Example 1: Intercorporate Investments / Errata recognized, anywhere, interest, solution, amount

Colum

Did the errata wrong a right?
In Example 1 solution: The CFA Errata says that interest income should be 13,500 and not 16500. I get that for Held-to-maturity.
However, why the same for all other cases. The CFA text, when discussing other classification, does not say anywhere that the interest recognized is after amortization and the amortized amount should be added to unrealized gain.
Specifically: at the end of 2008 for Held for trading, AFS, or DAVF cases why would the unrealized gain not be 350,000-300,000 = 50,000? Why does the 3,000 amortization has to be added into the unrealized gain. The text says nothing about this.
Can anyone explain?
Thanks
Vik

Colum

CP, thanks, and I see what your saying - I can follow the procedure, separating out the income that is due to interest (or effective interest) and that due to the difference (in fair value cases) between fair and carrying (amortized) values - I see that the net income (for Held for Trading) is the same anyway, because what’s “given up” in the interest allocation (in the case of premium bonds) is compensated for by a correspondingly greater income from the capital gain (because the carrying value is reduced, and the gap widened between it and market value).
Still, this approach isn’t intuitive for trading assets. It seems simpler to call the coupon “interest” and the let the market adjustments to the bond itself against what you actually paid for it be designated a capital gain/loss, also reported as income, however.
The complex amortization approach seems only to make sense for an asset held for a determined length of time, as in till maturity - since any premium or discount can be run down towards that definite date.
You’re probably right, and so therefore is the correction, but that still leaves a mistake (?) in Schweser where the coupon is specifically identified as the interest payment (for Held for Trading adn AFS).

needhelp1700

this erratum in CFAI is also comparatively late breaking, considering they have gone thro’ possibly 2 iterations, with the material being presented on that example the same way.

Carson

Also, sticking with Held for Trading, if the carrying value resets to fair value, which it must, how is the effective interest rate method and the amortization applied going forward?
Sticking with the CFA example. At the end of year one interest is ￡13,500 (4.5% of ￡300k initially paid) - the additional ￡3k received from the coupon amortizes the carrying value to ￡297k. Income (in addition to interest) comes from the capital gain as the bond at the end of the year has a market value of ￡350k, which is ￡53 higher than the carrying value.
So far so good. What happens now? Under Held to Maturity the effective rate (4.5%) would be applied in the following year to the outstanding carrying value, and excess coupon would be used to further amortize that carrying value going forward. However, because the value of the bond has been refreshed the situation is quite different. The carrying value is not ￡297k, it is ￡350k (because we are dealing with a Trading asset updated to fair value). So, are we supposed to apply 4.5% to ￡350k to work out the interest? This clearly won’t work - first, because we’re not approaching a value (so we’re not actually amortizing); and second, because the effective market rate has probably changed along with the bond value, so 4.5% is historical and irrelevant now. Perhaps we’re supposed to continue amortizing an underlying carrying value, and book income from the annual amortizations plus the gain in fair value? This seems messy, and the carrying value ceases to have a consistent meaning.
I really don’t see how this works…

franzino

Isn’t the problem with this that you recognize an unrealized gain in Year 1 (the difference between ￡350k fair value and ￡297k carrying value) and then in Year 2 you recognize another gain (against the continuously and consistently amortized carrying value), even though the fair value has dropped to ￡325k?
Shouldn’t the fact that you recognized growth on an asset which has since declined mean you should recognize a loss or reverse out the excess historical profit? This would be possible with Other Comprehensive Income, because that’s a cumulative account, I believe. However, straightforward income finds its way to retained earnings and can’t be reversed out - only lost.
If capital gains are measured only against carrying values, and carrying values are amortized as if held to maturity (even on trading assets), then the whole fair value thing becomes a bit of a nonesense, doesn’t it? What am I missing?

Wasteoftime

when the security is actually sold - the true value shows up….
and thats when the unrealized really becomes the realized.
Unrealized gets unwound from Retained earnings / Other Comprehensive Income.
Gets actually realized in the Earnings and then moves to the retained earnings.
At the end of the day - it is all good.
in the HTM thing - the amortized cost goes on the Balance sheet, unrealized never shows up, shows up as realized (of course with other sanctions when security is sold)…
in HFT, AFS - there is a unrealized component on the Income statement / BS (OCI) as well as on the Balance Sheet (Fair Value of the Investment Security). The Balance Sheet Investment security would be sold - on the actual sale of the asset.
unrealized gets unwound from the OCI
realized values gets on the income statement.

xilinx_altera

I know OCI can be unwound. I’ve never heard of retained earnings being unwound (except through losses). And it just seems wrong to keep re-earning (even temporarily) the difference between the underlying amortized value and the fair value - surely it’s too distorting to be true.
Say I buy a bond with no premium or discount and I classify it as HFT. Because there’s no premium or discount there’s nothing to amortize, so my carrying value remains at par for as long as I keep it (as long as its going). Under interest income I straightforwardly enter the coupon (also the effective rate). All good so far. However, CP, you’re suggesting that if at the end of Year 1 my bond purchased ￡1m has a fair value of ￡1.2m, I should enter the gain of ￡200k as additional income (along with the coupon). This is fine too. But come the end of Year 2 with no movement in fair value and no movement in carrying value I’m supposed to enter another gain of ￡200k (as well as the coupon again)
This can’t be right, can it? Assuming my company consists of nothing but this single bond, and the situation persists for 10 years, at the end of year ten I have net assets of ￡3.2m plus the accumulated coupon (i.e. the fair value of the bond + the retained growth + the retained interest)!
I think it’s absurd if the growth is annually re-measured against the amortized carrying value (because it’s multiple accounting). Alternatively it’s odd to amortize the underlying carrying value for the sake of calculating interest whilst using fair value as the carrying value for calculating growth. I think the pre-correction CFAI and Schweser positions are more intuitive, with traded assets reporting total return (realized or not) to income - and that would consist of the coupon plus the capital growth.
I appreciate your explanations, CP - I’m just not convinced about this!

LPoulin133

retained earnings may not be unwound per se. however if you sold stuff at a loss, that would be reflected in your net income (for the hft security) and move to the retained earnings - thus unwinding itself.

Fdez

Apart from that making the most transparent category (HFT) incredibly opaque, isn’t the problem that you wouldn’t necessarily be selling at a loss - and so there would never be any unwinding of previous false and accumulated gains?
To continue my example, let’s say at the end of year 10 the company sells the bond at fair value for ￡1.2m. The initial purhase price, also the carrying value, is ￡1m, so the company books a realized profit that year of ￡200k. That profit joins the ten years of coupons and the ￡2m of ten annually repeated unrealized “growth” gains of ￡200k. Nowhere does a balancing loss register, because unrealized and realized gains accumulate indifferently for HFT assets - the only way to prevent this would be to adjust the carrying value to reflect the fair value. But this brings us back to the original problem, which is what to do with the amortized value, if indeed we are required to amortize for HFT…

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