FINANCIAL INSTRUMENTS:

RECOGNITION AND MEASUREMENT

CO5:Comprehend and comply with the requirements of the Financial
Instruments: Recognition and Measurement (MFRS139)

INTRODUCTION

Over the past few years financial instruments have appeared on the market in
response to an economic environment that is more and more competitive
globally. Entities nowadays exposed to various types of financial risks.
Innovations in the financial markets have led to widespread use of financial
instruments.

The Standards dealing with financial instruments are MFRS132 Financial

Instruments: Presentation, MFRS139 Financial Instruments: Recognition and
Measurement, MFRS7 Financial Instruments: Disclosure, and MFRS9 Financial
Instruments: Classification and Measurement.

INTRODUCTION (contd)
Why do entities incur financial instruments?

To hedge their exposures to financial risks

To exploit opportunities to profit from the volatility of the prices, interest

rates or foreign exchange rates

To exploit tax loopholes and asymmetries

To take advantage of financial deregulation

To reduce transaction costs

To reduce agency costs

DEFINITIONS

A financial instrument is any contract that gives rise to a financial asset of

one entity and a financial liability or equity instrument of another entity
(MFRS 132.11).

A financial instrument exist so long as there is contractual relationship arising

from the instrument which establish the rights and obligations, may create
exposure to risk and rewards.

The rights and obligation approach used in accounting for financial

instruments is contrast from the risk and rewards approach used in
accounting for non-financial items like PPE.

Refer to Example 1 (TLT, Chapter 1, vol.2)

DEFINITIONS (contd)

FINANCIAL INSTRUMENTS

Financial assets

Financial liabilities

Equity instruments

DEFINITIONS (contd)
Financial assets is defined as any asset that is:

(a) cash;

(b) an equity instrument of another entity;

(c) a contractual right:

(i) to receive cash or another financial asset from another entity; or

(ii) to exchange financial assets or financial liabilities with another entity under conditions
that are potentially favourable to the entity; or

(d) a contract that will or may be settled in the entitys own equity instruments and is:

(i) a non-derivative for which the entity is or may be obliged tor eceive a variable number
of the entitys 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 entitys own equity instruments.
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DEFINITIONS (contd)
A financial liability is any liability that is:

(a) a contractual obligation :

(i)

(ii) to exchange financial assets or financial liabilities with another entity under conditions that
are potentially unfavourable to the entity; or

(b) a contract that will or may be settled in the entitys own equity instruments and is:

(i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the
entitys 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 entitys own equity instruments. For this purpose,
the entitys own equity instruments do not include instruments that are themselves contracts for
the future receipt or delivery of the entitys own equity instruments.

to deliver cash or another financial asset to another entity; or

DEFINITIONS (contd)

Equity instruments - any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities.

A derivative is a financial instrument or other contract with all three of the following
characteristics:

(a) its value changes in response to the change in a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or rates, credit
rating or credit index, or other variable, provided in the case of a non-financial variable
that the variable is not specific to a party to the contract (sometimes called the
underlying);

(b) it requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a similar
response to changes in market factors; and

(c) it is settled at a future date.

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CATEGORIES OF FINANCIAL ASSETS

Financial assets at fair value through profit or loss

o

Held for trading (mandatory classification)

Designated at FVTPL (optional classification)

Held-to-maturity investments
o

Non-derivative financial asset with fixed or determinable payments and fixed maturity and Entity has the positive
intention and able to hold to maturity

Refer to Example 4 (TLT, Chapter 1, vol.2)

The Tainting Rule - Refer to Example 5 (TLT, Chapter 1, vol.2)

Loans and receivables

o

Non-derivative financial asset with fixed or determinable payments not quoted in active market

Refer to Example 2 (TLT, Chapter 1, vol.2)

Refer to Example 6 (TLT, Chapter 1, vol.2)

Available-for-sale financial assets eg.7

o

Non-derivative financial asset that designated as AFS

o

Refer to Example 7 (TLT, Chapter 1, vol.2)

CATEGORIES OF FINANCIAL ASSETS (contd)

Classification of financial assets as in MFRS 9

MFRS 9 uses a business model approach to classify a financial asset.

A financial asset is classified into:

Amortised cost; or

Fair value

The classification is made on the basis of:

o

The entitys business model for managing the financial assets; and

The contractual cash flow characteristics of the financial asset.

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CATEGORIES OF FINANCIAL LIABILITIES

Financial liabilities at FVTPL

Financial liabilities measured at amortised cost

Other financial liabilities financial guarantees and commitments to provide

loans at below market rates.

Refer to Example 8 (TLT, Chapter 1, vol.2)

MFRS9 classifies financial liabilities as follows:

Financial liabilities at fair value through profit or loss: these financial liabilities are
subsequently measured at fair value which include all derivatives.

Other financial liabilities measured at amortized cost using the effective

interestmethod
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INITIAL RECOGNITION

An entity shall recognise a financial asset or financial liability in its statement

of financial position when, and only when, the entity becomes a party to the
contractual provisions of the instruments.
o

Date of contract

Contract establishes rights and obligation

Examples of initial recognition unconditional receivables and payables

Planned future transactions not assets or liabilities of an entity

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DERECOGNITION

Derecognition is the removal of a previously recognized financial asset from

an entitys statement of financial position.

Only when:

the contractual rights to the cash flows from the financial asset expire; or

it transfers the financial asset and the transfer qualifies for derecognition

Once the asset under consideration for derecognition has been determined, an
assessment is made as to whether the asset has been transferred, and if so,
whether the transfer of that asset is subsequently eligible for derecognition.
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DERECOGNITION (contd)

Examples:
o

Must derecognise: Sell receivables to bank but we continue to collect and remit,
for a handling fee. Bank assumes credit risk. Entity has no contractual rights to
the cash flows

May not derecognise: Same facts except entity agrees to buy back any receivables
in arrears for more than 120 days. Entity continues to recognise the receivables
until collected or writeoff as uncollectible. - Entity has contractual rights to the
cash flows

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DERECOGNITION (contd)

It is possible for only part of a financial asset to be recognized. This is allowed if the part
comprises:
o

only specifically identified cash flows; or

only a fully proportionate (pro rata) share of the total cash flows.

On derecognition of a financial asset in its entirety, the difference between:

(a) the carrying amount (measured at the date of derecognition) and
(b) the consideration received (including any new asset obtained less any new liability assumed) and any
cumulaive gain/loss recognised in OCI, shall be recognised in profit or loss.
Refer to Example 25 (TLT, Chapter 1, vol.2)

The various derecognition steps are summarised in the decision tree in AG36 of MFRS139.
Derecognition of a financial asset.docx
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MEASUREMENT
INITIAL MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

When a financial asset or financial liability is recognised initially, an entity shall

measure it at its fair value plus, in the case of a financial asset or financial
liability not at fair value through profit or loss, transaction costs that are directly
attributable to the acquisition or issue of the financial asset or financial liability.

FIVPL transaction costs shall be expensed when incurred

Transaction costs are incremental costs that are directly attributable to the
acquisition, issue or disposal of a financial asset or financial liability. An
incremental cost is one that would not have been incurred if the entity had not
acquired, issued or disposed of the financial instrument.

Effects of including transaction cost increase initial carrying, reduce effective interest rate

Refer to Example 2 (TLT, Chapter 2, vol.2)

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MEASUREMENT (contd)
SUBSEQUENT MEASUREMENT OF FINANCIAL ASSETS

After initial recognition, an entity shall measure financial assets, including

derivatives that are assets, at their fair values, without any deduction for
transaction costs it may incur on sale or other disposal, except for the
following financial assets:

(a) loans and receivables, which shall be measured at amortised cost using the
effective interest method;

(b) held-to-maturity investments, which shall be measured at amortised cost

using the effective interest method; and

(c) investments in equity instruments that do not have a quoted market price in
an active market and whose fair value cannot be reliably measured and
derivatives that are linked to and must be settled by delivery of such unquoted
equity instruments, which shall be measured at cost.
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MEASUREMENT (contd)
Fair value method

Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arms length transaction.*

Best: Quoted market price in an active market (bid price)

If quoted market price is not available: Estimate using a valuation technique (a model)

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MEASUREMENT (contd)
Amortised cost and Effective interest method

The amortised cost is 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 uncollectibility.

The effective interest method is a method of calculating the amortised cost of a

financial asset or a financial liability (or group of financial assets or financial liabilities)
and of allocating the interest income or interest expense over the relevant period.

The effective interest rate is the rate that exactly discounts estimated 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.

Refer to Example 3 (TLT, Chapter 2, vol.2)

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MEASUREMENT (contd)
SUBSEQUENT MEASUREMENT OF FINANCIAL LIABILITIES

After initial recognition, an entity shall measure all financial liabilities at

amortised cost using the effective interest method, except for:
(a) financial liabilities at fair value through profit or loss.
(b) financial liabilities that arise when a transfer of a financial asset does
not qualify for derecognition or when the continuing involvement
approach applies.
(c) financial guarantee contracts as defined
(d) commitments to provide a loan at a below-market interest rate.
Refer to Example 7 (TLT, Chapter 2, vol.2)

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RECLASSIFICATIONS

FIFVPL
o

HTMI
o

Change in intention or ability reclassify as AFS, remeasured at FV

Sale or rclassification of more than an insignificant amount remaining reclassify as AFSI

AFS assets not measured at FV

o

Only in rare circumstances unsual and highly unlikely to recur in near term

If reliable measure of FV available, remeasured at FV

Cost or Amortised cost becomes appropriate

o

FA with fixed maturity gain/loss amortised to P/L

FA without fixed maturity gain/loss remain in equity.

Refer to Example 17 (TLT, Chapter 2, vol.2)

MFRS9 prescribes that an entity shall reclassify FA between FV and amortised cost categories only when
there is a change in an entitys business model for managing FA, otherwise, reclassification is prohibited.
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GAINS AND LOSSES ON REMEASUREMENT

FAFVPL
o

AFS asset
o

Changes in FV are recognized as gain and losses in profit or loss.

Changes in FV are recognized in other comprehensive income

FA carried at amortised cost

o

Gain or loss is recognized in profit or losss when the FA derecognized or impaired,

and through the amortization process.

Refer to Example 20 (TLT, Chapter 2, vol.2)

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IMPAIRMENT OF FINANCIAL ASSETS

An entity shall assess at the end of each reporting period whether there is any
objective evidence that a financial asset or group of financial assets is impaired. If
any such evidence exists, the entity shall perform impairment test to determine
the amount of any impairment loss [MFRS139.58].

What are the evidences?

o

Significant financial difficulty of issuer

Default or delinquency

Abnormal concession granted to debtor by creditor

Probable debtor bankruptcy or reorganization

The disappearance of an active market for that financial asset because of financial
difficulties
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IMPAIRMENT OF FINANCIAL ASSETS (contd)

Financial assets carried at amortised cost

o

The amount of the loss is measured as the difference between the assets carrying amount and the present value of
estimated future cash flows discounted at the financial assets original effective interest rate (ie the effective
interest rate computed at initial recognition). The carrying amount of the asset shall be reduced either directly or
through use of an allowance account. The amount of the loss shall be recognized in profit or loss.

Refer to Example 24 (TLT, Chapter 2, vol.2)

Financial assets carried at cost

o

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. Such impairment losses shall not be reversed.

Refer to Example 25 (TLT, Chapter 2, vol.2)

AFS financial assets

o

If there is objective evidence that the asset is impaired, the cumulative loss that had been recognised in OCI shall
be reclassified from equity to profit or loss as a reclassification adjustment even though the financial asset has not
been derecognised. Such impairment losses shall not be reversed. Any subsequent increase, shall be recognized in
OCI.

Refer to Example 26 (TLT, Chapter 2, vol.2)

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INTRODUCTION TO HEDGE ACCOUNTING

Hedging of financial risks typically involves using financial instruments

(usually derivatives) that provide offsetting effects to the volatility of the fair
value or future cash flows of a hedged item.

Objective to take a position (the hedging instrument) that neutralizes the

risk, as far as possible, in the hedged item.
o

Short hedge taking a short or sell position in the hedging instrument

Aim to protect a fall in the price of the underlying hedged item

Long hedge taking a long or buy position in the hedging instrument.

Aim to protect a rise in the price of the underlying hedged item.

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INTRODUCTION TO HEDGE ACCOUNTING (contd)

Hedge accounting recognises the offsetting effects on profit or loss of changes in the fair
values of the hedging instrument and the hedged item.

Aim to realise a matched timing of recognition of gains and losses (the offsetting
effects) in profit or loss between the hedged items and the corresponding hedging
instrument.

Hedging relationships are of three types:

(a) 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 or loss.
(b) cash flow hedge: a hedge of the exposure to variability in cash flows that (i) is attributable
to a particular risk associated with a recognised asset or liability (such as all or some future
interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could
affect profit or loss.
(c) hedge of a net investment in a foreign operation as defined in MFRS 121.
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