Tag: Business economics

Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset or liability. The principal market is the one with the greatest volume and level of activity for the asset or liability that can be accessed by the entity.

The most advantageous market is the one, which maximises the amount that would be received for the asset or paid to extinguish the liability after transport and transaction costs. Often these markets would be the same.

Sensibly an entity does not have to carry out an exhaustive search to identify either market but should take into account all available information. Although transaction costs are taken into account when identifying the most advantageous market, the fair value is calculated before adjustment for transaction costs because these costs are characteristics of the transaction and not the asset or liability. However, if location is a factor, then the market price is adjusted for the costs incurred to transport the asset to that market. Market participants must be independent of each other and knowledgeable, and able and willing to enter into transactions.

This is a complex process and so IFRS 13 sets out a valuation approach, which refers to a broad range of techniques, which can be used. There are three approaches based on the market, income and cost. When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use of unobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the fair value measurement process

Fair value measurements are categorised into a three-level hierarchy, based on the type of inputs to the valuation techniques used, as follows:

Level 1 inputs are unadjusted quoted prices in active markets for items identical to the asset or liability being measured. As with current IFRS standards, if there is a quoted price in an active market, an entity uses that price without adjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity needs to be able to access the market at the measurement date. Active markets are ones where transactions take place with sufficient frequency and volume for pricing information to be provided. An alternative method may be used where it is expedient. The standard sets out certain criteria where this may be applicable. For example where the price quoted in an active market does not represent fair value at the measurement date. An example of this may be where a significant event takes place after the close of the market such as a business reorganisation or combination.

The determination of whether a fair value measurement is based on level 2 or level 3 inputs depends on:

• Whether the inputs are observable inputs or unobservable
• Their significance.

Level 2 inputs are inputs other than the quoted prices in determined in level 1 that are directly or indirectly observable for that asset or liability. They are likely to be quoted assets or liabilities for similar items in active markets or supported by market data. For example, interest rates, credit spreads or yields curves. Adjustments may be needed to level 2 inputs and, if this adjustment is significant, then it may require the fair value to be classified as level 3.

Finally, level 3 inputs are unobservable inputs. These inputs should be used only when it is not possible to use Level 1 or 2 inputs. The entity should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. However, situations may occur where relevant inputs are not observable and therefore these inputs must be developed to reflect the assumptions that market participants would use when determining an appropriate price for the asset or liability. The general principle of using an exit price remains and IFRS 13 does not preclude an entity from using its own data. For example cash flow forecasts may be used to value an entity that is not listed. Each fair value measurement is categorised based on the lowest level input that is significant to it.

IFRS 13 also sets out certain valuation concepts to assist in the determination of fair value. For non-financial assets only, fair value is determined based on the highest and best use of the asset as determined by a market participant. Highest and best use is a valuation concept that considers how market participants would use a non-financial asset to maximise its benefit or value. The maximum value of a non-financial asset to market participants may come from its use in combination with other assets and liabilities or on a standalone basis. In determining the highest and best use of a non-financial asset, IFRS 13 indicates that all uses that are physically possible, legally permissible and financially feasible should be considered. As such, when assessing alternative uses, entities should consider the physical characteristics of the asset, any legal restrictions on its use and whether the value generated provides an adequate investment return for market participants.

The fair value measurement of a liability, or the entity’s own equity, assumes that it is transferred to a market participant at the measurement date. In many cases there is no observable market to provide pricing information and the highest and best use is not applicable. In this case, the fair value is based on the perspective of a market participant who holds the identical instrument as an asset. If there is no corresponding asset, then a corresponding valuation technique may be used. This would be the case with a decommissioning activity. The fair value of a liability reflects the non performance risk based on the entity’s own credit standing plus any compensation for risk and profit margin that a market participant might require to undertake the activity. Transaction price is not always the best indicator of fair value at recognition because entry and exit prices are conceptually different.

The guidance includes enhanced disclosure requirements that include:

• Information about the hierarchy level into which fair value measurements fall
• Transfers between levels 1 and 2
• Methods and inputs to the fair value measurements and changes in valuation techniques, and
• Additional disclosures for level 3 measurements that include a reconciliation of opening and closing balances, and quantitative information about unobservable inputs and assumptions used.

Fair value of liabilities and equity

IFRS 13 requires that the fair value of a liability or equity instrument of the entity be determined under the assumption that the instrument would be transferred on the measurement date, but would remain outstanding (i.e., it is a transfer value not an extinguishment or settlement cost.).  Accordingly, the fair value of a liability must take account of non-performance risk, including the entity’s own credit risk

Offsetting positions

The new Standard allows a limited exception to the basic fair value measurement principles for a reporting entity that holds a group of financial assets and financial liabilities with offsetting positions in particular market risks as defined in IFRS 7, Financial Instruments: Disclosures, or counterparty credit risk (also as defined in IFRS 7) and manages those holdings on the basis of the entity’s net exposure to either risk. The exception allows the reporting entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position.

Valuation techniques

When transactions are directly observable in a market, the determination of fair value can be relatively straightforward, but when they are not, a valuation technique is used. IFRS 13 describes three valuation techniques that an entity might use to determiner fair value, as follows:

• The market approaches. An entity uses “prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities”.
• The income approaches. An entity converts future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted) amount.
• The cost approach.

Premiums and discounts

IFRS 13 permits a premium or discount to be included in a fair value measurement only when it is consistent with the unit of account for the item. This means that premiums or discounts that reflect size as a characteristic of the entity’s holding (e.g. a blockage factor reducing the price which could be achieved on disposal of an entire large equity holding) rather than as a characteristic of the asset or liability (e.g. a control premium when measuring the fair value of a controlling interest) are not included.

Disclosures

IFRS 13 requires a number of quantitative and qualitative disclosures about fair value measurements. Many of these are related to the following three-level fair value hierarchy on the basis of the inputs to the valuation technique: Level 1 inputs are fully observable (e.g. unadjusted quoted prices in an active market for identical assets and liabilities that the entity can access at the measurement date); Level 2 inputs are those other than quoted prices within Level 1 that are directly or indirectly observable; and Level 3 inputs are unobservable.

A nonmonetary exchange is the transfer of assets and/or liabilities with another entity. The most common situation is when two organizations exchange assets, such as a real estate swap or the exchange of one fixed asset for another. The accounting for a nonmonetary exchange is based on the fair values of the assets transferred. This results in the following set of alternatives for determining the recorded cost of a nonmonetary asset acquired in an exchange, in declining order of preference:

• At the fair value of the asset received, if the fair value of this asset is more evident than the fair value of the asset transferred in exchange for it.
• At the fair value of the asset transferred in exchange for it. Record a gain or loss on the exchange.
• At the recorded amount of the surrendered asset, if no fair values are determinable or the transaction has no commercial substance.

Types of Non-Monetary transactions

The following are the types of non-monetary transactions.

• Non-reciprocal transfers with nonowners such as charitable donation of property by an entity, land contribution by state or local governments to a private enterprise for the purpose of setting up a structure.
• Non-reciprocal transfer to owners such as stock split, exchange of non-monetary assets for common stock.
• Non-monetary exchanges such as inventory exchange for a similar product or any productive asset. Or exchange of productive assets.

Accounting for an Exchange of Nonmonetary Assets

There can be any number of variations on the nonmonetary exchange concept, including ones where some cash is exchanged, along with other nonmonetary assets. If there is a significant amount of monetary consideration paid (known as boot), the entire transaction is considered to be a monetary transaction. In GAAP, a significant amount of boot is considered to be 25% of the fair value of an exchange. Conversely, if the amount of boot is less than 25%, the following accounting applies:

Payer. The party paying boot is not allowed to recognize a gain on the transaction.

Recipient. The receiver of the boot recognizes a gain to the extent that the monetary consideration is greater than a proportionate share of the carrying amount of the surrendered asset. This calculation is based on the percentage of monetary consideration received to either:

• The fair value of the nonmonetary asset received.
• Total consideration received
• Nonmonetary exchanges of inventory should be recognized at the carrying amount of the inventory transferred.

Exchanges with commercial substance

A business transaction is said to have commercial substance when it is expected that the future cash flows of a business will change as a result of the transaction. A change in cash flows is considered to be when there is a significant change in any one of the following:

• Such as a change in the timing of cash inflows received as the result of a transaction; for example, a business agrees to a delayed payment in exchange for a larger amount.
• Such as experiencing an increase in the risk that inbound cash flows will not occur as the result of a transaction; for example, a business accepts junior secured status on a debt in exchange for a larger repayment amount.
• Such as a change in the amount paid as the result of a transaction; for example, a business receives cash sooner in exchange for receiving a smaller amount.

A contract is said to have the commercial substance if because of that contract there is a change in timing of cash flow, there is an increment in the cash flow, there is a change in the risk, or more benefits occur due to contract.

For example, A Ltd entered into a contract with ABX and Co. who is a major supplier of raw material required by A Ltd. for production of goods for supplying materials to A ltd.at a cost lower than the cost at which A Ltd. was buying from other suppliers, and because of it, the cost of production is decreased as a result the benefits will also be transferred to the customers by decreasing the selling price which thereby results in the increase in revenue. In this whole scenario, since there is a change in cash flow, it is said to have existed in the contract.

The concept of commercial substance is also applied to exchanges of assets between businesses. When there is commercial substance (which is when there is a change in cash flow resulting from the transaction), the parties should recognize a gain or loss on the exchange. If there is no commercial substance, record the acquired asset at the book value of the asset given up in the exchange. There are additional issues related to the recognition of a gain or loss when a transaction has no commercial substance.

Exchanges without commercial substance

situations where there is no commercial substance include:

• The swapping of bandwidth capacity by different Internet and phone service providers. By doing so, both entities recognize revenue, when in fact no real revenue generation occurs that would result in a change in profits.
• Sale of assets to the owner of a sole proprietorship, who immediately leases it back to the business. There is little distinction between a proprietorship and its owner, so it is likely that no real change of ownership occurred.

The retirement of bonds refers to the repurchase of bonds from investors that had been previously issued. The issuer retires bonds at the scheduled maturity date of the instruments. Or, if the bonds are callable, the issuer has the option to repurchase the bonds earlier; this is another form of retirement. Once bonds are retired, the issuer eliminates the bonds payable liability on its books.

Retirement of securities refers to the cancellation of stocks or bonds because their issuer has bought them back, or (in the case of bonds) because their maturity date has been reached.

Many securities are routinely bought back by their issuing company such as preferred stocks and corporate bonds. In the case of stock, this reduces the number of shares outstanding. In the case of bonds, it means that the company is essentially paying the investors who bought loaned them money their principal back and getting rid of its debt obligations.

Bond Retirement before Maturity

In some circumstances, the corporation or company wishes to retire all or some of its bonds before the maturity date. This is also called the early retirement of bonds. The main reason for the early retirement is the decreasing of interest significantly in the market. Thus, the issuers wish to replace its high-interest paying bonds with the new low-interest paying bonds.

There are two common ways that the issuers can retire their bonds before the maturity date. These are through the exercise a call option or purchase them through the open market.

Purchase on the open market: In this way, the issuers can retire the bonds early by repurchasing them on the open market. When the issuers repurchase bonds on the open market, they need to pay the bonds at the current price or current market value of the bonds.

Through exercise a call option: In this way, the issuers will need to issue a callable bond that allows them to exercise their right in order to retire the bonds early. In these callable bonds, the issuers reserve the right to exercise the option before the maturity by paying the par value bonds plus a call premium to the bondholders.

Bond Retirement at Maturity

For the retirement at maturity, the corporation issued the bond will need to repay the bondholders the carrying value of the bond. In this case, the carrying value of the bond is always equal to the par value of the bonds regardless of the bond issued at par, at a premium, or a discount.

Therefore, at the maturity date, the principal or par value of the bond will need to remove from the liability account.

Bond Retirement by Conversion

This retirement can be done through conversion. This occurs when a corporation issues convertible bonds that allow the bondholders to convert the bonds into common stock equity.

When the conversion occurs, the carrying value of the bonds is transferred to the equity account and there is no gain or loss recorded in the income statement. For a detailed calculation of the convertible bond, you can read another article on the convertible bond.

The journal entry for this retirement is as follow:

Bonds payable is a liability account that contains the amount owed to bond holders by the issuer. This account typically appears within the long-term liabilities section of the balance sheet, since bonds typically mature in more than one year. If they mature within one year, then the line item instead appears within the current liabilities section of the balance sheet.

Bonds payable are recorded when a company issues bonds to generate cash. As a bond issuer, the company is a borrower. As such, the act of issuing the bond creates a liability. Thus, bonds payable appear on the liability side of the company’s balance sheet. Generally, bonds payable fall in the non-current class of liabilities.

Terms of bonds payable are contained within a bond indenture agreement, which states the face amount of the bonds, the interest rate to be paid to bond holders, special repayment terms, and any covenants imposed on the issuing entity.

The carrying value is found through the following formula:

Carrying Value = Bonds Payable + Unamortized Premium/Discount

An entity is more likely to incur a bonds payable obligation when long-term interest rates are low, so that it can lock in a low cost of funds for a prolonged period of time. Conversely, this form of financing is less commonly used when interest rates spike. Bonds are typically issued by larger corporations and governments.

Important Terms

Coupon: Coupon payments represent the periodic interest payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond’s face value. As we note from above, Nike’s bond pays interest semiannually; generally, one half of the annual coupon is paid to the bondholders every six months.

Par value: The amount of money that is paid to the bondholders at maturity. It generally represents the amount of money borrowed by the bond issuer.

Maturity: Maturity represents the date on which the bond matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date.

Coupon rate: The coupon rate, which is generally fixed, determines the periodic coupon or interest payments. It is expressed as a percentage of the bond’s face value. It also represents the interest cost of the bond to the issuer.

Convertible Bonds

A convertible bond is the same as the bond with warrants. The major difference between convertible bonds and warrants is that warrants can be separated into distinct securities but convertible bonds are not. Convertible bonds are the fixed income securities that would be converted into common stocks after a certain period of time. Therefore, the convertible bond gives the holder the right to exchange for its a given number of shares of common stock any time on or before the expiration date.

Convertible securities also give investors the right to exchange their bond or shares for common stock of the company. Each convertible security will give specifics on the number of shares you’ll receive upon conversion, as well as the expiration date by which the security must be converted. In some cases, conversion is mandatory, while other convertible securities leave the conversion decision at the discretion of the owner.

Warrants

Warrants are financial assets giving the holder the right but not obligation to buy shares of common stocks directly from the issuing authority at a fixed price for a given period of time. Each warrant specifies the number of shares of common stock a holder can purchase at the exercise price at the expiration date. Some features of warrants are the same as those of call options. From the viewpoint of the holders call options and warrants like the same. But still there exists a significant difference in contractual features of them. Say warrants have a long maturity period. Some warrants are the same as the perpetual having no expiration date at all. The basic difference between call options and warrants is that call options are issued by individuals and warrants are issued by the firms. When a warrant is exercised, a firm must issue new shares of stock. Each time a warrant is exercised, the number of shares outstanding increases. In case of a call, options are not necessary i.e., when a call option is exercised, there is no change in the number of shares outstanding. Warrants vs Convertible Bonds.

Warrants, on the other hand, typically don’t have any intrinsic value of their own. Unlike convertible securities, there’s no underlying bond or preferred shares that give the warrant owner any additional rights. The only value that the warrant has comes from its conversion feature.

Warrants resemble options in that they typically require investors to make an additional payment within a specified time frame in order to exercise the warrant and receive common stock in exchange. Warrants tend to have longer lifespans than ordinary options, with expiration dates as much as 10 years into the future being relatively common. Investors aren’t required to exercise warrants, but they’re worthless after they expire unexercised.

Both warrants and convertible securities have their place within the capital structure of a company. The investments have some things in common, but their differences also have maximum value to different sets of investors. Those who want maximum reward will prefer warrants, but those who want some protection from worst-case scenarios will gravitate toward convertible securities.

The major difference is that the equity option embedded in a convertible bond is not detachable from the convert, so that you have to value the bond and the embedded option together. If you want to make a direct comparison with a detachable warrant, you can think of the embedded option in a convertible bond as having a strike price equal to the value of the remaining cash flows of the convertible bond, so that the strike prices change over time as coupon payments are made, and changes with the level of both interest rates and the credit quality of the bond issuer.

Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress to reduce and renegotiate its delinquent debts to improve or restore liquidity so that it can continue its operations.

Replacement of old debt by new debt when not under financial distress is called “refinancing”. Out-of-court restructurings, also known as workouts, are increasingly becoming a global reality.

Debt restructuring involves a reduction of debt and an extension of payment terms and is usually less expensive than bankruptcy. The main costs associated with debt restructuring are the time and effort spent negotiating with bankers, creditors, vendors, and tax authorities.

Creditors of corporates are generally banks and non-banking financial companies (NBFCs). The corporate debt restructuring is done by lowering the amount of payable towards the debt. Also, the interest rate is lowered. However, the repayment tenure is enhanced, which would help the company in paying the outstanding dues.

At times, a part of the company’s debt would be waived off by the creditors. But, that would be in exchange for equities of the company. Nevertheless, this kind of arrangement is more favourable for the distressed company as compared to declaring themselves to be bankrupt and undergo tedious procedures.

Methods

Debt-for-equity swap

In a debt-for-equity swap, a company’s creditors generally agree to cancel some or all of the debt in exchange for equity in the company.

Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors. This is because both the debt and the remaining assets in these companies are so large that there is no advantage for the creditors to drive the company into bankruptcy. Instead, the creditors prefer to take control of the business as a going concern. As a consequence, the original shareholders’ stake in the company is generally significantly diluted in these deals and may be entirely eliminated.

Bondholder haircuts

A debt-for-equity swap may also be called a “bondholder haircut”. Bondholder haircuts at large banks were advocated as a potential solution for the subprime mortgage crisis by prominent economists:

Economist Joseph Stiglitz testified that bank bailouts “are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this”. He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.

Economist Jeffrey Sachs has also argued in favor of such haircuts: “The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices.”

If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short term to buttress confidence in the recapitalized institution. For example, Wells Fargo owed its bondholders $267 billion, according to its 2008 annual report. A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.

Informal Debt Repayment Agreements

Companies that are restructuring debt can ask for lenient repayment terms and even ask to be allowed to write off some portions of their debt. This can be done by reaching out to the creditors directly and negotiating new terms of repayment. This is a more affordable method than involving a third-party mediator and can be achieved if both parties involved are keen to reach a feasible agreement.

Debt Restructuring vs. Debt Refinancing

Debt restructuring is distinct from debt refinancing. The former requires debt reduction and an extension to the repayment plan. On the other hand, debt refinancing is merely the replacement of an old debt with a newer debt, usually with slightly different terms, such as a lower interest rate.

Debt Restructuring vs. Bankruptcy

Debt restructuring usually involves direct negotiations between a company and its creditors. The restructuring can be initiated by the company or, in some cases, be enforced by its creditors.

On the other hand, bankruptcy is essentially a process through which a company that is facing financial difficulty is able to defer payments to creditors through a legally enforced pause. After declaring bankruptcy, the company in question will work with its creditors and the court to come up with a repayment plan.

In case the company is not able to honor the terms of the repayment plan, it must liquidate itself in order to repay its creditors. The repayment terms are then decided by the court.

The fair value option is the alternative for a business to record its financial instruments at their fair values. GAAP allows this treatment for the following items:

• A financial asset or financial liability
• A firm commitment that only involves financial instruments
• A loan commitment
• An insurance contract where the insurer can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
• A warranty in which the warrantor can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)

The fair value option cannot be applied to the following items:

• An investment in a subsidiary or variable interest entity that will be consolidated.
• Deposit liabilities of depository institutions.
• Financial assets or financial leases recognized under lease arrangements.
• Financial instruments classified as an element of shareholders’ equity.
• Obligations or assets related to pension plans, post-employment benefits, stock option plans, and other types of deferred compensation.

When you elect to measure an item at its fair value, do so on an instrument-by-instrument basis. Once you elect to follow the fair value option for an instrument, the change in reporting is irrevocable. The fair value election can be made on either of the following dates:

• The election date, which can be when an item is first recognized, when there is a firm commitment, when qualification for specialized accounting treatment ceases, or there is a change in the accounting treatment for an investment in another entity.
• In accordance with a company policy for certain types of eligible items.
• It is acceptable not to apply the fair value option to eligible items when reporting the results of a subsidiary of consolidated variable interest entity, but to apply the fair value option to these items when reporting consolidated financial statements.
• It is much easier to apply the fair value option for both subsidiary-level and consolidated financial results, so do not attempt separate treatment, even though it is allowed by GAAP.
• In most cases, it is acceptable to choose the fair value option for an eligible item, while not electing to use it for other items that are essentially identical.
• If you take the fair value option, report unrealized gains and losses on the elected items at each subsequent reporting date.

Fair value is a term with several meanings in the financial world. In investing, it refers to an asset’s sale price agreed upon by a willing buyer and seller, assuming both parties are knowledgeable and enter the transaction freely. For example, securities have a fair value that’s determined by a market where they are traded. In accounting, fair value represents the estimated worth of various assets and liabilities that must be listed on a company’s books.

Fair Value and Financial Statements

The International Accounting Standards Board defines fair value as the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on a certain date, typically for use on financial statements over time. The fair value of all a company’s assets and liabilities must be listed on the books in a mark-to-market valuation. The original cost is used to value assets in most cases.

In some cases, it may be difficult to determine a fair value for an asset if there is not an active market for it. This is often an issue when accountants perform a company valuation. Say, for example, an accountant cannot determine a fair value for an unusual piece of equipment. The accountant may use the discounted cash flows generated by the asset to determine a fair value. In this case, the accountant uses the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life. The value of the discounted cash flows is the fair value of the asset.

Consequently, the Board considered amending IAS 39 so that the fair value option could be applied only in specified circumstances. The specified circumstances would be those that the Board had in mind when it developed the option, i.e. for a financial asset or financial liability that is reliably measurable and meets one of the following:

• The item is a financial asset or financial liability that contains one or more embedded derivatives as described in paragraph 10 of IAS 39
• The item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value
• The exposure to a change in the fair value of the financial asset or financial liability is substantially offset by the exposure to the change in the fair value of another financial asset or financial liability, including a derivative.

An involuntary conversion occurs when your property is destroyed, stolen, condemned, or disposed of under the threat of condemnation and you receive other property or money in payment, such as insurance or a condemnation award. Involuntary conversions are also called involuntary exchanges.

Reporting Gain or Loss

Gain or loss from an involuntary conversion of your property is usually recognized for tax purposes unless the property is your main home. You report the gain or deduct the loss on your tax return for the year you realize it.

Involuntary conversion generally refers to a forced payment for property when that property is damaged or stolen. It is a common insurance term. Involuntary conversions typically also have taxation implications.

An involuntary conversion occurs when an owner loses their property unexpectedly but with certain provisions in place to cover their losses.2 An involuntary conversion is the opposite of a voluntary conversion. A voluntary conversion occurs when an owner sells, gifts, or generally exchanges their property under agreed upon terms usually with an agreed upon monetary value.

Involuntary conversions can occur when any type of individual or business property is damaged or stolen.

Property owners can take steps to mitigate the risk of involuntary losses through insurance policies. Any compensation an owner receives in exchange for property lost is associated with the “conversion” part of an involuntary conversion. Conversions may include cash payments from insurance policies and potentially accounting for replacement property. Without an insurance policy or other conversion agreement in place, involuntary damages or theft would simply result in a loss.

Insurance Policies

Property and casualty (P&C) insurance companies are typically the primary entities an owner can turn to for insurance policies that provide monetary compensation for involuntary losses. Property and casualty insurance companies can specialize in the areas of; auto, boat, home, and real estate. Individuals and business owners can pay a monthly premium to P&C companies for different types of policies that provide different amounts of monetary compensation in the event of an involuntary loss.

An intangible asset is an asset that lacks physical substance. Examples are patents, copyright, franchises, goodwill, trademarks, and trade names, as well as software. This is in contrast to physical assets (machinery, buildings, etc.) and financial assets (government securities, etc.). An intangible asset is usually very difficult to evaluate. They suffer from typical market failures of non-rivalry and non-excludability.

Intangibles can be acquired:

• By separate purchase
• As part of a business combination
• By a government grant
• By exchange of assets
• By self-creation (internal generation)

Financial accounting

General standards

The International Accounting Standards Board (IASB) offers some guidance (IAS 38) as to how intangible assets should be accounted for in financial statements. In general, legal intangibles that are developed internally are not recognized and legal intangibles that are purchased from third parties are recognized. Wordings are similar to IAS 9.

Under US GAAP, intangible assets are classified into: Purchased vs. internally created intangibles, and Limited-life vs. indefinite-life intangibles.

Expense allocation

Intangible assets are typically expensed according to their respective life expectancy. Intangible assets have either an identifiable or an indefinite useful life. Intangible assets with identifiable useful lives are amortized on a straight-line basis over their economic or legal life, whichever is shorter. Examples of intangible assets with identifiable useful lives are copyrights and patents. Intangible assets with indefinite useful lives are reassessed each year for impairment. If an impairment has occurred, then a loss must be recognized. An impairment loss is determined by subtracting the asset’s fair value from the asset’s book/carrying value. Trademarks and goodwill are examples of intangible assets with indefinite useful lives. Goodwill has to be tested for impairment rather than amortized. If impaired, goodwill is reduced and loss is recognized in the Income statement.

Intangible asset: an identifiable non-monetary asset without physical substance. An asset is a resource that is controlled by the entity as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected. Thus, the three critical attributes of an intangible asset are:

Identifiability control (power to obtain benefits from the asset) future economic benefits (such as revenues or reduced future costs)

Identifiability: an intangible asset is identifiable when it:

• Is separable (capable of being separated and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract).
• Arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

Recognition

Recognition criteria. IAS 38 requires an entity to recognise an intangible asset, whether purchased or self-created (at cost) if, and only if:

• It is probable that the future economic benefits that are attributable to the asset will flow to the entity.
• The cost of the asset can be measured reliably.

Types

Businesses have many different types of intangible assets. Many of these can be unique to a specific business, making it very hard to compile a comprehensive list of intangible assets. However, some of the more common types include:

• Patents, copyrights and licenses
• Customer lists and relationships
• Non-compete agreements
• Favorable financing
• Software
• Trained and assembled workforces
• Contracts
• Leasehold interests
• Unpatented proprietary technology
• Trademarks/Trade names

Research and Development

Research is a planned and detailed investigation into a product or service for gaining scientific or technical know-how. Development is the application of such researches to develop new and better products and service than the current portfolio a company has.

R&D is a part of internally generated intangible assets of a company. Companies spend millions of dollars on R&D and hence, it is a valuable intangible asset capable of taking a company to new heights.

Franchise Agreements

Franchise agreements are another type of intangible asset that grants the legal right to a business to operate using the name of another company or sell a product or service developed by another company. These are classified as assets because the business owners reap monetary gains with the help of these intangible assets.

For example, many fast food restaurants like KFC, McDonald’s, Subway, Dominos, etc. operate using a franchise system. Here the franchisor grants varying amount of autonomy to the franchisees to use the brand name and benefit from franchisor’s extensive marketing.

Licenses

A licensor can permit a licensee to use a trademark, patent, or copyright through a license in exchange for a fee or a charge. Such licenses usually have fixed time validity, and may even set geographical validity or restrictions. Intellectual property licensing, such as transfer of technology, franchising, and publication rights, are very important in present-day business. Violation of the license terms by the licensee or a third-party is also a punishable offense under the law.

Trademarks

A trademark is an intangible asset which legally prevents others from using a business’s name, logo or other branding items. It is a design, symbol or a logo used in connection with a particular product or a business.

Copyrights

Copyright grants an extensive right to the business to reproduce and sell a software, book, journal, magazine, etc. It is an intangible asset used to secure legal protection by preventing others from reproducing or publishing a work of authorship.

Patents

A patent is a type of intangible asset that grants a business the exclusive right to manufacture, sell or use a specific invention. A company can purchase the patent from another company or it can invent a new product and receive a patent for it.

Capitalized interest is the cost of the funds used to finance the construction of a long-term asset that an entity constructs for itself. The capitalization of interest is required under the accrual basis of accounting, and results in an increase in the total amount of fixed assets appearing on the balance sheet. An example of such a situation is when an organization builds its own corporate headquarters, using a construction loan to do so.

Capitalized interest is the cost of borrowing to acquire or construct a long-term asset. Unlike an interest expense incurred for any other purpose, capitalized interest is not expensed immediately on the income statement of a company’s financial statements. Instead, firms capitalize it, meaning the interest paid increases the cost basis of the related long-term asset on the balance sheet. Capitalized interest shows up in installments on a company’s income statement through periodic depreciation expense recorded on the associated long-term asset over its useful life.

Capitalization is the addition of unpaid interest to the principal balance of your loan. The principal balance of a loan increases when payments are postponed during periods of deferment or forbearance and unpaid interest is capitalized. As a result, more interest may accrue over the life of the loan, the monthly payment amount may be higher, or more payments may be required.

Accounting for Capitalized Interest

This interest is added to the cost of the long-term asset, so that the interest is not recognized in the current period as interest expense. Instead, it is now a fixed asset, and is included in the depreciation of the long-term asset. Thus, it initially appears in the balance sheet, and is charged to expense over the useful life of the asset; the expenditure therefore appears on the income statement as depreciation expense, rather than interest expense.

Which Borrowing Costs to Capitalize

Generally, borrowing costs attributable to a fixed asset are those that would otherwise have been avoided if the asset had not been acquired. There are two ways to determine the borrowing cost to include in an asset:

• Directly attributable borrowing costs. If borrowings were specifically incurred to obtain the asset, then the borrowing cost to capitalize is the actual borrowing cost incurred, minus any investment income earned from the interim investment of those borrowings.
• Borrowing costs from a general fund. Borrowings may be handled centrally for general corporate needs, and may be obtained through a variety of debt instruments. In this case, derive an interest rate from the weighted average of the entity’s borrowing costs during the period applicable to the asset. The amount of allowable borrowing costs using this method are capped at the entity’s total borrowing costs during the applicable period.

When to Capitalize Interest

The record keeping for the recordation of capitalized interest can be complicated, so it is generally recommended that the use of interest capitalization be confined to situations where there is a significant amount of related interest expense. Also, interest capitalization defers the recognition of interest expense, and so can make the results of a business look better than is indicated by its cash flows.

When to Stop Capitalizing Interest

Capitalization of borrowing costs terminates when an entity has substantially completed all activities needed to prepare the asset for its intended use. Substantial completion is assumed to have occurred when physical construction is complete; work on minor modifications will not extend the capitalization period. If the entity is constructing multiple parts of a project and it can use some parts while construction continues on other parts, then it should stop capitalization of borrowing costs on those parts that it completes.

How Much It Will interest Cost

The cost of a loan, ignoring any one-time fees, is the interest you pay. In other words, you repay what they gave you, plus a little extra. Total cost is driven by:

• The amount you borrow: The higher your loan balance, the more interest you’ll pay
• The interest rate: The higher the rate, the more expensive it is to borrow
• The amount of time you take to repay the loan: If you take longer to pay, there’s more time for your lender to charge interest.

Reasons for Interest on Drawn

Drawings are opposite to capital invested i.e. these are the funds drawn by partners from the business. Therefore, in order to keep the distribution of profit fair, a clause may be inserted in the agreement, where an interest is charged on the drawings of the partners. Again, this can be on the total amount or on an amount exceeding a specific limit. Both of the above things depend upon the agreement between partners.

Accounting Treatment

One may think that as Interest on Capital is paid to the partners, so it should be treated as business expense and Interest on Drawings is charged from the partners, therefore, it should be treated as income. But this is not the case. Just like partners salaries, both these items will be included in the Profit and Loss Appropriation Account. Partners’ salaries, interests etc. are never treated as expense or income of the business. They are a part of DISTRIBUTION OF PROFIT.