Ch 8. / KAP.12 - Financial Instruments Financial Assets and Loss allowance

Question 1

What are the definitions? of the following:

Financial Asset

Answer 1

Financial Asset: Any asset that is:

• Cash
• Equity Instrument of another company (Investment shares)
• A Contractual right to:
  
  • ​Receive cash
  • Another financial asset
  • Exchange of financial asset/liability that is potentially favourable.
• A Contract that will/may be settled in the entity own instruments.

Examples:

Shares as an investment
Options contract
Trade Receivables ^{(Technically financial instrument but is not treated by IFRS 9)}

Question 2

8.1 Standards

Which standards affect financial instruments? and what is the reasoning for them?

Answer 2

3 key standards:-

- IAS 32: Financial Instruments: Presentation (& classification)

- IFRS 7: Financial Instruments: Disclosures

- IFRS 9: Financial Instruments (Measurements)

Reasoning:-

Many financial instruments were recorded inconsistently or even “Off-balance sheet” which meant they were not being recognised or disclosed.

The lack of comparability and omission of the information, Exposed the shareholders to significant risk.

Question 3

When can a financial asset and financial liability be offset?

Answer 3

The net amount (offset amount) may only be reported when the entity:

• - Has a legally enforceable right to set off the amounts
• - Intends either to settle on a net basis or to realise the asset and settle the liability simultaneously’ (IAS 32, para 42).

Question 4

What are Treasury shares?

and

How is it recognised in the accounts?

Hints*

Undecided
Cancel
Issue

Answer 4

A treasury share is when a company buys back its own shares. which they may cancel or reissue at a later date.

Recognised as:

The amount paid presented as deducted/netted from equity. Any premiums or discount is recognised in reserves.

• Undecided if shares are to be cancelled or reissued, treasury shares held.

Dr Treasury shares = S.O.EQUITY

Cr. Cash

• If they decide to cancel
  
  • Dr - Ordinary Shares
  • Dr - Expense
  • Cr - Treasury shares
• If they decide to issue
  
  • Dr - Cash
  • Cr - Treasury Shares
  • Cr/Dr - share premium

Question 5

When are financial assets Recognised?

How should they be classified?

and

How does the classification affect the measurement basis?

the 2 Tests

Answer 5

IFRS 9 says that an entity should recognise a financial asset:

• ‘when, and only when, the entity becomes a party to the contractual provisions of the instrument’

Classification of Financial asset?

The Cash Flow Test ^{<em>is used to identify the type of financial asset:-</em>}

Do contractual terms of the financial asset give rise to, specified dates to cash flows that are Solely Payments of Principal and Interest S.P.P.I on the principal outstanding.?

Simply - Are the ONLY cashflows coming in capital and interest?

• Yes - Debt Instrument
• No - Equity Instrument

The Business Model Test:- ^{Is used to identify the measurement basis}

• Hold to collect
• Hold to collect and sell
• Other or unsure

Question 6

How to choose the Measurement basis of a Financial Asset that is an Equity Instrument?

What is the measurement method?

Answer 6

Business Model test

FVTOCI -

• • Long term Holdings
• • must not be held for trading, and
• - Irrevocable choice for this designation upon initial recognition of the asset.

FVTPL -

• The default Choice (the only expectation is that equity instruments with the designation of fvtpl or long term holding

FVTOCI Measurement

Initial Measurement:

• at F.V (Most likely the purchase price)
• + Plus Transaction Costs (capitalised)

Subsequent Measurement:

At each year-end or before disposal of an asset:

• The asset is remeasured to F.V
• Gains or losses recognised in the OCI

FVTPL Measurement

Initial Measurement:

• at F.V (Most likely the purchase price)
• Transactions costs are expensed to P/L

Subsequent Measurement:

• Asset is revalued to fair value
• with the gain or loss recorded P/L

Question 7

How are Investments into debt Instruments (Financial assets) accounted for?

Answer 7

The Business Model Test is carried out to see how they should be measured.

Hold to collect - To collect contractual cashflow SPPI —) Amortised Cost

E.g Investment into a Debenture or trade receivables.

Collect and Sell - To collect contractual cashflow and Sell —) OCI

E.g Government treasury bonds

Other/All other models - unsure if planning to trade, or anything else —) FVTPL

Question 8

How to measure a Debt Instrument?

Held to collect - To collect contractual cashflow SPPI —) Amortised Cost

Answer 8

Investments in debt that are measured at amortised cost:

• *- Initially recognised @ at F.V plus Transaction costs.
• Interest income is calculated using the effective rate of interest.**

Method-

Initial Recognition

Price Paid
+ Transactions Costs
= Initial FAIR VALUE

Subsequently

Opening Balance/ Opening F.V
+ Effective rate of interest
-Less Coupon Received
= Closing Balance

Question 9

How to measure a Debt Instrument?

Collect and sell - To collect contractual cashflow and Sell —) OCI

Hints*

Extra steps on the amortised cost model

Answer 9

Initial Recognition

F.V - The amount of money invested
+ Transactions costs
= Financial Asset

Subsequent Measurement:

Steps1 calculate the amortised cost method

step2 Extra steps, at year-end, revalue to fair market value by taking the amortised cost and the Closing fair market value and the balancing figure ( gain or loss to the oci)

Step3 the opening balances of the year are the new revalued fair market figures, but the effective rate of interest does not change from the original amoritised cost method.

O/B - Dr Financial Asset
Dr - Interest charge at Effective rate = Cr P/L Finance Income ^{(But Charged on the balance as if it was treated as amortised cost)}
Cr- Cash Flow/coupons Received = Dr Cash
C/B - Financial Asset
Bal Fig. - Revaluation gain or loss charged to OCi
C/B - Remeasuremed Financial Asset

Question 10

How to measure a Debt Instrument? Other

Other/All other business models - unsure if planning to trade, or anything else —) FVTPL

Answer 10

For investments in debt that are measured at fair value through profit or loss:

Initial Measurement

• The asset is initially recognised at fair value, (likely the purchase price)
• with any transaction costs expensed to the statement of profit or loss.
  
  • F.V = likely to be at cost Dr- Financial Asset - Cr Bank
  • Transactions costs - P/L Dr- P/L Expense - Cr Bank

Subsequent Measurement At the reporting date,

• the asset will be revalued to fair value at the year-end.
• gain or loss recognised in the statement of profit or loss.

The Disposal

Gain on disposal in the P.L

Similar process to the investment property

O/B Dr - Financial Asset
Dr - Interest Income charged on the principal
Cr - Cash Receipts/Coupon Interest Income
C/B Dr- Financial Asset before Remeasurement
Bal Fig. revaluation gain or loss via P/L
C/B Dr- Financial asset remeasured to F.V

Question 11

How is the reclassification of financial assets treated?

Answer 11

Reclassification of financial assets is Very rare.

Only applicable if there is a change in the business model.

Reclassification is done on a prospective basis.

Since previous years was accounted for correctly based on the business model in place at that time. Therefore previously recognised gains/losses are not restated.

If an entity changes its business model for managing financial assets, all affected financial assets are reclassified

Reclassification is not permitted for equity instruments classified as FVTOCI due to the irrevocable election made.

Question 12

Define the following Loss Allowance terms:

Loss allowance:

Credit loss:

Expected credit losses:

Lifetime expected credit losses:

12-month expected credit losses:

Answer 12

Loss Allowance: is an estimate linked to expected credit losses on a financial asset that is applied to reduce the carrying amount of the financial asset in the Statement of Financial Position

Credit loss: The present value of the difference between the cash flows that they legally entitled to vs the cash flows they expect to receive.

Expected credit losses: The weighted average credit losses.

Lifetime expected credit losses: The expected credit losses that result from all possible default events.

12-month expected credit losses: The portion of lifetime expected credit losses that result from default events that might occur 12 months after the reporting date.

Cashflows Legally receivable
Less Cash Flows Expected to be received
= Loss
X Discounted to the reporting date
= P.V Credit Losses

Question 13

What is loss allowance and how are financial assets impaired?

and

What type of financial assets is it applied to?

Answer 13

Usually applied to financial assets that are:

1. Held to collect sppi —> Amortised Cost

2. Held to collect sppi and possibly sell —>FVOCI

IFRS 9 uses a forward-looking impairment model.

Under this model, future expected credit losses are recognised. (A loss Allowance)(similar to a provision based on assumptions)

This is different to the impairment mode IAS 36. as impairment is only recognised when evidence of impairment has occurred and exists.

Question 14

How is loss allowance on Investments in debt instruments measured at amortised cost Presented in the accounts?

Answer 14

• Recognised in profit or loss Dr- P/L - loss allowance
• Credit losses held in a separate allowance account offset against the carrying amount of the asset:

Financial asset X
Cr - Allowance for credit losses (X)
Carrying amount (net of allowance for credit losses) X

Question 15

What is a loss allowance and how should they be treated?

Answer 15

Loss allowance must be recognised for Fin. Asset Held at

Amortised Cost - Held to Collect
Or
FVTOCI - Collect and Sell

How to Recognise and calculate Loss Allowances

There are three stages:-

Stage 1 - Initial Recognition of Fin.Asset-

A loss allowance equal to 12-month expected credit losses must be recognised.

Calculation Amount

P.V of Credit Loss Expected
x The probability of default in 12 months
= Credit Loss Amount

At Year-end

Effective Interest is charged on the gross amount and increasing the credit losses Provision

Stage 2 - Check if Credit risk has significantly increased if - Yes

E.g Borrower is in default by >30 days/or industry has seen a downturn.

Recognise a Provision for the P.V of full lifetime of credit losses = Gross Carrying Amount

Calculation -

P.V Lifetime Credit loss on the date of recognition
X Charge Interest rate for each year to Reporting Date
Less - Credit losses already accounted (12 months + any interest on this)
= Loss allowance to be Recognised in the current period.

Stage 3 - Objective Impairment

Recognise the P.V of full lifetime of credit losses on the Net Carrying Amount

Question 16

How do assess if credit risk has significantly increased?

Answer 16

IFRS 9 requires entities to compare the financial asset’s risk of default

• at the reporting date
• at initial recognition.

Entities should not rely solely on past information.

You can assume that credit risk

- Has not increased significantly if the Fin.Asset has a low credit risk at the reporting date.

- Has increased significantly if payments are more than 30 days overdue at the reporting date.

Question 17

How are loss allowances on Investments in debt instruments FVTOCI (COLLECT AND SELL) presented?

Answer 17

• *• Portion of the fall in F.V relating to credit losses recognised in P.L**
• *• Remainder recognised in OCI,**
• *• No allowance account is necessary because already carried at fair value (which is automatically reduced for any fall in value, including credit losses)**

Question 18

How loss allowance reversals treated?

Answer 18

Impairment reversals

• At each reporting date, the loss allowance is recalculated.
• It may be that the allowance was previously equal to lifetime credit losses but now, due to reductions in credit risk,
  
  • only needs to be equal to 12-month expected credit losses.
  • As such, there may be a substantial reduction in the allowance required.
• Gains or losses on remeasurement of the loss allowance are recorded in profit or loss.

Question 19

What simplifications are allowed in ifr9 Loss allowances?

Answer 19

Simplifications
IFRS 9 permits some simplifications:

• Trade Receivables and Contract Assets that do not have a significant financing component.
  
  • The loss allowance should always be at an amount equal to lifetime credit losses
• Lease Receivables, Trade Receivables and Contract Assets with a significant financing component,
  
  • the entity can Choose the accounting policy to measure the loss allowance at an amount equal to lifetime credit losses.

Question 20

When is a Financial Asset and Financial Liability Derecognised?

Answer 20

A financial asset should be derecognised if one of the following has occurred:

• The contractual rights have expired
• The financial asset has been sold and substantially all the risks and rewards of ownership have been transferred from the seller to the buyer.

Substance over Form?

• The analysis of where the risks and rewards of ownership lie after a transaction is critical.
• If an entity has retained substantially all of the risks and rewards of a financial asset then it should not be derecognised, even if it has been legally ‘sold’ to another entity.

A Financial Liability should be derecognised when the obligation is:

• - discharged
• - cancelled
• - expires.

Question 21

What is the Accounting Treatment for a derecognition of Financial asset and Financial Liability?

Answer 21

The accounting treatment of derecognition is as follows:

• The difference between the carrying amount of the asset or liability and the amount received or paid for it should be recognised in profit or loss for the period.
• For investments in EQUITY instruments held at FVTOCI, the cumulative gains and losses recognised in OCI are NOT reclassified to profit or loss on disposal.
• For investments in DEBT instruments held at FVTOCI, the cumulative gains and losses recognised in OCI are reclassified to profit or loss on disposal.

Question 22

What is the Definition of a Derivative?

When is a contract to sell or buy a Non-financial item a derivative?

Answer 22

• Definitions*
• *Derivative is a financial instrument with the following characteristics:**
• (a) Its value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable (called the ‘underlying’).
• (b) It requires little or no initial net investment relative to other types of contract that have a similar response to changes in market conditions.
• (c) It is settled at a future date.

Non-financial Items

A contract to buy or Sell a non-financial item (such as inventory or PPE is only a derivative if:

• A contract was not entered into for the purpose to actually receiver deliver the item. (Basically just trying to benefit from the F.V gain of the non-financial item, like a bet)
• It can be settled net in cash (or using another financial asset)

IFRS 9 contract considered to be settled net in cash when:

• terms of the contract permit either party to settle the contract net
• entity has a practice of settling similar contracts at net
• entity, for similar contracts, has a practice of taking delivery of the item and then quickly selling it in order to benefit from fair value changes
• non-financial item is readily convertible to cash.

Note:- If the contract is not a derivative then it is a simple executory contract. Such contracts are normally accounted for until the sale or purchase date.

Question 23

Name some common types of Derivative contracts?

Also, What is the difference between a forward and future Contract?

Answer 23

Forward contracts: The holder of a forward contract is obliged:

• to buy or sell a specific underlying asset,
• at a specified price
• at a specified future date.
  
  • e.g - large food manufacturers may purchase a farmer’s fruit in the future to lock in the price and control their manufacturing cost.

Futures contracts: oblige the holder to

• Buy or sell a standard quantity of a Specific underlying item
• at a specified future date.

Future vs Forward

Futures contracts are very similar to forward contracts. difference is that

• Futures contracts have standard terms and are traded on a financial exchange,
• Forward contracts are tailor-made and are not traded on a financial exchange.
• Swaps*
• *Two parties agree to exchange periodic payments at specified intervals over a specified time period.**

For example,

• in an interest rate swap, the parties may agree to exchange fixed and floating rate interest payments calculated by reference to a notional principal amount.
• or Currency Swaps
• *Options**
• *These give the holder the right, but not the obligation, to buy or sell a specific underlying asset on or before a specified future date.**

e.g

• Call options allow the holder to buy the asset at a stated price within a specific timeframe.
• Put options allow the holder to sell the asset at a stated price within a specific timeframe.

Question 24

How are derivatives accounted for?

Answer 24

• *Measurement of derivatives - FVTPL**
• On initial recognition,*
• - Measured at fair value. (Likely to be at cost)
  
  • - Transaction costs are expensed to P/L.

At the reporting date,

• Remeasured to fair value.
  
  • Movements in fair value are recognised in P/L

Question 25

What is an Embedded Derivative?

Answer 25

Definition - An embedded derivative is a:

‘component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a standalone derivative’ (IFRS 9, para 4.3.3).

• Hybrid Contract - generally combine both debt and equity characteristics
• Host Contract - The non-derivative element
• Eembedded Derivative - is the derivative component of a Hybrid Contract.

Question 26

How do you account for an embedded derivative?

Answer 26

• Host contract is within the scope of IFRS 9 (i.e a Fin.A or Fin.L)
  
  • Then the entire contract must be classified and measured in accordance with that standard.
• Host contract is NOT within the scope of IFRS 9 (i.e. it is not a i.e a Fin.A or Fin.L)
  
  • the embedded derivative can be SEPERATED out and measured at FVTPL if:
    
    • (i) ‘the economic risks and characteristics of the embedded derivative are NOT closely related to those of the host contract
• ​(ii) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.
• ​(iii) the entire instrument is not measured at fair value with changes in fair value recognised in profit or loss’ (IFRS 9, para 4.3.3).

Because of the complexity involved in splitting out and measuring an embedded derivative:-

• IFRS 9 permits a hybrid contract where the host element is outside the scope of IFRS 9 to be measured at FVTPL entirety.
• For the vast majority of embedded derivatives, the whole contract will simply be measured FVTPL

Question 27

When does IFRS 9 not require embedded derivatives to be separated from the host contract?

Answer 27

Question 28

What are the IFRS9 criteria that must be met for hedge accounting to be used?

Answer 28

Under IFRS 9, hedge accounting rules can only be applied if the hedging relationship meets the following criteria:

• 1 The hedging relationship consists only of eligible hedging instruments and hedged items.
• 2 At the inception of the hedge there must be formal documentation identifying the hedged item and the hedging instrument.
• 3 The hedging relationship meets all effectiveness requirements

Question 29

Define:

• Hedge Accounting
• Hedged Item
• Hedged Instrument

Answer 29

Hedge Accounting: – > is a method of managing/reducing risk by:

• - Designating a hedging instrument so that their change in fair value
• - Offset the change in fair value or cash flows of a hedged item.

Hedged item is an asset or liability that exposes the entity to risks of changes in fair value or future cash flows (and is designated as being hedged). There are 3 types of hedged item: (The element/item trying to protect)

• - A recognised asset or liability
• - An unrecognised firm commitment – a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date
• - A highly probable forecast transaction – an uncommitted but anticipated future transaction.

A Hedging instrument is the designated derivative or a non-derivative financial asset or financial liability, whose fair value or cash flows are expected to offset changes in fair value or future cash flows of the hedged item.

Question 30

What are Fair Value Hedges?

and

How are they accounted for?

Answer 30

• *8.1.1 Fair value hedges**
• *These hedge the change in the value of a recognised asset or liability that could affect profit or loss**

eg hedging the fair value of fixed-rate loan note due to changes in interest rates.

All gains and losses on both the hedged item and hedging instrument are recognised as follows:

• (a) Immediately in profit or loss FVTPL
• (b) Immediately in FVTOCI if the hedged item is an investment in an equity instrument held at FVTOCI

Question 31

What is a Cash Flow Hedge?

How do you Account for Cash Flow Hedge?

Answer 31

• *8. 1.2 Cash flow hedges**
• *These hedges the risk of change in the value of future cash flows from a recognised asset or liability (or highly probable forecast transaction)** That could affect profit or loss.

e.g variable rote interest income stream.

Accounted for as follows:

• (a) The effective portion of the gain or loss on the hedging instrument, (ie the value of the hedged item the instrument is protecting) ​
  
  • - is recognised in OCI. (basically matched/offset)

(b) Any excess in hedged profits or losses is recognised immediately in P/L

The amount that has been accumulated in the cash flow hedge reserve is then accounted for as follows :

• - If a Hedged forecast transaction results in the recognition of a non-financial asset or non-financial liability,
  
  • the amount shall be removed from the cash flow reserve and be included directly in the initial cost or carrying amount of the asset or liability.
• - For all other cash flow hedges, the amount shall be reclassified from OCI to P/L in the same period(s) that the hedged expected future cash flows affect profit or loss.

Question 32

What type of Financial Assets are loss allowances recognised for?

Answer 32

Question 33

How Do you account for factoring on financial asset - debt instruments?

Answer 33

To Be Completed

Check to see if the risk and rewards of the financial asset have been transferred?

WITHOUT RECOURSE - The risk and rewards of the Fin.A has been transferred, you must account for the expense of the factoring and reduce the trader receivable.
(Basically sold the debt lower than the contractual right to receive cash from the customer)

Dr - Bank - xxx
Cr - Liability - xxx
Cr - Factoring expense - xxx

WITH RECOURSE - if the customer does not pay the debt to the factoring provider then the company must make payments to the factoring company, also if any monies paid more then the amount factored debt will be receivable to the original entity,

Risk and Rewards stay with the original entity, so the amount of trade debt that has been factored in In effect, a loan and must immediately be account for as a Fin.L

Question 34

What are the requirements for hedge effectiveness?

Answer 34

• There must be an economic relationship between the hedged item and the hedging instrument.
• Credit risk does not dominate the value changes in the economic relationship.
• The hedge ratio of the relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of the hedged item.
  
  • (Basically, the underlying quantity of the H.Item should be the same as the H.Intrsument)
  • e.g company wants to protect their 10m GBP investment in Euros from forex changes, it enters into a futures contract the H.Instrument should match the 10m GBP.
    
    • If it only matches 5m of the GBP then only that portion of the hedge can be hedged.

Question 35

When can an entity Discontinue (stop) hedge accounting?

Answer 35

An entity must cease hedge accounting if any of the following occur:

• Hedging instrument expires or is exercised, (terminated or sold)
• The hedge no longer meets the hedging criteria.
• A forecast future transaction that qualified as a hedged item is no longer highly probable.

Discontinuance should be accounted for prospectively (entries posted to date are not reversed).

Discontinuing a cash flow hedge,
The accounting treatment of theaccumulated gains or lossesof the H.Intsrumentwithin reserves depends on the reason for the discontinuation.

IFRS 9 says:

• If the forecast transaction is no longer expected to occur,
  
  • Gains and Losses recognised in OCI must be taken to P/L immediately.
• If the transaction is still expected to occur,
  
  • Gains and Losses will be retained in equity until the former hedged transaction occurs.

Question 36

What are the Disclosures of financial instruments? (ifrs7)

Answer 36

IFRS 7 Financial Instruments: Disclosures provides the disclosure requirements for financial instruments.

The main disclosures required are:

• 1. Information about the significance of financial instruments for an entity’s financial position and performance.
• 2. Information about the nature and extent of risks arising from financial instruments.

Further Elaboration:-

1 . Significance of financial instruments

• Must disclose the significance of financial instruments for their financial position and performance for each class of financial instruments.
• An entity must disclose items of income, expense, gains, and losses, with separate disclosure of gains and losses from each class of financial instrument.
• **2. Nature and extent of risks arising from financial instruments*
• Qualitative disclosures describe:***
• Risk exposures for each type of financial instrument.
• Management’s objectives, policies, and processes for managing those risks
• Changes from the prior period.

Quantitative disclosures provide information about the extent of the risk exposer, based on information provided internally to the entity’s key management personnel. These disclosures include:

• Summary quantitative data about exposure to each risk at the reporting date.
• Disclosures about credit risk, liquidity risk, and market risk.
• Concentrations of risk.

Question 37

Stakeholder Perspective

Answer 37

To be completed

Question 38

What is a Purchased or originated credit-impaired financial asset?

and

How is it accounted for?

Answer 38

A purchased or originated credit-impaired financial asset:

• Is one that is credit-impaired on initial recognition.
• Interest income is calculated on such assets using the credit-adjusted effective interest rate.
• The credit adjusted effective interest rate incorporates all the contractual terms of the financial asset as well as expected credit losses. In other words, the higher the expected credit losses, the lower the credit adjusted effective interest rate.

Accounting

• Since credit losses anticipated at inception will be recognised through the credit-adjusted effective interest rate, the loss allowance on purchased or originated credit-impaired financial assets should be measured only as the change in the lifetime expected credit losses since initial recognition.

Question 39

How do you Measure Expected Credit Losses?

Answer 39

An entity’s estimate of expected credit losses should be:

• Unbiased and probability-weighted
• Reflective of the time value of money
• Based on information about
  
  • Past events,
  • Current conditions
  • Forecasts of future economic conditions.