IFRS/IAS Summary

IAS-39 - Financial Instruments: Recognition and Measurement (Revised Dec 2003)

Financial Instrument Defined

A financial instrument is a contract that results in a financial asset of one enterprise and a financial liability or equity instrument of another enterprise. A financial asset is cash, a contractual right to receive cash or another financial asset, a contractual right to exchange financial instruments with another enterprise on terms that are potentially favourable, or an equity instrument of another enterprise. A financial liability is an obligation to deliver cash or another financial asset or an obligation to exchange financial instruments with another enterprise on terms that are potentially unfavourable. [IAS 39.8] The same definition is used in IAS 32.

Common examples of financial instruments include:

  • Cash
  • Demand and time deposits
  • Commercial paper
  • Accounts, notes, and loans receivable and payable
  • Debt and equity securities. These are financial instruments from the perspectives of both the holder and the issuer. This category includes investments in subsidiaries, associates, and joint ventures
  • Asset backed securities such as collateralised mortgage obligations, repurchase agreements, and securitised packages of receivables
  • Derivatives, including options, rights, warrants, futures contracts, forward contracts, and swaps.
  • Leases
  • Rights and obligations with insurance risk under insurance contracts
  • Employers' rights and obligations under pension contracts

Some contracts that themselves are not financial instruments may nonetheless have financial instruments embedded in them. For example, a contract to purchase a commodity at a fixed price for delivery at a future date has embedded in it a derivative that is indexed to the price of the commodity.

Derivatives Defined

A derivative is a financial instrument:

  • Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index,
  • That requires little or no initial net investment, and
  • That is settled at a future date.

 

Examples of Derivatives
Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual delivery of the item specified in the contract, or by a net cash settlement.

Interest Rate Swaps and Forward Rate Agreements: Contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates.

Futures: Contracts similar to forwards but with the following differences: Futures are generic exchange-traded, whereas forwards are individually tailored. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash settlement.

Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. These can be individually written or exchange-traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option.

Caps and Floors: These are contracts sometimes referred to as interest rate options. An interest rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall below a predetermined rate.

Scope

IAS 39 applies to all financial instruments except: [IAS 39.1]

  • investments in subsidiaries [see IAS 27], investments in equity method associates [see IAS 28], and investments in joint ventures [see IAS 31]
  • rights and obligations under leases [see IAS 17], though the derecognition provisions of IAS 39 do apply to lease contracts
  • employer's assets and liabilities under employee benefit plans [see IAS 19]
  • rights and obligations under insurance contracts [IASB is currently working on a project on Accounting for Insurance Contracts]
  • equity instruments issued by the reporting enterprise [see IAS 32]
  • financial guarantee contracts
  • contingent consideration in a business combination [see IAS 32]
  • weather derivatives that pay off based on climatic or similar physical variables.

Classification as Liability or Equity

Since IAS 39 does not address accounting for equity instruments issued by the reporting enterprise but it does deal with accounting for financial liabilities, classification of an instrument as liability or as equity is critical. IAS 32, Financial Instruments: Disclosure and Presentation, addresses the classification question.

Initial Recognition

IAS 39 requires that all financial assets and all financial liabilities be recognised on the balance sheet. That includes all derivatives. Historically, in many parts of the world, derivatives have not been recognised on company balance sheets. The argument has been that at the time the derivative contract was entered into, there was no amount of cash or other assets paid. Zero cost justified non-recognition, notwithstanding that as time passes and the value of the underlying variable (rate, price, or index) changes, the derivative has a positive (asset) or negative (liability) value.

IAS 39 requires that purchases and sales of each broad category of financial assets be accounted for consistently using either trade date or settlement date accounting. If settlement date accounting is used, IAS 39 requires recognition of certain value changes between trade and settlement dates.

Initial Measurement

Under IAS 39, financial assets and financial liabilities are initially measured at cost, which is the fair value of whatever was paid or received to acquire the financial asset or liability. Cost includes transaction costs such as commissions, fees, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include premium or discount, financing costs, or allocations of internal administrative or holding costs. [IAS 39.17 and 39.66]

Subsequent Measurement - Financial Assets

All recognised financial assets fall into one of four IAS 39 categories:

1. Originated loans and receivables. These are loans and receivables originated by an enterprise and not held for trading. The enterprise need not demonstrate intent to hold originated loans and receivables to maturity.

2. Held-to-maturity investments. These are other fixed maturity investments, such as debt securities and mandatorily redeemable preferred shares, that an enterprise intends and is able to hold to maturity. Because this classification depends on management intent rather than objective evidence, IAS 39 imposes a somewhat punitive burden. If an enterprise actually sells a held-to-maturity investment other than in a circumstance that could not be anticipated or in insignificant amounts, all of its other held-to-maturity investments must be reclassified as available-for-sale (category 4 below) for the current and next two financial reporting years). [IAS 39.83]

3. Financial assets held for trading. These are financial assets acquired for the purpose of generating a profit from short-term fluctuations in price. For this purpose, derivative assets are always deemed held for trading (unless they are designated as hedging instruments - see discussion later in this chapter).

4. Available-for-sale financial assets. These are all financial assets that are not in one of the above three categories. This includes all investments in equity instruments that are not held for trading.

Principles for measuring each of the four categories of financial assets subsequent to their acquisition under IAS 39 are as follows [IAS 39.69-79]:

Originated loans and receivables that are not held for trading are measured at amortised cost, less reductions for impairment or uncollectibility. Amortised cost means after amortisation of premium or discount arising at initial acquisition using the effective interest method.

Held-to-maturity investments are measured at amortised cost, less reductions for impairment or uncollectibility.

Financial assets held for trading are measured at fair value, with changes in fair value reported in net profit or loss for the period.

Available-for-sale financial assets are measured at fair value - with a measurement reliability exception that IASC expects to be rare (see next paragraph). For available-for-sale financial assets that are remeasured to fair value, an enterprise will have a single, enterprise-wide option to adopt one or the other of the following accounting policies:

  • Recognise fair value changes in net profit or loss for the period.
  • Recognise the fair value changes directly in equity until the financial asset is sold, at which time the realised gain or loss is reported in net profit or loss.

The only exception to fair value measurement of available-for-sale assets is if a reliable estimate of fair value cannot be made, in which case the basis of measurement is cost. Quoted market price in an active market is the best measure of fair value. However, the fact that a debt or equity security is not quoted in an active market does not automatically mean that it escapes the fair valuation requirement of IAS 39. Indeed, IAS 39 states a presumption that 'fair value can be reliably determined for most financial assets classified as available for sale or held for trading'. And it provides guidance for determining fair value in the absence of quoted prices.

Fair value does not include transaction costs. And transaction costs that may be incurred on sale are not deducted in measuring the fair value of a financial asset. Therefore, if a financial instrument is acquired at a cost of 100 plus transaction costs of 2, it is initially measured at total cost of 102. If at the subsequent measurement date the quoted market price is 100 and transaction costs of 3 would be incurred on sale of the asset, it would be measured at 100 and a loss of 2 would be recognised. [IAS 39.69]

The following table summarises the classification and measurement scheme for financial assets under IAS 39:

IAS 39 Category of Financial Asset Description Measurement Basis
Originated loans and receivables Loans and receivables created by an enterprise by providing money, goods, or services directly to the debtor Amortised cost, subject to impairment recognition
Held-to-maturity investments Fixed maturity investments that the enterprise intends and is able to hold to maturity Amortised cost, subject to impairment recognition
Available for sale financial assets - normal case Includes:
  • Fixed maturity investments that the enterprise either does not intend or is not able to hold to maturity·
  • Equity investments with a quoted market price·
  • Equity investments with no quoted market price but able to estimate fair value
Fair value. Enterprise has a one-time, enterprise-wide choice of reporting changes in fair value (a) in net profit or loss or (b) in equity until the asset is sold or otherwise disposed of, at which time the cumulative gain or loss is reported in net profit or loss.
Available for sale financial assets - unusual Equity investments with no quoted market price and the enterprise is not able to estimate fair value Cost subject to impairment recognition
Financial assets held for trading Financial assets acquired for the purpose of generating a profit from short term fluctuations in price. This includes all derivative assets and liabilities. Fair value, changes in fair value in net profit or loss

Subsequent Measurement - Financial Liabilities

After acquisition most financial liabilities are measured at original recorded amount less principal repayments and amortisation of discounts and premiums. Only derivatives with a negative market value and liabilities held for trading (such as an obligation for securities borrowed in a short sale, which have to be returned in the future) are remeasured to fair value. [IAS 39.93]

Derecognition (Removal) of Financial Assets and Liabilities

IAS 39 establishes conditions for determining when control over a financial asset or liability has been transferred to another party and, therefore, should be removed from the balance sheet (derecognised). For financial assets, derecognition is normally appropriate if:

  • The transferee has the right to sell or pledge the asset; and
  • The transferor does not have the right to reacquire the transferred assets. However, such a right does not prevent derecognition if either the asset is readily obtainable in the market or the reacquisition price is fair value at the time of reacquisition. [IAS 39.35-43]

With respect to derecognition of liabilities, the creditor must legally release the debtor from primary responsibility for the liability either judicially or contractually, to derecognise the liability. [IAS 39.57]

If part of a financial asset or liability is sold or extinguished, the carrying amount is split based on relative fair values. If fair values are not determinable, IAS 39 prescribes a cost recovery approach to profit recognition.

Although financial guarantees are generally excluded from the scope of IAS 39, a guarantee obligation may have to be recognised in connection with a derecognition transaction in which the seller guarantees the collectability of a financial asset that has been sold. If a guarantee is recognised as a liability, thereafter it is remeasured to fair value until it expires (there is a reliability exception if fair value cannot be measured reliably).

Impairment of Financial Assets

If it is probable that the holder of a financial asset that is carried at amortised cost (loans, receivables, and held-to-maturity investments) will not be able to collect all of the principal and interest amounts due according to the original contractual terms, IAS 39 requires that an impairment or bad debt loss be recognised. The impairment calculation compares the carrying amount of the financial asset with the discounted present value of the currently estimated amounts and timings of payments. Thus, impairment is recognised if any interest or principal payments are reduced, forgiven, or delayed. The financial instrument's original effective interest rate is the rate to be used for discounting. Any impairment loss is charged to net profit or loss for the period. Impairment or uncollectability must be evaluated individually for material financial assets. A portfolio approach may be used for items that are individually small. [IAS 39.109]

Once impairment has been recognised, if the fair value of the financial asset increases in a subsequent period such that the impairment loss is reduced or eliminated, a reversal of the impairment loss is recognised, up to what the amortised-cost carrying amount would have been at the time of reversal. [IAS 39.114]

Impairment is also an issue for a financial asset carried at fair value, particularly if the fair value change is reported directly in equity. IAS 39 requires that impairment be assessed for these financial assets as well and, if impaired, any loss reported in equity is charged against net profit or loss. [IAS 39.117]

Collateral

Though IAS 39 as originally adopted had required a recipient of collateral to recognise collateral received as an asset and the obligation to repay the collateral as a liability in certain cases, in late 2000 IASC amended IAS 39 to substitute a note disclosure requirement for that accounting rule. The recipient will recognise collateral received in cash. [IAS 39.170]

Hedge Accounting

Hedging, for accounting purposes, means designating a derivative financial instrument as an offset in net profit or loss, in whole or in part, to the change in fair value or cash flows of a hedged item. A non-derivative financial instrument may also be a designated hedging instrument, but only with respect to hedges of foreign currency risks. The designation must be in writing, up front (no retrospective designations), and be consistent with an established risk management strategy. In essence, under IAS 39 hedge accounting is not mandatory. If an enterprise does not want to use hedge accounting, it simply does not designate a hedging relationship.

Hedge accounting is permitted under IAS 39 in certain circumstances, provided that the hedging relationship is: [IAS 39.142]

  • Clearly defined: what risk is being hedged and what is the expected relationship between that risk and the hedging instrument,
  • Measurable: what technique will be used to assess hedge effectiveness, and
  • Actually effective: if, despite strategies and expectations, the hedge was not effective, or was only partially effective, the ineffective portion is not eligible for hedge accounting.

The enterprise must designate a specific hedging instrument as a hedge of a change in value or change in cash flows of a specific hedged item, rather than as a hedge of an overall net balance sheet position. However, the approximate income statement effect of hedge accounting for an overall net position can be achieved, in some cases, by designating part of one of the underlying items as the hedged position. For example, an enterprise's overall net interest rate risk cannot be macro-hedged, but it may be able to qualify for hedge accounting by hedging a similar amount of interest rate risk inherent in a specific asset. Also, the hedged risk must be transferred to an independent party, for example by entering into a derivative contract.

IAS 39 recognises three types of hedges. They are: [IAS 39.137]

     

  • Fair value hedge: a hedge of the exposure to changes in the fair value of an asset or liability that is already recognised in the balance sheet (such as a hedge of exposure to changes in the fair value of fixed rate debt as a result of changes in interest rates). The gain or loss from the change in fair value of the hedging instrument is recognised immediately in net profit or loss. At the same time, the carrying amount of the hedged item is adjusted for the corresponding gain or loss since the inception of the hedge, which also is recognised immediately in net profit or loss.

     

  • Cash flow hedge: a hedge of the exposure to variability in cash flows relating to (a) a recognised asset or liability (such as all or some future interest payments on variable rate debt), (b) an unrecognised firm commitment (such as a noncancellable fixed price purchase order), or (c) a forecasted transaction (such as an anticipated purchase or sale). To the extent that the hedge is effective, the portion of the gain or loss on the hedging instrument is recognised initially directly in equity. Subsequently, that amount is included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss (for example, when cost of sales, depreciation, or amortisation are recognised). For hedges of forecasted transactions, the gain or loss on the hedging instrument will adjust the recorded carrying amount of the acquired asset or liability.

     

  • Hedge of a net investment in a foreign entity (as defined in IAS 21): These are accounted for as cash flow hedges.

Disclosure and Presentation of Financial Instruments - Continuing IAS 32 Requirements

Since 1996, IAS 32 has required quite comprehensive disclosures about financial instruments - including the fair values of all financial assets and all financial liabilities, whether on- or off-balance sheet. Here is a summary of the key IAS 32 disclosures:

  • For each class of financial asset and liability, and equity, both recognised and unrecognised, disclose information about:
    • Financial risk management policies, including heading policies. [IAS 32.43A]
    • The extent and nature of the financial instruments, including significant terms and conditions. [IAS 32.47]
    • Accounting policies and methods adopted. [IAS 32.47]
    • Specified information about exposure to interest rate risk. [IAS 32.56]
    • Specified information about exposure to credit risk. [IAS 32.66]
    • Specified information about fair value, or a statement that it is not practicable to provide such information. [IAS 32.77]
  • IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities for balance sheet presentation purposes. It specifies that a financial asset and a financial liability should be offset and the net amount reported when, and only when, an enterprise:
    • Has a legally enforceable right to set off the amounts, and
    • Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. [IAS 32.33]

Presentation - Treasury Shares

If an enterprise reacquires and holds its own equity instruments ('treasury shares'), those shares should be presented in the balance sheet as a deduction from equity. No gain or loss should be recognised in the income statement on the sale, issuance, or cancellation of treasury shares. Consideration received should be presented in the financial statements as a change in equity. [see SIC 16]

Disclosure and Presentation of Financial Instruments - Additional IAS 39 Requirements

IAS 39 supplements the disclosure requirements of IAS 32 regarding financial instruments. These are the principal new disclosure requirements of IAS 39: [IAS 39.166-170]

  • Methods and assumptions used in estimating fair values.
  • Accounting policy for changes in fair value of available-for-sale financial assets.
  • Whether purchases of financial assets are accounted for at trade date or settlement date.
  • A description of the enterprise's financial risk management objectives and policies.
  • For each category of hedge: a description of the hedge; which financial instruments are designated as hedging instruments; and the nature of the risks being hedged.
  • Significant items of income and expense and gains and losses resulting from financial assets and financial liabilities, and whether they are included in net profit or loss or as a separate component of equity and, if in equity, a reconciliation of movements in and out of equity.
  • Details of securitisation and repurchase agreements.
  • Nature, effect, and reasons for reclassifications of financial assets from amortised cost to fair value.
  • Nature and amount of any impairment loss or reversal of an impairment loss.

Effective Date

IAS 39 is effective for financial years beginning on or after 1 January 2001. This includes interim periods of those financial years. Earlier application is encouraged. [IAS 39.171]

Transition

On initial adoption of IAS 39, adjustments to bring derivatives and other financial assets and liabilities onto the balance sheet and adjustments to remeasure certain financial assets and liabilities from cost to fair value are made by adjusting retained earnings directly. [IAS 39.172]

If an enterprise applies International Accounting Standards in full for the first time in a period subsequent to the effective date of IAS 39, for example, in 2003, comparative information presented for 2001 and 2002 should not be restated to comply with IAS 39.

IAS 39 Implementation Guidance

An Implementation Guidance Committee (IGC), chaired by John T. Smith of Deloitte & Touche (USA), is developing implementation guidance on IAS 39 in the form of questions and answers. These are exposed for public comment before final issuance by the IGC. Six batches of Q&A have already been exposed. Of those, five batches containing over 200 Q&A have been approved for issuance in final form.

  • Batches 1-5 of Q&A. In July 2001, IASB issued a consolidated document that includes the Batches 1 to 5 of the questions and answers. Click here to Download the Combined Batch 1-5 Publication (PDF 1,053k).

     

  • Batch 6 of Q&A. The sixth and final batch of guidance, consisting of 17 Q&A and two examples, was released in November 2001. One of the questions and related examples address the particularly thorny issue of applying hedge accounting when a bank or other financial institution manages its interest rate risk on an enterprise-wide basis. The guidance includes an example of a methodology that allows for the use of hedge accounting and takes advantage of existing bank risk management systems so as to avoid unnecessary changes to it and to avoid unnecessary bookkeeping and tracking. Another example focuses on internal derivatives. Click to Download Batch 6 (PDF 278k) from IASB's website.

US FAS 133 Implementation Guidance

IAS 39 and US FASB Financial Accounting Standard 133 are similar (though not identical) when it comes to accounting for derivatives and hedge accounting. FASB's Derivatives Implementation Group (DIG) has prepared a wide range of questions and answers. in mid-2001, the FASB staff took over from the DIG responsibility for any remaining implementation issues regarding FAS 133.

FASB Guidance on FAS 133 Implementation Issues may be downloaded without charge, individually or in batches.

October 2000 Limited Revisions to IAS 39

The IASC Board approved five limited revisions to IAS 39, Financial Instruments: Recognition and Measurement, and other related Standards. None of the revisions alters a fundamental principle in IAS 39. Instead, the changes address technical application issues that have been identified following the approval of IAS 39 in December 1998. IAS 39 went into effect for financial years beginning 1 January 2001, and the revisions were effective the same date.

  • One change brings about symmetry in the dates for recognising purchases and sales of financial assets. As revised, IAS 39 requires that purchases and sales of each broad category of financial assets be accounted for consistently using either trade date or settlement date accounting. As originally approved, IAS 39 had allowed an enterprise to choose between trade date and settlement date for purchases but had permitted only settlement date accounting for sales.
  • Another change replaces the original IAS 39 requirement for a lender to recognise certain collateral received from a borrower in its balance sheet with a requirement for note disclosure about collateral.
  • The revisions clarify that impairment of financial assets (for instance, bad debt and loan loss provisions) should be recognised individually for significant financial assets. A portfolio basis is only acceptable for individually insignificant items.
  • Another revision brings about consistent accounting for temporary investments in equity securities between IAS 39 and IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries, IAS 28, Accounting for Investments in Associates, and IAS 31Financial Reporting of Interests in Joint Ventures.
  • Certain disclosure requirements for hedges in IAS 32, Financial Instruments: Disclosure and Presentation, that are regarded as redundant to the IAS 39 disclosures, have been eliminated.

Note:  Please note that these summaries are only for reference purposes and are not a substitute for the entire IFRS/IAS. Kindly read the whole text of IFRS/IAS before consulting these summaries.

Summaries are courtesy of Deloitte.


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