co-author of “S’initier aux IFRS” (“An Introduction to

Series directed by Julien Pagezy,

co-author of “S’initier aux IFRS” (“An Introduction to IFRS”) (Éd. de la Performance / Éd. Francis Lefebvre)

IFRS Financial instruments

Amélie Ober

Preface by Didier Kling and Christophe Bonte Managing Partner and Partner

Didier Kling & Associés

Foreword by Marc Breillout Global Head of Debt Finance

Société Générale Corporate & Investment Banking

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Chapter 2 : Accounting for

financial instruments (other than hedges)

Now that we have reviewed the key features of IAS 39, the aim of the present chapter is to examine the accounting treatment of financial instruments in more detail. We shall deal in turn with:

initial recognition,

the different categories of financial assets and financial li-abilities,

measurement at the balance sheet date,

impairment of financial assets,

subsequent reclassification,

derecognition. Financial instruments must be allocated to the appropriate cate-gory of financial assets or liabilities at the time of initial recogni-tion on the balance sheet. This process involves classifying each financial instrument, based on its nature and the purpose for


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which it is intended to be held, and determining for what amount it should be recognised. In the same way, at each balance sheet date financial instruments must be revalued in accordance with the rules applicable to each category whilst certain financial assets must equally be subjected, individually or collectively, to impairment testing and any im-pairment losses must be recognised. We shall also see in what circumstances an entity may, or some-times must, subsequently reclassify a financial instrument from the category initially chosen to another category, and how to pro-ceed in such instances. Finally, derecognition involves deciding at what stage a financial instrument should be removed from the balance sheet. This question may appear simple but in practice can be very complex in the case of certain sophisticated divestment transactions such as those involving securitisation.

2.1 Initial recognition

2.1.1 Recognition of financial instruments in the balance sheet

An entity must recognise a financial asset or a financial liability on its balance sheet when, and only when, the entity becomes a party to the contractual provisions of the instrument and as such obtains the right to receive economic benefits or the obliga-tion to pay out resources embodying economic benefits (cf. the definitions of assets and liabilities). When a financial asset or financial liability is initially recognised, the entity must measure it at its fair value.

Chapter 2: Accounting for financial instruments (other than hedges)

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The fair value may be increased (in the case of a financial asset) or decreased (in the case of a financial liability) by the amount of transaction costs directly attributable to the transaction (e.g. brokerage costs for a share acquisition).

Example

Company A acquires a bond at a price of 100 and recognises it as a held-to-maturity investment. The brokerage commission amounts to 1. The bond is recognised as an asset for an amount of 101.

In the case of financial instruments classified as financial assets or financial liabilities measured at fair value through profit or loss, the applicable transaction costs must be recognised as ex-penses as incurred.

2.1.2 Fair value

Fair value may be defined as the exit value of a financial in-strument. For example, an entity which owns a share must ask itself for what price it might sell its share today. IAS 32 provides a precise definition of fair value: the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. In other words:

the fair value of a financial instrument is the value for which an entity may discharge its obligations or sell its rights,

in terms of recognition in the balance sheet, fair value may be contrasted with the concept of amortised cost.

In practice, several methods are available for determining the fair value of a financial instrument and IAS 39 lists them in the fol-lowing order:

If a financial instrument is quoted in an active market, its fair value should be equated with the quoted price:


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More precisely, the appropriate price to use will be the counterparty’s price, i.e. the current bid price for an asset held or liability to be issued and the asking price for an asset to be acquired or liability held.

If the financial instrument is not quoted in an active market, the entity should seek to approximate fair value by use of the most appropriate valuation technique, notably:

by using recent arm’s length market transactions between knowledgeable, willing parties and adjusting them as ap-propriate, and/or

by applying such techniques as discounted cash flow analysis and option pricing models (such calculations may be performed by the entity itself or by a bank or other advisor on its behalf).

In application of the principle of continuing operations, the dis-count or premium for securities held must not be considered when recognising securities on the balance sheet.

Example

Company A holds 10% of the share capital in Company B whose shares are publicly traded in an active market. Company A obtains several independent estimates suggesting that if it sold its holding in B as a block it would expect to obtain a 5% premium above the quoted price. Should Company A measure its holding at fair value using the current quoted price of 100 or may it apply the specific price of €105.

No, as Company A applies the principle of continuing operation, and as the most recent quoted rate is taken as the best estimate for fair value.


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2.1.3 Amortised cost

The amortised cost of a financial asset or financial liability is the amount at which the financial asset or liability is measured at initial recognition:

minus repayments of principal;

plus or minus the cumulative amortisation, using the effec-tive interest method, of any difference between the initial amount and the maturity amount; and

minus any reduction (directly or through the use of an allow-ance account) for impairment or uncollectability.

The effective interest method is a method of calculating the amortised cost of a financial asset or liability and of allocating the interest income or interest expense over the relevant periods, ap-plying for this purpose the effective interest rate defined as the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. The main practical significance of this approach is that the calcula-tion includes all transaction costs, premiums or discounts etc., relating to the financial instrument, which are therefore spread on an actuarial basis (in the same way as the interest income or expense) over the life of the instrument. Note that under this method straight-line allocation of such items is prohibited, as is their immediate write-off.

Example

Amortised cost of a financial instrument

Company A purchases a debt instrument which it classifies as a held-to-maturity investment. The instrument has the following characteristics:

– purchase price: 105.2,

– coupon rate: 10%,

– redeemable at par i.e. 100,

– time remaining to maturity: 3 years.


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We assume there are no transaction costs. In this hypothesis, the debt instrument’s effective interest rate (which equates with its in-ternal rate of return or IRR) amounts to 8%.

The variation of the debt instrument in the balance sheet may be il-lustrated by the following summary:

Year 1 Year 2 Year 3 Opening principal 105.2 103.6 101.9 Interest income (1) 8.4 8.3 8.1 Cash received (2) 10.0 10.0 110.0 Closing principal (3) 103.6 101.9 0.0

(1) Interest income = effective interest rate x opening principal. (2) In year 3, payment of the principal as well as interest. (3) Closing principal = opening principal + interest income – cash re-

ceived.

2.1.4 Transaction costs

Transaction costs are the incremental costs that are directly at-tributable to the acquisition, issue or disposal of a financial asset or liability. They include:

fees and commissions paid to agents, advisers, brokers and dealers,

levies by regulatory agencies and securities exchanges,

transfer taxes and duties. They do not include debt issue or repayment premiums or dis-counts, financing costs (e.g. the initial fees paid to obtain access to credit facilities) or internal administrative or holding costs. They may however include other internal costs of the entity di-rectly attributable to a transaction.


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2.2 The different categories of financial assets and financial liabilities

We have already seen that a financial instrument is defined as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. We have seen that financial instruments also include derivatives. The four categories of financial assets and two categories of fi-nancial liabilities defined by IAS 39 are as follows:

Financial assets Financial liabilities

Am

ort

ise

d

cost

Loans and receivables

Held-to-maturity investments

Other liabilities

Fa

ir v

alu

e

Available-for-sale financial assets

Financial assets at fair value through profit or loss

Financial liabilities at fair value through profit or loss

The classification criteria to be applied are of a hybrid nature since they depend both on the nature of each financial in-strument and on the entity’s intention in holding it. One of the Standard’s objectives in creating these different cate-gories has been to provide information about an entity’s financial strategy and so to assist users of the financial statements in measuring the risks borne by the entity and the evolution of those risks over time. The accounting treatment of a financial asset or liability at the balance sheet date depends on the category in which the asset or liability has been placed since the main impact of the choice of category is in terms of the requirement for subsequent


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measurement on either a fair value or amortised cost basis. In addition, for financial assets required to be measured at fair value, the choice of category determines whether changes in fair value will be recognised via profit or loss or directly in equity. Further, financial assets measured at amortised cost, or at fair value with changes in fair value recognised directly in equity, are subject under the Standard to impairment testing6. For these reasons, the initial choice of category (when a choice is possible) is not devoid of accounting consequences in terms of volatility of the balance sheet and/or of the income statement.

2.2.1 Financial assets

As we have seen, there exist four categories of financial assets into one of which every financial asset (with the exception of hedging derivatives) must be classified. Specific criteria exist for each category and a financial asset may be allocated to any category whose criteria it meets. We have al-ready noted that these criteria depend both on the nature of each asset and on the entity’s intention in holding it.

1 – Loans and receivables IAS 39 defines loans and receivables as non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, with the notable exception of loans and receivables that an entity intends to sell immediately or in the near term, which must be classified as held for trading. 6 Impairment losses may, in the case of financial assets, reflect such factors as significant financial difficulty of the issuer of a debt, a significant or prolonged decline in the market value of an equity instrument below its cost, the disappearance of an active market, etc. The purpose of impairment testing is to determine the amount of loss that would not appear to be recoverable.


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For an industrial entity, loans and receivables will mainly com-prise its trade receivables and bank deposits. Because the defini-tion excludes financial assets quoted in an active market, a quoted debt instrument does not qualify for classification as a loan or receivable but a similar unquoted debt instrument does.

2 – Held-to-maturity investments Held-to-maturity investments are defined as non-derivative fi-nancial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity. Quoted debt instruments with either fixed or variable interest rates can thus satisfy the criteria for a held-to-maturity invest-ment. It should be stressed that “held-to-maturity” is not a syno-nym of “long-term” and in particular, to be classified in this cate-gory a financial asset must obligatorily have a maturity (i.e. a fi-nite as opposed to indefinite life) and cannot therefore be an eq-uity instrument such as an ordinary share. The entity’s intention and ability to hold such financial assets to maturity must be demonstrable both at the time of initial recog-nition and at each subsequent balance sheet date. In order to discourage entities from making inappropriate use of this category, simply as a means of avoiding the potential volatil-ity of reporting associated with the categories requiring continu-ing measurement at fair value (as opposed, for this category, at amortised cost), IAS 39 provides for a penalty (commonly des-ignated as the tainting rule) if an entity sells or reclassifies more than an insignificant amount of held-to-maturity invest-ments: the entity must immediately reclassify any remaining held-to-maturity investments as available for sale and is prohib-ited from making any further use of the held-to-maturity cate-gory for a period of two years. There exist certain exceptions to this rule which will be dealt with below (cf. § 2.5 “Reclassification between categories of financial assets”).


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This penalty is perceived as particularly dissuasive and has led a certain number of groups to decide not to use the category at all or to severely restrict its use for example by making it the pre-rogative of the parent company. The criteria for classification as a held-to-maturity investment are met for a financial asset that is callable (i.e. repayable or re-deemable before maturity) by the issuer if the holder intends and is able to hold it until it is called or until maturity and the holder would recover substantially all of its carrying amount (including any premium paid and capitalised transaction costs). This is be-cause the call option of the issuer, if exercised, simply accelerates the asset’s maturity. In contrast, a financial asset that is puttable (i.e. the holder has the right to require that the issuer repay or redeem the financial asset before maturity) cannot be classified as a held-to-maturity investment because paying for a put feature in a financial asset is inconsistent with expressing an intention to hold the financial asset until maturity.

3 – Available-for-sale financial assets Essentially, available-for-sale financial assets are those residual non-derivative financial assets that have not been classified within one of the three other financial asset categories. However in addition, certain non-derivative financial assets may be voluntarily allocated to this category with the notable excep-tion of assets which must obligatorily be designated as financial assets at fair value through profit or loss.


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4 – Financial assets at fair value through profit or loss Financial assets at fair value through profit or loss are defined as either:

Financial assets classified as held for trading; a finan-cial asset is classified as held for trading if it is:

acquired by an entity principally for the purpose of selling it in the near term (i.e. this criterion relates to the en-tity’s intention at the date of initial recognition of the fi-nancial asset);

part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking (i.e. this criterion is formally independent of the entity’s intention in acquiring the financial asset);

a derivative with positive fair value except for a derivative that is a designated and effective hedging instrument.

Financial assets voluntarily designated by the entity, upon initial recognition, as at fair value through profit or loss for one of the following reasons:

the instrument contains an embedded derivative that has a significant impact on the instrument’s cash flows and whose closely related character is not obvious (cf. Chapter 3);

the fair value designation eliminates or significantly re-duces an accounting mismatch which would otherwise arise from different measurement bases applying to a group of related financial assets and liabilities;

a group of financial assets, financial liabilities, or both are managed and their performance is evaluated on a fair value basis in accordance with a documented risk man-agement or investment strategy of the entity.

Allocation of financial assets to this category must be made at the time of initial recognition (i.e. of acquisition) and is irrevo-cable i.e. no transfers to or from this category may be made after a financial asset has been acquired.


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Nota Bene

(1) Unquoted equity instruments whose fair value cannot be relia-bly determined cannot be voluntarily designated as financial assets at fair value through profit or loss.

(2) All derivatives with positive market values are classified, with the exception of hedging instruments, as held for trading and thus as financial assets at fair value through profit or loss.

The following diagrams summarise the process of classification of a financial asset. Two classification phases are required:

1. determining into which categories a financial asset may be classified based on its own characteristics;

2. choosing the appropriate available category based on the en-tity’s intentions in holding the financial asset.

Given that all derivatives with positive market values are obliga-torily classified, with the exception of hedging instruments, as financial assets at fair value through profit or loss, and that hedg-ing instruments are excluded from the classification, the follow-ing decision tree is applicable to all financial assets other than derivatives.

Classification of a non-derivative financial assetbased on its own characteristics

Fixed maturity?Fixed or determinable

payments?

Quoted instrument?

Yes

YesYes No

No

No


Available-for-saleOR

At fair value through profit

or loss

Held-to-maturityOR


At fair value through profit or loss


At fair value through profit or

loss

Classification of a non-derivative financial assetbased on its own characteristics


payments?

Quoted instrument?

Yes

YesYes No

No

No




or loss

Held-to-maturityOR





loss


payments?

Quoted instrument?

Yes

YesYes No

No

No




or loss

Held-to-maturityOR





loss


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An unquoted equity share whose fair value may be reliably de-termined may be classified either as an available-for-sale finan-cial asset or as a financial asset at fair value through profit or loss. A quoted debt security may be classified in any one of the follow-ing three categories: held-to-maturity investments, available-for-sale financial assets or financial assets at fair value through profit or loss. In other words, the classification criteria based on financial as-sets’ own characteristics often leave an entity with several op-tions and the final choice will be determined by the entity’s inten-tion in holding the assets. The following decision tree illustrates this additional process.

Classification of a non-derivative financial assetbased on the entity’s intention in holding it


loss

Held-to-maturity

No

Intention to sell the financial asset in the near term?

Yes

No

Part of a portfolio with a recent actual pattern of short-term profit-taking?

Yes

Use of the fair value option by the entity?Yes

No

Positive intention and ability to hold the financial asset to maturity?

No

Yes

Available-for-sale

Classification of a non-derivative financial assetbased on the entity’s intention in holding it


loss

Held-to-maturity

No

Intention to sell the financial asset in the near term?

Yes

No

Part of a portfolio with a recent actual pattern of short-term profit-taking?

Yes

Use of the fair value option by the entity?Yes

No

Positive intention and ability to hold the financial asset to maturity?

No

Yes

Available-for-sale


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2.2.2 Financial liabilities

There exist two categories of financial liabilities.

1 – Financial liabilities at fair value through profit or loss Financial liabilities at fair value through profit or loss are defined as either:

Financial liabilities classified as held for trading; a financial liability is classified as held for trading if it is:

incurred by an entity principally for the purpose of repur-chasing it in the near term (i.e. this criterion relates to the entity’s intention at the date of initial recognition of the financial liability);

part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking (i.e. this criterion is formally independent of the entity’s intention in incurring the financial liability);

a derivative with negative fair value except for a deriva-tive that is a designated and effective hedging instrument.

Financial liabilities voluntarily designated by the en-tity, upon initial recognition, as at fair value through profit or loss for one of the following reasons:

the instrument contains an embedded derivative that has a significant impact on the instrument’s cash flows and whose closely related character is not obvious (cf. Chap-ter 3);

the fair value designation eliminates or significantly re-duces an accounting mismatch which would otherwise arise from different measurement bases applying to a group of related financial assets and liabilities;


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a group of financial assets, financial liabilities, or both are managed and their performance is evaluated on a fair value basis in accordance with a documented risk man-agement or investment strategy of the entity.

Allocation of financial liabilities to this category must be made at the time of initial recognition (i.e. of incurrence) and is ir-revocable i.e. no transfers to or from this category may be made after a financial liability has been incurred. With the exception of derivatives, few financial liabilities qualify to be recognised as held for trading. They may be encountered occasionally, for example in the case of short sales of securities (i.e. sales of securities which the seller does not possess) engaged in by certain market operators. The fair value option also makes it possible to recognise certain structured issues at fair value through profit or loss and thus to avoid the need for separate recognition of any embedded deriva-tives (cf. Chapter 3).

2 – Other financial liabilities Other financial liabilities are those residual financial liabilities that have not been classified as financial liabilities at fair value through profit or loss. This category includes in particular an entity’s borrowings and trade payables, financial guarantees issued and any loan com-mitments at below-market interest rates.


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2.3 Subsequent measurement

Financial instruments must be measured at each balance sheet date based on the rules applicable to each category.

2.3.1 Subsequent measurement of financial assets

The measurement bases applicable to financial assets are as fol-lows:

Loans and receivables, as well as held-to-maturity invest-ments, are measured at amortised cost using the effective in-terest method (i.e. recognised pro rata temporis) and dis-counts/premiums, and acquisition costs, are amortised on an actuarial basis.

Available-for-sale financial assets are measured at fair value with any changes in fair value recognised directly in equity.

Financial assets within these categories are additionally sub-ject to impairment testing and any losses are recognised in profit or loss.

Finally, financial assets at fair value through profit or loss are, as their name implies, measured at fair value with any changes in fair value recognised in profit or loss. Impairment testing is literally superfluous for this category of assets since any losses (as well as gains) arising on adjustment of assets’ fair value at the current balance sheet date are automatically reflected in the income statement.


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The table below provides a summary of these measurement rules.

Financial asset

category

Measure-ment basis

Impact Impairment

testing


Amortised cost

Profit or loss: - Accrued coupon - Amortisation of

premium/discount - Impairment losses

Yes

Held-to-maturity investments

Amortised cost

Profit or loss: - Accrued coupon - Amortisation of

premium/discount - Impairment losses

Yes

Available-for-sale financial assets

Fair value Equity: - Changes in fair value Profit or loss: - Accrued coupon - Impairment losses

Yes

Financial assets at fair value through profit or loss

Fair value Profit or loss: - Changes in fair value

No

Exceptionally, certain instruments (unquoted equity instruments or derivatives of unquoted equity instruments) whose fair value cannot be reliably measured, may be measured at cost subject to provision in the notes to the financial statements of specific dis-closures including an explanation of why fair value cannot be measured reliably.

2.3.2 Subsequent measurement of financial liabilities

Financial liabilities at fair value through profit or loss are, as their name implies, measured at fair value with any changes in fair value recognised in profit or loss. Other financial liabilities are measured at amortised cost using the effective interest method (i.e. pro rata temporis) and discounts/premiums, and issuing costs are amortised on an actuarial basis.


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Nota Bene

Financial liabilities are never subject to impairment testing.

The following table provides a summary of these measurement rules.

Financial liability category

Measure-ment basis

Impact Impairment

testing

Financial liabilities at fair value through profit or loss

Fair value Profit or loss: - Changes in fair value

N/A

Other financial liabilities

Amortised cost

Profit or loss: - Accrued interest - Amortisation of

premiums/discounts

N/A

Example

Let us return to the example of a quoted bond developed in § 2.1.3. We shall concentrate on the situation at the end of year 1 when the debt instrument pays a coupon at 10 and has a residual maturity of 2 years.

Interest rates have dropped and the bond’s “dirty price” (including the coupon) is at 117.3 and “clean price” (excluding the coupon) is 107.3 (coupon is still at 10). The change in amortised cost for the debt instrument is shown as follows:

Year 1 Year 2 Year 3

Opening principal 105.2 103.6 101.9 Interest income (1) 8.4 8.3 8.1 Cash received (2) 10.0 10.0 110.0 Closing principal (3) 103.6 101.9 0.0

(1) Interest income = effective interest rate x opening principal. (2) In year 3, payment of the principal as well as interest. (3) Closing principal = opening principal + interest income

– cash received.


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We shall now review the accounting entries at the end of year 1 for each of the three classification options open to Company A in re-spect of this financial asset.

I. The debt instrument is classified as a held-to-maturity investment

Debit Credit Asset – Cash

10.0

Profit or loss – Interest income 8.4 Asset – Held-to-maturity investment 1.6

Cash impact for the coupon is 10. Financial income recognised in the income statement amounts to 8.4.

The new amortised cost of the debt instrument is 103.6 (= 105.2 – 1.6).

II. The debt instrument is classified as an available-for-sale financial asset


10.0

Asset – Available-for-sale financial asset 2.1 Profit or loss – Interest income 8.4 Equity 3.7

Cash impact for the coupon is 10. Financial income recognised in the income statement amounts to 8.4 (coupon - amortisation of the premium). The new value of the debt instrument on the balance sheet equals its market price of 107.3.

The difference between the amortised cost of the debt instrument and its market price is recognised in equity (107.3 – 103.6).


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III. The debt instrument is classified as a financial asset at fair value through profit or loss


10.0

Asset – Asset at fair value through profit or loss 2.1 Profit or loss – Gain arising from

change in fair value 12.1

Cash impact for the coupon in 10.

The new value of the debt instrument on the balance sheet equals its market value, i.e. 107.3.

Total change in fair value is recognised in profit and loss.

2.3.3 Financial guarantee contracts issued and loan commitments

The subsequent adjustment of financial guarantee contracts is-sued depends on their nature and initial classification.

Financial guarantee contracts issued initially recognised at fair value through profit or loss are adjusted to fair value and changes will be recognised in profit and loss.

Financial guarantee contracts issued are recognised with con-tinuing involvement for complex asset transfers (cf. 2.6.1.) and are measured at the lower of:

the amount of the transferred asset, and

the maximum amount of consideration received that the entity may be required to reimburse.

Other financial guarantee contracts issued are measured at the higher of:

the amount determined in accordance with IAS 37, “Pro-visions, Contingent Liabilities and Contingent Assets” (i.e. the best estimate of the expenditure required to settle the present obligation at the balance sheet date), and


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the amount initially recognised less, when appropriate, cumulative amortisation.

The adjustment of loan commitments at balance sheet date in the scope of IAS 39 depends on their nature:

Loan commitments recognised at fair value through profit or loss are measured at fair value and changes are recognised as profit or loss.

Commitments to provide loans at below-market interest rates are measured at the higher of:

the amount recognised under IAS 37 “Provisions, Contin-gent Liabilities and Contingent Assets” (i.e. the best esti-mate of the expenditure required to settle the present ob-ligation at the balance sheet date), and

the amount initially recognised less, where appropriate, cumulative amortisation.

2.4 Impairment of financial assets

The following financial assets are subject to impairment testing:

those assets measured at amortised cost: loans and receiv-ables, held-to-maturity investments;

those assets measured at fair value with changes in fair value recognised directly in equity: available-for-sale financial as-sets.

In other words, impairment testing is a requirement for all financial assets other than financial assets at fair value through profit or loss.


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An impairment loss must be recognised if, at the balance sheet date, there exists objective evidence that a financial asset is impaired i.e. that the asset’s carrying amount is in excess of its estimated recoverable amount. The impairment loss is equal to the amount of any such excess. IAS 39 provides examples of such evidence including, but not limited to:

significant financial difficulty of the issuer or obligor,

a breach of contract, such as a default or delinquency in interest or principal payments,

it becoming probable that the borrower will enter bank-ruptcy or other financial reorganisation,

observable data indicating that there is a measurable de-crease in the estimated future cash flows from a group of fi-nancial assets since their initial recognition (e.g. deteriora-tion in the respect of due payment dates for a portfolio of consumer credit receivables).

Nota Bene

In itself, the simple fact of a decline in the quoted price of an equity instrument does not constitute objective evidence of impairment, however such objective evidence will be presumed in the event of a significant or prolonged decline, below its cost, in the quoted price of such an instrument.

2.4.1 Impairment of financial assets measured at amortised cost

An entity must first assess whether objective evidence of impair-ment exists for assets measured at amortised cost and that are individually significant (in which case a test is required). Al-though the significant asset does not require impairment, it will be included in a portfolio of financial assets that are not indi-vidually significant for collective testing.


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An entity must assess whether collective objective evidence of impairment exists (on the basis of a homogenous portfolio) for assets measured at amortised cost and that are not individually significant. This will determine if testing is necessary. The amount of any impairment loss is measured as the difference between the financial asset’s carrying amount and the present value of estimated future cash flows from use of the financial asset discounted at the asset’s original effective interest rate. It follows that subsequent income from the financial asset will equate with application of the original effective interest rate to the adjusted carrying amount. A previously recognised impairment loss may be reversed so long as it does not result in a carrying amount of the financial asset that exceeds what the amortised cost would have been (at the date the impairment is reversed) had the impairment not been recognised.

Example

At the end of year 1, Company A considers that it will not receive the expected cash flows from its investment (recognised in held-to-maturity investments). Estimated cash flows for the investment are resumed as follows:

Year 1 Year 2 Year 3 Original estimate 10.0 10.0 110.0 Revised estimate 0.0 0.0 90.0

The estimated recoverable amount of the investment is calculated by discounting the revised estimated future cash flows using the original effective interest rate of 8%; it amounts to 77.2. The im-pairment loss to be recognised thus amounts to 105.2 – 77.2 = 28. The required accounting entry is as follows:

Debit Credit Profit or loss – Impairment loss

28.0

Asset – Held-to-maturity investment

28.0


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The revised amortised cost summary is as follows:

Year 1 Year 2 Year 3

Opening principal 105.2 77.2 83.3 Interest income 0.0 6.2 6.7 Cash received 0.0 0.0 90.0 Impairment loss 28.0 0.0 0.0 Closing principal 77.2 83.3 0.0

2.4.2 Impairment of financial assets measured at cost

In the case of financial assets carried at cost because their fair value cannot be reliably measured, the amount of any impair-ment loss is measured as the difference between the carrying amount of the financial asset and the present value of estimated future cash flows discounted at the current market rate of re-turn for a similar financial asset. Impairment losses cannot sub-sequently be reversed.

2.4.3 Impairment of available-for-sale financial assets

Individual testing of available-for-sale financial assets is neces-sary. Impairment will take the form of a restatement of all amounts accumulated in equity. Impairment losses for debt instruments classified as available for sale may subsequently be reversed, with the amount of the reversal recognised in profit or loss, if objective evidence exists of an improvement in fair value. In contrast, impairment losses for investments in equity in-struments classified as available for sale cannot subsequently be reversed.


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2.5 Reclassification between categories of financial assets

The following table summarises the possibilities of reclassifica-tion between financial asset categories provided for by IAS 39.

To

From


Held-to-maturity

Available-for-sale

At fair value through

profit or loss


N/A Prohibited Prohibited Prohibited

Held-to-maturity

Prohibited N/A

As a sanction (tainting rule)

plus a few exceptions

Prohibited

Available-for-sale

Prohibited

Change in intention or

ability or expiry of tainting

N/A Prohibited


or loss Prohibited Prohibited Prohibited N/A

As a general rule, no reclassification between categories of finan-cial assets is allowed. In particular, whenever an entity sells more than an insignificant amount of held-to-maturity investments (thus de facto treating them as available for sale), application must be made of what is commonly called the tainting rule under which:

any remaining held-to-maturity investments must immedi-ately be reclassified by the entity as available for sale and the difference between their previous carrying amount and their fair value must be recognised directly in equity,

during the current and following two financial years, no fi-nancial assets may be classified by the entity as held to ma-turity.


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The tainting rule will apply at group level for consolidated finan-cial statements and must be disclosed. An error made by a sub-sidiary may therefore have an impact on the entire group. Certain specific circumstances do however exist in which the fol-lowing reclassifications are authorised:

From available-for-sale financial assets to held-to-maturity investments:

in the event of a change in intention or ability of the entity rendering the new classification more appropriate,

upon expiry of the tainting ban lasting two financial years.

The fair value carrying amount of the financial asset on the date of reclassification becomes its new amortised cost and serves as the basis for computation of the effective interest rate to be applied in discounting the future estimated cash flows associated with the asset.

From held-to-maturity investments to available-for-sale financial assets:

if the amount involved is insignificant,

if the financial assets involved are so close to maturity (for example, within three months of maturity) as not to be liable to any significant change in fair value,

if the entity has already collected substantially all of the financial asset’s original principal through scheduled payments or prepayments,

if a significant deterioration has taken place in the cred-itworthiness of the issuer of the financial instrument (e.g. if the credit rating for the investment has changed from investment grade to speculative grade),

if an isolated event occurs that is beyond the entity’s con-trol (e.g. a change in tax law or in regulatory require-ments).


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2.6 Derecognition

2.6.1 Derecognition of financial assets

An entity must derecognise a financial asset when, and only when:

the contractual rights to the cash flows from the financial as-set expire, or

the entity transfers the financial asset and the transfer meets specified criteria which qualify the transfer for recognition.

Derecognition principles are applied at a consolidated level. An entity must therefore first consolidate all its subsidiaries and then apply the following criteria to the resulting group. 95% of the time derecognition is a simple issue, as for example when an entity sells a bond which it held and, as a result, derec-ognises the financial asset (i.e. removes the asset from its balance sheet) and recognises on its balance sheet the cash received from the sale. However 5% of the time derecognition can raise complex issues, notably if a financial asset transfer is part of a complex transac-tion involving, for example, securitisation or assignment of re-ceivables. The derecognition principles instituted by IAS 39 re-quire successive analysis of whether the rights to the cash flows from an asset have expired or been, directly or indirectly, trans-ferred, and of whether more generally the risks and rewards of ownership of the financial asset still vest with the entity or have been transferred. The principles may apply to a single financial asset or to part of a financial asset (e.g. to the sale of 50% of the principal amount of an interest-bearing security but 100% of the associated interest income), or to a group of similar financial assets (e.g. a portfolio of trade receivables).


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IAS 39 includes a flowchart illustrating the evaluation of whether and to what extent a financial asset may/must be derecognised:

non

Consolidate all subsidiaries

(including special-purpose entities)

Determine whether the principles below are applied to a part or all of an asset (or

group of similar assets)

Have the rights to the cash flows from the asset expired?

Has the entity transferred its rights to receive the cash flows from the asset?OrHas the entity assumed an obligation to pay the cash flows from the asset that meets the following conditions?• The entity has no obligation to pay

amounts to the transferee(s) unless it collects equivalent amounts from the original asset• The entity is prohibited from selling or

pledging the original asset other than as security to the transferee(s) • The entity has an obligation to remit any

cash flows it collects on behalf of the transferee(s) without material delay

Has the entity transferred substantially all risks and rewards?

Has the entity retained substantially all risks and rewards?

Has the entity retained control of the asset?

Derecognise the asset

Continue to recognise the asset to the extent of the entity’s

continuing involvement

Continue to recognise the

asset

No

Derecognition of a financial asset

Yes

No

No

Yes

Yes

No

Yes

No

Yes

non

Consolidate all subsidiaries

(including special-purpose entities)

Determine whether the principles below are applied to a part or all of an asset (or

group of similar assets)

Have the rights to the cash flows from the asset expired?

Has the entity transferred its rights to receive the cash flows from the asset?OrHas the entity assumed an obligation to pay the cash flows from the asset that meets the following conditions?• The entity has no obligation to pay

amounts to the transferee(s) unless it collects equivalent amounts from the original asset• The entity is prohibited from selling or

pledging the original asset other than as security to the transferee(s) • The entity has an obligation to remit any

cash flows it collects on behalf of the transferee(s) without material delay

Has the entity transferred substantially all risks and rewards?

Has the entity retained substantially all risks and rewards?

Has the entity retained control of the asset?

Derecognise the asset

Continue to recognise the asset to the extent of the entity’s

continuing involvement

Continue to recognise the

asset

No

Derecognition of a financial asset

Yes

No

No

Yes

Yes

No

Yes

No

Yes

Derecognition thus involves several steps:

Step 1: Derecognition principles are applied at a consoli-dated level. An entity must therefore first consolidate all its subsidiaries, and then apply the remaining derecognition cri-teria to the resulting group.


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In the context of complex asset transfers, a practice had grown up whereby certain entities transferred one or more assets to an entity created for this purpose (Special Purpose Entities - SPEs). The first question raised often concerns the derecognition of the asset(s) and whether it is required. IAS 39 states that it is appropriate to start by considering if the SPE requires consolidation. If so, de-recognition is not essential as the entity (or parent com-pany) will “recover” assets in consolidation. Should con-solidation not be required, the decision tree applies.

Step 2: before applying the decision tree as such, identify which asset, assets or part of assets must be evaluated.

Step 3: if the rights to the cash flows from a financial asset have expired, the asset should be derecognised from the bal-ance sheet. If rights have not expired, more detailed evalua-tion is required.

For example, when an interest-bearing security held by an entity arrives at maturity its principal amount is nor-mally repaid by the issuer and the entity then has no right to any further cash flows from the financial asset.

Step 4: In summary, the question posed is whether the en-tity has directly or indirectly transferred to another party its rights to receive the cash flows of a financial asset. If no such transfer has taken place, it will not be possible to argue that the asset no longer has any place in the entity’s balance sheet and so it should continue to be recognised.

The rights to receive the cash flows of a financial asset are deemed to have been transferred to another party:

if the other party henceforth receives those cash flows di-rectly; or

if the transferring entity retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or


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more recipients in an arrangement that meets the follow-ing conditions:

– the entity has no obligation to pay amounts to the re-cipient(s) unless it collects equivalent amounts from the original asset;

– the entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the recipient(s) for the obli-gation to pay them the cash flows from the asset;

– the entity has an obligation to remit any cash flows it collects on behalf of the recipient(s) without material delay.

Example

A company sells its trade receivables to a bank. The company’s cus-tomers continue to pay the company, because they are not aware of the company’s obligation towards the bank, but the company im-mediately pays the amounts on to the bank in accordance with the following agreement: the company has no responsibility towards the bank for eventual bad debts; it has no right to resell or pledge the receivables it has sold to the bank; it is contractually bound to make immediate remittance to the bank of the sums it receives from customers.

In these circumstances, the company is deemed to have indirectly transferred its rights to receive the cash flows of its trade receiv-ables to the bank.

Step 5: In itself, the transfer to another party of the rights to receive the cash flows of a financial asset does not mean that the asset should be derecognised. Three situations in respect of any transfer of the risks and rewards of ownership of the financial asset may be distinguished:

1. If the entity has transferred substantially all the risks and rewards of ownership of the financial asset, the asset must be derecognised.


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2. If the entity retains substantially all the risks and re-wards of ownership of the financial asset, it must con-tinue to recognise the asset.

3. If the entity has neither transferred nor retained substantially all the risks and rewards of ownership of the financial asset, the determining factor is based as fol-lows on the concept of control of the financial asset:

if the transferee has obtained control of the finan-cial asset, i.e. is totally free to sell the asset to a third party, the asset itself must be derecognised by the transferring entity;

if the entity has retained control, the entity must continue to recognise the financial asset to the extent of its continuing involvement in the financial asset.

Example

Company A carries out a securitisation transaction on its customer receivables. Receivables are transferred at carrying amount, i.e. 1000, to an unconsolidated SPE.

Company A will retain initial losses relating to receivables (up to 10) by acquiring the tranche with the highest risk issued by the SPE. In other words, if 1% of receivables default, the SPE will lose 10 on its assets. This loss is absorbed by the tranche with the highest risk held by Company A. Defaults beyond this limit will be assigned to other tranches issued by the SPE according to a predefined order of subordination.

Company A will derecognise 1000 in receivables from the balance sheet for financial statements (with consideration in cash flow) and will recognise:

– a financial asset amounting to 10 corresponding to the tranche acquired in the securitisation SPE (with consideration in cash flow),

– another financial asset of 10 corresponding to the “involve-ment” in transferred receivables,

– and an associated financial liability amounting to 10 represent-ing cash flows that Company A is likely to not receive should the transferred receivables default.


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In conclusion, the critical points to retain are as follows:

a financial asset may be derecognised if, and only if, the rights to the cash flows from the asset have been transferred, directly or indirectly, and if substantially all the risks and re-wards relating to the financial asset have also been trans-ferred;

if substantially all the risks and rewards relating to the finan-cial asset have not been transferred, the criterion of control of the asset will apply from the point of view of the transferee only.

IAS 39 introduces the new and relatively complex concept of con-tinuing involvement. However, the application of this concept will rarely be encountered in practice as most SPEs used in secu-ritisation transactions will require consolidation according to IFRS standards.

2.6.2 Derecognition of financial liabilities

The criteria for derecognition of financial liabilities are different from those for financial assets but fortunately they are simpler! A financial liability (or a part of a financial liability) must be re-moved from an entity’s balance sheet when, and only when, the liability has been extinguished i.e. when the related contractual obligation has been discharged or cancelled or has expired. If a debt instrument is exchanged for another debt instrument with substantially different terms, or if the terms of an existing financial liability undergo substantial modification, IAS 39 provides that the changes must be treated as an extinguish-ment of the original financial liability and the recognition of a new financial liability.


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In the context of debt restructuring, contractual terms are deemed to be substantially different if the discounted present value of the cash flows under the new terms, discounted using the original effective interest rate, is at least 10% different from the discounted present value of the remaining cash flows of the original financial liability (i.e. prior to restructuring). Two situations thus arise:

if the change is substantial, the original debt is derecognised and any costs incurred are recognised as part of the gain or loss on the extinguishment;

if the change is not substantial, the original debt remains on the balance sheet and any costs or fees incurred adjust its carrying amount and are amortised (via the new effective in-terest rate of the modified debt instrument) over the remain-ing term of the modified liability.

Example

At the beginning of year 1, Company A takes out a 10 year bank loan of 100. The loan is subject to a fixed interest rate of 8% and, be-cause there are no transaction costs, the loan’s effective interest rate is equally 8%.

At the end of year 4, Company A wishes to renegotiate the terms of its loan. The bank proposes the following restructuring terms: 5 years (i.e. maturing at the end of year 9) subject to a fixed interest rate of 5% and an up-front restructuring fee of 5. The nominal amount of the loan remains unchanged at 100.

To determine whether the terms of the replacement finance are substantially different from the previous terms, the discounted pre-sent values of the cash flows under the two arrangements must be compared, using the original effective interest rate.


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The following table compares the fair values of both loans following the payment of the coupon for year 4 of the original loan, and in view of the payment of the restructuring fee of 5 for year 4:

Year 4 5 6 7 8 9 10 Present

value Cash flows of the original loan

8.0 8.0 8.0 8.0 8.0 108.0

Discounted at 8% 7.4 6.9 6.4 5.9 5.4 68.1 100.0 Cash flows of the new loan

5.0 5.0 5.0 5.0 5.0 105.0

Discounted at 8% 5.0 4.6 4.3 4.0 3.7 71.5 93.0

As the difference between the discounted present value of the initial loan (100) and the modified loan (93) is less than 10%, the terms of the two debt instruments are not deemed to be substantially differ-ent.

The initial amortised cost of the modified debt instrument is ad-justed by deducting from the previous carrying amount (i.e. 100) the amount of the restructuring fee (i.e. 100 – 5 = 95).

The modified loan’s effective interest rate amounts to 6.2% and the evolution till maturity of its amortised cost may be summarised as follows:

Year 5 6 7 8 9

Opening principal 95.0 95.9 96.8 97.8 98.9

Interest expense 5.9 5.9 6.0 6.1 6.1

Cash paid (5.0) (5.0) (5.0) (5.0) (105.0)

Closing principal 95.9 96.8 97.8 98.9 0.0

Had the restructured loan been negotiated at a fixed interest rate of 4%, its discounted present value using the original effective interest rate of 8% would have amounted to 89, i.e. a difference of more than 10% compared to the original terms, in which case the restruc-turing would have been accounted for as the extinguishment of the original loan and the separate recognition of the new loan.


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2.6.3 Repurchase agreements and securities lending

Repurchase agreements, and securities lending in general, are frequent transactions in the banking sector. In general, these transactions do not give rise to the derecogni-tion of the asset for the transferor as the latter retains substan-tially all the risks and rewards of ownership. The contract gener-ally provides for the recovery of the asset or of an asset which is substantially identical by the transferor. If the transferee has the right to sell or pledge the asset, the transferor reclassifies the asset in “Security transferred under repurchase agreements” in the original category of the asset. A financial liability is recognised in consideration of cash flow re-ceived by the transferor. The transferee recognises the asset on the balance sheet as “Bor-rowed asset” for example (or “Security received in a repurchase agreement”).

Example

Bank A borrows a government bond for a one month cash deposit under a repurchase agreement with Bank B. Bank B had classified the bond as an available-for-sale financial asset.

Bank A becomes the legal owner of the bond and has the right to sell it, but is required to return the bond to Bank B at the end of the one month period, at which time Bank B will repay the cash deposit received from Bank A.

Bank A recognises a financial asset, described as “Bank B – loan/ advance (reverse repurchase agreements and securities borrow-ing)”, as the double entry for its cash payment to Bank B.


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Bank B renames the bond as a “Security transferred under repur-chase agreements” within its available-for-sale financial assets cate-gory and recognises a financial liability, described as “Bank A – de-posit (repurchase agreements and stock lending)”, as the double en-try for its cash receipt from Bank A.

Documents

co-author of “S’initier aux IFRS” (“An Introduction to