KAS 14 – FINANCIAL INSTRUMENTS

EXPLANATORY NOTE

Explanatory notes to the Kosovo Accounting Standards are intended to provide additional understanding of the standards and technical guidance as to their use and application. In case of any divergence between Explanatory Notes and Standards, the Standards prevail.

1. This KAS concerns financial instruments. A financial instrument is any contract that creates both a financial asset of one enterprise and a financial liability or equity instrument of another. In Kosovo, this KAS is expected to apply most directly to the treatment of investments, loans and receivables.

Investment Classifications

2. There are four classifications of investment:

  1. Loans and receivables originated by the enterprise
  2. Held to maturity
  3. Trading
  4. Available for sale

3. Loans and receivables originated by the enterprise are those created by an by providing money, goods or services directly to the debtor. On the balance sheet, they are carried at amortized cost, subject to impairment recognition.

4. Held to maturity investments are those that the enterprise has both the intention and ability to hold until maturity. The investments must have fixed or determinable payments and a fixed maturity. Equity investments cannot be classified as held to maturity. On the balance sheet, held to maturity investments are classified as short-term or long-term, depending upon maturity date.

5. Trading investments are those acquired primarily for the intention of making a profit from short-term changes in price. Even if an investment is not sold prior to maturity, if the intention when purchased was for trading purposes, it is classified as a trading investment. All trading investments are classified as short-term investments on the balance sheet.

6. Available for sale investments are those investments that are not classified as loans and receivables originated by the enterprise, held to maturity or available for sale. If sale or maturity is expected within one year of the balance sheet date the investment is classified as a current asset, otherwise it is considered long-term. Examples of available for sale investments include an equity investment that an enterprise does not intend to trade, such as investment shares in another company that are intended to be held for an indefinite period, and an investment that could be held to maturity, but may instead be sold if necessary to meet the enterprise's liquidity needs.

Accounting for Original Purchase

7. Investment purchases should initially be recorded at cost, including all related broker commissions or agent fees. If an investment is purchased between interest payment dates, any accrued interest should be recorded as an interest receivable and not as part of the investment cost.

Example of investment purchase:

An investment is purchased under the following conditions:

Face value10,000

Premium paid150

Broker commission50

Accrued interest80

Total amount paid related to purchase10,280

The investment cost is 10,200 and will be entered as an investment on the accounting records. The accrued interest receivable is 80 and will be entered as a receivable asset on the accounting records. When interest is received, the interest receivable will be eliminated.

Balance Sheet Reporting for Held to Maturity Investments

8. The value shown on the balance sheet for an investment depends upon the classification of the investment. Investments classified as held to maturity are reported at acquisition cost, adjusted for any amortization or impairment.

9. When the purchase price of an investment is less than the face value, a discount exists. The investment is recorded at cost and the discount is accounted for as an increase of interest income and increase in the cost of the investment by entries over the term remaining until maturity. As a result, the balance of the investment on the accounting records is equal to its face value on the maturity date.

10. When the purchase price of an investment is more than the face value, a premium exists. The investment is recorded at cost and the premium is accounted for as a decrease of interest income and decrease in the cost of the investment by entries over the term remaining until maturity. As a result, the cost of the investment is equal to face value at the maturity date.

11. Transaction costs such as broker commissions that were added to the cost of the investment are also amortized over the term remaining until maturity.

Following is an example of accounting for an investment purchased at a discount.

Original cost of investment:9,200

Maturity value:10,000

Months remaining until maturity:16

The investment is recorded at its cost of 9,200. Assuming a straight-line method of amortization, the discount of 800 (10,000 - 9,200) is amortized over the 16 months remaining until maturity by the following monthly transaction on the enterprise's accounting records:

DebitInvestment balance50

CreditInterest income50

KAS notes that a method of amortization called the effective interest rate method should be used. This method uses a discounting formula to determine the amount of amortization for each reporting period. However, unless the enterprise has a significant volume of investments, the difference in amortization between the simpler straight-line method and the effective interest rate method is not material. It is expected that most enterprises in Kosovo will utilize the straight-line method when they hold a small volume investments.

Balance Sheet Reporting for Trading Investments

12. Trading investments are reported at fair market value. Increases and decreases to value are recorded on the balance sheet as adjustments to the investment account and on the income statement as gains and losses.

Example of trading investment valuation:

A security that was purchased for trading on November 1, XXX1 at a cost of 20,000 has a fair market value of 19,500 as of December 31, XXX1. The balance sheet dated December 31, XXX1 will reflect a balance of 19,500 for the security and the income statement will include a loss of 500. The accounting transaction to record adjustment of the investment to fair market value is:

DebitLoss on trading investments500

CreditTrading investments500

This transaction reduces the balance of the trading investment account to fair value and recognizes the decrease in value as a loss in the income statement.

However, if the fair value of a trading investment cannot be determined it should be reported at amortized cost. In order to determine fair value there should be a quoted market price in an active market available for the investment, or other methods available to reasonably estimate fair value.

Balance Sheet Reporting for Available for Sale Investments

13. Investments classified as available for sale are reported at fair market value. Increases and decreases to value are recorded on the balance sheet as adjustments to the investment account and on the income statement as gains and losses or in the equity section. Note that for normal available-for-sale investments, where the fair value is readily available, the enterprise has a one-time, enterprise-wide choice of reporting changes in fair value (a) in net profit or loss or (b) in equity until the asset is sold or otherwise disposed of, at which time the cumulative gain and loss is reported in net profit or loss.

Example of available for sale valuation:

A security that was purchased and classified as available for sale on November 15, XXX1 at a cost of 32,000 has a fair market value of 33,500 as of December 31, XXX1. The balance sheet dated December 31, XXX1 will reflect a balance of 33,500 for the security and the income statement will include a gain of 1,500 (assume enterprise chose to record adjustments in the income statement). The accounting transaction to record adjustment of the investment to fair market value is:

DebitAvailable for sale investments1,500

CreditGain on investments1,500

This transaction increases the balance of the available for sale investment account to fair value and recognizes the increase in value as a gain.

However, if the fair value of an available for sale investment cannot be determined it should be reported at amortized cost. In order to determine fair value there should be a quoted market price in an active market available for the investment, or other methods available to reasonably estimate fair value.

Impairment

14. If any financial instrument reported at amortized cost suffers a long-term loss in value it is considered an impairment of the item’s value. The carrying value must then be decreased on the balance sheet, with the corresponding loss recognized in the income statement. An impairment loss must be recognized on the financial statements in the period in which it occurs. An impairment loss is a long-term loss in value identified by greater than normal market price fluctuations, and expectation that the loss will not be reversed by an improvement in value in the near term.

15. A long-term loss may be recognized by the following events:

  • Significant financial difficulty of the issuer
  • Default or delinquency in principal or interest payments
  • High probability of bankruptcy or financial reorganization of the issuer

16. When it is probable that an enterprise will not be able to collect all principal and interest amounts due, an impairment has occurred. The amount of the loss is the difference between the carrying value of the item on the company’s records and the recoverable amount. If the situation causing the impairment changes, with a recovery in value, the amount of loss may be reversed, but cannot in any case result in a carrying value higher than amortized cost.

Accruals of Interest and Dividends

17. On investments that earn interest, accruals are made to recognize interest as it is earned during the term of the investment.

18. On equity investments, dividends are recorded as a receivable and revenue when the issuing company declares the dividend. The receivable balance is cleared when payment of the dividend is received.

19. The issuer of an interest-bearing financial instrument should accrue for and record interest expense.

20. The issuer of a stock certificate should record dividends as a reduction of retained earnings when the dividends are declared.

21. The accounting transaction when dividends are declared is:

DebitRetained earnings

CreditDividends payable

The payable balance is cleared when payment of the dividend is made.

Sales of Securities

22. Within KAS 14, the term applied to removing financial instruments from financial reporting is derecognition. Derecognition occurs when the enterprise loses control of the rights to the instrument, typically through sale or maturity. To properly account for the sale of an investment, the balances in several accounts related to the investment must be reviewed and adjusted if necessary. Each of the following steps must be completed when an investment sale occurs:

  • Interest should be accrued to the date of sale.
  • Any accrued interest should be eliminated, as well as the balance of the investment account. Amounts received that are greater than the carrying value of the investment will result in a gain. Any amounts received that are less than the carrying value of the investment result in a loss.

23. For example, if a security has a carrying value of 13,500, there is accrued interest of 250 related to the investment and the total amount received from the purchaser is 14,000, a gain of 250 on the sale will be recorded, as follows:

DebitCash14,000

CreditGain on investment sale250

CreditAvailable for sale investment13,500

CreditInterest receivable250

24. As another example, if a security has a carrying value of 13,500, there is accrued interest of 750 related to the investment and the total amount received from the purchaser is 14,000, a loss of 250 on the sale will be recorded, as follows:

Debit Cash14,000

Debit Loss on investment sale250

Credit Available for sale investment13,500

Credit Interest receivable750

Accounts Receivable

25. Receivables include claims for money, goods, services, and other non-cash assets from other firms. Receivables are classified as current or non-current depending on the remaining time to maturity or expected collection date. Accounts receivable often are supported only by a sales invoice. Notes receivable usually are supported by formal promissory notes. Trade receivables are amounts owed the company for goods and services sold in the normal course of business. Non-trade receivables arise from many other sources.

26. The earnings process is a crucial source of capital and a major source of receivables. For example, sales often are made on credit. The receivable recorded in a sale is a claim on another firm’s assets. The main accounting issues pertaining to receivables are recognition and validation. The collectibility of the receivable is the primary uncertainty affecting the measurement and reporting of receivables. Collectibility affects whether the receivable is recorded (the recognition issue), and at what amount (the valuation issue). Revenue, and the associated receivable is recorded only if collection is likely.

Recognition and Measurement of Accounts Receivable

27. Accounts receivable are amounts owed by customers for goods and services sold in the firm’s normal course of business. These receivables, also called trade receivables, are supported by sales invoices or other documents, rather than by formal written promises. These receivables include amounts expected to be collected either during the year following he balance sheet date or within the firm’s operating cycle, whichever is longer. Generally a period is allowed for payment, beyond which date the account is considered past due. Individual accounts receivable for customer with credit balances (from prepayments or overpayments) are reclassified and reported as liabilities. These credit balances should not be netted against accounts receivable.

Measuring Ucollectible Accounts Receivable

28. An enterprise will have buyers who don’t pay what they owe to the company. When credit is extended, some uncollectible receivables are inevitable. In order not to overestimate the value of its receivables, an enterprise must estimate the amount of uncollectible balances and record it in the accounts. This applies the principle of prudence so that the value of receivables is not overstated. The matching principle requires that the loss from uncollectibles be recognized in the period of sale. Estimated uncollectibles are recorded in bad debt expense, an operating expense often classified as a selling expense.

29. To account for the amount of estimated uncollectible receivable balances, an adjusting entry is needed at the end of an accounting period. For example, if a company initially estimates that 9,000 of accounts receivable is uncollectible, the following adjusting entry to record bad debt expense is recorded:

Debit Bad debt expense...... 9,000

Credit Allowance for doubtful accounts ...... 9,000

30. The Allowance for doubtful accounts is a contra account to accounts receivable and is used because the identity of specific uncollectible accounts is unknown at the time of the estimate. Net account receivable (after subtracting the allowance account) is an estimate of the net realizable value of the receivables.

31. Two other related events must be considered: (1) the write-off of a specific receivable and (2) collection of an account previously written off. The adjusting entry for bad debt expense created the allowance for doubtful accounts for future uncollectible accounts. When specific accounts are determined to be uncollectible, that part of the allowance is no longer needed. The bad debt estimation entry previously shown recognized the estimated economic effect of future uncollectible accounts. Thus written-offs of specific accounts do not reduce total assets further unless they exceed the estimate. Write-offs occur when the likelihood of collection does not support further collection efforts.

32. For example, the following entry is recorded by a company deciding not to pursue further collection efforts of a receivable with a balance of 1,000:

Entry to record write-off of specific account receivable:

Debit Allowance for doubtful accounts...... 1,000

Credit Accounts receivable...... 1,000

33. This entry affects neither income nor the net amount of accounts receivable outstanding. Instead, it is the culmination of the process that began with the adjusting entry to estimate bad debt expense. The write-off entry is recorded only after the firm concludes that an account is uncollectible.

34. Occasionally, amounts are received on account after a write-off. This might occur as the result of an improvement in the customer’s financial condition. In this case, the write-off entry is reversed to reinstate the receivable, and cash collection is recorded.

35. For example, assume that the company whose receivable was written off is able to pay 600 on account some time after the previous write-off entry was recorded. The following entries are recorded:

Entries to reinstate and collect written-off receivable:

Debit Accounts receivable ...... 600

Credit Allowance for doubtful accounts...... 600

Debit Cash...... 600

Credit Accounts receivable...... 600

The debt and credit to accounts receivable record the partial reinstatement and collection of the account.

Estimating Bad Debt Expense

36. As it is impossible to foresee which accounts will not be paid when the financial statements are prepared, it is necessary to calculate amounts that will cover the estimated losses. Of course the estimates may differ considerably. In difficult financial periods the losses from doubtful debts are usually more than in the periods of economic growth. But the final decision about the amount of the doubtful debts is made by the management. This decision is based an objective assessment of the company’s receivables.

37. The two general methods of estimating bad debts expense are the credit sales (income statement) method and the accounts receivable (balance sheet) method. Both are acceptable. The objective of the credit sales method is to measure accurately the expense caused by uncollectible accounts. The objective of the accounts receivable method is to measure accurately the net realizable value of accounts receivable.

Notes Receivable and Accounts Receivable Compared

38. The accounting issues affecting notes receivable and accounts receivable are similar. Recognition and valuation of notes receivable are affected by collectibility. If the collectibility of a note, either interest or principal, is in doubt, the note must be assessed for impairment and the value of the note written down to reflect its expected value. The amount of any write down is recognized as a loss.

Disclosure

39. An enterprise should disclose the extent of risk- price, credit, liquidity, or cash flow- related to both recognized and unrecognized financial instruments. These disclosures should include:

• The extent and nature of financial instruments, including significant terms and conditions which may affect the amount, timing, and certainty of future cash flows.

• The accounting policies and methods used in reporting financial instruments.

• The exposure to interest rate risk from financial assets and liabilities including information about contractual reporting or maturity dates and effective interest rates.

• The fair market value of financial instruments.

Refer to KAS 14 for a more detailed discussion of risks and disclosure requirements.

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