Financial Instruments_Part I_for Website 08 EXCELLENT SUMMARY

7/31/2019 Financial Instruments_Part I_for Website 08 EXCELLENT SUMMARY

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for Bank Accounting Professionals

IAS 32/39 Financial Instruments Part 1 Recognition

This Project is funded by EU

www.banks2ifrs.ru
http://www.accountingreform.ru/http://www.accountingreform.ru/


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Financial instruments under IFRS

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PREFACE

These workbooks are an update of those originally written by the project teamof the European Union funded project Accounting Reform II in the RussianFederation and revised by the project team of the European Union fundedproject, Implementation of Accounting Reform in the Russian Federation.This version has been produced by the European Union funded projectTransition to IFRS in the Banking Sector.

The workbooks cover various concepts of IFRS based accounting. They areintended to be practical self-instruction aids that professional accountants canuse to upgrade their knowledge, understanding and skills.

The purpose of this version is to help bank accountants in the use of IFRS.

Each workbook is a self-standing short course designed for approximately ofthree hours of study.

The members of the project team were contributed by PwC Moscow, FBK

Moscow, and European Savings Bank Group Brussels. Although theworkbooks are part of a series, each one is independent of the others.

A basic knowledge of accounting is assumed but if any additional knowledgeis required this is mentioned at t he beginning of the section.

Each workbook is a combination of Information, Examples, Self-TestQuestions and Answers.

The volumes within each series are described in detail and available fordownload from the project web site.

The copyright of the material contained in each workbook belongs to the

European Union and according to its policy may be used free of charge for anynon-commercial purpose.

The project team would like to express thanks to those who have contributedtheir time and thoughts to the content of the workbooks. In particular:

The European Union Delegation, Moscow

The Bank of Russia, Moscow

Note: Material from the following PricewaterhouseCoopers publications hasbeen used in this workbook:

-Applying IFRS

-IFRS News

-Accounting Solutions

-Financial instruments under IFRS 2006

-Illustrative consolidated financial statements 2006 Banks

Contact:

Moscow, Russia, June 2008 (Updated)

e-mail [email protected] www.banks2ifrs.ru

Tel. Fax.+ 7 495 772-7091 + 7 495 772-7094
mailto:[email protected]:[email protected]:[email protected]


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CONTENTS

1 IntroductionOVERVIEW

AimThe aim of this workbook is to facilitate an understanding of IAS 32 and IAS39.

IAS 32 deals with the presentation of financial instruments and especially theirclassification as debt or equity, whilst IAS 39 deals with recognition,derecognition, measurement and hedge accounting. IFRS 7 FinancialInstruments: Disclosures is the subject of a separate workbook.

These three standards provide comprehensive guidance on the accounting forfinancial instruments. The need for such guidance is crucial as financialinstruments are a large part of the assets and liabilities of many companies,especially financial institutions.

The standards require companies to disclose their exposure to financialinstruments and to account for their impacts-in most cases as they happen,rather than allowing problems to be hidden.

IAS 39 requires most derivatives to be reported at their fair or market value,rather than at cost.

This overcomes the problem that the cost of a derivative is often nil orimmaterial. If derivatives are measured at cost, they are often not included inthe balance sheet at all and their success (or otherwise) in reducing risk is notvisible.

In contrast, measuring derivatives at fair value ensures that their leveragednature and their success in reducing risk are reported.

IAS 32 and IAS 39

IAS 32 deals with the presentation of financial instruments (when instrumentsare presented as liability or equity, and the information is to be shown in thenotes).

IAS 39 deals with the measurement of financial instruments and with theirrecognition (when they should be included in financial statements and howthey should be valued).

Why do we need standards on financial instruments?

Financial instruments are a large part of the assets and liabilities of manyundertakings, especially financial institutions. They also play a key role in t heefficient operation of f inancial markets.

Financial instruments, including derivatives, can be useful tools fo r managingrisk, but they can also be very risky themselves. In recent years there havebeen many disasters associated with derivatives and other financial

instruments.

The standards require companies to disclose their exposure to f inancialinstruments and to account for their eff ects-in most cases as they happen,rather than allowing problems to be hidden away.

To which companies do the standards apply?

The standards apply to all companies reporting under IFRS.

To what financial instruments do the standards apply?

The standards apply to all financial instruments except: Those covered by another more specific standards-such a i nterests in

subsidiaries, associates and joint ventures, and post-employmentbenefits (pensions)

Insurance contracts, and certain simi lar contracts

Most loan commitments


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The standards also apply to contracts to buy or sell a non-financial item (suchas commodity contracts) where these are for dealing purposes.

The main requirements of IAS 32

Presentation by the issuer - debt or equity

IAS 32 adopts definitions of liabilities and equity based o n the IFRSFramework. It is similar to the frameworks used by many national standard-setters,

A financial instrument is a liability if it is a contractual obligation todeliver cash or other financial assets. The f inance cost of liabilities isaccounted for as an expense.

A financial instrument is equity if it evidences a residual interest in theassets of an undertaking after deducting all of its liabilities. Paymentsof equity are treated as distributions, not as expenses.

Convertible debt (that gives the holder choice of repayment in cash, or in

shares) is separated into its debt and equity components. It is analysed into anissue of ordinary debt at a discount, and a credit to equity for the conversionright.

All relevant features need to be considered when classifying a financialinstrument. For example:

If the issuer can or will be forced to redeem the instrument, classification as

a liability is appropriate;

If the choice of settling afinancial instrument in cash or otherwise iscontingent on the outcome of circumstances beyond the control of both the

issuer and the holder, the instrument is a liability as the issuer does not have

an unconditional right to avoid settlement; and

An instrument which includes an option for the holder to put the rightsinherent in that instrument back to the issuer for cash or another financial

instrument is a liability.

The treatment of interest, dividends, losses and gains in the income statement

follows the classification of the related instrument.

Not all instruments are either debt or equity. Some, known as compound

instruments, contain elements of both in a single contact.

Such instruments, such as bonds that are convertible into equity shares either

mandatorily or at the option of the holder, must be split into liability and equitycomponents.

Each is then accounted for separately. The liability element is determined first

by fair valuing the cash flows excluding any equity component, and the

residual is assigned to equity.

As well as ordinary debt, liabilities include mandatory redeemable shares,such as units of a mutual fund and some preferred shares, because theycontain an obligation to pay cash.

Offsetting

A financial asset and a financial liability may only be offset and the net amountreported in the balance sheet when an undertaking both:

Has a current right to set o ff the recognised amounts; and

Intends either to settle on a net basis, or to realise the asset and settlethe liability simultaneously.

Situations that generally do not qualify fo r offsetting include master nettingagreements, where there is no intention to settle net, and where assets are setaside to meet a liability but t he undertaking remains primarily liable.

The main requirements of IAS 39Measurement

IAS 39 divides financial assets and financial liabilities into four classes (plusone option treatment) as follows:

Trading assets and liabilities, including all derivatives that are nothedges, are measured at fair value through profit and loss

-all gains and losses are recognised in profit and loss as they arise.


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Loans and receivables are ordinarily accounted for at amortised cost,as are most liabilities.

Held-to-maturity investments are a lso accounted for at amortised cost.

All other financial assets are classified as available-for-sale and

measured at fair value, with all gains and loses taken to equity. Ondisposal, gains and losses previously taken to equity are recycled toprofit or loss.

There is an option to account for any financial asset or liability at fair valuethrough profit and loss.

There are special rules for hedge accounting as described i n a separateworkbook.

Another aspect of measurement is impairment - when and how losses shouldbe recognised in profit and loss on those assets that are not accounted for atfair value through profit and loss. Whenever there is objective evidence of

impairment as a result of a past event, impairment should be recognised.

Among other things, IAS 39 clarifies t hat:

Impairment should only take into account losses that have alreadybeen incurred, and not those that might happen in the future

Impairment losses on available-for-sale assets are taken from equityand recognised in profit and loss. For equity investments, evidence ofimpairment may include significant adverse changes in the issuersmarket position, or a significant or prolonged decline in the fair valueof the investment.

Fair value is the only measurement that can capture the risky nature of

derivatives. The information is essential to communicate to investors thenature of the rights and obligations inherent in them. Fair value makes thederivatives visible, so that problems are not hidden away.

Hedge Accounting

Hedging techniques are used by banks and undertakings to reduce existing

market, interest rate or fo reign currency risks. These include the use offutures, swaps and options. The success of a hedging strategy is measurednot by the profit produced by the hedge itself, but by t he extent to which thatprofit offsets the results of the item hedged.

IAS 39 describes three main kinds of hedging relationship and their accountingtreatment:

A cash flow hedge is a hedge of the exposure to variability in cash flows,often in foreign currencies. The hedge matches the cash inflows with cashoutflows to minimise foreign exchange exposure.

A fair value hedge - in which the fair value of the item being hedged,changes as market prices change. Changes in the fair value of boththe hedging instrument are initially reported in equity, and transferredto profit and loss to match the offsetting gains and losses on thehedged transaction.

A hedge of a net investment in foreign operation should be accountedfor in the same way as a cash flow hedge.Hedge accounting allows undertakings to depart selectively from the

normal accounting treatment and allows losses to be held back orgains to be accelerated.

The following principles have been adopted in order to provide discipline overthe use of hedge accounting:

The hedging relationship has to be defined by designation anddocumentation, re liably measurable, and actually effective

To the extent that a hedging relationship is effective, the offsettinggains and losses on the hedging instrument and the hedged item arerecognised in profit and loss at the same time

All hedge ineffectiveness is recorded immediately in profit and loss

Items must meet the definitions of assets and liabilities to berecognised in the balance sheet.

Hedge accounting for internal hedges is not permitted, as internal transactionsare eliminated on consolidation - the undertaking is merely dealing with itself.


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However, where internal hedges are used as a route to the market, via aninternal treasury centre, IAS 39 clarifies what needs to be done in order toachieve hedge accounting.

Part 4 of our workbooks on Financial Instruments covers hedge accounting.

Scope

The scope of the standards is very wide-ranging. Anything that meets thedefinition of a financial instrument is covered unless it falls within one of thespecific exemptions.

Within scope of IAS 32and IAS 39

Within scope ofIAS 32 only

Out of scope

Debt and equityinvestments

Investments insubsidiaries, associatesand joint ventures

Loans and receivables Lease receivables(Note 1)

Own debt Own equity Lease payables (Note1)Tax balancesEmployee benefits

Cash and cash equivalents

Derivatives e.g.:Interest rate swapsCurrency forwards/swapsPurchased/written optionsCommodity contracts(Note 2)

Collars/capsCredit derivativesCash or net sharesettleable derivatives onown shares

Derivatives on ownshares settled onlyby delivery of afixed number ofshares for a fixedamount of cash

Own-use commoditycontracts

Derivatives on

subsidiaries, associatesand joint ventures

Embedded derivatives

Loan commitments heldfor trading (Note 3)

Other loancommitments

Financial guarantees (Note4) Insurance contractsWeather derivatives

Note 1 Leases: Lease receivables are included in the scope of IAS 39 forderecognition and impairment purposes only. Finance lease payables aresubject to the derecognition provisions. Any derivatives embedded in leasecontracts are also within the scope of IAS 39.

Note 2 Commodity contracts:Contracts to buy or sell non-financialitems are within the scope of IAS 32 and IAS 39 if they can be settled net incash, or another financial asset, and they are not own-use commoditycontracts. Settling net includes taking delivery of the underlying asset andselling it within a short period to generate a profit from short-term fluctuationsin price.

Note 3 Loan commitments:Loan commitments are outside the scope ofIAS 39 if they cannot be settled net in cash or by some other financialinstrument, unless- they are held for trading or to generate assets of a class which theundertaking has a past practice of selling; or-the undertaking chooses to include them with other derivatives under IAS 39.

Note 4 Financial guarantees: A financial guarantee is a contract thatrequires the issuer to make specified payments to reimburse the holder for a loss that

it incurs because a specified debtor fails to make a payment when due in accordance

with the original or modified terms of a debt instrument.

The issuer of such a financial guarantee would account for it initially at fairvalue under IAS 39, and subsequently at the higher of that amount initially

recognised less cumulative amortisation recognised in accordance with IAS18 or the amount determined i n accordance with IAS 37. Guarantees based

on an underlying price or index are derivatives within the scope of IAS 39.


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2 Glossary

Amortised cost: the amount at which the financial asset or financial liabilityis measured at initial recognition minus principal repayments, plus or minus thecumulative amortisation using the effective interest method of any differencebetween that initial amount and the maturity amount, and minus any reduction

(directly or through the use of an allowance account) for impairment oruncollectability.Available-for-sale financial assets: those financial assets that aredesignated as available-for-sale or are not classified as (i) loans andreceivables, (ii) held-to-maturity investments, or (iii) financial assets at fairvalue through profit or loss.

Cash flow hedge: a hedge of the exposure to variability in cash f lows that:is attributable to a particular risk associated with an asset or liability or a highlyprobable forecast transaction and could affect profit.

Derecognition: removal of a financial asset or fi nancial liability from the

balance sheet.

Derivative: a financial instrument with all three o f the followingcharacteristics:

(i)Its value changes in response to the change in a specified i nterest rate,security price, commodity price, foreign exchange rate, index of prices or rates,a credit rating or credit index, or other variable (sometimes called theunderlying);

(ii)It requires no initial net investment or an initial net investment that is smallerthan would be required for o ther types of contracts that would be expected tohave a similar response to changes in market factors; and

(iii)It is settled at a future date.

Effective interest method: a method of calculating the amortised cost of afinancial asset or financial liability and of allocating the interest income orinterest expense over the relevant period.

Effective interest rate: the rate that exactly discounts future cash paymentsor receipts through the expected life o f the financial instrument or, whenappropriate a shorter period, to the net carrying amount of the financial asset orfinancial liability.

When calculating the effective interest rate, an undertaking shall consider allterms of the instrument (for example, prepayment, call and similar options) but

shall not consider future credit losses.

The calculation includes all fees paid or received, transaction costs, and allother premiums or discounts. Normally the cash flows and the expected life o fa group of similar financial instruments can be estimated reliably.

If not, the undertaking shall use the co ntractual cash flows over the fullcontractual term of the financial instrument (or group of financial instruments).

Embedded derivative: a component of a combined instrument where someof the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

An embedded derivative causes some or all of the cash flows that the contractwould otherwise require to be modified based on a specified interest rate,security price, commodity price, foreign exchange rate, index of prices or rates,or other variable

A derivative that is attached to a financial instrument but is transferableindependently of that instrument, or has a dif ferent counterparty from thatinstrument, is not an embedded derivative but a separate f inancial instrument.

Equity: any contract that gives a residual interest in the assets of anundertaking after deducting all of its liabilities.

Fair value: the amount for which an asset could be exchanged, or a liability

settled between knowledgeable, independent parties.

In an active market, for assets it is the market bid price and for liabilities it is themarket offer price.

Fair value hedge: a hedge of the exposure to changes in fair value of arecognised asset or liability or an unrecognised firm commitment, or an


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identified portion of such an asset, liability or firm commitment, that isattributable to a particular risk and could affect profit.

Financial instrument: any contract that gives rise to a financial asset of oneundertaking and a financial liability or equity instrument of another undertaking.

Financial asset: any asset that is:

(1) Cash;

(2) An equity instrument of another undertaking;

(3) A contractual right:

(i) To receive cash or another financial asset from another undertaking; or

(ii)To exchange financial assets or financial liabilities with another undertakingunder conditions that are potentially favourable to the undertaking; or

(4)A contract that will or may be settled in the undertakings own equityinstruments and is:

(i)A non-derivative for which the undertaking is or may be obliged to receive avariable number of the undertakings own equity instruments; or

(ii)A derivative that will or may be settled other than by the exchange of a fixedamount of cash or another financial asset fo r a fixed number of theundertakings own equity instruments.

The undertakings own equity instruments do not include instruments that arethemselves contracts for the future receipt or delivery of the undertakings ownequity instruments.

Financial asset or financial liability at fair value through profit or

loss: a financial asset or financial liability that meets either of the followingconditions:

(1)It is classified as held for trading (see trading financial assets and fi nancialliabilities below)

A financial asset or financial liability is classified as held for trading if it is:

(i) acquired or incurred principally for the purpose of selling or

repurchasing it in the near term;

(ii) 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; or

(iii) a derivative (except for a derivative that is a financial guarantee contractor a designated and effective hedging instrument).

(2)Upon initial recognition, it is designated as at fair va lue through profit o r loss.

An undertaking may use this designation only when doing so results in morerelevant information, because either:

(i) it eliminates or significantly reduces a measurement or recognitioninconsistency (sometimes referred to as an accounting mismatch) that wouldotherwise arise from measuring assets or liabilities or recognising the gainsand losses on them on diff erent bases; or

(ii) a group of financial assets, financial liabilities or both is managed and itsperformance is evaluated on a fair value basis, i n accordance with adocumented risk management or investment strategy, and information aboutthe group is provided internally on that basis to the undertakings keymanagement personnel (IAS 24, Related Party Disclosures), for example theundertakings board of directors and chiefexecutive officer.

An undertaking may also designate an entire hybrid (combined) contract as afinancial asset or financial liability at fair value through profit or loss if thecontract contains one or more embedded derivatives, unless:

(1) the embedded derivative(s) does not significantly modify the cash flowsthat otherwise would be required by the contract; o r

(2) it is clear with little or no analysis when a similar hybrid (combined)instrument is first considered, that separation of the embedded derivative(s) isprohibited, such as a prepayment option embedded in a loan that permits theholder to prepay the loan for approximately its amortised cost.


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Financial liability: any liability that is:

(1)A contractual obligation:

(i)To deliver cash or another f inancial asset to another undertaking; or

(ii)To exchange financial assets or financial liabilities with another undertakingunder conditions that are potentially unfavourable to the undertaking; or

(2)A contract that will or may be settled in the undertakings own equityinstruments and is:

(i)A non-derivative for which the undertaking is, or may be, obliged to deliver avariable number of the undertakings own equity instruments; or(ii)A derivative that will, or may be, settled other than by the exchange of afixed amount of cash or another f inancial asset for a fixed number of theundertakings own equity instruments.

For this purpose the undertakings own equity instruments do not include

instruments that are themselves contracts for the future receipt or delivery ofthe undertakings own equity instruments.

Financial guarantee:a contract that requires the issuer to make specifiedpayments to reimburse the holder for a loss it incurs because a specifieddebtor fails to make payment when due in accordance with the original ormodified terms of a debt instrument.

Firm commitment: a binding agreement for the exchange of a specifiedquantity of resources at a specified price on a specified future date or dates.

Forecast transaction: an uncommitted but anticipated future transaction.

Hedge effectiveness: the degree to which offsetting changes in the fairvalue or cash flows of the hedged item are offset by changes in t he fair valueor cash flows of the hedging instrument.

Hedged item: an asset, liability, firm commitment, highly-probable forecastfuture transaction, or net investment in a fo reign operation that

exposes the undertaking to risk of changes in fair value or future cash flowsandis designated as being hedged.

Hedging instrument: a designated derivative, or non-derivative financialasset or non-derivative financial liability, whose fair value or cash flows areexpected to offset changes in the fair value or cash flows of a designatedhedged item.

A non-derivative financial asset or non-derivative financial liability may bedesignated as a hedging instrument for hedge accounting purposes only if ithedges the risk of changes in fo reign currency exchange rates.

Held-to-maturity investments: a financial asset with fixed or determinablepayments and fixed maturity that an undertaking has the positive intent andability to hold to maturity, unless designated as held for trading or available-for-sale, or that meet the defi nition of loans and receivables.Loans and receivables: non-derivative financial assets with fixed ordeterminable payments that are not quoted in an active market, other than:

(i)Those that the undertaking intends to sell in the near term, which shall beclassified as held for trading, and those that the undertaking upon initialrecognition designates as at fair value through prof it or loss;

(ii)Those that the undertaking upon initial recognition designates as avai lable-for-sale; or

(iii)Those for which the holder may not recover substantially all o f its initialinvestment (other than because of credit deterioration) which shall be classifiedas available-for-sale.

An interest acquired in a pool of assets that are not loans or receivables (forexample, an interest in a mutual fund or a similar fund) is not a loan or

receivable.

Net investment in a foreign operation: the amount of the undertaking'sinterest in the net assets of that operation.


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Regular way purchase or sale: a contract for the purchase or sale of afinancial asset that requires delivery of the asset within the time frameestablished by regulation or convention in the marketplace concerned.

Tainting:where an undertaking sells or transfers more than an insignificantamount of its held-to-maturity investments, it must reclassify all of them asavailable-for-sale. It is t hen prohibited from classifying any assets as held-to-maturity for the next two full annual financial periods, until confidence in itsintentions is restored.

Trading financial assets and liabilities: a financial asset or financialliability is classified as held for trading if it is

(i) acquired or incurred for the purpose of selling or repurchasing it in t he nearterm;

(ii) part of a portfolio of financial instruments that are managed together and forwhich there is evidence of a recent actual pattern of short-term profit-taking; or

(iii) a derivative (except for a derivative that is a designated and effective

hedging instrument).

Transaction costs: incremental costs that are directly attributable to theacquisition or disposal of a financial asset or financial liability.An incremental cost is one that would not have been incurred if the undertakinghad not acquired, issued or disposed of the financial instrument.

Transaction costs include fees and commissions paid to agents, advisers,brokers and dealers, levies by regulatory agencies and securities exchanges,and transfer taxes and duties. Transaction costs do not include debt premiumsor discounts, financing costs or internal administrative or holding costs.

3 Work Book 1. - Initial Recognition andClassification Including Debt/EquityClassification

OVERVIEW

Key issues

Financial assets and liabilities are initially measured at fair value.

An undertaking may designate a financial instrument irrevocably on initialrecognition as held at fair value thr ough profit or loss, provided c ertain criteria

are met.

Loans purchased by the undertaking that would otherwise meet thedefinition of loans and r eceivables are classified as such.

Failure to comply with the rules for held-to-maturity assets taints the whole

category.

Transfers into and out of the held for trading category after initial recognitionare prohibited.

Embedded derivatives should be accounted for separately if their

economics are not closely related to those of the host contract.

4 Initial recognition

An undertaking shall recognise a financial asset or a f inancial liability on itsbalance sheet when the undertaking becomes a party to the contractualprovisions of the instrument.

An undertaking records all of its contractual rights and obligations underderivatives in its balance sheet as assets and liabilities, respectively, exceptfor derivatives that prevent a transfer of financial assets from being accountedfor as a sale.

If a transfer of a financial asset does not qualify fo r derecognition, thetransferee does not record the transferred asset as its asset. This would applyto the lender who receives securities as collateral, i ncluding REPOagreements.

Examples : recording contractual rights and obligations under derivatives in itsbalance sheet as assets and liabilities


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1. unconditional receivables and payables are recorded as assets or liabilitieswhen the undertaking becomes a party to t he contract and, as a consequence,has a legal right to receive or a legal obligation to pay cash.

2. assets to be acquired and liabilities to be incurred as a result of a firmcommitment to purchase or sell goods or services are generally notrecognised until at least one of the parties has performed under theagreement.

For example, an undertaking that receives a firm order does not generallyrecognise an asset (and the entity that places the order does not recognise aliability) at the time of the commitment but delays recognition until the orderedgoods or services have been shipped, delivered or rendered.

If a firm commitment to buy or sell non-financial items is within the scope ofIAS 39, its net fair va lue is recognised as an asset or liability on thecommitment date.

If a previously-unrecognised firm commitment is designated as a hedged itemin a fair value hedge, any change in the net fair value attributable to thehedged risk is recognised as an asset or liability after the inception of thehedge.

3. a forward contract that is within the scope of IAS 39 is recognised as anasset or a liability on the commitment date, ra ther than on the date on whichsettlement takes place.

When an undertaking becomes a party to a forward contract, the fair values ofthe right and obligation are of ten equal, so that the net fair va lue of the forwardis zero.

If the net fair value of the right and obligation is not zero, the contract is

recognised as an asset or liability.

4. option contracts that are within the scope o f IAS 39 are recognised asassets or liabilities when the holder or writer becomes a party to the contract.

Planned future transactions, no matter how likely, are not assets and liabilitiesbecause the entity has not become a party to a contract.

Example: Does possession of an asset indicate control?

IssueThe recognition of an asset in the balance sheet occurs when it is p robablethat the future economic benefits will flow to the entity and the asset has a costor value that can be measured reliably.

The entity must have control over the assets future economic benefits. Controlof an asset is defined as the power to obtain the future economic benefits thatflow from it.

Does possession of an asset automatically indicate control?

BackgroundEntity A enters into a legal arrangement to act as trustee for entity B byholding listed shares on Bs behalf. B makes all investment decisions and Awill act according to Bs instructions. A will earn a trustee fee fo r holding theshares. Any dividends or profit/(loss) from the i nvestments belong to B.

SolutionA should not recognise the listed shares as its asset even though it is inpossession of the shares.

A does not control the investments future economic benefits. Benefits fromthe investments flow to B, and A earns a trustee fee for holding the sharesregardless of how the shares perform. The listed shares therefore do not meetthe criteria of an asset in As balance sheet.

Banks commonly act as trustees and in other fiduciary capacities that result inthe holding or placing of assets on behalf of individuals, trusts, retirementbenefit plans and other i nstitutions.

Provided the trustee or similar relationship is legally supported, these assetsare not the banks and, therefore, are not included in its balance sheet. The

same principle applies to all other entities.


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Example: REPOs - Recognition of inventory sold to a bank with anagreement to repurchase similar inventory

IssueA sale and repurchase agreement is in substance a financing arrangementand does not give rise to revenue when the seller has retained the risks andrewards of ownership, even though legal title has been transferred [IAS18].

Should an entity recognise revenue on the sale o f goods when repurchaserights exist?

BackgroundThe management of entity A is considering the following two alternativetransactions:

a) sale of inventory to a bank for 500,000 with an obligation to repurchase theinventory at a later stage; or

b) sale of inventory to a bank for 500,000 with an option to repurchase theinventory any time up to 12 months from the date of sale.

The repurchase price in both alternatives is 500,000 p lus an imputed financingcost.

The bank is required to provide substantially the same quality and quantity ofinventory as was sold to it ( that is, the bank is not required to return preciselythe same physical inventory as was originally sold to it). The fair value o f theinventory sold to the bank is 1,000,000.

SolutionManagement should recognise the transactions as follows:

a) Sale with repurchase obligation: management should not recognise

revenue on the transfer of the inventory to the bank. The inventory shouldremain on entity As balance sheet and the proceeds from the bank should berecognised as a collateralised borrowing.

Even though the inventory repurchased from the bank is not the inventorysold, it is in substance the same asset. The substance of the transaction isthat the sale and repurchase are linked t ransactions, and entity A does not

transfer the risks and rewards associated with the i nventory to the bank.

b) Sale with repurchase option: management should not recognise revenueunless and until the option is a llowed to lapse. The inventory should remain onentity As balance sheet and the proceeds recognised as a collateralisedborrowing until As right to repurchase the inventory lapses.

Although the entity does not have title to the inventory during the period

between sale and repurchase, the substance of the transaction as a whole isstill that of a f inancing rather t han a sale of the inventory.

Example: Sale subject to share of future benefits - a financingarrangement

IssueAn entity should recognise revenue when [IAS18]:

a) it has transferred significant risks and rewards of ownership of the goods tothe buyer;

b) it does not retain continuing managerial involvement or control over thegoods sold;c) the amount of revenue can be measured reliably;d) it is probable that the economic benefits associated with the transaction willflow to the entity; ande) the costs incurred or to be i ncurred in respect of the transaction can bemeasured reliably.

What are the circumstances under which an entity retains a continuinginvolvement in an asset?

BackgroundEntity A owns a hotel resort located in the Bahamas. The resort includes a

casino that is housed in a separate building that is part of the premises of theentire hotel resort.

The casinos patrons are largely tourists and non-resident visitors. Entity Aoperates the hotel and other facilities on the hotel resort, including the casino.During the year, the casino was sold to entity B.


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A and B agree that A will operate the casino for its remaining useful life. EntityA will receive 85% of the net profit of the casino as operator fees, and theremaining 15% will be paid to entity B.

A has also provided a guarantee to B that the casino will have net profits of atleast 10 million.

Solution

Entity A should not recognise the arrangement as a sale of the casino, as itcontinues to enjoy substantially all of its risks and rewards and has acontinuing involvement in its management.

The transaction is in substance a financing arrangement and the proceedsshould be recognised as a borrowing.

Under IAS 39 an undertaking is required to record a financial asset or liability

on its balance sheet only when it becomes a party to the contractualprovisions of the instrument.

Initial measurement: financial assets and liabilities are initially measured at

fair value (discussed in the measurement chapter). Usually this will be the

same as the fair value of the consideration given (in the case of an ass et) orreceived (in the case of a liability).

However, if this is not the case, any difference is accounted for in accordance

with the substance of the transaction. For example, if the instrument is valued

by reference to a more favourable market than the one in which the transactiontook place, an initial profit is recognised. Alternatively, a loan given to a related

party at below-market rates will need to be remeasured at fair value bydiscounting it at the market rate.

Example: Loans with a below-market rate of interest

Issue

The fair value of a financial instrument on initial recognition is normally thetransaction price (that is, the fair value of the consideration given or received).

However, if part of the consideration given or received is for something otherthan the financial instrument, the fair value of the financial instrument is

estimated, using a valuation technique [IAS39].

How should management account for a low-interest loan given to an essentialsupplier?

Background

Entity A manufactures rocket engines. A third party, entity B, produces one ofthe components used in the engines. The component manufactured by B isrelatively small compared with the rocket engines, but is critical to Asoperations. Entity B owns the patents over the technology used in itscomponents.

B has been struggling to expand its production facilities to keep pace with As

demand for its components. Consequently, on 1 January 20X1, A lends10,000 to B to finance the expansion required. The loan is for a period of 5years, and A classifies the asset as an originated loan. The loan carriesinterest at a rate of 5% (payable annually), whereas the interest rate that Bwould be able to obtain on similar loans from the market is 10%. Thus, the

loans fair value, calculated as a net present value of interest payments andprincipal repayments, discounted at 10%, is 8,105.

Solution

As management should initially recognise the loan at its fair value of 8,105.The loan receivable bears interest at an effective rate of 10%, and should beamortised to its face value by the end of year 5.

The table below provides information about the amortised cost, interestincome and cash flows in each reporting period.

Year (a)

Amortised

cost at thebeginning of

the year

(b = a x

10%)

Interest

income

(c)

Cash

flows

(d = a + b -

c)

Amortisedcost at theend of theyear


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20x1 8,105.0 810.5 5008,415.5

20x2 8,415.5 841.5 5008,757.0

20x3 8,757.0 875.7 5009,132.7

20x4 9,132.7 913.3 5009,546.0

20x5 9,546.0 954.6 10,000 +500

10,000.0

In the following examples, I/B refers to Income Statement and Balance Sheet.

Example: more favourable marketYou buy a financial instrument fo r $20.000. The value in a more favo urablemarket is $21.000. You recognise the prof it of $1.000.

I/B DR CRFinancial instrument B 20.000

Cash B 20.000Purchase of Financial instrument

Financial instrument B 1.000Gain on Financial instrument I 1.000Recognition of profit

Example: Accounting for long-term loan to associate

Entity A has an associate, entity B.

Entity A has made a loan to entity B. The loan is non-interest bearing andrepayable on demand but entity A does not plan or expect to require

settlement of the loan for t he foreseeable future. The loan is not collateralised.

Entity A views the loan to the associate as part of its net investment in theassociate in accordance with IAS 28.29.

How should entity A account for and classify the loan to entity B?

Entity A should account for the loan in accordance with the guidance inIAS 39, even though it is considered part of the net i nvestment in theassociate. The loan should be initially recognised at fair value in accordancewith IAS 39.

A loan that is repayable on demand cannot have a fair value that is less thanthe amount repayable (IAS 39.49). Consequently the loan should berecognised at the amount leant to entity B.

Subsequent measurement of the loan should be at amortised cost, however,the loan will continue to be carried at cost under IAS 39.This is because thereis no effective interest rate and so no amortisation to record under theamortised cost method.

The loan may be classified on the balance sheet either as part of otherreceivables or as part of the i nvestment in associates. The notes to thefinancial statements should provide an adequate description of theloan balance so that its nature is c lear to a reader o f the financial statements.

Transaction costs: These are included in the initial carrying value of financial

assets and liabilities, unless they are carried at fair value through p rofit or losswhen the transaction costs are recognised in the income statement.

Transaction costs include fees and commissions paid to agents (including staffacting as selling agents), advisers, brokers and dealers, levies by regulatoryagencies and securities exchanges, and transfer taxes and duties.

Transaction costs do not include debt premiums or discounts, financing costsor internal administrative or holding costs.

Financial guarantee contracts

How does the holder of a f inancial guarantee account for any costs relating

to it, and how does a financial guarantee impact impairment calculation?

IAS 39 only applies to the issuer of financial guarantee contracts. The accountingby the holder of such a contract is therefore outside the standards scope.

The holders accounting treatment depends on whether the guarantee is


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purchased at origination of a debt instrument or to guarantee pre-existing debtinstruments.

In the first case, the purchaser of the financial guarantee contract treats t he costof the guarantee as a transaction cost under IAS 39. Thus the cost is amortisedusing the effective interest rate method, unless the debt instrumentis measured at fair value through profit and loss.

In the second case, the cost is recognised as a prepayment asset and amortisedover the shorter of the life of the guarantee and the expected life of theguaranteed debt instruments.

The asset is tested for impairment under IAS 36, Impairment of Assets. Lendersclassify the amortisation and impairment charges as a reduction of interestincome.

When estimating the expected future cash flows of a loan, an entity reflects thecash flows from any collateral.

Collateral includes financial guarantees that are entered into as part of thecontractual terms of the loan. A guarantee of an individual loan entered into at t hesame time as the loan contract effectively forms part of the contractual terms ofthe loan.

Therefore, the impairment charge is shown net of any financial guaranteereimbursement.

In the situation where a guarantee of a portfolio of loans has been entered intoseparately from the loans, the guarantee is separate f rom the loan and thereimbursement does not constitute cash from the loan.Therefore, the reimbursement is treated as a separate asset in accordance withIAS 37, Provisions, Contingent Liabilities and Contingent Assets,and not nettedagainst the impairment charge.

Accounting for financial guarantees IAS 39 or IFRS 4? IFRS NewsNovember 2005

All guarantee contracts are accounted for under IAS 39 unless the issuer haspreviously asserted explicitly (eg, in its financial statements or submissions to

regulators) that it regards the contracts in question as insurance contracts andhas applied the accounting treatment specifically applicable to insurancecontracts.

The issuer has a choice of applying IFRS 4 or IAS 39 for guarantee contracts thatmeet these two tests.

The accounting for financial guarantees will reflect the entitys business model. In

particular, credit insurers will retain most aspects of their existing accounting, andnon-insurers are not required to apply the requirements and disclosures of aninsurance standard.

The accounting treatment of a f inancial guarantee contract by t he holder remainsoutside the scope of IAS 39 and IFRS 4.

Definition of a financial guarantee contract

The following definition of a f inancial guarantee contact, which is currentlyincluded in IFRS 4, has been added to IAS 39:

A contract that requires the issuer to make specified payments to reimburse theholder for a loss it incurs because a specified debtor fails to make payment whendue in accordance with the original or modif ied terms of a debt instrument.

Financial guarantee contracts comprise three parties: the issuer of the financial guarantee, the holder of the financial guarantee, and a specified debtor.

Instruments with various legal forms will meet t his definition, including creditguarantees, some types of letters of credit, credit default contracts and creditinsurance contracts. Not all types of guarantee contract will meet this definition.

The key question is whether the contract requires payments even if the holder hasnot incurred a loss on the failure of the debtor to make payments when due.

A contract that requires payments in response to changes in a specified creditrating, for example, is a derivative contract that must be recognised andmeasured at fair value under IAS 39.


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Accounting treatmentThe accounting treatment and disclosure requirements differ depending onwhether IAS 39 or IFRS 4 is applied.

An issuer could apply the fair va lue option to those f inancial guarantee contractsto which IAS 39 is applied, provided the IAS 39 conditions are met.

Intra-group guarantees

The amendment does not provide an exemption for intra-group financialguarantees; for example, a guarantee issued by a parent to one if its subsidiaries.

The accounting treatment described above is applicable fo r the issuers stand-alone financial statements.

Practical difficulties may arise in measuring the fair value o f such intragroupfinancial guarantees. It is common either for no fee to be charged, or for the feenot to be on arms length terms and hence not to reflect the fair value of thefinancial guarantee.

The issuer is required to determine the fee that would be charged for theguarantee in an arms length, market transaction. When a parent company gives afinancial guarantee for less than its fair value (including where it charges no fee),the difference between the amount charged and fair value is a capital contribution.

This treatment of intra-group guarantees under IFRS is different from US GAAP,which excludes intra-group guarantees from the scope of FIN 45.

Accounting treatment for the holder of a f inancial guaranteeThe accounting treatment for the holder of a financial guarantee contract isoutside the scope of IAS 39 and IFRS 4.

The holder of a financial guarantee has two elements to account fo r: thepremium paid and payments received under the contract.

The premium paid is recognised as an asset in the balance sheet and amortisedover the life of the guarantee contract.

Payments (and potential payments) that become due because the specifieddebtor fails to make payment when due are taken into account when determiningthe amount of any impairment of the holders receivable from the debtor.

* IAS 37 is based on the best estimate ofthe expenditure required to settle thepresent obligation. Discounting is required.** Discounting is not mandatory under IFRS 4.

5 Classification Debt versus Equity

IAS 32 establishes principles for distinguishing between liabilities and equity.The economic substance of a f inancial instrument, rather than its legal form,governs its classification.

An instrument is a liability when the issuer is, or can be required, to delivereither cash or another financial asset to the holder. This distinguishes a liabilityfrom equity. An instrument is classified as equity when it represents a residualinterest in the net assets of the issuer.

All relevant features need to be considered when classifying a financial

instrument. For example:

If the issuer can, or will be forced to, redeem the instrument, it is a liability.

If the choice of settling a financial instrument in cash (or otherwise) iscontingent on the outcome of circumstances beyond the control of both the


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issuer and the holder, the instrument is a liability as the issuer does nothave an unconditional right to avoid settlement.

An instrument which has an option for the holder to sell the rights in thatinstrument back to the issuer fo r cash (or another financial instrument) is aliability.

The treatment of interest, dividends, losses and gains in the income statementfollows the classification of the related instrument.

Preference sharesEquity or Liability?

Traditionally, preference shares have been considered to be equity, as theyreward the holders with dividends, and have been shown within the capitalstructure of companies. IFRS determines whether or not preference (orpreferred) shares are equity or liabilities by assessing the particular rightsattaching to the share.

For example, a preference share that provides for redemption on aspecific date or at the option of the holder contains a financial liability, asthe issuer has an obligation to pay cash to the holder of the share.

The potential inability of an issuer to satisfy an obligation to redeem apreference share when contractually required to do so, whether because of alack of funds, a statutory restriction or insufficient profits or reserves, does notnegate the obligation or c lassification.

An option of the issuer to redeem the shares for cash does not satisfy thedefinition of a f inancial liability because the issuer does not have a presentobligation to transfer financial assets to the shareholders.

Redemption of the shares is solely at the discretion of the issuer.

An obligation to pay cash (and therefore a liability) may arise, however, when

the issuer exercises its option, usually by fo rmally notifying the shareholders ofan intention to redeem the shares.

When preference shares are non-redeemable, classification is based on anassessment of the substance of the contractual arrangements. Whendistributions to holders of the preference shares, whether cumulative or

non-cumulative, are at the discretion of the issuer, the shares are equityinstruments.

The classification of a preference share as an equity instrument or a fi nancialliability is not affected by, fo r example:

i. a history of making distributions;ii. an intention to make distributions in the future;

iii. a possible negative impact on the price of ordinary shares of the issuer ifdistributions are not made (because of restrictions on paying dividends onthe ordinary shares if dividends are not paid on the preference shares);

iv. the amount of the issuers reserves;v. an issuers expectation of a profit or loss for a period; orvi. an ability or inability of the issuer to influence the amount of its profit or loss

for the period.

Not all instruments are either only debt or o nly equity.

Compound instruments

Compound instruments contain elements o f both in a single contact.Instruments, such as bonds that are convertible into equity shares, eithermandatorily or at the option of the holder, must be split into liability and equitycomponents.

Each is then accounted for separately. The liability element is determined firstby fair valuing the cash flows excluding any equity component, and theresidual is assigned to equity.

Examples - non-cumulative preference share

1. A non-cumulative preference share is mandatorily redeemable for cash inten years, but that dividends are payable at the discretion of the entity beforethe redemption date.

Such an instrument is a compound financial instrument, with the liabilitycomponent being the present value of the redemption amount.


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The unwinding of the discount on this liability component is recognised in profitor loss and classified as interest expense.

Any dividends paid relate to the equity component and are recognised as adistribution of profit or loss.

Similarly, bonds with warrants attached must be split into liability and equitycomponents.

Application of the fixed for fixed principle

A contract to exchange a financial asset for an entitys own equity instrumentsis classified as equity only if both the amount of financial assets and thenumber of equity instruments are fixed.

If either the amount of financial assets or the number of equity instruments isnot fixed, a financial liability exists.

This raises the question of what f ixed means. For example, if the amount isfixed but in a currency other than the functional currency of the issuing entity,then the amount is not fixed for the purpose of classifying the financial

instrument. (See also Annex 1 IAS 32 - Frequently Asked Questions)

The Decision Tree below illustrates whether an instrument is a financial liabilityor equity instrument:


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Debt vs Equity

Decision Tree

Yes

Yes

No

Is settlement in cash either:-mandatory-at the option of the holder

Does the settlement depend on the outcomeof uncertain future events or circumstances

beyond the issuing undertakings control?

In substance, does the issuing undertakinghave full discretion to avoid cash

settlement?

Is the possibility that the issuingundertaking will be required to settle incash/other financial asset remote?

Is settlement in a variable number of theissuing undertakings equity securities?

Is the holder exposed to the risk offluctuations in (a)price or (b)(b)residualprice or (b) residual interest in the issuing

undertaking's own equity securities?

EQUITY LIABILITY

NoNo

No


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The table illustrates whether an instrument is a f inancial liability or equityinstrument.

Instrument Cashobligationfor

principal

Cashobligationfor coupon/

dividends

Settlement in fixednumber

of shares

Classification

Ordinary shares No No n/a Equity

Redeemablepreferenceshares with 5%fixed dividendeach yearsubject toavailability ofdistributableprofits

Yes Yes Yes Liability

Redeemablepreferenceshares withdiscretionarydividends

Yes No No Liability forprincipal andequity fordividends

Convertiblebond whichconverts intofixed number ofshares

Yes Yes Yes Liability for bondand equity forconversionoption

Convertible

bond whichconverts intoshares to thevalue of theliability

Yes Yes No Liability

Debt versus equity: update on IFRIC position - IFRS News May 2006

The classification of financial instruments as debt or equity instruments can becomplex.

The classifications resulting from IAS 32 can a lso be counter-intuitive anddiffer from those under tax laws or o ther regulatory frameworks. It is thereforenot surprising that IFRIC has received a number of requests for interpretationsof debt versus equity c lassification.

IFRIC rejected a request in March 2006 for an interpretation on theclassification of two common structures step-up instruments and linkedinstruments on the grounds that IAS 32 is clear.

This text looks at the IAS 32 principles that are relevant to these instrumentsand IFRICs decisions on them. It only considers instruments that are settled

in cash and does not cover instruments that may or will be settled i n theissuers own equity.

Debt / equity classification principles in IAS 32

A key feature of a financial liability under IAS 32 is a co ntractual obligation todeliver cash or another financial asset, or to exchange financial assets orliabilities under conditions that are potentially unfavourable.

An instrument that contains no such contractual obligation is c lassified asequity. This will be the case when the entity has discretion over whether to

make any cash payments.

A significant issue is therefore what is meant by discretion?

IAS 32 is clear that whether discretion exists is not affected by the entitys


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intention or ability to make distributions in the future, the amount of the issuer'sreserves, any economic compulsion to make distribution or the ranking of theinstrument on the liquidation of the entity.

IAS 32 also requires an instrument to be classified in accordance with itssubstance rather than its legal form; for example, a share can be classified asa liability under IAS 32 if it obliges the entity to make payments.

A note or bond can be classified as equity if it contains no such obligation.However, anything outside the contractual terms is not considered whenclassifying an instrument under IAS 32. It is only the substance of thecontractual terms of a f inancial instrument and whether these give rise to acontractual obligation that should be taken into consideration.

Applying principles to step-up instruments and linked instruments

Example: Step-up instruments

ExampleIn 2X06, an entity issues perpetual callab le preference shares with a 5%

dividend whose payment is mandatory if dividends are paid o n ordinaryshares.

Dividends on ordinary shares are payable at the discretion of the issuer. Theinstrument includes a step-up dividend clause that increases the dividend to apre-determined rate in 2X10 (for example, to 10% which is expected to besignificantly above market rates), and a cal l option for the issuer to redeem theinstrument in 2X10.

The entity is expected to call the instrument in 2X10 so as to avoid the abovemarket payments (this is commonly referred to as economic compulsion).

IFRIC conclusion

The instrument should be classified as equity under IAS 32. An economicincentive to make distributions or redeem an i nstrument is not a contractualobligation.

The entity could choose not to redeem the instrument and to pay nodistributions on it in perpetuity. Whilst a consequence of this would be that the

entity could not pay an ordinary dividend, this does not amount to acontractual obligation.

Example: Linked instruments

Example

An entity issues perpetual callable preference shares (the base instrument)that must pay dividends if interest is paid on another instrument (the linked

instrument) issued by the entity. The linked instrument is a liability, as itsterms oblige the entity to make interest payments.

IFRIC conclusion

The base instrument is a liability, as the linkage to the linked instrumentcreates a contractual obligation for the entity to pay dividends on the baseinstrument.

The linked instrument (sometimes called a baby preference share) frequentlyhas a small face amount compared to t he base instrument.

IFRIC stated that the insignificant value does not impact the liability

classification. It does not eliminate the fact that the issuer has no discretionover the payment of the dividend on the base instrument (ie, the linking hascreated a contractual obligation in this fact pattern).

CommentThe addition of a linked instrument is one of the most commonly usedpractices to achieve liability classification for a base instrument that wouldotherwise be classified as equity.

Management may wish to obtain liability classification when it has hedgedsome of the future payments on the base instrument, as hedge accountingcannot be used if the hedged base instrument is classified as equity.

ConclusionThe IFRIC decisions outlined above show that it i s critical to understand all thefeatures, terms and conditions of an instrument i n order to ensure itsappropriate classification as debt or equity. An economic incentive to makepayments no matter how great does not amount to a contractual obligationand is therefore not sufficient for liability classification.


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DERIVATIVES ON OWN SHARES (INCLUDING SHARE OPTIONS)

Derivative contracts that result in the delivery of a fixed amount of cash orother financial assets for a f ixed number of an undertakings own equityinstruments are classified as equity i nstruments.

All other derivatives on own equity are treated as derivatives and accountedfor as such under IAS 39. This includes any that: can, or must, be settled on a

net basis in cash (or other fi nancial assets) or in shares; may be settled grossby delivery of a variable number of own shares; or may be settled by deliveryof a fixed number of own shares for a variable amount of cash (or otherfinancial assets).Any derivative on own equity, which gives either party a choice over how it issettled (in cash or otherwise), is a f inancial asset or liability unless all o f thesettlement alternatives would result in equity classification. The table belowillustrates this.

Instrument Classification Example

A contract that is settled by theissuer delivering a fixed

number of the issuers ownshares in exchange for a f ixedmonetary amount of cash orother assets

Equity A warrant giving thecounterparty a right to

subscribe for a fixednumber of theundertakings shares fora fixed amount of cash

A contract that requires anundertaking to repurchase(redeem) its own shares forcash or other financial assetsat a fixed (or determinable)date, or on demand

Liability(redemptionamount)

Forward contract torepurchase own sharesfor cash

An obligation to redeem ownshares for cash that isconditional on the counterpartyexercising a right to redeem

Liability(redemptionamount)

Written option torepurchase own sharesfor cash

A contract that will be settled incash or other assets where the

Derivative assetor liability

Net cash settled shareoption

amount of cash that will bereceived (or delivered) isbased on changes in themarket price of theundertakings own equity

A contract that will be settled ina variable number of own

shares, determined so as toequal a fixed value or a valuebased on changes in anunderlying variable (e.g., acommodity price)


Forward contract on theprice of gold that is

settled in own shares

A contract containing multiplesettlement alternatives (e.g.,net in cash, net in own shares,or by exchanging own sharesfor cash or other financialassets)


Derivative asset orliabilityShare option that theissuer can decide tosettle either in cash or bydelivering own shares forcash

Examples: Classification of financial instruments debt versus equity

a) A company issues 300m of dated preference shares. The company candefer coupon payments on the preference shares. Would this instrument beclassified as a financial liability or an equity instrument under IAS 32?

The instrument has both financial liability and equity components. IAS 32states that an instrument is a financial liability when the issuer has acontractual obligation to deliver cash or another financial asset to anotherentity.

There is an obligation for the company to repay the principal in cash given thefact that the preference shares are dated and, as such, this component is afinancial liability.

However, with respect to coupon payments, this component is equity as theissuer has no contractual obligation to deliver cash to the holder of theinstrument given that it has discretion to defer coupon payments. Therefore,


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the instrument is a compound financial instrument.

In accordance with IAS 32, the i nitial carrying amount of a compound financialinstrument is allocated between its equity and liability components. The equitycomponent is assigned the residual amount after deducting f rom the fair valueof the instrument as a whole, t he amount separately determined for the liabilitycomponent.

b) A company issues 250m of 6.625% perpetual capital step-up securities.Interest is payable on this instrument on 1 June each year. The company candefer interest payments. These deferred payments will accumulate as deferredinterest. and be payable only upon redemption of the instrument.

In 2007, the interest rate will be reset to 7.25%.At the reset date theinstrument can be redeemed at the option of the issuer.

Would this instrument be classified as debt or equity under IAS 32?

This instrument would be classified as an equity i nstrument. IAS 32 statesthat if an entity does not have an unconditional right to avoid delivering cash oranother financial asset to settle a contractual obligation, the obligation meets

the definition of a financial liability.

In this case, the company is able to avoid redemption as this event is whollyunder the companys control. As such, the principal is not a fi nancial liability.

Similarly, with respect to the interest payments, these are payable only onredemption. As a result, the company has the ability to avoid payment ofinterest by not redeeming the instrument.

c) A company issues 100m of irredeemable bonds at a market rate of interest(instrument 1).

Coupon payments are payable on 1 June each year, however the company

can defer these coupon payments. The deferred coupon payments willaccumulate as deferred interest. and are payable in the event that thecompany makes a coupon payment on any other pari passu or subordinatedbonds in issue.

The company has in issue a 50m pari passu 5.5% bond (instrument 2) on

which the coupon payments are mandatory on 1 June each year.

Would instrument 1 be classified as a f inancial liability or an equity instrumentunder IAS 32?

Instrument 1 is a financial liability.

The terms establish an indirect obligation to pay the coupon on instrument 1 if,

and when, a coupon is paid o n any other pari passu or subordinated bonds.

As the company has such a bond in issue (instrument 2) and there is acontractual obligation to pay the coupon on instrument 2 each year, thiscreates an indirect contractual obligation for the company to also pay thecoupon on instrument 1 each year. As a result, instrument 1 is a financialliability.

A contract that contains an obligation for an entity to purchase its own equityinstruments for cash or another financial asset gives rise to a financial liabi lityfor the present value of the redemption amount (for example, for the presentvalue of the forward repurchase price, option exercise price or otherredemption amount).

This is the case even if the contract itself is an equity instrument. One exampleis an entitys obligation under a forward contract to purchase its own equityinstruments for cash.

When the financial liability is recognised initially under IAS 39, its f air value(the present value of the redemption amount) is reclassified from equity.

Subsequently, the financial liability is measured in accordance with IAS 39. Ifthe contract expires without delivery, the carrying amount of the financialliability is reclassified to equity.

An entitys contractual obligation to purchase its own equity instruments givesrise to a financial liability for t he present value of the redemption amount evenif the obligation to purchase is conditional on the counterparty exercising aright to redeem (eg a written put option that gives the counterparty the right tosell an entitys own equity instruments to the entity for a fixed price).


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6 Questions On Debt/Equity Classification

Question 1

Alfa has issued a perpetual preference share, which is redeemable at theoption of the undertaking but not at the option of the holders. Dividends of 10%must be paid annually, provided that there are sufficient distributable profits.Should the issue proceeds be classified as debt or equity in the accounts ofthe issuer?

Answer

Settlement is not mandatory and is at t he option of the issuer

The undertaking has no discretion to avoid i nterest payments The settlement does not depend on the outcome of uncertain future

events beyond the issuing undertakings control. The dividendpayments of 10% include an element of capital repayment and whichwill always be cash.

Therefore the instrument is a liability.

Question 2Beta has issued cumulative, non-redeemable 5% fixed preference shareswhere the payment of the dividend is solely at the discretion of the board ofdirectors. How should Beta classify the instrument?

AnswerAs equity. When preferred shares are non-redeemable, and when distributionsto holders of the preferred shares whether cumulative or non-cumulative are atthe discretion of the issuer, the shares are equity.

Question 3Tomsk issued series A and series B shares. Series A shares are considered

ordinary shares and issued to all shareholders while series B shares are issuedto only one shareholder. Series B shares have the same voting and dividendentitlements as series A shares. Also the holder of the series B shares isentitled to a discretionary dividend based on the profit of the Tomsks propertydivision. The series A shareholders are not entitled to this dividend. The B

shareholder will also participate in the dividends paid to the series Ashareholders.

The series B shareholder is entitled to the residual value of the propertydivision in the event of a liquidation of Tomsk.Should management classify series B shares (a special class of shares) as

i) financial liabilities or

ii) equity instruments?

AnswerThe series B shares should be classified as equity i nstruments. Themanagement of Tomsk has an obligation to distribute the property divisionsprofits to the B shareholders. The distribution occurs only as a result of thedeclaration of a dividend by Tomsks management. The obligation to make adistribution to the B shareholder is therefore at the discretion of Tomsksmanagement, and can be avoided if it chooses not to declare a dividend.

Question 4Orel has issued perpetual preference shares that give the holder the right to

receive annual dividends at a rate of 8%. The holder has no right to a return ofthe principal.What is the appropriate classification for perpetual preference shares?

AnswerThe shares should be classified as financial liabilities.IAS 32 confirms that perpetual preference shares are financial liabilities.

Perpetual instruments normally provide the issuer with a contractualobligation to make fixed dividend payments extending into the indefinitefuture. The payments are similar to interest payments, and give the holder alenders rate of return.

7 Classification financial assets andliabilities

Financial assets four categories


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Financial assets at fair valuethrough profit and loss

Available-for-sale financial assets

Loans and receivables Held-to-maturity investments

It is essential for a bank to have a documented policy on the classification offinancial instruments and for this policy to be rigorously enforced. This isbecause the different accounting policies for different categories wouldotherwise provide opportunities for profit manipulation.

Reclassification of financial instruments may be viewed by readers of financialstatements (and possibly bank supervisors) as either that the bank is infinancial trouble, or that its management is unable to manage its financialinstruments successfully. Either conclusion would be a serious b low to abanks reputation.

A bank (or other user) uses as many of the categories as it needs, notnecessarily all f our. For example, Held-to-maturity investments may not be o f

interest to the bank, or it may not have the financial capacity to f inance suchinvestments. The policy should identify that this category should not be used, ifthis is the case.


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Financial Instruments - Decision Tree for Categories

Asset is acquired/held togenerate profit? Or originatedto be sold in the short-term?

Part of portfolio with a patternof profit taking?

Is it a derivative?

Are there: -fixed and

determinable payments -fixedmaturity - intent & ability tohold maturity?

Is its designated &effective hedge

Apply hedgeaccounting

Is it created by givingmoney, goods or servicesdirectly to debtor?

Is there intention tosell in the short term?

YES

YES

YES

YES

YESYES

YES

Financial assets atfair value throughprofit and loss

Loans andreceivables

Available for sale Held to maturity

NO

NO

NO

NO

NONO

NO

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Financial Assets by class under IFRS 7 - examples

Category Class Examples

Debt securitiesTrading assets Equity securities

Financial assets at fair valuethrough profit or loss

Derivative financial instruments

Debt securities

Designated at fair value Equity securities

through profit and loss Loans and advances to banks

Loans and advances to clients

Loans and advances to banks

Overdrafts

Loans and receivables Loans to individuals (retail) Credit cards

Term loansMortgages

Loans and advances to clients

Large corporate

Loans to corporate entities SMEsOthers

Investment securities debt securities ListedHeld-to-maturity investments Unlisted

Investment securities debt securities Listed

Available-for-sale

financial assets Investment securities equity securities ListedUnlisted

Financial Liabilities by class under IFRS 7 - examples

Category Class Examples

Trading liabilities

Financial liabilities at fair value

through profit or loss Derivative financial instruments

Designated at fair value through profit and loss Debt securities in issue

Financial liabilities

at amortised cost Deposits from banks

Retail customers

Due to clients Large corporateSMEs

Debt securities in issue

Other deposits

Other borrowed funds

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Classes of financial instruments

IFRS 7, Financial Instruments: Disclosures, requires certain disclosures to begiven by class of financial i nstrument, for example, the reconciliation of anallowance account.

IFRS 7 does not provide a prescriptive list of classes of financial instruments. Itstates that a class should contain financial instruments of the same nature and

characteristics and that the classes should be reconciled to the line itemspresented in the balance sheet.

What considerations should an entity apply in identifying different classes offinancial instruments since a prescriptive list of classes is not provided? Forexample, should a bank disclose loans and advances as a single class, or shouldit be split further into separate classes?

A .class of financial instruments is not the same as a category of financialinstruments. Categories are defined i n IAS 39 as fi nancial assets at f air valuethrough profit or loss, held-to-maturity investments, loans and receivables,available-for-sale financial assets, f inancial liabilities at fair value through profit orloss and financial liabilities measured at amortised cost.

Classes are expected to be determined at a lower level than the measurementcategories in IAS 39 and reconciled back to the balance sheet, as required byIFRS 7.

However, the level of detail for a class should be determined on an entity-specificbasis.

In the case of banks, the category .loans and advances is expected to comprisemore than one class unless the loans have similar characteristics. It may beappropriate to provide separate classes by:

-types of customers . for example,commercial loans and loans to individuals; or

- types of loans . for example, mortgages, credit cards, unsecured loans andoverdrafts.

In some cases,.loans to clients. can be one class if all the loans have similarcharacteristics (eg, a saving bank providing only one type of loan to individuals).

8 Financial assets at fair value through profitand loss

This category has two sub-categories:

-financial assets held for trading and

-those designated to the category at i nception.

A financial asset is held fo r trading either:

if acquired (or originated) for the purpose of generating a profit from short-term fluctuations in price (or dealers margin) or

if, on initial recognition, it is part of a portfolio of identified instruments thatare managed together and for which there is evidence of a recent actualpattern of short-term profit-taking.

Trading assets include debt and equity securities and loans and receivablesacquired with the intention of making a short-term profit from price or dealers

margin.

Derivatives are always categorised as held for trading unless they are accountedfor as hedges or a a financial guarantee contract.

Example: Forward contract to purchase a commodity: pattern of netsettlement

IssueIAS 39 applies to those contracts to buy or sell a non-financial item that can besettled net in cash or another f inancial instrument, or by exchanging financialinstruments, as if the contracts were financial instruments.

Contracts that were entered into and continue to be held for the purpose of thereceipt or delivery of a non-financial item in accordance with the entitys expectedpurchase, sale or usage requirements are out of the scope of IAS 39.

Does an entitys historical pattern of settlement impact on whether an entityqualifies for the exemption under IAS39?



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BackgroundAn entity enters into a forward contract to purchase oil. The entity has anestablished pattern of settling such contracts before delivery by contracting with athird party. The entity settles any market value dif ference for the contract pricedirectly with the third party.

Solution

The forward contract to purchase oil is recognised as a derivative. IAS 39 appliesto a contract to purchase a non-financial asset if the contract meets the defi nitionof a derivative and the contract does not qualify for the exemption for delivery inthe normal course of business.

The entity does not expect to take delivery. A pattern of entering into offsettingcontracts that effectively accomplishes settlement on a net basis does not qualifyfor the exemption for delivery in the normal course of business.

The contract would not be recognised as a derivative if the entity intended to takedelivery and had consistently taken delivery in the past.

Example: Weather derivatives

Entity E is a farmer who operates in the wheat industry. Due to recent flooding,the entity enters into a contract in an attempt to reduce its exposure to the risk offlooding.

The contract requires the counterparty to pay entity E 100,000 for everymillimetre of rain in excess of 10mm in the region in which entity E operates.

How should entity E account fo r the contract?

The contract is within the scope of IAS 39 and should be accounted for as aderivative.

Insurance contracts are scoped out of IAS 39 and are within the scope of IFRS 4,Insurance Contracts. However, the above contract would not meet the definitionof an insurance contract.

In order for a contract to be considered an insurance contract, the payment

should compensate the policyholder for incurring a loss as a result of changes ina non-financial variable specific to a party of the contract.

Although there may be a loss incurred with increased rainfall, E may receive apayment even if it incurs no loss. (Refer to IFRS 4, BC55-BC60.)

The second sub-category (see Amendment to IAS 39: the fair value option

below) includes any financial assets that an undertaking has decided todesignate to the category on initial recognition, provided such a designation

results in more relevant information either:

because it eliminates or significantly reduces a measurement or recognition

inconsistency (ie, accounting mismatch); or

because it is part of a group of financial assets, financial liabilities or both that

is managed, and its performance is evaluated on a fair value basis inaccordance with a documented risk management or investment strategy, and

information about this group is provided internally on that basis to theundertakings key management personnel (as defined in IAS 24).

Amendment to IAS 39: the fair value option - IFRS News July 2005

IAS 39 previously allowed an entity to designate any financial asset or financialliability to be measured at fair value with changes in value recognised in profit orloss.

Some constituents primarily prudential supervisors of banks, securitiescompanies and insurers were concerned that this unrestricted option might beused inappropriately. The EUs decision to include the fair value option in itscarve out of IAS 39 reflected these concerns: the fair value optio n cannotcurrently be applied to the liabilities of EU companies.

Following consultation, the IASB has revised the fair value option.

The requirementsThe amendments permit the fair value option to be used only when doing soresults in more relevant information because either:



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it eliminates or significantly reduces a measurement or recognitioninconsistency (accounting mismatch) that would otherwise arise frommeasuring assets or liabilities, or recognising the gains and losses on them ondifferent bases; or

a group of financial assets and/orfinancial liabilities or both is managed and itsperformance is evaluated on a fair value basis, in accordance with a documentedrisk management or investment strategy and information about the assets and or

liabilities is provided internally to the entitys key management (as defined in IAS24).

If a contract contains one or more embedded derivatives, an entity may app

Documents

Financial Instruments_Part I_for Website 08 EXCELLENT SUMMARY