IFRS Seminar

IAS 39 Financial Instruments:

Recognition and Measurement

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Overview of session

• Review of key concepts

•Classification of financial assets

•Measurement of financial assets

•Impairment of financial assets

•Reclassification and tainting

•Conclusion

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Review of key concepts

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.

An equity instrument is any contract that evidences a residual interest in the assets of another

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Review of key concepts

A financial asset is any asset that is cash, an equity instrument of another entity, a contract that (subject to certain conditions) will or may be settled in the entity’s own equity instruments or a contractual right:

• To receive cash or another financial asset from another entity; or

• To exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity.

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Review of key concepts

A financial liability is any liability that is a contract that (subject to certain conditions) will or may be settled in the entity’s own equity instruments or a contractual obligation:

• To deliver cash or another financial asset to another entity; or

• To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity

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Classification – Financial assets (Four categories)

• Financial assets at fair value through profit or loss

• Loans and receivables

• Held to maturity

• Available for sale

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Classification – Financial liabilities (Two categories)

• Financial liabilities at fair value through profit or loss and

• Other financial liabilities

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Classification – Financial AssetsAt Fair Value Through Profit or Loss (FVTPL) 

 

At fair value through profit or loss

Held for trading

Designated at inception

Intention of short term profit;Derivatives – unless hedges or financial guarantee contracts

3 criteria for designation;Irrevocable

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The fair value option

Criterion 2Manage as

a portfolio ona fair value

basis

Criterion 1Accounting mismatch

Criterion 3Embeddedderivative

Available only if either of the 3 criterion met. These criteria are generally only met by financial institutions and other organisations with sophisticated treasury operations.

Classification – Financial AssetsAt Fair Value Through Profit or Loss (FVTPL)

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Classification - financial assetsLoans and receivables

Non-derivative

Fixed or determinable payments

Not quoted in an active

market

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Classification - financial assetsHeld to maturity

Non-derivative

Fixed or determinabl

epayments

Fixed maturity

Entity has a positive intention

and ability to hold to maturity

There are tainting rules that can stop an entity classifying assets as financial assets held-to-

maturity

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Classification - financial assetsAvailable-for-sale

Non-derivative

Not classified in any of the other categories

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Why Is Classification Important?

Because it drives subsequent measurement of the financial asset…

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Measurement of financial assets

• Initial recognition

- When (i.e. timing)

- How much (i.e amount)

- Which account (i.e category)

• Transaction costs

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Transaction costs

Directly attributable

and incremental

Fair value through profit

or loss - expense

All categories apart from Fair Value Through Profit or Loss –

include in initial

measurement

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Subsequent Measurement

Financial assets at fair value through profit or loss

Held to maturity

Available for sale

Loans and receivables

At FV through profit or loss

At amortized cost

At FV through equity

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Example: Initial fair value

An entity enters into a marketing agreement with another organisation. As part of the agreement the entity makes a two year £5,000 interest free loan. Equivalent loans would normally carry an interest rate of 6%, given the borrower’s credit rating. The entity made the loan in anticipation of receiving future marketing and product benefits.

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Example: Initial fair value

Solution:

The fair value of the loan can be determined by discounting the future cash flows to present value using the prevailing market interest rate for a similar instrument with a similar credit rating. The present value of the cash flow in two years time at 6% is £4,450 (£5,000 × (1/1.062)). On initial recognition of the financial asset the entity should recognise a loss of £550 as follows:

DR Loan £4,450

DR Loss (finance expense) £550

CR Cash £5,000

The difference between this initial amount recognised of £4,450 and the final amount received of £5,000 should be treated as interest received and recognised in profit or loss over the two year period.

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Example: At fair value through profit or loss

An entity acquired a derivative on 1 May 20X6 for £200 cash. On 31 December 20X6, the next reporting date, the fair value of the derivative was £340. On 31 December 20X7 the derivative’s fair value had fallen to £220.

Set out the journal entries to record these transactions.

Solution:

On 1 May 20X6:

DR Derivative financial asset £200

CR Cash £200

On 31 December 20X6:

DR Derivative financial asset £140

CR Profit or loss – gain on financial asset (£340 – £200) £140

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Example: At fair value through profit or loss

Solution:

On 31 December 20X7:

DR Profit or loss – loss on financial asset (£340 – £220) £120

CR Derivative financial asset £120

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Exercise: Held to maturity

An entity acquires a zero coupon bond with a nominal value of £20,000 on 1 January 20X6 for £18,900.

The bond is quoted in an active market and broker’s fees of £500 were incurred in relation to the purchase. The bond is redeemable on 31 December 20X7 at a premium of 10%. The effective interest rate on the bond is 6.49%.

Requirement

Set out the journals to show the accounting entries for the bond until redemption if it is classified as a held-to-maturity financial asset. The entity has a 31 December year end.

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Exercise: Held to maturity

Solution:

On 1 January 20X6

DR Financial asset (£18,900 plus £500) £19,400

CR Cash £19,400

On 31 December 20X6

DR Financial asset (£19,400 6.49%) £1,259

CR Interest income £1,259

On 31 December 20X7

DR Financial asset ((£19,400+£1,259) x 6.49%) £1,341

CR Interest income £1,341

DR Cash £22,000

CR Financial asset £22,000

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Held to maturity and Available for sale clasifications

Example:

An entity acquired a 6% £1,000 par value financial asset for its fair value of £970 at the beginning of Year 1. Interest of 6% was receivable annually in arrears. The financial asset was redeemable at the end of Year 3 at £1,030, a premium of 3% to par value. The financial asset is quoted in an active market and was classified as held to maturity by the entity.

Held-to-maturity financial assets should be measured at amortised cost. The effective interest rate of the financial instrument can be calculated at 8.1%. The rate is higher than the coupon rate, because it amortises the discount on issue and the premium on redemption.

The amortised cost carrying amount should be determined as follows.

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Amortised cost and effective interest method

Solution:

Year Opening Interest @ 8.1% Cash flow Closing balance

balance in profit or loss

£ £ £ £

1 970 78 (60) 988

2 988 80 (60) 1,008

3 1,008 82 (1,090) 0

If the entity had classified the financial asset as available for sale, the asset should have been measured at fair value at each reporting date.

If the fair values of the financial asset at the end of Year 1 and Year 2 were £1,100 and £1,050, the financial asset should have been recognised at the following amounts.

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Amortised cost and effective interest method

Solution:

If the entity had classified the financial asset as available for sale, the asset should have been measured at fair value at each reporting date.

If the fair values of the financial asset at the end of Year 1 and Year 2 were £1,100 and £1,050, the financial asset should have been recognised at the following amounts.

Gain/(loss) in

Other Closing

Opening Interest @ 8.1% Compreh. balance – fair

Year Balance in profit or loss Cash flow income (bal) value

£ £ £ £ £

1 970 78 (60) 112 1,100

2 1,100 80 (60) (70) 1,050

3 1,050 82 (1,090) (42) 0

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Fair value measurement

IAS 39 defines fair value as:

“the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.”

Fair value = Transaction price (fair value of consideration given or received)

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Fair value measurement

Example 1 – Interest free loan to an employee

An entity grants an interest free loan of € 1,000 to an employee for a period of two years. The market rate of interest to this individual for a two year loan payable at maturity is 10%.

What is the initial fair value?

Consideration given to employee consists of two assets:

• The fair value of the loan = €1,000/(1.10)2 = €826

• Difference of €174 is accounted for as employee compensation in accordance with IAS 19, ‘Employee benefits’

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Fair Value Hierarchy

Active market – Published quotations

No active market – Valuation

Techniques

No active market –

Unreliable fair value for equity

instrument – cost less any impairment

Best evidence

Alternative

Very rare

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Fair value measurement

Question 1

• Star owns 15% of shares of Moon.

• Shares quoted on a local stock exchange, trading volume indicates sufficiently active market.

• The quoted market price is €100 per share.

• If decided to sell entire block of shares, the price they believe they would be able to obtain would be €80 per share.

What value should be placed on the shares?

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Fair value measurement

Question 2

• Star purchases an AFS equity security for €100 and pays purchase commission of €2.

• At the end of Star’s financial year, the security’s quoted market price is €105. Commission of €3 would be payable if the security was sold on that date.

What amount is recognised initially and at the end of the financial year?

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Impairment of financial assets

Impairment occurs when

Carrying amount > Recoverable amount

Only relevant for financial assets carried at cost or amortised cost and AFS financial assets

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Impairment of financial asset

Step 1 – Objective evidence of impairment

Step 2 – Calculate recoverable amount / fair value

Step 3 – Record impairment in profit & loss

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Impairment Indicators for debt instruments

Significant difficulty of the issuer

Breach of contract for

failure to pay interest or principal

Lender grants

borrower in financial

difficulty a concession

that the lender would

not otherwise consider

High probability of bankruptcy

Disappearance of active

market because of financial

difficulties

National or local economic conditions that correlate with

defaults (eg a decrease in property prices for mortgages in a relevant

area)

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Impairment Indicators for AFS equity investments

Significant adverse changes that have taken place in the technological, market, economic or legal environment in which the issuer operates.

In addition to impairment indicators for debt instruments, indicators that are specific to equity

instruments include:

Significant or prolonged decline in fair value below

cost

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Impairment AFS equity instrumentsSignificant

How do we define “significant”?

JudgementVolatility relative

to current fair value

Decline consistent with

market

Share price subsequent

to year end?Percentage

decline?

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Impairment AFS equity instrumentsProlonged

How do we define “prolonged”?

Judgement

Length of time held

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Impairment Calculation - Example

AFS equity investment

Year X0

Fair Value 100

Impairment X1 = 100 – 70 = 30

X2 = 100 – 68 – 30 = 2

X3 = 100 – 69 – 32 = (1) no impairment in PL

Start with ORIGINAL cost

Further decline in value is assessed against the original cost

X1

70

X2

68

X3

69

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Reclassification between categories

Held-to-maturity Available-for-sale

Held-to-maturity Available-for-sale

Loans and receivables

Held for trading

Reclassification out of FVTPL designated on initial recognition is prohibited under any circumstances

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Reclassification out of HTM to AFS - Tainting

• Reclassify all investments to AFS at fair value. • Entire HTM portfolio is tainted.• Further classification not permitted for two years after sale.

Entity sells more than an insignificant amount of HTM investments

Exceptions:

• The sale is close to maturity.• Substantially all of the original principal collected

before sale.• The sale is an isolated event outside the control of the

entity.

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Reclassification out of AFS

To HTM :• Entity intends and has the ability to hold the

loan to maturity. • When the tainted held-to-maturity portfolio

has been ‘cleansed’ at the end of the second financial year following tainting.

To loans and Receivables: The AFS asset meets the criteria to be classified as loans and receivables at the date of reclassification and the entity has the intention and the ability to hold the financial asset for the foreseeable future or until maturity.

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Reclassification out of Held for Trading

To HTM or AFS

Transfer permitted only for assets that do not meet the definition of loans and receivables at the date of reclassification and only in ‘rare’ circumstances.

To loans and receivables:

The Held for Trading asset meets the criteria to be classified as loans and receivables at the date of reclassification and the entity has the intention and the ability to hold the financial asset for the foreseeable future or until maturity.

Rare -- Single event that is unusual and unlikely to recur in the near term.

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Conclusion

Key points to remember

• Classification drives measurement

• Mixed measurement model – fair value or amortised cost

• Fair value hierarchy - quoted price best evidence of fair value

• Impairment only if objective evidence

• Reclassifications are permitted only in certain circumstances.

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Thank you!