Be exam sharp!
1. What is a financial instrument? / A financial instrument is a contract that creates a financial asset in one entity and a financial liability or equity instrument in another.
Examples:
- Tesco plc buys £100,000 5% 5 year bonds (financial asset) issued by the Bank of England (records financial liability in same value)
- Google Inc buys $1.5m shares (financial asset: Investment in Equity Instruments) in Apple Inc (Equity instruments issued in exchange for cash).
- BP buys convertible bonds (financial asset) from AirBus (records a financial liability). The bonds are issued with an equity conversion option that gives BP the right, if it so wishes, to convert the debt to equity and become a shareholder at or after an agreed date).
2. Are you clear about the scope of IFRS 9 2010? / - IFRS9 (2009) addresses the recognition, classification and measurement of financial assets
- Since October 2010 IFRS 9 has become IFRS 9 2010 revised to include financial liabilities, rules about derecognition of financial assets and financial liabilities and guidance on measurement of fair value
3. Are you able to distinguish between financial assets and other assets? What are the key distinguishing features?
A financial asset is / Examples
i) Cash
ii) Equity instruments of another entity e.g. IEI / Investments in equity instruments of another entity
iii) A contractual right to receive cash, or an equivalent value of another financial asset from another entity, or for the exchange of financial assets or financial liabilities under terms that are favourable to the entity. / Receivables, interest, repayment of principal
Equivalent value of another financial asset: Negotiable instruments e.g. bills of exchange,
Loans to other entities, investments in bonds,
Exchange of financial assets or financial liabilities e.g. Interest rate SWAP involving exchange of variable interest rate for fixed interest rate
iv) A contract that may or will be settled in own equity but is not classified as equity. / Some derivatives on own equity such as a call option
Are you able to distinguish financial liabilities and other liabilities? What are the key distinguishing features?
A financial liability is any liability that is a contractual obligation to / Examples
i) deliver cash or another financial asset to another entity or / § Issued bonds and other debt instruments issued by the entity
§ Loans from other entities
§ Payables
ii) exchange financial assets or financial liabilities with another entity under conditions that are unfavourable to the entity / § Obligation to settle contract in own equity where variable amount of shares required to meet fair value obligation.
iii) contract that may or will be settled in entity’s own equity instruments and is not classified as equity instrument of the entity / § Obligation to deliver own shares worth a fixed amount of cash.
§ Some derivatives on own equity – embedded derivatives
There are two main categories of financial liabilities:
a) At fair value through profit or loss
b) At amortized cost
FINANCIAL LIABILITIES MEASURED AS AT FAIR VALUE THROUGH PROFIT OR LOSS
Financial liabilities that are classified as at fair value through profit or loss include those that are held for trading e.g. derivatives unless used in an effective hedge or classified as such. Other examples of financial liabilities held for trading:
- issued debt instrument that the entity intends to repurchase in the near term to make a profit from short term movements in interest rates
- the obligations relating to a security that an entity has borrowed and sold
Where the fair value option is exercised the entity selectively classifies financial liabilities as at fair value (regardless of whether the liability would have been naturally classified at amortized cost)
The fair value option may only be exercised once, at initial recognition, if any one of the following conditions are met:
- to eliminate, or significantly reduce, an accounting mismatch that would otherwise result from e.g. accounting for an embedded derivative (at fair value) in a hybrid instrument with a financial liability host (accounted for at amortised cost) such as a debt instrument with an equity conversion option.
- The entity measures and manages the performance of a portfolio using fair value information in accordance with documented risk and investment management strategies
- The embedded derivative in a hybrid instrument is not insignificant and separation of the hybrid is not practical.
FINANCIAL LIABILITIES MEASURED AT AMORTIZED COST
This is the default category for financial liabilities that do not meet the definition of FVTPL and most liabilities will be included in this category.
FINANCIAL GUARANTEE CONTRACTS AND LOAN COMMITMENTS
A financial guarantee contract is a contract that requires the issuer to reimburse the holder for the loss it incurs because a specified debtor fails to make payment when due in accordance with the terms of a debt instrument.
After initial recognition (at fair value) IAS 39 requires issued financial guarantee contracts to be measured at the higher of
- amount determined under IAS 37 and
- initial amount of the liability less cumulative amortisation (where relevant) recognised in accordance with IAS 18.
Issued commitments to provide a loan at below market rate should also be measured on this basis.
About the project
This is the second phase of the project to replace IAS 39Financial Instruments: Recognition and Measurement.The objective of this phase is to improve the decision-usefulness of financial statements for users by improving the amortised cost measurement, in particular the transparency of provisions for losses on loans and for the credit quality of financial assets.
4. Can you determine when a financial asset should be recognised? Can you determine when a financial liability should be recognized?
Syllabus extract
3.a) Apply and discuss the recognition … of financial assets and financial liabilities.[2]
Apply (the rule)
A financial asset or financial liability should be recognized when (and only when) the entity becomes a party to the contract and acquires rights and obligations under it. This is the rule under IFRS that deal with financial instruments e.g. IAS 39 (IFRS 9). The examiner requires a discussion of the recognition process and an evaluation of its rules because financial instrument transactions (e.g. an interest free loan) have aspects such as embedded derivatives that are accounted for within financial instrument standards and other aspects that are not, (e.g. arrangement fees) are recognised as revenue (by the creditor) under IAS 18 Revenue. An example of the application of the rule follows:
For example, derivative contracts that give the entity rights to acquire or sell financial assets are themselves financial assets and financial liabilities and should be recognized when the entity becomes a party to the contract, not when it is settled (in future).
Refer to Table 1 in Workbook for practice
Discuss (what does the examiner want you to discuss and why?)
Under IFRS (that don’t deal with financial instruments e.g. IAS 18 Revenue) firm commitments to purchase or sell goods or services do not entitle the entity to an asset or make it responsible for a liability until at least one of the parties to such a commitment has fulfilled its promise under the agreement.
Examples of recognition rules under IFRS (that don’t deal with financial instruments)
An entity that receives a firm order for goods and services does not recognize an asset upon receipt of the order, and the entity that places the order does not recognise a liability until the goods are delivered (or shipped) or services rendered.
The reason the examiner wants you to discuss this is that there are numerous exceptions to this general rule relating to financial instruments introduced by IAS 39 (IFRS 9).
Examples of exceptions to recognition rules under IFRS
a) If a firm commitment to buy or sell non-financial items is within the scope of IAS 39 (IFRS 9) its net fair value is recognised as an asset or liability on the commitment date. (See Example in Workbook q32)
b) If a previously unrecognised firm commitment is designated as a hedged item in a fair value hedge, any change in the net fair value attributable to the hedged risk is recognised as an asset or liability after the inception of the hedge.
These exceptions highlight a fundamental difference between the recognition criteria for financial instruments and those for other items in other standards. In general
- for financial instruments recognition is triggered by entering into a legal agreement (this is in line with a strict application of the definitions of assets and liabilities in the Framework)
- for other items recognition is triggered by performance (executory contracts)
(This is why the examiner wants you to discuss it so that you are aware of the differences)
Are fees part of financial instruments or charges for rendering of services?
Another reason the examiner requires a discussion is the difficulty of identifying those fees that are required by IAS 39 (IFRS 9) to be treated as part of the financial instrument and those that are to be (separated from and separately accounted for) treated as compensation for off-market terms or genuine rendering of services. Here is an example:
Bank B lends €5,000 to company C at 5 percent interest repayable in full after five years. The market rate for similar loans is 8%. An origination fee of €600 is charged by B on the loan and is payable immediately. There are no other charges directly related to this transaction.
Discussion
The loan is recorded at its fair value of €4,400, the present value of an annuity of interest of €250, and the principal repaid at the end of five years, discounted at the market rate. The sum of the fair value of €4,400 and the origination fee of €600 equate to the consideration (loan of €5,000) received. Therefore, no gain or loss is recognised on initial recognition of the loan. The questions is should that fee be recognised as part of the financial instrument because it is compensation to the bank for off-market terms or is it genuinely charges for the rendering of services inherent in producing the debt instrument? This is the question IAS 39 (IFRS9) requires us to consider by looking very carefully at the terms.
Exam insight
Part B case study on this is to be expected as the examiner likes to test understanding of principles. Your approach should be to be clear about the principles for identifying: i) rendering of services, ii) intangible assets, iii) financial asset.
i) IFRS 3 justified expensing acquisition costs on the basis that the benefits from the services received in incurring those costs are exhausted during the process of acquiring the business and no further benefit is derived from those services after the acquisition is completed. Therefore acquisition costs should be expensed. This is consistent with the matching concept.
ii) Could the origination fee be treated as an intangible asset under IAS 38? Three criteria should be met: a) the benefit should be controllable by the entity, b) it should yield future economic benefits and c) it should be separately identifiable. You need to discuss these in relation to the terms of the contract (detailed in the question). You may need to give advice explaining why it is not an intangible asset as may have been suggested by a director, etc.
iii) Could the origination fee be treated as a financial asset? Four criteria should be met for an item to be classified as a financial asset: a) it is cash, b) it is equity, c) it is right to receive cash or equivalent financial asset or to exchange one financial instrument for another, d) it is settled in own equity instrument (issue shares). Evaluate whether the terms of the contract relating to the item (in this case the origination fee) warrant classification as a financial asset.
Transactions between entities under common control
Where a parent lends money to a subsidiary (or a subsidiary lends money to another subsidiary under common control) on an interest-free or low interest basis, in its separate financial statements the parent (or subsidiary) is required to record a receivable (or payable) on initial recognition at a fair value that is lower than cost. The additional consideration is treated as an additional investment in the subsidiary or equity contribution from the parent (or subsidiary).
Interest-free loan to an employee
An interest free loan to an employee is recognised at fair value by the employer as a financial asset. The contractual terms of the loan and of employment may raise issues about the nature of any difference between the market value of the loan (determined at its face value) and the fair value determined at its interest-free contractual terms.
Example
As part of their remuneration package employees of Silco Ltd can borrow up to €1,000 subject to contractual terms including repayment of the loan in full upon leaving the company’s employment at relatively short notice. If the market rate of interest is 10% on similar loans maturing in three years, deemed to be the average retention period of employees of Silco, then the discount would be €249 on initial recognition of a loan of €1,000.