Accounting for Investments - Vol 1

Resources for the book Accounting for Investments - Vol 1

Disclosures – Summary

  • If the equity securities classified as available-for-sale are sold, then the realized gain/loss on such sale is transferred from the other comprehensive income (OCI) to the income statement and an entry is recorded to that effect.
  • When the equity securities are transferred from trading securities to available-for-sale category, then the gain/loss recognized as unrealized should not be reversed and no adjustment should be made to the OCI.
  • When the equity securities are transferred from available-for-sale category to trading category, then the unrealized gain/loss on such securities based on the fair value of the securities should be transferred from OCI and thus recognized as income immediately on such transfer.
  • Temporary impairment in respect of the equity securities that are held for trading is automatically tracked by valuing the securities at mark-to-market on every reporting day. Such temporary impairment is not to be recognized and acted upon for available-for-sale securities. However, if the impairment is anything other than temporary, then such impaired security must be written down to fair value. The realized loss on such impairment must be reported in the income statement. Once the impairment is recorded as loss, then even if the security recovers from such impairment, it would not be recognized in the earnings unless it is liquidated through the sale of the security.
  • Unrealized gain/loss is not recognized for income tax purposes until the same is realized through liquidation. Hence the unrealized gain/loss included in the income or other comprehensive income as the case may be represents temporary differences as defined by FAS 109. The tax effects of all temporary differences are to be recognized in the financial statements as deferred tax benefits or deferred tax liabilities.
  • For securities classified as trading, the unrealized gain/loss is included in the income and as such represents the temporary differences as defined in the accounting standard. The deferred tax effect of those changes should also be presented in the income statement itself.
  • For securities classified as available-for-sale, the unrealized gain/loss is included in the other comprehensive income and as such forms part of the temporary differences as defined in the accounting standard. The deferred tax effect of those changes should also be presented in the other comprehensive income itself.
  • As per FAS 115, under U.S. GAAP, for securities classified as available-for-sale, all reporting enterprises shall disclose
  • Aggregate fair value.
  • Gross unrealized holding gains.
  • Gross unrealized holding losses.
    These should be grouped by major security type as of each date for which a statement of financial position is presented.
  • IFRS 7 comes into effect for annual periods beginning on or after January 1, 2007. This standard requires that preparers should provide quantitative and qualitative disclosures that would enhance a user’s understanding of the entity’s exposures to financial risks and how the entity manages those risks.

Call Options – Summary

  • The accounting treatment of call options prima facie will depend upon the intention with which the call options are purchased—hedging or speculation (nonhedging).
  • If the position is taken as a hedge against some other position, then the relevant accounting standards for hedge accounting will be applicable and there are certain conditions that are to be fulfilled for the same.
  • If the call is purchased purely as a speculative trade, then the premium paid towards purchase of the call option is taken to the expense and the premium received on sale of the options is treated as revenue.
  • However, the value of the option is written back on the valuation date and shown as an asset in the case of purchase of call options. In effect, the net result of this method of accounting and the one shown for hedging activity would be the same.

Preface

Accounting for Investments attempts to give an exhaustive treatment of various accounting entries that should be recorded by any entity holding any financial asset. Over the past two decades there have been several innovative financial instruments from the Street that call for special treatment from the accounting, legal, and regulatory perspective. The accounting requirements are constantly being monitored and enhanced by the regulators and standard setters to provide more transparency in recording and reporting of these financial products.

This book is written from the practical angle and is meant to cater to the needs of accountants as a handbook. The first volume covers equity, futures, and options. It also covers the hedge accounting treatment for equity options, depositary receipts (ADR/GDR), contract for difference (CFD), short selling, and boxed position accounting.

This book assumes that the reader already has basic accounting knowledge. Those who are entirely new to the field of accounting should refer to some basic accounting book before attempting to use this book. However, Appendix A gives an overview of the basic accounting principles and concepts.

The entire trade life cycle of each of the aforementioned financial assets is covered in detail with the accounting entries that should be recorded. For each illustration, the journal entries, general ledger accounts, trial balance, income statement, and balance sheet are presented to give a complete understanding of the accounting treatment. Also, for all calculated numbers the details of such calculations are given. The notes on accounts and presentation and disclosure requirements for derivative products are covered in a separate chapter and not included for each and every illustration. Appendix C gives the complete financial statements for a sample fund with all the necessary notes on accounts and disclosures as required by International Financial Reporting Standards (IFRS).

Even though the investment banking institutions have suffered a serious setback due to the financial crisis witnessed in 2008, banks, hedge funds, and several other financial institutions do resort to trading and investment activities in several financial instruments covered in this volume. The need for comprehensively understanding these financial instruments, including the accounting aspects involved, assumes great importance. Even before the beginning of a trading day, the front office should know the positions of the various financial instruments held by the entity and have the flexibility to obtain detailed breakdown of cost and so on. Technology has made all this possible today at the touch of a button, and technology experts are much sought after to do the needful for these financial institutions. However, in spite of having the domain knowledge in financial products, the technology experts sometimes feel the necessity to have an in-depth understanding of the entire trade life cycle with the accounting treatment that accompanies it. This book proposes to fill the knowledge gap of these aspiring technology wizards and aspiring finance and accounting professionals who want to jump into the banking and financial domain.

An overview of the trade life cycle for each financial instrument is given. However, the reader is advised to refer other resources for a detailed treatment of the trade life cycle from the front office and middle office perspective. The trade life cycle insofar as it relates to the back office—that is, the accounting aspects—is covered in detail with appropriate reference to generally accepted accounting principles (GAAP) requirements. For each financial instrument, the relevant accounting standards that are applicable are given and a comparative chart showing the similarities and differences between the U.S. GAAP and IFRS is given. While the first volume covers broadly equities, equity options, and equity futures, subsequent volumes will cover the other financial instruments.

Key Features and Approach
This book proposes to cover the domain knowledge as well as the accounting treatment for the various financial products. It should be a good addition to the library of books that deal exclusively with the treatment of all financial products handled by financial institutions, banks, hedge funds, and so on, covering the domain knowledge about the respective financial products and the accounting treatment of the same with special reference to the regulatory requirements. A one-point source of information has been needed by the financial services industry for a long time. This book proposes to fulfill that need, as this series of books is aimed at providing that one-point reference.
Throughout this book the approach is to give illustrations and show detailed workings of the same. Wherever there is a computed number, the details of such calculations are given even at the cost of being somewhat repetitive for some advanced readers.

Intended Audience
This book is intended for all those who are directly involved in different capacities and roles in the financial sector, which today is one of the largest emerging sectors in the global economy. Since this book deals with the domain knowledge of many of the exotic products that have evolved over the past two decades, it will be of interest to accountants and the non-accountants alike to know about the trade life cycle of these products.
For an advanced user, the book is expected to pro-vide depth, while for a novice this book starts from the fundamentals. This book is expected to cater to the needs of an expert as well as a novice. This series of books starts from the basics for any financial product—defining the product, the way it is structured, its advantages and disadvantages, the different events in the trade cycle—and then discusses accounting journal entries that are passed for the same. Additionally, this book shows how the entries get reflected in the general ledger accounts, so as to a give a macro-level picture for the reader to understand the basics of the effect of such accounting. Last but not the least in importance is the presentation of the results in the final accounts; the income statement and balance sheet are also well covered in this book. Thus this series of books is expected to be extremely useful to an expert as well as a novice, not to mention the ever increasing number of tech consultants who are in great need of such a book.

Dr. K Sriram, Consulting Actuary

This book on “Accounting for Investments” is a pioneering work in demystifying the complex accounting mechanics associated with financial instruments – particularly the derivative instruments like options, futures, forwards and swaps.

Based on his hard-won experience in this field, the author Venkata Subramani has presented a thorough and insightful view of the investment accounting process through structured numerical examples which mirror the trade life cycle of the different financial instruments. The added advantage is that these examples are dovetailed to the US GAAP requirements.

This detailed step-by-step guidebook is an essential reading for anyone who seeks to have an end-to-end understanding of the investment accounting process. It is a ready-to-use comprehensive course-ware for any training program focused on investment accounting.

K. SRIRAM
B.Sc, PGDM (IIM-B), AICWA, Ph D, FIAI
Consulting Actuary

Dr. K. Sriram is a Consulting Actuary Engaged in Employee Benefits Consulting Practice. He is also an Actuarial Consultant to Genpact, India which is the largest BPO [Business Process Outsourcing] company in India. In his role as the Actuarial Consultant to Genpact, Sriram has the over-sight responsibility for life insurance & pensions related actuarial work, which Genpact does for the US life insurance companies.

Before setting up his practice, Sriram was the Chief Actuary & Appointed Actuary of MetLife India Insurance Company at Bangalore. Overall he has about 15 years of experience in actuarial engagements related to life insurance and pensions.

Sriram is a Fellow Member of the Institute of Actuaries of India and an Associate Member of the Institute of Cost & Works Accountants of India. He has a Masters Degree in Management from the Indian Institute of Management, Bangalore [IIMB] and has a Doctorate Degree in Management from the Bharathidasan University.

Sriram is a member of the Executive Council of the Institute of Actuaries of India [IAI] and is a member of the Financial Risk Management Advisory Group of IAI. He is also a Guest Faculty Member at IIM, Bangalore. He has published a number of papers in the areas of life insurance &Investments. He has authored a book on “Leasing, Hire Purchase & Factoring”.

Disclosures – Objective Questions

Objective Questions

1. When securities are transferred from trading securities to available-for-sale, then
a. Gain/loss recognized as unrealized should be reversed.
b. Gain/loss recognized as unrealized should not be reversed.
c. Gain/loss recognized as unrealized will be adjusted with other comprehensive income.
d. None of the above.

2. When securities are transferred from available-for-sale to trading, then
a. Unrealized gain/loss will be transferred from other comprehensive income and treated as income.
b. Unrealized gain/loss should not be reversed.
c. No changes are required at all.
d. None of the above.

3. Impairment other than temporary in respect of equity securities should be
a. Written down to fair value.
b. Treated alike as temporary impairment.
c. Written as a loss to be treated as temporary.
d. None of the above.

4. A stock dividend declared should be treated as
a. Income.
b. Increase in the value of original shares held.
c. Increase to the quantity (position) of shares held.
d. All of the above.

5. For securities classified as available-for-sale, which of the following items will be reported in the income statement of current period?
a. Both realized and unrealized gains.
b. Realized gain alone.
c. Unrealized gain alone.
d. None of the above.

6. For income tax purposes, unrealized gain/loss will be recognized for reporting
a. Automatically at the end of financial year.
b. Only if the securities are liquidated and realized.
c. As and when depending upon the corporate action.
d. None of the above.

7. Unrealized gain/loss included in the income/other comprehensive income represents
a. Temporary difference recognized as deferred tax benefits.
b. Permanent difference recognized as deferred tax benefits.
c. No effect.
d. None of the above.

8. For available-for-sale securities, the deferred tax effect should be presented in
a. The income statement.
b. Other comprehensive income.
c. No need for accounting.
d. None of the above.

9. For trading securities, the deferred tax effect should be presented in
a. The income statement.
b. Other comprehensive income.
c. No need for accounting.
d. None of the above.

10. As per U.S. GAAP, changes in fair value for available-for-sale securities are reported in
a. The income statement.
b. Other comprehensive income.
c. No need to report.
d. None of the above.

11. When the equity securities are transferred from available-for-sale (AFS) to trading securities,
a. The unrealized gain/loss is recognized on T + 2.
b. The unrealized gain/loss is not recognized at all.
c. The realized gain/loss is recognized immediately.
d. The unrealized gain/loss is recognized immediately.
e. Realized gain/loss of trading securities is treated in the same way as in AFS.

12. Shares received as stock dividend should be added to the original shares and when the mark-to-market process is performed the impact of the stock dividend
a. Should be treated as unrealized gains and reported as income for the period.
b. Should be treated as dividend income.
c. Should be treated as dividend income but should be shown as current asset on asset side of balance sheet.
d. Should be treated as realized gain/income for the period.
e. Both b and c.

13. As per the definition in FAS 109, the tax effects of all temporary differences arising from unrealized gain/loss are to be recognized in the financial statements as
a. Non-trading income.
b. Items exempted from taxes.
c. Deferred tax benefits or deferred tax liabilities.
d. Not recognized for current period, but carried forward to the next accounting period.
e. Income or expense for current period.

14. As per FAS 115, under U.S. GAAP, for securities classified as available-for-sale, all reporting enterprises shall disclose
a. Aggregate fair value.
b. Gross unrealized holding gains.
c. Gross unrealized holding losses.
d. All of the above.
e. None of the above.

15. For regular-way contracts, the IASB gives the option to follow either trade date accounting or settlement date accounting, provided it is followed consistently for purchases and sales of financial assets in the same category. This accounting standard is as per
a. U.S. GAAP (generally accepted accounting principles).
b. FASB (Financial Accounting Standards Board).
c. IFRS (International Financial Reporting Standards).
d. GASB (Governmental Accounting Standards Board).
e. IASC (International Accounting Standards Committee).

Disclosures – Theory Questions

Theory Questions

  1. Can the securities that are classified once be transferred to other category? If so, what precautions should be taken to adjust the unrealized gains or losses?
  2. How is the impairment of securities presented in the balance sheet?
  3. What is the treatment of stock dividend? Can you report this as income?
  4. How are the tax effects on unrealized gains/losses treated in the books of accounts in the securities classified as trading and as available-for-sale?
  5. What are the similarities in U.S. GAAP and IFRS as far as accounting for equity shares is concerned?
  6. What are the differences in U.S. GAAP and IFRS as far as accounting for equity shares is concerned?
  7. Critically examine the disclosure requirements under U.S. GAAP vis-à-vis IFRS.
  8. What are the recent developments in the disclosure requirements under IFRS pursuant to IFRS 7, becoming effective with effect from January 1, 2007?
  9. What is disclosure of cost method investment?

ADR/GDR – Journal Questions

Journal Questions

Question – 1

Prepare journal entries, general ledger, trial balance, income statement, and balance sheet for the following scenarios.

ADR Conversion to Local Equity Shares—BRL
Mark Antony Inc. traded in Bovespa shares in a Brazilian Stock Exchange through Henry Frank Brothers brokers and the details are as follows.

Trade Details
Date                    Product               CCY                  Quantity           Rate             B/S               Brokerage
15-Jan-X1       Bovespa—ADR        US$                    9,000            32.00              B                 US$ 900
28-Jan-X1       Bovespa—ADR        US$                    5,000            35.00              B                 US$ 525
5-Feb-X1        Bovespa—Local       BRL                  15,000            28.50              S                  BRL 1,280

Other Details
One ADR converts to two local shares in BRL currency.
Settlement: T + 2.
Conversion fees levied by broker to convert ADR shares into local shares for 7,500 ADRs amounts to $1,300.
Functional currency is US$.

Liquidation Methodology
FIFO

FX Rates
Date                   FX Rate
11-Jan-X1         1.6505
13-Jan-X1         1.6525
25-Jan-X1         1.6484
27-Jan-X1         1.6444
31-Jan-X1         1.6311
5-Feb-X1          1.6255
7-Feb-X1          1.6201
28-Feb-X1        1.6150

Market Rate
Bovespa ADR
January 31: $33.50
February 28: $38.00
Bovespa Local
January 31: BRL 26.25
February 28: BRL 32.50

———————————————————————–

Question – 2

ADR Conversion to Local Equity Shares—MXN

Mexico Opportunities Fund traded in America Movil shares in a Mexican Stock Exchange through Goldman Sachs and the details are as follows.

Trade Details
Date                  Product                       CCY          Quantity          Rate             B/S Brokerage
12-Jan-X1      America Movil—ADR     US$              1,500            51.50            B US$ 200
22-Jan-X1      America Movil—ADR     US$              3,500            52.50            B US$ 700
24-Jan-X1      America Movil—ADR     US$              1,800            53.50            S US$ 260
5-Feb-X1       America Movil—Local    MXN           30,000            57.50           S MXN 5,200

Other Details
One ADR converts to 10 local shares in MXN currency.
Settlement: T + 2.
Conversion fees levied by broker to convert ADR shares into local shares amount to $810.
Functional currency is US$.

Liquidation Methodology
Weighted average

FX Rates
Date                FX Rate
11-Jan-X1     10.6505
13-Jan-X1     10.6525
25-Jan-X1     10.6484
28-Jan-X1     10.6444
31-Jan-X1     10.6311
5-Feb-X1      10.6255
7-Feb-X1      10.6201
28-Feb-X1    10.6150

Market Rate
America Movil ADR
January 31: $54.50
February 28: $53.00
America Movil Local
January 31: MXN 58.00
February 28: MXN 55.00

ADR/GDR – Objective Questions

Objective Questions

1. An instrument representing ownership interest in securities of a foreign issuer is referred to as
a. An ownership certificate.
b. A depositary receipt.
c. An ownership receipt.
d. None of the above.

2. Depositary receipts that are traded in an international market other than the United States are referred to as
a. Global depositary receipts
b. International depositary receipts.
c. Open market depositary receipts.
d. None of the above.

3. Issuance of DRs is based on the increase of demand in the
a. Local market.
b. International market.
c. Existing shareholders.
d. All of the above.

4. Each DR is backed by a specific number of an issuer’s local shares. This is referred to as the
a. DR ratio.
b. Issuer’s holding ratio.
c. Market holding ratio.
d. None of the above.

5. Which of the following does not constitute a benefit of DRs for the issuer?
a. Offer a new avenue for raising equity capital.
b. Broaden and diversify a company’s investor base.
c. Enhance a company’s visibility and status.
d. None of the above.

6. Which of the following does not constitute a benefit of DRs for investors?
a. Facilitate diversification into securities of foreign issuers.
b. Eliminate unfamiliar custody safekeeping arrangements.
c. Broaden and diversify the investment base.
d. None of the above.

7. ADRs that do not qualify or are not intended to be listed on stock exchanges are referred to as
a. Level 1 ADRs.
b. Level 2 ADRs.
c. Level 3 ADRs.
d. None of the above.

8. ADRs listed on stock exchanges are referred to as
a. Level 1 ADRs.
b. Level 2 ADRs.
c. Level 3 ADRs.
d. None of the above.

9. Which of the following is not an advantage of ADRs?
a. Cost-effectiveness.
b. Diversification of investment.
c, Reduction in administration cost.
d. None of the above.

10. Which of the following is not associated with the risk involved in ADRs?
a. Political risk.
b. Exchange rate risk.
c. Inflationary risk.
d. None of the above.

11. Level 1 is the most basic type of ADR where the foreign company
a. Wishes its ADR to be listed on the U.S. exchanges alone.
b. Does not wish its ADR to be listed on an exchange.
c. Does not wish its ADR to be listed on an U.S. exchange.
d. Wishes its ADR to be listed on any exchange around the world.
e. Wishes its ADR to be listed on any exchange other than U.S. exchanges.

12. Regulation S shares cannot be held or traded by any ______________, as defined by SEC Regulation S rules.
a. Non-U.S. person.
b. U.S. person.
c. European person.
d. U.S. investment firm.
e. Non-U.S. investment firm.

13. In ADR trading, when the investor places the buy order and when the broker executes the same, it becomes a binding contract between the investor and the
a. Foreign company.
b. Broker.
c. Securities Exchange Commission.
d. Stock exchange.
e. All the above.

14. The process of valuation of ADRs is known as portfolio valuation, when the market rate at the end of the period is determined from the
a. Primary stock exchange where the shares are traded.
b. Secondary market.
c. Prime broker.
d. Broker.
e. Credit rating companies.

ADR/GDR – Summary

  • A depositary receipt (DR) represents an ownership interest in securities of a foreign issuer typically trading outside its home market. ADR is a tradable instrument, and the depositary receipts that are trading in the United States are known as American depositary receipts, or ADRs.
  • Depositary receipts that are traded in an international market outside the United States are known as global depositary receipts, or GDRs. Most depositary receipts are quoted and traded in US$ terms. There are some DRs that are traded in euros and pounds sterling.
  • Typically a bank issues depositary receipts and also functions as a depository and issuing agent for the same. read more…

Short Selling – Journal Questions

Journal Questions

For the following scenario, prepare journal entries, general ledgers, trial balance, income statement, and balance sheet for Abdul Razack Inc. for the period January 1 through February 28.

Box Position—Trade Currency BRL
Abdul Razack Inc. traded in Coca-Cola shares in a Brazilian stock exchange through Pompoodle brokers and the details are as follows.

Trade Details
Date                  Product           Quantity           Rate (BRL)           B/S                 Brokerage
11-Jan-X1     Coco Cola          17,000               34.00            Bought Long      BRL 12,500
25-Jan-X1     Coco Cola          14,000               39.00            Bought Long      BRL   7,800
5-Feb-X1      Coco Cola          23,000               45.00            Short sales         BRL 25,600

Other Details
The stock loan fee paid by Abdul Razack Inc. on short sales on February 28 is BRL 4,800.
An investor has introduced an amount of BRL 10 million as share capital on January 1 into the Abdul Razack Inc. fund.
Settlement: T + 2
Abdul Razack Inc. makes a deposit of BRL 1.05 million with the broker on February 5 as collateral.
Interest accrued on cash collateral amounts to BRL 7,800 due from the broker as of February 28.

FX Rates
Date              FX Rate
1-Jan-X         1.6540
11-Jan-X1     1.6505
13-Jan-X1     1.6525
25-Jan-X1     1.6484
27-Jan-X1     1.6444
31-Jan-X1     1.6311
5-Feb-X1      1.6255
7-Feb-X1      1.6201
28-Feb-X1    1.6150

Market Rate
January 31: 42.00
February 28: 39.00

R. Venkata Subramani

Financial Instruments

Hedge Accounting

ECL / CECL

IFRS / US GAAP / Ind AS

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