ACC 203 CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS ____________________________________________________________________________ Module 5 FINANCIAL INSTRUMENTS Week 5 Assessments Answer the following questions: 1. What are financial instruments? PAS 32, paragraph 11, defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Thus, the term “financial instrument” encompasses a financial asset, a financial liability and an equity instrument. 2. What are the differences between financial assets and financial liabilities? Explain. Financial asset: any asset that is: • • • 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 with another entity under conditions that are potentially favorable to the entity 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 ❖ 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. For this purpose, the entity's own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments ❖ puttable instruments classified as equity or certain liabilities arising on liquidation classified by IAS 32 as equity instruments Financial liability: any liability that is: • • a contractual obligation: ❖ to deliver cash or another financial asset to another entity ❖ to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity 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 ❖ 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. For this purpose, the entity's own equity instruments do not include: instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments; puttable instruments classified as equity or certain liabilities arising on liquidation classified by IAS 32 as equity instruments 3. What are the classifications of financial assets? Explain each. Classification of financial assets IAS 39 requires financial assets to be classified in one of the following categories: • Financial assets at fair value through profit or loss. This category has two subcategories: ❖ Designated. The first includes any financial asset that is designated on initial recognition as one to be measured at fair value with fair value changes in profit or loss. ❖ Held for trading. The second category includes financial assets that are held for trading. All derivatives (except those designated hedging instruments) and financial assets acquired or held for the purpose of selling in the short term or for which there is a recent pattern of short-term profit taking are held for trading. • Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on initial recognition as available for sale or any other instruments that are not classified as as (a) loans and receivables, (b) held-to-maturity investments or (c) financial assets at fair value through profit or loss. AFS assets are measured at fair value in the balance sheet. Fair value changes on AFS assets are recognized directly in equity, through the statement of changes in equity, except for interest on AFS assets (which is recognized in income on an effective yield basis), impairment losses and (for interest-bearing AFS debt instruments) foreign exchange gains or losses. The cumulative gain or loss that was recognized in equity is recognized in profit or loss when an available-for-sale financial asset is derecognized. • Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than held for trading or designated on initial recognition as assets at fair value through profit or loss or as available-for-sale. Loans and receivables for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, should be classified as available-forsale. Loans and receivables are measured at amortized cost. • Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments that an entity intends and is able to hold to maturity and that do not meet the definition of loans and receivables and are not designated on initial recognition as assets at fair value through profit or loss or as available for sale. Held-to-maturity investments are measured at amortized cost. If an entity sells a held-to-maturity investment other than in insignificant amounts or as a consequence of a non-recurring, isolated event beyond its control that could not be reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years. Held-to-maturity investments are measured at amortized cost. 4. What are the classifications of financial liabilities? Explain each. Classification of financial liabilities IAS 39 recognizes two classes of financial liabilities: • Financial liabilities at fair value through profit or loss. The category of financial liability at fair value through profit or loss has two subcategories: ❖ Designated. a financial liability that is designated by the entity as a liability at fair value through profit or loss upon initial recognition ❖ Held for trading. a financial liability classified as held for trading, such as an obligation for securities borrowed in a short sale, which have to be returned in the future • Other financial liabilities measured at amortized cost using the effective interest method 5. What are the proper measurement for financial assets, and for financial liabilities, respectively? Subsequent measurement of financial assets IFRS 9 divides all financial assets that are currently in the scope of IAS 39 into two classifications - those measured at amortized cost and those measured at fair value. Where assets are measured at fair value, gains and losses are either recognized entirely in profit or loss (fair value through profit or loss, FVTPL), or recognized in other comprehensive income (fair value through other comprehensive income, FVTOCI). For debt instruments the FVTOCI classification is mandatory for certain assets unless the fair value option is elected. Whilst for equity investments, the FVTOCI classification is an election. Furthermore, the requirements for reclassifying gains or losses recognized in other comprehensive income are different for debt instruments and equity investments. The classification of a financial asset is made at the time it is initially recognized, namely when the entity becomes a party to the contractual provisions of the instrument. [IFRS 9, paragraph 4.1.1] If certain conditions are met, the classification of an asset may subsequently need to be reclassified. Debt instruments A debt instrument that meets the following two conditions must be measured at amortized cost (net of any write down for impairment) unless the asset is designated at FVTPL under the fair value option: • Business model test: The objective of the entity's business model is to hold the financial asset to collect the contractual cash flows (rather than to sell the instrument prior to its contractual maturity to realize its fair value changes). • Cash flow characteristics test: The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Assessing the cash flow characteristics also includes an analysis of changes in the timing or in the amount of payments. It is necessary to assess whether the cash flows before and after the change represent only repayments of the nominal amount and an interest rate based on them. The right of termination may for example be in accordance with the cash flow condition if, in the case of termination, the only outstanding payments consist of principal and interest on the principal amount and an appropriate compensation payment where applicable. In October 2017, the IASB clarified that the compensation payments can also have a negative sign. A debt instrument that meets the following two conditions must be measured at FVTOCI unless the asset is designated at FVTPL under the fair value option: • Business model test: The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. • Cash flow characteristics test: The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. All other debt instruments must be measured at fair value through profit or loss (FVTPL). Fair value option Even if an instrument meets the two requirements to be measured at amortized cost or FVTOCI, IFRS 9 contains an option to designate, at initial recognition, a financial asset as measured at FVTPL if doing so 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 recognizing the gains and losses on them on different bases. Equity instruments All equity investments in scope of IFRS 9 are to be measured at fair value in the statement of financial position, with value changes recognized in profit or loss, except for those equity investments for which the entity has elected to present value changes in 'other comprehensive income'. There is no 'cost exception' for unquoted equities. 'Other comprehensive income' option If an equity investment is not held for trading, an entity can make an irrevocable election at initial recognition to measure it at FVTOCI with only dividend income recognized in profit or loss. [IFRS 9, paragraph 5.7.5] Measurement guidance Despite the fair value requirement for all equity investments, IFRS 9 contains guidance on when cost may be the best estimate of fair value and also when it might not be representative of fair value. Subsequent measurement of financial liabilities IFRS 9 doesn't change the basic accounting model for financial liabilities under IAS 39. Two measurement categories continue to exist: FVTPL and amortized cost. Financial liabilities held for trading are measured at FVTPL, and all other financial liabilities are measured at amortized cost unless the fair value option is applied. Fair value option IFRS 9 contains an option to designate a financial liability as measured at FVTPL if: • doing so 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 recognizing the gains and losses on them on different bases • the liability is part or a group of financial liabilities or financial assets and financial liabilities that 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. A financial liability which does not meet any of these criteria may still be designated as measured at FVTPL when it contains one or more embedded derivatives that sufficiently modify the cash flows of the liability and are not clearly closely related. IFRS 9 requires gains and losses on financial liabilities designated as at FVTPL to be split into the amount of change in fair value attributable to changes in credit risk of the liability, presented in other comprehensive income, and the remaining amount presented in profit or loss. The new guidance allows the recognition of the full amount of change in the fair value in profit or loss only if the presentation of changes in the liability's credit risk in other comprehensive income would create or enlarge an accounting mismatch in profit or loss. That determination is made at initial recognition and is not reassessed. Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss, the entity may only transfer the cumulative gain or loss within equity.
