CHAPTER 4

INTRODUCTION TO FINANCIAL ASSETS AND INVESTMENT IN EQUITY

SECURITIES

TOPIC OVERVIEW:
This chapter explains the introduction to financial instruments and its categories, initial
recognition, initial and subsequent measurement, and financial statement presentation for each
type of financial instrument.

LEARNING OBJECTIVES:
After studying this chapter, the students should be able to:
1. Identify and describe the types of financial instruments.
2. Explain the different classifications of financial assets.
3. Describe the initial recognition, initial measurement, subsequent measurement, derecognition
and financial statement presentation of financial asset.
4. Differentiate the accounting treatments for FVTPL, FVTOCI, and FAAC.

Definition of Investments
The International Accounting Standards Boards defines investments as follows:
• Investments are assets held by an entity for the accretion of wealth through distribution
such as interest, royalties, dividends and rentals, for capital appreciation or for other
benefits to the investing entity such as those obtained through trading relationships.
• Actually, investments are assets not directly identified with the operating activities of an
entity and occupy only an auxiliary relationship to the central revenue producing activities
of the entity.

Purposes of Investments
Investments are held for diverse reasons such as:
a. For accretion of wealth or regular income through interest, dividends, royalties and rentals.
b. For capital appreciation as in the case of investments in land and real estate held for
appreciation and direct investments in gold, diamonds and other precious commodities.
c. For ownership control as in the case of investments in subsidiaries and associates.
d. For meeting business requirements as in case of sinking fund, preference share redemption
fund, plant expansion fund and other noncurrent fund.
e. For protection as in case of interest in life insurance contract in the form of cash surrender
value.

Examples of Investments
Specifically, investments include the following:
1. Trading securities or financial asset at fair value through profit or loss
2. Financial asset at fair value through other comprehensive income
3. Investment in non-trading equity securities
4. Investment in bonds or financial asset at amortized cost
5. Investment in associate
6. Investment in subsidiary
7. Investment property
8. Investment in fund
9. Investment in joint venture
Statement classification
• Investment are classified either as current or noncurrent assets.
• Current investments are investments that are, by their very nature, readily realizable and
are intended to be held for not more than one year.
• Noncurrent or long-term investments are investments other than current investments.
• This residual definition means that the noncurrent investments are intended to be held for
more than one year or are not expected to be realized within twelve months after the end
of the reporting period.

Definition of Financial Asset

A financial asset is any asset that is:
a. Cash
b. A contractual right to receive cash or another financial asset from another entity.
c. A contractual right to exchange financial instrument with another entity under conditions
that are potentially favorable.
d. An equity instrument of another entity.

Examples of Financial Assets

• Cash or currency is a financial asset because it represents the medium of exchange and is
therefore the basis on which all transactions are measured and recognized in financial
statements.
• A deposit of cash with a bank or similar financial institutions is a financial asset because it
represents the contractual right of the depositor to obtain cash from the bank or to draw a
check against the balance in favor of a creditor in payment of a financial liability.
• But a gold bullion deposited in bank is not a financial asset because although it is very
precious the gold is a commodity.
• Financial assets representing a contractual right to receive cash in the future include trade
accounts receivable, notes receivable and loans receivable.
• In case of exchanges of financial instruments with another entity, conditions are potentially
favorable when such exchanges will result to gain or additional cash inflow to the entity.
• An example of a favorable condition is an option held by the holder to purchase shares of
another entity at less than market price.
• Investments in shares or another equity instruments such as trading securities can be
classified as financial assets.

Not Considered Financial Assets

• Intangible assets are not financial assets.
• Physical assets, such as inventory and property, plant and equipment are not also financial
assets.
• Control of such physical and intangible assets creates an opportunity to generate an inflow
of cash or another financial assets but it does not give rise to a present right to receive cash
or another financial asset.
• Prepaid expenses for which the future economic benefit is the receipt of goods or services
rather than the right to receive cash or another financial asset are not also financial assets.
• Leased assets are not also financial assets because control of such assets does not give rise
to a present right to receive cash or another financial asset.

Classifications of Financial Assets

Under PFRS 9, paragraph 4.1.1, financial assets are classified into three, namely:
1. Financial assets at fair value through profit or loss - include both equity securities and debt
securities.
2. Financial assets at fair value through other comprehensive income – include both equity
securities and debt securities.
 3. Financial assets at amortized cost – include only debt securities.

The classification depends on the business model for managing financial assets which may be:
a. To hold investments in order to realize fair value changes.
b. To hold investments in order to collect contractual cash flows.
c. To hold investments in order to collect contractual cash flows and sell the investments.

What is an equity security?

• The term “equity security” encompasses any instrument representing ownership shares and
right, warrants or options to acquire or dispose of ownership shares at a fixed or
determinable price.
• In simple language, equity securities represents an ownership interest in an entity.
• Ownerships shares include ordinary shares, preference shares and right and options to
acquire ownership shares.
• The owners of equity securities are legally known as shareholders.
• A share is the ownership interest or right of a shareholder in an entity. The share is
evidenced by an instrument called share certificate.
• This right pertains to the share in earnings, election of directors, subscription for additional
shares and share in net assets upon liquidation.
• Equity securities do not include redeemable preference shares, treasury shares and
convertible debt.

What is the debt security?

• A debt security is any security that represents a creditor relationship with an entity.
• A debt security has a maturity date and maturity value.
Examples of debt securities include the following:
a. Corporate bonds
b. BSP treasury bills
c. Government securities
d. Commercial papers
e. Preference shares with mandatory redemption date or are redeemable at the option of the
holder

Initial Measurement of Financial Asset

• PFRS 9, paragraph 5.1.1, provides that at initial recognition, an entity shall measure a
financial asset at fair value plus, in the case of financial asset not at fair value through
profit or loss, transaction costs that are directly attributable to the acquisition of the
financial asset.
• The fair value of a financial asset at initial recognition is normally the transaction price,
meaning, the fair value of the consideration given.
• In other words, a financial asset is recognized initially at fair value.
• As a rule, transaction costs that are directly attributable to the acquisition of the financial
asset shall be capitalized as cost of the financial asset.
• However, if the financial asset is held for trading or if the financial asset is measured at
fair value through profit or loss, transaction costs are expensed outright.
• Transactions costs include fees and commissions paid to agent, advisers, brokers and
dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and
duties.
• Transaction costs do not include debt premiums or discounts, financing costs and internal
administrative or holding costs.

Subsequent Measurement
PFRS 9, paragraph 5.2.1, provides that after initial recognition, an entity shall measure a financial
asset at:
a. Fair value through profit or loss (FVPL)
b. Fair value through other comprehensive income (FVOCI)
c. Amortized cost

Financial assets at fair value through profit or loss

The following financial assets shall be measured at “fair value through profit or loss”:
1. Financial assets held for trading or popularly known as “trading securities”.
These financial assets are measured at fair value through profit or loss “by requirement,”
meaning, required by the standard.
2. All other investments in quoted equity instruments.
These financial assets are measured at fair value through profit or loss “by consequence”
in accordance with Application Guidance B5.1.14 of PFRS 9.
3. Financial assets that are irrevocably designated on initial recognition as at fair value
through profit or loss.
These financial assets are measured at fair value through profit or loss “by irrevocable
designation” or “by option”.
This fair value option is applicable to investments in bonds and other debt instruments
which can be irrevocably designated as at fair value through profit or loss even if the
financial assets satisfy the amortized cost or fair value through other comprehensive
income measurement.
This irrevocable designation is the fair value option allowed in accordance with
Paragraph 4.1.5 of PFRS 9.
4. All debt investments that do not satisfy the requirements for measurement at amortized
cost and at fair value through other comprehensive income.
These financial assets are measured at fair value through profit or loss “by default” in
accordance with PFRS 9, paragraph 4.1.4.

Financial assets held for trading

Appendix A for PFRS 9 provides that a financial asset held for trading if:
a. It is acquired principally for the purpose of selling or repurchasing it in near term.
b. On initial recognition, it is part of a portfolio of identified financial assets that are managed
together and for which there is evidence of recent actual pattern of short term profit taking.
c. It is derivative, except for a derivative that is a financial guarantee contract or designated
and an effective hedging instrument.
In other words, trading securities are debt and equity securities that are purchased with the intent
of selling them in the "near term" or very soon. Trading securities are normally classified as
current assets.

Equity investment at fair value through OCI

At initial recognition, PFRS 9, paragraph 5.7.5, provides that an entity make an irrevocable
election to present in other comprehensive income or OCI subsequent changes in fair value of an
investment in equity instrument that is not held for trading.

The irrevocable approach is designed to impose discipline in accounting for non-trading equity
investment. The amount recognized in other comprehensive income is not reclassified to profit or
loss under any circumstances.
However, on derecognition, the amount may be transferred to equity or retained earnings.
If the investment in equity instrument is "held for trading" the election to present gain and loss in
other comprehensive income is not allowed.
If the investment in equity instrument is held for trading, subsequent changes in fair value are
always included in profit or loss
Debt investment at amortized cost
PFRS 9, paragraph 4.1.2, provides that a financial asset shall be measured at amortized cost if both
of the following conditions are met:
a. The business model is to hold the financial asset in order to collect contractual cash flows
on specified date.
b. The contractual cash flows are solely payments of principal and interest on the principal
amount outstanding.
In other words, the business model is to collect contractual cash flows if the contractual cash
flows are solely payment of principal and interest.
In such a case, the financial asset shall be measured at amortized cost.

Debt investment at fair value through OCI

PFRS 9, paragraph 4.1.2A, provides that a financial asset shall be measured at fair value through
other comprehensive income if both of the following conditions are met:
a. The business model is achieved both by collecting contractual cash flows and by selling
the financial asset.
b. The contractual cash flows are solely payments of principal and interest on the principal
outstanding.
Note that the business model includes selling the financial asset in addition to collecting
contractual cash flows.
In this case, the interest income is recognized using the effective interest method as in amortized
cost measurement.
On derecognition, the cumulative gain and loss recognized in other comprehensive income shall
be reclassified to profit or loss.

SUMMARY OF MEASUREMENT RULES

Measurement of equity investments
1. Held for trading - at fair value through profit or loss
2. Not held for trading - as a rule, at fair value through profit or loss.
3. Not held for trading - at fair value through other fair value through profit or loss.
4. All other investment quoted equity instruments - at fair value through profit or loss
5. Investments in unquoted equity instruments - at cost
6. Investments of 20% to 50% - equity method of accounting
7. Investments of more than 50% - consolidation method to be taken up in an advance
accounting course.

Measurement of debt investments

1. Held for trading - at fair value through profit or loss
2. Held for collection of contractual cash flows - at amortized cost
3. Held for collection of contractual cash flow - at fair value through profit or loss by
irrevocable designation or fair value option.
4. Held for collection of contractual cash flows and for sale of the financial asset - at fair
value through other comprehensive income
5. Held for collection of contractual cash flows and for sale of financial asset - at fair value
through profit or loss by irrevocable designation or fair value option.

Fair Value
Fair value of an asset is the price that would be received to sell an asset in an orderly transaction
between market participants at the measurement date.

The best evidence of fair value in descending hierarchy is the quoted price of identical asset in an
active market, the quoted price of similar asset in an active market and the quoted price of identical
and similar asset in an inactive market.
An active market is a market in which transactions take place with sufficient regularity and volume
to provide pricing information on an ongoing basis.
Simply stated, fair value is the price agreed upon by a buyer and a seller in arm's length or orderly
transaction.
The market and the seller who are the market participants must be independent, knowledgeable
and willing, meaning not forced or not compelled to enter into the transaction.

Quoted Price
Most often, the fair value of securities is the quoted price in the securities market, for example the
Philippine Stock Exchange. If the quoted price pertains to a share or equity security, it means pesos
per share. For example, if the investments in 10,000 shares of an entity costing P800,000 is quoted
at 90, the market value thereof is P900,000 computed by multiplying 10,000 shares by P90 per
share. If the quoted price pertains to a bond or debt security, it means percent of the face amount
of the bond. For example, if the investment in bond with face amount of P2,000,000 costing
P1,700,000 is quoted at 90, the market value is P1,800,000,computed by multiplying the face
amount of P2,000,000 by 90%.

Gain and loss - Financial asset at fair value

Under PFRS 9, paragraph 5.7.1, gain and loss on financial asset measured at fair value shall be
presented in profit or loss, except:
a. When the financial asset is an investment in non-trading equity instrument and the entity
has irrevocably elected to present unrealized gain and loss in other comprehensive income.
b. When the financial asset is a debt investment that is measured at fair value through other
comprehensive income.

In other words, unrealized gain and loss on financial asset held for trading and other financial asset
measured at fair value are reported in the income statement.

Unrealized gain or loss arise from investments that are reported at fair value.
In determining fair value, no deduction is made for transaction costs that may be incurred on
disposal of the financial asset. If the fair value is higher than carrying amount, the difference is an
unrealized gain. If the fair value is lower than carrying among, the difference is an unrealized loss.
Gain and loss that result from actually selling the investments are known as realized gain and
realized loss.

Gain and loss - Financial asset at amortized cost

Unrealized gain and loss on financial asset at amortized cost are not recognized simply because
such investment are not reported at fair value. PFRS 9, paragraph 5.7.2, provides that gain and loss
on financial asset measured at amortized cost shall be recognized in profit or loss when the
financial asset is derecognized, sold, impaired or reclassified and through the amortization process.

Illustration: Trading Securities

On January 1, 2020, an entity purchased marketable equity securities for P5,000,000. The equity
securities qualify as financial asset held for trading. The entity also paid P50,000 as commission
to the broker.

Trading securities 5,000,000

Commission expense 50,000
Cash 5,050,000

The acquisition may be debited to “Financial asset – FVPL”

FVPL means that the financial asset is measured at fair value through profit or loss
Observe that the commission paid to the broker is not capitalized as cost of the investment but
treated base outright expense.

On December 31, the trading securities have fair value of P 6,000,000. The increase in value is
recorded as follows:

Trading securities 1,000,000

Unrealized gain - TS 1,000,000

The unrealized gain classified in the income statement as other income.

On December 31, 2020, the statement of financial position will report the trading securities at fair
value of P6,000,000 with a disclosure of the cost of P5,000,000.

On December 31, 2021, the trading securities have a fair value of P 4,500,000. The decrease in
fair value is recorded as follows:
Unrealized loss - TS 1,500,000
Trading securities 1,500,000

The unrealized loss is reported in the income statement as other expense.

On December 31, 2021 the trading securities will be carried at P 4,500,000 with disclosure of the
cost of P 5,000,000.

Sale of trading securities

On December 31, 2022, the trading securities are sold for P 5,200,000. The sale is simply recorded
as follows:
Cash 5,200,000
Trading securities 4,500,000
Gain on sale of trading securities 700,000

PFRS 9, paragraph 3.2.12, provides that on derecognition of a financial asset the difference
between the carrying amount and the consideration received shall be recognized in profit or loss.
In other words, on disposal of a trading investment, the difference between the cash received and
the carrying amount is recognized as gain or loss in disposal to be reported in the income statement.

Illustration:
On January 1, 2020, an entity acquired trading securities with the following market value on
December 31, 2020:

Cost Market Gain (loss)

AAA preference shares 200,000 150,000 (50,000)
BBB ordinary shares 800,000 950,000 150,000
CCC ordinary shares 1,000,000 1,100,000 100,000
DDD bonds 3,000,000 2,500,000 (500,000)
5,000,000 4,700,000 (300,000)

The acquisition on January 1 is recorded as follows:

Trading securities 5,000,000
Cash 5,000,000

On December 31, 2020, the net decrease is recorded as follows:

Unrealized loss - TS 300,000
Trading securities 300,000
On January 15, 2021, the AAA preference shares are sold for P 80,000. The journal entry to record
the sale is
Cash 80,000
Loss on sale of trading securities 70,000
Trading securities 150,000

On December 31, 2021, the remaining trading securities have the following carrying amount and
market value:
Carrying Market Gain (loss)
amount
BBB ordinary shares 950,000 1,000,000 50,000
CCC ordinary shares 1,100,000 1,500,000 400,000
DDD bonds 2,500,000 2,400,000 (100,000)
4,550,000 4,900,000 350,000

The journal entry to record the net increase is

Trading securities 350,000
Unrealized gain - TS 350,000

Equity investment at fair value through OCI

As stated earlier, at initial recognition, an entity may make an irrevocable election to present in
other comprehensive income subsequent change in value of an investment in non-trading equity
instrument.

Illustration
On January 1, 2020, an entity purchased marketable equity securities for P 1,000,000. The entity
paid commission and taxes of P 100,000. The equity securities do not qualify as financial asset
held for trading. The entity made an irrevocable election to present unrealized gain and loss in
other comprehensive income.

The journal entry record the acquisition is:

Financial asset - FVOCI 1,100,000
Cash 1,100,000

FVOCI means the financial asset is measured at fair value through other comprehensive income.
Under PFRS 9, paragraph 5.1.1, a financial asset measured at fair value through other
comprehensive income shall be recognized initially at fair value plus transaction cost directly
attributable to the acquisition. Thus, the commission and taxes of P100,000 are capitalized as cost
of the investment.

On December 31, 2020, the securities have a market value of P 1,300,000. The increase in market
value is recorded as:
Financial asset - FVOCI 200,000
Unrealized gain - OCI 200,000

The unrealized gain is presented as component of other comprehensive income in the 2020
statement of comprehensive income. The financial asset- FVOCI on December 31,2020 is carried
at the market of P1,300,000, with disclosure of the cost of P1,100,00. The financial asset- FVOCI
is normally classified as noncurrent asset.

On December 31, 2021, the securities have a market value of P 1,600,000. The increase in market
value is recorded as:
Financial asset - FVOCI 300,000
Unrealized gain - OCI 300,000
All this point, the financial asset - FVOCI is carried at the market value of P 1,600,000, and the
total unrealized gain is P500,000 (P200,000+ P300,000). However, only P300,000 will be reported
in the 2021 statement of comprehensive income. The total amount of P500,000 will appear in the
statement of changes in equity.

Sale of equity investment – FVOCI

On July 1,2022, the securities are sold for P 2,000,000. The journal entry to record the sale is:
Cash 2,000,000
Financial asset - FVOCI 1,600,000
Retained earnings 400,000

Gain or loss on disposal of equity investment measured at fair value through other comprehensive
income is recognized in retained earnings in accordance with PFRS 9, paragraph 5.7.1b.

Moreover, the cumulative gain or loss previously recognized in other comprehensive income is
also transferred to retained earnings in accordance with PFRS 9 Application Guidance, paragraph
5.7.1. Accordingly, the cumulative unrealized gain of P 500,000 is transferred to retained earnings.
Unrealized gain - OCI 500,000
Retained earnings 500,000

The amount recognized in other comprehensive income is not classified to profit or loss under any
circumstances.

Illustration:
On January 1, 2020, an entity purchased marketable equity securities for P 2,000,000. The
securities do not qualify as financial asset held for trading. The entity elected to present changes
in fair value in other comprehensive income. The journal entry to record the acquisition is:
Financial asset - FVOCI 2,000,000
Cash 2,000,000

On December 31, 2020, the securities have a market value of P1,800,000. The decrease in market
value is recorded as:
Unrealized loss - OCI 200,000
Financial asset - FVOCI 200,000

The unrealized loss is reported as deduction as component of other comprehensive income in the
2020 statement of comprehensive income. The December 31, 2020 statement of financial position
will report the financial asset- FVOCI at market value of P 1,800,000 with disclosure of the cost
of P 2,000,000.

On December 31, 2021, the securities have market value of P 1,300,000. The decrease in market
value is recorded as:
Unrealized loss - OCI 500,000
Financial asset - FVOCI 500,000

The total unrealized loss is P 700,000 (P 200,000 + P 500,000) at this point in time.
However, only P 500,000 will be reported in 2021 statement of comprehensive income. The total
amount of P 700,000 will appear in the statement of changes in equity. The financial asset- FVOCI
is carried at the market value of P 1,300,000 in the December 31, 2021 statement of financial
position with disclosure of the cost of P2,000,000.
Sale of equity investment – FVOCI
On July 1, 2022, the securities are sold for P 1,200,000. The journal entry to record the sale is:
Cash 1,200,000
Retained earnings 100,000
Financial asset - FVOCI 1,300,000

The cumulative unrealized loss of P 700,000 previously recognized is charged to retained earnings.
Retained earnings 700,000
Unrealized loss - OCI 700,000

Illustration:
On January 1, 2020, an entity acquired marketable equity securities not qualifying as financial
asset held for trading. The entity elected to present changes in fair value as component of other
comprehensive income. On December 31, 2020, the securities have the following cost and market
value:

Cost Market Gain (loss)

Security A 1,000,000 1,100,000 100,000
Security B 2,000,000 2,700,000 700,000
Security C 3,000,000 2,800,000 (200,000)
6,000,000 6,600,000 600,000

The increase in market value is recorded as:

Financial asset - FVOCI 600,000
Unrealized gain - OCI 600,000

Sale of individual security

On July 1, 2021, Security A was sold for P 1,400,000. The journal entry to record the sale is
Cash 1,400,000
Financial asset - FVOCI 1,100,000
Retained earnings 300,000

The unrealized gain of P100,000 related to Security A is transferred to retained earnings.

Unrealized gain - OCI 100,000
Retained earnings 100,000

On December 31, 2021, the remaining securities have the following carrying amount and market
value:
Carrying Market Gain (loss)
amount
Security B 2,700,000 3,500,000 800,000
Security C 2,800,000 2,750,000 (50,000)
5,500,000 6,250,000 750,000

The increase in market value is recorded as:

Financial asset - FVOCI 750,000
Unrealized gain - OCI 750,000
INVESTMENT IN EQUITY SECURITIES
Investment in equity securities is the acquisition of equity securities for the purpose of acquiring
income through dividends and increase in market value, or controlling another entity. Equity
securities represent ownership shares such as ordinary shares, preference shares, and other share
capital. They may also represent rights and options to acquire ownership shares. The owner of
equity securities are legally known as shareholders.

Acquisition of equity investments

• The application guidance of PFRS 9 provides that when a financial asset is recognized
initially, an entity shall measure it at fair value plus transaction costs that are directly
attributable to the acquisition.
• The fair value is usually the transaction price, meaning, the fair value of the consideration
given.
• As a rule, transaction costs that are directly attributable to the acquisition of the financial
asset shall be capitalized as cost of the financial asset.
• However, , transaction costs directly attributable to the acquisition of the financial asset
held for trading of financial asset at fair value through profit or loss shall be expensed
immediately.

Acquisition by exchange
If the equity securities are acquired in an exchange, the acquisition cost is determined by reference
to the following in the order of priority:
a) fair value of asset given
b) Fair value of asset received
c) Carrying amount of asset given

Lump sum acquisition

If two or more equity securities are acquired at a single cost or lump sum, the single cost is
allocated to the securities acquired on the basis of their fair value. If only one security has a known
market value, an amount is allocated to the security with a known market value equal to its market
value. The remainder of the single cost is then allocated to the other security with no known market
value.

Investment categories
Investments in equity securities are accounted for as one of the following categories:
a) Trading securities or financial assets at fair value through profit or loss
b) Financial assets at fair value through other comprehensive income
c) Investment in associate
d) Investment in subsidiary
e) Investment in unquoted equity instruments

Investment in unquoted equity instruments

Under the Application Guidance B5.4.14 of PFRS 9, all investments in equity instruments shall be
measured at fair value. However, investments in unquoted equity instruments are measured at cost
if the fair value cannot be measured reliably.

Sale of equity shares

PFRS 9, paragraph 3.2.12, provides that on derecognition of a financial asset measured at fair
value through profit or loss, the difference between the consideration received and the carrying
amount of the financial asset shall be recognized in profit or loss. When equity shares are of the
same class acquired on different dates at a different costs, a problem will arise as to the
determination of cost of shares sold when only a portion is subsequently sold. In such case, the
entity shall determine the cost of the shares sold using either the FIFO or average cost approach.
Cash dividends
If the equity securities are measured at fair value through profit or loss, or at fair value through
other comprehensive income or at cost, dividends earned are considered as income.
a) When the cash dividends are earned but not received:
Dividends receivable xx
Dividends income xx
b) When the cash dividends are subsequently received:
Cash xx
Dividends receivable xx
The cash dividends do not affect the investment account.

When are dividends considered earned?

a) Date of declaration – This is the date on which the payment of dividends is approved by
the Board of Directors.
b) Date of record – This is the date on which the stock and transfer book of the corporation
is closed for registration.
c) Date of payment – This is the date on which the dividends declared shall be paid.

Between the date of declaration and the record date, the shares are selling “dividend-on”. This
means that when shares are sold after the date of declaration but prior to record date, they carry
with them the right to receive dividends. Between the date of record and the date of payment, the
shares are selling “ex-dividend” which means that the shares can be sold, and still the original
shareholder has the right to receive the dividends on payment date.

When to recognize dividends as income

Dividends shall be recognized as revenue when the shareholder’s right to receive payment is
established. Accordingly, the dividends shall be recognized as revenue on the date of declaration.
The reason is that when dividends are declared, the shareholder has already acquired the right
thereto so much so that if the shares are subsequently sold, the sale price normally includes the
accrued dividends. Once a dividend has been declared, a legal liability binding on the corporation
is created. When shares are sold on “dividend-on” and the dividend accrued is specifically included
in the sale price, that portion of the sale price pertaining to the accrued dividend should be credited
to dividend income. Only the remainder of the sale price should be used as basis for determining
gain or loss on the sale of investment.

Illustration:
A shareholder owns a 1,000 shares costing P 100,000. Subsequently, the shareholder receives
notice of dividend declaration of P 5 per share or P 5,000. If prior to record date, the shareholder
sells the investment for P 150,000, the journal entry to record the sale is:
Cash 150,000
Investment in shares 100,000
Dividend income 5,000
Gain on sale of investment 45,000

Property dividends
Property dividends or dividends in kind are dividends in the form of property or non-cash assets.
Property dividends are also considered as income and recorded at fair value.
Noncash asset xxx
Dividend income xxx

For example, X Company distributes its holding of 10,000 shares in Y Company as property
dividend. The shares of Y Company have a market value of P100 per share. A shareholder receives
500 shares of Y Company as property dividend from X Company. The property dividend is
recorder as follows:
Investment in shares 500,000
Dividend income 500,000

Another example of property dividend is when an entity declares P100 worth of merchandise for
every one share. If a shareholder owns 500 shares, the dividend in the form of merchandise would
be P50,000. The journal entry to record the property dividend is:
Merchandise inventory 50,000
Dividend income 50,000

Liquidating dividends
Liquidating dividends represent return of invested capital, and therefore, are not income. The
payment may be in the form of cash or noncash assets. The liquidating dividend is recognized as
follows:
Cash or other appropriate account xxx
Investment in shares xxx

Normally, liquidating dividends are paid when the corporation is dissolved and liquidated.
However, in the case of wasting asset corporation or mining entity, liquidating dividends maybe
paid even before dissolution and liquidation. Accordingly, when dividends are received from a
wasting asset corporation, the dividends are designated as partly income and partly return of
capital. That portion representing a liquidating dividend should be credited to the investment
account.

For example, a shareholder receives a P 100,000 dividend, designated as income P60,000 and
liquidating, P 40,000. The journal entry to record the dividend is:
Cash 100,000
Dividend income 60,000
Investment in shares 40,000

When liquidating dividends exceed the cost of investment, the difference is credited on the gain
on investment. On the other hand, when liquidation is completed and the carrying amount of
investment is not fully recovered, the balance is written off as a loss.

Share dividends or stock dividends

Share dividends are in the form of the issuing entity’s own shares. The IAS term for share dividend
is “bonus issue”. Shares of another entity declared as dividends are not share dividends but
property dividends.

Kinds of share dividends

Share dividends maybe the same as those held or different from those held. Share dividends
whether of the same class or different are not income. The reason is that there is no distribution of
the assets of the entity. The asset of the entity are the same before and after the issuance of the
share dividends. The shareholder receives additional shares but still has the same proportionate
equity interest in the entity. The shareholder may have more shares but at reduced market value.

Share dividends of same class

Share dividends of the same class are recorded only be means of a memorandum entry on the part
of the shareholder. An example of a memo entry for the receipt of share dividend is:
“Received 2,000 shares representing 20% share dividend on 10,000 original shares held.
Shares now held 12,000 shares.”
Share dividends do not affect the total cost of the investment but reduced the cost of the investment
per share. The original cost after the share dividend will now apply to a greater number of shares,
original shares plus those received as share dividends.

For example a shareholder owns 10,000 shares costing P 120 each or a total cost of P 1,200,000.
Subsequently, the shareholder receives 20% share dividend or 2,000 shares. The effect of this share
dividend maybe shown as follows:
Shares Cost per share Total Cost
Ordinary shares 10,000 120 1,200,000
Share dividend 2,000 - -
12,000 100 1,200,000

The total cost of P 1,200,000 applies now to 12,000 shares with an adjusted cost per share of P100.
The cost per share is reduced from P120 to P100.

Share dividends different from those held

A shareholder may receive a share dividend which is different from the original shares. Again,
share dividends of different class are not income. However, the original cost of the investment is
apportioned between the original shares and the share dividends on the basis of market value of
each at the date of receipt. For example, a shareholder owns 10,000 ordinary shares costing
P800,000. Subsequently the shareholder receives 10% share dividend in the form of preference
shares. The market value of ordinary share is P150, and the market value of preference share is
P100. The original cost of P 800,000 is allocated as follows:
Market Value Fraction Allocated Cost
Ordinary shares 1,500,000 15/16 750,000
Preference share 100,000 1/16 50,000
1,600,000 800,000

The receipt of the preference share as share dividend on the ordinary share investment is recorded
as follows:
Investment in preference shares 50,000
Investment in ordinary shares 50,000

Shares received in lieu of cash dividends

When cash dividends are declared and received, it is without doubt that they are income. A problem
will arise when shares are received in lieu of cash dividends declared. It is generally accepted that
shares received in lieu of cash dividends are income at fair value of the shares received. The reason
is that such shares are in effect property dividends. In the absence of fair value of the shares
received, the income is equal to the cash dividends that would have been received. For example, a
shareholder owns 10,000 shares costing P 1,000,000. Subsequently the shareholder receives 1,000
shares in lieu of cash dividend of P10 per share. The market value per share is P150. The receipt
of the 1,000 shares is recorded as follows:
Investment in shares 150,000
Dividend income 150,000

If there is no market value, the journal entry is:

Investment in shares 100,000
Dividend income 100,000

Cash received in lieu of share dividends

When share dividends are declared and received, unquestionably, they are not income. A problem
will arise when cash is received in lieu of share dividends.
Example:
A shareholder owns 10,000 shares costing P1,100,000. Subsequently, the shareholder receives
P150,000 cash in lieu of 1,000 shares originally declared as 10% share dividend. The "as if"
approach is followed. This means that the share dividends are assumed to be received and
subsequently sold at the cash received. Therefore, a gain or loss may be recognized.

As if approach
The original cost of P1,100,000 applies now to 11,000 shares which is the sum of the original
10,000 shares and the 1,000 shares assumed to be received as share dividends. The cost per share
would then be P100. The 1,000 shares representing share dividends are assumed to be sold for the
cash received.
Cash 150,000
Investment in shares 100,000
Gain on investment 50,000

BIR Approach
Under the ruling of Bureau of Internal Revenue, all cash received, whether originally designated
as cash dividend or share dividend, is recognized as income. Thus, under the "BIR" approach, the
cash received of P 150,000 is simply debited to cash and credited to dividend income. However,
the "as if" approach is theoretically sound and should be followed for financial purposes.

Share split
A corporation may restructure its capital by effecting a change in the number of shares without
capitalizing retained earnings or changing the amount of its legal capital. Share split may be split
up or split down. Split up is a transaction whereby the outstanding shares are called in and replaced
by a larger number, accompanied by a reduction in the par or stated value of each share. Split down
is a transaction whereby the outstanding shares are called in and replaced by smaller number,
accompanied by an increase in the par or stated value.
Share split does not affect the total cost of investment. But there is a decrease or an increase in the
cost per share because the total cost now will apply to a larger or smaller number of shares. Only
a memorandum entry is made to record the receipt of new shares by virtue of share split.

Example
A shareholder owns 10,000 shares costing P 2,000,000. Subsequently, the shareholder receives
notice that share is split 2-for-1.

"Received 20,000 new shares as a result of a 2-for-1 split of 10,000 original shares."

The total cost of P 2,000,000 will now apply to 20,000 shares or a cost per share of P100. Such
cost then be the basis for subsequent transactions.

Special Assessments
This are additional capital contribution of the shareholders. On the part of the shareholders, special
assessment are recorded as additional cost of the investment.

Example
A shareholder owns 10,000 shares costing P 500,000. Subsequently, the directors pass a resolution
to the effect that the shareholders shall contribute P5 for each share held to the corporation.
Investment in shares 50,000
Cash 50,000
Redemption of shares
Shares, particularly preference shares, may be called in for redemption and cancelation by the
entity issuing them. On the part of the shareholder, the redemption of share is recorded in the same
manner as sale of share. The redemption price is treated as the sale price.

Example:
Shareholder acquires 10,000 preference shares for P100 per share.
Investment in preference shares 1,000,000
Cash 1,000,000

If subsequently, the preference shares are called in by the issuing entity at P110 per share, the entry
to record the redemption is
Cash 1,100,000
Investment in preference shares 1,000,000
Gain on investment 100,000

Share right or stock right

A share right or preemptive right is a legal right granted to shareholders to subscribe for new shares
issued by a corporation at a specified price during a definite period. IAS term is "right issue". A
share right is inherent in every share. A shareholder receives one right for every share owned. A
share right is valuable to a shareholder because the price at which the new shares are sold is
generally below the prevailing market price. The ownership of share rights is evidenced by
instruments or certificates called shared warrants.

Accounting for share rights

PFRS 9 does not address this accounting issue categorically. But unquestionably, a share right is
a form of a financial asset. There are two schools of thought on the matter, namely:
1. Share rights are accounted for separately
2. Share rights are not accounted for separately

Accounted for separately

Under the application Guidance B5.4.14 of PFRS 9, all investments in equity instruments and
contracts on those instruments must be measured at fair value. Undoubtedly, share rights are a
form of equity instrument and therefore shall be measured initially at fair value. The reason for
such an allocation is that share rights are independent of the original shares from which they are
derived. When share rights are issued, investor is now the owner of original shares and related
share rights. Share rights classified as current assets.

Not accounted for separately

Share rights are recognized as embedded derivative but not a "stand-alone" derivative. Component
of a hybrid or combined contract (host contract) with the effect that some of the cash flows of the
combined contract vary in a way similar to a stand-alone derivative". PFRS 9, paragraph 4.3.3,
provides that an embedded derivative shall be separated from the host contract and accounted for
separately under certain conditions. The classification requirements are applied to the combined
host contract in its entirety. If the host contract is measured at fair value through profit or loss, the
embedded derivative is not separated.

Approach to be followed
PFRS 9, paragraph 4.3.4, states that this standard does not address whether an embedded derivative
shall be presented separately in the statement of financial position.
Example of a formal announcement of share right
"The board of directors in their meeting on December 15, 2020 approved to issue share rights to
the shareholders of record on January 15, 2021, entitling the shareholders to acquire one share at
P100 par for every five shares held, the right to expire on March 31, 2021".

Date of declaration - date on which issuance of share right is approved by the Board of directors
Date of record - date on which the stock and transfer book of the entity will be closed for
registration and only those shareholders registered as of the record date are entitled to receive share
rights. Date of record is also the date of issuing the share warrants
Expiration date - date up to which the share rights shall be exercised. After such date, share rights
would be worthless.

Between the date of declaration and date of record

During this period, the shares are considered to be selling right-on. No accounting problem is
encountered in this case because the share rights are not yet received by the shareholder. In the
event of subsequent, sale prior to the record date, the difference between the sale price and the
carrying amount of the investment is simply considered as gain or loss on sale of investment.

Illustration
A shareholder owns 5,000 shares costing P 500,000. Subsequently, the shareholder receives notice
of share rights to subscribe for 1,000 shares at the par value of P100 per share. Prior to the issuance
of the share warrants, the shareholder sells the investment for P 750,000.
Cash 750,000
Investment in shares 500,000
Gain on sale of investment 250,000

Between the date of record and expiration date

On the date of record, the warrants evidencing the share rights are issued to the shareholders. On
or after this date, the shares are said to be selling ex-right. This means that the share can now be
sold separate from the right or vice versa.

Illustration: Accounted for separately

A shareholder acquired 10,000 shares costing P 1,800,000. Subsequently, the shareholder received
10,000 share rights to subscribe for new shares at P100 per share for every five rights held. The
market value of the share is P150 and the market value of the right is P10.

Original investment
Investment in shares 1,800,000
Cash 1,800,000

Receipt of share rights

The share right received are initially measured and recorded at fair value.
Share rights 100,000
Investment in shares 100,000

Note:
The shareholder received 10,000 share rights because the shareholder owned 10,000 shares. The
fair value of share rights is 10,000 rights times P10 or P100,000. The original investment account
is credited when the rights are received because the share rights are "derived" from the original
investment.

Some academicians propose that the fair value of the share rights should be credited to unrealized
gain.
If the share rights do not have a market value, theoretical or parity value of the share rights is used
in measuring the fair value of the share rights.

Exercise of share rights

When share rights are exercised, the cost of the new investment includes the subscription price
and the cost of the share rights exercised. Since there are 10,000 share rights and the investor can
acquire one new share for every 5 rights, the investor would acquire 2,000 new shares at P100 per
share or P 200,000.
Journal entry:
Investment in shares 300,000
Cash 200,000
Share rights 100,000

When an investor is entitled only to a fraction of a share, the investor may purchase additional
rights in order to acquire one full share.

Sale of share rights

The share rights are financial assets separate from the original shares. Accordingly, the share rights
can be sold independently of the original investment. Thus, if the share rights are not exercised but
sold for P150,000, the journal entry is:
Cash 150,000
Share rights 100,000
Gain on sale of share rights 50,000

Expiration of share rights

Share rights can be exercised only up to a certain date after which the rights become worthless.
Thus, if the rights are not exercised but expired, the journal entry to record the expiration is:
Loss on share rights 100,000
Share rights 100,000

This approach is defended on the philosophy that the original shares have lost some of their value
because the new shares are offered for sale at a price which is below the current market price
thereby creating dilution in the value of such shares.

Theoretical or parity value of share rights

The theoretical or parity value is the assumed fair value of the right that is derived from the market
value of the share. Two formulas may be used:

When the share is selling right on

Market value of share right on minus subscription price
= Value of one right
Number of rights to purchase one share plus 1

When share is selling ex-right

Market value of share ex-right minus subscription price
= Value of one right
Number of rights to purchase one share

Illustration:
A shareholder acquired 10,000 shares costing P 2,500,000. Subsequently, the shareholder received
share rights to subscribe for new shares at P150 per share for every five rights held. This market
value of the share is P210 per share. The right has no known market value. If the market value of
the share of P210 is right-on, the theoretical value of right is computed as:
Market value of share right on minus subscription price
= Value of one right
Number of rights to purchase one share plus 1
 210 - 150
= Value of one right
5+1

60
= P 10 per right
6

Allocation of cost
Cost of original investment P 2,500,000
Theoretical value of share rights (10,000*10) 100,000
Remaining cost of original investment P 2,400,000

Note that the market value of the share is P210 right-on, meaning, this includes the value of the
right of P10. Therefore, the value of the share "ex-right" or excluding the right is P200.

If the market value of the share of P210 is ex-right, the theoretical value of the share right is
computed as:
Market value of share ex-right minus subscription price
= Value of one right
Number of rights to purchase one share

210 - 150
= P 12 per right
5

The cost of 2,500,000 is allocated as:

Cost of original investment P 2,500,000
Theoretical value of share rights (10,000*12) 120,000
Remaining cost of original investment P 2,380,000

Illustration: Not accounted for separately

A shareholder acquired 10,000 shares for P 1,500,000. Subsequently, the shareholder received
10,000 share rights to subscribe for new shares at P100 per share for every five rights held. The
market value of the share is P140, and the market value of the right is P10. The share rights are all
exercised by the shareholder.

Journal Entries
a. To record the acquisition of the original investment:
Investment in shares 1,500,000
Cash 1,500,000

b. To record the receipt of the share rights:

Memo entry- Received 10,000 share rights to subscribe for new shares at P100 per share for every
five rights held, or a total of 2,000 new shares.

c. To record the exercise of the share rights:

Investment in shares 200,000
Cash 200,000

If the share rights are not exercised but sold, the sale is simply recorder by debiting cash and
crediting the original investment account. No gain or loss is recognized from the sale.
Thus, if the 10,000 rights are sold for P 150,000, the journal entry is:
Cash 150,000
Investment in shares 150,000

If the share rights are not exercised but expired, only a memorandum is necessary to record the
expiration. Any subsequent transactions affecting the shares shall be accounted for using either the
FIFO or average method.

References:
Valix, Conrado T. et. al. (2020) Intermediate Accounting Volume. 1, 2020 Revised Edition, GIC
Enterprises Co., Inc. Manila
Asuncion, et. al. (2018). Applied Auditing Book 1 of 2, Baguio City: Real Excellence Publishing
Valix, et. al. (2016). Financial Accounting Volume 1, Manila Philippines