FAR Chapter 6

Universal CPA guide. Financial Instruments and Business Combinations

fair value

price that would be received when selling an asset or paid when transferring a liability in an orderly transaction between market participants. excludes transaction costs but includes cost of transporting items to the market

financial instrument

any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity

principal market

market with the greatest volume or level of activity for that particular asset or liability

most advantageous market

in the event that no principal market exists, use the market with the best price for the asset or liability. transaction costs are included when determining this market

fair value hierarchy of inputs

used to prioritize inputs that are used for valuation techniques

Level 1 fair value inputs (most accurate)

inputs that contain quoted prices in active markets for identical assets or liabilities in which the reporting entity will have access to on the measurement date. ex: stock

Level 2 fair value inputs

inputs outside of those from quoted market prices. include:

• prices of similar assets or liabilities in active markets

• prices of identical or similar assets in nonactive markets

• inputs that derived from or corroborated by observable market data

ex: municipal bonds

Level 3 fair value inputs

unobservable inputs for an asset or liability. these inputs will reflect the reporting entity’s assumptions and should be based on the best available information provided. ex: complex derivatives

fair valuation approaches

market, income, and cost

market approach

uses relevant information as well as market prices to dictate its transactions. think level 1 inputs. often involves identical or comparable assets/liabilities while measuring fair value

income approach

convert future amounts that include cash flows or earnings to one discounted amount when measuring fair value

cost approach

known to use current replacement costs when measuring an assets fair value

debt security

financial instrument that is issued by another entity and purchased by an investor. ex: corporate bonds, redeemable preferred stock, commercial paper, convertible debt, government securities

trading debt security

• reported as a current asset at fair value

• unrealized gains/losses reported on income statement

  • Dr/Cr Trading Security, Dr/Cr Unrealized loss/gain

• realized gain/loss activity reported in operating section in statement of cash flows

available for sale (AFS) debt security

• reported on balance sheet at fair value

• unrealized gains/losses reported in OCI

  • if a loss, Dr. Unrealized loss, Cr. Valuation Allowance

• realized activity reported in investing section of statement of cash flows

  • realized gain/loss reported in income statement

held to maturity (HTM) debt security

• reported at amortized cost on balance sheet

• no unrealized gains/losses since the security is being held until maturity date

• realized activity reported in investing section of statement of cash flows

converting trading securities to/from AFS or HTM

all unrealized gains go towards income statement

converting AFS securities to/from trading or HTM

• trading securities unrealized gain/loss goes towards income statement

• HTM securities unrealized gain/loss goes towards OCI

converting HTM securities to/from trading or AFS

• trading securities unrealized gain/loss goes towards income statement

• AFS securities unrealized gain/loss goes towards OCI

current expected credit losses

calculated for AFS and HTM securities only

1. calculate PV of future cash flows

2. determine expected credit loss: PV of future cash flows - amortized cost. If positive, gain goes to OCI. If negative, go to credit loss step

3. (AFS only) determine total loss and limit of credit loss in income statement: fair value - amortized cost. If positive, report gain in OCI. If negative, compare total loss to expected credit loss. If total loss is greater, difference is reported in OCI

equity security

common stock, preferred stock, options (calls and puts), and stock warrants

equity security reporting methods

• purchase less than 20% equity: fair value (cost) method, though you can still have significant influence

• purchase between 20 and 50% equity: equity method

• purchase greater than 50% equity: acquisition (consolidation) method

dividends declared on equity securities

• non-liquidating dividend: record dividend income, no impact to investment in balance sheet

• liquidating dividend: no dividend income, decreases investment in balance sheet