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Financial 10
IX. DISTINGUISHING LIABILITIES FROM EQUITY
Certain financial instruments have characteristics of both liabilities and equity. The following
financial instruments must be classified as liabilities:
X.
A.
Financial instruments in the form of shares that are mandatorily redeemable (i.e., mandatorily
redeemable preferred stock) and represent an unconditional obligation to the issuer to
redeem the instrument by transferring assets at a specified date or upon a future event,
unless the redemption is required upon the liquidation or termination of the issuer.
B.
Financial instruments, other than outstanding shares, that represent an obligation to
repurchase the issuer's equity shares by transferring assets.
C.
Financial instruments that represent an obligation to issue a variable number of shares.
Accounting for FInancial Instruments Under IFRS 9
IFRS 9, Financial Instruments, is a multi-phase IASB project. All three phases have been completed:
classification and measurement of financial assets and liabilities, impairment of financial instruments,
and hedge accounting. The FASB has not yet issued a pronouncement that converges with IFRS 9.
A.
Classification and Measurement of Financial Assets
Under IFRS 9, financial assets are initially recognized at fair value and then subsequently
measured at either amortized cost or fair value.
1.
Single Model for Classification and Measurement
IFRS 9 requires a single model for classification and measurement that applies to
all types of financial assets, including those that contain embedded derivatives. The
model consists of two parts: a business model for managing the financial assets and a
contractual cash flow model.
a.
Business Model for Managing Financial Assets
The business model for managing the financial assets is the entity's purpose for
holding the assets (e.g., for collecting contractual payments or for holding assets in
order to realize returns upon the sale of the assets).
b.
Contractual Cash Flow Model
The contractual cash flow model refers to how cash is received, either solely
payments of principal and interest (SPPI) or the collection of proceeds upon the
sale of the asset.
2.
Debt Instruments
Financial assets that are debt instruments are reported at amortized cost, fair value
through other comprehensive income (FVOCI), or fair value through profit or loss (FVPL).
a.
Amortized Cost Measurement
A financial asset that is a debt instrument is measured at amortized cost if both of
the following conditions are met:
(1) Business Model Test—The asset is held in a business model whose objective
is to hold assets in order to collect contractual cash flows.
(2) Cash Flow Characteristics Test—The contractual terms of the financial asset
give rise on specified dates to cash flows that are solely payments of principal
and interest.
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Financial 10
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b.
Fair Value Measurement
If the conditions for amortized cost measurement are not met, the debt instrument is
measured at fair value:
(1) Financial assets that are held in a portfolio where an entity both holds to
collect assets' cash flows (SPPI) and sells assets may be classified as FVOCI.
(2) Financial assets that do not contain cash flows that are SPPI must be
measured at FVPL (e.g., derivatives).
3.
Equity Instruments
A financial asset that is an equity instrument is reported at fair value with gains and
losses recognized in earnings (FVPL), unless:
a.
The entity makes an irrevocable election on initial recognition to present gains
and losses in other comprehensive income (FVOCI).
(1) Gains and losses recognized in other comprehensive income are never
recognized in earnings, but may be reclassified within equity.
4.Reclassifications
Reclassification of financial assets between amortized cost and fair value are required
only when the entity changes the business model under which it manages financial
instruments. Such changes should be infrequent and are accounted for prospectively.
The asset should be remeasured at fair value on the date of the reclassification, with
any gain or loss recognized in earnings.
B.
Classification and Measurement of Financial Liabilities
Under IFRS 9, financial liabilities are initially recognized at fair value and then subsequently
measured at either amortized cost or fair value.
1.
Amortized Cost Measurement
In general, financial liabilities are subsequently measured at amortized cost using the
effective interest method.
2.
Fair Value Measurement
Financial liabilities may be subsequently measured at fair value in certain
circumstances, such as when an entity at initial recognition irrevocably designates a
financial liability as measured at fair value through profit or loss. Gains and losses on
financial liabilities measured at fair value are recognized in earnings, unless the entity
is required to present the effects of changes in the liability's credit risk in other
comprehensive income.
3.Reclassification
Financial liabilities may not be reclassified between amortized cost and fair value.
C.Impairment
1.
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IFRS 9 requires a forward-looking impairment model referred to as the expected credit
loss model.
a.
This model does not apply to financial assets measured at fair value through profit
or loss.
b.
It does apply to financial assets that are measured at amortized cost or at fair value
through other comprehensive income.
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2.
3.
D.
Financial 10
The entity must recognize expected credit losses at all times (including at purchase) and
must update the amount of expected credit losses recognized at each reporting date to
reflect changes in the credit risk of financial instruments.
a.
As soon as a financial instrument is originated or purchased, 12-month expected
credit losses are recognized in profit or loss.
b.
If the credit risk increases significantly and the resulting credit quality is not
considered to be low credit risk, full lifetime expected credit losses are recognized.
Lifetime expected credit losses are only recognized if the credit risk increases
significantly from when the entity originates or purchases the financial instrument.
Impairment losses and, when necessary, the reversal of previously recognized
impairment losses are recognized through the use of a loss allowance account, rather
than a direct write-down of the assets.
a.
Financial Assets Measured at Amortized Cost—For financial assets that are
measured at amortized cost, impairment losses and the reversal of previously
recognized impairment losses are recognized in earnings.
b.
Financial Assets Measured at FVOCI—For financial assets that are measured
at fair value through other comprehensive income, the impairment losses or the
reversal of previously recognized impairment losses should be recognized in other
comprehensive income.
4.
A triggering event (e.g., known financial difficulties or a decline in credit ratings) is not
required in order to recognize credit losses. In assessing impairment, the entity should
consider historical, current, and forecast information that is reasonable and supportable
and available without undue cost or effort.
5.
The expected credit loss model is applied to all financial instruments that are subject to
impairment. It also applies to lease receivables, trade receivables, commitments to lend
money, and financial guarantee contracts.
Hedge Accounting
1.Introduction
a.
The definition and basics of the hedging process are discussed earlier in this
lecture. The highlights of IFRS 9 are discussed below.
b.
The IFRS 9 hedging requirements aim to provide a better link between an entity's
risk management strategy, the rationale for hedging, and the impact of hedging on
the financial statements.
c.
Hedge accounting remains optional and can only be applied to hedging
relationships that meet the qualifying criteria.
d.
A financial instrument's eligibility as a hedging instrument depends on whether the
financial instrument is measured at fair value through profit or loss (FVPL), not on
whether it is a derivative instrument.
(1) The IFRS 9 hedge accounting model permits entities to designate derivative
instruments as well as nonderivative financial instruments as hedging
instruments for all types of risks, as long as they are measured at FVPL.
(2) An example of a nonderivative financial instrument is a foreign currency
denominated debt instrument.
e.
Only contracts with a party external to the reporting entity can be designated as
hedging instruments.
f.
Only hedges of exposures that could affect profit or loss qualify for hedge accounting.
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Financial 10
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g.
Qualifying hedged items include:
(1) A recognized asset or liability
(2) An unrecognized firm commitment
(3) A highly probable forecast transaction
(4) A net investment in a foreign operation
h.
There are three types of hedging relationships:
(1) Fair Value Hedges—A hedge of the exposure to changes in fair value of a
recognized asset or liability or an unrecognized firm commitment that could
affect profit or loss.
(2) Cash Flow Hedges—A hedge of the exposure to variability in cash flows of a
hedged item or a highly probable forecast transaction that could affect profit
or loss.
(3) Hedges of Net Investments in Foreign Operations (Accounted for Similarly to
Cash Flow Hedges)—A hedge of the exposure to foreign exchange differences
arising from a difference between its own functional currency and that of its
foreign operation.
i.
Qualifying criteria for hedge accounting:
(1) The hedging relationship consists only of eligible hedging instruments and
eligible hedged items.
(2) At the inception of the hedging relationship, there is a formal designation and
documentation of the hedging relationship and the risk management objective
and hedging strategy.
(3) The hedging relationship meets all necessary hedge effectiveness requirements.
EXA M P LE
Hedge accounting means designating one or more hedging instruments so that their change in fair value
offsets the change in fair value or the change in cash flows of a hedged item.
• Hedged risk: Foreign currency risk.
• Hedged item: Receivable in a foreign currency.
• Hedging instrument: A foreign currency forward contract to sell the foreign currency at a fixed
exchange rate on a fixed date.
2.
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Accounting for Fair Value Hedges
a.
The gain or loss on the hedging instrument is recognized in profit or loss unless the
hedging instrument hedges an equity instrument for which an entity has elected to
present changes in fair value in other comprehensive income. In this case, the gain
or loss is recognized in other comprehensive income.
b.
The hedging gain or loss on a hedged item that is not an equity instrument will
adjust the carrying amount of the hedged item and be recognized in profit or loss,
even if the hedged item is a financial asset measured at FVOCI.
c.
If the hedged item is an equity instrument for which an entity has elected to present
changes in fair value in other comprehensive income, those amounts will remain in
other comprehensive income.
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3.
Financial 10
Accounting for Cash Flow Hedges
a.
A cash flow hedge reserve (CFHR) is the amount accumulated in other
comprehensive income for a cash flow hedge. The CFHR for the hedged item is
adjusted to the lower of:
(1) the cumulative gain or loss on the hedging instrument from the inception of
the hedge; or
(2) the cumulative change in fair value of the hedged item from inception of
the hedge.
4.
b.
The portion of the gain or loss on the hedging instrument that is deemed effective is
recognized in other comprehensive income. (This portion is offset by the change in
the cash flow hedge reserve.)
c.
Any remaining gain or loss (hedge ineffectiveness) is recognized in profit or loss.
Accounting for Hedges of a Net Investment in a Foreign Operation
a.
Hedges of a net investment in a foreign operation are accounted for similarly to
cash flow hedges.
b.
The gain or loss attributable to an effective hedge is recognized in other
comprehensive income.
c.
The ineffective portion is recognized in profit or loss.
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