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Financial Instruments
IAS 39 and IAS 32 Financial assets and liabilities
Scope exclusions
IAS 39 applies to all types of financial instruments except for the following,
which are scoped out of IAS 39:
*interests in subsidiaries, associates, and joint ventures accounted for
under IAS 27, IAS 28, or IAS 31; however IAS 39 applies in cases
where under IAS 27, IAS 28 or IAS 31 such interests are to be
accounted for under IAS 39. The standard also applies to derivatives
on an interest in a subsidiary, associate, or joint venture
*employers’ rights and obligations under employee benefit plans to
which IAS 19 applies
*contracts in a business combination to buy or sell an acquire at a
future date
*rights and obligations under insurance contracts, except IAS 39 does
apply to financial instruments that take the form of an insurance (or
reinsurance) contract but that principally involve the transfer of
financial risks and derivatives embedded in insurance contracts
*financial instruments that meet the definition of own equity under IAS
32
*financial instruments, contracts and obligations under share-based
payment transactions to which IFRS 2 applies
*rights to reimbursement payments to which IAS 37 applies
Definitions
Financial instrument: a contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument of another entity.
Financial asset: any asset that is:
*cash;
*an equity instrument of another entity;
*a contractual right:
* to receive cash or another financial asset from another entity
or
* to exchange financial assets or financial liabilities with another
entity under conditions that are potentially favourable to the
entity or
*a contract that will or may be settled in the entity’s own equity
instruments and is:
o a non-derivative for which the entity is or may be obliged to
receive a variable number of the entity’s own equity
instruments or
* a derivative that will or may be settled other than by the
exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments. For
this purpose the entity’s own equity instruments do not include
instruments that are themselves contracts for the future receipt
or delivery of the entity’s own equity instruments; they also do
not include puttable financial instruments
Financial liability: any liability that is:
*a contractual obligation:
* to deliver cash or another financial asset to another entity; or
* to exchange financial assets or financial liabilities with another
entity under conditions that are potentially unfavourable to the
entity; or
* a contract that will or may be settled in the entity’s own equity
instruments and is:
* a non-derivative for which the entity is or may be obliged to
deliver a variable number of the entity’s own equity
instruments or
* a derivative that will or may be settled other than by the
exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments. For
this purpose the entity’s own equity instruments do not
include: instruments that are themselves contracts for the
future receipt or delivery of the entity’s own equity instruments
or puttable instruments
Common Examples of Financial Instruments Within the
Scope of IAS 39
*cash
*demand and time deposits
*commercial paper
*accounts, notes, and loans receivable and payable
*debt and equity securities. These are financial instruments
from the perspectives of both the holder and the issuer.
This category includes investments in subsidiaries,
associates, and joint ventures
*asset backed securities such as collateralised mortgage
obligations, repurchase agreements, and securitised
packages of receivables
*derivatives, including options, rights, warrants, futures
contracts, forward contracts, and swaps.
A derivative is a financial instrument:
*Whose value changes in response to the change in an underlying
variable such as an interest rate, commodity or security price, or
index;
*That requires no initial investment, or one that is smaller than would
be required for a contract with similar response to changes in market
factors; and
*That is settled at a future date.
Examples of Derivatives
Forwards: Contracts to purchase or sell a specific quantity of a
financial instrument, a commodity, or a foreign currency at a
specified price determined at the outset, with delivery or
settlement at a specified future date. Settlement is at maturity by
actual delivery of the item specified in the contract, or by a net
cash settlement.
Interest Rate Swaps and Forward Rate Agreements: Contracts
to exchange cash flows as of a specified date or a series of
specified dates based on a notional amount and fixed and floating
rates.
Futures: Contracts similar to forwards but with the following
differences: futures are generic exchange-traded, whereas
forwards are individually tailored. Futures are generally settled
through an offsetting (reversing) trade, whereas forwards are
generally settled by delivery of the underlying item or cash
settlement.
Options: Contracts that give the purchaser the right, but not the
obligation, to buy (call option) or sell (put option) a specified
quantity of a particular financial instrument, commodity, or foreign
currency, at a specified price (strike price), during or at a specified
period of time. These can be individually written or exchangetraded.
The purchaser of the option pays the seller (writer) of the
option a fee (premium) to compensate the seller for the risk of
International Financial Reporting Standards Workbook
Revision 0.1 Magenta Financial Training March 2011 Page 161
payments under the option.
Caps and Floors: These are contracts sometimes referred to as
interest rate options. An interest rate cap will compensate the
purchaser of the cap if interest rates rise above a predetermined
rate (strike rate) while an interest rate floor will compensate the
purchaser if rates fall below a predetermined rate.
Embedded Derivatives
Some contracts that themselves are not financial instruments may
nonetheless have financial instruments embedded in them. For example, a
contract to purchase a commodity at a fixed price for delivery at a future
date has embedded in it a derivative that is indexed to the price of the
commodity.
An embedded derivative is a feature within a contract, such that the cash
flows associated with that feature behave in a similar fashion to a standalone
derivative. In the same way that derivatives must be accounted for at
fair value on the balance sheet with changes recognised in the income
statement, so must some embedded derivatives. IAS 39 requires that an
embedded derivative be separated from its host contract and accounted for
as a derivative when:
*the economic risks and characteristics of the embedded derivative
are not closely related to those of the host contract
*a separate instrument with the same terms as the embedded
derivative would meet the definition of a derivative, and
*the entire instrument is not measured at fair value with changes in
fair value recognised in the income statement
If an embedded derivative is separated, the host contract is accounted for
under the appropriate standard (for instance, under IAS 39 if the host is a
financial instrument). Appendix A to IAS 39 provides examples of embedded
derivatives that are closely related to their hosts, and of those that are not.
Examples of embedded derivatives that are not closely related to their hosts
(and therefore must be separately accounted for) include:
*the equity conversion option in debt convertible to ordinary shares
(from the perspective of the holder only) [IAS 39.AG30(f)]
*commodity indexed interest or principal payments in host debt
contracts[IAS 39.AG30(e)]
*cap and floor options in host debt contracts that are in-the-money
when the instrument was issued [IAS 39.AG33(b)]
*leveraged inflation adjustments to lease payments [IAS 39.AG33(f)]
*currency derivatives in purchase or sale contracts for non-financial
items where the foreign currency is not that of either counterparty to
the contract, is not the currency in which the related good or service
is routinely denominated in commercial transactions around the
world, and is not the currency that is commonly used in such
contracts in the economic environment in which the transaction takes
place. [IAS 39.AG33(d)]
If IAS 39 requires that an embedded derivative be separated from its host
contract, but the entity is unable to measure the embedded derivative
separately, the entire combined contract must be designated as a financial
asset as at fair value through profit or loss).
Classification of Financial Assets
IAS 39 requires financial assets to be classified in one of the following
categories:
*Financial assets at fair value through profit or loss
*Available-for-sale financial assets
*Loans and receivables
*Held-to-maturity investments
Those categories are used to determine how a particular financial asset is
recognised and measured in the financial statements.
Financial assets at fair value through profit or loss. This category has
two subcategories:
Designated. The first includes any financial asset that is designated on
initial recognition as one to be measured at fair value with fair value
changes in profit or loss.
Held for trading. The second category includes financial assets that are
held for trading. All derivatives (except those designated hedging
instruments) and financial assets acquired or held for the purpose of selling
in the short term or for which there is a recent pattern of short-term profit
taking are held for trading.
Available-for-sale financial assets (AFS) are any non-derivative financial
assets designated on initial recognition as available for sale or any other
instruments that are not classified as as (a) loans and receivables, (b) heldto-
maturity investments or (c) financial assets at fair valoue through profit or
loss. [IAS 39.9] AFS assets are measured at fair value in the balance sheet.
Fair value changes on AFS assets are recognised directly in equity, through
the statement of changes in equity, except for interest on AFS assets (which
is recognised in income on an effective yield basis), impairment losses and
(for interest-bearing AFS debt instruments) foreign exchange gains or
losses. The cumulative gain or loss that was recognised in equity is
recognised in profit or loss when an available-for-sale financial asset is
derecognised.
Loans and receivables are non-derivative financial assets with fixed or
determinable payments that are not quoted in an active market, other than
held for trading or designated on initial recognition as assets at fair value
through profit or loss or as available-for-sale. Loans and receivables for
which the holder may not recover substantially all of its initial investment,
other than because of credit deterioration, should be classified as availablefor-
sale. Loans and receivables are measured at amortised cost.
Held-to-maturity investments are non-derivative financial assets with fixed
or determinable payments that an entity intends and is able to hold to
maturity and that do not meet the definition of loans and receivables and are
not designated on initial recognition as assets at fair value through profit or
loss or as available for sale. Held-to-maturity investments are measured at
amortised cost. If an entity sells a held-to-maturity investment other than in
insignificant amounts or as a consequence of a non-recurring, isolated
event beyond its control that could not be reasonably anticipated, all of its
other held-to-maturity investments must be reclassified as available-for-sale
for the current and next two financial reporting years. Held-to-maturity
investments are measured at amortised cost.
Classification of Financial Liabilities
IAS 39 recognises two classes of financial liabilities:
*Financial liabilities at fair value through profit or loss
*Other financial liabilities measured at amortised cost using the
effective interest method
The category of financial liability at fair value through profit or loss has two
subcategories:
*Designated. a financial liability that is designated by the entity as a
liability at fair value through profit or loss upon initial recognition
*Held for trading. a financial liability classified as held for trading,
such as an obligation for securities borrowed in a short sale, which
have to be returned in the future
Initial Recognition
IAS 39 requires recognition of a financial asset or a financial liability when,
and only when, the entity becomes a party to the contractual provisions of
the instrument, subject to the following provisions in respect of regular way
purchases.
Regular way purchases or sales of a financial asset. A regular way
purchase or sale of financial assets is recognised and derecognised using
either trade date or settlement date accounting. The method used is to be
applied consistently for all purchases and sales of financial assets that
belong to the same category of financial asset as defined in IAS 39 (note
that for this purpose assets held for trading form a different category from
assets designated at fair value through profit or loss). The choice of method
is an accounting policy.
IAS 39 requires that all financial assets and all financial liabilities be
recognised on the balance sheet. That includes all derivatives. Historically,
in many parts of the world, derivatives have not been recognised on
company balance sheets. The argument has been that at the time the
derivative contract was entered into, there was no amount of cash or other
assets paid. Zero cost justified non-recognition, notwithstanding that as time
passes and the value of the underlying variable (rate, price, or index)
changes, the derivative has a positive (asset) or negative (liability) value.
Initial Measurement
Initially, financial assets and liabilities should be measured at fair value
(including transaction costs, for assets and liabilities not measured at fair
value through profit or loss).
Measurement Subsequent to Initial Recognition
Subsequently, financial assets and liabilities (including derivatives) should
be measured at fair value, with the following exceptions:
*Loans and receivables, held-to-maturity investments, and nonderivative
financial liabilities should be measured at amortised cost
using the effective interest method.
*Investments in equity instruments with no reliable fair value
measurement (and derivatives indexed to such equity instruments)
should be measured at cost.
*Financial assets and liabilities that are designated as a hedged item
or hedging instrument are subject to measurement under the hedge
accounting requirements of the IAS 39.
*Financial liabilities that arise when a transfer of a financial asset does
not qualify for de-recognition, or that are accounted for using the
continuing-involvement method, are subject to particular
measurement requirements.
Fair value is the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm’s length
transaction. IAS 39 provides a hierarchy to be used in determining the fair
value for a financial instrument:
*Quoted market prices in an active market are the best evidence of
fair value and should be used, where they exist, to measure the
financial instrument.
*If a market for a financial instrument is not active, an entity
establishes fair value by using a valuation technique that makes
maximum use of market inputs and includes recent arm’s length
market transactions, reference to the current fair value of another
instrument that is substantially the same, discounted cash flow
analysis, and option pricing models. An acceptable valuation
technique incorporates all factors that market participants would
consider in setting a price and is consistent with accepted economic
methodologies for pricing financial instruments.
*If there is no active market for an equity instrument and the range of
reasonable fair values is significant and these estimates cannot be
made reliably, then an entity must measure the equity instrument at
cost less impairment.
Amortised cost is calculated using the effective interest method. The
effective interest rate is the rate that exactly discounts estimated future cash
payments or receipts through the expected life of the financial instrument to
the net carrying amount of the financial asset or liability. Financial assets
that are not carried at fair value though profit and loss are subject to an
impairment test. If expected life cannot be determined reliably, then the
contractual life is used.
IAS 39 Fair Value Option
IAS 39 permits entities to designate, at the time of acquisition or issuance,
any financial asset or financial liability to be measured at fair value, with
value changes recognised in profit or loss. This option is available even if
the financial asset or financial liability would ordinarily, by its nature, be
measured at amortised cost – but only if fair value can be reliably
measured.
In June 2005 the IASB issued its amendment to IAS 39 to restrict the use of
the option to designate any financial asset or any financial liability to be
measured at fair value through profit and loss (the fair value option). The
revisions limit the use of the option to those financial instruments that meet
certain conditions:
*the fair value option designation eliminates or significantly reduces an
accounting mismatch, or
*a group of financial assets, financial liabilities or both is managed and
its performance is evaluated on a fair value basis by entity’s
management.
Once an instrument is put in the fair-value-through-profit-and-loss category,
it cannot be reclassified out with some exceptions.
IAS 39 Available for Sale Option for Loans and Receivables
IAS 39 permits entities to designate, at the time of acquisition, any loan or
receivable as available for sale, in which case it is measured at fair value
with changes in fair value recognised in equity.
Impairment
A financial asset or group of assets is impaired, and impairment losses are
recognised, only if there is objective evidence as a result of one or more
events that occurred after the initial recognition of the asset. An entity is
required to assess at each balance sheet date whether there is any
objective evidence of impairment. If any such evidence exists, the entity is
required to do a detailed impairment calculation to determine whether an
impairment loss should be recognised. The amount of the loss is measured
as the difference between the asset’s carrying amount and the present
value of estimated cash flows discounted at the financial asset’s original
effective interest rate.
Assets that are individually assessed and for which no impairment exists are
grouped with financial assets with similar credit risk statistics and
collectively assessed for impairment.
If, in a subsequent period, the amount of the impairment loss relating to a
financial asset carried at amortised cost or a debt instrument carried as
available-for-sale decreases due to an event occurring after the impairment
was originally recognised, the previously recognised impairment loss is
reversed through profit or loss. Impairments relating to investments in
available-for-sale equity instruments are not reversed through profit or loss.
De-recognition of a Financial Asset
The basic premise for the de-recognition model in IAS 39 is to determine
whether the asset under consideration for de-recognition is:
*an asset in its entirety or
*specifically identified cash flows from an asset or
*a fully proportionate share of the cash flows from an asset or
*a fully proportionate share of specifically identified cash flows from a
financial asset
Once the asset under consideration for de-recognition has been
determined, an assessment is made as to whether the asset has been
transferred, and if so, whether the transfer of that asset is subsequently
eligible for de-recognition.
An asset is transferred if either the entity has transferred the contractual
rights to receive the cash flows, or the entity has retained the contractual
rights to receive the cash flows from the asset, but has assumed a
contractual obligation to pass those cash flows on under an arrangement
that meets the following three conditions:
*the entity has no obligation to pay amounts to the eventual recipient
unless it collects equivalent amounts on the original asset
*the entity is prohibited from selling or pledging the original asset
(other than as security to the eventual recipient),
*the entity has an obligation to remit those cash flows without material
delay
Once an entity has determined that the asset has been transferred, it then
determines whether or not it has transferred substantially all of the risks and
rewards of ownership of the asset. If substantially all the risks and rewards
have been transferred, the asset is derecognised. If substantially all the
risks and rewards have been retained, de-recognition of the asset is
precluded.
If the entity has neither retained nor transferred substantially all of the risks
and rewards of the asset, then the entity must assess whether it has
relinquished control of the asset or not. If the entity does not control the
asset then de-recognition is appropriate; however if the entity has retained
control of the asset, then the entity continues to recognise the asset to the
extent to which it has a continuing involvement in the asset.
De-recognition of a Financial Liability
A financial liability should be removed from the balance sheet when, and
only when, it is extinguished, that is, when the obligation specified in the
contract is either discharged or cancelled or expires. [IAS 39.39] Where
there has been an exchange between an existing borrower and lender of
debt instruments with substantially different terms, or there has been a
substantial modification of the terms of an existing financial liability, this
transaction is accounted for as an extinguishment of the original financial
liability and the recognition of a new financial liability. A gain or loss from
extinguishment of the original financial liability is recognised in profit or loss.
[IAS 39.40-41]
Hedge Accounting
IAS 39 permits hedge accounting under certain circumstances provided that
the hedging relationship is:
*formally designated and documented, including the entity’s risk
management objective and strategy for undertaking the hedge,
identification of the hedging instrument, the hedged item, the nature
of the risk being hedged, and how the entity will assess the hedging
instrument’s effectiveness and
*expected to be highly effective in achieving offsetting changes in fair
value or cash flows attributable to the hedged risk as designated and
documented, and effectiveness can be reliably measured and
*assessed on an ongoing basis and determined to have been highly
effective
Hedging Instruments
Hedging instrument is an instrument whose fair value or cash flows are
expected to offset changes in the fair value or cash flows of a designated
hedged item.
All derivative contracts with an external counterparty may be designated as
hedging instruments except for some written options. A non-derivative
financial asset or liability may not be designated as a hedging instrument
except as a hedge of foreign currency risk.
For hedge accounting purposes, only instruments that involve a party
external to the reporting entity can be designated as a hedging instrument.
This applies to intragroup transactions as well. However, they may qualify
for hedge accounting in individual financial statements.
Hedged Items
Hedged item is an item that exposes the entity to risk of changes in fair
value or future cash flows and is designated as being hedged. [IAS 39.9]
A hedged item can be:
*a single recognised asset or liability, firm commitment, highly
probable transaction or a net investment in a foreign operation
*a group of assets, liabilities, firm commitments, highly probable
forecast transactions or net investments in foreign operations with
similar risk characteristics
*a held-to-maturity investment for foreign currency or credit risk
*a portion of the cash flows or fair value of a financial asset or financial liability or
*a non-financial item for foreign currency risk only for all risks of the
entire item
Effectiveness
IAS 39 requires hedge effectiveness to be assessed both prospectively and
retrospectively. To qualify for hedge accounting at the inception of a hedge
and, at a minimum, at each reporting date, the changes in the fair value or
cash flows of the hedged item attributable to the hedged risk must be
expected to be highly effective in offsetting the changes in the fair value or
cash flows of the hedging instrument on a prospective basis, and on a
retrospective basis where actual results are within a range of 80% to 125%.
All hedge ineffectiveness is recognised immediately in profit or loss
(including ineffectiveness within the 80% to 125% window).
Categories of Hedges
A fair value hedge is a hedge of the exposure to changes in fair value of a
recognised asset or liability or a previously unrecognised firm commitment
or an identified portion of such an asset, liability or firm commitment, that is
attributable to a particular risk and could affect profit or loss. The gain or
loss from the change in fair value of the hedging instrument is recognised
immediately in profit or loss. At the same time the carrying amount of the
hedged item is adjusted for the corresponding gain or loss with respect to
the hedged risk, which is also recognised immediately in net profit or loss.
A cash flow hedge is a hedge of the exposure to variability in cash flows
that (i) is attributable to a particular risk associated with a recognised asset
or liability (such as all or some future interest payments on variable rate
debt) or a highly probable forecast transaction and (ii) could affect profit or
loss. The portion of the gain or loss on the hedging instrument that is
determined to be an effective hedge is recognised in other comprehensive
income.
If a hedge of a forecast transaction subsequently results in the recognition
of a financial asset or a financial liability, any gain or loss on the hedging
instrument that was previously recognised directly in equity is ‘recycled’ into
profit or loss in the same period(s) in which the financial asset or liability
affects profit or loss.
If a hedge of a forecast transaction subsequently results in the recognition
of a non-financial asset or non-financial liability, then the entity has an
accounting policy option that must be applied to all such hedges of forecast
transactions:
*Same accounting as for recognition of a financial asset or financial liability – any gain or loss on the hedging instrument that was previously recognised in other comprehensive income is ‘recycled’ into profit or loss in the same period(s) in which the non-financial
asset or liability affects profit or loss.
*’Basis adjustment’ of the acquired non-financial asset or liability – the
gain or loss on the hedging instrument that was previously
recognised in other comprehensive incomeis removed from equity
and is included in the initial cost or other carrying amount of the
acquired non-financial asset or liability.
A hedge of a net investment in a foreign operation as defined in IAS 21
is accounted for similarly to a cash flow hedge.
A hedge of the foreign currency risk of a firm commitment may be
accounted for as a fair value hedge or as a cash flow hedge.
Discontinuation of Hedge Accounting
Hedge accounting must be discontinued prospectively if:
*the hedging instrument expires or is sold, terminated, or exercised
*the hedge no longer meets the hedge accounting criteria – for
example it is no longer effective
*for cash flow hedges the forecast transaction is no longer expected to
occur, or
*the entity revokes the hedge designation
For the purpose of measuring the carrying amount of the hedged item when
fair value hedge accounting ceases, a revised effective interest rate is
calculated.
If hedge accounting ceases for a cash flow hedge relationship because the
forecast transaction is no longer expected to occur, gains and losses
deferred in other comprehensive income must be taken to profit or loss
immediately. If the transaction is still expected to occur and the hedge
relationship ceases, the amounts accumulated in equity will be retained in
equity until the hedged item affects profit or loss. [IAS 39.101(c)]
If a hedged financial instrument that is measured at amortised cost has
been adjusted for the gain or loss attributable to the hedged risk in a fair
value hedge, this adjustment is amortised to profit or loss based on a
recalculated effective interest rate on this date such that the adjustment is
fully amortised by the maturity of the instrument. Amortisation may begin as
soon as an adjustment exists and must begin no later than when the
hedged item ceases to be adjusted for changes in its fair value attributable
to the risks being hedged.
Example 1
On 2 January 2009, a company buys $100,000 of 6% loan stock for
$93,930. Interest will be received on 31 December each year and the stock
will be redeemed at par on 31 December 2013. The company intends to
hold the stock until maturity and calculates the effective interest rate to be
7.5% per annum. Financial statements are prepared to 31 December each
year.
a) The loan stock is measured initially at $93,930.
b) The amortised cost of the loan stock at the end of each year is
calculated as follows:
Year Balance Interest Amount Amortised
b/f @ 7.5% received cost
$ $ $ $
2009 93,930 7,045 (6,000) 94,975
2010 94,975 7,123 (6,000) 96,098
2011 96,098 7,207 (6,000) 97,305
2012 97,305 7,298 (6,000) 98,603
2013 98,603 7,397 (106,000) 0
36,070
Notes:
i) The interest earned each year is 7.5% of the balance brought
forward. This is recognised as income in the company’s financial
statements. Interest at 7.5% for 2013 would in fact be $7,395 but this
has been adjusted to $7,397 to ensure that the balance remaining at
the end of the year is $nil. It would appear that the effective rate of
interest is actually very slightly more than 7.5%.
ii) The effective interest rate (7.5% is higher than the rate (6%) at which
annual interest payments are calculated because the company will
receive a premium of $6,070 ($100,000 – $93,930) when the loan
stock is redeemed. The effective interest method spreads this
premium fairly over the life of the loan stock.
iii) Total income is $36,070. This amount is equal to annual interest of
$6,000 for five years plus the premium of $6,070.
c) If the amounts receivable during the life of the loan stock are discounted
at an annual rate of 7.5%, the present value of each amount is as
follows:
Workings
Present Value
$
Receivable 31 December 2009 $6,000 ÷ 1.075 5,581
Receivable 31 December 2010 $6,000 ÷ (1.075)² 5,192
Receivable 31 December 2011 $6,000 ÷ (1.075)³ 4,830
Receivable 31 December 2012 $6,000 ÷ (1.075)4 4,493
Receivable 31 December 2013 $106,000 ÷ (1.075)5 73,835
93,931
Apart from a small rounding difference, an effective rate of 7.5% does
indeed discount estimated future cash receipts to the initial carrying
amount of $93,930.
Question 1
Company A is evaluating whether each of these items is a financial
instrument and whether it should be accounted for under IAS 32:
(a) Cash deposited in banks
(b) Gold bullion deposited in banks
(c) Trade accounts receivable
(d) Investments in debt instruments
(e) Investments in equity instruments, where Company A does not have significant influence over the investee
(f) Investments in equity instruments, where Company A has significant influence over the investee
(g) Prepaid expenses
(h) Finance lease receivables or payables
(i) Deferred revenue
(j) Statutory tax liabilities
(k) Provision for estimated litigation losses
(l) An electricity purchase contract that can be net settled in cash
(m) Issued debt instruments
(n) Issued equity instruments
Question 2
During 2004, Entity A has issued a number of financial instruments. It is
evaluating how each of these instruments should be presented under IAS 32:
(a) A perpetual bond (i.e., a bond that does not have a maturity date) that pays 5% interest each year
(b) A mandatorily redeemable share with a fixed redemption amount (i.e., a share that will be redeemed by the entity at a future date)
(c) A share that is redeemable at the option of the holder for a fixed amount of cash
(d) A sold (written) call option that allows the holder to purchase a fixed number of ordinary shares from Entity A for a fixed amount of cash
For each of the above instruments, discuss whether it should be classified as a financial liability and, if so, why.
Question 3
Which of the following assets is not a financial asset?
A Cash.
B An equity instrument of another entity.
C A contract that may or will be settled in the entity’s own equity instrument and is not classified as an equity instrument of the entity.
D Prepaid expenses.
Question 4
Which of the following liabilities is a financial liability?
A Deferred revenue.
B A warranty obligation.
C A constructive obligation.
D An obligation to deliver own shares worth a fixed amount of cash.
Question 5
A company has a building under construction that is being financed with
$8 million of debt, $6 million of which is a construction loan directly on the
building. The rest is financed out of the general debt of the company. The
company will use the building when it is completed. The debt structure of
the firm is as follows:
Construction loan @ 11 % $6M
Long-term debentures @ 9% $9M
Long-term subordinated debentures @ 10% $3M
What amount of interest expense should be reported on the income statement?
A $920,000
B $1,140,000
C $925,000
D $1,770,000
Question 6
On 1 January 2009, a company issues $200,000 of 7% loan stock at par. Interest on
this loan stock is payable on 31 December each year. The stock is due for
redemption at par on 31 December 2012 but may be converted into ordinary shares
on that date instead.
Assuming that the market rate of interest to be used in discounted cash flow
calculations is 9% p.a., calculate the liability component and the equity component of
this loan stock.
Question7
On 1 July 2009, a company issues $1 million of 8% loan stock. The stock is issued
at a 10% discount (so only $900,000 is received from the lenders) and issue costs of
$39,300 are incurred. Interest is payable in arrears on 30 June each year and the
loan stock is redeemable at par on 30 June 2012. The effective interest rate is
calculated to be 14% per annum. The company prepares financial statements to 30
June each year.
State the amount at which this loan stock should be measured on 1 July 2009.
Calculate the amount at which the loan stock should be measured on 30 June 2010,
2011 and 2012
IFRS 9 Replacing IAS 39
Recognition and measurement
This standard introduces new requirements for the classification and measurement
of financial assets and is effective from 1 January 2013, with early adoption
permitted. New requirements for classification and measurement of financial
liabilities, de-recognition of financial instruments, impairment and hedge accounting
are to be added to IFRS 9 in 2010. Early adoption of the standard is a major step for
any entity, because an early adopter of IFRS 9 continues to apply IAS 39 for other
accounting requirements for financial instruments that are not covered by IFRS 9,
that is classification and measurement of financial liabilities, recognition and derecognition of financial assets and financial liabilities, impairment of financial assets
and hedge accounting. In some jurisdictions, the new standards will have to be
adopted before they can be applied, and in others there will be some restrictions on
early adoption. It would seem wise to wait until the whole of the new standard has
been finalised.
The standard retains a mixed-measurement model, with some assets measured at
amortised cost and others at fair value. The distinction between the two models is
based on the business model of each entity and a requirement to assess whether
the cashflows of the instrument are only principal and interest. The business-model
approach is fundamental to the standard, and is an attempt to align the accounting
with the way in which management uses its assets in its business while also looking
at the characteristics of the business. A debt instrument generally must be measured
at amortised cost if both the ‘business model test’ and the ‘contractual cash flow
characteristics test’ are satisfied. The business model test is whether the objective of
the entity’s business model is to hold the financial asset to collect the contractual
cashflows rather than have the objective to sell the instrument before its contractual
maturity to realise its fair value changes.
The contractual cashflow characteristics test is whether the contractual terms of the
financial asset give rise, on specified dates, to cashflows that are solely payments of
principal and interest on the principal amount outstanding.
All recognised financial assets that are in the scope of IAS 39 will be measured at
either amortised cost or fair value. The standard contains only the two primary
measurement categories for financial assets, unlike IAS 39 where there were
multiple measurement categories. Thus the existing IAS 39 categories of held to
maturity, loans and receivables and available for sale are eliminated, as are the
tainting provisions of the standard.
A debt instrument, such as a loan receivable, that is held within a business model
whose objective is to collect the contractual cashflows and has contractual cashflows
that are solely payments of principal and interest generally must be measured at
amortised cost. All other debt instruments must be measured at fair value through
profit or loss (FVTPL). An investment in a convertible loan note would not qualify for
measurement at amortised cost because of the inclusion of the conversion option,
which is not deemed to represent payments of principal and interest. This criterion
will permit amortised cost measurement when the cashflows on a loan are entirely
fixed, such as a fixed-interest-rate loan or where interest is floating or a combination
of fixed and floating interest rates.
IFRS 9 contains an option to classify financial assets that meet the amortised cost
criteria as at FVTPL if doing so eliminates or reduces an accounting mismatch. An
example of this may be where an entity holds a fixed-rate loan receivable that it
hedges with an interest rate swap that changes the fixed rates for floating rates.
Measuring the loan asset at amortised cost would create a measurement mismatch,
as the interest rate swap would be held at FVTPL. In this case, the loan receivable
could be designated at FVTPL under the fair value option to reduce the accounting
mismatch that arises from measuring the loan at amortised cost.
Gains and losses
All equity investments within the scope of IFRS 9 are to be measured in the
statement of financial position at fair value with the default recognition of gains and
losses in profit or loss. Only if the equity investment is not held for trading can an
irrevocable election be made at initial recognition to measure it at fair value through
other comprehensive income (FVTOCI) with only dividend income recognised in
profit or loss. The amounts recognised in other comprehensive income (OCI) are not
recycled to profit or loss on disposal of the investment although they may be
reclassified in equity.
The standard eliminates the exemption allowing some unquoted equity instruments
and related derivative assets to be measured at cost. However it includes guidance
on the rare circumstances where the cost of such an instrument may be appropriate
estimate of fair value.
The classification of an instrument is determined on initial recognition and
reclassifications are only permitted on the change of an entity’s business model and
are expected to occur only infrequently. An example of where reclassification from
amortised cost to fair value might be required would be when an entity decides to
close its mortgage business, no longer accepting new business, and is actively
marketing its mortgage portfolio for sale.
When a reclassification is required it is applied from first day of the first reporting
period following the change in business model.
All derivatives within the scope of IFRS 9 are required to be measured at fair value.
IFRS 9 does not retain IAS 39’s approach to accounting for embedded derivatives.
Consequently, embedded derivatives that would have been separately accounted for
at FVTPL under IAS 39 because they were not closely related to the financial asset
host will no longer be separated. Instead, the contractual cash flows of the financial
asset are assessed as a whole and are measured at FVTPL if any of its cashflows
do not represent payments of principal and interest.
A frequent question is whether IFRS 9 will result in more financial assets being
measured at fair value. It will depend on the circumstances of each entity in terms of
the way it manages the instruments it holds, the nature of those instruments and the
classification elections it makes. One of the most significant changes will be the
ability to measure some debt instruments, such as investments in government and
corporate bonds, at amortised cost. Many available-for-sale debt instruments
measured at fair value will qualify for amortised cost accounting.
Many loans and receivables and held to maturity investments will continue to be
measured at amortised cost but some will have to be measured at FVTPL. For
example, some instruments, such as cash-collateralised debt obligations, that may
under IAS 39 have been measured entirely at amortised cost or as available-for-sale,
will more likely be measured at FVTPL.
Measured in entirety
Some financial assets that are currently disaggregated into host financial assets that
are not at FVTPL will instead by measured at FVTPL in their entirety. Assets that are
classified as held-to-maturity are likely to continue to be measured at amortised cost
as they are held to collect the contractual cash flows and often give rise to only
payments of principal and interest.
IFRS 9 does not address impairment. However as IFRS 9 eliminates the available
for sale (AFS) category, it also eliminates the AFS impairment rules. Under IAS 39
measuring impairment losses on debt securities in illiquid markets based on fair
value often led to reporting an impairment loss that exceeded the credit loss
management expected. Additionally, impairment losses on AFS equity investments
cannot be reversed under IAS 39 if the fair value of the investment increases. Under
IFRS 9, debt securities that qualify for the amortised cost model are measured under
that model and declines in equity investments measured at FVTPL are recognised in
profit or loss and reversed through profit or loss if the fair value increases.
The aim of the revision of IAS 39 is to remove inconsistencies between US GAAP
and IFRS in accounting for financial instruments. This will enable easy comparisons
to be made between entities applying IFRSs and those using US GAAP. IFRS 9 was
a first step in this direction. In order to work towards convergence of their
requirements both the IASB and the US Financial Accounting Standards Board
(FASB) are reconsidering the financial instruments standards.