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P-2 Corporate Reporting

IAS-32, IAS-39
IFRS-7,IFRS-9

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.
A financial asset is 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 to receive 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.

An equity instrument is any contract that evidences a


residual interest in the assets of an entity after deducting
all of its liabilities.
A financial liability is any liability that is:
(a) a contractual obligation :
(i) to deliver cash or another financial asset to another entity; or
(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.

A puttable instrument is a financial instrument that gives


the holder the right to put the instrument back to the issuer
for cash or another financial asset

The amortized cost of a financial asset or financial liability


is the amount at which the financial asset or financial liability
is measured at initial recognition minus principal repayments,
plus or minus the cumulative amortization using the effective
interest method of any difference between that initial amount
and the maturity amount, and 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 amortized 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 (same as IRR).
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.

Initial recognition and measurement


Initial recognition
The issuer of a financial instrument shall classify the
instrument, or its component parts, on initial recognition as a
financial liability, a financial asset or an equity instrument in
accordance with the substance of the contractual arrangement
and the definitions of a financial liability, a financial asset and
an equity instrument.
An entity shall recognize a financial asset or a financial liability
in its statement of financial position when, and only when, the
entity becomes party to the contractual provisions of the
instrument.
The following are examples of the entity becomes party .
Unconditional receivables and payables are recognized as
assets or liabilities when the entity becomes a party to the
contract and, as a consequence, has a legal right to receive or
a legal obligation to pay cash.

Assets to be acquired and liabilities to be incurred as a result of


a firm commitment to purchase or sell goods or services are
generally not recognized until at least one of the parties has
performed under the agreement. For example, an entity that
receives a firm order does not generally recognize an asset
(and the entity that places the order does not recognize a
liability) at the time of the commitment but, rather, delays
recognition until the ordered goods or services have been
shipped, delivered or rendered.
A forward contract is recognized as an asset or a liability on the
commitment date, rather than on the date on which settlement
takes place. When an entity becomes a party to a forward
contract, the fair values of the right and obligation are often
equal, so that the net fair value of the forward is zero. If the net
fair value of the right and obligation is not zero, the contract is
recognized as an asset or liability.
Option contracts are recognized as assets or liabilities when
the holder or writer becomes a party to the contract.
Planned future transactions, no matter how likely, are not
assets and liabilities because the entity has not become
a party to a contract.

Initial measurement
At initial recognition, an entity shall measure a financial asset or
financial liability at its fair value (normal its cost) plus or minus,
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.
Fair Value of Financial instrument
Where Active market exist
The existence of published price quotations in an active market is
the best evidence of fair value and when they exist they are
used to measure the financial asset or financial liability.
Where no active market exist
If the market for a financial instrument is not active, an entity
establishes fair value by using a valuation technique. Valuation
techniques include using recent arms length market
transactions between knowledgeable, willing parties, if
available, reference to the current fair value of another
instrument that is substantially the same, discounted cash
flow analysis and option pricing models.

Classification of financial
assets
Debt instrument
An entity shall classify financial assets as subsequently
measured at either amortized cost or fair value on the basis of
both:
(a) the entitys business model for managing the financial assets and
(b) the contractual cash flow characteristics of the financial asset.

A financial asset shall be measured at amortized cost if both of


the following conditions are met:
(a) The asset is held within a business model whose objective is to hold
assets in order to collect contractual cash flows.
(b) The contractual terms of the financial asset give rise on specified dates
to cash flows that are solely payments of principal and interest on the
principal amount outstanding.

Equity instrument
An equity instrument either measured at
Fair value through profit or Loss or
Fair value through other comprehensive income

Classification of financial
assets
The classification of a financial asset, which is an equity instrument,
through other comprehensive income is only possible when and only
when
At initial recognition, an entity may make an irrevocable election to
present in other comprehensive income and
This financial asset is not not held for trading.

Subsequent measurement
Subsequent changes in fair value (gains and losses) should be reported
in other comprehensive income and the subsequent reclassification
of gain and losses in profit or loss is not possible (although it can be
transfer with in the equity at de recognition [disposal]).
Dividend income
If an entity makes the election of this classification of financial asset, it
shall recognize in profit or loss dividends from this investment when
the entitys right to receive payment of the dividend is established.

Classification of financial
liabilities
An entity shall classify all financial liabilities as
subsequently measured at amortized cost using the
effective interest method, except for financial liabilities at
fair value through profit or loss. Such liabilities, including
derivatives that are liabilities, shall be subsequently
measured at fair value.
Under IFRS the issuer should classify the instrument, or its
component parts, as a financial liability or as equity in accordance
with the substance of the contractual arrangement on initial
recognition, and the definitions of a financial liability and a equity
instrument. The classification made at the date of issue
Some financial instruments have the legal form of equity but are, in
substance, liabilities. For example an issuer has a contractual
obligation to either deliver cash or another financial asset
(redeemable preference shares).

Compound instrument
A compound instrument is a financial instrument that has
characteristics of both equity and liabilities, for example debt
that can be converted into shares.
The bondholder has the prospect of acquiring cheap shares in an
entity, because the terms of conversion are normally quite generous.
Even if the bondholder wants cash rather than shares, the deal may
still be good. On maturity the cash hungry bondholder will accept the
conversion, and then sell the shares on the market for a tidy profit.
In exchange though, the bondholders normally have to accept a below
market rate of interest, and will have to wait some time before they
get the shares that form a large part of their return. There is also the
risk that the entitys shares will underperform, making the conversion
unattractive.
IAS 32 requires compound financial instruments be split into their
component parts:
a financial liability (the debt)
an equity instrument (the option to convert into shares).
These must be shown separately in the financial statements.

Amortize Cost Examples


5.9% Debt is issued for $1,000. The debt is redeemable at
$1,250 after five years. The effective rate of interest is
10%.
Giles issues three debt instruments, each with a nominal value
of $10,000 and redeemable in two years. The effective
interest rate for all three is 10%.
Q1 has a coupon rate of 0%, is issued at par and is redeemed
at a premium of $2,100.
Q2 has a coupon rate of 0%, is issued at a discount of $1,736
and is redeemed at par.
Q3 has a coupon rate of 2%, is issued at a discount of $500
and is redeemed at a premium of $1,075.

Examples of Compound
instrument
On 1 January 20X1 D issued a $50m three year convertible bond at par.
There were no issue costs. The coupon rate is 10%, payable annually
in arrears on 31 December. The bond is redeemable at par on 1
January 20X4. Bondholders may opt for conversion. The terms of
conversion are two 25 cent shares for every $1 owed to each
bondholder on 1 January 20X4. Bonds issued by similar companies
without any conversion rights currently bear interest at 15%. Assume
that all bondholders opt for conversion in full.
How will this be accounted for by D?.
C issues a $100,000 4% three year convertible loan on 1 January 20X6.
The market rate of interest for a similar loan without conversion rights
is 8%. The conversion terms are one ordinary $1 share for every $2 of
debt. Conversion or redemption at par takes place on 31 December
20X8.
How should this be accounted for.

Interest, dividends, losses and gains relating to a financial instrument or a


component that is a financial liability shall be recognized as income or
expense in profit or loss.
Distributions to holders of an equity instrument shall be debited by the entity
directly to equity, net of any related income tax benefit.
Impairment of Financial assets
Financial asset classified being Fair value through profit and loss and Fair
value through other comprehensive income are not subject to impairment
review because remeasurement at reporting date will automatically taken
account of any impairment.
For financial assets measured at amortized cost, IAS 39 requires that an
assessment be made, at every reporting date, as to whether there is any
objective evidence that a financial asset is impaired, i.e. whether an event
has occurred that has had a negative impact on the expected future cash
flows of the asset.
The event causing the negative impact must have already happened. An
event causing an impairment in the future shall not be anticipated.
For example, on the last day of its financial year a bank lends a customer
$100,000. The bank has consistently experienced a default rate of 5%
across all its loans. The bank is not permitted immediately to write this
loan down to $95,000 based on its past experience, because no default has
occurred at the reporting date.
Examples of objective evidence of impairment are: significant financial
difficulty of the borrower and the failure of the borrower to make interest
payments on the due date.

Example of impairment
On 1 February 20X6, Eve makes a four year loan of $10,000
to Fern. The coupon on the loan is 6%, the same as the
effective rate of interest. Interest is received at the end of
each year. On 1 February 20X9, it becomes clear that Fern
is in financial difficulties. This is the necessary objective
evidence of impairment. At this time the current market
interest rate is 8%. It is estimated that the future remaining
cash flows from the loan will be only $6,000, instead of
$10,600 (the $10,000 principal plus interest for the fourth
year of $600).
Reversals of impairment losses
A reversal of an impairment loss is only permitted as a
result of an event occurring after the impairment loss has
been recognized. An example would be the credit rating of
a customer being revised upwards by a rating agency.
Impairment losses in respect of financial assets measured
at amortized cost are recognized in profit or loss.

Reclassification
When, and only when, an entity changes its business model for
managing financial assets it shall reclassify all affected
financial assets in accordance with the requirement of this
IFRS.
An entity shall not reclassify any financial liability.
If an entity reclassifies financial assets, it shall apply the reclassification
prospectively from the reclassification date. The entity shall not restate
any previously recognized gains, losses or interest.
If an entity reclassifies a financial asset so that it is measured at fair
value, its fair value is determined at the reclassification date. Any gain
or loss arising from a difference between the previous carrying amount
and fair value is recognized in profit or loss.
If an entity reclassifies a financial asset so that it is measured at
amortized cost, its fair value at the reclassification date becomes its
new carrying amount.

Drecognition
An entity shall derecognize a financial asset when, and
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
(eg. Sold it and substantially all risks and rewards of the ownership have
been transferred from seller to buyer)

Transfers of a financial asset


An entity transfers a financial asset if, and only if, it either:
(a) transfers the contractual rights to receive the cash flows of
the financial asset, or
(b) retains the contractual rights to receive the cash flows of the
financial asset, but assumes a contractual obligation to pay the
cash flows to one or more recipients in an arrangement where
The entity has no obligation to pay amounts to the eventual recipients unless
it collects equivalent amounts from the original asset.
The entity is prohibited by the terms of the transfer contract from selling or
pledging the original asset
The entity has an obligation to remit any cash flows it collects on behalf of
the eventual recipients without material delay.

Right to service the financial asset


If an entity transfers a financial asset in a transfer that qualifies
for derecognition in its entirety and retains the right to service
the financial asset for a fee, it shall recognize either a servicing
asset or a servicing liability for that servicing contract. If the
fee to be received is not expected to compensate the entity
adequately for performing the servicing, a servicing liability for
the servicing obligation shall be recognized at its fair value. If
the fee to be received is expected to be more than adequate
compensation for the servicing, a servicing asset shall be
recognized for the servicing right.

Transfers that do not qualify for derecognition


If a transfer does not result in derecognition because the entity
has retained substantially all the risks and rewards of
ownership of the transferred asset, the entity shall continue to
recognize the transferred asset in its entirety and shall
recognize a financial liability for the consideration received. In
subsequent periods, the entity shall recognize any income on
the transferred asset and any expense incurred on the
financial liability.

Derecognition of financial liability


An entity shall remove a financial liability (or a part of a financial
liability) from its statement of financial position when, and only
when, it is extinguished ie when the obligation specified in the
contract is discharged (eg. Paid) or cancelled (e.g. through
exchange of a new liability or through the action of law) or
expires (laps of time e.g. time bar debts).
An exchange between an existing borrower and lender of debt
instruments with substantially different terms shall be accounted
for as an extinguishment of the original financial liability and the
recognition of a new financial liability. Similarly, a substantial
modification of the terms of an existing financial liability or a part
of it (whether or not attributable to the financial difficulty of the
debtor) shall be accounted for as an extinguishment of the original
financial liability and the recognition of a new financial liability.

Gains and Losses on Derecognition


On derecognition of a financial asset or liability, the difference
between:
The carrying amount (measured at the date of derecognition) and
The consideration received (including any new asset obtained less any new
liability assumed) shall be recognized in profit or loss.

Drecognition
Bell buys an investment for trading purposes from Book. It cost
$10 million at 1 January 20X7. At 31 December 20X7, the
investment had a fair value of $30 million. On 1 June 20X8
Bell sold the investment to Candle for its market value of
$100 million.
(1) How should this be accounted for?
(2) Would the answer have been different if Bells purchase
contract had contained a put option giving Bell the power to
sell the investment back to Book at market value on 31
December 20X8?
(3) Would the answer have been different if Bells sale contract
had provided Bell with a call option and Candle with a put
option over the investment, each at a price of $105 million
over the next 12 months?

Derivatives
A derivative is a financial instrument with the following characteristics:
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 similar variable
(called the underlying).
It requires little or no initial net investment relative to other types of
contract that have a similar response to changes in market
conditions.
It is settled at a future date.
Derivatives include the following types of contracts:
Forward contracts
Futures contracts
Forward rate agreements
Swaps
Options

Measurement of derivatives
On recognition, derivatives should initially be measured
at fair value. Transaction costs may not be included.
The derivatives could be used for two broad purposes
Speculation
Hedging
Subsequent measurement depends on how the derivative is
categorized.
If these are for speculation purpose then it should be
measured at fair value through profit or loss with changes in
the fair value recognized in profit or loss.
However if the derivative is used as a hedge then the
changes in fair value should be recognized in according to
hedge accounting.

Entity A enters into a call option on 1 June 20X5, to purchase


10,000 shares in another entity on 1 November 20X5 at a
price of $10 per share. The cost of each option is $1. A has a
year end of 30 September. By 30 September the fair value of
each option has increased to $1.30 and by 1 November to
$1.50, with the share price on the same date being $11. A
exercises the option on 1 November and the shares are
classified as at fair value through profit or loss.
How should this be accounted for?
Hoggard buys a call option on 1 January 20X6 for $5 per option
that gives the right to buy 100 shares in Rowling on 31
December at a price of $10 per share. How should this be
accounted for, given the following outcomes?
A. The options are sold on 1 July 20X6 for $15 each.
B. On 31 December 20X6, Rowlings share price is $8 and
Hoggard lets the option lapse unexercised.
C. The option is exercised on 31 December when Rowlings
share price is $25. The shares are classified as held for
trading.

Hedge accounting
Hedging is a method of managing risk by designating one
or more hedging instruments so that their change in fair
value is offset, in whole or in part, to the change in fair
value or cash flows of a hedged item.
A hedged item is an asset or liability that exposes the
entity to risks of changes in fair value or future cash flows
(and is designated as being hedged).
A hedging instrument is a designated derivative whose
fair value or cash flows are expected to offset changes in
fair value or future cash flows of the hedged item.
So the item generates the risk and the instrument modifies
it.

Types of hedge
IAS 39 identifies three types of hedge, first two of which are within
the P2 syllabus:
Fair value hedge This hedges against the risk of changes in the fair value
of a recognized asset or liability. For example, the fair value of fixed rate
debt will change as a result of changes in interest rates.
Cash flow hedge This hedges against the risk of changes in expected cash
flows. For example, a UK entity may have an unrecognized contractual
commitment to purchase goods in a years time for a fixed amount of US
dollars.
Net Investment Hedges same accounting treatment as cash flow
hedge

Hedge effectiveness
One of the requirements of IAS 39 is that to use hedge accounting, the hedge
must be effective. IAS 39 describes this as the degree to which the
changes in fair value or cash flows of the hedged item are offset by
changes in the fair value or cash flows of the hedging instrument. A hedge
is viewed as being highly effective if actual results are within a range of
80% to 125%.

Accounting for a fair value


hedge
Under IAS 39 hedge accounting rules can only be applied to a fair value
hedge if the hedging relationship meets four criteria.
(1) At the inception of the hedge there must be formal documentation
identifying the hedged item and the hedging instrument.
(2) The hedge is expected to be highly effective.
(3) The effectiveness of the hedge can be measured reliably (i.e. the
fair value/cash flows of the item and the instrument can be measured
reliably).
(4) The hedge has been assessed on an ongoing basis and is
determined to have been effective.
Accounting treatment
The hedging instrument will be remeasured at fair value, with all gains
and losses being reported in the statement of comprehensive income /
income statement as part of the net profit or loss.
The hedged portion of the hedged item will be remeasured at fair
value, with all gains and losses being reported in the statement of
comprehensive income / income statement as part of the net profit or
loss.

Problem Area
Strauss buys an 8% $10million fixed rate debenture when
interest rates are 8% for the fair value of $10 million. The
asset is classified as an available for sale financial asset.
Strauss is risk averse and wishes to enter into a derivative to
protect it against a fall in the value of the asset if interest
rates should rise. As a result it enters into an interest rate
swap, which is designated as a hedging instrument for the
debenture. Interest rates increase to 9%.
How should this be accounted for?

Accounting
for a cash flow hedge
For cash flow hedge, the hedging relationship must meet five
criteria. These are the four same as listed for a fair value
hedge plus
The transaction giving rise to the cash flow risk is highly
probable and will ultimately affected profitability.
Accounting Treatment
The hedge instrument will be remeasured at fair value. The gain and
loss on the portion of the instrument that deemed to be an effective
hedge will be taken to equity and recognize in the statement of
change inequity.
The ineffective portion of the gain or loss will be reported in profit or
loss immediately in the income statement.
If the hedge item eventually result in the recognition of a non
current asset or liability, the gain or loss held in equity must be
recycled in one of the two following ways
The gain / loss goes to adjust the carrying amount of non financial asset/liability.
The gain / loss is transferred to profit or loss in the line with the consumption of
the non financial asset/ libility.

Grayton (whose functional currency is the $)


decided in January that it will need to buy an item
of plant in one years time for Rs. 200,000. As a
result of being risk averse, it wishes to hedge the
risk that the cost of buying Rs. will rise and so
enters into a forward rate agreement to buy Rs.
200,000 in one years time for the fixed sum of
$100,000. The fair value of this contract at
inception is zero and is designated as a hedging
instrument.
At Graytons year end on 31 July, the Rs. has
depreciated and the value of Rs. 200,000 is
$90,000. It remains at that value until the plant is
bought. How should this be accounted for?