Objectives and scope Financial instruments are addressed in three standards: IAS 32, which deals with distinguishing debt from equity and with netting; IAS 39, which contains requirements for recognition and measurement; and IFRS 7, which deals with disclosures. The objective of the three standards is to establish requirements for all aspects of accounting for financial instruments, including distinguishing debt from equity, netting, recognition, derecognition, measurement, hedge accounting and disclosure. The scope of the standards is wide-ranging. The standards cover all types of financial instrument, including receivables, payables, investments in bonds and shares, borrowings and derivatives. They also apply to certain contracts to buy or sell non-financial assets (such as commodities) that can be net settled in cash or another financial instrument. Nature and characteristics of financial instruments Financial instruments include a wide range of assets and liabilities. They can mostly be exchanged for cash. They are recognized and measured according to IAS 39 requirements and are disclosed in accordance with IFRS 7.
Financial instruments represent contractual rights or obligations to receive or pay cash or other financial asset. A financial asset is cash; a contractual right to receive cash or another financial asset; a contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable; or an equity instrument of another entity.
A financial liability is a contractual obligation to deliver cash or another financial asset or to exchange financial instruments with another entity under conditions that are potentially unfavourable. An equity instrument is any contract that evidences a residual interest in the entity’s assets after deducting all its liabilities.
A derivative is a financial instrument that derives its value from an underlying price or index, requires little or no initial investment and is settled at a future date. In some cases contracts to receive or deliver a company’s own equity can also be derivatives.
Embedded Derivatives in Host Contracts
Some financial instruments and other contracts combine, in a single contract, both a derivative element and a non-derivative element. The derivative part of the contract is referred to as an ‘embedded derivative’ and its effect is that some of the cash flows of the contract will vary in a similar way to a standalone derivative. For example, the principal amount of a bond may vary with changes in a stock market index. In this case, the embedded derivative is an equity derivative on the relevant stock market index.
Embedded derivatives that are not ‘closely related’ to the rest of the contract are separated and accounted for as if they were stand-alone derivatives (i.e.: measured at fair value, generally with changes in fair value recognized in profit or loss). An embedded derivative is not closely related if its economic characteristics and risks are different from those of the rest of the contract.
IAS 39 sets out examples to help determine when this test is (and is not) met.
Analyzing contracts for potential embedded derivatives and accounting for them is one of the more challenging aspects of IAS 39.
Classification of Financial Instruments
The way that financial instruments are classified under IAS 39 drives how they are subsequently measured and where changes in measurement are accounted for.
There are four classes of financial asset under IAS 39: available for sale, held to maturity, loans and receivables, and fair value through profit or loss.
The factors taken into account in classifying financial assets include:
- The cashflows arising from the instrument – are they fixed or determinable? Does the instrument have a maturity date?
- Are the assets held for trading; does management intend to hold the instruments to maturity?
- Is the instrument a derivative or does it contain an embedded derivative?
- Is the instrument quoted on an active market?
- Has management designated the instrument into a particular classification at inception?
Financial liabilities are classified as fair value through profit or loss if they are so designated (subject to various conditions) or if they are held for trading. Otherwise they are classed as ‘other liabilities’. Financial assets and liabilities are measured either at fair value or at amortised cost, depending on this classification. Changes are taken to either the income statement or directly to equity.
Financial Liabilities and Equity
The classification of a financial instrument by the issuer as either a liability (debt) or equity can have a significant impact on an entity’s reported earnings, its borrowing capacity, and debt-to-equity and other ratios that could affect the entity’s debt covenants.
The substance of the contractual arrangements of a financial instrument, rather than its legal form, governs its classification. This means, for example, that since a preference share redeemable (puttable) by the holder is economically the same as a bond, it is accounted for in the same way as the bond. Therefore, the redeemable preference share is treated as a liability rather than equity, even though legally it is a share of the issuer.
The critical feature of debt is that under the terms of the instrument the issuer is, or can be, required to deliver either cash or another financial asset to the holder and cannot avoid this obligation. For example, a debenture, under which the issuer is required to make interest payments and redeem the debenture for cash, is a financial liability.
An instrument is classified as equity when it represents a residual interest in the issuer’s assets after deducting all its liabilities. Ordinary shares or common stock, where all the payments are at the discretion of the issuer, are examples of equity of the issuer.
A special exception exists to the general principal of classification for certain subordinated redeemable (puttable) instruments that participate in the prorate net assets of the entity. Where specific criteria are met such instruments would be classified as equity of the issuer. The amendment to IAS 32 relating to puttable instruments is effective for annual periods beginning on or after 1 January 2009, with earlier application permitted.
Some instruments contain features of both debt and equity. For these instruments, an analysis of the terms of each instrument in light of the detailed classification requirements will be necessary. Such instruments, such as bonds that are convertible into a fixed number of equity shares either mandatorily or at the holder’s option, must be split into debt and equity (being the option to convert) components.
A financial instrument, including a derivative, is not an equity instrument solely because it may result in the receipt or delivery of the entity’s own equity instruments. The classification of contracts that will or may be settled in the entity’s own equity instruments is dependent on whether there is variability in either the number of own equity delivered and/or variability in the amount of cash or other financial assets received, or whether both are fixed.
The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument. So, if a preference share is classified as debt, its coupon is shown as interest. But the dividend payments on an instrument that is treated as equity are shown as a distribution.
Recognition and De-recognition
Recognition issues for financial assets and financial liabilities tend to be straightforward. An entity recognises a financial asset or a financial liability at the time it becomes a party to a contract.
De-recognition is the term used for ceasing to recognize a financial asset or financial liability on an entity’s balance sheet. The rules here are more complex.
An entity that holds a financial asset may raise finance using the asset as security for the finance, or as the primary source of cash flows from which to repay the finance. The derecognition requirements of IAS 39 determine whether the transaction is a sale of the financial assets (and, therefore, the entity ceases to recognize the assets) or whether finance secured on the assets has been raised (and the entity recognizes a liability for any proceeds received). This evaluation might be straightforward. For example, it is clear with little or no analysis that a financial asset is derecognized in an unconditional transfer of it to an unconsolidated third party with no risks and rewards of the asset being retained. Conversely, it is clear that de-recognition is not allowed where an asset has been transferred, but it is clear that substantially all the risks and rewards of the asset have been retained through the terms of the agreement. However, in many other cases, the analysis is more complex. Securitization and debt factoring are examples of more complex transactions where de-recognition will need careful consideration.
An entity may only cease to recognise (derecognise) a financial liability when it is extinguished – that is, when the obligation is discharged, cancelled or expired, or when the debtor is legally released from the liability by law or by the creditor agreeing to such a release.
Measurement of Financial Assets and Liabilities
Under IAS 39, all financial instruments are measured initially at fair value.
The fair value of a financial instrument is normally the transaction price — that is, the amount of the consideration given or received. However, in some circumstances, the transaction price may not be indicative of fair value. In that situation, an appropriate fair value is determined using data from current observable transactions in the same instrument or based on a valuation technique whose variables include only data from observable markets.
The measurement of financial instruments after initial recognition depends on their initial classification. All financial assets are measured at fair value except for loans and receivables, held-to-maturity assets and, in rare circumstances, unquoted equity instruments whose fair values cannot be measured reliably or derivatives linked to and which must be settled by the delivery of such unquoted equity instruments that cannot be measured reliably.
Loans and receivables and held-to-maturity financial assets are measured at amortized cost. The amortized cost of a financial asset or liability is measured using the ‘effective interest method’.
Available-for-sale financial assets are measured at fair value with changes in fair value recognised in equity. For available-for-sale debt securities, interest is recognized in income using the ‘effective interest method’. Available-for sale equity securities dividends are recognised in income as the holder becomes entitled to them.
Derivatives (including separated embedded derivatives) are measured at fair value. All fair value gains and losses are recognized in profit or loss except where they qualify as hedging instruments in cash flow hedges.
Financial liabilities are measured at amortized cost using the effective interest method unless they are measured at fair value through profit or loss. Financial assets and liabilities that are designated as hedged items may require further adjustments under the hedge accounting requirements.
All financial assets, except those measured at fair value through profit or loss, are subject to review for impairment. Therefore, where there is objective evidence that such a financial asset may be impaired, the impairment loss is calculated and recognized in profit or loss.
‘Hedging’ is the process of using a financial instrument (usually a derivative) to mitigate all or some of the risk of a hedged item. ‘Hedge accounting’ changes the timing of recognition of gains and losses on either the hedged item or the hedging instrument so that both are recognised in profit or loss in the same accounting period.
To qualify for hedge accounting, an entity (a) at the inception of the hedge, formally designates and documents a hedge relationship between a qualifying hedging instrument and a qualifying hedged item; and (b) both at inception and on an ongoing basis, demonstrates that the hedge is highly effective.
There are three types of hedge relationship:
- Fair value hedge: a hedge of the exposure to changes in the fair value of a recognized asset or liability, or a firm commitment.
- Cash flow hedge: a hedge of the exposure to variability in cash flows of a recognized asset or liability, a firm commitment or a highly probable forecast transaction.
- Net investment hedge: a hedge of the foreign currency risk on a net investment in a foreign operation.
For a fair value hedge, the hedged item is adjusted for the gain or loss attributable to the hedged risk. That element is included in the income statement where it will offset the gain or loss on the hedging instrument.
For a cash flow hedge, gains and losses on the hedging instrument, to the extent it is an effective hedge, are initially included in equity. They are reclassified to the profit or loss when the hedged item affects the income statement. If the hedged item is the forecast acquisition of a non-financial asset or liability, the entity may choose an accounting policy of adjusting the carrying amount of the non-financial asset or liability for the hedging gain or loss at acquisition.
Hedges of a net investment in a foreign operation are accounted for similarly to cash flow hedges.
Presentation and Disclosure
There have been significant developments in risk management concepts and practices in recent years. New techniques have evolved for measuring and managing exposures to risks arising from financial instruments. The need for more relevant information and improved transparency about an entity’s exposures arising from financial instruments and how those risks are managed has become greater. Financial statement users and other investors need such information to make more informed judgements about risks that entities run from the use of financial instruments and their associated returns.
However, the disclosures in IAS 30 (disclosure requirements for banks and similar financial institutions) and IAS 32 were no longer in keeping with such developments, and there was a need to revise and enhance the disclosure framework for risks arising from financial instruments. IFRS 7, ‘Financial instruments: disclosures’, was issued in August 2005 to address this need.
IFRS 7 sets out disclosure requirements that are intended to enable users to evaluate the significance of financial instruments for an entity’s financial position and performance and to understand the nature and extent of risks arising from those financial instruments to which the entity is exposed.
IFRS 7 does not just apply to banks and financial institutions. All entities that have financial instruments are affected, even simple instruments such as borrowings, accounts payable and receivable, cash and investments.
You may want to read the other chapters as well:
IFRS-1: First Time Adoption of IFRS
IFRS-2: Share-based Payment
IFRS-3: Business Combination
IFRS-4: Insurance Contract
IFRS-5: Disposal of Subsidiaries, Business and Non-current Asset
IFRS-6: Extractive Industries
IFRS-7, IAS 32 & 39: Financial Instruments
IFRS-8: Segment Reporting