Basic Financial Instruments: IAS 32, IAS 39 and IFRS 7 Wiecek and Young IFRS Primer Chapter 17

2 Basic Financial Instruments Related standards IAS 32, IAS 39 and IFRS 7 Current GAAP comparisons IFRS financial statement disclosures Looking ahead End-of-chapter practice

3 Related Standards FAS 115 Accounting for Certain Investments in Debt and Equity Securities FAS 130 Reporting Comprehensive Income FAS 133 and 138 Accounting for Derivative Instruments and Hedging Activities FAS 140 and 156 Accounting for the Transfer and Servicing of Financial Assets and Extinguishment of Financial Liabilities FAS 150 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity FAS 155 Accounting for Certain Hybrid Financial Instruments FAS 157 Fair Value Measurements FAS 159 The Fair Value Option for Financial Assets and Financial Liabilities

4 Related Standards IAS 1 Presentation of Financial Statements

5 IAS 32, IAS 39 and IFRS 7 – Overview Objective and scope Recognition and derecognition Measurement Presentation Disclosures

6 Objective and Scope The framework for accounting for financial instruments is laid out in three standards as follows: IAS 32, which deals with presentation from the perspective of the issuer (only) IAS 39, which deals with measurement and recognition of financial assets and financial liabilities IFRS 7, which deals with disclosures IAS 1 deals with financial statement presentation (including comprehensive income)

7 Objective and Scope According to IAS 32.11, “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” The majority of items on the balance sheets of many companies are financial instruments Some exceptions are: – Inventories – Prepaids – Property, plant, and equipment

Objective and Scope 8

9 Financial assets, liabilities, and equity instruments are defined in IAS 32 A financial asset is (a) cash (b) an equity instrument (of another entity) or (c) a contractual right to receive cash (or another financial asset) or to exchange financial assets or financial liabilities under conditions that are potentially favorable An equity instrument is a contract that represents a residual interest in the net assets of the company A financial liability is basically a contractual obligation to deliver cash (or another financial asset) or to exchange financial assets or financial liabilities under conditions that are potentially unfavorable

10 Objective and Scope The financial instruments that are either completely or partially scoped out of the standards are as follows: – IAS 32: Investments that are consolidated or equity accounted for under: IAS 27, 28, 31 Rights and obligations under employee benefit plans (IAS 19) and insurance contracts (IFRS 4) Share-based payments (IFRS 2) – IAS 39: Those noted above as well as: – Rights and obligations under leases covered under IAS 17 – Equity instruments of the entity (issuer) that are classified as equity (IAS 32) – Contracts to buy/sell an acquiree at a future date – Some loan commitments (IAS 37) – Rights to payments to reimburse the entity for expenditures to settle a liability

11 Recognition and Derecognition INITIAL RECOGNITION Financial instruments should be recognized when the entity becomes a party to the contract When financial instruments are initially recognized, they must be classified as one of the following (which are defined in IAS 39.9): 1. Financial assets at fair value through profit or loss (FVTPL) 2. Held to maturity investments (HTM) 3. Loans and receivables 4. Available for sale financial assets (AFS) The classification is important because it dictates how the asset/liability will be measured going forward and where the profits and losses will be booked

12 Recognition and Derecognition Financial Assets at Fair Value through Profit or Loss (FVTPL) Under IAS 39.9, FVTPL assets/liabilities are either held for trading (HFT) or designated as FVTPL by the entity Instruments may be classified as HFT if they: Are acquired with the intent to sell or repurchase in the near term, Are part of a portfolio of instruments that are managed together to maximize profits, or Are derivatives (other than financial guarantee contracts or designated and effective hedging instruments) In other words, the instruments are traded for profit (“active and frequent buying and selling”)

13 Recognition and Derecognition Financial Assets at Fair Value through Profit or Loss (FVTPL) An entity may, as an accounting policy choice, designate assets as FVTPL if certain criteria are met This option is available to encourage the use of fair value and to reduce the need for having to use hedge accounting Under the standard, entities are allowed to use this option when doing so results in more relevant information Where there is no market value and fair value is not reliably measurable, equity instruments may not be classified as FVTPL Once an item is classified as FVTPL, it may not be reclassified to another category

14 Recognition and Derecognition Held to Maturity Investments (HTM) HTM investments have the following characteristics: They are not derivatives They have fixed and determinable payments and fixed maturity dates HTM investments are meant to be held to maturity and the entity must demonstrate positive intent and ability to do so These investments may be disposed of or reclassified prior to maturity only in very limited circumstances If the entity disposes of or reclassifies more than an insignificant amount of investments prior to maturity in the current year or in the previous two years, it will not be allowed to use the HTM category going forward

15 Recognition and Derecognition Held to Maturity Investments (HTM) It is acceptable, under the standard, to dispose of the investment under the following situations: The investment is very close to maturity The entity has collected substantially all of the amounts under the terms of the debt or Circumstances exist that are attributable to an isolated event beyond the entity’s control, which is nonrecurring and could not have been anticipated Thus, there may be some unanticipated, one-time situations where it is acceptable under the standard to dispose of the instrument prior to maturity.

16 Recognition and Derecognition Held to Maturity Investments (HTM) This restriction on reclassification exists because HTM investments are measured at amortized cost – Reclassification would potentially trigger a gain or loss and may lead to manipulation of income How does an entity demonstrate positive intent and ability? – Positive intent and ability can be shown by many factors – These factors must be assessed upon initial recognition and subsequently

17 Recognition and Derecognition Loans and Receivables Loans and receivables have the following characteristics: They are non-derivative They have fixed and determinable payments They are not quoted in an active market Therefore, this category includes loan assets, trade receivables, and investments in debt instruments Available for Sale Financial Assets Available for sale financial assets are those that are not classified as one of the others, i.e., FVTPL, HTM, or loans and receivables This category is a default category, i.e., instruments are presented here if they do not meet the definitions of the other categories

18 Recognition and Derecognition DERECOGNITION OF A FINANCIAL ASSET Derecognition is the process of removing an item from the balance sheet (statement of financial position) Financial assets are derecognized when: The contractual rights to the cash flows related to the asset expire, or The rights are transferred and certain derecognition criteria are met Transfers Many companies transfer their financial assets to other companies – This allows the entity (transferor) to free up capital. – It is common practice in the retail business to factor receivables In general, the act of transferring the asset qualifies the asset for derecognition as long as the risks and rewards of ownership are passed to the transferee

19 Recognition and Derecognition DERECOGNITION OF A FINANCIAL LIABILITY Liabilities are removed from the balance sheet when the obligation is extinguished (i.e., it is discharged or cancelled, or it expires) For instance, when the entity has paid out all principal and interest, then it would derecognize the liability Things get complicated when an entity extinguishes an obligation earlier than required or modifies the obligation

20 Measurement INITIAL MEASUREMENT OF FINANCIAL ASSETS AND LIABILITIES Financial assets/liabilities are initially recognized at fair value Transaction costs that are directly attributable to the transaction should be added to the carrying value unless the asset is classified as FVTPL SUBSEQUENT MEASUREMENT OF FINANCIAL ASSETS AND LIABILITIES Subsequent measurement depends on the classification upon initial recognition The chart in Illustration 17-3 (next slide) explains how to measure the financial instruments and where the resulting gains/losses are booked

21 Measurement

22 Measurement

23 Measurement FAIR VALUE MEASUREMENT CONSIDERATIONS Fair value is defined as: “ the amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arm’s-length transaction” How do you determine fair value? – The best evidence is quoted prices in an active market – A market is active if the prices are readily and regularly available and reflect actual arm’s-length transactions According to the standard, market inputs should be used as much as possible, with less reliance on inputs that are specific to the entity

24 Measurement FAIR VALUE MEASUREMENT CONSIDERATIONS As a secondary choice, the entity would use a valuation technique. – The objective is to arrive at a value that would have been paid “in an arm’s length exchange motivated by normal business considerations” – Valuation techniques should use whatever market data are available – Examples include discounted cash flows and options pricing models Following are examples of inputs: Time value of money Credit risk Foreign exchange rates Commodity prices Equity prices Volatility (variability in value)

25 Measurement RECLASSIFICATIONS Once an instrument has been classified as FVTPL, it may not be subsequently reclassified out of the FVTPL category Similarly, instruments may not be subsequently reclassified into the FVTPL category If it is no longer appropriate to classify an item as HTM, classify it as AFS IMPAIRMENT AND UNCOLLECTIBILITY OF FINANCIAL ASSETS If there is objective evidence of impairment, the asset should be written down through profit or loss In assessing whether there is objective evidence of impairment, the standard focuses on the existence of events (referred to as loss events) such as financial difficulty or bankruptcy

26 Measurement

27 Presentation Liabilities and Equity Financial instruments should be classified as debt or equity according to their economic substance, which should dictate the accounting Compound financial instruments contain both debt and equity components – These instruments should be divided into their respective debt and equity components and presented as part debt and part equity The instrument is an equity instrument if both the following conditions are met: The instrument contains no contractual obligation, and The instrument may be settled in a fixed number of the issuer’s own equity instruments When an instrument contains both debt and equity, the liability would usually be measured at the present value of the future cash flows – Any remaining consideration exchanged for the instrument is booked as equity

28 Presentation Interest, Dividends, Losses, and Gains Interest, dividends, losses, and gains are accounted for consistently with the economic substance of the underlying financial instrument (not the legal form) For instance, term-preferred shares are debt in substance and therefore the dividends would be accounted for as interest and deducted from profit or loss Offsetting a Financial Asset and a Financial Liability Offsetting is the process of netting financial assets and liabilities Financial assets and liabilities may be offset when: – There is a legally enforceable right to offset (upon eventual cash flow payments) and – Where there is intent to settle on a net basis

29 Disclosures IFRS requires additional disclosures including information about: – Fair and carrying values – Use of FVTPL – Reclassifications – Derecognition – Collateral – Compound instruments – Defaults and breach – Hedges and risks – Gains and losses In general, the disclosures give information about the significance of the financial instruments and the nature and extent of related risks

30 Current GAAP Comparisons Pages 52, 70, 76, 86, 122 & 142 of 164 of

31 IFRS Financial Statement Disclosures Del Monte Pacific Limited Summary of Significant Accounting Policies Financial Instruments page 60 of 108

32 Looking Ahead Due to the complexity of accounting for financial instruments, the IASB and FASB are working on a project to simplify the accounting Following are the main principles: All financial instruments are measured at fair value with gains/losses to net income Simplify or eliminate hedge accounting Provide new standards for derecognition

33 End-of-Chapter Practice

34 End-of-Chapter Practice

35 End-of-Chapter Practice

36 End-of-Chapter Practice

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