OVERVIEW
Objective
¾
To explain the rules on measurement, recognition, presentation and disclosure of financial instruments.DEFINITIONS
RECOGNITION PRESENTATION
DISCLOSURE
¾ IAS 32
¾ IAS 39
¾ Liabilities and equity
¾ Settlement in own equity
instruments
¾ Offset
¾ Interest, dividends, losses
and gains
¾ Compound instruments
¾ Treasury shares
¾ Rules
¾ Initial recognition
¾ Examples
MEASUREMENT
¾ Initial
¾ Fair value considerations
¾ Subsequent measurement
APPLICATION AND SCOPE
¾ IAS 32
¾ IFRS 7
¾ IAS 39
BACKGROUND ¾¾ Traditional accounting Financial instruments
¾ History
DERECOGNITION
¾ Financial asset
¾ Financial liability
IAS 32 & 39 & IFRS 7
IAS 32
IFRS 7
1
BACKGROUND
1.1
Traditional accounting
¾
Traditional accounting practices are based on serving the needs of manufacturing companies. Accounting for such entities is concerned with accruing costs to be matched with revenues. A key concept in such a process is revenue and cost recognition.¾
The global market for financial instruments has expanded rapidly over the last twenty years, not only in the sheer volume of such instruments but also in their complexity. Entity’s have moved from using “traditional” instruments (e.g. cash, trade debtors, long-term debt and investments) to highly sophisticated risk management strategies based around derivatives and complex combinations of instruments.¾
The traditional cost-based concepts are not adequate to deal with the recognition and measurement of financial assets and liabilities. Specifically: Traditional accounting bases recognition on the transfer of risks and rewards.
It is not designed to deal with transactions that divide up the risks and rewards associated with a particular asset (or liability) and allocate them to different parties.
Some financial instruments have no or little initial cost (e.g. options) and are not
adequately accounted for (if at all) under traditional historical cost based systems.
¾
If a transaction has no cost, traditional accounting cannot Dr and CR. In addition, thehistorical cost of financial assets and liabilities has little relevance to risk management activities.
1.2
Financial instruments
¾
A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.¾
Instruments include: primary instruments (e.g. receivables, payables and equity securities); and derivative instruments (e.g. financial options, futures and forwards, interest rate
swaps and currency swaps).
1.3
History
¾
IAS 32 “Financial Instruments: Disclosure and Presentation” was first issued in June 1995.¾
IAS 39 “Financial Instruments: Recognition and Measurement” was first issued in December 1998.¾
IFRS 7 was issued in 2005 to replace IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions and to take over the disclosure issues of IAS 32. IAS 32 is now solely concerned with presentation issues.¾
This time difference between the initial issue of IAS 32 and IAS 39, reflects the complexity of the recognition and measurement issues. The first exposure draft on financial instruments (issued in 1991) had sought to address disclosure, presentation, recognition and measurement in one standard. The subsequent revisions reflect the “learning process” of dealing with the complexities of financial instruments and new issues that have been raised since the standards were first issued.2
APPLICATION AND SCOPE
2.1
IAS 32
¾
Classification of financial instruments between: financial assets;
financial liabilities; and equity instruments.
¾
Presentation and offset of financial instruments and the related interest, dividends, losses and gains.2.2
IFRS 7
¾
Disclosure of: factors affecting the amount, timing and certainty of cash flows;
the use of financial instruments and the business purpose they serve; and the associated risks and management’s policies for controlling those risks.
2.3
IAS 39
¾
Recognition and derecognition of financial assets and financial liabilities.¾
Classification of financial assets and financial liabilities.¾
Initial measurement and subsequent measurement of financial assets and financial liabilities.3
DEFINITIONS
3.1
From IAS 32
Definition
¾
A financial asset is any asset that is: cash;
a contractual right to receive cash or another financial asset from
another entity;
a contractual right to exchange financial instruments with another
entity under conditions that are potentially favourable;
an equity instrument of another entity; or
certain contracts that will (or may) be settled in 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.
¾
A financial liability is any liability that is a contractual obligation: to deliver cash or another financial asset to another entity; to exchange financial instruments with another entity under
conditions that are potentially unfavourable; or
certain contracts that will (or may) be settled in the entity’s own
equity instruments.
Commentary
Physical assets (e.g. prepayments), liabilities that are not contractual in nature (e.g. taxes), operating leases, and contractual rights and obligations relating to non-financial assets that are not settled in the same manor as a non-financial instrument) are not financial instruments.
Preferred shares that provide for mandatory redemption by the issuer, or that give the holder the right to redeem the share, meet the definition of liabilities and are classified as such even though, legally, they may be equity.
¾
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.3.2
From IAS 39
3.2.1
Derivatives
Definition
¾
A derivative is a financial instrument: whose value changes in response to the change in a specified interest
rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the “underlying”);
that requires little or no initial net investment relative to other types of
contracts that would be expected to have a similar response to changes in market conditions; and
that is settled at a future date.
3.2.2
Categories of financial assets
¾
IAS 39 currently identifies four categories of financial assets.¾
A financial asset or financial liability at fair value through profit or loss is a financial asset or financial liability that is either: classified as held for trading; or
designated initially at fair value through profit or loss.
Commentary
Except for investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured, any financial asset or financial liability within the scope of IAS 39 may be designated when initially recognised at fair value through profit or loss, subject to certain criteria.
Once a financial asset has been designated as at fair value through profit or loss, it must remain in that category until de-recognition.
¾
Held-to-maturity investments are non-derivative financial assets with fixed ordeterminable payments and fixed maturity that an entity has the positive intent and ability to hold to maturity other than those:
designated as at fair value through profit or loss on initial recognition; designated as available for sale; or
Commentary
Fixed or determinable payments and fixed maturity means a contractual arrangement that defines the amounts and dates of payments to the holder, such as interest and principal payments on debt.
¾
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than those: intended for immediate sale (classified as held for trading);
designated initially as at fair value through profit or loss or available for sale; or loans where repayment of the initial loan is in doubt (other than where there is a
fall in credit rating), in which case they will be classed as available for sale.
¾
Available-for-sale financial assets are those non-derivative financial assets that aredesignated available-for-sale or are not classified as:
loans and receivables;
held-to-maturity investments; or
financial assets at fair value through profit or loss.
Commentary
Any financial asset, other than one “held for trading” may be designated within this category.
3.2.3
Recognition and measurement
¾
Amortised cost of a financial asset or financial liability is: the amount at which it was measured at initial recognition;
minus
principal repayments;
plus or minus
the cumulative amortisation of any difference between that initial amount and the
maturity amount; and minus
any write-down (directly or through the use of an allowance account) for
impairment or uncollectability.
¾
The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected useful life of the financial instrument to the netcarrying amount of the financial asset (or financial liability). The computation includes all cash flows (e.g. fees, transaction costs, premiums or discounts) between the parties to the contract.
¾
The effective interest rate is sometimes termed the ”level yield-to-maturity” (or to the next re-pricing date), and is the internal rate of return of the financial asset (or liability) for that period.¾
Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset (or financial liability).Commentary
An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument. Examples include fees and commissions paid to agents.
Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.
Illustration 1— Amortised cost using the effective interest rate method
A company issues a $100,000 zero coupon bond redeemable in 5 years at $150,000.
The internal rate of return (the yield) on these flows is 8.45%. This should be used to allocate the expense.
Period Opening balance Interest @ 8.45% Closing balance
1 100,000 8,450 108,450
2 108,450 9,164 117,614
3 117,614 9,938 127,552
4 127,552 10,778 138,330
5 138,330 11,689 150,019
This should be 150,000. The difference of 19 is
due to rounding
4
PRESENTATION (IAS 32)
4.1
Liabilities and equity
¾
On issue, financial instruments should be classified as liabilities or equity in accordance with the substance of the contractual arrangement on initial recognition.¾
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.Illustration 2— Preference shares
Redeemable preference shares are not classified as equity under IAS 32 as there is a contractual obligation to transfer financial assets (e.g. cash) to the holder of the shares. They are therefore a financial liability.
If such shares are redeemable at the option of the issuer, they would not meet the definition of a financial liability as there is no present obligation to transfer a financial asset to the holder of the shares. When the issuer becomes obliged to redeem the shares, they become a financial liability and will then be
transferred out of equity.
For non-redeemable preference shares, the substance of the contract would need to be studied. For example, if distributions to the holders of the
instrument are at the discretion of the issuer, the shares are equity instruments.
4.2
Settlement in own equity instruments
¾
A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity’s own equity instruments.¾
A financial liability will arise when: there is a contractual obligation to deliver cash or another financial asset, to
exchange financial assets or financial liabilities, under conditions that are potentially unfavourable to the issuer;
there is a non-derivative contract to deliver, or be required to deliver, a variable
number of own equity instruments;
there is a derivative that will or may be settled other than by issuing a fixed number
of own equity instruments.
¾
An equity instrument will arise when: there is a non-derivative contract to deliver, or be required to deliver a fixed number
of own equity instruments;
there is a derivative that will or may be settled by issuing a fixed number of own
equity instruments.
4.3
Offset
¾
Financial assets and liabilities must be offset where the entity: has a legal right of offset; and
intends to settle on a net basis or to realise the asset and settle the liability
Commentary
Offset might be of trade receivables and payables, or of accounts in debit and credit at a bank.
4.4
Interest, dividends, losses and gains
¾
Interest, dividends, losses and gains relating to a financial instrument (or a component) that is classified as a liability, shall be recognised in profit or loss as income or expense.¾
Dividends on preferred shares classified as a financial liability are accounted for asexpenses, rather than as distributions of profit.
¾
Distributions to holders of equity instruments should be debited directly to equity.¾
Gains or losses on refinancing or redemption of a financial instrument are classified asincome/expense or equity according to the classification of the instrument.
¾
Transaction costs relating to the issue of a compound financial instrument are allocated to the liability and equity components in proportion to the allocation of proceeds.Commentary
Basically, such items follow the classification of the underlying component.
4.5
Compound instruments
4.5.1 Presentation
¾
Financial instruments that contain both a liability and an equity element are classified into separate component parts.¾
As an example, convertible bonds are primary financial liabilities of the issuer which grant an option to the holder to convert them into equity instruments in the future. Such bonds consist of: the obligation to repay the bonds, which should be presented as a liability; and the option to convert, which should be presented in equity.
¾
The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares.4.5.2 Carrying amounts
¾
The equity component is the residual amount after deduction of the more easily measurable debt component from the value of the instrument as a whole.Example 1
An entity issues 2,000 convertible, $1,000 bonds at par on 1 January 2007. Interest is payable annually in arrears at a nominal interest rate of 6%.
The prevailing market rates of interest at the date of issue of the bond was 9%. The bond is redeemable 31 December 2009.
Required:
Calculate the values at which the bond will be included in the financial statements of the entity at initial recognition and the amounts that would be included in the financial statements in respect to the first year of issue.
4.6
Treasury shares
¾
If an entity acquires its own equity instruments, those instruments (‘treasury shares’) are deducted from equity.¾
No gain or loss is recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments.¾
Such treasury shares may be acquired and held by the entity or by other members of the consolidated group.¾
Consideration paid or received is recognised directly in equity.¾
The amount of treasury shares held is disclosed separately either on the face of the statement of financial position or in the notes, in accordance with IAS 1.¾
If own equity instruments are acquired from related parties IAS 24 disclosure requirements apply.5
DISCLOSURE (IFRS 7)
5.1
Rules
5.1.1
Introduction
¾
The purpose of disclosure is to: enhance understanding of the significance of financial instruments to an entity’s
financial position, performance and cash flows;
assist in assessing the factors affecting the amount, timing and certainty of future
cash flows associated with those instruments; and
provide information to assist users of financial statements in assessing the extent of
related risks.
5.1.2
Risk management and hedging activities
¾
An entity must describe its financial risk management objectives and policies including its policy for hedging forecasted transactions.Commentary
The level of detail to be given needs to strike a balance between excessive detail and over aggregation.
¾
For each type of hedge: a description of the hedge;
a description of the financial instruments designated as hedging instruments and
the nature of the risks being hedged.
¾
When a gain or loss on a hedging instrument in a cash flow hedge has been recognised in other comprehensive income disclose: the amount recognised in other comprehensive income during the current period; the amount reclassified from equity to profit or loss in the period; and
the amount transferred from equity into the acquisition cost of a non-financial asset
or liability.
5.1.3
Interest rate risk
¾
An entity must disclose information about its exposure to interest rate risk. Such information includes: contractual re-pricing or maturity dates; effective interest rates; and
which financial assets and liabilities are exposed to fair value or cash flow interest
rate risk and those that are not directly exposed to interest rate risk.
5.1.4
Credit risk
¾
An entity must disclose information about its exposure to credit. Such information includes: the maximum credit exposure risk; and significant concentrations of credit risk.
5.1.5
Fair value risk
¾
An entity must disclose information about the fair value of each class of financial asset and financial liability.¾
It must disclose the methods and significant assumptions applied in estimating fair values of financial assets and financial liabilities that are carried at fair value, separately for each significant class of financial assets.Commentary
In applying the above, an entity will disclose prepayment rates, rates of estimated credit losses, and interest or discount rates.
¾
Whether fair values are determined directly by reference to published price quotations in an active market or are estimated using a valuation technique.¾
If fair value cannot be reliably measured for financial assets, disclose: that fact;
a description of them; carrying amount;
an explanation of why fair value cannot be reliably measured; and
if possible, the range of estimates within which fair value is highly likely to lie.
5.1.6
Other disclosures
¾
Disclose material items of income, expense, and gains and losses resulting from financial assets and financial liabilities, whether included in profit or loss or as other comprehensive income.¾
Disclose the carrying amount of financial assets pledged as collateral and any material terms and conditions relating to such pledged assets.¾
For a financial liability designated as at fair value through profit or loss, disclose: the amount of change in its fair value that is not attributable to changes in a
benchmark interest rate (e.g. LIBOR); and
the difference between its carrying amount and the amount the entity would be
contractually required to pay at maturity to the holder of the obligation
¾
If the entity has reclassified a financial asset as one required to be reported at amortised cost rather than at fair value, disclose the reason for that reclassification.¾
Disclose the nature and amount of any impairment loss or reversal of an impairment loss recognised for a financial asset.6
RECOGNITION (IAS 39)
6.1
Initial recognition
¾
An entity should recognise a financial asset (or liability) on the statement of financial position when, and only when, it becomes a party to the contractual provisions of the instrument.¾
As a consequence of this rule, an entity must recognises all of its contractual rights or obligations under derivatives as assets or liabilities.6.2
Examples
¾
A forward contract (i.e. a commitment to purchase or sell a specified financial instrument or commodity on a future date at a specified price) is recognised as an asset or a liability on the commitment date, rather than waiting until the closing date on which theexchange actually takes place.
¾
Planned future transactions, no matter how likely, are not assets and liabilities of an entity since the entity, as of the financial reporting date, has not become a party to a contract requiring future receipt or delivery of assets arising out of the future transactions.7
DERECOGNITION
7.1
Derecognition of a financial asset
7.1.1
Basic derecognition criteria
¾
An entity should derecognise a financial asset (or a part of it) when, and only when: the contractual rights to the cash flows from the financial asset expire; or it transfers the financial asset and the transfer qualifies for derecognition.
¾
In many cases derecognition of a financial asset is straight forward – if there are no longer any contractual rights, the asset is derecognised. If contractual rights remain, the standard requires three further steps to be considered, i.e. transfer, risks and rewards, control.7.1.2
Transfer of a financial asset
¾
An entity transfers a financial asset if, and only if, it either: gives the contractual rights to receive the cash flows to a third party; or
retains the contractual rights to receive the cash flows, but assumes a contractual
obligation to pay the cash to a third party.
7.1.3
Profit or loss on derecognition
¾
On derecognition, the difference between: the carrying amount of an asset (or portion of an asset) transferred to another party;
and
the sum of:
−
the proceeds received or receivable; and−
any prior adjustment to reflect the fair value of that asset that had been reported as other comprehensive income,should be included in profit or loss for the period.
7.2
Derecognition of a financial liability
¾
This condition is met when either: the debtor discharges the liability by paying the creditor, normally with cash, other
financial assets, goods, or services; or
the debtor is legally released from primary responsibility for the liability (or part
thereof) either by process of law or by the creditor.
Commentary
The fact that the debtor may have given a guarantee does not necessarily mean that this condition is not met.
¾
The difference between: the carrying amount of a liability (or portion) extinguished or transferred to another
party (including related unamortised costs); and
the amount paid for it,
should be included in profit or loss for the period.
8
MEASUREMENT (IAS 39)
8.1
Initial measurement of financial assets and financial liabilities
¾
When a financial asset (or liability) is initially recognised, it is measured at its fair value (usually the fair value of the consideration given or received for it).¾
Transaction costs that are directly attributable to the purchase of a financial asset or the issue of a financial liability are included in the initial measurement of all financial assets and liabilities, except those for a financial asset or financial liability at fair value through profit or loss.Commentary
Costs of an equity transaction are only those incremental external costs directly attributable to the equity transaction that would otherwise have been avoided.
¾
The costs of a transaction which fails to be completed should be expensed.¾
Transaction costs that relate to the issuance of a compound instrument that contains both a liability and an equity element should be allocated to the component parts in proportion to the allocation of proceeds.8.2
Fair value considerations
¾
The fair value is reliably measurable if: the variability in the range of reasonable fair value estimates is not significant; or the probabilities of the estimates can be reasonably assessed and used in the
estimates of fair value.
¾
Fair value exists in the following circumstances: there is a published price in an active market;
a debt instrument has been rated by an independent rating agency;
an appropriate valuation model exists for which the inputs come from active
markets (i.e. Black-Scholes);
a generally accepted method (e.g. use of price/earnings ratios and discounted cash
flow techniques).
8.3
Subsequent measurement of financial liabilities
¾
After initial recognition all financial liabilities, except for financial liabilities at fair value through profit or loss, are measured at amortised cost using the effective interestmethod.
8.4
Subsequent measurement of financial assets
8.4.1
Classification of financial assets
¾
For the purpose of subsequent measurement IAS 39 uses the four categories: loans and receivables;
held-to-maturity investments;
available-for-sale financial assets; and
8.4.2
The rules
Loans and
receivables Held-to-maturity Available-for-sale through profit Fair value and loss
Subsequent
measurement AMORTISED COST AMORTISED COST VALUE FAIR VALUE FAIR
Accounting Recognised gain or loss on the fair value exercise
Not applicable Not applicable COMPREHENSIVE OTHER INCOME
PROFT OR LOSS
Amortisation PROFT OR
LOSS PROFT OR LOSS Not applicable Not applicable
Impairment PROFT OR
LOSS PROFT OR LOSS PROFT OR LOSS Not applicable
¾
However, investments in equity instruments that do not have a market price and whose fair value cannot be reliably measured, will be measured at cost.¾
For financial instruments designated as hedging instrument, the above measurement rules are set aside and different treatments followed.¾
For financial assets and financial liabilities carried at amortised cost, a gain or loss is recognised in profit or loss when the financial asset or financial liability is derecognised or impaired, and through the amortisation process.¾
Impairment of available for sale assets will only occur if there is objective evidence, such as financial difficulties of the issuer, that an impairment has occurred. It would be unusual for these type of assets to be impaired.¾
The movement in fair value of Available for sale assets is taken to other comprehensive income. When that asset is disposed the cumulative gain/loss included in equity is reclassified to profit or loss in the year of disposal.FOCUS
You should now be able to:
¾
explain the need for an accounting standard on financial instruments;¾
define financial instruments in terms of financial assets and financial liabilities;¾
indicate for the following categories of financial instruments how they should bemeasured and how any gains and losses from subsequent measurement should be treated in the financial statements:
fair value through profit and loss; held to maturity (use of amortised cost); available for sale;
loans and receivables.
¾
distinguish between debt and equity capital;¾
apply the requirements of relevant accounting standards to the issue and finance costs of: equity;
redeemable preference shares and debt instruments with no conversion rights.
EXAMPLE SOLUTION
Solution 1
On initial recognition
$Present value of the principle repayable in 3 years time
$2,000,000 × 0.772 (3 year, 9% discount factor) 1,544,000 Present value of the interest stream
$120,000 × 2.531 (3 year, cumulative,9% discount factor) ________ 303,720
Total liability component 1,847,720
Equity component (taken as a balancing figure) 152,280 ________
Proceeds of the issue 2,000,000
________
Recognised during first year
Initial liability recognised
Interest expense for year (to profit or loss) 1,847,720
$1,847,720 × 9% 166,295
Cash interest paid
$2,000,000 × 6% (120,000)
________
Year end liability 1,894,015
A simple discount factor is r
1 where r is the discount rate.
Commentary
A cumulative discount factor is the sum of simple discount factors. You will not have to calculate discount factors in the examination.
The liability at the end of year 3, the date of maturity, will be $2,000,000.
