Slide 11.1 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Chapter 11 - FINANCIAL INSTRUMENTS (IAS32, IAS39, IFRS7, IFRS9) ACTG 6580

Slide 11.2 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Definitions (IAS32) A financial instrument is "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity" A financial asset is "any asset that is … cash… or … an equity instrument of another entity… or … a contractual right to receive cash …" A financial liability is "any liability that is … a contractual obligation … to deliver cash …" An equity instrument is "any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities"

Slide 11.3 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Examples of Financial Instruments Financial instruments include contracts relating to: – the issue of shares – the making of loans – trade receivables and payables Financial instruments also include more complex arrangements such as: – convertible debt – perpetual instruments – derivatives – hedging instruments – interest swaps etc…

Slide 11.4 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Objective of IAS32 "to establish principles for presenting financial instruments as liabilities or equity" IAS32 takes a substance over form approach to distinguishing between liabilities and equity.

Slide 11.5 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Classification of Financial Instruments "The issuer of a financial instrument shall classify the instrument … in accordance with the substance of the contractual arrangement …" A financial instrument is an equity instrument if and only if "the instrument includes no contractual obligation … to deliver cash or another financial asset …" Redeemable preference shares are classified as liabilities and dividends paid to the holders of such shares are classified as expenses.

Slide 11.6 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Compound Financial Instruments Compound financial instruments are those which contain both a liability component and an equity component. IAS32 requires that compound financial instruments should be separated (bifurcated) into their two components and that each of these components should then be recognized separately, one as a financial liability and the other as equity. Loans that are convertible to ordinary shares at the option of the lender is an example of a compound financial instrument.

Slide 11.7 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Classification, Recognition and Measurement Instruments that require settlement with a variable number of shares establish a debtor/creditor relationship and are thus treated as liabilities. This is true even if the legal form is preferred stock. Those that require settlement with a fixed number of shares generally establish more of a shareholder relationship and are thus treated as equity. Similar, although preferred stock is referred to as preference shares. IFRSUS GAAP

Slide 11.8 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Classification, Recognition and Measurement Classification of debt versus equity IFRS ► Classification starts with the definitions. ► The focus is on whether there is a contractual obligation to deliver cash, other assets or a variable number of the entity’s own shares. If such an obligation exists, a liability exists. This is applied to all instruments whether they are loans/bonds or preferred or common stock. Unless the entity has an unconditional right to avoid delivering cash or other financial assets, it is a liability. IAS 32, paragraphs 17 through19 address this issue. US GAAP ► Classification is addressed on an instrument-by- instrument basis: ► The legal form often dictates the classification — that is, a bond or loan is debt and preferred or common stock is equity. ASC 480 requires that specific instruments be classified as liabilities, even if they are stock and even if they have characteristics of both debt and equity. Some examples of instruments that must be accounted for as debt include: ► Mandatorily redeemable shares. ► Instruments that must be redeemed or repaid using a variable number of the entity’s shares. ► Instruments requiring an entity to repurchase its own stock for cash or other assets.

Slide 11.9 Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Bifurcation of Hybrid Financial Instruments IFRS ► The liability and equity components are determined as follows: ► The liability component is calculated as the net present value of all potential contractual future cash flows at market interest rates at the time of issuance. ► The difference between the proceeds from the offering and the net present value calculated above is the equity component. This component is included in equity generally under a heading of “other capital reserves.” ► Issuance costs are also bifurcated by determining the fair value of the components and applying the percentage to the issuance costs. Liability component issuance costs are offset directly to the balance of the liability component. Equity component issuance costs are charged to equity generally under a heading of “other capital reserves.” US GAAP ► Hybrid financial instruments are not split into debt and equity components unless certain conditions are met, as may be the case with instruments that include embedded derivatives, conversion features, redemption features, etc. Careful analysis is required on an individual instrument-by-instrument basis to determine if bifurcation is appropriate. ► Related debt issuance costs are recorded as deferred assets and amortized over the life of the liability.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 1 Hang Glide Inc. (Hang) issues $2.0 million worth of convertible bonds at par with an annual interest rate of 6% when the market rate is 9%. The bonds, due in three years, are convertible into 250 common shares. Debt Versus Equity – Hybrid Instruments Example ► Prepare the initial journal entry to record these bonds under US GAAP and IFRS.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 1 solution: US GAAP: Cash$2,000,000 Bonds payable$2,000,000 Split accounting would not apply. Debt versus Equity – Hybrid Instruments Example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 1 solution (continued): IFRS: The instrument would be split into a debt component (measured at the present value of the cash flows of the debt at the market rate of interest) with the equity components being the residual. The present value at three years, 9% annual interest of $120,000 and principal repayment of $2,000,000: Interest $120,000 (PV annuity) $ 303,721 Principal $2,000,000 (par value $1) 1,544,401 Value of liability $1,848,122 Value of equity = $2,000,000 – $1,848,122 = $151,878 Cash$2,000,000 Bonds payable$1,848,122 Equity – conversion option 151,878 Debt versus Equity – Hybrid Instruments example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 2: The Really Cheap Company (RCC) issued $20 million of five-year convertible bonds at par with 6% annual interest, which would be due December 31, The 6% bonds are convertible at any time after issuance, which was January 1, 2011, at the rate of 10 shares of common stock for each $1,000 of the face value of the convertible bonds. Issuance costs total $100,000. The current market rate for non-convertible bonds is 8% interest. Convertible Debt Example ► Show the journal entries to record the issuance of the convertible bonds using US GAAP and IFRS (round to the nearest thousand). ► Calculate the expenses related to the convertible debt that RCC should record each year using US GAAP and IFRS (round to the nearest thousand). Provide the journal entries.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 2 solution: Issuance of convertible bonds: US GAAP: RCC would record a liability for the amount of the bonds and a deferred charge for the issuance costs. Cash$19,900,000 Unamortized bond issuance costs 100,000 Convertible bonds payable$20,000,000 Convertible Debt Example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 2 solution (continued): IFRS: RCC needs to bifurcate the convertible debt and issuance costs between liability and equity components. RCC should calculate the liability component as the net present value (NPV) of future cash flows using the current 8% market rates at the time of issuance. Cash flow for year 1 through year 4 is the interest payment calculated as $20,000,000 x 6% = $1,200,000. Cash flow for year 5 includes the proceeds of $20 million and interest of $1.2 million. Based on the NPV of these cash flows, the liability component is calculated as $18,403,000 as shown in the table. Convertible Debt Example Cash flowNPV at 8% Year 1$ 1,200,000$ 1,111,000 Year 2 $ 1,200,000 1,029,000 Year 3$ 1,200,000953,000 Year 4$ 1,200,000882,000 Year 5$21,200,000 14,428,000 Fair value of liability com- ponent $18,403,000

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 2 solution (continued): RCC then calculates the equity component of $1.597 million as the proceeds of $20 million less the liability component of $ million. The issuance costs would be allocated to equity based on the equity component percentage as follows: $1,597,000/$20,000,000 = 8% The equity component issuance costs are $8,000 (8% x $100,000). Convertible Debt Example The journal entry would be as follows: Cash $19,900,000 Convertible bonds pay.$18,311,000 Other capital reserves 1,589,000 Cash received would be $20 million less $100,000 of issuance costs. The convertible bonds would be recorded as $ million with an offset for debt issuance costs of $92,000. Other capital reserves in equity would be credited with $1.597 million and charged with issuance costs of $8,000.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 2 solution (continued): US GAAP: RCC should record amortization of bond issuance expense annually of $20,000, calculated as the total of the issuance costs of $100,000 amortized on a straight-line basis over the five-year life of the bonds. RCC should record interest expense of $1.2 million each year, calculated as $20 million multiplied by the stated rate of 6%. The journal entries for each year would be as follows: Amortization expense $20,000 Unamortized bond issuance costs $20,000 Interest expense $1,200,000 Cash $1,200,000 Convertible Debt Example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 2 solution (continued): IFRS: In substance, the amount of interest expense should reflect the effective interest assuming the bonds did not have the convertible feature. Therefore, the effective interest rate on this debt is determined by solving for the effective yield on the difference between the face value of the bonds of $20.0 million and the amount allocated to the liability component of $18,311,000. The effective interest rate is 8.125%. Therefore, interest expense by year would be as follows: Convertible Debt Example Journal entries: Year 1: Interest expense $1,488,000 Cash$1,200,000 Liability 288,000 Year 2: Interest expense $1,511,000 Cash$1,200,000 Liability 311,000 Year 3: Interest expense $1,536,000 Cash$1,200,000 Liability 336,000 Year 4: Interest expense $1,563,000 Cash$1,200,000 Liability 363,000 Year 5: Interest expense $1,591,000 Cash $1,200,000 Liability 391,000

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Beginning liability Interest expense at 8.125%Interest paidEnding liability Year 1 $18,311,000$1,488,000$(1,200,000)$18,599,000 Year 2 $18,599,0001,511,000 (1,200,000)$18,910,000 Year 3 $18,910,0001,536,000 (1,200,000) $19,246,000 Year 4 $19,246,0001,563,000 (1,200,000)$19,609,000 Year 5 $19,609,0001,591,000 (1,200,000)$20,000,000 $7,689,000

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Classification, Recognition and Measurement Stock or shares with settlement options that are contingent upon another event IFRS ► These instruments are recognized as liabilities if the issuer does not have an unconditional right to avoid delivering cash or another financial asset. ► Per IAS 32.25, there are certain limited situations when such instruments would not be classified as liabilities. US GAAP ► These financial instruments are not classified as liabilities until the instruments are mandatorily redeemable. ► For example, a share may become redeemable if a certain future event happens (such as a consumer price index rising above a certain point). This future event is uncertain. When the contingency resolves itself in the future (i.e., occurs or not), the instrument is reassessed to see if a liability exists. If it does, an amount equaling the fair value of the liability is reclassified from equity to liability.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 3 On December 31, 2011, the Motor Cross Company (MCC) issued redeemable preferred shares for $100 that are redeemable if the S&P index rises beyond a certain benchmark. On December 31, 2012, the S&P reaches the benchmark. Debt versus equity – contingency example ► How should MCC account for these shares under US GAAP and IFRS at December 31, 2011 and December 31, 2012?

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 3 solution: US GAAP: Upon issuance, the shares are only contingently redeemable (as opposed to mandatorily redeemable). US GAAP does not use split accounting for these, and the legal form is equity. Therefore, the shares are initially treated as equity. However, on December 31, 2012, a liability is created and now the shares are indeed mandatorily redeemable. An amount equal to the fair value of the liability would be reclassified from equity and to a liability classification on the balance sheet Cash$100 Redeemable preferred shares – equity$ Redeemable preferred shares – equity$100 Redeemable preferred shares – liability$100 Debt versus equity – contingency example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 3 solution (continued): IFRS: At December 31, 2010, a liability exists. MCC has an obligation to repay the principal if a future event occurs that is beyond its control. Since MCC does not have an unconditional right to avoid delivering the cash, the instrument is a liability Cash$100 Redeemable preferred shares – liability$ There are no journal entries necessary. Debt versus equity – contingency example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Classification, recognition and measurement Preferred stock IFRS ► Preference shares that pay dividends may require bifurcation. The present value of the dividend payments will be classified as a liability, even if the preferred shares are otherwise classified as equity. US GAAP ► Preferred shares that pay dividends do not require bifurcation.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 4 The Rock Star Records Company (RSR) decides to issue $20 million of redeemable preferred stock (preference shares using IFRS terminology) on January 1, The redeemable preferred stock has a 5% fixed annual cash dividend (no vote of shareholders or others is required), has no maturity date and RSR can repay it at any time. Current market interest rates are 5%. Preferred stock example ► Explain how RSR should account for the preferred stock using US GAAP and IFRS. (No journal entries required.)

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 4 solution: For US GAAP, which does not require split accounting, these shares would be evaluated for their redemption features. If there were any redemption features required upon the occurrence of certain contingent events (e.g., an IPO, change in control, liquidation event, achievement of a performance condition) or upon the option of the holder, then this instrument would be classified as a liability. However, if redemption of the instrument is not certain to occur, which is assumed in this example, the instrument is classified as equity for US GAAP purposes. For IFRS purposes, split accounting would be considered and the components of the instrument would be evaluated for liability and equity characteristics: –The repayment of the principal would be considered an equity instrument as payment is at the issuer’s option and there is no present obligation to transfer financial assets to the holder. –The dividend is fixed and payment is not at the discretion of the issuer, thus this represents a mandatory or potential obligation to transfer assets or cash to the holder. Accordingly, the dividend component of the financial instrument would be a liability. Preferred stock example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 4 solution (continued): –The fair value of the stream of perpetual dividends would be substantially equivalent to the face value of the preferred stock. Therefore, little to no value will actually be ascribed to the residual equity component, and the preferred stock issuance would be classified as a liability. –Also, if the principal amount is paid at some point after issuance, then this would be an indication that the issuance was debt and was classified appropriately as a liability. Preferred stock example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Treatment of Interest and Dividends Payable Interest and dividends which relate to a financial liability should normally be recognized as an expense when calculating profit or loss. Distributions to holders of an equity instrument should be debited directly to equity. If dividends are classified as an expense, they should be presented in the statement of comprehensive income either with interest payable or as a separate item.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IAS39 and IFRS9 These two standards establish principles for recognizing and measuring financial assets and financial liabilities. IAS39 is gradually being replaced by IFRS9. Recognition is concerned with determining when a financial asset or liability should be shown in the statement of financial position. Measurement is concerned with the amount at which financial assets and liabilities should be shown (initially and subsequently).

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Recognition of Financial Assets and Liabilities Financial assets and financial liabilities arising in consequence of a financial instrument should be recognized only when the entity "becomes party to the contractual provisions of the instrument". Recognition occurs when the contractual arrangements become binding.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Measurement of Financial Assets and Liabilities Financial assets and liabilities are recognised initially at their fair value. This is equal to the value of the consideration which was given when the asset was acquired (or received when the liability was incurred). Initial measurement: Subsequent measurement: The amount at which a financial asset or liability is measured subsequently depends upon the type of that asset or liability.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Types of Financial Assets (IAS39) 1.Financial assets at fair value through profit or loss 2.Held-to-maturity investments 3.Loans and receivables 4.Available-for-sale financial assets Financial assets "at fair value through profit or loss" are usually financial assets that are held for trading. This means that the assets have been acquired with the intention of re-selling them at a profit in the fairly near future.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Subsequent Measurement of Financial Assets (IAS39) Financial assets at fair value through profit or loss are measured at fair value. Gains or losses are recognized in the calculation of profit or loss for the period in which they arise. Available-for-sale financial assets are measured at fair value. Gains or losses are recognized in other comprehensive income. Otherwise, financial assets should normally be measured "at amortized cost using the effective interest method".

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Measurement bases FVO IFRS ► An entity must prove either of the following to use the FVO. ► The use of FVO reduces measurement or recognition inconsistencies. ► The assets in question are managed by the entity and performance is evaluated on a fair-value basis. ► Equity-method investments must use the equity method of accounting. US GAAP ► There are no criteria for using the FVO, although there are certain financial assets that may not be revalued under the FVO. ► Equity-method investments may use the equity method of accounting or the FVO.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 5: Extreme Surf (Extreme) has recently raised financing by issuing $1,000 of fixed-rate bonds (5%) to institutional investors. The bonds would otherwise be carried at amortized cost. Assume that the bonds were issued at par. The money was used to invest in $1,000 of fixed rate (6%) corporate bonds. These bonds are classified as AFS with fair value gains/losses being recorded in OCI. Assume by year-end, interest rates have declined to 5.45%, resulting in the fair value of the bond to be $1,100. Use of the FVO example ► Assuming no use of the FVO, provide the journal entries for how Extreme would record these transactions in year one under US GAAP and IFRS? ► Discuss whether the FVO is allowed under US GAAP and IFRS in this situation. ► Assuming that the FVO was selected upon initial recording of the bonds, provide the journal entries for how Extreme would record these transactions in year one under US GAAP and IFRS assuming that by year end, interest rates have declined to 4.35%, resulting in the fair value of the issued bonds to be $1,150 and the fair value of the bonds acquired to be $1,380.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 5 solution: Bond issuance: Cash$1,000 Bonds payable$1,000 Year-end: Interest expense$50 Cash$50 Bond acquisition: Investment in corporate bonds (AFS)$1,000 Cash$1,000 Year-end: Investment in corporate bonds (AFS)$100 Unrealized gain – OCI $100 Cash$60 Interest income$60 Use of the FVO example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011  The debt and investment are linked since one was used to finance the other. Because they are both fixed rate, the economic gains on one will offset the losses on another. This is a natural hedge. However, for accounting purposes, there will be a mismatch because the loans on the liability side are carried at amortized cost and not revalued, whereas the bonds on the asset side are classified as AFS, and are, therefore, valued at fair value with unrealized holding gains/losses being reported in OCI.  If the FVO is used, both the asset and liability will be measured at fair value with unrealized holding gains/losses being reported in income.  Under US GAAP, Extreme may designate any financial asset under the FVO. Under IFRS, this would also be allowed since there is an accounting mismatch if the FVO is not chosen. Thus, the FVO reduces recognition inconsistencies. Use of the FVO example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Bond issuance: Cash$1,000 Bonds payable$1,000 Year-end: Interest expense$50 Cash$50 Unrealized loss – income $150 Bonds payable$150 Bond acquisition: Investment in corporate bonds$1,000 Cash$1,000 Year-end: Investment in corporate bonds $380 Unrealized gain – income$380 Cash$60 Interest income$60 Use of the FVO example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 6 Skydivers Inc. (Skydivers) recently loaned $1,000 to a customer on January 5, The loan is interest bearing at 10% (which equals the market interest rate). The loan is due in three years. Skydivers plans to hold the loan until it matures. Assume all criteria for the FVO are met. The fair value of the loan is as follows: December 31, 2010 – $1,010 December 31, 2011 – $1,005 December 31, 2012 – $1,000 Loans receivable example ► How would Skydivers account for the loan in 2010 through 2012 under US GAAP and IFRS?

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 6 solution: US GAAP: Skydivers may elect to use the FVO to measure and report this loan. This means that the loan would be measured at fair value at each balance sheet date with unrealized holding gains/losses being recognized in income along with interest. There would be no need to test for impairment. Otherwise, given that Skydivers plans to hold onto the asset and since it is clearly not a marketable security (this is a loan to a customer, not an instrument that trades on a stock exchange), the loan could be recorded at the amortized cost of $1,000 with interest recognized as interest income. Note that in this case, since market interest is equal to the interest rate on the receivable, there would be no discount and amortized cost would be equal to cost. The instrument would be tested for impairment. Loans receivable example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Loans receivable example Amortized cost Fair value option January 5, 2010 Loan receivable $1,000 Cash $1,000 Cash$1,000 December 31, 2010 Cash $100 Interest income $100 Interest income$100 Loan receivable$10 Unrealized gain – income $10 December 31, 2011 Cash $100 Interest income $100 Interest income $100 Unrealized loss – income $5 Loan receivable $5 December 31, 2012 Cash $100 Interest income $100 Interest income $100 Cash $1,000 Cash$1,000 Loan receivable $1,000 Unrealized loss - income 5 Loan receivable$1,005

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS: Similar to US GAAP, Skydivers can elect to use the FVO or carry the loan at amortized cost. However, an additional option is open to Skydivers. The receivable may be classified as AFS (even though the intent is not to sell or dispose of it). This means that it would be measured at fair value at each balance sheet date with gains and losses recognized in OCI. Loans receivable example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Loans receivable example AFS January 5, 2010 Loan receivable (AFS) $1,000 Cash $1,000 December 31, 2010 Cash $100 Interest income $100 Loan receivable (AFS)$10 Unrealized gain – OCI $10 December 31, 2011(assuming no impairment) Cash $100 Interest income $100 Unrealized loss – OCI $5 Loan receivable $5 December 31, 2012 Cash $100 Interest income $100 Cash $1,000 Unrealized loss – OCI 5 Loan receivable (AFS)$1,005

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Derecognition Guidance stipulates when a financial asset should be recognized and derecognized. Similar IFRSUS GAAP

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Derecognition IFRS ► Derecognition considers both transfers of risk and rewards and, as a secondary test, control (if the transferor continues to collect and service the assets). The control test requires that three conditions be met before an asset is derecognized — see next slide. US GAAP ► Requires derecognition of financial assets where effective control has been surrendered. This would normally be the case when there is legal isolation (i.e., the assets are physically and legally separate from the entity). There are three criteria that must be met before an asset is derecognized — see next slide.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Derecognition IFRS Asset derecognition criteria: 1. The transferor has no obligation to pay any amounts above and beyond what it collects from the original customer. 2. The transferor may not sell the instruments to anyone else. 3. The transferor must remit the amounts collected without material delay. There is no legal isolation test. US GAAP Asset derecognition criteria: 1. There is legal isolation of the instruments from the transferor. 2. The transferee has the right to pledge or exchange receiving assets. 3. Transferor does not maintain effective control over the transferred assets.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 7 Scuba Divers Inc. (Scuba) has receivables from an unrelated party with a face value of $1,000. Scuba transfers these receivables to the Fin Company (Fin) for $900. The difference reflects the credit risk. The receivables will continue to be collected by Scuba and deposited to Scuba’s bank account with the cash flows being remitted in total each month-end to Fin. Embedded in the $100 discount is a fee for providing this service. Scuba is not allowed to sell or pledge the receivables to anyone else. There is no agreement to repurchase. Derecognition example ► How should Scuba account for the receivables under US GAAP and IFRS?

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 7 solution: US GAAP: The first question is whether legal isolation exists. The receivables remain with Scuba which will continue to collect them (legal entitlement to collect rests with Scuba). In addition, if Scuba went bankrupt, would creditors have access to the cash flows related to the receivables? Since the cash collected on the receivables is initially deposited to Scuba’s bank account, it is commingled with Scuba’s other operating cash flows. It is likely that the legal isolation test may not have been met, although likely that a lawyer would have to provide an opinion. In addition, while it is clear that Scuba is not allowed to pledge the assets, it is not clear that Fin is allowed to pledge them. Therefore, the second test is not met. Because there are no repurchase obligations for Scuba, the third test is met. The assets are, therefore, not derecognized and this would be accounted for as a secured borrowing. Cash $900 Expense 100 Liability$1,000 Derecognition example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS: The first question is whether the risks and rewards of ownership have passed. Since the selling price is fixed, Scuba is no longer at risk for any credit losses. In fact, it has received the $900 already and is under no obligation to repay no matter what happens. Therefore, the risks and rewards have passed. Because Scuba has retained the contractual rights to receive the cash while at the same time taking on a contractual obligation to pay those cash flows to the transferee, Scuba must assess whether control has passed as a secondary test. Scuba appears to meet the three required criteria: it is under no obligation to pay any more than it collects, Scuba may not resell the receivables to anyone else and Scuba has agreed to remit the money collected in a timely manner. Therefore, it would appear that this would be accounted for as a sale, and thus derecognized. Cash$900 Loss on sale 100 Accounts receivable$1,000 Derecognition example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Summary chart for impairment determination, measurement, reporting and reversal Summary of impairment Impairment determination Impairment measurementImpairment reportingImpairment reversal Category US GAAP IFRS US GAAP IFRS US GAAP IFRS US GAAP IFRS AFS – debtIf fair value is less than the amortized cost basis and other- than-temporary impairment If objective evidence of impairment Amortized cost basis less fair value Income for impairment due to credit losses IncomeNot permitted Permitted in income if the reversal can be objectively related to an event occurring after the impairment was recognized OCI for impairment due to other factors IncomeOCI AFS – equityIf fair value is less than the cost basis and other- than-temporary impairment If objective evidence of impairment Cost basis less fair value IncomeNot permitted HTM – debtIf fair value is less than the amortized cost basis and other- than-temporary impairment If objective evidence of impairment Amorti zed cost basis less fair value Amortized cost basis less the present value of estimated future cash flows discounted at the original interest rate Income for impairment due to credit losses IncomeNot permitted Permitted in income if the reversal can be objectively related to an event occurring after the impairment was recognized OCI for impairment due to other factors IncomeAccreted in income up to the carrying value

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 8 The Jumpin’ Jones Company (Jones) has the following investments: – Common shares of Bungee Inc. – accounted for as AFS (carrying value equal to cost of $100) – Bonds of Bridge Inc. – accounted for as AFS (carrying value equal to cost of $100) Impairment of AFS debt and equity assets due to credit losses example ► How should Jones account for these investments at both year-end dates under US GAAP and IFRS? At year-end December 31, 2010, the shares are valued at $90 and the bonds at $80. Both are considered to be impaired for both US GAAP and IFRS. At year-end December 31, 2011, the shares are worth $100 and the bonds $95. Assume the values reflect incurred credit losses only and are equal to fair value.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 8 solutions: US GAAP: 2010 Loss$30 Investments – AFS equity$10 Investments – AFS debt 20 The loss is recognized in income since this is considered to be an impairment. Otherwise, the decline in value would be reported in OCI Investments – AFS equity$10 Investments – AFS debt 15 Unrealized gain – OCI$25 The recovery of the value on both the debt and equity are never reflected in income. The impairment establishes a new cost base. Since the assets are valued at fair value, the recovery is recognized in OCI. Impairment of AFS debt and equity assets due to credit losses example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS: 2010 Loss$30 Investments – AFS equity$10 Investments – AFS debt 20 The loss is recognized in income since this is considered to be an impairment. Otherwise, the decline in value would be reported in OCI Investments – AFS equity$10 Investments – AFS debt 15 Unrealized gain – OCI (equity)$10 Reversal of impairment loss – income (debt) 15 The recovery in value of the debt instrument (only) may be reported in income. Since the assets are valued at fair value, the recovery on the equity investment is reported in OCI. Impairment of AFS debt and equity assets due to credit losses example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 9 The Marvelous Mountain Bike Company (Marvelous) invested in a 5%, $100 bond at par. The bond is classified as HTM and at year-end has a fair value of $50. This is partially due to the fact that interest rates have risen to 7% and also due to the fact that the interest and principal may not be collected under the terms of the bond. The present value of the estimated cash flows at year-end using a 5% discount rate is $70. Impairment of HTM debt assets example ► Prepare the journal entries to reflect any impairment at year-end under both US GAAP and IFRS. For US GAAP impairment testing purposes, there is a potential impairment since the fair value is less than the carrying value. Marvelous establishes that there is objective evidence of impairment for IFRS impairment testing purposes. The company determines that the decline in value is other than temporary. Marvelous has no intent to sell the bond.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Example 9 solutions: US GAAP: Impairment loss – income $30 Impairment loss – OCI 20 Bond (HTM)$50 The impairment loss is measured at carrying value less fair value. The amount related to credit losses of $30 (amortized cost basis of $100 less the year end estimated cash flows of $70) is recognized in income. The impairment loss due to the change in interest rate of $20 ($70-$50) is charged to OCI as Marvelous has no intent to sell the bond. IFRS: Impairment loss – income $30 Bond (HTM)$30 The impairment loss under IFRS is measured at the carrying value less discounted cash flows. The impairment loss under US GAAP is measured at the carrying value less fair value. Under the new impairment rules, however, only the part of this related to the incurred credit loss is recognized in income. Impairment of HTM debt assets example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Summary of transfers between categories of financial assets Category Reclassification into category allowed? Reclassification out of category allowed? FVONo Trading/FVPLNo Yes – in limited circumstances AFSNo Yes – in limited circumstances HTM Yes – in limited circumstances Yes – may trigger tainting rules Loans and receivables Yes – in limited circumstances

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 The Efective Interest Method The "amortized cost" of a financial asset is equal to the amount at which the asset was initially recognized, plus the amount of interest earned to date, minus any repayments received to date. The "effective interest method" calculates the amount of interest earned to date using an interest rate that exactly discounts estimated future cash receipts to the initial carrying amount of the asset. The calculation takes into account not only interest receivable, but also items such as premiums and discounts. Trade receivables may be measured at the original invoice amount if the effect of discounting is not material.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS 9, Financial Instruments Financial assets will be classified (at the portfolio level). Initially, all financial assets will be measured at fair value and subsequently measured at: –Amortized cost if the following criteria are met: The assets are held within a business model whose objective is to hold the instrument to collect contractual cash flows (business model test). This is evaluated based on fact and not management intent. The contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest (characteristics of the financial asset test). –Fair value: FVO: At initial recognition, an entity may designate a debt security as measured at FVPL, to address accounting mismatch. Fair value through OCI (FVOCI): At initial recognition, an entity may irrevocably designate an equity instrument that is not held for trading to be measured at fair value, with subsequent changes in fair value reported in OCI (with no recycling). Dividends are recognized in income. FVPL: All other instruments, except where the FVOCI option is used.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS 9, Financial Instruments Impairment requirements are unchanged from IAS 39. Reclassifications will be required when an entity changes its business model but will be prohibited in all other circumstances.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Diagram of classification and measurement under IFRS 9

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS 9, Financial Instruments Under IFRS 9, financial liabilities are initially recognized at their fair value plus or minus, in the case of a financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the issuance of the financial liability. Subsequent to initial recognition, financial liabilities are measured at amortized cost using the effective interest method, except for: –Financial liabilities at fair value through profit or loss, including derivatives that are liabilities. –Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition. –Financial guarantee contracts. –Commitments to provide a loan at below-market interest rates.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 IFRS 9, Financial Instruments FVO: Financial liabilities may also be measured at fair value through profit or loss, if, at initial recognition, the financial liability is so designated to be measured at fair value because of either of the following scenarios: –The accounting eliminates or reduces an accounting mismatch. –A group of liabilities is managed on a fair value basis for risk management or investment strategy purposes. For FVO liabilities, the change in the fair value of a liability that is attributable to changes in credit risk must be presented in OCI. The remainder of the change in fair value is presented in profit or loss. However, if the change in the credit risk in OCI would create or enlarge an accounting mismatch, the change is reported in profit or loss.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Subsequent Measurement of Financial Liabilities (IAS39 and IFRS9) Most financial liabilities are measured at amortized cost using the effective interest method. But financial liabilities at fair value through profit or loss (i.e. financial liabilities held for trading) are measured at fair value. Gains or losses are usually recognized in the calculation of profit or loss for the period in which they arise. Trade payables may be measured at the original invoice amount if the effect of discounting is not material.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Bonds and Long-term Notes Payable Valuation of bonds Bonds and notes are presented on the balance sheet at the present value of future interest and principal payments, which generally equal the cash received by the issuer. Discounts and premiums on bonds and notes are amortized over the life of the bond using the effective- interest method. Similar IFRSUS GAAP Similar

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Issuance costs Direct and incremental costs related to the issuance of debt, such as legal fees, accounting fees and banker fees, are not expensed. Internal costs are generally excluded from consideration for capitalization. Similar These costs are referred to as “issuance costs.” Referred to as “transaction costs.” IFRSUS GAAP

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Issuance costs example Example 10 On December 31, 2011, an airplane manufacturer, Airways, issued $1 million in bonds at 5% annual interest, due December 31, 2014, at par. Airways incurred bank fees of $100,000, legal fees of $50,000 and salaries of $25,000 for its employees in conjunction with issuing the bonds. ► Describe how Airways should record the issuance/transaction costs using US GAAP and IFRS? ► Show the related journal entries.

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Solution: Using both US GAAP and IFRS, Airways can capitalize the $100,000 of bank fees and $50,000 of legal fees. Salaries must be expensed as they are internal costs and are not direct and incremental. The transaction costs directly reduce the carrying value for IFRS and are recorded as a deferred charge for US GAAP. US GAAP: Cash$825,000 Salary expense25,000 Unamortized bond issuance costs150,000 Bonds payable$1,000,000 IFRS: Cash$825,000 Salary expense25,000 Bonds payable $850,000 Issuance costs example

Slide Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011 Disclosures Relating to Financial Instruments IFRS7 requires many detailed disclosures relating to financial instruments. The main purpose of these disclosures is to enable users to evaluate the significance of financial instruments for the entity’s financial position and performance. Disclosures are also required which will enable users to evaluate the nature and extent of any risk related to financial instruments.