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hi – can you explain why amortized cost has the cashflow and business model tests for debt financial instruments that are assets. I’m trying to understand why these were created in the first place – presumably there’s some benefit to recording as amortized cost as oppose to the fair value alternatives?
It is trying to distinguish between the different classes of asset as we effectively have investment in debt, investments in equity and receivables (at an FR level anyway).
Investments in equity are investments in shares effectively, where we have no guaranteed annual cash receipt but there will be a fair value (especially if traded).
The investments in debt have guaranteed annual cash receipts (coupon interest) and most of the time might not have a fair value (think banks and mortgages and loans that they grant), so this is what amortised cost it trying to capture and to do so will need to have specific criteria. If there aren’t specific criteria then companies might try to include equity investments in this category that are performing poorly so as to keep the losses out of the profit or loss.
Just don’t worry too much about the reasoning too much at this level as it goes deeper than this plus won’t be asked in the exam. the key is to know what instruments are classified as which and how to account for them.
Thanks
Thanks for such a clear and comprehensive reply. This is really helpful. I’m just trying to understand as I’m finding this area tough – I can remember the treatment but have a sense that I don’t fully understand why I’m doing things in a particular way. However hopefully this will become clearer as my studies progress?
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