IAS 39

This is the first of a two-part article outlining the main requirements of IAS 39, Financial Instruments: Recognition and Measurement. It is difficult to detail all the requirements of IAS 39 in these two articles - the standard itself must also be consulted. IAS 39 is an extremely detailed standard. It is comprehensive and has caused significant controversy in Europe and throughout the world. It is important that students read around the subject and try and grasp the main principles. It is not an easy topic, and changes to IAS 39 are envisaged in the future.

This first article deals with the application, recognition and de-recognition, classification, and measurement of financial instruments. IAS 39 addresses the accounting for financial assets and financial liabilities, dealing with the following areas:

• the recognition of a financial asset or financial liability in the balance sheet
• the de-recognition of a financial asset or financial liability from the balance sheet
• the classification of a financial asset or financial liability into different categories, and their measurement
• whether a gain or loss on a financial asset or financial liability should be recognised either in profit or loss, or in reserves.

Presentation and disclosure are dealt with in IAS 32, Financial Instruments: Disclosure and Presentation.

Application of IAS 39
A financial instrument is any contract that gives rise to a financial asset of one company and a financial liability or equity instrument of another company. Examples of financial assets are cash, deposits in other companies, trade receivables, loans to other companies, investments in debt instruments, investments in shares, and other equity instruments. Examples of financial liabilities are trade payables, loans from other companies, and debt instruments issued by the company.

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 companies to speculate on future changes in the market at a relatively low cost, or no initial cost at all.

Apart from items that meet the definition of financial instruments, IAS 39 also applies to some contracts that do not meet this definition, but have characteristics similar to derivative financial instruments. This means that IAS 39 applies to contracts to purchase or sell non-financial items, such as precious metals, at a future date when the following applies:

• the contract is subject to possible net settlement - a situation whereby the company can settle the contract net in cash rather than by delivering or receiving, for example, a precious metal
• the contract is not part of the normal purchase or sale requirements of the company. If the purchase of the precious metal was normal for the company then it is excluded from the scope of IAS 39.

Example
A company enters into a contract to purchase a quantity of a metal for a fixed price at a future date. The metal is actively traded on the metals exchange and is readily converted to cash. The company is in the retail industry.

This contract is within the scope of IAS 39 because it is a contract to buy or sell a non-financial item and the contract is subject to a potential net settlement. Also, it is unlikely that the normal business of the company includes the purchase of metals.

IAS 39 does not apply to a company's own issued equity instruments. Investments in equity instruments issued by other companies, 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 IFRSs. Investments in subsidiaries, for example are accounted for under IFRS 3, Business Combinations.

Recognition and de-recognition
Recognition
A company should recognise a financial asset or financial liability on its balance sheet when the company becomes a party to the contractual provisions of the instrument, rather than when the contract is settled. Derivatives are therefore recognised in the financial statements, even though the company may have paid or received nothing on entering into the derivative.

De-recognition of financial assets
De-recognition of a financial asset occurs if one of the following criteria is met:

• the contractual rights to the cash flows of the financial asset have expired
• the financial asset has been transferred (eg sold) and the transfer qualifies for de-recognition based on the extent of the transfer of the risks, and the rewards of ownership of the financial asset.

The contractual rights to cash flows may expire because, for instance, a customer has paid-off an obligation to the company, or an option held by the company has expired worthless. De-recognition occurs because the rights associated with the financial asset no longer exist. The second criterion for
de-recognition of financial assets occurs when a company sells or transfers a financial asset to another party. Here the company must evaluate the extent to which it has transferred the risks and rewards of ownership to the other party. This evaluation is based on a comparison of the amounts and timing of the net cash flows of the asset before and after the transfer of the asset. If a company transfers substantially all risks and rewards of ownership of a financial asset, the company de-recognises the financial asset entirely. The risks and rewards of ownership are transferred where, in the sale of a financial asset:

• the seller does not retain any rights or obligations associated with the asset sold
• the seller retains a right to repurchase the financial asset in the future at the current fair value of the asset on the repurchase date. For example, a company retains substantially all risks and rewards of ownership if, when the financial asset is sold, the asset is returned to the transferor for a fixed price at a future date. The sale would not qualify for de-recognition.

Examples
A company sells an investment in shares, but retains a call option to repurchase the shares at any time, at a price equal to their current fair value on the repurchase date. The company will de-recognise the asset as it only has an option to purchase.

A company sells an investment in shares and enters into a total return swap with the buyer. Under this arrangement, the buyer will return any increases in value to the company, and the company will pay the buyer interest plus compensation for any decrease in the value of the investment. The company will not de-recognise the investment as it has retained substantially all the risks and rewards.

De-recognition of financial liabilities
The de-recognition criteria for financial liabilities are different from those for financial assets. There is no requirement to assess the extent to which the company has retained risks and rewards in order to de-recognise a financial liability. The de-recognition requirements focus on whether the financial liability has been extinguished. For example if a put option, written by a company, expires then it will be de-recognised. However if a company has a liability which is transferred to a trust, then de-recognition is not appropriate as the liability has not been extinguished.

Classification
There are four categories of financial assets and two categories of financial liabilities. Classification determines:

• the measurement of the item at cost, amortised cost, or fair value in the balance sheet
• where a gain or loss should be recognised, either in profit or loss, or equity (reserves).

Financial assets
A company 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 company either holds for trading purposes or has otherwise elected to classify into this category. 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 company acquired it for the purpose of selling it in the near future, or it 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 other than those held for trading may also be classified on initial recognition at fair value through profit or loss. This is often referred to as the 'fair value option'. The IASB has issued an exposure draft that proposes to limit the use of the fair value option, and the EU has amended IAS 39 in this regard.

Held-to-maturity investments
These include investments in debt instruments that the company will not sell before their maturity date, irrespective of changes in market prices or the company's financial position or performance. Generally, investments in shares do not have a maturity date, and should not be classified as held-to-maturity investments. 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.

Loans and receivables
These include financial assets with fixed or determinable payments that do not have a quoted price in an active market. A company can classify accounts 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 company shows an intention to hold the loans and receivables to maturity.

Available-for-sale financial assets
This category includes financial assets that do not fall into any of the other categories, or those assets that the company has elected to classify into this category. For example, a company 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.

Examples

• A trade receivable that is not held-for-trading should be classified into the category of loans and receivables.
• 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.
• An investment in an equity instrument that is not quoted, and for which there is no intention to sell, should be classified as available-for-sale.

In the above examples, the item could also be classified as at fair value through profit and loss. A debt security, purchased by a company, that is not quoted in an active market, and that is not held-for-trading, should be classified as loans and receivables unless the company designates it as either at fair value through profit or loss, or available-for-sale.

Financial liabilities
There are two categories of financial liabilities:

• at fair value through profit or loss
• measured at amortised cost.

Fair value through profit or loss
Financial liabilities at fair value through profit or loss include financial liabilities that the company either has incurred for trading purposes or has otherwise elected to classify into this category. Derivative liabilities are always treated as held-for-trading unless they are designated as effective hedging instruments. An issued debt instrument that the company intends to repurchase soon - to make a gain from short-term movements in interest rates - is an example of a liability held for trading.

Measured at amortised cost
Financial liabilities measured at amortised cost is the default category for financial liabilities that do not meet the definition of financial liabilities at fair value through profit or loss. For many companies, most financial liabilities will fall into this category. Examples of financial liabilities that would generally be classified in this category are accounts payables, loan notes payable, issued debt instruments, and deposits from customers.

Reclassification
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 and held-to-maturity categories are possible, although reclassifications of a significant amount of held-to-maturity investments would necessitate reclassification of all remaining such investments to available-for-sale. A company cannot reclassify from loans and receivables to available-for-sale. Companies would be able to manage earnings if these restrictions were not in place.

Measurement
The measurement requirements deal with the valuation of financial instruments and whether gains and losses on financial assets and financial liabilities should be included in profit or loss, or recognised directly in reserves.

When a financial asset or financial liability is initially recognised 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, it is generally equal to the amount of consideration paid or received for the financial asset or financial liability on initial recognition.

Example
A debt security that is held for trading is purchased for £6,000. Transaction costs are £400. The initial carrying amount is £6,000 and the transaction costs of £400 are expensed. This treatment applies because the debt security is classified as held-for-trading and, therefore, is measured at fair value.

A bond classified as available-for-sale is purchased for £5,500 and transaction costs are £500. The initial carrying amount is £6,000, ie 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.

Subsequent measurement
Subsequent to initial recognition, financial assets and financial liabilities are measured using one of the following methods:

• cost
• amortised cost
• fair value.

The measurement method depends on classification and whether fair value can be reliably determined. Subsequent to initial recognition, only one type of financial instrument is measured at cost - investments in unquoted equity instruments that cannot be reliably measured at fair value.

Amortised cost
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. For example, if the amortised cost of an investment in a debt instrument - for which no interest or principal payments are made during the year at the beginning of 20X6 is £5,000 and the effective interest rate is 6% - the amortised cost at the end of 20X6 is £5,300 (5000 + (6% x 5,000)).

Subsequent to initial measurement, the following financial assets and financial liabilities are measured at amortised cost in the balance sheet:

• held-to-maturity investments
• loans and receivables
• financial liabilities not measured at fair value through profit or loss.

Example
A debt security has a stated principal amount of £5,000. This will be repaid in five years at an interest rate of 6% per year, payable annually at the end of each year. The company purchases the security on 1 January 20X4, at a discount, for £4,670. The company 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 (See Table 1 below).
At the end of 2004, the company makes the following entry:
Dr Cash 300
Dr Debt security 57
Cr Interest income 357

Fair value
The following financial assets and financial liabilities are normally measured at fair value in the balance sheet:

• financial assets at fair value through profit or loss
• available-for-sale financial assets
• financial liabilities at fair value through profit or loss.

The exception is investments in equity instruments that are not quoted in an active market and cannot be reliably measured at fair value. Such instruments are measured at cost instead of fair value. For financial assets and liabilities at fair value through profit or loss, all changes in fair value are recognised in profit or loss when they occur. This includes unrealised holding gains and losses.

For available-for-sale financial assets, unrealised holding gains and losses are deferred in reserves until they are realised, or impairment occurs. Only interest and dividend income, impairment losses, and certain foreign currency gains and losses, are recognised in profit or loss. IAS 39 establishes rules for determining fair value. The existence of a published price quoted in an active market is the best evidence of fair value. For assets or liabilities that are not quoted in an active market, fair value is determined using valuation techniques, such as discounted cash flow or option-pricing models.

Examples
Financial assets at fair value through profit or loss

A company acquires, for cash, 500 shares at £5 per share and classifies them as at fair value through profit or loss. At the year-end, the quoted price increases to £6. The company sells the shares for £3,400 just after the year-end.

Initial recognition
Dr Financial assets at fair
value through profit or loss £2,500
Cr Cash £2,500
Year-end
Dr Financial assets at fair value through profit or loss £500
Cr Income statement £500

After year-end
Dr Cash £3,400
Cr Financial assets at fair value through profit or loss £3,000
Cr Income statement £400

Available-for-sale financial assets
If the company had classified the shares as available-for-sale, the entries would be as follows:

Initial recognition
Dr Available-for-sale financial assets £2,500
Cr Cash £2,500

Year-end
Dr Available-for-sale financial assets £500
Cr Reserves £500

After year-end
Dr Cash £3,400
Dr Reserves £500
Cr Available-for-sale financial assets £3,000
Cr Income statement £900

The second article will be published in the June/July issue of student accountant. Alternatively, read it online now at www.accaglobal.com in the Paper 3.6 resources section.

Graham Holt is examiner for Paper 3.6