Financial Instruments:
PSAK 71
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Financial Instruments
– Definition
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Definition – Financial Instrument
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.
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Definition – Financial Asset
Financial asset is
•
•
•
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cash
an equity instrument of another entity
a contractual right:
• to receive cash or another financial asset from another entity
• to exchange financial assets or financial liabilities under favorable conditions a
contract that will or may be settled in the entity's own equity instruments and is
• a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity's own equity instruments; or
• a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity's own
equity instruments
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Exercise- identify financial assets?
Instruments
1. Bank Balance
2.Shares of subsidiary companies
3. Advance given for purchase of goods
4. Investment in perpetual debt carrying interest at fixed rate
5. Prepaid expense
6. Tax assets
7. Gold bullion: Whether a financial instrument (like cash) or a
commodity
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Yes
No
Definition – Financial Liability
Financial liability is
•
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A contractual obligation
•
to deliver cash or other financial assets to another entity
•
to exchange financial assets/ liabilities under potentially unfavourable
conditions; or
•
a contract that will or may be settled in the entity’s own equity instruments and is:
•
a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
•
a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s
own equity instruments
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Exercise- identify financial liablities?
Instruments
1. Tax liability
2. Finance lease obligations
3. Non-refundable revenue received in advance
4. Non-refundable advance received against sale of government
securities
5. Liability for damages under a lawsuit
6. Deferred Revenue
7. Financial guarantees given
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Yes
No
Scope under IFRS 9
Out of scope
Subsidiaries, associates &
joint ventures
Employee benefits
Share-based
payments
Leases
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Within Scope
Debt & equity investments
Originated loans
Own debt
Financial guarantees
Derivatives
Interest rate swaps
Currency forwards/swaps
Purchased written options
Commodity contracts
Collars/caps
Own equity instruments
Insurance contracts
Own use commodity
contracts
Recognition and initial Measurement
•
Recognise a financial asset or liability when and only when the entity becomes party
to the contractual provisions of the instrument
•
Initial measurement:
– At fair value (in some cases plus/minus incremental directly attributable
transaction costs)
– transaction price is often the best indicator of fair value on initial recognition
– Derivatives likely to have a low or zero cost at initial recognition
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Classification & Measurement
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Classification and measurement–
Financial Assets
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Categories of financial assets – based on subsequent
measurement
2
1
Fair Value
Amortised
cost
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2A
2B
Fair value
through OCI
Fair value
through P&L
Application to investments in debt securities
Debt investments
Derivative investments
Contractual cash flows solely
payments of principal and interest
(A)
Fail
Pass
Fail
Business model (BM) test
(at entity level)
(B)
1
Equity investments
Hold to collect
2
contractual
cash flows
Fail
Held for trading?
BM to collect Neither
contractual
cash flows and 1 or 2
sell asset
No
Yes
Fair value option elected?
No
Yes
No
Amortised
cost
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Yes
No
FVOCI (with
recycling)
FVOCI option
elected?
FVPL
FVOCI (no
recycling)
Application to derivatives
Debt investments
Derivative investments
Equity investments
Contractual cash flows solely
payments of principal and interest
Fail
Pass
Fail
Business model (BM) test
(at entity level)
1
Hold to collect
contractual
cash flows
2
Fail
Held for trading?
BM to collect
contractual
cash flows
and sell asset
Neithe
r 1 or
2
No
Yes
Fair value option elected?
No
Yes
No
Amortised
cost
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Yes
No
FVOCI (with
recycling)
FVOCI option
elected?
FVPL
FVOCI (no
recycling)
Application to equity investments
Debt investments
Derivative investments
Equity investments
Contractual cash flows solely
payments of principal and interest
Fail
Pass
Fail
Business model (BM) test
(at entity level)
1
Hold to
collect
contractual
cash flows
2
No
Amortised
cost
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Held for trading?
BM to collect
contractual
cash flows
and sell asset
Fair value option elected?
Neithe
r 1 or
2
No
Yes
No
Yes
FVOCI option
elected?
Yes
No
FVOCI (with
recycling)
Fail
FVPL
FVOCI (no
recycling)
Financial assets- at amortised cost
Examples of financial instrument that are likely to meet the criteria and measured at
amortised cost :•
Trade receivables
•
loans receivables
•
investment in government banks which are not held for trading
•
investment in term deposits at standard interest rates
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The concept of amortised cost – Financial Assets
Amortised
cost
=
Amount
initially
recognised
-
Principal
repayments
+/-
cumulative
amortisation
-
Impairment
using EIR
Effective interest rate is the rate that exactly discounts the expected stream of future cash
payments or receipts through maturity to the net carrying amount at initial recognition.
No option to use straight line method
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Business model
What it is…
• a matter of fact and not merely an assertion
• determined by entity’s key management personnel (KMP)
• determined at a level that reflects how groups of financial assets are managed together
to achieve a particular business objective
• observable through the activities that the entity undertakes to achieve the objective of the
business model
• a single entity may have more than one business model for managing its financial
instruments
What it is not…
• does not depend on management’s intentions for an individual instrument
• need not be determined at the reporting entity level
• not determined on the basis of scenarios that the entity does not reasonably expect to occur
(‘worst case’ or ‘stress case’ scenarios)
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Business model
'Hold to collect' business model
(Amortized Cost)
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'Hold to collect' business model
Objective
Factors to
consider
Examples of
exceptions
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• collect contractual payments over life of the instrument
• entity manages the assets held within the portfolio to collect those particular
contractual cash flows
Frequency of
sales in prior
periods
Value of sales in
prior periods
Timing of sales in
prior periods
Reason for such
sales
Expectations
about future
• policy to sell assets when there is an increase in the asset's credit risk or to
manage credit concentration risk
• sales close to maturity of the assets where proceeds approximate remaining
contractual cash flows
• increased sales in a particular period if the entity can explain the reasons for the
sales
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'Hold to collect' business model - Example
Sales in a held-to-collect business model
Example
Entity A has a portfolio of financial assets which is part of a held-to-collect business model. Due
to change in legal requirement, entity A has sell some of the assets and has to significantly
rebalance its portfolio.
Whether, business model needs to be assessed or changed
Solution
No, as the selling activity is considered an isolated or one time event.
However, if the rules require entity A to routinely sell financial assets from its portfolio and the
value of assets sold is significant, entity A's business model would not be held-to-collect.
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Business model
'Hold to collect and sell' business model
(FVTOCI)
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'Hold to collect and sell' business model (B-2)
• KMP's decision – both:
‒ collecting contractual cash flows and
‒ selling financial assets
are integral to achieving the objective of the business model
• compared to 'hold to collect' business model, this business model will typically involve
greater frequency and value of sales
•
no threshold for the frequency or value of sales
•
Examples of objectives consistent with 'hold to collect and sell' business model:
‒ manage everyday liquidity needs
‒ maintain a particular interest yield profile
‒ match the duration of the financial assets to the duration of the liabilities that those
assets are funding
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'Hold to collect and sell' business model –
Examples
❑ A bank holds financial assets to meet its everyday liquidity needs
❑ The bank seeks to minimise the costs of managing its liquidity needs and therefore actively
manages the return on the portfolio
❑ The bank typically holds some financial assets to collect contractual cash flows and sells
others to reinvest in higher yielding assets or to better match the duration of liabilities
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Business model
'Other' business models – the residual
Category (FVTPL)
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'Other' business models – the residual category
(B – 3)
• Financial assets are measured at fair value through profit or loss if they are not held within a
business model whose objective is:
‒ to hold assets to collect contractual cash flows, or
‒ achieved by both collecting contractual cash flows and selling financial assets
•
Examples
− assets managed with the objective of realising cash flows through sale
− a portfolio that is managed, and whose performance is evaluated, on a fair value basis
− a portfolio that meets the definition of ‘held-for-trading’
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Contractual cash flow characteristics’
test
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'Solely payment of principal and interest' ('SPPI')
test– (A)
• Contractual cash flows that are SPPI are consistent with a basic lending arrangement
• Principal is the fair value of the financial asset at initial recognition – principal amount may
change over the life of the financial asset (for example, if there are repayments of principal)
• Interest elements – consideration consistent with basic lending arrangement:
‒ time value of money
‒ credit risk
‒ other basic lending risks (example, liquidity risk)
‒ costs associated with holding the financial asset for a particular period of time
‒ profit margin that is consistent with a basic lending arrangement
•
Assessment done in the currency in which financial asset is denominated
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SPPI test – Examples of terms consistent
with basic lending arrangement
1.
a bond with a stated maturity date where principal and interest are linked (on a nonleveraged basis) to an inflation index of the currency in which the instrument is issued
2.
a variable rate instrument with a stated maturity date that permits the borrower to choose
the market interest rate on an ongoing basis
3.
a bond with a stated maturity date which pays a variable market interest rate subject to a
cap
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SPPI test – Examples of terms inconsistent
with basic lending arrangement
1.
a bond that is convertible into a fixed number of equity instruments of the issuer.
2.
a loan that pays an inverse floating interest rate (ie the interest rate has an inverse
relationship to market interest rates)
3.
derivatives
4.
investments in equity instruments
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Summary of effect of different classification
categories
Category
Balance sheet
Statement of comprehensive income
Amortised cost
•
•
amortised cost
impairment
allowance
•
FVOCI
•
fair value
•
•
•
presented in P&L
− interest using effective interest rate (EIR)
− initial impairment allowance and subsequent
changes
changes in FV in OCI
presented in P&L:
− interest calculated using EIR
− initial impairment allowance and subsequent
changes (offsetting entry presented in OCI)
− FOREX gains and losses
cumulative FV gains/losses recycled on derecognition or
reclassification
FVPL
•
fair value
change in FV presented in P&L
Equity FVOCI
•
fair value
•
•
•
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changes in fair value presented in OCI
no reclassification to P&L on disposal
dividends recognised in P&L
Classification and measurement–
Financial liabilities
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Classification and measurement principles –
Financial liabilities
1
2
FVTPL
Amortised
cost
•
Liabilities held for trading (includes all derivatives) are measured at fair value
•
•
Contingent consideration recognised by an acquirer in a business combination
Liabilities designated using the FV option
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Classification and measurement principles –
Financial liabilities
•
34
1
2
FVTPL
Amortized
Cost
All liabilities not covered under FVTPL
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Financial liabilities – Fair Value Option
1. Eliminates or significantly reduces an accounting mismatch
– including a "mismatch" related to a non-financial asset/liability
2. Part of a group of financial instruments managed on a FV basis
– only if evaluated on a FV basis in accordance with a documented risk management
strategy, and
– FV basis information about the group is provided to key management
In order to apply the option to designate a financial liability at initial recognition as at fair
value through profit or loss, an entity needs to demonstrate that it falls within one (or both)
of these two circumstances.
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Subsequent measurement financial liabilities
Subsequent measurement – Financial liabilities
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At fair value through
Profit or loss
Carried at fair value,
changes taken to
income statement
Other Liabilities
Carried at amortised
cost
The concept of amortised cost – Financial
Liability
Amortised
cost
=
Amount
cumulative
Principal
+/- amortisation
initially
repayments
recognised
using EIR
Use effective interest rate method
No option to use straight line method
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Hedge accounting
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Introduction
Objective of hedge accounting is to reduce variability in cash flows from
(i) Assets/ liabilities on balance sheet
(ii) Future transactions
Without Hedge Accounting
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With Hedge Accounting
Fixed rate debt
Interest rate
swap
Fixed rate debt
(hedged item)
Interest rate swap
(hedging
instrument)
Amortised cost
Fair value
Risk-adjusted
value
Fair value
Loss or gain
on the
hedged item
Gain or loss
on the
hedging
instrument
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Definition - Hedged items
A hedged item is defined as an asset, liability, firm commitment, highly probable forecast
transaction or net investment in a foreign operation that
a. exposes the entity to risk of changes in fair value or future cash flows and
b. is designated as being hedged
Hedged items
Recognized asset or
liability
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Unrecognized firm
commitment
Highly probable
forecast transaction
Net investment in a
foreign operation
Definition - Hedged items
Is a firm commitment same as a forecast transaction?
- No,
•
A forecast transaction -an uncommitted but anticipated future transaction
•
A firm commitment- a binding agreement for the exchange of a specified quantity of resources at a
specified price on a specified future date or dates
How can financial items be hedged?
– In entirety, portion, proportion, or part
•
A financial asset or financial liability can be hedged in its entirety, and can also be designated as a
hedged item:
a. for the risks associated with only a portion of its cash flows or fair value, or
b. for a specific risk (a separately identifiable component of total risk)
Can a financial item also be hedged for a part of its life?
– Yes, for example, a 10 year loan can be hedged only for a 5 year period
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Definition - Hedged items
Can only financial items be hedged?
– No, non-financial items can also be hedged
•
•
A non-financial asset or non-financial liability can also be designated as a hedged item.
However, a non-financial item can be hedged only
✓ for foreign currency risks, or
✓ each identifiable risk provided the effectiveness can be reliably measured.
•
This is because it is generally difficult to measure the change in cash flows or fair value
associated with a specific risk for a non-financial item, other than foreign currency risk, and
thereby hedge effectiveness that is one of the conditions for hedge accounting.
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Definition – Hedging instruments
A hedging instrument is defined as:
a. designated derivative or
b. [for a hedge of the risk of changes in foreign currency exchange rates only], a designated
non-derivative financial asset or non-derivative financial liability
whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a
designated hedged item.
Hedging Instruments
Qualifying
instruments
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Derivatives
•
•
•
•
Futures/Forwards
Swaps
Options
and other instruments
Cash instruments
only for hedge of FX risk
Hedge accounting – types of hedge
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Fair value hedge
Cash flow hedge
Net investment hedge
Hedge of exposure to
changes in fair value of a
recognised asset or liability;
an unrecognised firm
commitment; or an identified
portion of any of the above
two, that is attributable to a
particular risk.
Hedge of exposure to
variability in cash flows that is
attributable to a particular risk
associated with a recognised
asset or liability or a highly
probable forecast transaction
and could affect profit or loss.
E.g. An entity with fixed rate
debt converts the debt into a
floating rate using an
interest rate swap.
E.g. An entity with floating
rate debt converts the rate on
the debt to a fixed rate using
an interest rate swap.
Hedge of a net investment
in a foreign operation
(including a hedge of a
monetary item that is
accounted for as part of the
net investment), as defined
in FRS 21 - ‘The effect of
changes in foreign
exchange rates’ is
accounted for similarly to a
cash flow hedge.
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Fair value hedge accounting
Hedged item
Remeasurement to fair
value in respect of
hedged risk
recognised in profit
or loss
Hedging instrument
• Derivative FVTPL
(regular measurement)
• Non-derivative
monetary item remeasurement in profit
or loss
Solves accounting mismatch
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Fair value hedge accounting - Example
D Limited is an Irish company that prepares its financial statements to 31 December each year. On 1 January
2011 D Limited purchased a fixed interest bond for €100. The company has decided to account for the
investment as FVOCI financial asset. The fair value of the bond on 31 December 2011 and 2012 was €110
and €105 respectively. On 31 December 2011 D Limited purchased a derivative, and its fair value had
increased by €4 on 31 December 2012.
Requirement
Assuming that the derivative asset is designated as a hedge from 1 January 2012, explain the accounting
treatment in 2011 and 2012.
Solution
Year ended 31 December 2011:
The increase in fair value of the investment will be taken to equity and the security will be recorded at its fair
value of €110 in the statement of financial position at 31 December 2011.
Year ended 31 December 2012:
The decline in value of €5 on the security will be taken to the P&L. Increase in value of €4 derivative will be
taken to P&L. At 31 December 2012, the statement of financial position will show a security at €105, a
derivative at €4, with the net effect on the P&L being €1.
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Cash flow hedge accounting
Hedged item
Hedging instrument
•
Regular recognition and
measurement
•
Measured at fair value with:
Effective portion of changes in
its fair value recognised in OCI
and reclassified to profit or loss
when hedged item affects profit
or loss
Ineffective portion of changes in
its fair value recognised in profit
or loss
Solves accounting mismatch
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Cash flow hedge accounting - Example
A Ltd borrows a variable rate loan on Jan 1, 2018. The variable rate is LIBOR + 2%.
Initial LIBOR is 5%. A enters into a pay fixed- receive variable swap.
Terms of swap:
Notional amount
A pays
A receives
Pay and receive dates
Variable reset
Period
$100 million
5.5%
LIBOR
Annual (Dec 31)
Annual (Dec 31)
LIBOR
Swap Fair
Value
Dec 2018
6.57%
4,068,000
Dec 2019
7.7%
5,793,000
Dec 2020
6.79%
2,303,000
Dec 2021
5.76%
241,000
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Cash flow hedge accounting - Example
The effect of the debt swap is
that A pays and recognises
interest expenses a at 7.5%
through the term of the debt.
Pays 5.5% under
Swap +2%
credit spread
Therefore swap will be
effective if A achieves the 7.5%
debt and swap accrual.
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Net investment hedge accounting
Hedging instrument
(Foreign currency
loan)
Hedged item
(Foreign operation)
Measured at fair value with:
Regular measurement per
PSAK 10:
• Foreign exchange
differences recognised in
OCI
•
•
Effective portion of foreign
exchange differences recognised
in OCI and reclassified to profit
or loss when the hedged item
affects profit or loss
Ineffective portion of changes in
its fair value recognised in profit
or loss
Solves accounting mismatch
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Net investment hedge accounting - Example
•
•
Entity A, a GBP functional currency entity, has a net investment in a EUR foreign operation.
In its consolidated accounts, Entity A hedges the net investment with a 5 year EUR term loan and
applies hedge accounting.
Accounting Impact
•
•
•
•
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All foreign currency gains and losses on retranslating the net assets of the foreign operation are
recognised in other comprehensive income.
These are calculated by retranslating the net investment at the relevant spot rate.
The effective portion of the gains and losses on the hedging instrument (the loan) are also recognised in
other comprehensive income.
These gains and losses remain in the hedging reserve until disposal or partial disposal of the foreign
operation when they are reclassified to profit or loss.
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Hedge Accounting: Risk management strategy and
objective
Risk management strategy
•
•
•
•
•
•
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Established at a high level (e.g.,
entity)
Identifies risks (in general) and how
entity responds to them
Typically in place for longer period
May include flexibility
Often a formal policy document
Part of hedge documentation
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Risk management objective
Applies at level of particular
hedging relationship
How a particular hedging
instrument is used to hedge a
particular exposure designated
as the hedged item
Part of hedge
documentation
Hedge Accounting: Effectiveness Assessment
Economic relationship
• Between hedged item and hedging instrument
• Systematic change (opposite direction) in response to same or economically
related underlyings
Credit risk does not dominate
• Credit risk does not frustrate economic relationship
• Credit risk can arise from hedging instrument and hedged item
Hedge ratio
• Consistent with actual ratio used by entity
• Different ratio only if accounting outcome would be inconsistent with purpose of
hedge accounting
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Thank you
Questions
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