Saturday, December 15, 2012

Accounting for Financial Instruments under IFRS – When numbers meet words

My today’s assignment is to explain 152 pages of IFRS language in a few lucid paragraphs. If you have ever tried to read IFRS 9 and 32 and IAS 39, you will recognize that this is not an easy task.

You might think that this post is an oversimplification of the above rules, and I will probably agree with you to some extend. However, I prefer some oversimplification to the obscurity inherent in IFRS’ language.





Recognition of financial instruments

To pinpoint financial instruments, you need a contract. Conversely, in absence of a contract, there is no financial instrument.

At this stage, legal and accounting definitions require each-other. Let’s, therefore, stick to the very basic civil law rules, e.g. the Roman corpus iuris civilis. In the Second Book, Title XIV, No. 1, § 2, you can read “Et est pactio, duorum pluriumve in idem placitum consensus.” (= A contract is the consent of two or more persons on the same subject.).


Classification of financial instruments

IFRS accounting rules differentiate assets, liabilities, and equity. Derivatives represent a specific category of financial instruments and will be subject of a later post.

Every discipline defines the above categories in another way. From an IFRS perspective,

  • A financial asset is cash; a contractual right to receive a financial asset; a contractual right to exchange financial assets, liabilities, or equity; or equity of a third party.
  • A financial liability is a contractual obligation to deliver or exchange a financial asset.
  • Equity is a residual interest in the assets of the entity, after deducting liabilities.

Classifying financial instruments means considering the substance of the contract. In other words, a contract will not become a financial asset just because you label it as such.

In case of a compound financial instrument, asset and liability components are separated first and the residual is recognized as equity.

A reclassification of financial assets is possible if the entity changes its business model for managing financial assets; financial liabilities and equity shall not be reclassified.


Measurement of financial instruments

Financial assets

Financial assets shall be recorded at amortized costs, if the company holds them to collect its cash flows (= payments of principal and interest). Amortized costs refer to the value of the asset’s future cash flows, discounted at the effective interest rate and net of any adjustment for impairment and uncollectibility. Additional gains or losses can only be recognized upon derecognition of the asset.

If the company does not intend to hold the financial asset until maturity (= held for trading), it is measured at fair value. Fair value means transaction costs. If, however, the transaction costs differ from the market price, the asset is accounted at the amount of the transaction costs plus or minus the difference with the market price, the latter being recognized as a profit or loss, either immediately or differed. Subsequently, fair value is the asset's market price at measurement date.
The movements of the market price are normally recognized as a profit or loss. However, the firm can opt for presenting a gain or loss on equity, not held for trading, outside the company’s income statement, as other comprehensive income.

Financial liabilities

In principle, financial liabilities are measured at amortized cost.

Per contra, the following liabilities are measured at fair value:

  • financial liabilities held for trading;
  • residual liabilities after imperfect derecognition of financial liabilities;
  • guarantees;
  • loan commitments at below market interest rates;
  • Financial liabilities subject to fair value accounting upon option of the company (Such option is only available in specific cases such as embedded derivatives and accounting mismatch.)

Amortized cost and fair value definitions are the essentially the same as for financial assets. Similar to the above, the firm can present subsequent gains or losses on liabilities, measured at fair value, outside its regular earnings, as other comprehensive income.

Equity

The initial value of equity consists of par value plus additional paid-in capital minus transaction costs.

Changes in the fair value of equity are not recognized in the financial statements.


Derecognition of financial instruments

Financial assets and liabilities can be derecognized upon

  • discharge, cancellation, or expiry of contractual rights to the cash flows; or
  • transfer of the financial instrument, either directly, or indirectly by committing oneself to forward the cash flows received.

A partial derecognition for specifically identified cash flows is possible.

Upon derecognition, the difference between the carrying amount at the date of derecognition and the consideration received (if any) shall be recognized in profit or loss.


Resources:

  • IFRS 9 – Financial Instruments
  • IFRS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement