Professional Documents
Culture Documents
IAS-32, IAS-39
IFRS-7,IFRS-9
Definitions
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.
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entitys own equity
instruments and is:
(i) a non-derivative for which the entity is or may be obliged to receive a
variable number of the entitys own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a
fixed amount of cash or another financial asset for a fixed number of the
entitys own equity instruments.
Initial measurement
At initial recognition, an entity shall measure a financial asset or
financial liability at its fair value (normal its cost) plus or minus,
in the case of a financial asset or financial liability not at fair
value through profit or loss, transaction costs that are directly
attributable to the acquisition or issue of the financial asset or
financial liability.
Fair Value of Financial instrument
Where Active market exist
The existence of published price quotations in an active market is
the best evidence of fair value and when they exist they are
used to measure the financial asset or financial liability.
Where no active market exist
If the market for a financial instrument is not active, an entity
establishes fair value by using a valuation technique. Valuation
techniques include using recent arms length market
transactions between knowledgeable, willing parties, if
available, reference to the current fair value of another
instrument that is substantially the same, discounted cash
flow analysis and option pricing models.
Classification of financial
assets
Debt instrument
An entity shall classify financial assets as subsequently
measured at either amortized cost or fair value on the basis of
both:
(a) the entitys business model for managing the financial assets and
(b) the contractual cash flow characteristics of the financial asset.
Equity instrument
An equity instrument either measured at
Fair value through profit or Loss or
Fair value through other comprehensive income
Classification of financial
assets
The classification of a financial asset, which is an equity instrument,
through other comprehensive income is only possible when and only
when
At initial recognition, an entity may make an irrevocable election to
present in other comprehensive income and
This financial asset is not not held for trading.
Subsequent measurement
Subsequent changes in fair value (gains and losses) should be reported
in other comprehensive income and the subsequent reclassification
of gain and losses in profit or loss is not possible (although it can be
transfer with in the equity at de recognition [disposal]).
Dividend income
If an entity makes the election of this classification of financial asset, it
shall recognize in profit or loss dividends from this investment when
the entitys right to receive payment of the dividend is established.
Classification of financial
liabilities
An entity shall classify all financial liabilities as
subsequently measured at amortized cost using the
effective interest method, except for financial liabilities at
fair value through profit or loss. Such liabilities, including
derivatives that are liabilities, shall be subsequently
measured at fair value.
Under IFRS the issuer should classify the instrument, or its
component parts, as a financial liability or as equity in accordance
with the substance of the contractual arrangement on initial
recognition, and the definitions of a financial liability and a equity
instrument. The classification made at the date of issue
Some financial instruments have the legal form of equity but are, in
substance, liabilities. For example an issuer has a contractual
obligation to either deliver cash or another financial asset
(redeemable preference shares).
Compound instrument
A compound instrument is a financial instrument that has
characteristics of both equity and liabilities, for example debt
that can be converted into shares.
The bondholder has the prospect of acquiring cheap shares in an
entity, because the terms of conversion are normally quite generous.
Even if the bondholder wants cash rather than shares, the deal may
still be good. On maturity the cash hungry bondholder will accept the
conversion, and then sell the shares on the market for a tidy profit.
In exchange though, the bondholders normally have to accept a below
market rate of interest, and will have to wait some time before they
get the shares that form a large part of their return. There is also the
risk that the entitys shares will underperform, making the conversion
unattractive.
IAS 32 requires compound financial instruments be split into their
component parts:
a financial liability (the debt)
an equity instrument (the option to convert into shares).
These must be shown separately in the financial statements.
Examples of Compound
instrument
On 1 January 20X1 D issued a $50m three year convertible bond at par.
There were no issue costs. The coupon rate is 10%, payable annually
in arrears on 31 December. The bond is redeemable at par on 1
January 20X4. Bondholders may opt for conversion. The terms of
conversion are two 25 cent shares for every $1 owed to each
bondholder on 1 January 20X4. Bonds issued by similar companies
without any conversion rights currently bear interest at 15%. Assume
that all bondholders opt for conversion in full.
How will this be accounted for by D?.
C issues a $100,000 4% three year convertible loan on 1 January 20X6.
The market rate of interest for a similar loan without conversion rights
is 8%. The conversion terms are one ordinary $1 share for every $2 of
debt. Conversion or redemption at par takes place on 31 December
20X8.
How should this be accounted for.
Example of impairment
On 1 February 20X6, Eve makes a four year loan of $10,000
to Fern. The coupon on the loan is 6%, the same as the
effective rate of interest. Interest is received at the end of
each year. On 1 February 20X9, it becomes clear that Fern
is in financial difficulties. This is the necessary objective
evidence of impairment. At this time the current market
interest rate is 8%. It is estimated that the future remaining
cash flows from the loan will be only $6,000, instead of
$10,600 (the $10,000 principal plus interest for the fourth
year of $600).
Reversals of impairment losses
A reversal of an impairment loss is only permitted as a
result of an event occurring after the impairment loss has
been recognized. An example would be the credit rating of
a customer being revised upwards by a rating agency.
Impairment losses in respect of financial assets measured
at amortized cost are recognized in profit or loss.
Reclassification
When, and only when, an entity changes its business model for
managing financial assets it shall reclassify all affected
financial assets in accordance with the requirement of this
IFRS.
An entity shall not reclassify any financial liability.
If an entity reclassifies financial assets, it shall apply the reclassification
prospectively from the reclassification date. The entity shall not restate
any previously recognized gains, losses or interest.
If an entity reclassifies a financial asset so that it is measured at fair
value, its fair value is determined at the reclassification date. Any gain
or loss arising from a difference between the previous carrying amount
and fair value is recognized in profit or loss.
If an entity reclassifies a financial asset so that it is measured at
amortized cost, its fair value at the reclassification date becomes its
new carrying amount.
Drecognition
An entity shall derecognize a financial asset 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
(eg. Sold it and substantially all risks and rewards of the ownership have
been transferred from seller to buyer)
Drecognition
Bell buys an investment for trading purposes from Book. It cost
$10 million at 1 January 20X7. At 31 December 20X7, the
investment had a fair value of $30 million. On 1 June 20X8
Bell sold the investment to Candle for its market value of
$100 million.
(1) How should this be accounted for?
(2) Would the answer have been different if Bells purchase
contract had contained a put option giving Bell the power to
sell the investment back to Book at market value on 31
December 20X8?
(3) Would the answer have been different if Bells sale contract
had provided Bell with a call option and Candle with a put
option over the investment, each at a price of $105 million
over the next 12 months?
Derivatives
A derivative is a financial instrument with the following characteristics:
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).
It requires little or no initial net investment relative to other types of
contract that have a similar response to changes in market
conditions.
It is settled at a future date.
Derivatives include the following types of contracts:
Forward contracts
Futures contracts
Forward rate agreements
Swaps
Options
Measurement of derivatives
On recognition, derivatives should initially be measured
at fair value. Transaction costs may not be included.
The derivatives could be used for two broad purposes
Speculation
Hedging
Subsequent measurement depends on how the derivative is
categorized.
If these are for speculation purpose then it should be
measured at fair value through profit or loss with changes in
the fair value recognized in profit or loss.
However if the derivative is used as a hedge then the
changes in fair value should be recognized in according to
hedge accounting.
Hedge accounting
Hedging is a method of managing risk by designating one
or more hedging instruments so that their change in fair
value is offset, in whole or in part, to the change in fair
value or cash flows of a hedged item.
A 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).
A hedging instrument is a designated derivative whose
fair value or cash flows are expected to offset changes in
fair value or future cash flows of the hedged item.
So the item generates the risk and the instrument modifies
it.
Types of hedge
IAS 39 identifies three types of hedge, first two of which are within
the P2 syllabus:
Fair value hedge This hedges against the risk of changes in the fair value
of a recognized asset or liability. For example, the fair value of fixed rate
debt will change as a result of changes in interest rates.
Cash flow hedge This hedges against the risk of changes in expected cash
flows. For example, a UK entity may have an unrecognized contractual
commitment to purchase goods in a years time for a fixed amount of US
dollars.
Net Investment Hedges same accounting treatment as cash flow
hedge
Hedge effectiveness
One of the requirements of IAS 39 is that to use hedge accounting, the hedge
must be effective. IAS 39 describes this as the degree to which the
changes in fair value or cash flows of the hedged item are offset by
changes in the fair value or cash flows of the hedging instrument. A hedge
is viewed as being highly effective if actual results are within a range of
80% to 125%.
Problem Area
Strauss buys an 8% $10million fixed rate debenture when
interest rates are 8% for the fair value of $10 million. The
asset is classified as an available for sale financial asset.
Strauss is risk averse and wishes to enter into a derivative to
protect it against a fall in the value of the asset if interest
rates should rise. As a result it enters into an interest rate
swap, which is designated as a hedging instrument for the
debenture. Interest rates increase to 9%.
How should this be accounted for?
Accounting
for a cash flow hedge
For cash flow hedge, the hedging relationship must meet five
criteria. These are the four same as listed for a fair value
hedge plus
The transaction giving rise to the cash flow risk is highly
probable and will ultimately affected profitability.
Accounting Treatment
The hedge instrument will be remeasured at fair value. The gain and
loss on the portion of the instrument that deemed to be an effective
hedge will be taken to equity and recognize in the statement of
change inequity.
The ineffective portion of the gain or loss will be reported in profit or
loss immediately in the income statement.
If the hedge item eventually result in the recognition of a non
current asset or liability, the gain or loss held in equity must be
recycled in one of the two following ways
The gain / loss goes to adjust the carrying amount of non financial asset/liability.
The gain / loss is transferred to profit or loss in the line with the consumption of
the non financial asset/ libility.