European Commission Accounting Rule 11: Financial Instruments PDF

Ref. Ares(2020)7699290 - 17/12/2020 EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting EUROPEAN UNION ACCOUNTING RULE 11 Financial Instruments EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 2 of 62 INDEX 1. Objective....................................................................................................................................... 4 2. Scope............................................................................................................................................. 4 3. Definitions..................................................................................................................................... 5 4. Presentation................................................................................................................................. 10 5. Recognition and derecognition................................................................................................... 12 5.1 Initial Recognition.............................................................................................................. 12 5.2 Derecognition of financial assets....................................................................................... 13 5.3 Derecognition of Financial Liabilities............................................................................... 17 6. Classification............................................................................................................................... 18 6.1 Classification of Financial Assets...................................................................................... 18 6.2 Classification of Financial Liabilities................................................................................ 19 6.3 Embedded derivatives........................................................................................................ 19 6.4 Management models for financial assets........................................................................... 20 6.5 Contractual cash flow characteristics (‘SPPI’ assessment)................................................ 22 7. Measurement............................................................................................................................... 25 7.1 Initial Measurement........................................................................................................... 25 7.2 Subsequent Measurement of Financial Assets................................................................... 28 7.3 Subsequent Measurement of Financial Liabilities............................................................. 28 7.4 Fair Value Measurement Considerations........................................................................... 29 7.5 Amortized Cost Measurement........................................................................................... 32 7.6 Impairment......................................................................................................................... 34 EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 3 of 62 7.7 Reclassification.................................................................................................................. 43 7.8 Gains and losses................................................................................................................. 44 8. Disclosures.................................................................................................................................. 45 9. Effective date and transition....................................................................................................... 58 10. Reference to other rules.............................................................................................................. 61 Categories of financial instruments.................................................................................................... 62 EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 4 of 62 1. Objective The objective of this EU accounting rule (EAR) is to prescribe the accounting treatment of financial instruments. It applies to the classification, presentation, recognition and measurement of financial instruments as well as to disclosures on financial instruments and on how the European Union man- ages the risks arising from financial instruments. 2. Scope This EAR applies to accounting for all financial instruments (financial assets, financial liabilities, equity instruments, financial guarantee contracts) in the financial statements of the European Union (EU) entities, except: Interests in controlled entities, joint ventures and associates (except where otherwise re- quired by EAR 2); Trust funds falling under the scope of EAR 2; Rights and obligations under leases to which EAR 8, Leases applies. However: (i) Finance lease receivables (i.e., net investments in finance leases) and operating lease receivables recognized by a lessor are subject to the derecognition and impairment requirements of this EAR; (ii) Lease liabilities recognized by a lessee are subject to the derecognition require- ments of this EAR; and (iii) Derivatives that are embedded in leases are subject to the em- bedded derivatives requirements of this EAR; Pre-financing (EU Accounting Rule 5); Employers rights and obligations under EAR 12 (Employee benefits); Loan commitments other than loan commitments to provide a loan at below-market interest rate; however an EU entity shall apply impairment, derecognition and disclosure require- ments of this accounting rule to all loan commitments issued; Rights to payments to reimburse the EU entity for expenditure that it is required to make to settle a liability that it recognizes as a provision in accordance with EAR 10 (Provisions, Contingent Liabilities and Contingent Assets) or for which, in an earlier period, it recog- nized a provision in accordance with EAR 10. Non-exchange transactions under EAR 17 (revenue from non-exchange transactions) Guarantees in scope Only contractual financial guarantees (or guarantees that are in substance, contractual) are within the scope of this EAR. In assessing whether a guarantee is contractual or non-contractual, an EU entity distinguishes the right to issue the guarantee and the actual issue of the guarantee. The right to issue the guarantee in terms of legislation or other authority is non-contractual. Non-contractual EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 5 of 62 guarantees are not within the scope of this EAR, as they do not meet the definition of a financial instrument. This EAR prescribes recognition and measurement requirements only for the issuer of financial guarantee contracts, as defined in section 3, i.e. to the contracts that require the issuer to make spec- ified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. Some guarantees do not, as a precondition for payment, require that the holder is exposed to, and has incurred a loss on, the failure of the debtor to make payments on the guaranteed asset when due. An example of such a guarantee is one that requires payments in response to changes in a specified credit rating or credit index, or one that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because of the change in a financial instruments price (e.g. underlying is an equity investment). Such guarantees are not financial guarantee contracts as defined in this EAR, and are not insurance contracts. Such guarantees are derivatives and the issuer applies this EAR to them. Other guarantees, which do not meet definition of either a financial guarantee liability or a deriva- tive under the section 3, e.g. a financial guarantee contract issued in connection with the sale of goods, are outside the scope of this EAR. Any present or possible obligations stemming from such guarantees shall be accounted for or disclosed, as appropriate, under EAR10. The issuer applies EAR 4 in determining when it recognizes the revenue from the guarantee and from the sale of goods. 3. Definitions The following terms are used in this accounting rule with the meanings specified: 1) A financial instrument is any contract that gives rise to a financial asset of one EU entity and a financial liability or equity instrument of another EU entity. 2) A financial asset is any asset that is: (a) Cash; (b) An equity instrument of another EU entity; (c) A contractual right: (i) To receive cash or another financial asset from another EU entity; or (ii) To exchange financial assets or financial liabilities with another EU entity under condi- tions that are potentially favourable to the EU entity; or (d) A contract that will or may be settled in the EU entity’s own equity instruments and is: (i) A non-derivative for which the EU entity is or may be obliged to receive a variable num- ber of the EU entity’s own equity instruments; or EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 6 of 62 (ii) 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 EU entity’s own equity instruments. For this purpose the EU entity’s own equity instruments do not include puttable financial in- struments classified as equity instruments, instruments that impose on the EU entity an obli- gation to deliver to another party a pro rata share of the net assets of the EU entity only on liquidation and are classified as equity instruments, or instruments that are contracts for the future receipt or delivery of the EU entity’s own equity instruments. 3) A financial liability is any liability that is: (a) A contractual obligation: (i) To deliver cash or another financial asset to another EU entity; or (ii) To exchange financial assets or financial liabilities with another EU entity under condi- tions that are potentially unfavorable to the EU entity; or (b) A contract that will or may be settled in the EU entity’s own equity instruments and is: (i) A non-derivative for which the EU entity is or may be obliged to deliver a variable num- ber of the EU entity’s own equity instruments; or (ii) 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 EU entity’s own equity instruments. For this purpose the EU entity’s own equity instruments do not include puttable financial in- struments classified as equity instruments, instruments that impose on the EU entity an obli- gation to deliver to another party a pro rata share of the net assets of the EU entity only on liquidation and are classified as equity instruments, or instruments that are contracts for the future receipt or delivery of the EU entity’s own equity instruments. 4) An equity instrument is any contract that evidences a residual interest in the assets of an EU entity after deducting all of its liabilities. 5) 12-month expected credit losses are the portion of lifetime expected credit losses1 that repre- sent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. 6) The amortized cost of a financial asset or financial liability is the amount at which the finan- cial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between that initial amount and the maturity amount and, for financial assets, adjusted for any loss allowance. 7) A credit-impaired financial asset is a financial asset that is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired include observable data about the following events: 1 Definition of lifetime expected credit losses further below paragraph 21 EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 7 of 62 a) Significant financial difficulty of the issuer or the borrower; b) A breach of contract, such as a default or past due event; c) The lender(s) of the borrower, for economic or contractual reasons relating to the bor- rower’s financial difficulty, having granted to the borrower a concession(s) that the lender(s) would not otherwise consider; d) It is becoming probable that the borrower will enter bankruptcy or other financial reor- ganization; e) The disappearance of an active market for that financial asset because of financial diffi- culties; or f) The purchase or origination of a financial asset at a deep discount that reflects the in- curred credit losses. It may not be possible to identify a single discrete event instead, the combined effect of several events may have caused financial assets to become credit-impaired. 8) Credit loss is the difference between all contractual cash flows that are due to an EU entity in accordance with the contract and all the cash flows that the EU entity expects to receive (i.e., all cash shortfalls), discounted at the original effective interest rate (or credit-adjusted effective in- terest rate for purchased or originated credit-impaired financial assets). An EU entity shall esti- mate cash flows by considering all contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial in- strument. The cash flows that are considered shall include cash flows from the sale of collateral held or other credit enhancements that are integral to the contractual terms. There is a presump- tion that the expected life of a financial instrument can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the expected life of a financial instrument, the EU entity shall use the remaining contractual term of the financial instrument. 9) Credit-adjusted effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial asset to the amortized cost of a financial asset that is a purchased or originated credit-impaired financial asset. When calcu- lating the credit-adjusted effective interest rate, the same provisions apply as for calculating the effective interest rate (see definition of effective interest rate) 10) Derecognition is the removal of a previously recognized financial asset or financial liability from an EU entity’s statement of financial position. 11) A derivative is a financial instrument or other contract within the scope of this EAR with all three of the following characteristics. a) Its value changes in response to the change in a specified interest rate, financial instru- ment price, commodity price, foreign exchange rate, index of prices or rates, credit ra- ting or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underly- ing’). EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 8 of 62 b) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. c) It is settled at a future date. 12) Dividends or similar distributions are distributions to holders of equity instruments in propor- tion to their holdings of a particular class of capital. 13) The effective interest method is the method that is used in the calculation of the amortized cost of a financial asset or a financial liability and in the allocation and recognition of the interest revenue or interest expense in surplus or deficit over the relevant period. 14) The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortized cost of a financial liability. When calculating the effective interest rate, an EU entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and simi- lar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effec- tive interest rate, transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be esti- mated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the EU entity shall use the contractual cash flows over the full contractual term of the financial instru- ment (or group of financial instruments). 15) An expected credit loss is the weighted average of credit losses with the respective risks of a default occurring as the weights. 16) A financial guarantee contract is a contract that requires the issuer to make specified pay- ments to reimburse the holder for a loss it incurs because a specified debtor fails to make pay- ment when due in accordance with the original or modified terms of a debt instrument. 17) A financial liability at fair value through surplus or deficit is a financial liability that meets the definition of held for trading. 18) The gross carrying amount of a financial asset is the amortized cost of a financial asset, be- fore adjusting for any loss allowance. 19) A held for trading financial instrument is a financial asset or financial liability that: a) Is acquired or incurred principally for the purpose of selling or repurchasing it in the near term; b) On initial recognition is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short - term profit-taking; or c) Is a derivative (except for a derivative that is a financial guarantee contract). EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 9 of 62 20) An impairment gain or loss is recognized in surplus or deficit in accordance with para- graph161 and arises from applying the impairment requirements in this accounting rule, 21) Lifetime expected credit losses are the expected credit losses that result from all possible de- fault events over the expected life of a financial instrument. 22) A loss allowance is the allowance for expected credit losses on financial assets measured at amortised cost, lease receivables, the accumulated impairment amount for financial assets measured at fair value through net assets/equity and the provision for expected credit losses on loan commitments and financial guarantee contracts. 23) A modification gain or loss is the amount arising from adjusting the gross carrying amount of a financial asset to reflect the renegotiated or modified contractual cash flows. The EU entity re- calculates the gross carrying amount of a financial asset as the present value of the estimated fu- ture cash payments or receipts through the expected life of the renegotiated or modified finan- cial asset that are discounted at the financial asset’s original effective interest rate (or the origi- nal credit-adjusted effective interest rate for purchased or originated credit- impaired financial assets). When estimating the expected cash flows of a financial asset, an EU entity shall consid- er all contractual terms of the financial asset (for example, prepayment, call and similar options) but shall not consider the expected credit losses, unless the financial asset is a purchased or orig- inated credit-impaired financial asset, in which case an EU entity shall also consider the initial expected credit losses that were considered when calculating the original credit-adjusted effec- tive interest rate. 24) A financial asset is past due when a counterparty has failed to make a payment when that pay- ment was contractually due. 25) A purchased or originated credit-impaired financial asset is credit-impaired on initial recog- nition. 26) The reclassification date is the first day of the first reporting period following the change in management model that results in an EU entity reclassifying financial assets. 27) A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regula- tion or convention in the marketplace concerned. 28) Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the EU entity had not acquired, issued or disposed of the financial instrument. Transaction costs include fees and commission paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and security ex- changes, and transfer taxes and duties. Transaction costs do not include debt premiums or dis- counts, financing costs or internal administrative or holding costs. 29) Credit risk is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. 30) Credit risk rating grades is a rating of credit risk based on the risk of a default occurring on EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 10 of 62 the financial instrument. 31) Currency risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. 32) Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. 33) Liquidity risk is the risk that an EU entity will encounter difficulty in meeting obligations as- sociated with financial liabilities that are settled by delivering cash or another financial asset. 34) Loans payable are financial liabilities, other than short-term trade payables on normal credit terms. 35) Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: curren- cy risk, interest rate risk, and other price risk. 36) Other price risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the mar- ket. 37) Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. 38) A puttable financial instrument includes a contractual obligation for the issuer to repurchase or redeem that instrument for cash or another financial asset on exercise of the put. 4. Presentation Liabilities and net assets / equity 39) An EU entity that issues financial instruments (‘issuer’) shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity in- strument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. 40) When an issuer applies the definitions in section 3 to determine whether a financial instrument is an equity instrument rather than a financial liability, the instrument is an equity instrument if, and only if, both conditions (a) and (b) below are met. (a) The instrument includes no contractual obligation: (i) To deliver cash or another financial asset to another EU entity; or (ii) To exchange financial assets or financial liabilities with another EU entity under condi- tions that are potentially unfavorable to the issuer. (b) If the instrument will or may be settled in the issuer’s own equity instruments, it is: EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 11 of 62 (i) A non-derivative that includes no contractual obligation for the issuer to deliver a varia- ble number of its own equity instruments; or (ii) A derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the EU entity’s own equity instru- ments for a fixed amount of any currency are equity instruments if the EU entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. A contractual obligation, including one arising from a derivative financial instrument, that will or may result in the future receipt or delivery of the issuer’s own equity instruments, but does not meet conditions (a) and (b) above, is not an equity instrument. 41) In general, a critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation of one party to the financial instrument (the issuer) ei- ther to deliver cash or another financial asset to the other party (the holder) or to exchange finan- cial assets or financial liabilities with the holder under conditions that are potentially unfavorable to the issuer. Although the holder of an equity instrument may be entitled to receive a pro rata share of any dividends or similar distributions declared, or distributions of the net assets/equity, the issuer does not have a contractual obligation to make such distributions because it cannot be required to deliver cash or another financial asset to another party. 42) The substance of a financial instrument, rather than its legal form, governs its classification on the EU entity’s statement of financial position (balance sheet). Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity instruments but are liabilities in substance and others may combine features associated with equi- ty instruments and features associated with financial liabilities. 43) Interest, dividends or similar distributions, losses, and gains relating to a financial instrument or a component that is a financial liability shall be recognized as revenue or expense in surplus or deficit. Distributions to holders of an equity instrument shall be recognized by the EU entity di- rectly in net assets/equity. Transaction costs incurred on transactions in net assets/equity shall be accounted for as a deduction from net assets/equity. Offsetting 44) A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when, and only when, an EU entity: (a) Currently has a legally enforceable right to set off the recognised amounts; and (b) Intends either to settle on a net basis, or to realise the asset and settle the liability simultane- ously. In accounting for a transfer of a financial asset that does not qualify for derecognition, the EU entity shall not offset the transferred asset and the associated liability. EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 12 of 62 45) Offsetting a recognised financial asset and a recognised financial liability and presenting the net amount differs from the derecognition of a financial asset or a financial liability. Although offsetting does not give rise to recognition of a gain or loss, the derecognition of a financial in- strument not only results in the removal of the previously recognised item from the statement of financial position but also may result in recognition of a gain or loss. 46) Simultaneous settlement of two financial instruments occurs when there is no exposure to credit or liquidity risk or where the exposure to the credit risk and the liquidity risk are relatively brief. Accordingly, the realization of a financial asset and settlement of a financial liability are treated as simultaneous only when the transactions occur at the same moment. 47) The conditions set out in paragraph 44 are generally not satisfied and offsetting is usually in- appropriate when: (a) Several different financial instruments are used to emulate the features of a single financial instrument (a "synthetic instrument"); (b) Financial assets and financial liabilities arise from financial instruments having the same primary risk exposure (e.g., assets and liabilities within a portfolio of forward contracts or other derivative instruments) but involve different counterparties; (c) Financial or other assets are pledged as collateral for non-recourse financial liabilities; (d) Financial assets are set aside in trust by a debtor for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation (e.g., a sinking fund arrangement); or (e) Obligations incurred as a result of events giving rise to losses are expected to be recovered from a third party by virtue of a claim made under an insurance contract. 48) An EU entity that undertakes a number of financial instrument transactions with a single counterparty may enter into a “master netting arrangement” with that counterparty. Such an agreement provides for a single net settlement of all financial instruments covered by the agreement in the event of default on, or termination of, any one contract. A master netting ar- rangement does not provide a basis for offsetting unless both of the criteria in paragraph 44 are satisfied. 5. Recognition and derecognition 5.1 Initial Recognition 49) An EU entity shall recognize a financial asset or a financial liability in its statement of financial position when, and only when, the EU entity becomes party to the contractual provisions of the instrument. When an EU entity first recognizes a financial asset, it shall classify it in accordance with the classification requirements of this EAR and measure it in accordance with the initial measurements of this EAR. When an EU entity first recognizes a financial liability, it shall clas- sify it in accordance with the classification requirements of this EAR and measure it in accord- ance with the initial measurement requirements of this EAR. EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 13 of 62 Regular Way Purchase or Sale of Financial Assets 50) A regular way purchase or sale of financial assets shall be recognized and derecognized, as ap- plicable, using trade date accounting or settlement date accounting. 51) An EU entity shall apply the same method consistently for all purchases and sales of financial assets that are classified in the same way in accordance with this rule. 52) A contract that requires or permits net settlement of the change in the value of the contract is not a regular way contract. Instead, such a contract is accounted for as a derivative in the period be- tween the trade date and the settlement date. 53) The trade date is the date that an EU entity commits itself to purchase or sell an asset. Trade date accounting refers to (a) the recognition of an asset to be received and the liability to pay for it on the trade date, and (b) derecognition of an asset that is sold, recognition of any gain or loss on disposal and the recognition of a receivable from the buyer for payment on the trade date. Generally, interest does not start to accrue on the asset and corresponding liability until the set- tlement date when title passes. 54) The settlement date is the date that an asset is delivered to or by an EU entity. Settlement date accounting refers to (a) the recognition of an asset on the day it is received by the EU entity, and (b) the derecognition of an asset and recognition of any gain or loss on disposal on the day that it is delivered by the EU entity. When settlement date accounting is applied an EU entity ac- counts for any change in the fair value of the asset to be received during the period between the trade date and the settlement date in the same way as it accounts for the acquired asset. In other words, the change in value is not recognized for assets measured at amortized cost; it is recog- nized in surplus or deficit for assets classified as financial assets measured at fair value through surplus or deficit; and it is recognized in net assets/equity for financial assets measured at fair value through net assets/equity. 5.2 Derecognition of financial assets 55) Before evaluating whether, and to what extent, derecognition is appropriate under paragraphs 56-60, an EU entity determines whether those paragraphs should be applied to a part of a finan- cial asset (or a part of a group of similar financial assets) or a financial asset (or a group of simi- lar financial assets) in its entirety, as follows. (a) Paragraphs 56-60 apply to a part of a financial asset (or a part of a group of similar fi- nancial assets) if, and only if, the part being considered for derecognition meets one of the following three conditions. (i) The part comprises only specifically identified cash flows from a financial asset (or a group of similar financial assets). (ii) The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset (or a group of similar financial assets). (iii) The part comprises only a fully proportionate (pro rata) share of specifically iden- tified cash flows from a financial asset (or a group of similar financial assets). EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 14 of 62 (b) In all other cases, this section applies to the financial asset in its entirety (or to the group of similar financial assets in their entirety). The term ‘financial asset’ in this section refers to either a part of a financial asset (or a part of a group of similar financial assets) as identified in (a) above or, otherwise, a financial asset (or a group of similar financial assets) in its entirety. 56) An EU entity shall derecognize a financial asset when, and only when: a) The contractual rights to the cash flows from the financial asset expire or are waived, or b) It transfers the financial asset as set out in paragraphs 57 and 58 and the transfer quali- fies for derecognition in accordance with paragraph 59. 57) An EU entity transfers a financial asset if, and only if, it either: a) Transfers the contractual rights to receive the cash flows of the financial asset, or b) Retains the contractual rights to receive the cash flows of the financial asset, but as- sumes a contractual obligation to pay the cash flows to one or more recipients in an ar- rangement that meets the conditions in the next paragraph 58) When an EU entity retains the contractual rights to receive the cash flows of a financial asset (the ‘original asset’), but assumes a contractual obligation to pay those cash flows to one or more entities (the ‘eventual recipients’), the EU entity treats the transaction as a transfer of a fi- nancial asset if, and only if, all of the following three conditions are met. a) The EU entity has no obligation to pay amounts to the eventual recipients unless it col- lects equivalent amounts from the original asset. Short-term advances by the EU entity with the right of full recovery of the amount lent plus accrued interest at market rates do not violate this condition. b) The EU entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows. c) The EU entity has an obligation to remit any cash flows it collects on behalf of the even- tual recipients without material delay. In addition, the EU entity is not entitled to rein- vest such cash flows, except for investments in cash or cash equivalents (as defined in EAR 1 Financial statements) during the short settlement period from the collection date to the date of required remittance to the eventual recipients, and interest earned on such investments is passed to the eventual recipients. 59) When an EU entity transfers a financial asset, it shall evaluate the extent to which it retains the risks and rewards of ownership of the financial asset. In this case: a) If the EU entity transfers substantially all the risks and rewards of ownership of the fi- nancial asset, the EU entity shall derecognize the financial asset and recognize separate- ly as assets or liabilities any rights and obligations created or retained in the transfer. EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 15 of 62 b) If the EU entity retains substantially all the risks and rewards of ownership of the finan- cial asset, the EU entity shall continue to recognize the financial asset. c) If the EU entity neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset, the EU entity shall determine whether it has retained control of the financial asset. In this case: i. If the EU entity has not retained control, it shall derecognize the financial asset and recognize separately as assets or liabilities any rights and obligations created or retained in the transfer. ii. If the EU entity has retained control, it shall continue to recognize the financial asset to the extent of its continuing involvement in the financial asset (see para- graphs for continuing involvement in financial assets below). 60) The transfer of risks and rewards is evaluated by comparing the EU entity’s exposure, before and after the transfer, with the variability in the amounts and timing of the net cash flows of the transferred asset. An EU entity has retained substantially all the risks and rewards of ownership of a financial asset if its exposure to the variability in the present value of the future net cash flows from the financial asset does not change significantly as a result of the transfer. Transfers that Qualify for Derecognition 61) If an EU entity transfers a financial asset in a transfer that qualifies for derecognition in its entirety and retains the right to service the financial asset for a fee, it shall recognize either a servicing asset or a servicing liability for that servicing contract. If the fee to be received is not expected to compensate the EU entity adequately for performing the servicing, a servicing lia- bility for the servicing obligation shall be recognized at its fair value. If the fee to be received is expected to be more than adequate compensation for the servicing, a servicing asset shall be recognized for the servicing right at an amount determined on the basis of an allocation of the carrying amount of the larger financial asset in accordance with paragraph 64. 62) If, as a result of a transfer, a financial asset is derecognized in its entirety but the transfer re- sults in the EU entity obtaining a new financial asset or assuming a new financial liability, or a servicing liability, the EU entity shall recognize the new financial asset, financial liability or servicing liability at fair value. 63) On derecognition of a financial asset in its entirety, the difference between: a) The carrying amount (measured at the date of derecognition); and b) The consideration received (including any new asset obtained less any new liability as- sumed) shall be recognized in surplus or deficit. 64) If the transferred asset is part of a larger financial asset and the part transferred qualifies for derecognition in its entirety, the previous carrying amount of the larger financial asset shall be allocated between the part that continues to be recognized and the part that is derecognized, on the basis of the relative fair values of those parts on the date of the transfer. For this purpose, a EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 16 of 62 retained servicing asset shall be treated as a part that continues to be recognized. The difference between: a) The carrying amount (measured at the date of derecognition) allocated to the part derec- ognized; and b) The consideration received for the part derecognized (including any new asset obtained less any new liability assumed) shall be recognized in surplus or deficit. Transfers that do not Qualify for Derecognition 65) If a transfer does not result in derecognition because the EU entity has retained substantially all the risks and rewards of ownership of the transferred asset, the EU entity shall continue to recognize the transferred asset in its entirety and shall recognize a financial liability for the con- sideration received. In subsequent periods, the EU entity shall recognize any revenue on the transferred asset and any expense incurred on the financial liability. Continuing Involvement in Transferred Assets 66) If an EU entity neither transfers nor retains substantially all the risks and rewards of owner- ship of a transferred asset, and retains control of the transferred asset, the EU entity continues to recognize the transferred asset to the extent of its continuing involvement. The extent of the EU entity’s continuing involvement in the transferred asset is the extent to which it is exposed to changes in the value of the transferred asset. For example, when the EU entity’s continuing in- volvement takes the form of guaranteeing the transferred asset, the extent of the EU entity’s continuing involvement is the lower of (i) the amount of the asset and (ii) the maximum amount of the consideration received that the EU entity could be required to repay (‘the guarantee amount’). 67) When an EU entity continues to recognize an asset to the extent of its continuing involvement, the EU entity also recognizes an associated liability. Despite the other measurement require- ments in this EAR, the transferred asset and the associated liability are measured on a basis that reflects the rights and obligations that the EU entity has retained. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is: a) The amortized cost of the rights and obligations retained by the EU entity, if the trans- ferred asset is measured at amortized cost; or b) Equal to the fair value of the rights and obligations retained by the EU entity when meas- ured on a stand-alone basis, if the transferred asset is measured at fair value. 68) The EU entity shall continue to recognize any revenue arising on the transferred asset to the extent of its continuing involvement and shall recognize any expense incurred on the associated liability. 69) For the purpose of subsequent measurement, recognized changes in the fair value of the trans- ferred asset and the associated liability are accounted for consistently with each other in accord- EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 17 of 62 ance with paragraph 215, and shall not be offset. 70) If an EU entity’s continuing involvement is in only a part of a financial asset (e.g., when an EU entity retains an option to repurchase part of a transferred asset, or retains a residual interest that does not result in the retention of substantially all the risks and rewards of ownership and the EU entity retains control), the EU entity allocates the previous carrying amount of the finan- cial asset between the part it continues to recognize under continuing involvement, and the part it no longer recognizes on the basis of the relative fair values of those parts on the date of the transfer. The difference between: a) The carrying amount (measured at the date of derecognition) allocated to the part that is no longer recognized; and b) The consideration received for the part no longer recognized shall be recognized in surplus or deficit. All Transfers 71) If a transferred asset continues to be recognized, the asset and the associated liability shall not be offset. Similarly, the EU entity shall not offset any revenue arising from the transferred asset with any expense incurred on the associated liability. 72) If a transferor provides non-cash collateral (such as debt or equity instruments) to the trans- feree, the accounting for the collateral by the transferor and the transferee depends on whether the transferee has the right to sell or repledge the collateral and on whether the transferor has de- faulted. The transferor and transferee shall account for the collateral as follows: (a) If the transferee has the right by contract or custom to sell or repledge the collateral, then the transferor shall reclassify that asset in its statement of financial position (e.g., as a loaned asset, pledged equity instruments or repurchase receivable) separately from other assets. (b) If the transferee sells collateral pledged to it, it shall recognize the proceeds from the sale and a liability measured at fair value for its obligation to return the collateral. (c) If the transferor defaults under the terms of the contract and is no longer entitled to re- deem the collateral, it shall derecognize the collateral, and the transferee shall recognize the collateral as its asset initially measured at fair value or, if it has already sold the col- lateral, derecognize its obligation to return the collateral. (d) Except as provided in (c), the transferor shall continue to carry the collateral as its asset, and the transferee shall not recognize the collateral as an asset. 5.3 Derecognition of Financial Liabilities 73) An EU entity shall remove a financial liability (or a part of a financial liability) from its statement of financial position when, and only when, it is extinguished i.e., when the obligation specified in the contract is discharged, waived, canceled or expires. EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 18 of 62 74) An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. 75) The difference between the carrying amount of a financial liability (or part of a financial lia- bility) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognized in surplus or deficit. Where an obligation is waived by the lender or assumed by a third party as part of a non- exchange transaction, an EU entity applies EAR 17. 76) If an EU entity repurchases a part of a financial liability, the EU entity shall allocate the pre- vious carrying amount of the financial liability between the part that continues to be recognized and the part that is derecognized based on the relative fair values of those parts on the date of the repurchase. The difference between (a) the carrying amount allocated to the part derecog- nized and (b) the consideration paid, including any non-cash assets transferred or liabilities as- sumed, for the part derecognized shall be recognized in surplus or deficit. 6. Classification 6.1 Classification of Financial Assets 77) An EU entity shall classify financial assets as subsequently measured at amortized cost, fair value through net assets/equity or fair value through surplus or deficit on the basis of both: (a) The EU entity’s management model for financial assets and (b) The contractual cash flow characteristics of the financial asset. 78) A financial asset shall be measured at amortized cost if both of the following conditions are met: (a) The financial asset is held within a management model whose objective is to hold finan- cial assets in order to collect contractual cash flows and (b) 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. 79) A financial asset shall be measured at fair value through net assets/equity if both of the fol- lowing conditions are met: (a) The financial asset is held within a management model whose objective is achieved by both collecting contractual cash flows and selling financial assets and (b) 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. 80) A financial asset shall be measured at fair value through surplus or deficit unless it is meas- EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 19 of 62 ured at amortized cost or at fair value through net assets/equity. 6.2 Classification of Financial Liabilities 81) An EU entity shall classify all financial liabilities as subsequently measured at amortized cost, except for: (a) Financial liabilities at fair value through surplus or deficit. (b) Financial liabilities that arise when a transfer of a financial asset does not qualify for de- recognition or when the continuing involvement approach applies. (c) Financial guarantee contracts. (d) Commitments to provide a loan at a below-market interest rate. (e) Contingent consideration recognized by an acquirer in a public sector combination to which EAR 19 applies. 6.3 Embedded derivatives 82) An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract with the effect that some of the cash flows of the combined instru- ment vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A derivative that is attached to a financial instrument but is contractually transferable independently of that in- strument, or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument 83) If a hybrid contract contains a host that is an asset within the scope of this EAR, an EU entity shall apply the financial assets classification requirements to the entire hybrid contract. 84) If a hybrid contract contains a host that is not an asset within the scope of this EAR, an embed- ded derivative shall be separated from the host and accounted for as a derivative under this EAR if, and only if: (a) The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host. (b) A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and (c) The hybrid contract is not measured at fair value with changes in fair value recognized in surplus or deficit (i.e., a derivative that is embedded in a financial liability at fair value through surplus or deficit is not separated). EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 20 of 62 85) If an embedded derivative is separated, the host contract shall be accounted for in accordance with the appropriate EAR. This EAR does not address whether an embedded derivative shall be presented separately in the statement of financial position. 86) However, if a contract contains one or more embedded derivatives and the host is not an asset within the scope of this EAR an EU entity may designate the entire hybrid contract as at fair value through surplus or deficit unless: a) The embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract; or (b) It is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amor- tized cost. 87) If an EU entity is required by this EAR to separate an embedded derivative from its host, but is unable to measure the embedded derivative separately either at acquisition or at the end of a subsequent financial reporting period, it shall designate the entire hybrid contract as at fair value through surplus or deficit. 88) If an EU entity is unable to measure reliably the fair value of an embedded derivative on the ba- sis of its terms and conditions, the fair value of the embedded derivative is the difference be- tween the fair value of the hybrid contract and the fair value of the host. If the EU entity is una- ble to measure the fair value of the embedded derivative using this method, the previous para- graph applies and the hybrid contract is designated as at fair value through surplus or deficit 6.4 Management models for financial assets 89) An EU entity’s management model is determined at a level that reflects how groups of financial assets are managed together to achieve a particular objective. The EU entity’s management model does not depend on management’s intentions for an individual instrument. Accordingly, this condition is not an instrument-by-instrument approach to classification and should be de- termined on a higher level of aggregation. However, a single EU entity may have more than one management model for its financial instruments. Consequently, classification need not be de- termined at the reporting EU entity level. 90) An EU entity’s management model refers to how an EU entity manages its financial assets in order to generate cash flows. Consequently, this assessment is performed on the basis of scenar- ios that the EU entity reasonably expects to occur. If cash flows are realized in a way that is dif- ferent from the EU entity’s expectations at the date that the EU entity assessed the management model, that does not give rise to a prior period error in the EU entity’s financial statements, nor does it change the classification of the remaining financial assets held in that management mod- el as long as the EU entity considered all relevant information that was available at the time that it made the management model assessment. However, when an EU entity assesses the manage- ment model for newly originated or newly purchased financial assets, it must consider infor- mation about how cash flows were realized in the past, along with all other relevant infor- EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 21 of 62 mation. 91) An EU entity’s management model for financial assets is a matter of fact and not merely an as- sertion. It is typically observable through the activities that the EU entity undertakes to achieve the objective of the management model. An EU entity will need to use judgment when it assess- es its management model for financial assets and that assessment is not determined by a single factor or activity. Instead, the EU entity must consider all relevant evidence that is available at the date of the assessment. Such relevant evidence includes, but is not limited to: (a) How the performance of the management model and the financial assets held within that management model are evaluated and reported to the EU entity’s key manage- ment personnel; (b) The risks that affect the performance of the management model (and the financial as- sets held within that management model) and, in particular, the way in which those risks are managed; and (c) How management is compensated (for example, whether the compensation is based on the fair value of the assets managed or on the contractual cash flows collected). Management model whose objective is to hold assets in order to collect contractual cash flows 92) Financial assets that are held within a management model whose objective is to hold assets in order to collect contractual cash flows are managed to realize cash flows by collecting contrac- tual payments over the life of the instrument. That is, the EU entity manages the assets held within the portfolio to collect those particular contractual cash flows (instead of managing the overall return on the portfolio by both holding and selling assets). In determining whether cash flows are going to be realized by collecting the financial assets’ contractual cash flows, it is necessary to consider the frequency, value and timing of sales in prior periods, the reasons for those sales and expectations about future sales activity. However sales in themselves do not de- termine the management model and therefore cannot be considered in isolation. Instead, infor- mation about past sales and expectations about future sales provide evidence related to how the EU entity’s stated objective for managing the financial assets is achieved and, specifically, how cash flows are realized. An EU entity must consider information about past sales within the con- text of the reasons for those sales and the conditions that existed at that time as compared to cur- rent conditions. 93) Although the objective of an EU entity’s management model may be to hold financial assets in order to collect contractual cash flows, the EU entity need not hold all of those instruments until maturity In addition, the management model may be to hold assets to collect contractual cash flows even if the EU entity sells financial assets when there is an increase in the assets’ credit risk because the credit quality of financial assets is relevant to the EU entity’s ability to collect contractual cash flows Management model whose objective is achieved by both collecting contractual cash flows and selling financial assets 94) An EU entity may hold financial assets in a management model whose objective is achieved by EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 22 of 62 both collecting contractual cash flows and selling financial assets. In this type of management model, the EU entity’s key management personnel have made a decision that both collecting contractual cash flows and selling financial assets are integral to achieving the objective of the management model. There are various objectives that may be consistent with this type of man- agement model. For example, the objective of the management model may be to manage every- day liquidity needs, to maintain a particular interest yield profile or to match the duration of the financial assets to the duration of the liabilities that those assets are funding. To achieve such an objective, the EU entity will both collect contractual cash flows and sell financial assets. Other management models 95) Financial assets are measured at fair value through surplus or deficit if they are not held within a management model whose objective is to hold assets to collect contractual cash flows or within a management model whose objective is achieved by both collecting contractual cash flows and selling financial assets. One management model that results in measurement at fair value through surplus or deficit is one in which an EU entity manages the financial assets with the ob- jective of realizing cash flows through the sale of the assets. The EU entity makes decisions based on the assets’ fair values and manages the assets to realize those fair values. In this case, the EU entity’s objective will typically result in active buying and selling. Even though the EU entity will collect contractual cash flows while it holds the financial assets, the objective of such a management model is not achieved by both collecting contractual cash flows and selling fi- nancial assets. This is because the collection of contractual cash flows is not integral to achiev- ing the management model’s objective; instead, it is incidental to it. 96) A portfolio of financial assets that is managed and whose performance is evaluated on a fair value basis is neither held to collect contractual cash flows nor held both to collect contractual cash flows and to sell financial assets. The EU entity is primarily focused on fair value infor- mation and uses that information to assess the assets’ performance and to make decisions. In addition, a portfolio of financial assets that meets the definition of held for trading is not held to collect contractual cash flows or held both to collect contractual cash flows and to sell financial assets. For such portfolios, the collection of contractual cash flows is only incidental to achiev- ing the management model’s objective. Consequently, such portfolios of financial assets must be measured at fair value through surplus or deficit. 97) The management and performance evaluation on a fair value basis is documented in a risk man- agement or investment strategy. The provision of information to the EU entity’s key manage- ment personnel is also on that basis. The documentation of the EU entity’s strategy need not be extensive but should be sufficient to demonstrate compliance with the fair value basis. Such documentation is not required for each individual item, but may be on a portfolio basis. 6.5 Contractual cash flow characteristics (‘SPPI’ assessment) 98) Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding are consistent with a basic lending arrangement. In a basic lending ar- rangement, consideration for the time value of money and credit risk are typically the most sig- nificant elements of interest. However, in such an arrangement, interest can also include consid- EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 23 of 62 eration for other basic lending risks (for example, liquidity risk) and costs (for example, admin- istrative costs) associated with holding the financial asset for a particular period of time. In ad- dition, interest can include a profit margin that is consistent with a basic lending arrangement. In extreme economic circumstances, interest can be negative if, for example, the holder of a finan- cial asset either explicitly or implicitly pays for the deposit of its money for a particular period of time (and that fee exceeds the consideration that the holder receives for the time value of money, credit risk and other basic lending risks and costs). However, contractual terms that in- troduce exposure to risks or volatility in the contractual cash flows that is unrelated to a basic lending arrangement, such as exposure to changes in equity prices, commodity prices, a specific profitability or income threshold being reached by the borrower or lender, or the achievement (or otherwise) of specific financial or other ratios, do not give rise to contractual cash flows that are solely payments of principal and interest on the principal amount outstanding. An originated or a purchased financial asset can be a basic lending arrangement irrespective of whether it is a loan in its legal form. 99) The principal is the fair value of the financial asset at initial recognition. However that principal amount may change over the life of the financial asset (for example, if there are repayments of principal). 100) An EU entity shall assess whether contractual cash flows are solely payments of principal and interest on the principal amount outstanding for the currency in which the financial asset is denominated. 101) Time value of money is the element of interest that provides consideration for only the pas- sage of time. However, in some cases, the time value of money element may be modified (i.e., imperfect). That would be the case, for example, if a financial asset’s interest rate is periodically reset but the frequency of that reset does not match the tenor of the interest rate. In such cases, an EU entity must assess the modification to determine whether the contractual cash flows rep- resent solely payments of principal and interest on the principal amount outstanding. When as- sessing a modified time value of money element, the objective is to determine how different the contractual (undiscounted) cash flows could be from the (undiscounted) cash flows that would arise if the time value of money element was not modified (the benchmark cash flows). 102) If a financial asset contains a contractual term that could change the timing or amount of contractual cash flows (for example, if the asset can be prepaid before maturity or its term can be extended), the EU entity must determine whether the contractual cash flows that could arise over the life of the instrument due to that contractual term are solely payments of principal and interest on the principal amount outstanding. To make this determination, the EU entity must assess the contractual cash flows that could arise both before, and after, the change in contractu- al cash flows. The EU entity may also need to assess the nature of any contingent event (i.e., the trigger) that would change the timing or amount of the contractual cash flows. While the nature of the contingent event in itself is not a determinative factor in assessing whether the contractual cash flows are solely payments of principal and interest, it may be an indicator. 103) The following are examples of contractual terms that result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding: EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 24 of 62 a) A variable interest rate that consists of consideration for the time value of money, the credit risk associated with the principal amount outstanding during a particular period of time (the consideration for credit risk may be determined at initial recognition only, and so may be fixed) and other basic lending risks and costs, as well as a profit margin; b) A contractual term that permits the issuer (i.e., the debtor) to prepay a debt instrument or permits the holder (i.e., the creditor) to put a debt instrument back to the issuer before maturity and the prepayment amount substantially represents unpaid amounts of princi- pal and interest on the principal amount outstanding, which may include reasonable compensation for the early termination of the contract; and c) A contractual term that permits the issuer or the holder to extend the contractual term of a debt instrument (i.e., an extension option) and the terms of the extension option result in contractual cash flows during the extension period that are solely payments of princi- pal and interest on the principal amount outstanding, which may include reasonable compensation for the extension of the contract. 104) A financial asset that would otherwise have contractual terms which lead to SPPI contractu- al cash flows but does not do so only as a result of a contractual term that permits (or requires) the issuer to prepay a debt instrument or permits (or requires) the holder to put a debt instrument back to the issuer before maturity is eligible to be measured at amortized cost or fair value through net assets/equity (subject to meeting the management model requirements) if: (a) The EU entity acquires or originates the financial asset at a premium or discount to the contractual par amount; (b) The prepayment amount substantially represents the contractual par amount and accrued (but unpaid) contractual interest, which may include reasonable additional compensation for the early termination of the contract; and (c) When the EU entity initially recognizes the financial asset, the fair value of the prepay- ment feature is insignificant. 105) Irrespective of the event or circumstance that causes the early termination of the contract, a party may pay or receive reasonable compensation for that early termination. For example, a party may pay or receive reasonable compensation when it chooses to terminate the contract early (or otherwise causes the early termination to occur). 106) A contractual cash flow characteristic does not affect the classification of the financial asset if it could have only a de minimis effect on the contractual cash flows of the financial asset. To make this determination, an EU entity must consider the possible effect of the contractual cash flow characteristic in each reporting period and cumulatively over the life of the financial in- strument. In addition, if a contractual cash flow characteristic could have an effect on the con- tractual cash flows that is more than de minimis (either in a single reporting period or cumula- tively) but that cash flow characteristic is not genuine, it does not affect the classification of a financial asset. A cash flow characteristic is not genuine if it affects the instrument’s contractual EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 25 of 62 cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur 7. Measurement 7.1 Initial Measurement 107) At initial recognition, an EU entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through surplus or deficit, transaction costs that are directly attributable to the acquisition or is- sue of the financial asset or financial liability. 108) The best evidence of the fair value of a financial instrument at initial recognition is normally the transaction price. 109) When an EU entity uses settlement date accounting for an asset that is subsequently measured at amortized cost, the asset is recognized initially at its fair value on the trade date 110) By exception, at initial recognition, an EU entity may measure short-term receivables and payables at the original invoice amount if the effect of discounting is immaterial. Initial measurement - Concessionary Loans 111) Concessionary loans are granted to or received by an EU entity at below market terms. Be- low market terms can result from interest and/or principal concessions. 112) The granting or receiving of a concessionary loan is distinguished from the waiver of debt owing to or by an EU entity. The intention of a concessionary loan at the outset is to provide or receive resources at below market terms. A waiver of debt results from loans initially granted or received at market related terms where the intention of either party to the loan has changed sub- sequent to its initial issue or receipt. An EU entity would treat the subsequent write-off of the loan as a waiver of debt and apply the derecognition requirements of this rule. 113) Concessionary loans also share many characteristics with originated credit-impaired loans. Whether a loan is classified as concessionary or originated credit-impaired determines whether the difference between the transaction price and the fair value of the loan is recognized as a concession or as a credit loss in the statement of financial performance. 114) Whether a loan is concessionary or originated credit-impaired depends on its substance. An intention to incorporate a non-exchange component into the transaction, such as a transfer of re- sources, indicates the loan is concessionary. The non-exchange component is incorporated into the transaction by granting the loan at below market terms. By contrast, originated credit- impaired loans are loans where one or more events, that have a detrimental impact on the esti- mated future cash flows of the financial asset, have occurred. 115) As concessionary loans are granted or received at below market terms, the transaction price on initial recognition of the loan may not be its fair value. At initial recognition, an EU entity therefore analyzes the substance of the loan granted or received into its component parts, and EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 26 of 62 accounts for those components using the principles in paragraphs 116 and 118 below. 116) An EU entity firstly assesses whether the substance of the concessionary loan is in fact a loan, a non-exchange transaction, a contribution from owners or a combination thereof. If an EU entity has determined that the transaction, or part of the transaction, is a loan, it assesses wheth- er the transaction price represents the fair value of the loan on initial recognition. An EU entity determines the fair value of the loan by using the principles in chapter 7.4. Where an EU entity cannot determine fair value by reference to an active market, it uses a valuation technique. Fair value using a valuation technique could be determined by discounting all future cash receipts using a market related rate of interest for a similar loan. 117) Any difference between the fair value of the loan and the transaction price (the loan pro- ceeds) is treated as follows: a) Where the loan is received by an EU entity, the difference is accounted for in accordance with EAR 17. b) Where the loan is granted by an EU entity, the difference is treated as an expense in surplus or deficit at initial recognition, except where the loan is a transaction with owners, in their capacity as owners. Where the loan is a transaction with owners in their capacity as owners, for example, where a controlling EU entity provides a concessionary loan to a controlled EU entity, the difference may represent a capital contribution, i.e., an investment in an EU enti- ty, rather than an expense. 118) After evaluating the substance of the concessionary loan and measuring the loan component at fair value, an EU entity subsequently assesses the classification of concessionary loans in ac- cordance with the classification requirements of this EAR and measures concessionary loans in accordance with the subsequent measurement requirements of this EAR. 119) In some circumstances a concessionary loan may be granted that is also originated credit- impaired. For example, a government may provide loans with concessionary terms on a recur- ring basis to a borrower that historically has not been able to repay in full. If the concessionary loan is credit impaired, an EU entity measures the instrument at the fair value including the ex- pected credit losses over the life of the instrument. An EU entity applies paragraph 117 (b) to account for the component parts and recognizes the credit losses and concessionary element in its entirety as a concession. Initial measurement - Financial support loans without market 120) Financial support loans granted by EU entities from borrowed funds are not concessionary loans. Rather, these are loans granted with the sole purpose of providing financial support to the beneficiary – thus there is an absence of an active comparable market. The EU only bor- rows money so as to provide this assistance so therefore it does not seek out alternate invest- ment opportunities for borrowed monies and thus there is no basis of comparison with market rates. Examples of such financial support facilities include the European Financial Stabilisation Mechanism and the temporary Support to mitigate Unemployment Risks in an Emergency. In EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 27 of 62 accordance with paragraph 108 the transaction price is considered to be at fair value at transaction date. Initial measurement - Financial Guarantees 121) Under the requirements of this EAR, financial guarantee contracts, like other financial assets and financial liabilities, are required to be initially recognized at fair value. Initial measurement - Valuing Financial Guarantees Issued Through a Non-Exchange Trans- action 122) An EU entity may provide a guarantee by way of non-exchange transactions, i.e., at no or nominal consideration, in order to achieve its policy objectives. Where there is consideration for a financial guarantee, an EU entity should determine whether that consideration arises from an exchange transaction and whether the consideration represents a fair value. If the consideration does represent a fair value, entities should recognize the financial guarantee at the amount of the consideration. Subsequent measurement should be at the higher of the amount of the loss allow- ance determined in accordance with the impairment requirements of this EAR and the amount initially recognized, less, when appropriate, cumulative amortization recognized in accordance with EAR 4. Where the EU entity concludes that the consideration is not a fair value, an EU en- tity determines the carrying value at initial recognition in the same way as if no consideration had been paid. 123) At initial recognition, where no fee is charged or where the consideration is not fair value, an EU entity firstly considers whether there are quoted prices available in an active market for financial guarantee contracts directly equivalent to that entered into. Evidence of an active mar- ket includes recent arm’s length market transactions between knowledgeable willing parties, and reference to the current fair value of another financial guarantee contract that is substantially the same as that provided at nil or nominal consideration by the issuer. The fact that a financial guarantee contract has been entered into at no consideration by the debtor to the issuer is not, of itself, conclusive evidence of the absence of an active market. 124) Where there is no active market for a directly equivalent guarantee contract; the EU entity considers whether a valuation technique other than observation of an active market is available and provides a reliable measure of fair value. Such a valuation technique may rely on mathemat- ical models which consider financial risk. For example, EU entity guarantees a loan of a devel- opment bank to a company. As the development bank has an EU guarantee backing its loan op- eration, the loan has a lower interest rate than if it were not secured by a EU guarantee. This is because the EU guarantee lowers the risk profile of the loan for the bank. The guarantee fee could be determined by using the spread between what the interest rate would have been had the loan not been backed by a EU guarantee and the interest rate with the EU guarantee in place. Where a fair value is obtainable either by observation of an active market or through another valuation technique, the EU entity recognizes the financial guarantee at that fair value in the statement of financial position and recognizes an expense of an equivalent amount in the state- ment of financial performance. When using a valuation technique that is not based on observa- EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 28 of 62 tion of an active market an EU entity needs to satisfy itself that the output of any model is relia- ble and understandable. 125) If no reliable measure of fair value can be determined, either by direct observation of an ac- tive market or through another valuation technique, an EU entity is required to measure the fi- nancial guarantee contract at the amount of the loss allowance equal to lifetime expected credit loss, determined in accordance with the impairment requirements of this EAR. 7.2 Subsequent Measurement of Financial Assets 126) After initial recognition, an EU entity shall measure a financial asset in accordance with the classification requirements of this EAR at: a) Amortized cost; b) Fair value through net assets/equity; or c) Fair value through surplus or deficit. 127) If a financial instrument that was previously recognized as a financial asset is measured at fair value through surplus or deficit and its fair value decreases below zero, it is a financial lia- bility measured in accordance with the classification requirements of this EAR. 128) An EU entity shall apply the impairment requirements to financial assets that are measured at amortized cost and to financial assets that are measured at fair value through net assets/equity. Investments in equity instruments 129) All investments in equity instruments and contracts on those instruments must be measured at fair value. However, in limited circumstances, cost may be an appropriate estimate of fair value. That may be the case if insufficient more recent information is available to measure fair value, or if there is a wide range of possible fair value measurements and cost represents the best esti- mate of fair value within that range. 130) An EU entity shall use all information about the performance and operations of the investee that becomes available after the date of initial recognition, which may indicate that cost might not be representative of fair value. In such cases, the EU entity must measure fair value. 131) Cost is never the best estimate of fair value for investments in quoted equity instruments (or contracts on quoted equity instruments). 7.3 Subsequent Measurement of Financial Liabilities 132) After initial recognition, an EU entity shall measure a financial liability at amortized cost, ex- cept for: (a) Financial liabilities at fair value through surplus or deficit. Such liabilities, including de- rivatives that are liabilities, shall be subsequently measured at fair value. (b) Financial liabilities that arise when a transfer of a financial asset does not qualify for de- EUROPEAN COMMISSION Budget Treasury, accounting and financial reporting Accounting Version: 4 EAR 11: FINANCIAL INSTRUMENTS Date: December 2020 Page 29 of 62 recognition or when the continuing involvement approach applies. Paragraphs 65 and 67 ap- ply to the measurement of such financial liabilities. (c) Financial guarantee contracts. After initial recognition, an issuer of such a contract shall (unless one of the paragraphs 132 (a) and 132 (b) above apply) subsequently measure it at the higher of: (i) The amount of the loss allowance determined in accordance with the impairment requirements of this EAR; and (ii) The amount initially recognized less, when appropriate, the cumulative amount of amortization recognized in accordance with the principles of EAR 4. (d) Commitments to provide a loan at a below-market interest rate. An issuer of such a com- mitment shall (unless paragraph 132 (a) applies) subsequently measure it at the higher of: i. The amount of the loss allowance determined in accordance with the impairment re- quirements of this EAR and ii. The amount initially recognized less, when appropriate, the cumulative amount of amor- tization recognized in accordance with the principles of EAR 4. (e) Contingent consideration recognized by an acquirer in a public sector combination to which EAR 20 applies. Such contingent consideration shall subsequently be measured at fair value with changes recognized in surplus or deficit. 7.4 Fair Value Measurement Considerations 133) The underlying presumption of fair value definition is that an EU entity is going concern. However, fair value reflects the credit quality of the instrument. 134) The best evidence of fair value is quoted prices in an active market. A financial instrument is regarded as quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices represent actual and regularly occurring market transactions on an arm’s length basis. Fair value is defined in terms of a price agreed by a willing buyer and a willing seller in an arm’s length transaction. The objective of determining fair value for a financial instrument that is traded in an active market is to arrive at the price at which a transaction would occur at the end of the r

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