CHAPTER 7

Investment in Equity Instruments

Answers to Questions

1.
1) Marketable equity securities are carried on the statement of financial
position at fair value.
2) For trading securities, net income is affected by dividend, foreign exchange
gains or losses, realized gains or losses on the sale of the investment, and
unrealized gains or losses due to changes in fair value during the reporting
period.
3) For FA@FVTOCI, net income is affected by dividend and gains or losses
on derecognition of the investment.
4) Trading securities are distinguished from FA@FVTOCI by management
intentions to trade the portfolio actively, with sales usually expected within
a few months.
2. The requirement prevents manipulation of earnings by reclassifying securities at
opportune times. The original choice for classification will affect subsequent
earnings. If the company wants to obtain the benefits (higher or lower earnings)
of a different classification, the rule requires revaluation as if the investment
were sold and then repurchased. This provision generally eliminates the
incentive to reclassify investments when the purpose is to manipulate income.
For example, the market value of a large investment in TS may have declined
significantly during the year. Without the requirement to reclassify at market
value, there would be an incentive to reclassify the investments to
FA@FVTOCI at the end of the year to avoid recognizing the unrealized holding
loss in earnings. As FA@FVTOCI, the holding loss would be “buried” in
owners’ equity. The reclassification rule would require immediate recognition
of the loss, thus eliminating the incentive to reclassify to avoid the loss.
As another example, investments originally classified as FA@FVTOCI may
have dropped significantly in value. The firm has reaped the benefit of
recognizing the losses in owners’ equity rather than earnings. Should the market
value begin to turn around, there would normally be an incentive to reclassify
the securities as TS. Future gains then would be recognized in earnings,
whereas the past losses were “buried” in owners’ equity. The required
reclassification at market value eliminates that incentive because the past losses
would be recognized in earnings. It should be noted however that
reclassification of FA@FVTOCI is not allowed under PFRS 9.
3. An impairment loss is recorded only when there is a significant and permanent
decrease in the market value of an asset. For investments in securities classified
as available for sale and as held to maturity, impairment losses are recognized
 and new cost basis recorded for the permanently impaired investments. It
should be noted however that only FA@AC is subject to impairment in
accordance with PFRS 9.
4. In accounting for an ordinary share dividend, or a share split, the investor should
make no entry for revenue nor change in the investment account other than to
make a memorandum entry to record the number of shares received. In either
case, a share dividend or share split, the number of shares increases, the total
investment cost remains the same and the cost (or carrying value) per share is
reduced.
5. A share right (warrant) is a privilege given to shareholders (investors) to receive
a specified number of additional shares from the issuing corporation at a specific
price (or at no price) and by a specific future date.
Share rights meet the definition of derivatives and should be accounted as such
(i.e., as FA@FVTPL - held for trading).
6.
1) The equity method is used for an investment in voting equity securities
when the investor is in a position to exercise significant influence over the
investee. This is assumed to happen at 20% in the absence of evidence to
the contrary.
2) Securities accounted for under the equity method are initially recognized at
cost and adjusted thereafter for the post acquisition change in the investor’s
share of net assets of the investee. The comprehensive income of the
investor includes the investor's share of the profit or loss and other
comprehensive income of the investee. Distributions (such as dividends)
received from the investee reduce the carrying amount of the investment.
3) For securities carried under the equity method, net income is affected by the
investor’s share of the associate’s profit or loss, impairment and realized
gains or losses on the sale of the investment.
4) The equity method is preferred for investments in which the investor has
significant influence over the investee because (1) investor income is less
easily manipulated, since dividends are not the significant factor in income,
and (2) it treats the investment as part of an economic entity which includes
the investor and the owned part of the investee.
7. Refer to page 182.
8. An underlying is a special interest rate, security price, commodity price, index
of prices or rates, or other market-related variable. Changes in the underlying
determine changes in the value of the derivative. Payment is determined by the
interaction of the underlying with the face amount and the number of shares, or
other units specified in the derivative contract (these elements are referred to as
notional amounts).
 9.
Traditional Financial Derivative Financial
Instrument Instrument (e.g., Call
Feature (e.g., Trading Security) Option)
Payment Provision Share price times the Change in share price
number (underlying) times number of
of shares. shares (notional amount).
Initial Investment Investor pays full cost. Initial investment is less than
full cost.
Settlement Deliver shares to receive Receive cash equivalent,
cash. based on changes in share
price times the number of
shares.
For a traditional financial instrument, an investor generally must pay the full
cost, while derivatives require little initial investment. In addition, the holder of
a traditional security is exposed to all risks of ownership, while most derivatives
are not exposed to all risks associated with ownership in the underlying. For
example, the intrinsic value of a call option only can increase in value. Finally,
unlike a traditional financial instrument, the holder of a derivative could realize
a profit without ever having to take possession of the underlying. This feature is
referred to as net settlement and serves to reduce the transaction costs associated
with derivatives.
10. The unrealized holding gain or loss on non-trading equity investments should be
reported as income when this security is designated as a hedged item in a
qualifying fair value hedge. If the hedge meets the special hedge accounting
criteria (designation, documentation, and effectiveness), the unrealized holding
gain or losses is reported as income.
11. Refer to page 185.
12. Refer to page 186.

Answers to Multiple Choice Questions

1. C 11. B 21. A 31. A

2. B 12. B 22. D 32. B
3. A 13. B 23. D 33. C
4. A 14. C 24. A 34. C
5. D 15. D 25. B 35. A
6. C 16. D 26. D 36. D
7. C 17. D 27. A
8. D 18. D 28. B
9. C 19. C 29. D
10. B 20. C 30. B