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This article was first published in the October 2006 edition of Accounting and Business magazine.
Current requirements for financial instruments are included in IAS 32, Financial Instruments: Presentation, IAS 39, Financial Instruments: Recognition and Measurement, and IFRS 7, Financial Instruments: Disclosures. The purpose of this article is to provide an introduction to IFRS requirements for financial instruments. It is not a comprehensive guide to all of the requirements of the standards.
IAS 32 includes requirements for the presentation of financial instruments as either financial liabilities or equity, including:
- when a financial instrument should be presented as a financial liability or equity instrument by the issuing entity
- how to separate and present the components of a compound financial instrument that contains both liability and equity elements.
Further, it sets out the nature of the presentation of interest, dividends, losses and gains related to financial instruments and the circumstances in which financial assets and financial liabilities should be offset.
IFRS 7 deals with financial instruments’ disclosures and pulls them together in a new standard. Disclosure was formerly dealt with by IAS 32.
The two main categories of disclosures required by IFRS 7 are:
- information about the significance of financial instruments
- information about the nature and extent of risks arising from financial instruments.
This article deals with the following areas of IAS 39:
- the application of IAS 39
- the recognition of a financial asset or financial liability in the balance sheet
- the classification of a financial asset or financial liability into different categories of financial assets or financial liabilities and their measurement.
Application of IAS 39
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. The definition is wide and includes cash, deposits in other entities, trade receivables, loans to other entities. investments in debt instruments, investments in shares and other equity instruments. Examples of financial liabilities are: trade payables, loans from other entities, and debt instruments issued by the entity.
IAS 39 also applies to more complex, derivative financial instruments such as call options, put options, forwards, futures, and swaps. Derivatives are contracts that allow entities to speculate on future changes in the market at a relatively low or no initial cost.
Apart from items that meet the definition of financial instruments, IAS 39 also applies to some contracts that do not meet the definition of a financial instrument, but have characteristics similar to derivative financial instruments. This means that IAS 39 applies to contracts to purchase or sale of non-financial items such as precious metals at a future date when the following applies:
- the contract is subject to possible net settlement which is the situation where the entity can settle the contract net in cash rather than by delivering or receiving for example a precious metal or a commodity
- the contract is not part of the normal purchase or sale requirements of the entity. If the purchase of the precious metal was normal for the entity then it is excluded from the scope of IAS 39.
IAS 39 does not apply to an entity’s own issued equity instruments. Investments in equity instruments issued by other entities, however, are financial assets. IAS 39 also provides exceptions for some other items that meet the definition of a financial instrument as they are accounted for under other IFRS. For example, investments in subsidiaries are accounted for under IFRS 3, Business Combinations, and employers' assets and liabilities under employee benefit plans, which are accounted for under IAS 19, Employee Benefits.
An entity should recognise a financial asset or financial liability on its balance sheet when the entity becomes a party to the contractual provisions of the instrument rather than when the contract is settled. Thus derivatives are recognised in the financial statements even though the entity may have paid or received nothing on entering into the derivative. IAS 39 is a partial rather than a full fair value model. Financial assets and liabilities are measured at fair value or amortised cost depending upon their classification.
A substance over form model is applied to debt/equity classification. The critical test is whether the issuer has discretion over the transfer of benefits (cash, for example). If the issuer has no discretion over payment, then the instrument is a liability. Thus certain instruments, such as redeemable preference shares, will be shown as liabilities.
There are four clearly defined categories of financial assets and two clearly defined categories of financial liabilities. The classification of a financial asset or financial liability determines:
- the measurement of the item (at cost, amortised cost, or fair value)
- where the gain or loss should be recognised (either in profit or loss or in equity (reserves).
All financial assets, including derivatives, are recognised on the balance sheet under IFRS. They are initially measured at fair value plus, in the case of a financial asset not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition of the asset.
An entity is required to classify its financial assets into one of the following four categories:
- financial assets at fair value through profit or loss
- held-to-maturity investments
- loans and receivables
- available-for-sale financial assets.
Financial assets at fair value through profit or loss
These include financial assets that the entity either holds for trading purposes or upon initial recognition it designates as at fair value through profit or loss. A entity may use this latter designation when doing so results in more relevant information by eliminating or significantly reducing a measurement or recognition inconsistency (an accounting mismatch) or where a group of financial assets and/or financial liabilities is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the assets and/or liabilities is provided internally to the entity's key management personnel.
Financial assets that are held for trading are always classified as financial assets at fair value through profit or loss. A financial asset is held for trading if the entity acquired it for the purpose of selling it in the near future or is part of a portfolio of financial assets subject to trading. Derivative assets are always treated as held for trading unless they are effective hedging instruments.
Financial assets at fair value through profit or loss are re-measured to fair value at each subsequent balance sheet date until the assets are de-recognised. The gains and losses arising from changes in fair value are included in the income statement in the period in which they occur. Gains and losses will include both realised gains and losses arising on the disposal of these financial assets and unrealised gains and losses arising from changes in the fair value of the assets still held.
This category is intended for investments in debt instruments that the entity will not sell before their maturity date irrespective of changes in market prices or the entity’s financial position or performance. Investments in shares generally do not have a maturity date, and thus should not be classified as held-to-maturity investments. IAS 39 requires a positive intent and ability to hold a financial asset to maturity.
In order to be classified as held-to-maturity, a financial asset must also be quoted in an active market. This fact distinguishes held-to-maturity investments from loans and receivables. Loans and receivables, and financial assets that are held for trading, including derivatives, cannot be classified as held-to-maturity investments. Floating rate debt is considered to have determinable payments and can therefore be included in the held-to-maturity category.
When an entity's actions cast doubt on its intent or ability to hold investments to maturity, the entity is prohibited from using the held-to-maturity category for a reasonable period of time. A penalty is therefore effectively imposed for a change in management's intention. The entity is forced to reclassify all its held-to-maturity investments as available-for-sale (see below) and measure them at fair value until it is able, through subsequent actions, to restore faith in its intentions. An entity may not classify any financial assets as held to maturity if during the current or preceding two years it has sold or reclassified more than an insignificant amount of held to maturity investments except in very narrowly defined circumstances.
Held-to-maturity assets are subsequently carried at amortised cost, and are subject to impairment testing.
Loans and receivables
These include financial assets with fixed or determinable payments that are not quoted in an active market. An entity can classify account receivables, and loans to customers in this category. Financial assets with a quoted price in an active market and financial assets that are held for trading, including derivatives, cannot be classified as loans and receivables. This category differs from held-to-maturity investments as there is no requirement that the entity shows an intention to hold the loans and receivables to maturity. If it is thought that the owner of the asset may not recover all of the investment other than because of credit deterioration, then the asset may not be classified as loans and receivables.
Loans and receivables are subsequently measured at amortised cost and are subject to impairment testing. Amortised cost is discussed below.
Available-for-sale financial assets (AFS)
This category includes financial assets that do not fall into any of the other categories or those assets that the entity has elected to classify into this category. For example, an entity could classify some of its investments in debt and equity instruments as available-for-sale financial assets. Financial assets that are held for trading, including derivatives, cannot be classified as available-for-sale financial assets. Thus, AFS is a residual category. The AFS category will include all equity securities except those classified as fair value through profit or loss.
Available-for-sale financial assets are carried at fair value subsequent to initial recognition. There is a presumption that fair value can be readily determined for most financial assets either by reference to an active market or by a reasonable estimation process. The only exemption to this are equity securities that do not have a quoted market price in an active market and for which a reliable fair value cannot be reliably measured. Such instruments are measured at cost instead of fair value.
For available-for-sale financial assets, unrealised holding gains and losses are deferred in reserves until they are realised or impairment occurs. Only interest income and dividend income, impairment losses, and certain foreign currency gains and losses are recognised in profit or loss.
An accounts receivable that is not held for trading should be classified as loans and receivables unless the entity decides that it will classify it as at fair value through profit and loss or available for sale.
An investment in shares that has a quoted price and that is not held for trading should be classified as an available-for-sale financial asset unless the entity decides to classify it as at fair value through profit and loss.
A debt security purchased by an entity that is not quoted in an active market and that is not held for trading should be classified as loans and receivables unless the entity can designate it as either at fair value through profit or loss or available for sale.
There are two categories of financial liabilities:
- at fair value through profit or loss
- at amortised cost.
These include financial liabilities that the entity either holds for trading purposes or upon initial recognition it designates as at fair value through profit or loss. The conditions to be met in order to designate a financial liability at fair value through profit or loss are the same as for financial assets. Derivative liabilities are always treated as held for trading unless they are designated and effective hedging instruments.
An issued debt instrument that the entity intends to repurchase soon to make a gain from short-term movements in interest rates is an example of a liability held for trading. Financial liabilities measured at amortised cost are the default category for financial liabilities that do not meet the definition of financial liabilities at fair value through profit or loss. For most entities, most financial liabilities will fall into this category. Examples of financial liabilities that generally would be classified in this category are accounts payables, loan notes payable, issued debt instruments, and deposits from customers.
IAS 39 restricts the ability to reclassify financial assets and financial liabilities to another category. Reclassifications in or out of the fair value through profit and loss category are not permitted. Reclassifications between the available for sale (AFS) and held to maturity categories (HTM) are possible, although reclassifications of a significant amount of HTM investments would necessitate reclassification of all remaining HTM investments to AFS as set out above. An entity also cannot reclassify from loans and receivables to AFS. Entities would be able to manage earnings if these restrictions were not in place.
When a financial asset or financial liability is recognised initially in the balance sheet, the asset or liability is measured at fair value (plus transaction costs in some cases). Since fair value is a market price, on initial recognition, fair value may not equal the amount of consideration paid or received for the financial asset or financial liability.
A debt security that is held for trading is purchased for £8,000.
Transaction costs are £600. The initial carrying amount is £8,000 and the transaction costs of £600 are expensed. This treatment applies because the debt security is classified as held for trading and, therefore, measured at fair value with changes in fair value recognised in profit or loss.
A bond classified as available for sale is purchased for £10,000 and transaction costs are £1000. The initial carrying amount is £11,000, i.e. the amount paid for the bond and the transaction costs. This treatment applies because the bond is not measured at fair value with changes in fair value recognised in profit or loss. Any changes in fair value of the bond are taken to reserves until the bond is sold.
Subsequent to initial recognition, financial assets and financial
liabilities are measured using one of the following methods:
- amortised cost
- fair value.
Whether a financial asset or financial liability is measured at cost, amortised cost, or fair value depends on its classification above and whether its fair value can be reliably determined.
Subsequent to initial recognition, only one type of financial instrument is measured at cost and that is investments in unquoted equity instruments that cannot be reliably measured at fair value,
Amortised cost is the cost of an asset or liability adjusted to achieve a constant effective interest rate over the life of the asset or liability.
An entity must apply the effective interest rate method in the measurement of amortised cost. The effective interest rate method also determines how much interest income or interest expense should be reported in profit and loss.
A debt security has a stated principal amount of £50,000, which will be repaid in five years at an interest rate of 6% per year payable annually at the end of each year. The entity purchases the security on 1 January 2006 at a discount for £46,700. The entity classifies the debt security as held to maturity.
The effective interest rate of the investment in the debt security is approximately 7.65%. This is the discount rate that will give a present value of the future cash flows that equals the purchase price.
Based on the effective interest rate of 7.65%, the following can be computed