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IAS 32/39 Financial Instruments Part 3: Subsequent Recognition
2011
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
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edited the first two versions. We are proud to realise his vision.
Robin Joyce
Professor of the Chair of
International Banking and Finance
Financial University
under the Government of the Russian Federation
Visiting Professor of the Siberian Academy of Finance and Banking
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Moscow, Russia
2011 Updated
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
CONTENTS
1
Introduction .......................................................... 3
2.
Scope .................................................................... 6
3.
Glossary ................................................................ 8
4.
Work Book 3 - Subsequent Recognition, Fair
Values and Impairment ...................................... 12
5.
Multiple choice questions .................................. 48
6.
Answers to multiple choice questions ............. 49
Note: Material from the following PricewaterhouseCoopers
publications has been used in this workbook:
-Applying IFRS
-IFRS News
-Accounting Solutions
1
Introduction
OVERVIEW
Aim
IFRS 9 will replace IAS 39. Until it does, we will support IAS 39
workbooks. There are separate IAS 32 and IFRS 9 workbooks.
The aim of this workbook is to facilitate an understanding of IAS 32
and IAS 39. This book has bookkeeping for each category of
financial instruments.
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IAS 32 deals with the presentation of financial instruments and
especially their classification as debt or equity whilst IAS 39 deals
with recognition, derecognition, measurement and hedge
accounting. IFRS 7 Financial Instruments: Disclosures is the
subject of a separate workbook.
These three standards provide comprehensive guidance on the
accounting for financial instruments. The need for such guidance is
crucial as financial instruments are a large part of the assets and
liabilities of many companies, especially financial institutions.
The standards require companies to disclose their exposure to
financial instruments and to account for their impacts-in most cases
as they happen, rather than allowing problems to be hidden.
IAS 39 requires most derivatives to be reported at their ‘fair’ or
market value, rather than at cost.
This overcomes the problem that the cost of a derivative is often nil
or immaterial. If derivatives are measured at cost, they are often not
included in the balance sheet at all and their success (or otherwise)
in reducing risk is not visible.
In contrast, measuring derivatives at fair value ensures that their
leveraged nature and their success in reducing risk are reported.
IAS 32 and IAS 39
IAS 32 deals with the presentation of financial instruments,
(whether instruments are presented as liabilities or equity).
IAS 39 deals with the measurement of financial instruments and
with their recognition (when they should be included in financial
statements and how they should be valued).
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Why do we need standards on financial instruments?
Financial instruments are a large part of the assets and liabilities of
many undertakings, especially financial institutions. They also play
a key role in the efficient operation of financial markets.
Financial instruments, including derivatives, can be useful tools for
managing risk, but they can also be very risky themselves. In recent
years there have been many ‘disasters’ associated with derivatives
and other financial instruments.
The standards require companies to disclose their exposure to
financial instruments and to account for their effects-in most cases
as they happen, rather than allowing problems to be hidden away.
To which companies do the standards apply ?
The standards apply to all companies reporting under IFRS.
To what financial instruments do the standards apply?
The standards apply to all financial instruments except:
 Those covered by another more specific standards-such a
interests in subsidiaries, associates and joint ventures, and
post-employment benefits (pensions)
 Insurance contracts, and certain similar contracts
 Most loan commitments
The standards also apply to contracts to buy or sell a non-financial
item (such as commodity contracts) where these are for dealing
purposes.
The main requirements of IAS 32
Presentation by the issuer - debt or equity
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IAS 32 adopts definitions of liabilities and equity based on the IFRS
Framework. It is similar to the frameworks used by many national
standard-setters,

A financial instrument is a liability if it is a contractual
obligation to deliver cash or other financial assets. The
finance cost of liabilities is accounted for as an expense.

A financial instrument is equity if it evidences a residual
interest in the assets of an undertaking after deducting all of
its liabilities. Payments of equity are treated as distributions,
not as expenses.
Convertible debt (that gives the holder choice of repayment in cash,
or in shares) is separated into its debt and equity components. It is
analysed into an issue of ordinary debt at a discount, and a credit to
equity for the conversion right.
All relevant features need to be considered when classifying a
financial instrument. For example:
• If the issuer can or will be forced to redeem the instrument,
classification as a liability is appropriate;
• If the choice of settling a financial instrument in cash or otherwise
is contingent on the outcome of circumstances beyond the control
of both the issuer and the holder, the instrument is a liability as the
issuer does not have an unconditional right to avoid settlement;
and
• An instrument which includes an option for the holder to put the
rights inherent in that instrument back to the issuer for cash or
another financial instrument is a liability.
The treatment of interest, dividends, losses and gains in the
income statement follows the classification of the related
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
instrument.
Not all instruments are either debt or equity. Some, known as
compound instruments, contain elements of both in a single
contact.
Such instruments, such as bonds that are convertible into equity
shares either mandatorily or at the option of the holder, must be
split into liability and equity components.
Each is then accounted for separately. The liability element is
determined first by fair valuing the cash flows excluding any equity
component, and the residual is assigned to equity.
As well as ordinary debt, liabilities include mandatory redeemable
shares, such as units of a mutual fund and some preferred shares,
because they contain an obligation to pay cash.
Offsetting
A financial asset and a financial liability may only be offset and the
net amount reported in the balance sheet when an undertaking
both:


Has a current right to set off the recognised amounts; and
Intends either to settle on a net basis, or to realise the asset
and settle the liability simultaneously.
Situations that generally do not qualify for offsetting include master
netting agreements, where there is no intention to settle net, and
where assets are set aside to meet a liability but the undertaking
remains primarily liable.
The main requirements of IAS 39
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Measurement
IAS 39 divides financial assets and financial liabilities into four
classes (plus one option treatment) as follows:
 Trading assets and liabilities, including all derivatives that
are not hedges, are measured at fair value through profit and
loss -all gains and losses are recognised in profit and loss
as they arise.

Loans and receivables are ordinarily accounted for at
amortised cost, as are most liabilities.

Held-to-maturity investments are also accounted for at
amortised cost.

All other financial assets are classified as available-for-sale
and measured at fair value, with all gains and loses taken to
equity. On disposal, gains and losses previously taken to
equity are recycled to profit or loss.
There is an option to account for any financial asset or liability at
fair value through profit and loss.
There are special rules for hedge accounting as described in a
separate workbook.
Another aspect of measurement is impairment - when and how
losses should be recognised in profit and loss on those assets that
are not accounted for at fair value through profit and loss.
Whenever there is objective evidence of impairment as a result of a
past event, impairment should be recognised.
Among other things, the IAS 39 clarifies that:
 Impairment should only take into account losses that have
already been incurred, and not those that might happen in
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
the future


Impairment losses on available-for-sale assets are taken
from equity and recognised in profit and loss. For equity
investments, evidence of impairment may include significant
adverse changes in the issuer’s market position, or a
significant or prolonged decline in the fair value of the
investment.
Fair value is the only measurement that can capture the risky
nature of derivatives. The information is essential to communicate
to investors the nature of the rights and obligations inherent in
them. Fair value makes the derivatives visible, so that problems are
not hidden away.
Hedge Accounting
Hedging techniques are used by banks and undertakings to reduce
existing market, interest rate or foreign currency risks. These
include the use of futures, swaps and options. The success of a
hedging strategy is measured not by the profit produced by the
hedge itself, but by the extent to which that profit offsets the results
of the item hedged.
IAS 39 describes three main kinds of hedging relationship and their
accounting treatment:
 A cash flow hedge is a hedge of the exposure to variability in
cash flows, often in foreign currencies. The hedge matches
the cash inflows with cash outflows to minimise foreign
exchange exposure.

A fair value hedge - in which the fair value of the item being
hedged, changes as market prices change. Changes in the
fair value of both the hedging instrument are initially reported
in equity, and transferred to profit and loss to match the
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offsetting gains and losses on the hedged transaction.
A hedge of a net investment in foreign operation should be
accounted for in the same way as a cash flow hedge.
Hedge accounting allows undertakings to depart selectively
from the normal accounting treatment and allows losses to
be held back or gains to be accelerated.
The following principles have been adopted in order to provide
discipline over the use of hedge accounting:
 The hedging relationship has to be defined by designation
and documentation, reliably measurable, and actually
effective
 To the extent that a hedging relationship is effective, the
offsetting gains and losses on the hedging instrument and
the hedged item are recognised in profit and loss at the
same time
 All hedge ineffectiveness is recorded immediately in profit
and loss
 Items must meet the definitions of assets and liabilities to be
recognised in the balance sheet.
Hedge accounting for internal hedges is not permitted, as internal
transactions are eliminated on consolidation - the undertaking is
merely dealing with itself.
However, where internal hedges are used as a route to the market,
via an internal treasury centre, IAS 39 clarifies what needs to be
done in order to achieve hedge accounting.
Part 4 of our workbooks on Financial Instruments covers hedge
accounting.
2. Scope
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
The scope of the standards is very wide-ranging. Anything that
meets the definition of a financial instrument is covered unless it
falls within one of the specific exemptions.
Within scope of IAS
32 and IAS 39
Debt and equity
investments
Within scope
of IAS 32 only
Loans and receivables
Own debt
Own equity
Out of scope
Investments in
subsidiaries,
associates and joint
ventures
Lease receivables
(Note 1)
Lease payables
(Note 1)
Tax balances
Employee benefits
Cash and cash
equivalents
Derivatives – e.g.:
Interest rate swaps
Currency
forwards/swaps
Purchased/written
options
Commodity contracts
(Note 2)
Collars/caps
Credit derivatives
Cash or net share
settleable derivatives
on own shares
Derivatives on
own shares
settled only by
delivery of a
fixed number of
shares for a
fixed amount of
cash
Own-use
commodity
contracts
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Derivatives on
subsidiaries,
associates and joint
ventures
Embedded derivatives
Loan commitments
held for trading (Note
3)
Financial guarantees
(Note 4)
Other loan
commitments
Insurance contracts
Weather derivatives
Note 1 – Leases: Lease receivables are included in the scope of
IAS 39 for derecognition and impairment purposes only. Finance
lease payables are subject to the derecognition provisions. Any
derivatives embedded in lease contracts are also within the scope
of IAS 39.
Note 2 – Commodity contracts: Contracts to buy or sell nonfinancial items are within the scope of IAS 32 and IAS 39 if they can
be settled net in cash, or another financial asset, and they are not
own-use commodity contracts. Settling net includes taking delivery
of the underlying asset and selling it within a short period to
generate a profit from short-term fluctuations in price.
Note 3 – Loan commitments: Loan commitments are outside the
scope of IAS 39 if they cannot be settled net in cash or by some
other financial instrument, unless
- they are held for trading or to generate assets of a class which the
undertaking has a past practice of selling; or
-the undertaking chooses to include them with other derivatives
under IAS 39.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Note 4 – Financial guarantees: A financial guarantee is a
contract that requires the issuer to make specified payments to
reimburse the holder for a loss that it incurs because a specified
debtor fails to make a payment when due in accordance with the
original or modified terms of a debt instrument.
The issuer of such a financial guarantee would account for it
initially at fair value under IAS 39, and subsequently at the higher
of that amount initially recognised less cumulative amortisation
recognised in accordance with IAS 18 or the amount determined
in accordance with IAS 37. Guarantees based on an underlying
price or index are derivatives within the scope of IAS 39.
Derivative: a financial instrument with all three of the following
characteristics:
(i) Its value changes in response to the change in a specified
interest rate, security price, commodity price, foreign exchange rate,
index of prices or rates, a credit rating or credit index, or other
variable (sometimes called the “underlying”);
ii) 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; and
3. Glossary
(iii) It is settled at a future date.
Amortised cost: the amount at which the financial asset or financial
liability is measured at initial recognition minus principal
repayments, plus or minus the cumulative amortisation using the
effective interest method of any difference between that initial
amount and the maturity amount, and minus any reduction (directly
or through the use of an allowance account) for impairment or
uncollectability.
Effective interest method: a method of calculating the amortised
cost of a financial asset or financial liability and of allocating the
interest income or interest expense over the relevant period.
Available-for-sale financial assets: those financial assets that are
designated as available-for-sale or are not classified as (i) loans and
receivables, (ii) held-to-maturity investments, or (iii) financial assets
at fair value through profit or loss.
Cash flow hedge: a hedge of the exposure to variability in cash
flows that:
is attributable to a particular risk associated with an asset or liability
or a highly probable forecast transaction and could affect profit.
Derecognition: removal of a financial asset or financial liability from
the balance sheet.
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Effective interest rate: the rate that exactly discounts future cash
payments or receipts through the expected life of the financial
instrument or, when appropriate a shorter period, to the net carrying
amount of the financial asset or financial liability.
When calculating the effective interest rate, an undertaking shall
consider all terms of the instrument (for example, prepayment, call
and similar options) but shall not consider future credit losses.
The calculation includes all fees paid or received, transaction costs,
and all other premiums or discounts. Normally the cash flows and
the expected life of a group of similar financial instruments can be
estimated reliably.
If not, the undertaking shall use the contractual cash flows over the
full contractual term of the financial instrument (or group of financial
instruments).
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Embedded derivative: a component of a combined instrument
where some of the cash flows of the combined instrument vary in a
way similar to a stand-alone derivative.
(2) An equity instrument of another undertaking;
An embedded derivative causes some or all of the cash flows that
the contract would otherwise require to be modified based on a
specified interest rate, security price, commodity price, foreign
exchange rate, index of prices or rates, or other variable
(i) To receive cash or another financial asset from another
undertaking; or
A derivative that is attached to a financial instrument but is
transferable independently of that instrument, or has a different
counterparty from that instrument, is not an embedded derivative
but a separate financial instrument.
Equity: any contract that gives a residual interest in the assets of an
undertaking after deducting all of its liabilities.
Fair value The price that would be received to sell an asset, or
paid to transfer a liability, in an orderly transaction
between market participants at the measurement
date. (IFRS 13)
Fair value hedge: a hedge of the exposure to changes in fair value
of a recognised asset or liability or an unrecognised firm
commitment, or an identified portion of such an asset, liability or firm
commitment, that is attributable to a particular risk and could affect
profit.
Financial instrument: any contract that gives rise to a financial
asset of one undertaking and a financial liability or equity instrument
of another undertaking.
Financial asset: any asset that is:
(1) Cash;
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(3) A contractual right:
(ii) To exchange financial assets or financial liabilities with another
undertaking under conditions that are potentially favourable to the
undertaking; or
(4) A contract that will or may be settled in the undertaking’s own
equity instruments and is:
(i) A non-derivative for which the undertaking is or may be obliged to
receive a variable number of the undertaking’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 undertaking’s own equity instruments.
The undertaking’s own equity instruments do not include
instruments that are themselves contracts for the future receipt or
delivery of the undertaking’s own equity instruments.
Financial asset or financial liability at fair value through profit
or loss: a financial asset or financial liability that meets either of the
following conditions:
(1) It is classified as held for trading (see ‘trading financial assets
and financial liabilities’ below)
A financial asset or financial liability is classified as held for trading
if it is:
(i) acquired or incurred principally for the purpose of
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
selling or repurchasing it in the near term;
(ii) 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
(iii) a derivative (except for a derivative that is a financial
guarantee contract or a designated and effective
hedging instrument).
(2) Upon initial recognition, it is designated as at fair value through
profit or loss.
Any financial asset or financial liability may be designated when
initially recognised at fair value through profit or loss, except for
equity instruments that do not have a quoted price in an active
market, and whose fair value cannot be reliably measured.
An undertaking may also designate an entire hybrid (combined)
contract as a financial asset or financial liability at fair value through
profit or loss if the contract contains one or more embedded
derivatives, unless:
(1) the embedded derivative(s) does not significantly modify the
cash flows that otherwise would be required by the contract; or
(2) it is clear with little or no analysis when a similar hybrid
(combined) 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 amortised cost.
Financial liability: any liability that is:
(1) A contractual obligation:
An undertaking may use this designation only when doing so results
in more relevant information, because either:
(i) To deliver cash or another financial asset to another undertaking;
or
(i) it eliminates or significantly reduces a measurement or
recognition inconsistency (sometimes referred to as ‘an accounting
mismatch’) that would otherwise arise from measuring assets or
liabilities or recognising the gains and losses on them on different
bases; or
(ii) To exchange financial assets or financial liabilities with another
undertaking under conditions that are potentially unfavourable to the
undertaking; or
(ii) a group of financial assets, financial liabilities or both is
managed and its performance is evaluated on a fair value basis, in
accordance with a documented risk management or investment
strategy, and information about the group is provided internally on
that basis to the undertaking’s key management personnel (IAS 24,
Related Party Disclosures), for example the undertaking’s board of
directors and chief executive officer.
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(2) A contract that will or may be settled in the undertaking’s own
equity instruments and is:
(i) A non-derivative for which the undertaking is, or may be, obliged
to deliver a variable number of the undertaking’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 undertaking’s own equity instruments.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
For this purpose the undertaking’s own equity instruments do not
include instruments that are themselves contracts for the future
receipt or delivery of the undertaking’s own equity instruments.
Financial guarantee:a contract that requires the issuer to make
specified 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.
Firm commitment: a binding agreement for the exchange of a
specified quantity of resources at a specified price on a specified
future date or dates.
Forecast transaction: an uncommitted but anticipated future
transaction.
Hedge effectiveness: the degree to which offsetting changes in the
fair value or cash flows of the hedged item are offset by changes in
the fair value or cash flows of the hedging instrument.
Hedged item: an asset, liability, firm commitment, highly-probable
forecast future transaction, or net investment in a foreign operation
that
exposes the undertaking to risk of changes in fair value or future
cash flows and is designated as being hedged.
Hedging instrument: a designated derivative, or non-derivative
financial asset or non-derivative financial liability, whose fair value or
cash flows are expected to offset changes in the fair value or cash
flows of a designated hedged item.
A non-derivative financial asset or non-derivative financial liability
may be designated as a hedging instrument for hedge accounting
purposes only if it hedges the risk of changes in foreign currency
exchange rates.
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Held-to-maturity investments: a financial asset with fixed or
determinable payments and fixed maturity that an undertaking has
the positive intent and ability to hold to maturity, unless designated
as held for trading or available-for-sale, or that meet the definition of
loans and receivables.
Loans and receivables: non-derivative financial assets with fixed
or determinable payments that are not quoted in an active market,
other than:
(i)Those that the undertaking intends to sell in the near term, which
shall be classified as held for trading, and those that the undertaking
upon initial recognition designates as at fair value through profit or
loss;
(ii)Those that the undertaking upon initial recognition designates as
available-for-sale; or
(iii)Those for which the holder may not recover substantially all of its
initial investment (other than because of credit deterioration) which
shall be classified as available-for-sale.
An interest acquired in a pool of assets that are not loans or
receivables (for example, an interest in a mutual fund or a similar
fund) is not a loan or receivable.
Net investment in a foreign operation: the amount of the
undertaking's interest in the net assets of that operation.
Regular way purchase or sale: a contract for the purchase or sale
of a financial asset that requires delivery of the asset within the time
frame established by regulation or convention in the marketplace
concerned.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Tainting: where an undertaking sells or transfers more than an
“insignificant amount” of its held-to-maturity investments, it must
reclassify all of them as available-for-sale. It is then prohibited from
classifying any assets as held-to-maturity for the next two full annual
financial periods, until confidence in its intentions is restored.
1.1
Key issues

Trading financial assets and liabilities: a financial asset or
financial liability is classified as ‘held for trading’ if it is
(i) acquired or incurred for the purpose of selling or repurchasing it
in the near term;
(ii) part of a portfolio of financial instruments that are managed
together and for which there is evidence of a recent actual pattern of
short-term profit-taking; or
(iii) a derivative (except for a derivative that is a designated and
effective hedging instrument).
Transaction costs: incremental costs that are directly attributable
to the acquisition or disposal of a financial asset or financial liability.
An incremental cost is one that would not have been incurred if the
undertaking had not acquired, issued or disposed of the financial
instrument.
Transaction costs include fees and commissions paid to agents,
advisers, brokers and dealers, levies by regulatory agencies and
securities exchanges, and transfer taxes and duties.
Transaction costs do not include debt premiums or discounts,
financing costs or internal administrative or holding costs.
4. Work Book 3 - Subsequent Recognition, Fair Values
and Impairment
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Overview
Subsequent measurement of financial assets and liabilities
depends on the classification:
– Trading assets and liabilities and available-for-sale assets are
measured at fair value.
– Loans and receivables and held-to-maturity investments are
carried at amortised cost.

The best evidence of fair value is quoted market prices in an
active market.

If quoted market prices are not available, undertakings use
valuation techniques incorporating market data.

Cost less impairment is a last resort for investments in unlisted
equity instruments.

Objective evidence that a loss has been incurred is required
before calculating an impairment loss.
1.2
Subsequent measurement – financial assets
There are four categories of financial assets as described earlier in
the workbook ‘Initial recognition’. This classification is important
because it determines the subsequent measurement of the asset.
The following table summarises the principles:
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Financial
assets
Measurement
Changes in
carrying
amount
Financial
assets at fair
value through
profit and loss
Loans and
receivables
Held-tomaturity
investments
Available-forsale financial
assets
Fair value
Income
statement
Impairment
test (if
objective
evidence)
No
Review these 6 transactions that Tamara has entered into during
the year. She is determined to avoid volatility in her income
statement and therefore wherever possible financial instruments
should not be classified as held-for-trading. Measurement currency
of Tamara is Euros.
Please complete the table for each of the following:
Amortised cost
Amortised cost
Fair value
Income
statement
Income
statement
Yes
Equity
Yes
1- Determine how each of these transactions should be classified
(assume no hedge accounting).
Yes
2- Determine the balance sheet treatment (i.e. fair value, amortised
cost, etc).
Loans and receivables are measured at amortised cost without
regard to the undertaking's intention to hold them to maturity.
If a financial asset is measured at fair value and its fair value falls
below zero, it becomes a financial liability.
If the available-for-sale financial asset has fixed or determinable
payments, the transaction costs are amortised to the income
statement using the effective interest method.
If the available-for-sale financial asset does not have fixed or
determinable payments, the transaction costs are recognised in the
income statement when the asset is derecognised or becomes
impaired.
3- Determine how gains and losses should be recognised.
1 Investment in marketable bond
Tamara acquires a bond. The bond is listed and matures in 18
months. Management has purchased the bond because it expects
the price to increase in the short-term. It intends to sell the bond
whenever it believes the price has peaked, but definitely within the
next 30 days.
2. Investment in equity shares
Tamara acquires 5% of the equity shares in Go, a start-up business
in the Netherlands, which it believes has good prospects. She
expects Go to be listed within 2 years and hopes to make a
substantial return on its investment over 3-5 years.
3 Investment in debt security
EXAMPLES
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Tamara has invested surplus cash in a bond denominated in euros.
The maturity of the bond is 3 years and management intends to
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
hold the bond to maturity, when it will use the proceeds for a
planned acquisition in Germany.
Security
maturity
income and
exchange
differences
recognised in
income
4 Fixed
interest debt
Financial
liability
Amortised Cost
Only interest
expense
recognised in
income
5 Trade
receivable
Loans and
receivables
Amortised Cost
Exchange
differences
recognised in
income
6 Short
Position in
securities
Trading
financial liability
Fair value
Income
4-Fixed interest debt
Tamara issues a CHF 10m fixed-interest note with a three-year
term.
5 Trade Receivable
Tamara has sold goods to a customer, which is invoiced in
Singapore Dollars. The Customer is expected to pay for the goods
in 30 days.
6 Short position in securities
Tamara hears a rumour that the share price of Black Dog will fall
within the next 3 days. She borrows Black Dog shares from a
broker for 5 days and immediately sells them in the market. On day
5, she intends to buy shares at a lower price in the market and
return them to the broker.
Note: The solutions in the table assume that no hedge accounting
is used. Hedge Accounting is covered in a separate workbook.
1.3
Answers
Transaction
Classification
Balance sheet
measurement
Gains and
losses in …?
1 Marketable
bond
Held for trading
Fair Value
Income
2 Equity
investment
Available-forsale
Fair value
Equity
3 Debt
Held-to-
Amortised cost
Only interest
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Subsequent measurement – financial liabilities
There are only two categories of financial liabilities: those at
fair value through profit or loss (including trading liabilities)
and other.
Trading liabilities (including derivatives when they have
negative fair values) are measured at fair value. The changes
in fair value are included in the net profit or loss for the period.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
All other (non-trading) financial liabilities are carried at
amortised cost.
1.4
Amortised cost and effective interest method
Amortised cost is the original face value of a financial
instrument adjusted for any discount or premium paid.
EXAMPLE-bond discount or premium
Alex issues bonds for $100 each. Each bond offers 7% fixed
interest. Interest rates are rising, so the bond’s fixed interest rate is
less attractive than some other investments.
To sell the bond, Alex prices the bond at $97, a discount of $3. The
$3 discount provides investors with an additional return.
Investors account for this discount by amortising it over the life of
the bond.
Instead of amortising it on a straight-line basis, the method used is
the effective interest method (described below).
If Alex issues the bonds for $105, the $5 premium will be amortised
in the same manner.
A premium will be additional cost to the buyer; a discount will be a
bonus to the buyer.
The carrying amount of a financial instrument carried at amortised
cost is:
-
the amount to be paid/repaid at maturity (usually the
principal amount or face value);
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-
plus or minus any unamortised original premium or discount,
net of any origination fees and transaction costs and
less principal repayments.
It is important to note that it is the discount or premium that is
amortised (not the cost). If there is no discount or premium,
there is no amortisation.
The amortisation is calculated using the effective interest method.
This is the real rate of return, taking into account any discount or
premium on price of the financial instrument.
The effective interest rate calculation is defined by most Central
Banks to provide borrowers with standardised information. The
principle is that all fees and commissions charged by a bank are
extra interest charges to the client.
The client wants to know the total charges relating to a loan in order
to compare them with the charges of competitors. The client is not
interested in how charges are described by the bank, just the total
cost.
This method calculates the rate of interest that is necessary to
discount the planned stream of principal and interest cash flows
(excluding any impact of credit losses) through the expected life of
the financial instrument (or when appropriate a shorter period) to
equal the amount at initial recognition.
That rate is then applied to the carrying amount at each reporting
date to determine the interest income (assets) or interest expense
(liabilities) for the period. In this way, interest income or expense is
recognised on a level yield to maturity basis.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
For example, if the interest rate of a loan is 7%, the bank
recognises 7% interest income on the outstanding balance of the
loan in each year. If the principal of the loan is repaid over the life of
the loan, the interest income falls after each repayment of principal.
In the determination of the effective interest rate, the estimation of
the cash flows does not take into consideration any future credit
losses anticipated on that instrument.
Practical Impact of Amortised Cost (Amortised Income)
The net result of the calculation of all the cash flows at the start and
during the term of the loan is the effective interest yield. These cash
flows include changes in the original contract bond amount such as
a premium redeemed at maturity.
Effective interest rate is calculated over the expected life of the
instrument or, when applicable, a shorter period.
A shorter period is used when the variable (eg interest rates) to
which the fee, transaction costs, discount or premium relates is
repriced to market rates before the expected maturity of the
instrument.
1. A bank granting a loan - Amortised Income
In such a case, the appropriate amortisation period is the period to
the next such repricing date.
All income generated by the credit grantor relating to a loan, before
it is granted and during the term of the loan, is recognised over the
term of the loan, regardless of the timing of the cash flows of the
income. Fees received at the inception of the loan are recognised in
this manner.
If an undertaking revises its estimates of payments or receipts, it
should adjust the carrying amount of the financial instrument to
reflect actual and revised estimated cash flows.
Costs and expenses directly attributable to the loan, with the
exception of the direct cost of funds, reduce this income.
The net result of the calculation of all the cash flows at the start and
during the term of the loan is the effective interest yield. These cash
flows include changes in the original contract loan amount.
2. The purchase of a bond held to maturity - Amortised Cost
All costs related to the bond, including any premium or discount
(negative cost), paid at the inception of the loan are recognised
over the term of the bond, regardless of the timing of the cash flows
of the expenses.
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The adjustment is recognised as income or expense in profit or
loss. The undertaking recalculates the carrying amount by
computing the present value of remaining cash flows at the original
effective interest rate of the financial instrument.
This approach has the practical advantage that it does not require
recalculation of the effective interest rate, ie the undertaking simply
recognises the remaining cash flows at the original rate.
Example- Amortised Cost
On 1 JANUARY 2XX0, Tula originates a loan for a price of 1,000,
which is its fair value at that time. The principal amount is 1,000 and
the instrument is repayable on 31 December 2XX4. The rate of
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
interest is specified in the debt agreement as a percentage of the
principal amount as follows:
In the following examples, I/B refers to Income Statement and
Balance Sheet (SFP).
5% in 2XX0, 6% in 2XX1, 7.5% in 2XX2, 8% in 2XX3 and 9% in
2XX4.
The interest rate that exactly discounts the stream of future cash
payments through maturity is 7%.
EXAMPLE amortised cost 2XX0 (as above)
I/B
Cash
B
Bond liability
B
Issue of Financial instrument
Interest cost
I
Interest payable
B
Recording interest payable at the
effective interest rate
Interest payable
B
Cash
B
Recording interest payment
Amortised cost =1.000+70-50=1.020
Transaction costs are ignored in this example.
That gives us with the following carrying amounts and cash
streams:
Year
DR
1.000
CR
1.000
70
70
50
50
The instrument has to be recognised at its fair value (net of
transaction costs) at inception, which is 1000.
The interest rate that exactly discounts the stream of future cash
(ii)=(i)x 7% (iii) Cash
Interest
Flows
cost @ 7%
2XX0
(i)
Amortised
cost at the
beginning of
the year
1000
70
50
(iv)
amortised
cost at the
end of the
year
1020
2XX1
1020
71.4
60
1031.4
2XX2
1031.4
72.2
75
1028.6
2XX3
1028.6
72.0
80
1020.6
In each period, the amortised cost at the beginning of the period is
multiplied by the effective interest rate of 7% and added to the
amortised cost. Any cash payments in the period are deducted from
the resulting number.
2XX4
1020.6
71.4
1000+90
0
EXAMPLE- Calculation of amortised cost
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payments through maturity is 7%. Therefore, cash interest
payments are reallocated over the term of the instrument to
determine amortised cost in each period.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Undertaking A is transitioning to IFRS and holds some investments
in bond B, which have a maturity of 10 years. It will classify the
bonds it has purchased as held to maturity.
Subsequent measurement of the bonds is therefore at amortised
cost.
Included in its portfolio of bonds are several tranches of bond B that
it acquired three years ago.
A’s management is considering the calculation of the opening
balance of its bonds on adoption of IAS 39 / IFRS 9. Can A’s
management use the average cost of the B bonds to calculate
amortised cost for the bonds as a whole with one effective interest
rate, or must it calculate amortised cost for each separate tranche
of B bonds?
A’s management may calculate the amortised cost and effective
interest rate for the holding of B bonds as a whole rather than
separately for each individual tranche.
IAS 39 / IFRS 9 describes the effective interest rate as a method of
calculating the amortised cost of a financial asset or group of
financial assets, and the allocation of the interest income over the
relevant period.
Any subsequent purchases of B bonds will lead to an adjustment of
the effective interest rate of the portfolio of B bonds.
EXAMPLE- Loan origination fees
Issue
Financial service fees should be distinguished between fees that
are an integral part of a financial instrument’s effective interest rate,
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fees that are earned as services are provided and fees that are
earned on the execution of a significant act.
Should loan origination fees be recognised as an integral part of the
financial instrument’s effective yield, or as fees earned for services
provided?
Background
Undertaking A grants a loan to undertaking B for 100,000 on 1
January 20X1. The loan is repayable at 31 December 20X5.
Interest of 8% that is equal to the market rate is payable annually.
The loan origination fees amount to 2,000 and are paid by B to A on
1 January 20X1.
Solution
Loan origination fees charged by A are an integral part of
establishing a loan. These fees are deferred and recognised as an
adjustment to the effective yield.
The effective yield is the interest needed to discount all the cash
flows (8,000 for 5 years and the principle amount of 100,000) to the
present value of 98,000.
In this case the effective yield obtained by a DCF calculation is
approximately 8.51% and therefore the undertaking recognises a
finance cost at 8.51% on the carrying amount in each period.
The journal entries for the recognition of the transaction are set out
below:
1 January 20X1
Dr
Loan (100,000 less
2,000)
98,000
Cr
Cash
98,000
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
31 December
20X1
Dr
Loan
431
Cr
Interest income
[(98,703+397)x8.51]
8,431
Dr
Cash
8,000
Dr
Loan
337
31 December
20X5
Dr
Cash
Interest income
(98,000x8.51%)
8,337
Dr
Loan
469
Cr
Interest income
[(99,100+431)x8.51]
8,469
Cr
31 December
20X2
8,000
Dr
Cash
8,000
Dr
Loan
366
Dr
Cash
100,000
Cr
Interest income
[(98,000+337)*8,51%]
8,366
Cr
Loan
100,000
EXAMPLE- Accounting for fees on unutilised credit lines
(Note: not effective interest rate method)
31 December
20X3
Dr
Cash
8,000
Issue
Dr
Loan
397
Cr
Interest income
[(98,337+366)x8.51%]
8,397
Assets (such as prepaid expenses) for which the future economic
benefit is the receipt of goods or services, rather than the right to
receive cash or another financial asset, are not financial assets
[IAS32].
31 December
20X4
Dr
Cash
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8,000
A prepayment is not precluded as being recognised as an asset
when payment for the delivery of goods or services has been made
in advance of the delivery of goods or the rendering of services
[IAS38].
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
How should fees paid related to the setting up of unutilised credit
lines be accounted for?
service provided by the bank. If the fee is paid at the end of each
quarter, the fee should be accrued on a straight-line basis. If the
fee is paid in advance the fee is recognised in the balance sheet
and amortised over the quarter on a straight-line basis.
Background
Example - Dual currency bond
An undertaking has a credit line with a bank with the following
conditions:
Maximum utilisation : 1 billion euros
Interest rate on utilisations: Euribor 1 month + margin
Set-up fee: 5,000,000 euros
Commitment fee: 0.50% per annum paid quarterly on the
unutilised credit line
Term: 2 years
The undertaking has no immediate or projected funding
requirements.
How should the undertaking account for:
(a)
(b)
the set-up fee?
the commitment fee?
Solution
(a)
Set-up fee
The set-up fee is a prepayment of the liquidity service provided by
the bank. It is recognised as an asset in the balance sheet and
amortised over the term of the credit line on a straight-line basis.
(b)
Maypole plc has a sterling functional currency.
Maypole issues a bond with a principal denominated in euros
repayable at the end of the bond term and interest payable each
year denominated in US dollars, calculated as a fixed percentage of
a notional US dollar amount.
How should this instrument be accounted for by Maypole?
A bond issued in a currency that is not the functional currency of
the undertaking is a foreign currency monetary item. Such a
monetary item is accounted for under IAS 21, The Effects of
Changes in Foreign Exchange Rates, which requires foreign
currency gains and losses to be recognised in the income
statement.
Therefore, a foreign currency derivative that may be embedded in
such a host debt instrument is considered closely related and is not
separated. This also applies to dual currency bonds.
For measurement purposes, therefore, the fixed rate dual currency
bond should be analysed into its two components:
■ a zero coupon bond denominated in euros; and
■ an instalment bond with annual payments denominated in US
dollars.
Commitment fee
The commitment fee is the on-going payment for the liquidity
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Each component is recognised initially at fair value, being the
present value of the future payments to be made.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Subsequently, each component is measured separately at
amortised cost (unless the entire bond is classified as at ‘fair value
though profit and loss’) using the effective interest rate method in
accordance with IAS 39.
The interest cost of each component is calculated separately in the
relevant foreign currency (that is, in euros for the zero coupon bond
and in US dollars for the instalment bond) and translated into
sterling at the relevant average rate under IAS 21.
The resulting carrying amount of each component is translated to
sterling at each period end using the closing rate, with exchange
movements recognised in the income statement in accordance with
IAS 21.
Example - Foreign currency bond
Undertaking D has a Thai baht functional currency. It has issued a
convertible bond denominated in US dollars in order to raise capital
from foreign investors. EachUS$10 bond is convertible into 10
ordinary shares of undertaking D.
Undertaking D’s management is considering how this bond should
be accounted for under IFRS.
The convertible bond is a foreign currency bond and is accounted
for as a financial liability with an embedded derivative that is not
closely related to the underlying (IAS 39).
way because an exchange of a fixed amount of shares for a fixed
amount of foreign currency represents a variable amount of cash
measured in the functional currency of undertaking D.
The financial liability host contract of the convertible bond is a
monetary item, accounted for at amortised cost and translated
into Thai baht at the closing rate.
The embedded derivative is a financial instrument at fair value
through profit and loss in Thai baht. If D’s management is not
able to determine reliably the fair value of the embedded derivative,
it should treat the whole instrument as a financial liability at fair
value through profit and loss.
EXAMPLE- Exchange of debt instruments
Undertaking G has debt (long-term notes) in issue. It intends to
exchange the notes into convertible debt butrequires the consent of
a majority of the note holders to do so.
To encourage a quick response from the note holders, undertaking
G is offering a cash inducement to those who respond favourably
within 30 days.
The new instrument will have different terms and conditions from
the previous notes because of its convertible nature.
The payment of the inducement is conditional on the exchange into
convertible debt taking place.
A convertible bond that is denominated in the functional currency of
the issuer is treated as a compound financial instrument: the debt
element is treated as a liability and the equity conversion element
as equity (IAS 32).
Can the inducement be included in the initial recognition of the new
convertible debt and therefore deferred and amortised as part of the
effective interest method under IAS 39?
However, the instrument described here is not accounted for in this
The treatment of the inducement will depend on various factors.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
1.5
IAS 39 states that an exchange of debt instruments between issuer
and holder on substantially different terms should be treated as an
extinguishment of the old debt and recognition of a new debt; it is
likely a gain or loss will arise on the extinguishment of the old debt.
If the terms are not substantially different, then the exchange is not
treated as an extinguishment and reissue and any costs meeting
the capitalisation criteria in IAS 39 adjust the carrying amount of the
debt and are amortised over the remaining term of the modified
liability.
The new debt is hybrid in nature due to the convertible feature
whereas the old debt is plain vanilla term debt.
On that basis, the terms of the old and new instruments would be
substantially different and the old debt is extinguished.
Undertaking G then needs to consider whether the inducement is a
transaction cost that falls to be included in the calculation of
the effective interest rate of the new instrument.
Although the cost would not have been incurred if undertaking G
had not issued the new convertible debt, it is not directly attributable
to the new debt.
The new debt could still have been issued had the inducement not
been paid.
The inducement merely encouraged the note holders to respond
quickly but was not directly related to the issue of the new debt.
Undertaking G should include the cost of the inducements into the
calculation of the gain or loss on redemption of the old notes and
take the cost directly to the profit and loss account.
Financial Instruments – Bookkeeping
Introduction
IFRS does not prescribe bookkeeping, so our recommendations
are for illustration only.
We cover the 4 asset and 2 liability categories, plus financial assets
held at cost.
1. Financial assets at fair value through profit and loss
The bookkeeping for this category is similar to that of accounting for
current assets in foreign currency.
The assets are revalued daily, or less frequently if trading occurs
less often.
Positive and negative revaluations (gains and losses) go to the
income statement.
This is the only category where transaction costs are expensed
(elsewhere they are capitalised).
2. Available-for-sale financial assets – equity instruments
The bookkeeping for this category is similar to that of financial
assets at fair value through profit and loss, though gains and losses
(other than impairment) go to equity until the asset is sold.
Impairment charges go to the income statement. Impairment
charges cannot be reversed.
3. Available-for-sale financial assets – debt instruments
As equity instruments, but impairment charges can be reversed, if
the value recovers.
4. Loans and Receivables + 5. Held to Maturity Asset
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Accounting is identical for these 2 categories.
EXAMPLE - Financial assets at fair value through profit and loss
If there is no discount or premium, the only accounting for the
principal is at the start and end of the ownership. If there is a
discount or premium, then this is amortised using the effective
interest rate.
Asset
Revaluation income
I/B
B
I
DR
CR
3
3
3. Impairment reduces value to 33
Examples of both discount and premium are given.
6. Financial Asset at cost
The only issue here is impairment which is charged to the income
statement.
Impairment charges cannot be reversed.
7. Financial liability at fair value through profit and loss
As 1. financial assets at fair value through profit and loss, though
debits and credits are reversed.
8. Other Financial liabilities
As 4. loans and receivables + 5. held to maturity asset, though
debits and credits are reversed.
I/B
I
B
DR
CR
30
30
EXAMPLE - Financial assets at fair value through profit and loss
I/B
B
I
DR
CR
4
4
5. Asset revalued to 70
EXAMPLE - Financial assets at fair value through profit and loss
1. Buy asset for 60 + 5 transaction costs
EXAMPLE - Financial assets at fair value through profit and loss
Asset
Transaction costs
Cash
Revaluation expense
Asset
4. Interest received 4
Cash
Interest received
1. Financial assets at fair value through profit and loss
I/B
B
I
B
EXAMPLE - Financial assets at fair value through profit and loss
DR
CR
60
5
2. Revalue to 63
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Asset
Revaluation income
I/B
B
I
DR
CR
37
37
6. Asset sold for 79
65
EXAMPLE - Financial assets at fair value through profit and loss
I/B
DR
CR
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Cash
Profit on sale of asset
B
I
(The revaluation loss in equity could be expensed now.)
79
9
4. Dividend received 4
Asset
B
70
2. Available-for-sale financial assets – equity instrument
(Impairment cannot be reversed)
EXAMPLE - Available-for-sale financial assets – equity
instrument
Cash
Dividend received
1. Buy asset for 60 + 5 transaction costs
I/B
B
I
DR
CR
4
4
EXAMPLE - Available-for-sale financial assets – equity
instrument
Asset
Cash
I/B
B
B
DR
5. Asset revalued to 70
CR
65
65
EXAMPLE - Available-for-sale financial assets – equity
instrument
2. Revalue to 63
EXAMPLE - Available-for-sale financial assets – equity
instrument
Revaluation loss -equity
Asset
I/B
B
B
DR
Asset
Revaluation gain -equity
I/B
B
B
DR
CR
37
37
6. Asset sold for 79
CR
2
2
EXAMPLE - Available-for-sale financial assets – equity
instrument
3. Impairment reduces value to 33
EXAMPLE - Available-for-sale financial assets – equity
instrument
Impairment of equity instrument
Asset
I/B
I
B
DR
Cash
Profit on sale of asset
Asset
Revaluation gain –equity - reversal
Revaluation loss –equity - reversal
CR
30
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I/B
B
I
B
B
B
DR
CR
79
44
70
37
2
30
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
(Profit is calculated after impairment charge of 30 – see step 3)
Cash
Interest received
3. Available-for-sale financial assets – debt instrument
(Impairment can be reversed)
B
I
EXAMPLE - Available-for-sale financial assets – debt instrument
EXAMPLE - Available-for-sale financial assets – debt instrument
Asset
Cash
DR
CR
65
65
2. Revalue to 63
I/B
B
B
DR
DR
CR
37
30
B
7
2
2
EXAMPLE - Available-for-sale financial assets – debt instrument
I/B
I
B
DR
Cash
Profit on sale of asset
Asset
Revaluation gain -equity- reversal
Revaluation loss -equity- reversal
I/B
B
I
B
B
B
DR
CR
79
14
70
7
2
4. Loans and Receivables – Amortisation of Discount –
Amortised Cost
CR
30
30
4. Interest received 4
EXAMPLE - Available-for-sale financial assets – debt instrument
I/B
EXAMPLE - Available-for-sale financial assets – debt instrument
CR
3. Impairment reduces value to 33
Impairment of debt instrument
Asset
Asset
Impairment of debt instrument
reversal
Revaluation gain -equity
I/B
B
- I
6. Asset sold for 79
EXAMPLE - Available-for-sale financial assets – debt instrument
Revaluation loss -equity
Asset
4
5. Asset revalued to 70 (Impairment is reversed)
1. Buy asset for 60 + 5 transaction costs
I/B
B
B
4
DR
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CR
Yea
r
1
2
3
Openin
g Value
93400
94533
95753
Cash Amortisatio Effectiv
Interes
n of
e
t
discount
Interest
6000
1133
7133
6000
1220
7220
6000
1313
7313
Effectiv
Closin
e
g
Interest
Value
Rate
94533
7,64%
95753
7,64%
97066
7,64%
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
4
97066
6000
1413
7413
5
98479
6000
1521
7521
98479
10000
0
7,64%
End of year 2
7,64%
Elena issues a 5-year loan at 6% interest. Interest is paid at the end
of each year.
Tamara, the client, pays commission of 6.600 on day 1 for the loan.
She therefore receives only 93.400 in cash, a discount of 6.600.
This commission forms part of the effective interest rate – an
effective rate of 7,64%.
The discount is amortised in Elena’s books over the period of the
loan, using the effective interest rate (7.64%).
Accounting on Day 1
EXAMPLE - Loans and Receivables – Amortisation of Discount –
Amortised Cost
Loan - Tamara
Cash
Deferred commission
I/B
B
B
B
DR
100.000
CR
93.400
6.600
End of year 1
EXAMPLE - Loans and Receivables – Amortisation of Discount –
Amortised Cost
Cash
Interest receivable
Deferred commission
Commission
I/B
B
I
B
I
DR
6.000
CR
6.000
1.133
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EXAMPLE - Loans and Receivables – Amortisation of Discount –
Amortised Cost
Cash
Interest receivable
Deferred commission
Commission
I/B
B
I
B
I
DR
6.000
CR
6.000
1.220
1.220
End of year 3
EXAMPLE - Loans and Receivables – Amortisation of Discount –
Amortised Cost
Cash
Interest receivable
Deferred commission
Commission
I/B
B
I
B
I
DR
6.000
CR
6.000
1.313
1.313
End of year 4
EXAMPLE - Loans and Receivables – Amortisation of Discount –
Amortised Cost
Cash
Interest receivable
Deferred commission
Commission
I/B
B
I
B
I
DR
6.000
CR
6.000
1.413
1.413
1.133
26
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
End of year 5
EXAMPLE - Loans and Receivables – Amortisation of Discount –
Amortised Cost
Cash
Interest receivable
Loan - Tamara
Deferred commission
Commission
I/B
B
I
B
B
I
DR
106.000
CR
6.000
100.000
Yea
r
1
2
3
4
5
Openin
g Value
106600
105397
104140
102826
101453
Accounting on Day 1
EXAMPLE - Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
1.521
1.521
5. Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
Cash Amortisatio
Interes
n of
t
premium
6000
-1203
6000
-1257
6000
-1314
6000
-1373
6000
-1454
Anna will hold the bond to maturity. She will amortise the premium
over the life of the bond. Her effective interest rate is 4,5% after
adjusting for the premium.
Effective
Interest
4797
4743
4686
4627
4546
Closing
Value
105397
104140
102826
101453
100000
Effectiv
e
Interest
Rate
4,5%
4,5%
4,5%
4,5%
4,5%
Anna buys a 5-year listed bond for 106.600, paying a premium of
6.600 as it has a face value of 100.000.
The bond pays 6% interest at the end of each year. Anna paid the
premium as 6% is an attractive rate of interest compared to other
similar investments.
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Bond
Bond premium
Cash
End of year 1
I/B
B
B
B
DR
100.000
6.600
CR
106.600
EXAMPLE - Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
Cash
Interest receivable
Interest expense
Bond premium
I/B
B
I
I
B
DR
6.000
CR
6.000
1.203
1.203
End of year 2
EXAMPLE - Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
Cash
Interest receivable
Interest expense
Bond premium
I/B
B
I
I
B
DR
6.000
CR
6.000
1.257
1.257
27
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
End of year 3
6. Financial Asset at cost
EXAMPLE - Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
1. Buy unlisted asset for 60 + 5 transaction costs
EXAMPLE - Financial assets at cost
Cash
Interest receivable
Interest expense
Bond premium
I/B
B
I
I
B
DR
6.000
CR
6.000
1.314
Asset
Cash
I/B
B
B
DR
I/B
I
DR
CR
65
65
1.314
End of year 4
2. Impairment reduces value to 33
EXAMPLE - Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
Cash
Interest receivable
Interest expense
Bond premium
I/B
B
I
I
B
DR
6.000
EXAMPLE - Financial assets at cost
CR
Revaluation expense - impairment
CR
32
6.000
Asset
1.373
B
32
1.373
4. Interest received 4
End of year 5
EXAMPLE - Financial assets at cost
EXAMPLE - Held to Maturity Asset – Amortisation of Premium –
Amortised Cost
Cash
Interest receivable
Bond
Interest expense
Bond premium
I/B
B
I
B
I
B
DR
106.000
CR
6.000
100.000
Interest received
I
DR
CR
4
4
5. Asset sold for 79
1.454
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Cash
I/B
B
1.454
28
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
EXAMPLE - Financial assets at cost
Cash
Profit on sale of asset
I/B
B
I
DR
I/B
B
I
Commodity liability
Revaluation income
CR
DR
CR
30
30
79
46
4. Commodity liability revalued to 70
Asset
B
33
EXAMPLE - Financial liability at fair value through profit and loss
7. Financial liability at fair value through profit and loss
Olga’s bank has a (forward position) liability for a commodity
contract. The commodity is listed on a commodity exchange.
1. Client pays Olga 65 to take on the liability
Cash
Commodity liability
DR
65
65
Commodity liability
Loss on settlement of liability
Cash
EXAMPLE - Financial liability at fair value through profit and loss
I/B
B
I
CR
37
37
EXAMPLE - Financial liability at fair value through profit and loss
CR
2. Revalue to 63
Commodity liability
Revaluation income
Revaluation expense
Commodity liability
DR
5. Commodity liability settled for 79
EXAMPLE - Financial liability at fair value through profit and loss
I/B
B
B
I/B
I
B
DR
I/B
B
I
B
DR
CR
70
9
79
8. Other Financial liability - Amortisation of Discount –
Amortised Cost
CR
2
2
3. Commodity liability revalued to 33
EXAMPLE - Financial liability at fair value through profit and loss
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Yea
r
1
2
3
4
5
Openin
g
Value
93400
94533
95753
97066
98479
Cash
Intere
st
6000
6000
6000
6000
6000
Effectiv
Amortisati
Closin
e
on of
Effective
g
Interest
discount
Interest Value
Rate
1133
7133 94533 7,64%
1220
7220 95753 7,64%
1313
7313 97066 7,64%
1413
7413 98479 7,64%
1521
7521 10000 7,64%
29
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
0
Katya’s bank issues a 5-year bond that will pay interest of 6% at the
end of each year.
On the date of issue, interest rates for similar instruments rise and
she issues the bond at a discount of 6.600. This lifts the effective
interest rate to 7,64%. Katya will amortise the premium over the life
of the bond using the effective interest rate of 7,64%.
Interest paid
Cash
Interest paid
Bond discount
I/B
I
B
I
B
DR
6.000
CR
6.000
1.220
1.220
Accounting on Day 1
EXAMPLE - Other Financial liability – Amortisation of Discount –
Amortised Cost
Cash
Bond discount
Bond
I/B
B
B
B
DR
93.400
6.600
100.000
EXAMPLE - Other Financial liability – Amortisation of Discount –
Amortised Cost
Interest paid
Cash
Interest paid
Bond discount
DR
6.000
EXAMPLE - Other Financial liability – Amortisation of Discount –
Amortised Cost
CR
End of year 1
I/B
I
B
I
B
End of year 3
CR
Interest paid
Cash
Interest paid
Bond discount
1.133
End of year 2
EXAMPLE - Other Financial liability – Amortisation of Discount –
Amortised Cost
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DR
6.000
CR
6.000
1.313
1.313
End of year 4
EXAMPLE - Other Financial liability – Amortisation of Discount –
Amortised Cost
6.000
1.133
I/B
I
B
I
B
Interest paid
Cash
Interest paid
Bond discount
I/B
I
B
I
B
DR
6.000
CR
6.000
1.413
1.413
End of year 5
30
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
EXAMPLE - Other Financial liability – Amortisation of Discount –
Amortised Cost
Bond
Interest paid
Cash
Interest paid
Bond discount
1.6
I/B
B
I
B
I
B
DR
100.000
6.000
IAS 39 uses the terms 'bid price' and 'asking price' ('current offer
price') in the context of quoted market prices, and the term 'the bidask spread' to include only transaction costs.
CR
106.000
1.521
1.521
Fair value
Fair value The price that would be received to sell an asset, or
paid to transfer a liability, in an orderly transaction
between market participants at the measurement
date. (IFRS 13)
IFRS 13 covers Fair Value. These notes were written before IFRS
Other adjustments to arrive at fair value (eg for counterparty credit
risk) are not included in the term 'bid-ask spread'.
For a reliable measure of fair value, IAS 39 provides a hierarchy to
be used in determining an instrument’s fair value:
No active market – valuation techniques
Active market – quoted
market price
13. Generally fair value can be reliably measured for all financial
instruments.
Underlying the definition of fair value is a presumption that an
undertaking is a going concern. Fair value is not, therefore, the
amount that an undertaking would receive or pay in a forced
No active market – use
valuation techniques
transaction, involuntary liquidation or distress sale. However, fair
value reflects the credit quality of the instrument.
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31
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
When an undertaking has assets and liabilities with offsetting
market risks, it may use mid-market prices as a basis for
establishing fair values for the offsetting risk positions and apply the
bid or asking price to the net open position as appropriate.
No active market:
equity instruments –
cost less impairment
Active market – quoted market price: The existence of published
price quotations in an active market is the best evidence of fair
value, and they must be used to measure the financial instrument.
“Quoted in an active market” means that quoted prices are readily
and regularly available, and those prices represent actual and
regularly occurring market transactions by independent traders.
The price can be taken from the most favourable market readily
available to the undertaking even if that was not the market in which
the transaction actually occurred.
The quoted market price cannot be adjusted for “blockage” or
“liquidity” factors (where very large or very few transactions are
taking place). The fair value of a portfolio of financial instruments is
the product of the number of units of the instrument and its quoted
market prices.
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If conditions have changed since the time of the transaction (eg a
change in the risk-free interest rate following the most recent price
quote for a corporate bond), the fair value reflects the change in
conditions by reference to current prices or rates for similar financial
instruments, as appropriate.
Similarly, if the undertaking can demonstrate that the last
transaction price is not fair value (as it reflected the amount that an
undertaking would receive or pay in a forced transaction,
involuntary liquidation or distress sale), that price is adjusted.
The fair value of a portfolio of financial instruments is the product of
the number of units of the instrument and its quoted market price. If
a published price quotation only exists for its component parts, fair
value is determined on the basis of the relevant market prices for
the component parts.
If the market-quoted rate does not include credit risk or other
factors that market participants would include in valuing the
instrument, the undertaking adjusts for those factors.
It might be possible to recognise a gain on initial recognition of a
financial instrument. However, the circumstances in which this will
be permitted are very tightly controlled.
No active market – valuation techniques: If the market for a
financial instrument is not active, fair value is established by using a
valuation technique.
32
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Valuation techniques that are well established in financial markets
include
(1) it reasonably reflects how the market could be expected to price
the instrument and
-recent market transactions,
-reference to a similar transaction,
(2) the inputs to the valuation technique reasonably represent
market expectations and measures of the risk-return factors
inherent in the financial instrument.
-discounted cash flows and
Therefore, a valuation technique
-option pricing models.
(1) incorporates all factors that market participants would consider
in setting a price and
An acceptable valuation technique incorporates all factors that
market participants would consider in setting a price. It should be
consistent with accepted methodologies for pricing financial
instruments.
(2) is consistent with accepted economic methodologies for pricing
financial instruments.
Normally the amount paid or received for a financial instrument is
the best estimate of fair value at inception. However, where all data
inputs to a valuation model are obtained from observable market
transactions, the resulting calculation of fair value can be used for
initial recognition.
If the financial instrument is a debt instrument (such as a loan), its
fair value can be determined by reference to the market conditions
that existed at its acquisition or origination date and current market
conditions or interest rates currently charged by the undertaking or
by others for similar debt instruments (ie similar remaining maturity,
cash flow pattern, currency, credit risk, collateral and interest
basis).
If there is a valuation technique commonly used by market
participants to price the instrument and that technique has been
demonstrated to provide reliable estimates of prices obtained in
actual market transactions, the undertaking uses that technique.
Fair value is estimated on the basis of the results of a valuation
technique that makes maximum use of market inputs, and relies as
little as possible on undertaking-specific inputs.
A valuation technique would be expected to arrive at a realistic
estimate of the fair value if
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Alternatively, provided there is no change in the credit risk of the
debtor and applicable credit spreads after the origination of the debt
instrument, an estimate of the current market interest rate may be
derived by using a benchmark interest rate reflecting a better credit
quality than the underlying debt instrument, holding the credit
spread constant, and adjusting for the change in the benchmark
interest rate from the origination date.
If conditions have changed since the most recent market
transaction, the corresponding change in the fair value of the
financial instrument being valued is determined by reference to
33
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
current prices or rates for similar financial instruments, adjusted as
appropriate, for any differences from the instrument being valued.
The same information may not be available at each measurement
date. For example, at the date that an undertaking makes a loan or
acquires a debt instrument that is not actively traded, the
undertaking has a transaction price that is also a market price.
However, no new transaction information may be available at the
next measurement date and, it would be reasonable to assume, in
the absence of evidence to the contrary, that no changes have
taken place in the spread that existed at the date the loan was
made.
The undertaking would be expected to make reasonable efforts to
determine whether there is evidence that there has been a change
in such factors. When evidence of a change exists, the undertaking
would consider the impacts of the change in determining the fair
value of the financial instrument.
In applying discounted cash flow analysis, an undertaking uses one
or more discount rates equal to the prevailing rates of return for
financial instruments having substantially the same terms and
characteristics, including the credit quality of the instrument, the
remaining term over which the contractual interest rate is fixed, the
remaining term to repayment of the principal and the currency in
which payments are to be made.
Short-term receivables and payables with no stated interest rate
may be measured at the original invoice amount if the impact of
discounting is immaterial.
The fair value of a financial liability with a demand feature (eg a
demand deposit) is not less than the amount payable on demand,
discounted from the first date that the amount could be required to
be paid.
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No active market – equity instruments: Normally it is possible to
estimate the fair value of an equity instrument acquired from an
outside party.
The fair value of investments in equity instruments that do not have
a quoted market price in an active market and derivatives that are
linked to and must be settled by delivery of such an unquoted
equity instrument is reliably measurable if
(1) the variability in the range of reasonable fair value estimates is
not significant for that instrument or
(2) the probabilities of the various estimates within the range can be
reasonably assessed and used in estimating fair value.
However, if the range of reasonable fair value estimates is
significant, and no reliable estimate can be made, an undertaking is
permitted to measure the equity instrument at cost less impairment
as a last resort.
A similar dispensation applies to derivative financial instruments
related to such unquoted equity instruments.
Reclassifications
An undertaking shall not reclassify a financial instrument into, or out
of, the fair value through profit or loss category while it is held or
issued.
If, as a result of a change in intention or ability, it is no longer
appropriate to classify an investment as held to maturity, it shall be
reclassified as available for sale and remeasured at fair value.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Whenever sales or reclassification of more than an insignificant
amount of held-to-maturity investments are tainted, any remaining
held-to-maturity investments shall be reclassified as available for
sale.
statement. If the financial asset is subsequently impaired any
previous gain or loss that has been recognised directly in equity is
recognised in the income statement.
Gains and losses
If a reliable measure becomes available for a financial asset or
financial liability for which such a measure was previously not
available, and the asset or liability is required to be measured at fair
value if a reliable measure is available, the asset or liability shall be
remeasured at fair value.
If, a reliable measure of fair value is no longer available or because
the 'two preceding financial years' (relating to tainted held-to
maturity investments) have passed, it becomes appropriate to carry
a financial asset or financial liability at cost or amortised cost rather
than at fair value, the fair value carrying amount of the financial
asset or the financial liability on that date becomes its new cost or
amortised cost, as applicable.
A gain or loss arising from a change in the fair value of a financial
asset or liability (that is not part of a hedging relationship) shall be
recorded, as follows.
1. A gain or loss on a financial asset or financial liability classified
as at fair value through profit or loss shall be recorded in the
income statement.
2. A gain or loss on an available-for-sale financial asset shall be
recorded directly in equity, through the statement of changes in
equity, except for impairment losses and foreign exchange gains
and losses, until the financial asset is derecognised.
Any previous gain or loss on that asset that has been recognised
directly in equity shall be accounted for as follows:
At that time the cumulative gain or loss previously recorded in
equity shall be transferred to the income statement.
1. For a financial asset with a fixed maturity, the gain or loss shall
be amortised to the income statement over the remaining life of the
held-to-maturity investment using the effective interest method.
However, interest calculated using the effective interest method is
recognised in the income statement.
Any difference between the new amortised cost and maturity
amount shall also be amortised over the remaining life of the
financial asset using the effective interest method. If the financial
asset is subsequently impaired, any gain or loss that has been
recognised directly in equity is recognised the income statement.
2. For a financial asset that does not have a fixed maturity, the gain
or loss shall remain in equity until the financial asset is sold (or
otherwise disposed of), when it shall be recognised in the income
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Dividends on an available-for-sale equity instrument are recorded in
the income statement when the undertaking's right to receive
payment is established (see IAS 18).
For financial assets and liabilities carried at amortised cost, a gain
or loss is recorded in the income statement when the financial asset
or financial liability is derecognised or impaired, and through the
amortisation process.
35
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
If an undertaking recognises financial assets using settlement date
accounting, any change in the fair value of the asset to be received
during the period between the trade date and the settlement date is
not recognised for assets carried at cost or amortised cost (other
than impairment losses).
An appropriate technique for estimating the fair value of a particular
financial instrument would incorporate observable market data
about the market conditions and other factors that are likely to
affect the instrument's fair value. The fair value of a financial
instrument will be based on one or more of the following factors.
For assets carried at fair value, however, the change in fair value
shall be recognised in the income statement or in equity.
1. The time value of money (ie interest at the basic or risk-free
rate). Basic interest rates can usually be derived from observable
government bond prices and are often quoted in financial
publications. These rates typically vary with the expected dates of
the projected cash flows along a yield curve of interest rates for
different time horizons.
Gains and losses – foreign currency
Any foreign exchange gains and losses on monetary assets and
monetary liabilities are recognised in the income statement.
An exception is a monetary item that is designated as a hedging
instrument in either a cash flow hedge or a hedge of a net
investment. A monetary available-for-sale financial asset is treated
as if it were carried at amortised cost in the foreign currency.
Exchange differences resulting from changes in amortised cost are
recognised in the income statement and other changes in carrying
amount are recognised.
For available-for-sale financial assets that are not monetary items
(for example, equity instruments), the gain or loss that is recognised
directly in equity includes any related foreign exchange component.
If there is a hedging relationship between a non-derivative
monetary asset and a non-derivative monetary liability, changes in
the foreign currency component of those financial instruments are
recognised in the income statement.
Inputs to valuation techniques
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An undertaking may use a well-accepted and readily observable
general rate, such as LIBOR or a swap rate, as the benchmark rate.
(As a rate such as LIBOR is not the risk-free interest rate, the credit
risk adjustment appropriate to the particular financial instrument is
determined on the basis of its credit risk in relation to the credit risk
in this benchmark rate.)
In some countries, the central government's bonds may carry a
significant credit risk. In such a case, basic interest rates may be
more appropriately determined by reference to interest rates for the
highest rated corporate bonds issued in the currency of that
jurisdiction.
2. Credit risk. The impact on fair value of credit risk (ie the premium
over the basic interest rate for credit risk) may be derived from
observable market prices for traded instruments of different credit
quality or from observable interest rates charged by lenders for
loans of various credit ratings.
3. Foreign currency exchange prices. Active currency exchange
markets exist for most major currencies, and prices are quoted
daily.
36
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
4. Commodity prices. There are observable market prices for many
commodities.
5. Equity prices. Prices (and indexes of prices) of traded equity
instruments are readily observable in some markets. Present value
based techniques may be used to estimate the current market price
of equity instruments for which there are no observable prices.
6. Volatility (ie size of future changes in price of the financial
instrument or other item). Measures of the volatility of actively
traded items can normally be reasonably estimated on the basis of
historical market data or by using volatilities implied in current
market prices.
7. Prepayment risk and surrender risk. Expected prepayment
patterns for financial assets and expected surrender patterns for
financial liabilities can be estimated on the basis of historical data.
(The fair value of a financial liability that can be surrendered by the
counterparty cannot be less than the present value of the surrender
amount.)
8. Servicing costs for a financial asset or a financial liability. Costs
of servicing can be estimated using comparisons with current fees
charged by other market participants.
If the costs of servicing a financial asset or financial liability are
significant and other market participants would face comparable
costs, the issuer would consider them in determining the fair value
of that financial asset or financial liability.
It is likely that the fair value at inception of a contractual right to
future fees equals the origination costs paid for them, unless future
fees and related costs are out of line with market comparables.
EXAMPLE- Held for sale subsidiary with financial assets
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Undertaking D, a subsidiary of undertaking E, meets the definition
of a held-for-sale asset in accordance with IFRS 5, Non-current
Assets Held for Sale and Discontinued
Operations.
Financial assets within the scope of IAS 39 comprise the majority of
the value of
D.
Such assets are outside the scope of IFRS 5 for measurement
purposes.
On initial classification as held for sale, E measured D at the lower
of carrying amount and fair value less costs to sell (IFRS 5).
If the value of the financial assets within D increases above the
initial value of the disposal group, can E record the increase?
IFRS 5 notes that on subsequent remeasurement of a disposal
group, the carrying amount of any assets and liabilities that are not
within the scope
of the measurement requirements of IFRS 5, but are included in a
disposal group classified as held for sale, shall be re-measured in
accordance with applicable IFRSs before the fair value less coststo-sell of the disposal group is re-measured.
Therefore, on subsequent re-measurement, the financial assets
within the scope of IAS 39 should be remeasured first in
accordance with IAS 39.
The value of the E disposal group as a whole should then be
determined and recorded at the lower of carrying value (ie the
current IAS 39 value plus the carrying amount of other out-of-scope
assets and liabilities plus carrying value of
37
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
IFRS 5 assets and liabilities) and fair value less costs-to-sell of the
disposal group as a whole.
1.7
Impairment of financial assets
Impairment is the risk, or certainty, that some of the interest,
dividends or capital of a financial instrument may not be paid in full,
and is similar to making a doubtful debt provision for accounts
receivable.
A financial asset or a group of financial assets is impaired, and
impairment losses are incurred, only if there is objective evidence of
impairment as a result of a past event that occurred after the initial
recognition of the asset.
Expected losses as a result of future events, no matter how likely,
are not recognised.
An undertaking should assess at each balance sheet date whether
there is objective evidence that a financial asset or group of assets
may be impaired.
Examples of factors to consider are:
Significant financial difficulty of the issuer
High probability of bankruptcy
Granting of a concession to issuer
Disappearance of an active market because of financial difficulties
Breach of contract, such as default or delinquency in interest or principal
Adverse change in a factor (e.g., unemployment rates)
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38
IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
The disappearance of an active market, or the downgrade of
through the use of a provision account. The amount of the loss
an undertaking’s credit rating, is not of itself, evidence of
is included in net profit for the period.
impairment, although it may be evidence of impairment when
considered with other information. A significant or prolonged
decline in the fair value of an investment in an equity
instrument below its cost is also objective evidence of
impairment.
If there is objective evidence that impairment has been
incurred and the carrying amount of a financial asset carried at
amortised cost exceeds its estimated recoverable amount,
then the asset is impaired.
The recoverable amount is the present value of the expected
future cash flows discounted at the instrument’s original
EXAMPLE - impairment of a financial asset
options
I/B
Bond
B
Cash
B
Issue of Financial instrument
Impairment of bond
I
Bond
B
Option 1.Reducing carrying value of
bond
Impairment of bond
I
Provision for impairment of Bond
B
Option 2.Creating a provision for
impairment
– 2 bookkeeping
DR
5.000
CR
5.000
1.250
1.250
1.250
1.250
EXAMPLE - Credit crunch, impairment of available-for-sale
debt securities
D plc, an IFRS reporter, holds an investment in debt securities
which it classifies as available-for-sale (AFS). D plc is
considering the impact of the increase in market interest rates
as a result of the credit crunch.
effective interest rate.
The use of this rate prevents a market value approach from
being imposed for loans and receivables. The carrying amount
should be reduced to its recoverable amount either directly, or
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D plc is deliberating whether to retain the investment. D plc
decides to sell the investment in the near future, but has not
sold it at the year end. The fair value of the investment is less
that its amortised cost.
The loss has been driven by the increase in interest rates only
and the expected cashflows on the securities have not
decreased.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
necessarily evidence of impairment.
1. Is an increase in market interest rates objective evidence of
impairment of an AFS debt instrument?
2. Is D plc’s intention to sell the debt instrument at a loss
objective evidence of impairment of the AFS debt instrument?
1. An increase in market interest rates of itself is not
considered objective evidence of impairment of an AFS debt
instrument.
Under IAS 39, a financial asset is impaired and impairment
losses are incurred if, and only if, there is objective evidence of
impairment as a result of one or more events that occurred
after the initial recognition of the asset (a ‘loss event’) and that
loss event has an impact on the estimated future cashflows of
the financial asset or group of financial assets that can be
reliably measured.
2. There is no consideration of the intent or ability of an
undertaking to hold a financial asset when assessing whether
a financial asset is impaired in accordance with
IAS 39.
If D plc sells the debt instrument shortly after the year end at a
loss, and the loss is driven solely by the increase in interest
rates, the debt instrument would not be considered impaired at
the year end.
There is no impairment arising from the cash flows of the
asset; the loss is driven by D plc’s decision to sell the asset.
Therefore, the loss should be recognised when the debt
instrument is sold.
Financial assets carried at amortised cost
IAS 39 clarifies that the factors which should be considered
when assessing whether there is objective evidence of
impairment, include:
■ significant financial difficulty of the issuer;
■ breach of contract, such as default or delinquency in interest
or principal;
■ granting of a concession to the issuer;
■ high probability of bankruptcy;
■ disappearance of an active market because of financial
difficulties; and
■ observable data indicating there is a measurable decrease in
the estimated future cashflows since initial recognition.
Example 4.10 in the implementation guidance to IAS 39
confirms that a decline in the fair value of a financial asset
below its cost or amortised cost, for example, a decline in the
fair value of an investment in a debt instrument that results
from an increase in the basic, risk-free interest rate, is not
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If there is objective evidence that an impairment loss on:
-
loans and receivables or
held-to-maturity investments carried at amortised cost
has been incurred, the amount of the loss is measured as the
difference between:
- the asset's carrying amount and
- the present value of estimated future cash flows
(excluding future credit losses that have not been
incurred) discounted at the financial asset's original
effective interest rate
(ie the effective interest rate computed at initial
recognition).
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
The carrying amount of the asset shall be reduced either
directly or using of an allowance account. The amount of the
loss shall be recognised in the income statement.
Option 2.Eliminating provision for
impairment
An undertaking first assesses whether objective evidence of
impairment exists individually for financial assets that are
individually significant, and individually or collectively for
financial assets that are not individually significant.
The reversal shall not result in a carrying amount of the
financial asset that exceeds what the amortised cost would
have been had the impairment not been recognised at the date
the impairment is reversed.
If it determines that no objective evidence of impairment exists
for an individually assessed financial asset, whether significant
or not, it includes the asset in a group of financial assets with
similar credit risk characteristics and collectively assesses
them for impairment.
The amount of the reversal shall be recognised in the income
statement.
Assets that are individually assessed for impairment and for
which an impairment loss is, or continues to be, recognised are
not included in a collective assessment of impairment.
If, in a subsequent period, the amount of the impairment loss
decreases and the decrease can be related objectively to an
event occurring after the impairment was recorded (such as an
improvement in the debtor's credit rating), the previouslyrecognised impairment loss shall be reversed either directly or
by adjusting an allowance account.
EXAMPLE reversal of impairment of a financial asset – 2
bookkeeping options (see previous example)
I/B
DR
CR
Impairment of bond - reversal
I
1.250
Bond
B
1.250
Option 1.Restoring carrying value of
bond
Impairment of bond - reversal
I
1.250
Provision for impairment of Bond
B
1.250
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Impairment of a financial asset carried at amortised cost is
measured using the financial instrument's original effective
interest rate as discounting at the current market rate of
interest would impose fair value measurement on financial
assets that are measured at amortised cost.
If the terms of a loan, receivable or held-to-maturity investment
are renegotiated or otherwise modified because of financial
difficulties of the borrower or issuer, impairment is measured
using the original effective interest rate before the modification
of terms.
Cash flows relating to short-term receivables are not
discounted if the impact of discounting is immaterial. If a loan,
receivable or held-to-maturity investment has a variable
interest rate, the discount rate for measuring any impairment
loss is the current effective interest rate(s) determined under
the contract.
A creditor may measure impairment of a financial asset carried
at amortised cost on the basis of an instrument's fair value
using an observable market price. The calculation of the
present value of the estimated future cash flows of a
collateralised financial asset reflects the cash flows that may
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
result from foreclosure, less costs for obtaining and selling the
collateral, whether or not foreclosure is probable.
The process for estimating impairment considers all credit
exposures, not only those of low credit quality. If an
undertaking uses an internal credit grading system it considers
all credit grades, not only those reflecting a severe credit
deterioration.
The process for estimating the amount of an impairment loss
may result either in a single amount or the best estimate within
the range, taking into account all relevant information available
before the financial statements are issued about conditions
existing at the balance sheet date.
Historical loss experience is adjusted on the basis of current
observable data to reflect the impacts of current conditions.
Estimates of changes in future cash flows reflect and are
directionally consistent with changes in related observable
data from period to period (such as changes in unemployment
rates, property prices, commodity prices, payment status or
other factors that are indicative of incurred losses in the group
and their magnitude).
The methodology and assumptions used for estimating future
cash flows are reviewed regularly to reduce any differences
between loss estimates and actual loss experience.
EXAMPLE -'incurred but not reported' losses
For a collective evaluation of impairment, financial assets are
grouped on the basis of similar credit risk characteristics that
reflect the debtors' ability to pay all amounts due according to
the contractual terms (for example, on the basis of a credit risk
evaluation or grading process that considers asset type,
industry, geographical location, collateral type, past-due status
and other relevant factors).
Impairment losses recognised on a group basis represent an
interim step pending the identification of impairment losses on
individual assets in the group. When information is available
that specifically identifies losses on individually impaired
assets in a group, those assets are removed from the group.
Future cash flows in a group of financial assets that are
collectively evaluated for impairment are estimated on the
basis of historical loss experience for assets with credit risk
characteristics similar to those in the group. Undertakings that
have no undertaking-specific loss experience or insufficient
experience, use peer group experience for comparable groups
of financial assets.
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An undertaking may determine, on the basis of historical
experience, that one of the main causes of default on credit
card loans is the death of the borrower. The undertaking may
observe that the death rate is unchanged from one year to the
next.
Some of the borrowers in the undertaking's group of credit card
loans may have died in that year, indicating that an impairment
loss has occurred on those loans, even if, at the year-end, the
undertaking is not yet aware which specific borrowers have
died. It would be appropriate for an impairment loss to be
recognised for these 'incurred but not reported' losses.
However, it would not be appropriate to recognise an
impairment loss for deaths that are expected to occur in a
future period, because the necessary loss event (the death of
the borrower) has not yet occurred.
When using historical loss rates in estimating future cash
flows, it is important that information about historical loss rates
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
is applied to groups that are defined in a manner consistent
with the groups for which the historical loss rates were
observed. Therefore, the method used should enable each
group to be associated with information about past loss
experience in groups of assets with similar credit risk
characteristics and relevant observable data that reflect current
conditions.
Formula-based or statistical methods may be used to
determine impairment losses in a group of financial assets (eg
for smaller balance loans). Any model used would incorporate
the impact of the time value of money, consider the cash flows
for all of the remaining life of an asset (not only the next year),
consider the age of the loans within the portfolio and not give
rise to an impairment loss on initial recognition of a financial
asset.
Financial assets carried at cost
If there is objective evidence that an impairment loss has been
incurred on:
-
-
an unquoted equity instrument that is not carried at fair
value (because its fair value cannot be reliably
measured), or
a derivative asset that is linked to and must be settled
by delivery of such an unquoted equity instrument,
the amount of the impairment loss is measured as the
difference between:
- the carrying amount of the financial asset and
- the present value of estimated future cash flows
discounted at the current market rate of return for a
similar financial asset.
Available-for-sale financial assets
When a decline in the fair value of an available-for-sale
financial asset has been recognised directly in equity, and
there is objective evidence that the asset is impaired, the
cumulative loss that had been recognised directly in equity
shall be removed from equity and transferred to the income
statement, even though the financial asset has not been
derecognised.
EXAMPLE - Available-for sale financial assets
F plc owns 10% of G plc (over which it does not have
significant influence) and classifies this equity investment on its
balance sheet as available-for-sale in accordance with IAS 39.
F plc has a 31 May year-end and prepares an interim financial
report in accordance with IAS 34, Interim Financial Reports, as
at 30 November.
The shares in G plc cost £100 and, at 31 May 2004, their fair
value was £120.
J plc manufactures widgets specifically for one customer. On
15 October 2004, G plc announced that its single customer
had ceased trading.
At 30 November 2004, the shares in G plc had a value of £30
and F plc, when preparing its interim financial report, reviewed
its financial assets for impairment, as it is required to do at
each balance sheet date, and recognised an impairment of
£70 through profit and loss as required by IAS 39.
In March 2005, G plc identified a new use for its widgets which
it announced to the market and, on 31 May 2005, the price of
its shares had risen to £160.
Such impairment losses shall not be reversed.
When preparing its annual financial statements, how should F
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
plc recognise the increase in value?
The increase in value of £130 should be recognised in equity.
F plc is prohibited by IAS 39from reversing an impairment loss
on an investment in an equity instrument through profit or loss.
IAS 34 states in para 28 that the frequency of an undertaking’s
interim reporting should not affect the annual results.
Had F plc not prepared an interim financial report, it would
have recognised a gain in equity of £40 in its annual financial
statements (the increase in the asset.s value from £120 at 31
May 2004 to £160 at 31 May 2005) but it has actually
recognised a loss in profit or loss of £90 and a gain in equity of
£130.
Is the recognition in the annual financial statements required
by IAS 39 compliant with IAS 34?
Yes, this is compliant. It is the recognition of the impairment at
a balance sheet date and not the preparation of the interim
financial report that causes the impact on the annual financial
statements as described above.
The amount of the cumulative loss that is removed from equity
and transferred to the income statement shall be the difference
between:
- the acquisition cost (net of any principal repayment and
amortisation) and
- current fair value, less any impairment loss on that
financial asset previously recognised in the income
statement.
Impairment losses recognised in profit or loss for an
investment in an equity instrument classified as available for
sale shall not be reversed through profit or loss.
If, in a subsequent period, the fair value of a debt instrument
classified as available for sale increases and the increase can
be objectively related to an event occurring after the
impairment loss was recognised in the income statement, the
impairment loss shall be reversed, with the amount of the
reversal recognised in the income statement.
Undertakings are prohibited from reversing impairments on
investments in equity securities.
Had F plc published a balance sheet and recognised the
impairment in profit or loss for the purposes of preparing a
prospectus, for bank covenant reporting or for any other
reason, the reversal of the impairment in the second half of the
year ending 31 May 2005 would still have been recognised in
equity.
For a collective evaluation of impairment, financial assets are
grouped on the basis of similar credit risk characteristics (for
example, on the basis of a credit risk evaluation or grading
process that considers asset type, industry, geographical
location, collateral type, past-due status and other relevant
factors).
It is not therefore the frequency of interim reporting but rather
the frequency of balance sheet dates and impairment
assessments that affect the annual results and the accounting
required by IAS 39 is consistent with the principles contained
in IAS 34.
Those characteristics should be relevant to the estimation of
future cash flows for groups of such assets by being indicative
of the debtors’ ability to pay all amounts due according to the
contractual terms of the assets being evaluated.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
Future cash flows in a group of financial assets that are
collectively evaluated for impairment are estimated on the
basis of the contractual cash flows of the assets in the group
and historical loss experience for assets with credit risk
characteristics similar to those in the group.
Historical loss experience is adjusted on the basis of current
observable data to reflect the effects of current conditions.
Estimates of changes in future cash flows for groups of assets
should reflect changes in related observable data from period
to period (such as changes in unemployment rates, property
prices, payment status, or other factors indicative of changes
in the probability of losses in the group and their magnitude).
EXAMPLE- observable data no longer relevant
A borrower is in financial difficulties. In such cases, an
undertaking uses its experienced judgement to estimate the
amount of any impairment loss.
Similarly an undertaking uses its experienced judgement to
adjust observable data for a group of financial assets to reflect
current circumstances. The use of reasonable estimates is an
essential part of the preparation of financial statements and
does not undermine their reliability.
The methodology and assumptions used for estimating future
cash flows are reviewed regularly to reduce any differences
between loss estimates and actual loss experience.
Financial guarantee contracts
How does the holder of a financial guarantee account for
any costs relating to it, and how does a financial
guarantee impact impairment calculation?
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IAS 39 only applies to the issuer of financial guarantee
contracts. The accounting by the holder of such a contract is
therefore outside the standard’s scope.
The holder’s accounting treatment depends on whether the
guarantee is purchased at origination of a debt instrument or to
guarantee pre-existing debt instruments.
In the first case, the purchaser of the financial guarantee
contract treats the cost of the guarantee as a transaction cost
under IAS 39. Thus the cost is amortised using the effective
interest rate method, unless the debt instrument is measured
at fair value through profit and loss.
In the second case, the cost is recognised as a prepayment
asset and amortised over the shorter of the life of the
guarantee and the expected life of the guaranteed debt
instruments.
The asset is tested for impairment under IAS 36, Impairment of
Assets. Lenders classify the amortisation and impairment
charges as a reduction of interest income.
When estimating the expected future cash flows of a loan, an
undertaking reflects the cash flows from any collateral.
Collateral includes financial guarantees that are entered into
as part of the contractual terms of the loan.
A guarantee of an individual loan entered into at the same time
as the loan contract effectively forms part of the contractual
terms of the loan. Therefore, the impairment charge is shown
net of any financial guarantee reimbursement.
In the situation where a guarantee of a portfolio of loans has
been entered into separately from the loans, the guarantee is
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
separate from the loan and the reimbursement does not
constitute cash from the loan.
Therefore, the reimbursement is treated as a separate asset in
accordance with IAS 37, Provisions, Contingent Liabilities and
Contingent Assets, and not netted against the impairment
charge.
The liability is subsequently amortised and recorded as income
over the period the guarantee applies unless the liability,
measured in terms of IAS 37, Provisions, Contingent Liabilities
and Contingent Assets, exceeds the carrying amount.
Therefore in 20X6, the entry would be:
Dr financial guarantee contract £100
Cr income £100
EXAMPLE- Financial guarantee contracts -accounting
Undertaking D provides a financial guarantee to a third party,
undertaking E, on 1 January 20X6. Under the guarantee, if
undertaking E defaults on a specific loan of £10,000 that it has
with a bank, undertaking D will become liable to repay the loan
to the bank (excluding interest).The guarantee lasts for five
years.
On the date of the guarantee being provided, undertaking E
paid undertaking D £500, which is considered to be the fair
value for granting the guarantee. In 20X7, the credit market
has deteriorated to such a degree that it has become probable
that undertaking E will default on its loan to the bank.
Undertaking D accounts for financial guarantees in accordance
with IAS 39. How should undertaking D account for the
guarantee in its 31 December 20X6 and 20X7 annual financial
statements?
IAS 39 provides specific guidance on accounting for financial
guarantee contracts. On initial recognition, the guarantee is
recognised at fair value in undertaking D’s financial
statements:
Dr cash £500
Cr financial guarantee liability £500
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In 20X7, because it has become probable that undertaking D
will be required to repay the loan on behalf of undertaking E,
undertaking D would be required to measure the liability in
terms of IAS 37.
This would require undertaking D to make a best estimate of
the expenditure required to settle the obligation at the balance
sheet date:
Dr expense £9,250
Cr financial guarantee liability £9,250*
*Assume undertaking D’s best estimate of the liability at the
balance sheet date is £9,650.
EXAMPLE-Intra-group financial guarantee contracts
Company C is the parent company of a large group.
Many of its subsidiaries have bank loans in respect of which C
has provided a guarantee whereby C would repay the loan to
the bank should a subsidiary fail to do so.
C applies IAS 39 and it has a 31 December year-end.
Does IAS 39 contain an exemption for intra-group financial
guarantee contracts?
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
There is no exemption for intra-group guarantees. IAS 39
requires that all financial guarantees within its scope are
measured initially at fair value and then subsequently at the
higher of that amount, less amortisation, and an amount that
would be recognised as a provision in accordance with IAS 37.
Where a financial guarantee is issued to an unrelated third
party in an arm’s length transaction, the fair value is likely to
equal the premium received.
However, the guarantees provided by C are not issued in an
arm’s length transaction and the company has not received
any valuable consideration and there are no comparable
observable transactions with third parties.
Accordingly, fair value will need to be estimated using a
valuation technique.
One possible method is to calculate the value of the difference
between the interest charged on the guaranteed loan and what
would have been charged had the loan not been guaranteed.
Once fair value has been determined, the debit entry in the
issuer’s accounts will be to the investment in the subsidiary.
Financial guarantees are not within the scope of IAS 39 where
the issuer has previously asserted explicitly that it regards
such contracts as insurance contracts and has used
accounting applicable to such contracts.
Within the consolidated financial statements the financial
guarantee is not recognised as a separate contract as the
group’s liability to the bank is recognised in full.
Interest income after impairment recognition
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Once a financial asset or a group of similar financial assets
has been written down as a result of an impairment loss,
interest income is thereafter recorded using the rate of interest
used to discount the future cash flows for the purpose of
measuring the impairment loss.
1.8
Transition
For existing IFRS preparers - points to consider:
• Changes in fair value of available-for-sale investments must
be recognised in equity.
• A loan or other financial asset measured at amortised
cost that is individually assessed for impairment and found
not to be impaired has to be included in a group of similar
financial assets that are assessed for impairment on a
portfolio basis.
In addition, there is new guidance on what constitutes
objective evidence of impairment. An existing IFRS preparer
may need to amend its systems for evaluating impairment of
financial assets, particularly if it does this on a portfolio
basis.
• Impairment losses on an equity instrument
classified as available-for-sale cannot be reversed.
• Impairment losses on a debt instrument classified as
available-for-sale can be reversed through the income
statement if its fair value increases, and the increase can
be objectively related to an event occurring after the loss
was recognised.
• Effective interest rates are now calculated based on
estimated cash flows. Existing IFRS preparers may have to
revise previous effective rates based on the new definition.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
For first-time adopters - points to consider:

Impairment methodology is likely to be different from that
used under an undertaking’s previous GAAP. In particular,
general provisions are not permitted and all impairment of
debt instruments must be measured using a discounted cash
flow methodology.

An undertaking’s estimates of loan impairments at the date
of transition to IFRSs are consistent with estimates made for
the same date under previous GAAP.

Many financial instruments will need to be fair valued, with
no adjustments for blockage or liquidity provisions, if they
are quoted in an active market.

The amortised cost at the date of transition will need to be
calculated, using effective interest rates as set out in IAS 39.
5. Multiple choice questions
1. Subsequent measurement of financial assets and
liabilities depends on:
1. The size of company.
2. The type of organisation.
3. The classification of the financial instruments.
2. Trading assets and liabilities and available-for-sale
assets are measured at:
1. Historic cost.
2. Fair value.
3. Amortised cost.
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3. Loans and receivables and held-to-maturity investments
are carried at:
1. Historic cost.
2. Fair value.
3. Amortised cost.
4. If quoted market prices are not available, undertakings
use
1. Historic cost.
2. Fair value.
3. Amortised cost.
4. Valuation techniques incorporating market data.
5. Changes in carrying amount are recorded in equity only
for:
1. Financial assets at fair value.
2. Loans and receivables.
3. Held-to-maturity investments.
4. Available-for-sale financial assets.
6. Amortised cost excludes:
1. The amount to be paid/repaid at maturity.
2. Any unamortized original premium or discount.
3. Origination fees and transaction costs.
7. The amortisation of amortised cost is calculated using:
1. Regression analysis.
2. The effective interest method.
3. Market interest rates.
8. At inception, a financial instrument has to be
recognised at its
1.
Historic cost.
2. Fair value.
3. Amortised cost.
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IAS 32/39 Financial Instruments Part 3 Subsequent Recognition
4. Fair value (net of transaction costs).
9. In relation to “blockage” or “liquidity” factors, the
quoted market price,
1. Should take these into account.
2. May take them into account.
3. Cannot be adjusted for them.
10. Valuation techniques that are well established in
financial markets include:
(i) Recent market transactions.
(ii) Reference to a transaction that is substantially the same.
(iii) Discounted cash flows.
(iv) Option pricing models.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
6. Answers to multiple choice questions
Question
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Answer
3
2
3
4
4
3
2
4
3
4
1
3
11. There is evidence that impairment may been incurred
when:
1. The carrying amount of a financial asset carried at
amortised cost exceeds its estimated recoverable
amount.
2. The carrying amount of a financial asset carried at
amortised cost exceeds its fair value.
3. The fair value of a financial asset exceeds its estimated
recoverable amount.
12. Reversing impairments on investments in equity
securities:
1. Should be done systematically.
2. Should be done annually.
3. Is prohibited.
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