Chapter 4 Financial instruments: recognition and measurement Flashcards
1.1 Objective and scope of IAS32 Financial instruments
Use of financial instruments by business for funding, investment and risk management purposes is an essential part of operations. The use, especially derivatives, although providing solutions to financial management can significantly change the risk profile of organisations. The scope of these standards apply to all types of financial instruments and entities, with the exception of:
- Interests in subsidiaries, associates or joint ventures accounted for under another standard.
- Rights and obligations under pension schemes
- Share-based payment transactions
2.1 IAS32 Financial instruments: presentation
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial asset includes cash, contractual right to receive cash or exchange financial assets/liabilities on favourable terms and an equity instrument in another entity.
Financial liability is a contractual obligation to deliver cash or obligation to exchange assets/liabilities on unfavourable terms.
Equity instrument is a residual interest in the net assets of an entity without any contractual obligations.
2.2 Substance of transactions
Key areas that IAS32 deals with are:
- Preference shares: entity has an obligation to redeem the shares. Therefore, recognise as financial liabilities. Irredeemable means the entity has no obligation to redeem and therefore recognise as equity unless there is a mandatory obligation to pay a dividend. In this case the shares will be treated as a financial liability
- Convertible instruments: these have features of both equity and financial liabilities. Need to split into component parts. The present value of the amount repayable is calculated to represent the fair value of the financial liability. The difference between this fair value of the financial liability and the value of the entire instrument is shown as equity. After initial recognition the liability element is accounted for at amortised cost using the effective interest rate. The interest is recognised as a finance cost in the SPL and the carrying amount at the year-end is a liability in the SFP. After initial recognition the equity amount will remain unchanged in the SFP until the end of the instrument’s life.
2.3 Servicing of finance
The service of finance includes interest, dividends and gain and losses on the disposal of financial instruments. If the instrument is a financial liability or asset, the servicing of finance is shown as a finance cost or interest income. If the instrument is shown as equity, the servicing of finance is shown as a dividend. With convertible instruments, the servicing of finance is deemed to belong to the financial liability component.
3.1 Financial liabilities
There are two categories of financial liability:
- Financial liabilities at fair value through profit or loss: liabilities held for trading, acquired for the purpose of repurchasing in the short term. This category includes all unfavourable derivatives. It may include the designation of any liability that would normally be accounted for at amortised cost but has been designated to be accounted for at FVPL to reduce or eliminate an accounting mismatch.
- Amortised cost: financial liabilities that are not classified as FVPL.
3.2 Initial recognition
A financial liability should be recognised when the entity enters into the contractual provisions. The liability should initially be recognised at the fair value which takes into account whether the instrument needs discounting to present value. The treatment of transaction costs such as brokers/professional fees depends on the classification of the liability:
- If a FVPL financial liability: then the transaction costs are not included as an adjustment to the initial fair value but are instead expenses to profit or loss.
- If an amortised cost financial liability: then deduct transaction costs from the initial fair value.
3.3 Subsequent treatment of financial liabilities
FVPL liabilities are revalued to fair value at the reporting date with gains and losses taken to the SPL. Under the amortised cost approach, interest is accounted for over the life of the liability using the effective rate of interest and taken to the SPL. The coupon interest is deducted from the carrying amount as paid. The coupon rate is the cash element of the interest, based on the nominal value of the instrument.
3.3 Credit risk on financial liabilities classified at FVPL.
If a company’s credit risk rating were to deteriorate, this would lead to a decline in the fair value of the liability and hence create a gain. IFRS 9 requires that any element of the gain related to the deterioration in credit risk is credited to OCI, not the SPL.
3.4 Derecognition of financial liabilities
An entity shall remove a financial liability from its SFP when it is extinguished (when obligation specified in the contract is discharged or cancelled or expires). Any differences arising on derecognition is taken to profit or loss.
3.5 Exchange or modification of debt
If an existing loan is exchanged for a new loan with the existing lender, or the terms are changed, the accounting treatment will depend on whether the new terms are deemed to be substantially different. To be substantially different, the PV of the cash flows under the new arrangement, including fees (all discounted at the original effective rate), must be at least 10% different to the PV of the remaining cash flows under the original arrangement.
For a difference of 10% or more: the old liability is deemed to be extinguished and a new liability is recognised in its place. Derecognise the existing liability, recognise a new liability at its fair value, the difference is recognised in the SPL and any fees incurred are also recognised in the SPL.
For a difference of less than 10%: the original liability is deemed to have been modified. Do not derecognise the existing liability, restate the liability to the PV of the revised cash flows (discounted at the original effective rate) and deduct any fees paid. Any difference is taken to the SPL.
4.1 Treasury shares
When companies reacquire their own shares, the consideration paid is recorded directly in equity: Dr Treasury shares and Cr Cash.
If the company reissues the shares at a later date, the difference between the carrying amount of the equity reserve and the cash received is recorded in equity: Dr Cash, Cr Treasury Shares and Dr/Cr Equity
5.1 Classification of financial assets per IFRS9
Per IFRS 9, all financial assets should be classified as one of the following categories:
- Financial assets are at fair value through profit or loss.
- Financial assets at fair value through other comprehensive income
- Amortised cost
Classification should be made when the instrument is first recognised.
5.2 Classification: investments in equity instruments
Investments in equity instruments: the default position is FVPL. If not held for short-term trading and an irrevocable designation is made, then FVOCI.
An exception to the rule is IAS27. This allows a parent company, in its individual accounts to recognise an investment in a subsidiary, associate or joint venture at either cost, fair value in accordance with IFRS9 or using equity accounting.
5.3 Classification: investments in debt
IFRS9 specifies three ways of classifying financial assets that are debt instruments:
- Amortised cost
- Fair value through other comprehensive income
- Fair value through profit or loss
Determining which category of financial asset to use requires consideration of both tests. The financial asset is measured at amortised cost if it passes both:
- The business model test: objective of the business model within which the asset is held is to hold the asset to maturity to collect the contractual cash flows, and
- Contractual cash flow test: contractual terms of the asset give rise to cash flows that are solely repayments of principal and interest on the principal amount outstanding.
The financial asset is measured at fair value through other comprehensive income if:
- The objective of the business model within which the asset is held is to both collect contractual cash flows but also to increase returns, when possible, by selling the asset, and
- The contractual terms of the asset give rise to cash flows that are solely repayments of principal and interest on the principal amount outstanding.
If not classified through either, then the asset is measured at fair value through profit or loss.
5.4 Classification: derivatives with gains
Derivatives with gains are classified as fair value through profit or loss.
6.1 Accounting treatment of financial assets per IFRS9: initial recognition
The following issues need to be considered: initial recognition, subsequent measurement, reclassification, impairments and derecognition.
A financial asset should be recognised when the entity enters into the contractual provisions. The asset should initially be recognised at fair value, this takes into account whether the instrument needs discounting to PV (the PV is the initial amount of the receivable, the difference between proceeds and present value is an expenses in the SPL).
Transaction costs are not part of FV but should be taken into account when acquiring a financial asset. If a FVPL asset do not add transaction costs to FV, but to the P+L. If any other asset, add to the initial FV when recognised.
6.2 Subsequent measurement
The measurement of a financial instrument is determined by its categorisation:
- FVPL and FVOCI assets: revalue to fair value at the reporting date.
- Other assets: hold at amortised cost.
6.3 Amortised cost accounting
The financial asset is initially recorded at fair value with any transaction costs added. Interest is accounted for over the life of the asset using the effective rate of interest and taken to SPL. The coupon interest is deducted from the carrying amount as received. The coupon rate is the cash element of the interest based on the nominal value of the instrument.
6.4 Fair value accounting
FVPL assets: items are revalued to FV at the reporting date and any gains or losses on revaluation go to the SPL.
FVOCI assets: revalued to FV at the reporting date and any gains or losses on revaluation are shown as OCI and accumulated in a separate reserve in equity. On disposal of an FVOCI asset, a gain or loss would be recognised based upon the difference between disposal proceeds and carrying amount. Interest on an interest-bearing asset should be calculated using the effective interest method and recognised in SPL.
6.5 IFRS13 Fair value measurement
IFRS 13 defines FV as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants are the measurement date. It applies when another IFRS standard requires or permits FV measurements. The requirements do not apply for share-based payments under IFRS 2 share-based payments, leases under IFRS 16 leases, NRV for inventories in IAS 2 Inventories or value in use for IAS 36 impairment of assets.
IFRS 13 seeks to increase consistency and comparability in FV measurement. A FV hierarchy exists, which identifies inputs used in valuation techniques to determine fair value:
- Level 1 inputs: quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
- Level 2 inputs: inputs other than level 1 that are observable for the asset or liability, either directly or indirectly
- Level 3 inputs: unobservable inputs for the asset or liability such as an income approach. These should be kept to a minimum.
Quoted price of an instrument in an active market (level 1):
When an active market exists, two prices are quoted. The bid price (price at which the dealer will buy (lower)) and the ask price (the price at which the dealer will sell). These should be accounted for as follows:
- Bid price is at fair value.
- Ask spread (difference between the bid and ask price) on acquisition = transaction cost
A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either:
- In the principal market for the asset or liability, or
- In the absence of a principal market, in the most advantageous market for the asset or liability
6.6 Reclassification of financial assets
IFRS 9 requires that when an entity changes its business model for managing financial assets, it should reclassify all affected financial assets. A change only occurs when an entity begins or ceases to perform an activity that is significant to operations. The reclassification is applied prospectively from the reclassification date. However, if a financial asset is classified at amortised cost, it does not mean that the entity can never sell the asset. Infrequent or insignificant sales are permitted, provided the business model to collect contractual cash flows remains unchanged.
6.7 Impairments of financial assets
The following instruments are in scope of IFRS 9 requirements:
- Financial assets which are debt instruments measured at amortised costs or FVOCI.
- IFRS 9 impairment rules do not apply to financial assets classified at FVPL and equity instruments designated as FVOCI on initial recognition.
- Expected credit losses: a probability-weighted estimate of credit losses.
- Lifetime expected credit losses: expected credit losses over the remaining life of a financial asset.
- 12-month expected credit losses: the proportion of lifetime expected credit losses that result from default events that are possible within 12 months of the reporting date
Credit loss: this is the difference between the PV of the contractual cash flows that are due to an entity and the PV of the cash flows that the entity actually expects to receive, both discounted at the original effective interest rate of the instrument.
Impairment accounting under IFRS 9: for financial assets within the scope of the impairment rules, entities must create a loss allowance upon initial recognition of the asset. This allowance is based on the expected loss as a result of default. On initial recognition, this loss allowance will be equal to 12 month expected credit losses. The loss allowance will subsequently need to be adjusted depending on whether the credit quality of the financial asset has significantly deteriorated since its initial recognition. For this purpose, the impairment model of IFRS 9 classifies financial assets into three stages as follows:
- Stage 1: financial assets whose credit quality has not significantly deteriorated since initial recognition. The loss allowance is equal to 12-month expected credit losses.
- Stage 2: financial assets whose credit quality has significantly deteriorated since their initial recognition (rebuttable presumption if > 30 days past due). The loss allowance is equal to lifetime expected credit losses.
- Stage 3: financial assets for which there is objective evidence of impairment at the reporting date. The loss allowance is equal to the lifetime expected credit losses.
Stage 3: the following are indications that a financial asset or group of assets may be impaired:
- Significant financial difficulty of the issuer
- A breach of contract, such as a default in interest or principal payments
- The lender granting a concession to the borrower that the lender would not otherwise consider, for reasons relating to the borrower’s financial difficulty.
- It becomes probable that the borrower will enter bankruptcy.
- The disappearance of an active market for that financial asset because of financial difficulties
- The purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses.
Calculation of interest income: interest income at stage 1 or 2 is calculated on the gross carrying amount of the asset. However, for stage 3, interest is calculated based on the net carrying amount (after deducting the credit impairment allowance from the gross carrying amount).
6.8 Accounting for financial assets that are debt impairments measured at FVOCI.
Debt instruments classified as FVOCI are subject to the expected loss impairment model of IFRS 9, which increases or decreases in the allowance recognised in profit or loss.
Since a FVOCI financial asset is already carried at FV, the loss allowance is not netted off against the value of the asset on the face of the SFP. If the financial asset is measured at FVOCI then the entry to record an increase in the allowance is: Dr SPL Cr OCI.
This transfers part of the fall in fair value relating to expected credit losses from OCI to profit or loss.
For trade receivables that do not have an IFRS 15 element (not been discounted to PV because the cash flow is less than 12 months from the initial sale), the loss allowance is measured at the lifetime expected credit losses, from initial recognition. For other trade receivables, the entity can choose to apply the three-stage approach or to recognise an allowance for lifetime expected credit losses from initial recognition.
6.9 Derecognition
A financial asset should be derecognised when: the entity transfers substantially all the risks and rewards of ownership to another party, or the contractual rights to the cash flows have expired. This applies to the whole, or part of, a financial asset. Any gains or losses on derecognition are recognised in the profit or loss or OCI, depending on classification. Common derecognition issues are:
- Repurchase agreements: this is when a company sells an asset and simultaneously enters into a contract to repurchase the asset at a fixed future date. The details of the agreement need to be examined to determine whether the company has significantly transferred the risks and rewards of ownership of the asset.
- Factoring/invoice discounting: a factor gives the company cash in exchange for the rights to the future receipts from the company’s receivables. If the factoring/invoice discounting arrangement is without recourse, then the company does not have to compensate the factor for non-payment or late payment by the receivables and has therefore passed on the risks of ownership of the asset. If the factoring discounting arrangement is with recourse, then the company guarantees the future performance of receivables and will compensate the factor if they are slow to pay or do not pay. In this case, the facts must be examined to determine whether substantially all the risks of ownership have been transferred.
