1. IFRS Seminar
IAS 39 Financial Instruments: Recognition and Measurement

2. Overview of session Review of key concepts
Date
Overview of session
Review of key concepts
Classification of financial assets
Measurement of financial assets
Impairment of financial assets
Reclassification and tainting
Conclusion
Here is an overview of the session that we intend to cover over the next 90 minutes or so.
We will review some of the key concepts dealing with classification and measurement of financial assets.
We will talk about the situations in which a company can change the initial classification of financial assets and how to account for transfers of financial assets from one category to another. We look at the tainting rules that apply in relation to the reclassification of held-to-maturity assets.
We will look at measurement of financial assets – fair value and amortised cost and work through an example to calculate amortised cost of a financial asset and consider the impact of amortised cost calculation on floating rate/inflation linked debt.
Finally, we will look at circumstances that can give rise to impairment of financial assets and how impairment losses are calculated for various types of financial assets.
Hopefully, by then, you will have learnt all you need to know to master the most difficult issues arising on the recognition, classification and measurement of non-derivative financial assets.

3. Date
Review of key concepts
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.
An equity instrument is any contract that evidences a residual interest in the assets of another
We will start by reviewing the key concepts of classification and measurement of financial instruments.
IAS 39 requires you to classify an entity’s financial assets into one of four categories.
Ask: Can you name those categories?
Response should be: (see next slide)

4. Date
Review of key concepts
A financial asset is any asset that is cash, an equity instrument of another entity, a contract that (subject to certain conditions) will or may be settled in the entity’s own equity instruments or a contractual right:
To receive cash or another financial asset from another entity; or
To exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity.
We will start by reviewing the key concepts of classification and measurement of financial instruments.
IAS 39 requires you to classify an entity’s financial assets into one of four categories.
Ask: Can you name those categories?
Response should be: (see next slide)

5. Date
Review of key concepts
A financial liability is any liability that is a contract that (subject to certain conditions) will or may be settled in the entity’s own equity instruments or a contractual obligation:
To deliver cash or another financial asset to another entity; or
To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity
We will start by reviewing the key concepts of classification and measurement of financial instruments.
IAS 39 requires you to classify an entity’s financial assets into one of four categories.
Ask: Can you name those categories?
Response should be: (see next slide)

6. Classification – Financial assets (Four categories)
Date
Classification – Financial assets (Four categories)
Financial assets at fair value through profit or loss
Loans and receivables
Held to maturity
Available for sale
Ok. These are the four categories of financial assets.
Lets look at them in turn.

7. Classification – Financial liabilities (Two categories)
Date
Classification – Financial liabilities (Two categories)
Financial liabilities at fair value through profit or loss and
Other financial liabilities
Ok. These are the four categories of financial assets.
Lets look at them in turn.

8. At fair value through profit or loss
Date
Classification – Financial Assets At Fair Value Through Profit or Loss (FVTPL)
At fair value through profit or loss
Held for trading
Designated at inception
Financial assets at fair value through profit or loss
This category has two sub-categories: (1) financial assets held for trading; & (2) those designated to the category at inception.
A financial asset is held for trading if it is:
acquired principally for the purpose of selling or repurchasing in the near term; or
part of a portfolio of identified instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking.
Trading assets include debt and equity securities and loans and receivables acquired by the entity with the above intentions.
Derivatives are always categorised as held for trading except those that are financial guarantee contracts or designated and effective hedging instruments.
The second sub-category includes certain financial assets that an entity may designate to this category on initial recognition, but only if they meet 3 specified criteria in IAS 39.
Two important features of the fair value option:
Designation as at FVTPL can only be made on initial recognition.
The designation is irrevocable. Once designated, the asset cannot be moved to another category during its life.
Additionally, investments in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured cannot be designated as at fair value through profit or loss.
Intention of short term profit;
Derivatives – unless hedges
or financial guarantee contracts
3 criteria for designation;
Irrevocable

9. Date
Classification – Financial Assets At Fair Value Through Profit or Loss (FVTPL)
The fair value option
Available only if either of the 3 criterion met. These criteria are generally only met by financial institutions and other organisations with sophisticated treasury operations.
Criterion 1
Accounting
mismatch
Criterion 2
Manage as
a portfolio on
a fair value
basis
Criterion 3
Embedded
derivative
The three CRITERIA for designation at fair value through profit or loss: Cover briefly – do not explain in detail
1. it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as 'an accounting mismatch') that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases; or
2. a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity's key management personnel; or
3. if a contract contains one or more embedded derivatives, an entity may designate the entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss unless:
a. the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or
b. it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.
Example of criterion 3: a bank issues a complex product which contains several embedded derivatives. The process for determining what the embedded derivatives are, deciding whether they should be separated from the host contract and measuring each embedded derivative and the host separately would be a costly and time consuming exercise. In this case, the bank can now choose to designate the entire contract as at FVTPL.

10. Classification - financial assets Loans and receivables
Date
Classification - financial assets Loans and receivables
Non-derivative
Fixed or determinable payments
Not quoted in an active market
Highlight for the participants the key criteria for each category
Loans and receivables
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market other than
Those held for trading or those designated at fair value through profit or loss,
Those designated by the entity as AFS,
Those for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which shall be classified as AFS.
They typically arise when an entity provides money, goods or services directly to a debtor with no intention of trading the receivable. However, a loan acquired as a participation in a loan from another lender is also included in this category, as are loans purchased by the entity that would otherwise meet the definition.

11. Classification - financial assets Held to maturity
Date
Classification - financial assets Held to maturity
Non-derivative
Fixed or determinable
payments
Fixed maturity
Entity has a positive intention and ability to hold to maturity
Held-to-maturity investments
Held-to-maturity investments are financial assets with fixed or determinable payments and fixed maturity (e.g., debt securities and redeemable preference shares) that an entity has the positive intent and ability to hold to maturity.
This category excludes loans and receivables, designated AFS and designated at FVTPL instruments.
Equity securities cannot be classified as held-to-maturity because they do not have a fixed maturity date.
The intent and ability must be assessed not only when the assets are initially acquired but also at each subsequent balance sheet date.
A positive intent to hold assets to maturity is a much higher hurdle than simply having no present intention to sell.
If an entity sells more than an insignificant amount of held-to-maturity securities, other than in exceptional circumstances, this casts doubt on its intent or ability to hold investments to maturity and taints the portfolio. We will look at tainting later when we deal with reclassification.
There are tainting rules that can stop an entity classifying assets as financial assets held-to-maturity

12. Classification - financial assets Available-for-sale
Date
Classification - financial assets Available-for-sale
Non-derivative
Not classified in any of the other categories
Available-for-sale financial assets
The available-for-sale category includes financial assets other than those classified as at FVTPL, HTM or loans and receivables.
An entity also has the right to designate any asset, other than a trading one, into this category at inception.

13. Why Is Classification Important?
Date
Why Is Classification Important?
Because it drives subsequent measurement of the financial asset…
Why is classification important? Why did we spend the last 10 minutes on classification
It is important because it determines subsequent measurement of the financial asset. Classification is not a free choice but is based on facts and the intent of management at the date of purchase and so should be correct at inception.
Transfers between categories after initial recognition are rare and can only be done in certain circumstances. We will look at reclassification later.
We will now consider how each category of financial assets will be measured in the financial statements.

14. Measurement of financial assets
Date
Measurement of financial assets
Initial recognition
When (i.e. timing)
How much (i.e amount)
Which account (i.e category)
Transaction costs
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

15. Directly attributable and incremental
Date
Transaction costs
All categories apart from Fair Value Through Profit or Loss – include in initial measurement
Directly attributable and incremental
Fair value through profit or loss - expense
The entity may also incur transaction costs in the acquisition of the financial asset. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability.
ASK:
What do you think would be included in transaction costs?
Response should include:
Inclusions
Fees and commissions paid to agents (including employees acting as selling agents), advisors, brokers and dealers
Levies by regulatory agencies and securities exchanges
Transfer taxes and duties
What do you think would be excluded from transaction costs?
Exclusions
Transaction costs do not include for example, internal administrative or holding costs, nor cost to exit or sell the asset, debt premium or discount or financing costs.
Once we have determined what are eligible transaction costs, we need to account for them.
Transaction costs that are directly attributable to the acquisition or issue of a financial instrument are included in the instrument’s initial fair value. This applies to all financial assets except those that are classified as at fair value through profit or loss.
For instruments classified as at fair value through profit or loss, transaction costs are immediately recognised as an expense on initial recognition.

16. Subsequent Measurement
Date
Subsequent Measurement
Financial assets at fair value through profit or loss
At FV through profit or loss
Loans and receivables
At amortized cost
Held to maturity
There is a mixed measurement model in IAS 39 depending on classification.
The name of the first category gives us clear guidance regarding the measurement. All gains and losses arising from changes in fair value are recognised, not surprising, in profit or loss. This means that assets falling within this category are not subject to review for impairment as losses due to fall in value (including impairment) are automatically reflected in profit or loss.
What about the other categories?
Ask participants how should each category be measured?
HTM assets, loans and receivables and Other financial liabilities are all measured at amortised cost using the effective interest rate method.
AFS are measured at fair value with changes in fair value recognised in equity. However, interest calculated using the effective interest rate method is recognised in income.
If there is a single principle in IAS 39 – derivatives should be at fair value.
Dividends are also recognised in income.
Finally, impairment and foreign currency gains & losses on debt instruments are recognised in profit or loss as well.
Let us now look at how amortised cost is calculated using the effective interest method.
At FV through equity
Available for sale

17. Example: Initial fair value
Date
Example: Initial fair value
An entity enters into a marketing agreement with another organisation. As part of the agreement the entity makes a two year £5,000 interest free loan. Equivalent loans would normally carry an interest rate of 6%, given the borrower’s credit rating. The entity made the loan in anticipation of receiving future marketing and product benefits.
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

18. Example: Initial fair value
Date
Example: Initial fair value
Solution: The fair value of the loan can be determined by discounting the future cash flows to present value using the prevailing market interest rate for a similar instrument with a similar credit rating. The present value of the cash flow in two years time at 6% is £4,450 (£5,000 × (1/1.062)). On initial recognition of the financial asset the entity should recognise a loss of £550 as follows: DR Loan £4,450 DR Loss (finance expense) £550 CR Cash £5,000 The difference between this initial amount recognised of £4,450 and the final amount received of £5,000 should be treated as interest received and recognised in profit or loss over the two year period.
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

19. Example: At fair value through profit or loss
Date
Example: At fair value through profit or loss
An entity acquired a derivative on 1 May 20X6 for £200 cash. On 31 December 20X6, the next reporting date, the fair value of the derivative was £340. On 31 December 20X7 the derivative’s fair value had fallen to £220. Set out the journal entries to record these transactions. Solution: On 1 May 20X6: DR Derivative financial asset £200 CR Cash £200 On 31 December 20X6: DR Derivative financial asset £140 CR Profit or loss – gain on financial asset (£340 – £200) £140
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

20. Example: At fair value through profit or loss
Date
Example: At fair value through profit or loss
Solution: On 31 December 20X7: DR Profit or loss – loss on financial asset (£340 – £220) £120 CR Derivative financial asset £120
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

21. Exercise: Held to maturity
Date
Exercise: Held to maturity
An entity acquires a zero coupon bond with a nominal value of £20,000 on 1 January 20X6 for £18,900. The bond is quoted in an active market and broker’s fees of £500 were incurred in relation to the purchase. The bond is redeemable on 31 December 20X7 at a premium of 10%. The effective interest rate on the bond is 6.49%. Requirement Set out the journals to show the accounting entries for the bond until redemption if it is classified as a held-to-maturity financial asset. The entity has a 31 December year end.
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

22. Exercise: Held to maturity
Date
Exercise: Held to maturity
Solution: On 1 January 20X6 DR Financial asset (£18,900 plus £500) £19,400 CR Cash £19,400 On 31 December 20X6 DR Financial asset (£19,400  6.49%) £1,259 CR Interest income £1,259 On 31 December 20X7 DR Financial asset ((£19,400+£1,259) x 6.49%) £1,341 CR Interest income £1,341 DR Cash £22,000 CR Financial asset £22,000
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

23. Held to maturity and Available for sale clasifications
Date
Held to maturity and Available for sale clasifications
Example: An entity acquired a 6% £1,000 par value financial asset for its fair value of £970 at the beginning of Year 1. Interest of 6% was receivable annually in arrears. The financial asset was redeemable at the end of Year 3 at £1,030, a premium of 3% to par value. The financial asset is quoted in an active market and was classified as held to maturity by the entity. Held-to-maturity financial assets should be measured at amortised cost. The effective interest rate of the financial instrument can be calculated at 8.1%. The rate is higher than the coupon rate, because it amortises the discount on issue and the premium on redemption. The amortised cost carrying amount should be determined as follows.
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

24. Amortised cost and effective interest method
Date
Amortised cost and effective interest method
Solution: Year Opening 8.1% Cash flow Closing balance balance in profit or loss £ £ £ £ (60) (60) 1, , (1,090) 0 If the entity had classified the financial asset as available for sale, the asset should have been measured at fair value at each reporting date. If the fair values of the financial asset at the end of Year 1 and Year 2 were £1,100 and £1,050, the financial asset should have been recognised at the following amounts.
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

25. Amortised cost and effective interest method
Date
Amortised cost and effective interest method
Solution: If the entity had classified the financial asset as available for sale, the asset should have been measured at fair value at each reporting date. If the fair values of the financial asset at the end of Year 1 and Year 2 were £1,100 and £1,050, the financial asset should have been recognised at the following amounts. Gain/(loss) in Other Closing Opening 8.1% Compreh. balance – fair Year Balance in profit or loss Cash flow income (bal) value £ £ £ £ £ (60) 112 1, , (60) (70) 1, , (1,090) (42) 0
But before we talk about measurement, we first need to determine when financial assets should be recognised, that is, included in an entity’s balance sheet.
There are three things that we need to think about on initial recognition:
When (i.e. timing),
How much (i.e. amount)
Which account (i.e. Category)
An entity should recognise a financial asset on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. For example, an unconditional receivable would be recognised when the entity becomes a party to the contract and, as a result, has a legal right to receive cash. This means that planned future transactions, no matter how likely, cannot give rise to assets because the entity has not become a party to a contract.
Note that any right to receive cash only due to legal, but not contractual provisions, does not constitute a financial asset (e.g. tax asset)
When a financial asset is recognised initially, an entity should measure it at its fair value. Fair value is the amount for which as asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best evidence of fair value on initial recognition is the transaction price. However, it is possible that the instrument’s fair value many not be the transaction price. We will look at fair values later.
Finally, the instrument will be included in a category in accordance with the classification rules that we discussed earlier.

26. Fair value measurement
Date
Fair value measurement
IAS 39 defines fair value as: “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” Fair value = Transaction price (fair value of consideration given or received)
We will now take a look at fair value measurement.
The IASB believes that fair value is the most relevant measure for financial instruments and is the only relevant measure for derivatives. We have already seen IAS 39 give entities an option to measure financial assets at fair values if they meet certain criteria.
The importance of fair value in the measurement process arises because it is a market based notion, unaffected by the history of the instrument, the specific entity that holds the instrument and the future use of the instrument. Thus, it represents an unbiased measure of the instrument from year to year. As a result if an investor knows a financial instrument’s fair value and has information about its essential terms and risks, it has all the information it needs to make decisions about that instrument.
IAS 39 defines fair value as ““the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.”
Given that fair value is the arm’s length price that market participants will pay or receive in a routine transaction, it follows that a financial instrument’s initial fair value will normally be the transaction price, that is the fair value of consideration given or received.
In some circumstances, however, the consideration give or received may not necessarily be the financial instrument’s fair value.
Lets look at an example.

27. Fair value measurement
Date
Fair value measurement
Example 1 – Interest free loan to an employee
An entity grants an interest free loan of € 1,000 to an employee for a period of two years. The market rate of interest to this individual for a two year loan payable at maturity is 10%.
What is the initial fair value?
Consideration given to employee consists of two assets:
The fair value of the loan = €1,000/(1.10)2 = €826
Difference of €174 is accounted for as employee compensation in accordance with IAS 19, ‘Employee benefits’
In this example, the fair value of the two year loan that carries no interest is not equal to its face amount of €1,000. Part of the consideration received is something other than fair value. As the loan receivable would have to be recorded initially at its fair value, its fair value has to be estimated.
As we will see in a minute the best evidence of fair value is the price quoted in an active market. There is unlikely to be an active market for employee loans. In the absence of an active market the fair value has to be estimated using a valuation technique that uses market data.
In this example, the fair value of the interest free loan can be estimated using a DCF valuation technique using the prevalent market rate of interest for a similar loan (similar as to currency, term and other factors) with a similar credit rating. The DCF valuation is €826. Any additional amount lent is an expense or a reduction of income, unless it qualifies for recognition as some other type of asset. [IAS 39 para AG 64]. In this example, the difference of €174 is written off as an expense over the two year service period.
So to recap the only exception to using transaction price is if the fair value is evidenced by observable market transactions in the same instrument, or is based on a valuation technique whose variable include only market data. In that situation, the entity must use that value. The difference between the estimated fair value and the transaction price is recognised as a day ‘1’ gain or loss.

28. Active market – Published quotations No active market – Valuation
Date
Fair Value Hierarchy
Active market –
Published quotations
Best evidence
No active market –
Valuation
Techniques
Alternative
No active market – Unreliable fair value for equity instrument – cost less any impairment
Fair values may be determined in a number of ways. However, IAS 39 sets out a hierarchy for determining the fair value of financial instruments.
Active market
As can be seen, the hierarchy gives the highest priority to quoted prices in an active market.
Published price quotations in an active market provide the best evidence of fair value and should be used where they exist to measure the financial instrument.
The appropriate quoted market price for a financial asset held is usually the current bid price – the price a dealer is willing to pay for the instrument and, therefore, the price the entity would receive if it sold the asset.
The appropriate price for an asset to be acquired is the ask price – the price at which a dealer is willing to sell the instrument and, therefore, the price at which the entity would pay to acquire the asset The ask price is often referred to as the ‘offer’ price. The ask price is always higher than the bid price and the difference represents the dealer’s profit, which is called the ‘spread’.
The only departure from a market quotation is when the market is not active
ASK: How do I work out if I have an active market?
Whether the market is sufficiently active, can be established from looking at
bid/offer spreads;
relative trading volumes on the market and
whether there were recent frequent transactions on the market.
No active market – valuation techniques:
If the market for a financial instrument is not active, fair value is established by using a valuation technique.
Valuation techniques that are well established in financial markets include
recent market transactions,
reference to a transaction that is substantially the same,
discounted cash flows and
option pricing models.
An acceptable valuation technique incorporates all factors that market participants would consider in setting a price, and should be consistent with accepted economic methodologies for pricing financial instruments:
Use only well-established valuation techniques
discounted cash flow analysis for debt instruments
valuation methodologies for unquoted equity instruments
option pricing models and discounted cash flow models for derivatives
models using market price inputs
What happens if fair value is not determinable?
There is a presumption that fair value can be reliably determined for all financial assets. The presumption that fair value can be determined can be overcome only in very limited circumstances.
No active market – equity instruments:
Where there is no active market for an unquoted equity instrument , the range of reasonable fair value estimates is significant, and these estimates cannot be made reliably, an entity is permitted to measure the equity instrument at cost less impairment as a last resort. A similar dispensation applies to derivative financial instruments that can only be settled by physical delivery of such unquoted equity instruments.
Tutor asks: Could you please read the fact pattern on the next slide (go to the next slide). You have 2 minutes to consider the issue. We will discuss your thoughts thereafter.
Very rare

29. Fair value measurement
Date
Fair value measurement
Question 1
Star owns 15% of shares of Moon.
Shares quoted on a local stock exchange, trading volume indicates sufficiently active market.
The quoted market price is €100 per share.
If decided to sell entire block of shares, the price they believe they would be able to obtain would be €80 per share.
What value should be placed on the shares?
We will now consider a couple of simple questions on fair values.
Take a look at question 1 and tell me what value should be placed on the shares?
Star must use the published price quotation of €100 per share as the basis for determining fair value of shares of Moon. IAS 39 states that a published price quotation in an active market is the best estimate of fair value and it when the quotation exists it should be used to measure the financial asset or a financial liability. Star cannot depart from the quoted market price solely because its estimates indicate that it would obtain a lower price by selling the holding as a block.
Another question for you to consider (go to next slide).

30. Fair value measurement
Date
Fair value measurement
Question 2
Star purchases an AFS equity security for €100 and pays purchase commission of €2.
At the end of Star’s financial year, the security’s quoted market price is €105. Commission of €3 would be payable if the security was sold on that date.
What amount is recognised initially and at the end of the financial year?
Answer : Initially the security is recognised at €102. The purchase commission of €2 must be included in the initial fair value because the security is not designated as at fair value through profit or loss.
On the financial reporting date, the asset is measured at €105 and a gain of €3 is recognised in equity. Transaction costs of €3 expected to be payable on disposal are never included in the security’s measurement.

31. Impairment of financial assets
Date
Impairment of financial assets
Impairment occurs when Carrying amount > Recoverable amount
Only relevant for financial assets carried at cost
or amortised cost and AFS financial assets
We will now look at impairment of financial assets
A financial asset is impaired when its carrying amount exceeds its recoverable amount.
Impairment issues are not relevant for financial assets carried at fair value through profit or loss as any diminution in value is already reflected in the fair value and, hence, in profit or loss.
It follows that impairment issues are only relevant to financial assets that are carried at cost or amortised cost and available-for-sale financial assets whose fair value changes are recognised in equity.

32. Impairment of financial asset
Date
Impairment of financial asset
Step 1 – Objective evidence of impairment Step 2 – Calculate recoverable amount / fair value Step 3 – Record impairment in profit & loss
An entity should assess at the end of each reporting period whether there is any objective evidence that a financial asset or group of assets is impaired. If this evidence exists then step 2 applies.
In step 2, the amount of the impairment loss is calculated. This involves estimating the recoverable amount or the fair value of the financial asset at the date when the impairment assessment is made.
For financial assets carried at amortised cost , the recoverable amount is the present value of the expected future cash flows discounted at the instrument’s original effective interest rate.
For AFS financial assets, the recoverable amount is the current fair value (for AFS equity instruments) or the present value of the expected cash flows (for AFS debt instruments).
In step 3, the difference between the carrying value and the recoverable amount is recognised in profit or loss as an impairment loss.
Let’s look at step 1 in some detail. As we can only record impairment if we have objective evidence of impairment, it is important to remind ourselves what is considered objective evidence of impairment for debt instruments and AFS equity investments. In other words, what objective evidence must be present to support recognition of an impairment loss.

33. Impairment Indicators for debt instruments
Date
Impairment Indicators for debt instruments
Significant difficulty of the issuer
Breach of contract for failure to pay interest or principal
Disappearance of active market because of financial difficulties
Lender grants borrower in financial difficulty a concession that the lender would not otherwise consider
National or local economic conditions that correlate with defaults (eg a decrease in property prices for mortgages in a relevant area)
What objective evidence does IAS 39 tell us to consider?
For debt instruments objective evidence of impairment includes observable data that comes to the attention of the holder of the asset from one or more loss events identified above. The loss events identified above must occur after the initial recognition of the asset and must have an impact, either individually or in combination with other loss events, on the estimated future cash flows of the financial asset.
NOT EVIDENCE:
The disappearance of an active market because an entity's financial instruments are no longer publicly traded is not evidence of impairment.
A downgrade of an entity's credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information.
A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of an investment in a debt instrument that results from an increase in the risk-free interest rate).
High probability of bankruptcy

34. Impairment Indicators for AFS equity investments
Date
Impairment Indicators for AFS equity investments
In addition to impairment indicators for debt instruments, indicators that are specific to equity instruments include:
Significant adverse changes that have taken place in the technological, market, economic or legal environment in which the issuer operates.
Significant or prolonged decline in fair value below cost
For marketable equity investments, any impairment trigger other than decline in fair value below cost is likely to be arbitrary. Nevertheless, questions arise in practice about when such investments become impaired. IAS 39 provides additional indicators of impairment for equity investments noted about. They apply in addition to the impairment indicators for debt instruments considered earlier.
Significant adverse changes in technological, market, economic or legal environment may be due to:
Structural changes in the industry or industries in which the issuer operates, such as changes in production technology or the number of competitors.
Changes in the level of demand for the goods or services sold by the issuer resulting from factors such as changing consumer tastes or product obsolescence.
Changes in the political or legal environment affecting the issuer’s business, such as enactment of new environment protection, tax or trade laws.
Changes in the issuer’s financial condition evidenced by changes in factors such as its liquidity, credit rating, profitability, cash flows, debt/equity ratio and level of dividend payments.
What is a ‘significant’ or ‘prolonged’ decline in the fair value of an equity instrument will require judgement. So let’s examine these terms in some detail.

35. Impairment AFS equity instruments Significant
Date
Impairment AFS equity instruments Significant
How do we define “significant”?
Share price subsequent to year end?
Percentage decline?
Judgement
We’ve received a lot of questions as to how we interpret significant. As I mentioned, the standard does not give a bright line and we don’t require one.
If our shares were down 50% at the end of the year, but have miraculously recovered before we publish our accounts should we use that information in assessing whether the security was impaired? The answer is no. The judgement about impairment is made solely based on the conditions that existed at the end of the year since the judgement is based on “fair value” at that date.
Do we allow merely looking at the market overall and qualitatively saying that the markets around the world have decreased and therefore we should be able to get to no-impairment? No, generally we require that the impairment analysis be done on an instrument by instrument basis and we don’t consider the general movements in the market.
An entity needs to develop an accounting policy to consider the meaning of significant. Often a company will select a benchmark for declines in fair value that it uses to assess impairment. It is important that this benchmark be set with common sense, taking into account what the users of the financial statements would consider to be significant. Most often, when companies are applying benchmark percentages we see companies with policies of around 20-30% declines. FYI, one other firm requires a benchmark of 20% and another requires 30%.
We also allow companies to use volatility in assessing whether a decline is significant. What does volatility represent? Volatility is the tendency for a stock’s value to fluctuate. Stocks with a higher volatility are considered riskier because their value changes more from day to day. Stocks with a lower volatility are more stable and therefore viewed as less risky.
Let’s consider two companies. Company A is a major established supermarket chain. On average the value of the company changes by 3% per day. Company B is a speculative mining company and its shares fluctuate on average 10% per day. We’d probably be willing to accept more of a drop in Company B’s shares before we said it was significant because Company B’s shares already have a tendency to fluctuate more.
It is important to note that where we use quantitative measures of volatility we always calculate them relative to fair value, not cost. So, an equity that had declined 80% with a volatility of 90% would be impaired. Volatility is a measure of how likely it is the stock will change from its current fair value and is not related to its original cost.
The company should disclose its policy for interpreting “significant”.
Volatility relative to current fair value
Decline consistent with market

36. Impairment AFS equity instruments Prolonged
Date
Impairment AFS equity instruments Prolonged
How do we define “prolonged”?
Length of time held
Judgement
How do we look at prolonged?
Can we consider the length of time we’ve already held the security? No, we don’t consider the length of time the security has already been held because that is not relevant to the consideration of what constitutes a prolonged period. That is, we wouldn’t say we use a prolonged period of 1 year for a security held for 5 years and a period of 3 years for a security held for 10 years.
We generally would expect that a client would have a policy of impairing equities with a fair value below cost for 12 months or more. Other firms have different views with one requiring a 6 month period and one a 9 month period.
The company should disclose its policy for interpreting “prolonged”.

37. Impairment Calculation - Example
Date
Impairment Calculation - Example
AFS equity investment
Year X0
Fair Value
100 X1 70 X2 68 X3 69
Impairment X1 = – 70 = 30
X2 = – 68 – 30 = 2
X3 = – 69 – 32 = (1)  no impairment in PL
Start with ORIGINAL cost
Further decline in value is assessed against the original cost
Let’s see how impairment for AFS equity instrument is calculated.
Company A holds an equity investment classified in AFS.
The investment purchased at 100 drops in value in year X1 to 70.
Company A evaluates this as a significant decline in value and determines that the investment is impaired.
At end of year X1, 30 is recognized in PL – the difference between cost of 100 and the fair value of 70.
At end of year X2, the fair value drops further to 68.
While compared to the current carrying value of 70, this may not be a significant decline in value, the impairment model under IAS 39 requires that impairment be assessed comparing the cost of 100 and the fair value of 68, rather than the carrying value of 70 and the fair value of 68.
Therefore, Company A determines that the investment is impaired and calculates the amount to be recognized in PL as the difference between cost of 100 and the fair value of 68 less the previous impairment recognized of 30, which leave a loss of 2 to be recognized in current PL.
At the end of year X3, the same logic would apply and the investment would most likely be deemed impaired, but the calculation of the impairment loss would result in a positive number and therefore there would be no impairment to be recognzised in PL.
This guidance is included in E 4.9 Impairment of non-monetary available for sale financial asset.
The focus here is that there is no new cost basis established when impairment is recognized. Decline in value is defined to compare to original cost – disregarding the impairment previously recognized.
This would cause most additional declines in fair value after impairment to be continuously recognized in PL as impairment under IAS 39.

38. Reclassification between categories
Date
Reclassification between categories
Held-to-maturity
Available-for-sale
Available-for-sale
Held-to-maturity
Held for trading
Loans and receivables
In this section, we will look at the circumstances in which an entity can transfer a financial asset from one category to another subsequent to initial recognition.
We have already seen that classification is not a free choice but is based on facts and the intent of management at the date of purchase. Transfers between categories after initial recognition are, therefore, required or permitted only in certain circumstances. The transfers that are permissible are shown above.
The first two transfers – from held-to-maturity to AFS and vice-versa have been in place since the introduction of IAS 39, but transfers out of AFS to loans and receivables and from held for trading category to other categories were brought in with effect from 1 July 2008 when IAS 39 was amended in response to the severe downturn experienced by the financial markets during 2008.
Reclassification out of the Fair value through profit or loss category for financial assets that were so designated on initial recognition is prohibited under any circumstances.
Let’s take a look at each of these transfers
Reclassification out of FVTPL designated on initial recognition is prohibited under any circumstances

39. Reclassification out of HTM to AFS - Tainting
Date
Reclassification out of HTM to AFS - Tainting
Entity sells more than an insignificant amount of HTM investments
Reclassify all investments to AFS at fair value.
Entire HTM portfolio is tainted.
Further classification not permitted for two years after sale.
Exceptions:
The sale is close to maturity.
Substantially all of the original principal collected before sale.
The sale is an isolated event outside the control of the entity.
We know that an entity can classify a financial asset as held-to-maturity only if it has the intent and the ability to hold a financial asset to maturity.
So if an entity’s actions cast doubt on its intent or ability to hold investments to maturity because, it sells or transfers more than an insignificant amount of such investments, the entity is forced to reclassify all its held-to-maturity investments as available-for-sale and measure them at fair value at the date of reclassification. The difference between fair value and previous carrying amount is recognised in equity.
As a result of the above, the entire held-to-maturity portfolio is deemed to be ‘tainted’ and the entity is prohibited from using the held-to-maturity category for two years. When the prohibition ends (at the end of the second financial year following the tainting), the portfolio becomes ‘cleansed’ and the entity is once more able to assert that it has the intent and the ability to hold the investments to maturity.
There are some exceptions to the tainting rules as shown.
The sale is so close to maturity (for example, less than three months from maturity) that changes in the market rate of interest would not significantly affect the financial asset’s fair value. Such sales would not cause tainting.
Where the entity has collected substantially all of the financial asset’s original principal through scheduled payments or pre-payments before it sells the asset, again this would not cause the HTM portfolio to be tainted.
The sale is an isolated event that is beyond the entity’s control, is non-recurring and could not have been reasonably anticipated by the entity. For example, a disaster scenario that is only remotely possible, such as a run on a bank or a similar situation affecting an insurance company would qualify as it is not something that the entity would have taken into account in deciding that it has the positive intent and the ability to hold the investment to maturity.

40. Reclassification out of AFS
Date
Reclassification out of AFS
To HTM :
Entity intends and has the ability to hold the loan to maturity.
When the tainted held-to-maturity portfolio has been ‘cleansed’ at the end of the second financial year following tainting.
To loans and Receivables:
The AFS asset meets the criteria to be classified as loans and receivables at the date of reclassification and the entity has the intention and the ability to hold the financial asset for the foreseeable future or until maturity.
Reclassification out of AFS to HTM is permissible in the following two cases as shown –
First , when the entity intends and has the ability to hold a loan, which was initially classified as AFS, to maturity.
Secondly, when the HTM portfolio has been ‘cleansed’ at the end of the second year following tainting, assets held in AFS category during the two year period may be transferred back to HTM.
Reclassification out of AFS to loans and receivables is similarly permitted if the AFS asset meets the definition of loans and receivables at the date of reclassification (for example, a loan with fixed or determinable payment that was previously quoted in an active market is no longer quoted at the date of reclassification following disappearance of an active market) and the entity intends and has the ability to hold the financial asset for the foreseeable future.
The transfer out of AFS to HTM or Loans and Receivables category is made at the fair value of the asset at the date of reclassification, which becomes the asset’s new amortised cost.

41. Reclassification out of Held for Trading
Date
Reclassification out of Held for Trading
To loans and receivables:
The Held for Trading asset meets the criteria to be classified as loans and receivables at the date of reclassification and the entity has the intention and the ability to hold the financial asset for the foreseeable future or until maturity.
To HTM or AFS
Transfer permitted only for assets that do not meet the definition of loans and receivables at the date of reclassification and only in ‘rare’ circumstances.
Reclassification out of Held for trading to loans and receivables is permissible if the definition of loans and receivables is met at the date of reclassification and the entity has the intention and the ability to hold the financial asset for the foreseeable future or until maturity.
However, where the definition of loans and receivables is not met at the date of reclassification, the transfer out of held for trading category to HTM or AFS can only be made in ‘rare’ circumstances. The IASB concluded that rare circumstances arise from a single event that is unusual and highly unlikely to recur in the near term. The IASB has also indicated that the deterioration of the financial markets that has occurred during the third quarter of 2008 is a possible example of rare circumstances.
Rare -- Single event that is unusual and unlikely to recur in the near term.

42. Classification drives measurement
Date
Conclusion
Key points to remember
Classification drives measurement
Mixed measurement model – fair value or amortised cost
Fair value hierarchy - quoted price best evidence of fair value
Impairment only if objective evidence
Reclassifications are permitted only in certain circumstances.
So that’s all I am going to say about non derivative financial assets.
Some of the key messages to take away from this session are:
Classification is a not a free choice – depends upon facts and intention of management. So it is essential to be able to correctly classify a financial asset as it affects subsequent measurement.
IAS 39 is based on a mixed measurement model – fair value vs amortised cost. HTM and loans and receivables are carried at amortised cost. Items classified as held for trading or designated voluntarily at fair value through profit or loss are carried at fair value. AFS assets are carried at fair value with gains and losses recognised in equity.
We have looked at fair value hierarchy. Quoted price in active markets is the best evidence of fair value. In the absence of an active market, fair value is determined using valuation models.
Impairment of financial assets is only recognised when there is objective evidence of impairment. The assessment must be made at each balance sheet date.
Reclassifications are permitted only in certain circumstances.

43. Date
Thank you!