Accounting for Financial Instruments

Accounting for Financial Instruments

David M. Chen

Professor, Graduate Institute of Finance Fu Jen Catholic University

June 2005

IAS 32 Financial Instruments:

Disclosure and Presentation

Version: Dec. 31, 2004

Applied for annual periods beginning on or after 1 January 2005. Earlier application is permitted.

Objective

Enhance FS users’ understanding of the

significance of FIs to an entity’s financial

position, performance and cash flows. 1

Presentation 2

Classification of FIs, from the perspective of the issuer, into financial assets,

financial liabilities and equity instruments.

Classification of related interest, dividends, losses and gains.

Circumstances in which FAs

and FLs should be offset.

Disclosure

Factors that affect the amount, timing and

certainty of an entity’s future CFs relating to FIs.

Accounting policies applied

Nature and extent of an entity’s use of FIs, the business purposes they serve,

the risks associated with them, and

management’s policies for controlling those risks.

Scope

 Applied by all entities to all types of FIs except 4

a. Interests in subsidiaries (IAS 27), associates (IAS 28) and joint ventures (IAS 31)

 Still apply if accounted for under IAS 39

• In these cases, shall also apply the disclosure requirements in IAS 27, IAS 28 and IAS 31.*

 Shall also apply to all derivatives on interests in

subsidiaries, associates or joint ventures.**

b. Employers’ rights and obligations under employee benefit plans (IAS 19)

c. Contracts for contingent consideration in a business combination (IFRS 3).*

 This exemption applies only to the acquirer.

d. Insurance contracts (IFRS 4)

 Still applies to derivatives that are embedded in insurance contracts if required to be accounted for separately.

e. FIs that are within the scope of IFRS 4 because they contain a discretionary participation feature.**

 The issuer is exempt from applying to these features 15–32 and

AG25–AG35 regarding the distinction between FLs and EIs.

 However, these instruments are subject to all other requirements of this Standard.

 Still applies to derivatives that are embedded in these instruments.

f. FIs, contracts and obligations under share-based payment transactions (IFRS 2), except for

1. Contracts within the scope of 8–10 to which this Standard applies.*

2. 33 and 34 shall be applied to treasury shares purchased,

sold, issued or cancelled in connection with employee

share option plans, employee share purchase plans, and

all other share-based payment arrangements.

Applies to recognised and unrecognised FIs 5

Recognised FIs include EIs issued by the entity and FAs and FLs that are within the scope of IAS 39.*

Unrecognised FIs include some FIs that,

although outside the scope of IAS 39, are

within the scope of this Standard (such as

some loan commitments).*

Other Standards specific to particular types of FI contain additional presentation and disclosure requirements 7

E.g., IAS 17 Leases and IAS 26 Accounting and Reporting by Retirement Benefit Plans incorporate specific disclosure requirements relating to finance leases and retirement benefit plan investments,

respectively.

Some requirements of other Standards, particularly

IAS 30 Disclosures in the Financial Statements of

Banks and Similar Financial Institutions, apply to

FIs.

Applied to those contracts to buy or sell a non-

financial item that can be settled net in cash or another FI, or by exchanging FIs, as if the contracts were FIs, 8

Include 9

a)the terms of the contract permit either party to settle it that way;

b)the ability to settle it that way is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts that way (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse);

c)for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin; and

d) when the non-financial item that is the subject of the contract is readily convertible to cash.

 With the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage

requirements.

• A contract to which b) and c) applies is not entered into for the purpose of the exception.

• A written option to buy or sell a non-financial item that can be settled that way, in accordance with 9 a) or d) is within the scope of this

Standard. Such a contract cannot be entered into

for the purpose of the exception.* 10

Definition

Financial instrument (FI) 11

• Any contract that gives rise to a FA of one entity and a FL or EI of another entity.

• ‘Contract’ and ‘contractual’ refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and thus FIs, may take a variety of forms and need not be in writing. 13

Financial asset (FA)

• Any asset that is*

a) cash;

b) an EI of another entity;

c) a contractual right

1) to receive cash or another FA from another entity; or 2) to exchange FAs or FLs with another entity under

conditions that are potentially favourable to the entity; or d) a contract that will or may be settled in the entity’s own EIs

and is*

1) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own EIs; or 2) a derivative that will or may be settled other than by the

exchange of a fixed amount of cash or another FA for a

fixed number of the entity’s own EIs.**For this purpose

the entity’s own EIs do not include instruments that are

themselves contracts for the future receipt or delivery of

the entity’s own EIs.***

Financial assets Cash

Another entity’s equity

Contractual rights:

Receivable Positive position Contracts (may be) settled in own equity:

Non-derivatives: receive a variable number Derivative: not exchanging a fixed amount

for a fixed number of own shares

 Financial liability (FL)

• Any liability that is

a) a contractual obligation

1) to deliver cash or another FA to another entity;

2) or to exchange FAs or FLs with another entity under conditions that are potentially unfavourable to the entity; or

b) a contract that will or may be settled in the entity’s own EIs and is 1) a non-derivative for which the entity is or may be obliged to

deliver a variable number of the entity’s own EIs; or

2) a derivative* that will or may be settled other than by the exchange of a fixed amount of cash or another FA for a fixed number of the entity’s own EIs (not include those that are for the future receipt/delivery of the entity’s own EIs).

• Contingent settlement provisions

– A FI may require the entity to deliver cash or another FA (or otherwise to settle it in such a way that it would be a FL), in the event of the occurrence or non-occurrence of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the

instrument, such as a change in a stock market index, consumer price index, interest rate or taxation requirements, or the issuer’s future revenues, net income or debt-to-equity ratio.

– The issuer of such an instrument does not have the unconditional right to avoid delivering cash or another FA. Therefore, it is a FL of the issuer unless (a) the part of the contingent settlement

provision that could require settlement in cash or another FA is not genuine or (b) the issuer can be required to settle the obligation in cash or another FA only in the event of liquidation of the issuer.*

25

Equity instrument (EI)

• Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Fair value

• The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Financial Liability Contractual obligation:

Payable

Negative position

Contracts (may be) settled in own equity:

Non-derivatives: deliver a variable number Derivative: not exchanging a fixed amount

for a fixed number of own shares

Contingent

settlement

provisions

Application guidance (AG)

Circularity of definition

• A chain of contractual rights or contractual obligations meets the

definition of a FI if it will ultimately lead to the receipt or payment of cash or to the acquisition or issue of an equity instrument. 7

Perpetual debt instruments

• Normally provide the holder with the contractual right to receive payments on account of interest at fixed dates extending into the

indefinite future, either with no right to receive a return of principal or a right to a return of principal under terms that make it very unlikely or very far in the future.

• The issuer assumes a contractual obligation to make a stream of future interest payments having a FV of issuing price on initial recognition.

The holder and issuer of the instrument have a FA and a FL, respectively. 6

Conditional right or obligation

• The ability to exercise a contractual right or the requirement to satisfy a contractual obligation may be absolute, or it may be contingent on the occurrence of a future event.

• A contingent right and obligation meet the definition of a FA and a FL, even though such assets and liabilities are not always recognised in the FSs.* Some of these contingent rights and obligations may be insurance contracts within the scope of IFRS 4. 8

Leases

• A finance lease is regarded as a FI and an operating lease is not regarded as a FI (except as regards individual payments currently due and

payable).

• The lessor accounts for its investment in the amount receivable under the finance lease contract rather than the leased asset itself.

• The lessor continues to account for the leased asset itself rather than any amount receivable in the future under the operating lease contract. 9

Physical & intangible assets

• Control of such physical and intangible assets creates an opportunity to generate an inflow of cash or another FA, but it does not give rise to a present right to receive cash or another FA. 10

Prepaid expenses, deferred revenue and warranty obligations

• The future economic benefit or outflow is the receipt or delivery of goods or services, rather than the right to receive or the obligation to pay cash or another FA, are not FAs or FLs. 11

Non-contractual

• Liabilities or assets that are not contractual (e.g., income taxes that are created as a result of statutory requirements) are not FLs or FAs. 12

Contingent liabilities and contingent assets

• Constructive obligations, as defined in IAS 37 Provisions, Contingent Liabilities and Contingent Assets, do not arise from contracts and are not FLs.*

Non-financial contracts

• Although the Standard was not developed to apply to commodity or other contracts that do not satisfy the definition of a FI or fall within 8, entities may regard it as appropriate to apply the relevant

disclosure requirements of this Standard to such

contracts. 24

Presentation

 Classification of FIs

 The issuer of a FI 15

 shall classify the instrument, or its component parts, on initial recognition

• as a FL, a FA or an EI in accordance with the substance of the contractual arrangement and the definitions.

 Liabilities vs. equity 16

• When applies the definitions, the instrument is an EI if,

and only if, both conditions (a) and (b) below are met.

a) Includes no contractual obligation :

1) to deliver cash or another FA to another entity;

2) or to exchange FAs or FLs with another entity under

conditions that are potentially unfavourable to the issuer.*

 Explanation of (a)

• Although the holder of an EI may be entitled to receive a pro rata share of any dividends or other distributions of equity, the issuer does not have a contractual obligation to make such distributions. 17

• Some take the legal form of equity but are liabilities in

substance, and others may combine features associated

with EIs and features associated with FLs.

• E.g., a preference share that provides for mandatory

redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a FL.*

• This is so even when the amount of cash or other FAs is

determined on the basis of an index or other item that has the potential to increase or decrease, or when the legal form of the puttable instrument gives the holder a right to a residual interest in the assets of an issuer.

• E.g., open-ended mutual funds, unit trusts, partnerships and some co-operative entities may provide their unitholders or members with a right to redeem their interests in the issuer at any time for cash equal to their proportionate share of the asset value of the issuer.

• However, classification as a FL does not preclude the use of descriptors such as ‘net asset value attributable to unitholders’

and ‘change in net asset value attributable to unitholders’ on the face of the FSs of an entity that has no contributed equity or the use of additional disclosure to show that total members’

interests comprise items such as reserves that meet the

definition of equity and puttable instruments that do not.* 18

• If an entity does not have an unconditional right to avoid

delivering cash or another FA to settle a contractual obligation, that obligation meets the definition of a FL, e.g., conditional on a counterparty exercising its right to redeem.**

• A restriction on the ability of an entity to satisfy a contractual obligation, such as lack of access to foreign currency or the need to obtain approval for payment from a regulatory

authority, does not negate the entity’s contractual obligation or the holder’s contractual right. 19

• A FI may establish an obligation indirectly through its terms and conditions.

• May contain a non-financial obligation that must be settled if, and only if, the entity fails to make distributions or to redeem the instrument. If the entity can avoid a transfer of cash or another FA only by settling the non-financial obligation, the FI is a FL.*

• May provide that on settlement the entity will deliver either (i) cash or another FA or (ii) its own shares whose value is

determined to exceed substantially the value of the cash or other FA. The value of the share settlement alternative is such that the entity will settle in cash. In any event, the holder has in substance been guaranteed receipt of an amount that is at least equal to the cash settlement option. 20

b) If the instrument will or may be settled in the issuer’s own EI, it is:

1) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own EIs; or

2) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another FA for a fixed number of its own EIs (not include those that are for the future receipt or delivery of the issuer’s own EIs).

 Explanation of (b)

• A contract is not an EI solely because it may result in the receipt or delivery of the entity’s own EIs. An entity may have a contractual right or obligation to receive or deliver a number of its own shares or other EIs that varies so that the FV of the entity’s own EIs to be received or delivered equals the amount of the contractual right or obligation.*

• Such a contractual right or obligation may be for a fixed amount or an amount that fluctuates in part or in full in response to

changes in a variable other than the market price of the entity’s own EI (e.g., an interest rate, a commodity price or a FI price).

• Such a contract is a financial liability of the entity even though the entity must or can settle it by delivering its own EI.

• It is not an EI because the entity uses a variable number of its own EIs as a means to settle the contract. Accordingly, the contract does not evidence a residual interest in the entity’s assets after deducting all of its liabilities. 21

• A contract that contains an obligation for an entity to purchase its own EIs for cash or another FA gives rise to a FL for the present value of the redemption amount. This is the case even if the

contract itself is an EI. One example is an entity’s obligation under a forward contract to purchase its own EI for cash.* 23

• When the FL is recognised initially under IAS 39, its FV is reclassified from equity. If the contract expires without

delivery, the carrying amount of the FL is reclassified to equity. An entity’s contractual obligation to purchase its own EIs gives rise to a FL for the present value of the redemption amount even if the obligation to purchase is conditional on the counterparty exercising a right to redeem. 23

• A contract that will be settled by the entity delivering or

receiving a fixed number of its own EIs in exchange for a

variable amount of cash or another FA is a FA or FL. An

example is a contract for the entity to deliver 100 of its own

EIs in return for an amount of cash calculated to equal the

value of 100 ounces of gold.* 24

• A contract that will be settled by the entity (receiving or) delivering a fixed number of its own EIs in exchange for a fixed amount of cash or another FA is an EI. Any consideration received is added directly to equity. Any consideration paid is deducted directly from equity. Changes in the FV of an EI are not recognised in the FSs.

22

• When a derivative FI gives one party a choice over how it is settled, it is a FA or a FL unless all of the settlement alternatives would result in it being an equity instrument. A share option that the issuer can decide to settle net in cash or by exchanging its own shares for cash is a FL.* 26

• For some contracts to buy or sell a non-financial item in exchange for the entity’s own EIs, because they can be settled either by

delivery of the non-financial item or net in cash or another FI, they are FAs or FLs and not EIs. 27

Equity instrument

Involving only price risk of own EIs

Obligation to purchase own EIs (others have the option):

Reclassified as a FL

Own EI settlement:

Nonderivative: not to deliver a variable number Derivative: exchange a fixed

amount for a fixed number No contractual obligation:

Have an unconditional right to avoid (others do not have the option)

No indirect obligation

Not an own-share settlement alternative

Application guidance

Preference share

• An option of the issuer to redeem the shares for cash does not satisfy the definition of a FL because the issuer does not have a present obligation to transfer FAs to the shareholders. In this case, redemption of the shares is solely at the discretion of the issuer.

• An obligation may arise, however, when the issuer of the shares exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares. 25

• When distributions to holders of the preference shares, whether

cumulative or non-cumulative, are at the discretion of the issuer, the shares are EIs. 26

Own equity settlement

• A contract that will be settled by the entity receiving or delivering a fixed number of its own shares for no future consideration is an EI.* 27(a)

• A contract that will be settled in cash or another FA is a FA or FL even if the amount of cash or another FA that will be received or delivered is based on changes in the market price of the entity’s own equity. One example is a net cash-settled share option.*

27(c)

• A contract that requires settlement in cash or a variable number of the entity’s own shares only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur is an EI. Similarly, settlement in a fixed number of an entity’s own shares may be contractually precluded in circumstances that are outside the control of the entity, but if these circumstances have no genuine possibility of occurring, classification as an EI is appropriate. 28

• When classifying a FI in consolidated FSs, an entity considers all terms and conditions agreed between members of the group and the holders of the instrument in determining whether the group as a whole has an obligation to deliver cash or another FA in respect of the

instrument or to settle it in a manner that results in liability classification.

• When a subsidiary issues a FI and a parent or other group entity agrees additional terms directly with the holders of the instrument (e.g., a guarantee), the group may not have discretion over distributions or redemption. Although the subsidiary may appropriately classify the instrument without regard to these additional terms in its individual FSs, the effect of other agreements is considered in order to ensure that consolidated FSs reflect the contracts entered into by the group as a whole.*

• To the extent that there is such an obligation or settlement provision, the instrument (or the component of it that is subject to the obligation) is classified as a FL in consolidated FSs. 29

Basis for conclusion (BC)

The classification as FAs, FLs or EIs of FIs that are indexed to, or settled in, an entity’s own EIs.

• The original IAS 32 dealt with aspects of this issue piecemeal and it was not clear how various transactions should be treated under the Standard. 5

• Decided that a FI that gives the holder the right to put the

instrument back to the entity for cash or another FA is a FL of the entity. Such FIs are commonly issued by mutual funds, unit trusts, co–operative and similar entities, often with the redemption amount being equal to a proportionate share in the net assets of the entity.

• The classification as a FL is independent of considerations such as when the right is exercisable, how the amount payable or receivable upon exercise of the right is determined, and whether the puttable instrument has a fixed maturity. 7

• Did not debate whether an obligation can be established implicitly rather than explicitly because this is not within the scope of an improvements project. This question will be considered in the project on revenue, liabilities and equity. Consequently, retained the existing notion that an instrument may establish an obligation indirectly through its terms and conditions.

• However, decided that the example of a preference share with a contractually accelerating dividend which, within the foreseeable future, is scheduled to yield a dividend so high that the entity will be economically compelled to redeem the instrument, was

insufficiently clear. The example was therefore removed and replaced with others that are clearer and deal with situations that have proved problematic in practice.* 9

• An entity’s obligation to purchase its own shares establishes a maturity date for the shares that are subject to the contract.

• Without a requirement to recognise a FL for the PV of the share

redemption amount, entities with identical obligations to deliver cash in exchange for their own EIs could report different information in their FSs depending on whether the redemption clause is embedded in the EI or is a free-standing derivative contract.* 11

• Some suggested when an entity writes an option that, if exercised, will result in the entity paying cash in return for receiving its own shares, it is incorrect to treat the full amount of the exercise price as a financial liability because the obligation is conditional upon the option being exercised.

• The Board rejected this argument because the entity has an obligation to pay the full redemption amount and cannot avoid settlement in cash or another FA for the full redemption amount unless the counterparty decides not to exercise its redemption right or specified future events or circumstances beyond the control of the entity occur or do not occur.** 12

• The Board also noted that a change would require a

reconsideration of other provisions in IAS 32 that require liability treatment for obligations that are conditional on events or choices that are beyond the entity’s control: the treatment of preference shares that are redeemable at the option of the holder as FLs for the full amount of the conditional obligation.

• Precluding equity treatment for such a contract (own equity as

currency) limits incentives for structuring potentially favourable or unfavourable transactions to obtain equity treatment. 14

• The Board rejected the argument that a contract that is settled in the entity’s own shares must be an equity instrument because no change in assets or liabilities, and thus no gain or loss, arises on settlement of the contract. The Board noted that any gain or loss arises before settlement of the transaction, not when it is settled. 15

• SIC-5 requires that a FI for which the manner of settlement

depends on the occurrence or not of uncertain future events, or on the outcome of uncertain circumstances that are beyond the

control of both the issuer and the holder is a FL. 16

• The amendments do not include the exception previously

provided in SIC-5.6 for circumstances in which the possibility of the entity being required to settle in cash or another FA is remote at the time the FI is issued. It is not consistent with the definitions of FLs and EIs to classify an obligation to deliver cash or another FA as a FL only when settlement in cash is probable.* 17

• Contingent settlement provisions that would apply only in the event of liquidation of an entity should not influence the

classification of the instrument because to do so would be

inconsistent with a going concern assumption. Such provision is similar to an EI. 18

• Entities should not be able to circumvent the accounting

requirements for FAs and FLs simply by including an option to settle a contract through the exchange of a fixed number of shares for a fixed amount. Past practice and management intentions should not be determining factors (difficult to apply because some entities do not have any history of similar transactions and the assessment of whether an established practice exists and of what is

management’s intention can be subjective). 20

• In finalising the revisions to IAS 32 the Board considered, but rejected, a number of alternative approaches:

a) To classify as an EI any contract that will be settled in the entity’s own shares. (as currency)

b) Only if (i) the contract will be settled in the entity’s own shares, and (ii) the changes in the FV of the contract move in the same direction as the changes in the FV of the shares from the

perspective of the counterparty.*

c) Will be settled in the entity’s own shares unless its value changes in response to something other than the price of the entity’s own shares (creates an exception to the principle that non-derivative contracts that are settled in a variable number of an entity’s own shares should be treated as FAs or FLs).*

d) To limit classification as EIs to outstanding ordinary

shares, and classify as FAs or FLs all contracts that

involve future receipt or delivery of the entity’s own

shares (represent a fundamental shift in the concept of

equity: warrants not equity). 21

• IFRIC 2 states that members’ shares that would be classified as equity in the absence of the members’ right to request

redemption are equity if either of the following conditions is met.

a) the entity has an unconditional right to refuse redemption of the members’ shares.

b) redemption is unconditionally prohibited by local law, regulation or the entity’s governing charter. However, provisions in local law or regulations or the entity’s governing charter that prohibit redemption only if

conditions—such as liquidity constraints—are met (or are

not met) do not result in members’ shares being equity.

• Under the proposed amendments to IAS32, Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation, the following types of financial instruments would be classified as equity, provided that specified criteria are met:

– ordinary shares that are puttable to (ie redeemable from) the issuer at fair value;*

– ordinary shares of limited life entities; and

– partners’ interests in a partnership that must liquidate upon exit of a partner (eg on retirement or death).

• Basis for conclusion

– If recognized as a liability, then when the entity performs well and the fair value of the liabilities increases, a loss is recognised. When the entity performs poorly and the fair value of the liability

decreases, a gain is recognised. The amendments propose to classify these instruments as equity, provided specified criteria are met.

Compound FIs

• The issuer of a non-derivative FI shall evaluate the terms of the FI to determine whether it contains both a liability and an equity component. Such components shall be classified separately as FLs, FAs or EIs. 28

• An entity recognises separately the components of a FI that (a) creates a FL of the entity and (b) grants an option to the holder of the instrument to convert it into an EI of the entity.

• The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt

instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. 29

• Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised, even when exercise may

appear to have become economically advantageous to some holders.

• Holders may not always act in the way that might be expected because, e.g., the tax consequences resulting from conversion may differ among holders. Furthermore, the likelihood of conversion will change from time to time. The entity’s contractual obligation to

make future payments remains outstanding until it is extinguished through conversion, maturity of the instrument or some other

transaction. 30

• When the initial carrying amount of a compound FI is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the FV of the instrument as a whole the amount separately determined for the liability

component.*

• The value of any derivative features (such as a call option)

embedded in the compound FI other than the equity component (such as an equity conversion option) is included in the liability component. No gain or loss arises from initially recognising the components of the instrument separately. 31

Application guidance

Conversion

• No gain or loss on conversion at maturity.* 32

• When an entity extinguishes a convertible instrument before maturity through an early redemption in which the original conversion privileges are unchanged, the entity allocates the

consideration paid and any transaction costs for the redemption to the liability and equity components of the instrument at the date of the transaction.

• The method used is consistent with that used in the original allocation to the separate components of the proceeds received by the entity

when the convertible instrument was issued. 33

• Once the allocation of the consideration is made, any resulting gain or loss is treated in accordance with accounting principles applicable to the related component. 34

• An entity may amend the terms of a convertible instrument to induce early conversion, for example by offering a more favourable

conversion ratio or paying other additional consideration in the event of conversion before a specified date. The difference, at the date the terms are amended, between the fair value of the consideration the holder receives on conversion of the instrument under the revised terms and the fair value of the consideration the holder would have received under the original terms is recognised as a loss in profit or loss. 35

 Basis for conclusion

 Assigning initial carrying amount

• The previous version of IAS 32 suggested approaches that might be considered, such as: 23

a) assigning to the less easily measurable component the residual amount after deducting from the instrument as a whole the amount separately determined for the component that is more easily

determinable (a ‘with-and-without’ method); and

b) measuring the liability and equity components separately and, to the extent necessary, adjusting these amounts pro rata so that the sum of the components equals the amount of the instrument as a whole (a ‘relative FV’ method).

• IAS 39.43 requires a FL to be measured on initial recognition at its FV.

Therefore, a relative FV method could result in an initial measurement of the liability component that is not in compliance with IAS 39. 25

Treasury shares

• If an entity reacquires its own EIs, those instruments shall be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own EIs. Such treasury shares may be acquired and held by the entity or by other

members of the consolidated group. Consideration paid or received shall be recognised directly in equity. 33

• The amount of treasury shares held is disclosed

separately either on the face of the BS or in the notes, in accordance with IAS 1.

• An entity provides disclosure in accordance with IAS 24

Related Party Disclosures if the entity reacquires its own

EIs from related parties. 34

• When an entity holds its own equity on behalf of others, e.g. a financial institution holding its own equity on behalf of a client, there is an agency relationship and as a result those holdings are not included in the entity’s BS. AG36

• The acquisition and subsequent resale by an entity of its own EIs represents a transfer

between those holders of EIs who have given up and those who continue to hold, rather than a gain or loss to the entity (SIC-16 Share Capital

—Reacquired Own Equity Instruments).* BC32

Interest, dividends, losses, and gains

Those relating to a FI or a component that is a FL shall be recognised as income or expense in profit or loss.

Distributions to holders of an EI shall be debited by the entity directly to equity, net of any related income tax benefit. 35

• Dividend payments on shares wholly recognised as liabilities are recognised as expenses in the same way as interest on a bond.

• Changes in the fair value of an EI are not recognised in the FSs.

• Gains and losses associated with redemptions or refinancings of FLs are recognised in profit or loss, whereas redemptions or refinancings of EIs are recognised as changes in equity. 36

• An entity typically incurs various costs in issuing or acquiring its own EIs, include registration and other

regulatory fees, amounts paid to legal, accounting and other professional advisers, printing costs and stamp duties.

• The transaction costs of an equity transaction (other than costs of issuing an EI that are directly attributable to the acquisition of a business) are accounted for as a deduction from equity (net of any related income tax benefit) to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided.*

• The costs of an equity transaction that is abandoned are recognised as an expense. 37

• Transaction costs that relate to the issue of a compound FI are allocated to the liability and equity components in proportion to the allocation of proceeds.

• Transaction costs that relate jointly to more than one transaction (for example, costs of a concurrent offering of some shares and a stock exchange listing of other shares) are allocated to those

transactions using a basis of allocation that is rational and consistent with similar transactions. 38

• The amount of transaction costs accounted for as a deduction from equity in the period is disclosed separately under IAS 1.

• The related amount of income taxes recognised directly in equity is included in the aggregate amount of current and deferred

income tax credited or charged to equity that is disclosed under IAS 12 Income Taxes. 39

• Dividends classified as an expense may be presented in the IS either with interest on other liabilities or as a separate item.*

• Disclosure of interest and dividends is subject to the requirements of IAS 1 and IAS 30.

• In some circumstances, because of the differences between interest and dividends with respect to matters such as tax deductibility, it is desirable to disclose them separately. 40

• Gains and losses related to changes in the carrying amount of a FL are recognised as income or expense in profit or loss even when they relate to an instrument that includes a right to the residual interest in the assets of the entity in exchange for cash or another FA.*

• Under IAS 1 the entity presents any gain or loss arising from remeasurement of such an instrument separately on the face of the IS when it is relevant in explaining the entity’s performance. 41

Application guidance

 Compound FIs

• Assume that a non-cumulative preference share is

mandatorily redeemable for cash in five years, but that

dividends are payable at the discretion of the entity before

the redemption date. Such an instrument is a compound FI,

with the liability component being the present value of the

redemption amount.

• The unwinding of the discount on this component is

recognised in profit or loss and classified as interest expense.

Any dividends paid relate to the equity component and,

accordingly, are recognised as a distribution of profit or loss.

• A similar treatment would apply if the redemption was not mandatory but at the option of the holder, or if the share was mandatorily convertible into a variable number of ordinary shares calculated to equal a fixed amount or an amount based on changes in an underlying variable (e.g., commodity).

• However, if any unpaid dividends are added to the redemption

amount, the entire instrument is a liability. In such a case, any

dividends are classified as interest expense. 37

Corrections made to examples

• P. 1296: Dr forward gain 4300 should be Dr forward liability 4300

• P. 1297: (c) Shares for shares (‘net share

settlement’) should be (c) Cash for shares (‘gross physical settlement’)

• P. 1303 IE19: 31 December 2003 should be 31 January 2003.

• P. 1305: Dr Put option asset102,000 Cr Cash

102,000 should change the amount to 5,000

Offsetting a FA and a FL

Shall be offset and the net amount presented in the BS when, and only when

a)an entity 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 simultaneously.

• In accounting for a transfer of a FA that does not qualify

for derecognition, the entity shall not offset the transferred

asset and the associated liability. 42

• When an entity has the right to receive or pay a single net

amount and intends to do so, it has, in effect, only a single FA or FL. 43

• Offsetting does not give rise to recognition of a gain or loss, the derecognition of a FI not only results in the removal of the

previously recognised item from the BS but also may result in recognition of a gain or loss. 44

• A right of set-off is a debtor’s legal right, by contract or

otherwise, to settle or otherwise eliminate all or a portion of an amount due to a creditor by applying against that amount an amount due from the creditor.

• In unusual circumstances, a debtor may have a legal right to apply an amount due from a third party against the amount due to a creditor provided that there is an agreement between the three parties that clearly establishes the debtor’s right of set-off.

• Because the right of set-off is a legal right, the conditions supporting the right may vary from one legal jurisdiction to another and the laws applicable to the relationships between the parties need to be considered. 45

• The existence of the right, by itself, is not a sufficient basis for offsetting. In the absence of an intention to exercise the right or to settle simultaneously, the amount and timing of an entity’s future cash flows are not affected.

• An intention by one or both parties to settle on a net basis without the legal right to do so is not sufficient to justify

offsetting because the rights and obligations associated with the individual FA and FL remain unaltered. 46

• When an entity has a right of set-off, but does not intend to settle net or to realise the asset and settle the liability

simultaneously, the effect of the right on the entity’s credit risk exposure is disclosed in accordance with 76. 47

• An entity may settle two instruments by receiving and paying separate amounts, thus exposed to credit risk for the full amount of the asset or liquidity risk for the full amount of the liability. Such risk exposures may be significant even though relatively brief. Accordingly,

realisation of a FA and settlement of a FL are treated as simultaneous only when the transactions occur at the same moment. 48

Offsetting criteria generally not satisfied and offsetting is usually inappropriate when:

a)several different FIs are used to emulate the features of a single FI (a

‘synthetic instrument’);

b) FAs and FLs arise from FIs having the same primary risk exposure (for example, 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 FLs;*

d) FAs 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 (for example, 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. 49

 A master netting arrangement

• An agreement provides for a single net settlement of all FIs covered by the agreement in the event of default on, or

termination of, any one contract.

• These arrangements are commonly used by financial

institutions to provide protection against loss in the event of bankruptcy or other circumstances that result in a

counterparty being unable to meet its obligations.

• A master netting arrangement commonly creates a right of set-off that becomes enforceable and affects the realisation or settlement of individual FAs and FLs only following a specified event of default or in other circumstances not expected to arise in the normal course of business, hence, does not provide a basis for offsetting unless both of the criteria in 42 are satisfied.

• When FAs and FLs subject to a master netting

arrangement are not offset, the effect of the

arrangement on an entity’s exposure to credit

risk is disclosed in accordance with 76. 50

Application guidance

Right of set-off

• An entity must have a currently enforceable legal right to set off the recognised amounts. It may have a conditional right, such as in a master netting

agreement or in some forms of non-recourse debt, but such rights are enforceable only on the

occurrence of some future event, usually a default of

the counterparty. Thus, such an arrangement does

not meet the conditions for offset.* 38

Disclosure

Purpose

To provide information to enhance understanding of the significance of FIs to an entity’s financial position, performance and cash flows,

And assist in assessing the amounts, timing and certainty of future cash flows associated with those instruments. 51

Assessing the extent of risk related to FIs.

a)Market risk includes three types of risk:

1)currency risk —the risk that the value of a FI will fluctuate

because of changes in foreign exchange rates.

2) fair value interest rate risk —the risk that the value of a FI will fluctuate because of changes in market interest rates.

3) price risk —the risk that the value of a FI will fluctuate as a result of changes in market prices, whether those changes are caused by factors specific to the individual instrument or its issuer or factors affecting all instruments traded in the market.

• Market risk embodies not only the potential for loss but also the potential for gain.

b) Credit risk —the risk that one party to a FI will fail to discharge an obligation and cause the other party to incur a loss.

c) Liquidity risk (also referred to as funding risk)—the

risk that an entity will encounter difficulty in raising

funds to meet commitments associated with FI.

• May result from an inability to sell a financial asset quickly at close to its fair value.*

d) Cash flow interest rate risk —the risk that the future cash flows of a FI will fluctuate because of changes in market interest rates.

• In the case of a floating rate debt instrument, e.g., such

fluctuations result in a change in the effective interest rate of the FI, usually without a corresponding change in its fair value. 52

 Format, location and classes of FIs

 This Standard does not prescribe either the format of the information required to be disclosed or its location within the FSs.

• To the extent that the required information is presented on the face of the FSs, it is unnecessary to repeat it in the notes.

• Disclosures may include a combination of narrative

descriptions and quantified data, as appropriate to the nature of the instruments and their relative significance to the entity.

53

• Determining the level of detail to be disclosed about particular FIs requires the exercise of judgment taking into account the relative significance of those instruments.

• It is necessary to strike a balance between overburdening FSs with excessive detail that may not assist users of FSs and

obscuring important information as a result of too much

aggregation. E.g., when an entity is party to a large number of FIs with similar characteristics and no single contract is

individually material, a summary by classes of instruments is appropriate. On the other hand, information about an

individual instrument may be important when it is a material component of an entity’s capital structure. 54

• The management of an entity groups FIs into classes that are appropriate to the nature of the information disclosed, taking into account matters such as the characteristics of the

instruments and the measurement basis that has been applied.

In general, classes distinguish items measured at cost or amortised cost from items measured at fair value.*

• Sufficient information is provided to permit a reconciliation to relevant line items on the BS.

• When an entity is a party to FIs not within the scope of this Standard, those instruments constitute a class or classes of FAs or FLs separate from those within the scope of this

Standard. Disclosures about those FIs are dealt with by other IFRSs. 55

Risk management (RM) policies and hedging activities

Shall describe financial RM objectives and policies,

including its policy for hedging each main type of forecast transaction for which hedge accounting is used.* 56

• In addition to providing specific information about particular balances and transactions related to FIs, an entity provides a discussion of the extent to which FIs are used, the associated risks and the business purposes served.**

• A discussion of policies for controlling the risks associated with FIs includes policies on matters such as hedging of risk

exposures, avoidance of undue concentrations of risk and requirements for collateral to mitigate credit risk (provides a

valuable additional perspective that is independent of the specific instruments held or outstanding at a particular time). 57

 Shall disclose separately for designated fair value hedges, CF hedges and hedges of a net investment in a foreign operation:

a) a description of the hedge;

b) a description of the FIs designated as hedging instruments (HIs) and their fair values at the BS date;

c) the nature of the risks being hedged; and

d) for CF hedges, the periods in which the CFs are expected to occur, when they are expected to enter into the determination of profit or loss, and a description of any forecast transaction for which hedge accounting had previously been used but no longer expected to occur.

58

• When a gain or loss on a HI in a CF hedge has been recognised directly in equity, through the statement of changes in equity, shall disclose:

a) the amount that was so recognised in equity during the period;

b) the amount that was removed from equity and included in profit or loss for the period; and

c) the amount that was removed from equity during the period and included in the initial measurement of the acquisition cost or other carrying amount of a non-FA or non-FL in a hedged highly probable forecast transaction. 59

 Terms, conditions & accounting policies

 For each class of FA, FL and EI, an entity shall disclose:

a) information about the extent and nature of the FIs, including significant terms and conditions that may affect the amount, timing and certainty of future CFs; and

b) the accounting policies and methods adopted, including the

criteria for recognition and the basis of measurement applied. 60

• Shall disclose, for each category of FAs, whether regular way purchases and sales of FAs are accounted for at trade date or at settlement date. 61

• The contractual terms and conditions of a FI that affect the amount, timing and certainty of future cash receipts and payments by the parties to the instrument. When FIs are significant, either individually or as a class, to the financial position of an entity or its future operating results, their terms and conditions are disclosed.

• If no single instrument is individually significant to the future CFs of the entity, the essential characteristics of the

instruments are described by reference to appropriate groupings of like instruments. 62

• When FIs held or issued by an entity, either individually or as a class, create a potentially significant exposure to the risks

described in 52, terms and conditions that warrant disclosure:

a) the principal, stated, face or other similar amount, which, for some derivative instruments, such as interest rate swaps, might be the amount (referred to as the notional amount) on which future payments are based;

b) the date of maturity, expiry or execution;

c)early settlement options held by either party to the instrument, including the period in which, or date at which, the options can be exercised and the exercise price or range of prices;*

d)options held by either party to the instrument to convert the instrument into, or exchange it for, another FI or some other asset or liability, including the period in which, or date at which, the options can be exercised and the conversion or exchange ratio(s);

e) the amount and timing of scheduled future cash receipts or payments of the principal amount of the instrument,

including instalment repayments and any sinking fund or similar requirements;

f) stated rate or amount of interest, dividend or other periodic return on principal and the timing of payments;

g) collateral held, in the case of a FA, or pledged, in the case of a FL;

h) in the case of an instrument for which CFs are denominated in a currency other than the entity’s

functional currency, the currency in which receipts or payments are required;

i) in the case of an instrument that provides for an exchange,

information described in items (a)–(h) for the instrument to

be acquired in the exchange;* and

j) any condition of the instrument or an associated covenant that, if contravened, would significantly alter any of the other terms (for example, a maximum debt-to-equity ratio in a bond covenant that, if contravened, would make the full principal amount of the bond due and payable immediately). 63

• When the BS presentation of a FI differs from the

instrument’s legal form, it is desirable for an entity to explain in the notes the nature of the instrument. 64

• The usefulness of information about the extent and nature of FIs is enhanced when it highlights any relationship between individual instruments that can significantly affect the

amount, timing or certainty of the future cash flows of an entity. The extent to which a risk exposure is altered by the relationship among the assets and liabilities may be apparent to FS users 63, but in some circumstances further disclosure is necessary.* 65

• In accordance with IAS 1, an entity provides disclosure of all significant accounting policies, including the general principles adopted and the method of applying those principles to transactions, other events and conditions arising in the entity’s business. In the case of FIs, such disclosure includes: 66

a)the criteria applied in determining when to recognise a FA or FL and when to derecognise it;

b)the basis of measurement applied to FAs and FLs on initial recognition and subsequently; and

c)the basis on which income and expenses arising from FAs

and FLs are recognised and measured.

 Interest rate risk

 For each class of FAs and FLs, an entity shall disclose information about its exposure to interest rate risk,

including:

a) contractual repricing or maturity dates, whichever dates are earlier; and

b) effective interest rates, when applicable. 67

• An entity provides information about its exposure to the effects of future changes in the prevailing level of interest rates.

• Changes in market interest rates have a direct effect on the contractually determined CFs associated with some FAs and FLs (cash flow interest rate risk) and on the fair value of others (fair value interest rate risk). 68

• Information about maturity dates (or repricing dates when they are earlier) indicates the length of time for which interest rates are fixed, and information about effective interest rates indicates the levels at which they are fixed.

• Disclosure of this information provides users of FSs with a basis for evaluating the fair value interest rate risk to which an entity is exposed and, thus, the potential for gain or loss.

• For instruments that are repriced to a market rate before maturity, disclosure of the period until the next repricing is more important for this purpose than disclosure of the period to maturity. 69

• An entity may elect to disclose information about expected

repricing or maturity dates when those dates differ significantly from the contractual dates.

• E.g., may be particularly relevant when an entity is able to predict, with reasonable reliability, the amount of fixed rate mortgage loans that will be repaid before maturity and it uses this information as the basis for managing its interest rate risk exposure.*

• The additional information includes disclosure that it is based on management’s expectations of future events and an explanation of the assumptions made about repricing or maturity dates and how those assumptions differ from the contractual dates. 70

• Indicates which of its FAs and FLs are:

a) exposed to fair value interest rate risk, such as financial FAs and FLs with a fixed interest rate;

b) exposed to cash flow interest rate risk, such as FAs and FLs with a floating interest rate that is reset as market rates change; and

c) not directly exposed to interest rate risk, such as some investments in equity instruments. 71

• The requirement 67(b) does not apply to FIs such as

investments in EIs and derivative instruments that do not bear a determinable effective interest rate.

• E.g., even though instruments such as interest rate derivatives (swaps, forward rate agreements & options) are exposed to FV or CF risk from changes in market interest rates, disclosure of an effective interest rate is not required. However, when

providing effective interest rate information, an entity discloses the effect of hedging transactions such as interest rate swaps. 72

• An entity may become exposed to interest rate risk as a result of a transaction in which no FA or FL is recognised on its BS. In such circumstances, the entity discloses information that

permits users of its FSs to understand the nature and extent of its exposure.*

• E.g, when an entity has a commitment to lend funds at a fixed interest rate, the disclosure normally includes the stated principal, interest rate and term to maturity of the amount to be lent and the significant terms of the transaction giving rise to the exposure. 73

• When an entity has a variety of FIs exposed to FV or CF interest rate risk, it may adopt one or more of the following approaches to

presenting:

a)The carrying amounts of FIs may be presented in tabular form, grouped by those that are contracted to mature or be repriced in the following periods after the BS date:

1) in one year or less;

2) in more than one but not more than two years;

3) in more than two but not more than three;

4) in more than three but not more than four;

5) in more than four but not more than five; and 6) in more than five years.

b) When the performance of an entity is significantly affected by the level of its exposure to interest rate risk or changes in that exposure, more detailed information is desirable. An entity such as a bank may disclose, for example, separate groupings of the carrying amounts of financial instruments contracted to mature or be repriced:

1) in one month or less after the BS date;

2) in more than one month but not more than three months after the BS date; and

3) in more than three months but not more than twelve months after the balance sheet date.*

c) Similarly, an entity may indicate its exposure to CF interest rate risk through a table indicating the aggregate carrying amount of groups of floating rate FAs and FLs maturing within various future time periods.**

d) Interest rate information may be disclosed for individual FIs.

Alternatively, weighted average rates or a range of rates may be presented for each class of FI. An entity may group into separate classes instruments denominated in different

currencies or having substantially different credit risks when those factors result in instruments having substantially

different effective interest rates. 74

• An entity may be able to provide useful information by indicating the effect of a hypothetical change in market interest rates on the fair value of its FIs and future profit or loss and CFs. Such information may be based on, for

example, an assumed one percentage point (100 basis points) change in market interest rates occurring at the BS date. The effects include changes in interest income and expense

relating to floating rate FIs and gains or losses resulting from changes in the fair value of fixed rate instruments.

• The reported interest rate sensitivity may be restricted to the direct effects of an interest rate change on interest-bearing FIs recognised at the BS date because the indirect effects of a rate change on

financial markets and individual entities cannot normally be predicted reliably. When disclosing interest rate sensitivity

information, an entity indicates the basis on which it has prepared the information, including any significant assumptions.* 75

Credit risk

For each class of FAs and other credit exposures, shall

disclose information about exposure to credit risk, including:

a)the amount that best represents its maximum credit risk exposure at the BS date, without taking account of the FV of any collateral, in the event of other parties failing to perform their obligations under FIs; and

b)significant concentrations of credit risk. 76

• To assess the extent to which failures by counterparties to discharge their obligations could reduce the amount of future cash inflows from FAs recognised at the BS date or require a cash outflow from other credit exposures (such as a credit derivative or an issued guarantee of the obligations of a third party). Such failures give rise to a loss recognised in an entity’s profit or loss. 76 does not require an entity to disclose an

assessment of the probability of losses arising in the future. 77

• The purposes of disclosing amounts exposed to credit risk without regard to potential recoveries from realisation of collateral are:

a)to provide users of FSs with a consistent measure of the amount exposed to credit risk for FAs and other credit exposures; and b)to take into account the possibility that the maximum exposure

to loss may differ from the carrying amount of FAs recognised.

78

• In the case of FAs exposed to credit risk, the carrying amount of the assets in the BS, net of any applicable provisions for loss, usually represents the amount exposed to credit risk. E.g., in the case of an interest rate swap carried at FV, the maximum exposure to loss at the BS date is normally the carrying amount because it represents the cost, at current market rates, of

replacing the swap in the event of default. In these

circumstances, no additional disclosure beyond that provided on the BS is necessary.

• On the other hand, an entity’s maximum potential loss from some FIs may differ significantly from their carrying amount and from other disclosed amounts such as their FV or principal amount. In such circumstances, additional disclosure is

necessary to meet the requirements of 76(a).* 79