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
