of the debentures is four years and will be redeemed on 31 December 20×4. Effective interest rate is 6.55% per annum.

Fair values of the financial asset are given below:

  • Fair value on 31 December 20×1: $200,000
  • Fair value on 31 December 20×2: $208,000
  • Fair value on 31 December 20×3: $215,000

The debentures were redeemed as per contractual terms on 31 December 20×4.

How will this financial asset be accounted for by XYZ Company, if the company’s business model is both to hold such investments and sell them as well?

Answer

As the company’s business model is to be open to both options, i.e. to hold such investments and to sell such investments, and the contractual cash flows are solely payment of principal and interest, the investment in debentures will be classified as financial asset at fair value through other comprehensive income (FVOCI).

On 1 January 20×1, financial asset will be recognized at its fair value plus transaction costs.

Financial asset = $200,000 + $4,000 = $204,000

Subsequent measurement of the financial asset is shown below.