Financial Assets and Accounts Receivable

OK, let’s stop nerding out about financial ratios and individual line-item analysis and go back to the actual financial statements.

Quick recap — what account titles have we covered so far?

Inventory, tangible assets, investment property, intangible assets, corporate bonds, lease receivables & assets, pension fund assets… right?

Yeah, I think that’s roughly it heh heh heh. And honestly we kept it pretty shallow on all of those!!!! heh heh heh heh

Anyway, the plan is to march through the rest of the B/S account titles one by one,

but the depth is gonna stay light, so for exam purposes you should be totally fine heh heh heh

Looks like next up is a quick tour of financial assets.

So — what is a financial instrument?

First off, financial instruments split into non-derivative and derivative,

and intermediate accounting only covers the non-derivative side (CFA Level 1 maps onto the intermediate accounting chunk),

while advanced accounting is where the derivative stuff lives (CFA Level 2’s FRA maps onto advanced accounting :-))

OK, so within non-derivatives,

you’ve got financial assets sitting on the Asset side, and financial liabilities sitting on the Liability side.

You know how this goes — when a company needs to raise cash,

it can either issue corporate bonds and pull in debt capital, or issue shares and pull in equity capital.

There’s clearly a side that issues, and a side that buys.

The side issuing the bonds is the side that borrowed money, so they recognize bonds payable as a Liability. (Under IFRS → it gets recognized as an AC financial liability or an FVPL financial liability.)

The side issuing shares has technically also borrowed money in some sense, so it goes on the credit side too, but it shows up under Equity, and the accounting treatment hits paid-in capital and additional paid-in capital.

(Accounting-cycle aside: since this is a transaction with shareholders, it doesn’t get explained on the I/S side — it goes straight into the equity section. I’ll do a separate post on that one later.)

But!!! What we’re looking at right now is NOT the financial liabilities side.

It’s the financial assets side!!!! Fin-as(sets), baby!!! heh heh heh heh

Please park fin-li(abilities) off to the side for juuuust a sec heh heh heh. Better for your mental health, trust me haha

(If I tried to cram financial assets and financial liabilities into the same post haha…… you might just…… give up entirely…………)

OK, so first thing — we need to think about telling debt instruments (bonds) apart from equity instruments (stocks)….

If you’re coming at this academically, or as a beginner, the rule you probably learned first was:

“If there’s a maturity date → Debt / If there’s no maturity date → Equity.”

Yeah heh heh heh heh — except there are also redeemable preferred shares that get classified as Debt despite having no maturity date, you know???? heh heh heh heh heh heh

(I’ll explain in a second.)

So what’s the right criterion for splitting Debt from Equity???

It might not be the textbook formulation,

but I think a decent way to put it is: “If you can’t dodge the obligation to pay → Debt / If you can → Equity.”

The redeemable preferred shares I just mentioned —

depending on which side holds the redemption right (whether it’s the Issuer or the Investor),

they can land in Debt OR in Equity heh heh heh

In English those rights get split into Call and Put….

In Korean both versions are just called 상환우선주 (redeemable preferred shares), so… (sigh)

(This has actually shown up on past exams :-))

OK so we know how to tell whether a financial asset is a debt instrument or an equity instrument.

UNDER US-GAAP

Whether it’s a financial asset (debt) or a financial asset (equity instrument), the treatment differs, but for now let’s say there are 3 buckets:

Held to Maturity / Trading Security / Available for Sale Security.

The classification is based on “Intent & Ability” — the company’s intent, plus whether it actually has the ability to follow through on that intent. And:

If the goal is Capital Gain and you’ve got the means → Trading Security.

If the goal is Interest (interest income) → Held to Maturity.

If neither fits → Available for Sale Security.

That’s how it goes, apparently.

If the financial asset is in Debt form (we call these investment bonds…),

Debt instruments classified as Trading Securities get measured and presented at Market Value on the financial statements.

Unrealized gains and losses also get explained on the I/S and flow through Net Income.

Debt instruments classified as Available for Sale Securities are also measured and presented at Market Value,

but unrealized gains and losses get routed through OCI and don’t hit Retained Earnings.

(The vibe is: “this bond is trading high right now so the unrealized gain is big, but we might end up holding this thing to maturity, so we’re NOT pushing it into Retained Earnings!!! Just because the bond looks juicy on paper, please do not, I repeat do NOT, demand dividends in that amount, dear investors!!!!” — that’s the spirit of it.)

In what we’ve covered so far, when did we run something through OCI? Right — the Gain on tangible assets under the Revaluation Model went through OCI, remember?!

But back then ONLY the Gain went through OCI; the Loss got dumped into Net Income. Whereas with investment bonds, BOTH the unrealized Gain AND the unrealized Loss go through OCI — that’s the difference!!!

Lastly, investment bonds classified as Held to Maturity Securities are measured and presented at Amortized Cost,

so it ends up working the same way as when we did bonds payable earlier.

That means the bond’s current market value has zero effect on the accounting treatment,

and instead you just discount the future cash flows from the bond and pull them back to present value!

(Because we’re literally just gonna hold it to maturity and that’s that!!!)

Everything above is about how the bond’s current market valuation gets reflected in the books,

and since these are bonds, Interest comes in at scheduled times → interest income,

and any Realized Gain & Loss from selling the thing midway → disposal gain/loss,

these of course don’t need OCI or anything fancy — they just naturally land in Net Income (profit or loss for the period)!!!!!!

Now let’s also look at the case of investment shares.

Obviously, with shares there’s no such thing as “Held to Maturity,” so there’s no way they end up in the Amortized Cost bucket,

and for the rest of the cases it’s identical to the bond version.

(About the Influence-via-Voting-Rights piece — what that’s getting at is: the investment shares we’re talking about right now are the case where you only bought a small chunk of shares.

In contrast, if Company A holds more than 50% of Company B’s shares, A can basically control B outright (dominate it). And if A grabs around 30% instead of 50%, A doesn’t fully control B but B is going to be hyper-aware of A. We call this situation “A exercising significant influence over B.”)

(In the situation where A controls B, when A puts together its financial statements, instead of just treating B’s shares as the investment shares we just described, A has to prepare consolidated financial statements……… And if A is exercising significant influence over B, then when A records B’s shares, A has to apply “equity method” accounting — not just slotting them in as investment shares but measuring and presenting them as subsidiary investment shares (people usually shorthand this as “sub-investment shares”)…. There’s that whole thing — but it lives in ‘advanced accounting’ territory. And since about 80% of CFA Level 2’s FRA is advanced accounting content, the message basically is: we’ll get to that at Level 2~ kind of thing heh heh heh heh)

Sigh… and that little reference blurb on derivatives down there………

If you enter into a derivative just because you went “Gold prices are about to RIP!!!!!!!!! Super Long@@@@@” and signed a gold futures or gold forward contract to profit off the move, THAT kind of derivative gets classified as a financial asset in this current section, gets marked to market at every reporting date and put on the financial statements. BUT — if instead a company goes “Hmm… we’re gonna need gold as a raw material a year from now, but gold prices look like they’re about to moon over the next year? (sigh) Let’s lock in a forward to buy gold a year out and hedge that risk!!” and enters into a gold forward contract, then the accounting treatment in that case…… requires understanding the logic behind equity-method accounting first, so…… we’re not doing it today~ that’s the deal here…heh.heh heh heh heh heh

(And whether that hedge is hedging value fluctuation or hedging the company’s cash flows…. the accounting treatment branches based on that too haha haha haha haha haha haha. Being an accountant is NOT a job for just anyone, I’m telling you haha haha haha haha haha haha haha haha haha haha)

Anyway!

Let’s wrap up financial assets under US-GAAP and slide into the next thing!!!

Now — how financial assets are accounted for under IFRS………………

is apparently content that wasn’t originally on Level 1 but got newly added…. heh heh. The detailed treatment lives in Level 2,

and on Level 1 it’s basically: just know the high-level concepts? just the terminology??? roughly that level.

So, under IFRS, the first cut is made through this thing called the SPPI test (SPPI; Solely Payment of Principal & Interest).

The point being: it’s NOT cleanly split into bonds vs. stocks…..

And once you’ve done that classification,

For the ones that landed on the bond side,

they get sorted into Amortized Cost Security (financial assets measured at amortized cost) / FVPL (financial assets at fair value through profit or loss) / FVOCI (financial assets at fair value through other comprehensive income) — and since these concepts map pretty cleanly onto US-GAAP’s Trading / Available for Sale / Held to Maturity,

let’s just tag this with “yeah, that exists” and keep moving heh heh heh

(For the CPA exam, this single section in an intermediate accounting course is more than 10 lectures long ^^ Honestly feels like winning the lottery to be skating past it at this level heh heh heh heh heh)

(If we say juuuust a tiny bit more — they said the very first step is testing whether the financial asset consists of just principal and interest, and when distinguishing the purpose of acquisition there’s a Business test happening in the diagram above — in Korean this gets phrased as evaluating the “business model.” Within that, you split into: “purpose is to sell” (→ FVPL) / “purpose is to collect cash flows” (→ FVOCI) / “both — selling and collecting cash flows” (→ AC financial assets) :-))

OK let’s wrap up the financial assets section~~~~~~~~~phew~~~~~

Next up: Accounts Receivable…. you know…..

Sigh… this one is also originally super~~~~~~~~~~long haha haha haha haha haha haha haha haha haha haha

Don’t worry though — for CFA exam purposes it’s actually super short heh heh heh

What you actually need to know about accounts receivable, set up like this:

The accounts receivable line representing “hey, we have money coming in~” from your company selling inventory on credit —

if the company that’s supposed to pay starts looking shaky, on your financial statements,

what was showing “we’re owed 1,000 won!” gets quietly marked down to “we’re owed 700 won!” via conservative accounting,

and the account title used for that is the “allowance for doubtful accounts”! That’s apparently the whole thing you need to know heh heh heh

Of course, with bonds we hold, when it’s “Oh!!! The bond issuer is looking like they can’t pay!!!!”, there’s also accounting treatment that marks down the bond’s carrying amount a bit. In that case we use the word “impairment” — the impairment loss flows through the I/S, and the account title showing the cumulative impairment on that bond on the B/S is called “loss allowance” —

and honestly, accounts receivable are basically bonds too, and the impairment treatment for them is in essence the same thing as bad debt,

but by accounting convention, impairment on accounts receivable gets called bad debt (Bad Debt), apparently.

(Bad debt expense flows through the I/S → what accumulates on the B/S is the allowance for doubtful accounts.)

(Bad debt expense is treated as an expense under selling and administrative expenses, sub-categorized on the I/S.)

There’s also a whole thing about how you actually compute that bad debt expense — estimating expected bad debts using expected credit loss (or recovery rate),

and the CPA exam covers it,

but looks like we don’t need to go that deep here.

Just this much: the bad-debt accounting treatment is a way of “doing the accounting in advance for losses on stuff that might end up as a loss~”

So that later, when the loss is actually confirmed, there’s nothing left to do at that point. Why? Because we already did it ahead of time ^.^

Knowing that much logic and moving on seems like enough heh heh heh

And also, for CFA exam purposes there are some odds-and-ends account titles like

Prepaid Expenses, plus this thing called a note (Note Payable) —

let’s just hear about those briefly and keep moving!

A note………….

What could a note be………

Aren’t you a little curious????

The stuff below this point includes some content that’s actively harmful to your mental health,

so let’s just learn enough about notes to stay at “general knowledge” level??? OK??? heh heh heh heh heh heh

Right, so — now please close the window!

Great work, everyone!!!!

What is a note?

A note is actually a sub-area of commercial law and gets fully explained in the “Bills and Checks Act” (어음수표법),

and I’ve heard this is a notoriously hard topic — to the point that there are people known as “bill-dropouts” (people who give up on the bills section).

But I’ve also heard it’s scheduled for a legal revision sometime in 2023 or 2024 heh heh heh

OK first, starting with checks —

there are lots of types of checks, but the form most of us know is the cashier’s check, right?

Bank-issued cashier’s checks, third-party-issued current account checks, third-party-issued household checks, remittance checks, traveler’s checks, etc…..

Anyway, a check can basically be called ‘money’,

whereas a note isn’t ‘money’ as such — it’s more like a legally recognized ‘promissory document.’

A note has the following written on it:

Maturity amount / Drawer (A) / Payee (rights holder) (B) / Issue date / Maturity date

— basically a piece of paper with a promise written on it that “the drawer will give the rights holder the maturity amount on the maturity date,”

and since the note represents the right to receive money, whoever holds it puts it on the asset side of their financial statements.

And that note —

if it came from selling inventory on credit and receiving the credit amount, it gets recorded as accounts receivable,

if it came from selling some non-inventory asset on credit, it gets recorded as other receivables,

and if you lent money out and got the note as proof of money to be received, it gets recorded as a loan receivable.

But I think the biggest defining feature of a note is the dishonor process.

First off, a note allows “endorsement to transfer the rights of the note,”

Endorser: B’s name and seal / Endorsee: C’s name and seal

If the rights are transferred this way, C can show up at A on the maturity date and go “give me my money!”

A goes “one moment please^^ let me just verify the endorsement is in order~” and then hands over the cash.

But — if A can’t pay? Then “A is in default (dishonor)!!!!!!!!” — and this is something that has to be publicly disclosed.

So a note is apparently a notch more powerful than plain accounts receivable.

Which means: even if inventory gets sold on credit and accounts receivable get recorded, whether those receivables are ’notes receivable’ or just ’trade receivables (credit sales)’ makes a real difference.

(With straight credit sales it’s not that there’s NO penalty for late payment, but stuff like having to publicly disclose a dishonor doesn’t apply.)

And to push this just a little further, C — who acquired the rights via endorsement — can also pass those rights on to someone else,

B → C → D → E → F, and it can keep getting endorsed all the way down to F,

and F just has to go collect from A at maturity, but if A defaults,

F can chase down anyone who endorsed before them and demand the money — this is called “recourse rights” (소구권), apparently.

Recourse rights mean: if any of the prior endorsers actually have assets, you can go through legal procedures to seize and dispose of those assets to collect, apparently.

If F invokes recourse rights against D, then D in turn invokes recourse rights against A, B, C, who came before D…. it works something like that….

For more detail you’d have to dig into commercial law!

But while back in the day notes were issued on paper, these days they’re mostly all electronic notes, apparently…. heh

So a legal revision is incoming to keep up with the times heh heh heh

OK so I started writing this just intending to cover notes at general-knowledge level,

but now that we’re here, aren’t you also a little curious about current accounts (당좌예금)?!?!?!? heh heh heh heh heh heh heh

Let me spin a quick yarn about current accounts too heh heh heh heh

Cash, in accounting terms, doesn’t just mean physical bills and coins — it also includes a category called “demand deposits,” which get treated as cash.

And demand deposits, in plain English, are “money the bank will pay you the moment you ask for it” —

so the regular bank savings account you have is one type of demand deposit,

and another type of demand deposit is precisely the current account (당좌예금).

You deposit cash or checks into the bank,

and withdrawals go out via the issuance of checks or notes —

and you might be wondering, why on earth would anyone need this?????

But back in the day, when you couldn’t just wire money over the internet, sending big sums was kind of awkward — so apparently they’d route it through a bank as middleman, cut a check, and hand it over that way.

To even open a current account in the first place, you have to put up a security deposit of around 3 to 5 million won,

and since this money comes back to you when you close the current account, it gets classified as a “non-current financial asset” (in practice they apparently use the account title “long-term financial assets.”)

Now, while running a current account, there can be moments where the balance briefly goes negative (−), and in that case a dishonor process would normally kick in…..

BUT — you can also contract with the bank so that, within a certain limit, the dishonor process doesn’t trigger even if the balance briefly dips negative. This kind of arrangement is called an overdraft agreement,

and the negative-balance amount itself is called overdraft (당좌차월).

Overdraft, on the B/S, gets classified as “short-term borrowings” heh heh heh

Originally written in Korean on my Naver blog (2021-09). Translated to English for gdpark.blog.