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Questions and Answers
What does IAS 32 set out the definitions of?
What does IAS 32 set out the definitions of?
Financial assets, liabilities, and equity instruments.
What does IFRS 7 contain?
What does IFRS 7 contain?
Disclosure requirements.
What does IFRS 9 include procedures for?
What does IFRS 9 include procedures for?
The recognition and measurement of financial instruments.
Which of the following are considered primary financial instruments?
Which of the following are considered primary financial instruments?
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Which of the following are considered secondary (derivative) financial instruments?
Which of the following are considered secondary (derivative) financial instruments?
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Contracts to buy/sell non-financial assets are considered financial instruments.
Contracts to buy/sell non-financial assets are considered financial instruments.
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The 'substance over form' test in IAS 32 aims to encourage companies to classify instruments as equity instruments.
The 'substance over form' test in IAS 32 aims to encourage companies to classify instruments as equity instruments.
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Which of the following is NOT a condition that equity instruments must meet according to IAS 32?
Which of the following is NOT a condition that equity instruments must meet according to IAS 32?
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Compound financial instruments contain both a liability and an equity component.
Compound financial instruments contain both a liability and an equity component.
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The equity component of a compound financial instrument is remeasured alongside the liability component.
The equity component of a compound financial instrument is remeasured alongside the liability component.
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Interest expense related to a financial liability is recognized on the statement of changes in equity.
Interest expense related to a financial liability is recognized on the statement of changes in equity.
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IFRS 9 applies to all entities and to all types of financial instruments.
IFRS 9 applies to all entities and to all types of financial instruments.
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Which of the following is NOT an exception to IFRS 9?
Which of the following is NOT an exception to IFRS 9?
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Study Notes
Chapter 7 - Financial Instruments
- IFRS standards, particularly IAS 32, IFRS 7, and IFRS 9, are contentious standards that were revised following the 2008 financial crisis.
- IAS 32 defines financial assets, liabilities, and equity instruments.
- IFRS 7 details disclosure requirements for financial instruments.
- IFRS 9 outlines procedures for recognizing and measuring financial instruments.
What is a Financial Instrument?
- A financial instrument is any contract that results in a financial asset of one entity and a financial liability or equity instrument of another.
- Primary instruments include cash, receivables, shares, payables, bonds, and loans.
- Secondary instruments (derivatives) derive their value from an underlying item (e.g., share price, interest rate). Examples include financial options and forward exchange contracts.
Common Financial Instruments
- The table summarizes common financial instruments categorized as financial assets, financial liabilities, and equity instruments.
- Examples include cash, accounts receivable, notes receivable, loans receivable, bank overdrafts, accounts payable, notes payable, loans payable, ordinary shares, and preference shares.
Financial Instruments - Further Considerations
- Contracts for non-financial assets (e.g. futures/options on commodities like oil or copper) are not considered financial instruments unless they involve monetary settlement or have markets for them.
- The treatment of preference sharing might be as liabilities in certain cases. A substantial over form test (IAS 32) strives to limit the desire to misclassify instruments as equity.
- Debt and equity distinctions are essential; these impact gearing, solvency ratios, and treatment of payments (e.g., dividends).
Distinguishing Financial Liabilities from Equity Instruments - Substance Over Form Test
- Equity instruments must meet two conditions:
- No contractual obligation to deliver cash or other financial assets to another entity.
- No unfavorable transactions for the issuer.
- Compound financial instruments contain both a liability and an equity component.
- In these cases, the liability component is calculated initially, and the equity component is considered the residual.
- The equity component is not remeasured.
Scope of IFRS 9
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IFRS 9 aims to establish principles, though arguably it presents more as rules than principles.
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It applies to all entities and types of financial instruments with eleven exceptions (e.g., investments in subsidiaries, associates, joint ventures, leases, employee benefits, share-based payments).
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Investments in subsidiaries are governed by IFRS 10 (Consolidated Financial Statements).
Measurement Categories for Financial Assets
- IFRS 9 covers debt instruments measured at amortized cost and at fair value (through either other comprehensive income or profit or loss).
- It also deals with equity instruments measured at fair value (through other comprehensive income).
- Debt instruments, derivatives, and equity instruments are measured at fair value through profit or loss (FVPL) by IFRS 9.
Measurement Categories for Financial Liabilities
- Financial liabilities are often measured at 'amortised cost` , except for those designated at fair value through profit or loss.
Cash Flow Characteristics
- The principle of cash flow characteristics is assessed at the individual asset level.
- Cash flow assessments focus on determining if the flows are solely principal and interest payments, and whether the effective interest method is applicable mechanically.
Business Models
- The business model assessment isn't done at the instrument level; it's conducted at a higher aggregate level. A financial institution assessing business models may classify instruments to be 'held-to-collect', 'held-to-collect and sell' and 'held for trading'.
Recognition Criteria and Measurement
- Recognition of assets or liabilities occurs when the entity becomes part of the contractual instrument provisions.
- Initial recognition includes fair value plus transaction costs (less so in cases when instruments are at fair value through profit and loss).
- Transaction costs include fees, commissions, levies, taxes; financing costs, and administrative costs are not included.
Fair Value of FI
- Fair value is usually equivalent to the transaction price, though estimates may need to be made using valuation techniques when the consideration involves something other than the financial instrument.
Subsequent Measurement
- Subsequent measurement depends on the asset/liability type and the relevant category for those types.
- The categories include, at amortized cost, which pertains to debt instruments; at fair value through OCI, relating to debt and equity instruments; fair value through profit/loss for debt, equity, and derivatives.
Amortised Cost Method
- The amortized cost method is based on initial recognition value less principal payments and added or subtracted cumulative amortisation of interest using the effective interest method.
- The effective interest method calculates the amortization of cost, and allocates interest revenue or expense over the period.
- Calculating the effective interest involves finding the rate that discounts the future cash flows of the instrument to its current gross carrying value.
Determining the Effective Interest
- The effective interest calculations are done per example provided.
A Word on the Amortized Cost
- Effective interest rates are computed considering the present value of a financial instrument's cash flows.
- For instance, a bond issued at par (face value) with an initial interest rate and a specific maturity time will have an initial effective interest rate calculated accordingly.
- Transaction costs modify effective rates.
Liabilities
- Financial liabilities are measured, by IFRS 9, at either amortized cost, or fair value though profit or loss.
Gains and Losses
- Gains and losses from a financial instrument at fair value are recorded in profit or loss unless the gain or loss relates to hedging, investment in equity instruments, a debt instrument at fair value through OCI, or a financial liability that requires the effects of credit risk to be recorded in OCI.
Impairment and Uncollectability - The Forward Looking Expected Credit Loss Model
- The framework uses a forward-looking, expected loss approach for impairment assessment of financial assets.
- Three stages (performing, underperforming, and nonperforming) differentiate the credit quality.
- Impairment recognition depends on the credit quality changes since initiation.
Operational Simplifications to Assess Credit Risk
- For low-risk financial assets (investment grade), entities can assume no substantial changes in credit risk.
- When forward-looking information is absent, an increase in credit risk is presumed if contractual payments are more than 30 days past due.
Purchased or Originated Credit- Impaired Financial Assets
- The approach doesn't vary significantly from the general model; instead, increased credit loss is reflected in an adjusted effective interest rate.
- Impairment recognition is solely based on changes to lifetime expected credit losses.
Measurement of Expected Credit Losses
- Lifetime expected credit losses are estimated from the present value of all future cash shortfalls over the remaining life of a financial instrument.
- 12-month expected credit losses are derived based on present value of expected losses expected within 12 months following reporting.
- The maximum contractual period and probability-weighted outcomes are considered for assessing losses over the instrument's life.
- Discounting losses uses the effective interest rate from initial recognition.
The Impairment Rules Do Not Apply To…
- Impairment rules do not apply to equity instruments measured at fair value through OCI. They also do not apply to derivatives, debt instruments, and equity instruments measured at fair value through profit or loss or losses.
Recognition of Impairment Losses
- For instruments measured at amortized cost, impairment losses are recorded in the income statement and the balance sheet.
- Impairment losses for FVOCI instruments are recorded in OCI and do not affect the asset's carrying amount.
Hedge Accounting
- Hedge arrangements safeguard entities from risks (e.g., currency, interest rate).
- Hedge accounting aims for a closer link between balance sheet effects and profit or loss effects—this smooths out volatility in income. This is key to hedging.
Hedge Accounting- Definitions
- Hedging instruments are financial assets where cash flows offset changes in fair value of a designated 'hedged item' or an item exposed to future cash flow risk or foreign investment risk.
Hedge Accounting - Conditions
- Hedge accounting needs a formally designated and documented hedge at inception.
- The hedge relationship includes only eligible instruments and hedged items.
- The relationship satisfies hedge effectiveness requirements.
Hedge Accounting - Types of Hedges
- Fair value hedges cover exposure to changes in fair value (asset, liability, or firm commitment).
- Cash flow hedges protect from variability in recognized asset or liability cash flows or forecasted transactions.
- Hedges of net investments in foreign operations have accounting that is similar to cash flow hedge accounting.
Cash Flow Hedge
- Illustration of how Bank S might hedge cash flow risk.
Hedge Accounting - Summary
- Fair value hedges measure the hedging instrument (derivative) at fair value with gains/losses in P/L and the hedged item in P/L.
- Cash flow hedges measure the hedging instrument at fair value with gains/losses in OCI; the hedged item is recorded at cost.
Additional Notes
- Specific page references for details on examples are mentioned.
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Description
Test your knowledge on international financial reporting standards with this quiz focusing on IAS 32, IFRS 7, and IFRS 9. Explore definitions, classifications, and components of financial instruments and their treatment in different scenarios. Perfect for finance students and professionals seeking to review their understanding of these important standards.
