Chapter 16 FINANCIAL INSTRUMENTS PRESENTATION (IAS -32)

Transcription

1 Chapter 16 FINANCIAL INSTRUMENTS PRESENTATION (IAS -32) Objective The objective of this IAS is to enhance user s understanding of the significance of financial instruments to an entity s financial position, performance and cash flows. The main issues are: - Classification of financial instruments from the perspective of issuer; Classification of related interest, dividend, losses and gains; and The circumstances in which financial asset can be set off against the liability Scope This IAS is applicable to all entities to all types of financial instruments except: - Those interests in subsidiaries, associates and joint ventures accounted for under IASs 27, 28 & 31, however, where IAS-39 is applied for these instruments, the requirements of this IAS will be operative; Employer s rights and obligations where IAS-19 is applicable; Insurance contracts where IFRS-4 is applicable except embedded derivatives; and Contracts and obligations under share based payments under IFRS-2 except where this IAS or IAS-39 is applicable This Standard shall be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity s expected purchase, sale or usage requirements. There are various ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. Examples are: - (a) When the terms of the contract permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments; (b) when the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument, or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse); (c) when, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of (d) 1 P a g e generating a profit from short-term fluctuations in price or dealer s margin; and When the non-financial item that is the subject of the contract is readily convertible to cash. Definitions Financial instrument is any contract that gives rise to financial asset of one enterprise and financial liability or equity instrument of another enterprise. 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

2 ii. to exchange financial assets or financial liability with another entity under conditions that are potentially favorable to the entity; or d) a contract that will or may be settled in the entity s own instruments and is: i. a non-derivative for which the entity is or may be obliged to receive a variable number of the entity 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 entity s own equity instruments. For this purpose the entity s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity s own equity instruments. Examples of financial assets are cash, deposits in other companies, trade receivables, loan to other companies, investment in debt instruments, investment in shares, and other equity instruments. 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 liability with another entity under conditions that are potentially un-favorable to the entity; or b) a contract that will or may be settled in the entity s own instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity 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 entity s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes the entity s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity s own equity instruments. As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D. Examples of financial liability are trade payables, loans from other companies and debt instruments issued by the entity. Equity instrument: 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: Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index;

3 That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and That is settled at a future date. Contract and contractual refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing. 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 or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. Puttable financial instruments will be presented as equity only if all of the following criteria are met: (i) the holder is entitled to a pro-rata share of the entity s net assets on liquidation; (ii) the instrument is in the class of instruments that is the most subordinate and all instruments in that class have identical features; (iii)the instrument has no other characteristics that would meet the definition of a financial liability; and (iv) the total expected cash flows attributable to the instrument over its life are based substantially on the profit or loss, the change in the recognized net assets or the change in the fair value of the recognized and un-recognized net assets of the entity (excluding any effects of the instrument itself). Profit or loss or change in recognized net assets for this purpose is as measured in accordance with relevant IFRSs. In addition to the criteria set out above, the entity must have no other instrument that has terms equivalent to (iv) above and that has the effect of substantially restricting or fixing the residual return to the holders of the puttable financial instruments. Presentation Financial Liability and Equity The issuer of a financial instrument shall classify the instrument, or its components parts, on initial recognition as a financial liability, financial asset or an equity instrument in accordance with the substance of the contractual arrangement and definitions of a financial liability, a financial asset and equity instrument. Classification A financial instrument is an equity instrument only if: - a) the instrument includes no contractual obligation to deliver cash or another financial asset to another entity or to exchange financial asset/liability with another entity under conditions which are potentially unfavorable to issuer; and b) if the instrument will or may be settled in the issuer's own equity instruments, it is either: a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes the issuer s own equity instruments do not include 3 P a g e

4 instruments that have all the features and meet the conditions described in paragraphs 16A and 16B or paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the issuer s own equity instruments. Illustration - preference shares If an enterprise issues preference (preferred) shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that they are a contractual obligation to deliver cash and, therefore, should be recognized as a liability. In contrast, normal preference shares do not have a fixed maturity, and the issuer does not have a contractual obligation to make any payment. Therefore, they are equity. Illustration putt-able instruments A financial instrument that gives the holder the right to return it to the issuer for cash or another financial asset (a 'puttable instrument') is a financial liability even if the amount of cash or other financial assets is determined on the basis of an index or other variable that has the potential to increase or decrease, or when the legal form of the puttable instrument gives the holder a right to a residual interest in the assets of an issuer except when paragraph 16 A to 16 to 16 D of IAS 32 applied. (Mutual funds, unit trusts) Illustration - issuance of fixed monetary amount of equity instruments A contractual right or obligation to receive or deliver a number of its own shares or other equity instruments that varies so that the fair value of the entity's own equity instruments to be received or delivered equals the fixed monetary amount of the contractual right or obligation is a financial liability. (To deliver/receive shares equal to Rs. 100 or 10 ounces of gold) Illustration - Fixed amount of cash and fixed number of shares When a contract that will be settled by the entity receiving or delivering fixed number of shares for no future consideration or exchanging a fixed number of its own shares for a fixed amount of cash or another financial asset, is an equity instrument. Example is Forward contract to repurchase fixed number of own shares against fixed amount of cash. c) A financial instrument may require the entity to deliver cash or another financial asset, or otherwise to settle it in such a way that it would be a financial liability, in the event of the occurrence or non-occurrence of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the instrument, such as a change in a stock market index, consumer price index, interest rate or taxation requirements, or the issuer s future revenues, net income or debt-to-equity ratio. The issuer of such an instrument does not have the unconditional right to avoid delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). Therefore, it is a financial liability of the issuer unless: (a) The part of the contingent settlement provision that could require settlement in cash or another financial asset (or otherwise in such a way that it would be (b) a financial liability) is not genuine; or The issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer. Illustration contract settled in cash or another financial asset A contract that will be settled in cash or another financial asset is a financial asset or liability even if the amount of cash or another financial asset that will be received or

5 paid is based on changes in the market value of entity s own equity. Example is a net cash settled share option. d) When a derivative financial instrument gives one party a choice over how it is settled (e.g. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash), it is a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument. e) Compound Financial Instruments Some financial instruments - sometimes called compound instruments - have both a liability and an equity component from the issuer's perspective. In that case, IAS 32 requires that the component parts be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices, or other event that changes the likelihood that the conversion option will be exercised. To illustrate, a convertible bond contains two components. One is a financial liability, namely the issuer's contractual obligation to pay cash, and the other is an equity instrument, namely the holder's option to convert into common shares. Another example is debt issued with detachable share purchase warrants. When the initial carrying amount of a compound financial instrument is required to be allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. On conversion of a convertible instrument at maturity the entity de-recognizes the liability component and recognize it as equity. There is no gain/loss recognition on conversion at maturity. When an entity extinguishes a convertible instrument before maturity i.e. redemption or repurchase in which original conversion privileges are unchanged, the entity allocates the consideration paid and transaction cost to liability and equity component at the date of transaction. The method is same as used for original allocation of debt/equity. Interest, dividends, gains, and losses relating to an instrument classified, as a liability should be reported in the income statement. This means that dividend payments on preferred shares classified as liabilities are treated as expenses. On the other hand, distributions (such as dividends) to holders of a financial instrument classified as equity should be charged directly against equity, not against earnings. f) Treasury shares The cost of an entity's own equity instruments that it has reacquired ('treasury shares') is deducted from equity. Gain or loss is not recognized on the purchase, sale, issue, or cancellation of treasury shares. Treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received is recognized directly in equity. g) Off-setting IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It specifies that a financial asset and a financial liability should be offset and the net amount reported when and only when, an enterprise: has a legally enforceable right to set off the amounts; and 5 P a g e

6 intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously. Offsetting is usually inappropriate when: several different financial instruments are used to emulate the features of a single financial instrument (a synthetic instrument ); financial assets and financial liabilities arise from financial instruments having the same primary risk exposure (for example, assets and liabilities within a portfolio of forward contracts or other derivative instruments) but involve different counterparties; financial or other assets are pledged as collateral for non-recourse financial liabilities; financial assets are set aside in trust by a debtor for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation (for example, a sinking fund arrangement); or obligations incurred as a result of events giving rise to losses are expected to be recovered from a third party by virtue of a claim made under an insurance contract. h) Costs of issuing and reacquiring equity instruments Costs of issuing or reacquiring equity instruments (other than in a business combination) are accounted for as a deduction from equity, net of any related income tax benefit. An entity typically incurs various costs in issuing or acquiring its own equity instruments. Those costs might include registration and other regulatory fees, amounts paid to legal, accounting and other professional advisers, printing costs and stamp duties. The transaction costs of an equity transaction are accounted for as a deduction from equity (net of any related income tax benefit) to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided. The costs of an equity transaction that is abandoned are recognized as an expense. Transaction costs that relate to the issue of a compound financial instrument are allocated to the liability and equity components of the instrument in proportion to the allocation of proceeds. Transaction costs that relate jointly to more than one transaction (for example, costs of a concurrent offering of some shares and a stock exchange listing of other shares) are allocated to those transactions using a basis of allocation that is rational and consistent with similar transactions. Examples-1 An enterprise issues 2,000 convertible bonds at the start of Year 1. The bonds have a threeyear term, and are issued at par with a face value of Rs.1,000 per bond giving total proceeds of Rs.2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each bond is convertible at any time up to maturity into 250 common shares. When the bonds are issued the prevailing market interest rate for similar debt without conversion options is 9%. The entity has incurred Rs. 100,000 as issuance cost of compound instrument. The effective rate considering the issuance cost of debt is 11% p.a. Required: - Determine the debt and equity component? Pass necessary double entries for all the three years? Pass necessary double entries at the maturity date if the investor exercises cash option or share option? Example-2 On January 01, 1999 Entity A issued 10% convertible debentures with face value of Rs. 1,000,000 maturing at December 31, The debenture is convertible into ordinary shares

7 of entity A at Rs. 25 per share. Interest is payable half yearly in cash. The market interest rate for non-convertible debenture at the issue date is 11%. On January 01, 2004, the convertible debenture has a fair value of Rs. 1,700,000. Entity A makes a tender offer to the holders of the debentures for Rs. 1,700,000, which the holders accepted. At the date of repurchase entity could have issued non-convertible debt with a five-year term bearing a coupon rate of 8%. Required: Determine the debt and equity component at the issue of loan and what accounting entries to be passed at the date conversion? Past Papers The following information pertains to Crow Textile Mills Limited (CTML) for the year ended 30 June 2012: (b) On 1 July 2011, 2 million convertible debentures of Rs. 100 each were issued. Each debenture is convertible into 25 ordinary shares of Rs. 10 each on 30 June Interest is payable annually in 8% per annum. On the date of issue, market interest rate for similar debt without conversion option was 11% per annum. However, on account of expenditure of Rs. 4 million, incurred on issuance of shares, the effective interest rate increased to 11.81%. (08) Required:- Prepare Journal entries for the year ended 30 June 2012 to record the above transactions. (Show all necessary calculations) 7 P a g e

8 FINANCIAL INSTRUMENTS RECOGNITION AND MEASUREMENT IAS 39 SCOPE IAS 39 applies to all types of financial instruments except for the following, which are scoped out of IAS 39: interests in subsidiaries, associates, and joint ventures accounted for under IAS 27, IAS 28, or IAS 31; however IASs 32 and 39 apply in cases where under IAS 27, IAS 28, or IAS 31 such interests are to be accounted for under IAS 39 - for example, derivatives on an interest in a subsidiary, associate, or joint venture; employers' rights and obligations under employee benefit plans to which IAS 19 applies; contracts requiring payment based on climatic, geological, or other physical variable, except derivatives embedded in such contracts are subject to IAS 39; rights and obligations under insurance contracts, except IAS 39 does apply to financial instruments that take the form of an insurance (or reinsurance) contract but that principally involve the transfer of financial risks and derivatives embedded in insurance contracts; financial instruments that meet the definition of own equity under IAS 32, however, the holder of this instrument will apply this IAS. Leases IAS 39 applies to lease receivables and payables only in limited respects: It applies to lease receivables with respect to de-recognition and impairment provisions. It applies to lease payables with respect to the de-recognition provisions. IAS 39 applies to derivatives embedded in leases. derivatives that are embedded in leases are subject to the embedded derivatives provisions of this Standard Financial guarantees. The financial guarantees are in the scope of IAS. Loan Commitments (a) Loan commitments that the entity designates as financial liabilities at fair value through profit or loss. An entity that has a past practice of selling the assets resulting from its loan commitments shortly after origination shall apply this Standard to all its loan commitments in the same class. (b) Loan commitments that can be settled net in cash or by delivering or issuing another financial instrument. These loan commitments are derivatives. A loan commitment is not regarded as settled net merely because the loan is paid out in installments (for example, a mortgage construction loan that is paid out in installments in line with the progress of construction). (c) C commitments to provide a loan at a below-market interest rate. Contracts to buy or sell financial items Contracts to buy or sell financial items are also within the scope of IAS 39. Contracts to buy or sell non-financial items Contracts to buy or sell non-financial items are within the scope of IAS 39 if they can be settled net in cash or another financial asset and are not entered into and held for the purpose of the receipt or delivery of a non-financial

9 item in accordance with the entity's expected purchase, sale, or usage requirements. Contracts to buy or sell non-financial items are inside the scope if net settlement occurs. The following situations constitute net settlement: the terms of the contract permit either counterparty to settle net; there is a past practice of net settling similar contracts; there is a past practice, for similar contracts, of taking delivery of the underlying and selling it within a short period after delivery to generate a profit from short-term fluctuations in price, or from a dealer's margin; or the non-financial item is readily convertible to cash. Definitions A derivative is a financial instrument: Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index; That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and That is settled at a future date. Examples of derivatives Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual delivery of the item specified in the contract, or by a net cash settlement. Interest Rate Swaps and Forward Rate Agreements: Contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates. Futures: Contracts similar to forwards but with the following differences: Futures are generic exchange-traded, whereas forwards are individually tailored. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash settlement. Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. These can be individually written or exchange-traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option. Caps and Floors: These are contracts sometimes referred to as interest rate options. An interest rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall below a predetermined rate. 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 for impairment or un-collectability. The effective interest method is a method of calculating the amortized cost of a financial asset or a financial liability 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. When calculating the effective interest rate, an entity shall estimate cash 9 P a g e

10 flows considering all contractual terms of the financial instrument but shall not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. IFRS 9 OBJECTIVE IFRS 9 s objective is to establish principles for the financial reporting of financial assets that will present relevant and useful information to users of financial statements for their assessment of amounts, timing and uncertainty of the entity s future cash flows. SCOPE IFRS 9 generally has to be applied by all entities preparing their financial statements in accordance with IFRS and to all types of financial assets within the scope of IAS 39, including derivatives. Essentially any financial assets that are currently accounted for under IAS 39 will fall within the IFRS 9's scope. INITIAL RECOGNITION AND MEASUREMENT An entity shall recognize a financial asset or financial liability in its statement of financial position when and only and only when it becomes party to contractual provisions of the instrument. All financial assets and financial liability in IFRS 9 are to be initially recognized at fair value, plus, in the case of a financial asset or financial liability that is not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition of the financial asset. Regular way purchase or sale of financial assets A regular way purchase or sale of financial asset is recognized using either trade date accounting or settlement date accounting. When an entity uses settlement date accounting for an asset that is subsequently measured at amortized cost, the asset is recognized initially at its fair value on the trade date. CLASSIFICATION AND MEASUREMENT IFRS 9 has two measurement categories: amortized cost and fair value. In order to determine the financial assets that fall into each measurement category, it may be helpful for management to consider whether the financial asset is an investment in an equity instrument as defined in IAS 32, 'Financial instruments: Presentation'. If the financial asset is not an investment in an equity instrument, management should consider the guidance for debt instruments below. Classification and measurement - Debt instruments If the financial asset is a debt instrument, management should consider whether both the following tests are met: The objective of the entity's business model is to hold the asset to collect the contractual cash flows. The asset's contractual cash flows represent only payments of principal and interest. Interest is consideration for the time value of money and the credit risk associated with

11 the principal amount outstanding during a particular period of time. If both these tests are met, the financial asset falls into the amortized cost measurement category. If the financial asset does not pass either of the above tests, or only one of the above tests, it is measured at fair value through profit or loss. Even if both tests are met, management also has the ability to designate a financial asset as at fair value through profit or loss if doing so reduces or eliminates a measurement or recognition inconsistency ( accounting mismatch ). IFRS 9 retains only one of the three conditions in IAS 39 to qualify for using the fair value option. It removes the conditions regarding being part of a group of financial assets that is managed and its performance evaluated on a fair value basis and where the financial asset contains one or more embedded derivatives, as they are no longer necessary under the classification model in IFRS 9. Classification and measurement - Business model Financial assets are subsequently measured at amortized cost or fair value based on the entity s business model for managing the financial assets. An entity assesses whether its financial assets meet this condition based on its business model as determined by the entity s key management personnel. Management will need to apply judgment to determine at what level the business model condition is applied. That determination is made on the basis of how an entity manages its business; it is not made at the level of an individual asset. Therefore, the entity s business model is not a choice and does not depend on management s intentions for an individual instrument; it is a matter of fact that can be observed by the way an entity is managed and information is provided to its management. Although the objective of an entity s business model may be to hold financial assets in order to collect contractual cash flows, some sales or transfers of financial instruments before maturity would not be inconsistent with such a business model. The following are examples of sales before maturity that would not be inconsistent with a business model of holding financial assets to collect contractual cash flows: an entity may sell a financial asset if it no longer meets the entity s investment policy, because its credit rating has declined below that required by that policy; when an insurer adjusts its investment portfolio to reflect a change in the expected duration (that is, payout) for its insurance policies; or when an entity needs to fund capital expenditure. However, if more than an infrequent number of sales are made out of a portfolio, management should assess whether and how such sales are consistent with an objective of collecting contractual cash flows. There is no set rule for how many sales constitutes infrequent ; management will need to use judgment based on the facts and circumstances to make its assessment. An entity s business model is not to hold instruments to collect the contractual cash flows for example, where an entity manages the portfolio of financial assets with the objective of realizing cash flows through sale of the assets. Another example is when an entity actively manages a portfolio of assets in order to realize fair value changes arising from changes in credit spreads and yield curves, which results in active buying and selling of the portfolio. Example 1 Factoring An entity has a past practice of factoring its receivables. If the significant risks and 11 P a g e

12 rewards have transferred from the entity, resulting in the original receivable being derecognized from the balance sheet, the entity is not holding these receivables to collect its cash flows but to sell them. However, if the significant risks and rewards of these receivables are not transferred from the entity, and the receivables do not, therefore, qualify for de-recognition, the client's business objective may still be to hold the assets in order to collect the contractual cash flows. Example 2 Syndicated loans An entity s business model is to lend to customers and hold the resulting loans for the collection of contractual cash flows. However, sometimes the entity syndicates out portions of loans that exceed their credit approval limits. This means that, at inception, part of such loans will be held to collect contractual cash flows and part will be held-forsale. The entity, therefore, has two business models to apply to the respective portions of the loans. Example 3 Portfolio of sub-prime loans An entity that operates in the sub-prime lending market purchases a portfolio of subprime loans from a competitor that has gone out of business. The loans are purchased at a substantial discount from their face value, as most of the loans are not currently performing (that is, no payments are being received, in many cases because the borrower has failed to make payments when due). The entity has a good record of collecting sub-prime loan arrears. It plans to hold the purchased loan balances to recover the outstanding cash amounts relating to the loans that have been purchased. As the business model is to hold the acquired loans and not to sell them, the business model test is met. Classification and measurement - Contractual cash flows that are solely payments of principal and interest The other condition that must be met in order for a financial asset to be eligible for amortized cost accounting is that 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". In this case, interest is defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time. In order to meet this condition, there can be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Leverage is generally viewed as any multiple above one. However, unlike leverage, certain contractual provisions will not cause the solely payments of principal and interest test to be failed. For example, contractual provisions that permit the issuer to pre-pay a debt instrument or permit the holder to put a debt instrument, back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest as long as the following certain conditions are met: The pre-payment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding (which may include reasonable additional compensation for the early termination of the contract). Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument are also regarded as being solely payments of principal and interest, provided during the term of the extension the contractual cash flows are solely

13 payments of principal and interest as well (for example, the interest rate does not step up to some leveraged multiple of LIBOR) and the provision is not contingent on future events. The following are examples of contractual cash flows that are not solely payments of principal and interest: Links to equity index, borrower s net income or other non-financial variables. Deferrals of interest payments where additional interest does not accrue on those deferred amounts. Convertible bond (from the holder s perspective). If a contractual cash flow characteristic is not genuine, it does not affect the financial asset's classification. In this context, not genuine means the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur. Example 1 Changing credit spread An entity has a loan agreement that specifies that the interest rate will change depending on the borrower s credit rating, EBITDA or gearing ratio. Such a feature will not fail the solely payments of principal and interest test provided the adjustment is considered to reasonably approximate the credit risk of an instrument with that level of EBITDA, gearing or credit rating. That is, if such a covenant compensates the lender with higher interest when the borrower's credit risk increases then this is consistent with interest being defined as the consideration for the credit risk and the time value of money. However, if the covenant results in more than just compensation for credit or provides for some level of interest based on the entity's profitability that will not meet the test. Example 2 Average rates An entity has a loan agreement where interest is based on an average LIBOR rate over a period. That is, the loan has no defined maturity, but rolls every two years with reference to the two year LIBOR rate. The interest rate is reset every two years to equal the average two year LIBOR rate over the last two years. The economic rationale is to allow borrowers to benefit from a floating rate, but with an averaging mechanism to protect them from short-term volatility. Such a feature will not fail the solely payments of principal and interest test provided the average rate represents compensation for only the time value of money and credit risk. Classification and measurement - Non-recourse A non-recourse provision is an agreement that, should the debtor default on a secured obligation, the creditor can look only to the securing assets (whether financial or nonfinancial) to recover its claim. Should the debtor fail to pay and the specific assets fail to satisfy the full claim, the creditor has no legal recourse against the debtor's other assets. The fact that a financial asset is non-recourse does not necessarily preclude the financial asset from meeting the condition to be classified at amortized cost. If a non-recourse provision exists, the creditor is required to assess (to look through to ) the particular underlying assets or cash flows to determine whether the financial asset's contractual cash flows are solely payments of principal and interest. If the instrument's terms give rise to any other cash flows or limit the cash flows in a manner inconsistent with solely payments of principal and interest, the instrument will be measured in its entirety at fair value through profit or loss. There is limited guidance as to how the existence of a non-recourse feature may impact the classification of non-recourse loans at amortized cost. Judgment will, therefore, be 13 P a g e

14 needed to assess these types of lending relationships. Classification and measurement - Equity instruments Investments in equity instruments are always measured at fair value. Equity instruments that are held for trading are required to be classified as at fair value through profit or loss. For all other equities, management has the ability to make an irrevocable election on initial recognition, on an instrument-by-instrument basis, to present changes in fair value in other comprehensive income (OCI) rather than profit or loss. If this election is made, all fair value changes, excluding dividends that are a return on investment, will be reported in OCI. There is no recycling of amounts from OCI to profit and loss for example, on sale of an equity investment nor are there any impairment requirements. However, the entity may transfer the cumulative gain or loss within equity. Example 1 Investment in perpetual note An entity (the holder) invests in a subordinated perpetual note, redeemable at the issuer's option, with a fixed coupon that can be deferred indefinitely if the issuer does not pay a dividend on its ordinary shares. The issuer classifies this instrument as equity under IAS 32. The holder has the option to classify this investment at fair value through OCI under IFRS 9, as it is an equity instrument as defined in IAS 32. Example 2 Investment in a puttable share An entity (the holder) invests in a fund that has puttable shares in issue that is, the holder has the right to put the shares back to the fund in exchange for its pro rata share of the net assets. The puttable shares may meet the requirements to be classified as equity from the fund s perspective, but this in an exception, as they do not meet the definition of equity in IAS 32. However, the holder does not have the ability to classify this investment as fair value through OCI, as paragraph 96C of IAS 32 states that puttable should not be considered an equity instrument under other guidance. Investments in puttable shares are, therefore, required to be classified as fair value through profit or loss, as they cannot be regarded as equity instruments for IFRS 9. Example 3 Dividend return on investment An entity invests in shares at a cost of C12 and designates these at fair value through OCI. The fair value then increases to C22, giving rise to an unrealized gain of C10 in OCI. The issuer then pays a special dividend of C10. This dividend is recorded in profit or loss in accordance with IAS 18, Revenue ; as such a dividend does not represent a recovery of part of the cost of the investment. Example 4 Hybrid equity instrument An entity invests in preference shares that have a maturity date for the repayment of principal, but that also pays discretionary dividends based on the profits of the issuing entity and give a right to share in the net assets on liquidation. These shares are considered a compound instrument by the issuer and are treated as part liability and part equity. Under paragraph 4.7 of IFRS 9, a hybrid financial asset is to be classified in its entirety. This investment in its entirety does not meet the definition of an equity instrument in IAS 32; it is not, therefore, eligible to use the fair value through OCI classification. The contractual cash flows of this investment would need to be assessed. As it is not solely receiving payments of principal and interest, it would be measured at fair value through profit or loss. Equity Instruments at Cost The standard removes the requirement in IAS 39 to measure unquoted equity investments at cost when the fair value cannot be determined reliably. However, it indicates that in limited circumstances, cost may be an appropriate estimate of fair value for example, when insufficient more recent information is available from which to determine fair value;

15 or when there is a wide range of possible fair value measurements and cost represents the best estimate of fair value within that range. However, IFRS 9 includes indicators of when cost might not be representative of fair value. These are: A significant change in the investee's performance compared with budgets, plans or milestones. Changes in expectation that the investee s technical product milestones will be achieved. A significant change in the market for the investee s equity or its products or potential products. A significant change in the global economy or the economic environment in which the investee operates. A significant change in the performance of comparable entities or in the valuations implied by the overall market. Internal matters of the investee such as fraud, commercial disputes, litigation, or changes in management or strategy. Evidence from external transactions in the investee s equity, either by the investee (such as a fresh issue of equity) or by transfers of equity instruments between third parties. Given the indicators above, it is not expected that cost will be representative of fair value for an extended period of time. Option to designate a financial asset at fair value through profit or loss An entity may at initial recognition irrevocably designate a financial asset at fair through profit or loss if doing so eliminates or significantly reduces a measurement or recognition inconsistency. Classification and measurement - Embedded derivatives The accounting for embedded derivatives in host contracts that are financial assets is simplified by removing the requirement to consider whether or not they are closely related and should, therefore, be separated. The classification approach in the new standard applies to all financial assets, including those with embedded derivatives. Many embedded derivatives introduce variability to cash flows. This is not consistent with the notion that the instrument s contractual cash flows solely represent the payment of principal and interest. If an embedded derivative was not considered closely related under the existing requirements, this does not automatically mean the instrument will not qualify for amortized cost treatment under the new standard. However, most hybrid contracts with financial asset hosts will be measured at fair value in their entirety. The accounting for embedded derivatives in non-financial host contracts and financial liabilities currently remains unchanged. CLASSIFICATION OF FINANCIAL LIABILITIES An entity shall classify all financial liabilities as subsequently measured at amortized cost using the effective interest method, except for: (a) Financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value. (b) Financial liabilities that arise when a transfer of a financial asset does not qualify for de-recognition or when the continuing involvement approach applies. (c) Financial guarantee After initial recognition, an issuer of such a contract shall measure it at the higher of: 15 P a g e

16 (i) the amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets and (ii) the amount initially recognized less, when appropriate, cumulative amortization recognized in accordance with IAS 18 Revenue. (d) Commitments to provide a loan at a below-market interest rate. After initial recognition, an issuer of such a commitment shall subsequently measure it at the higher of: (i) the amount determined in accordance with IAS 37 and (ii) the amount initially recognized less, when appropriate, cumulative amortization recognized in accordance with IAS 18. (e) Contingent consideration of an acquirer in a business combination to be measured subsequently at fair value. OPTION TO DESIGNATE A FINANCIAL LIABILITY AT FAIR VALUE THROUGH PROFIT OR LOSS An entity may, at initial recognition, irrevocably designate a financial liability as measured at fair value through profit or loss when permitted by this IFRS or when doing so results in more relevant information, because either: (a) 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 recognizing the gains and losses on them on different bases; or (b) a group of financial liabilities or financial assets and financial liabilities 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 entity s key management personnel, for example the entity s board of directors and chief executive officer. Embedded Derivatives An embedded derivative is a component of a hybrid contract that also includes a nonderivative host with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to 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. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument. Hybrid Contract with financial asset hosts If a hybrid contact contains a host that is a financial asset, the whole of the contract will be measured at fair value through profit or loss account. Other Hybrid Contracts If a hybrid contract contains a host that is not an asset within the scope of this IFRS, an embedded derivative shall be separated from the host and accounted for as a derivative under this IFRS if, and only if: (a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host; (b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and (c) the hybrid contract is not measured at fair value with changes in fair value

17 recognized in profit or loss (i.e. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated). If an embedded derivative is separated, the host contract shall be accounted for in accordance with the appropriate IFRSs. This IFRS does not address whether an embedded derivative shall be presented separately in the statement of financial position. If an entity is required by this IFRS to separate an embedded derivative from its host, but is unable to measure the embedded derivative separately either at acquisition or at the end of a subsequent financial reporting period, it shall designate the entire hybrid contract as at fair value through profit or loss. SUBSEQUENT MEASUREMENT OF FINANCIAL ASSETS After initial recognition, an entity shall measure a financial asset at fair value or amortized cost as appropriate under categories of fair value or amortized cost. SUBSEQUENT MEASUREMENT OF FINANCIAL LIABILITIES After initial recognition, an entity shall measure a financial liability at fair value or amortized cost as appropriate under categories of fair value or amortized cost. IMPAIRMENT AND UN-COLLECTABILITY OF FINANCIAL ASSETS Impairment losses are incurred only if there is objective evidence as a result of one or more events that occurred after the initial recognition of the asset. The amount of the loss is measured as the difference between the asset s CV and the PV of estimated cash flows discounted at the financial asset s original effective interest rate. Impairment of HTM investments and loans and receivables carried at amortized cost is recognized through profit or loss. Any reversal of the loss is also recognized through profit or loss. GAINS AND LOSSES A gain or loss on a financial asset or financial liability that is measured at fair value shall be recognized in profit or loss unless: (a) it is part of a hedging relationship; (b) it is an investment in an equity instrument and the entity has elected to present gains and losses on that investment in other comprehensive income; or (c) it is a financial liability designated as at fair value through profit or loss and the entity is required to present the effects of changes in the liability s credit risk in other comprehensive income. A gain or loss on a financial asset that is measured at amortized cost and is not part of a hedging relationship shall be recognized in profit or loss when the financial asset is derecognized, impaired or reclassified and through the amortization process. A gain or loss on a financial liability that is measured at amortized cost and is not part of a hedging relationship shall be recognized in profit or loss when the financial liability is derecognized and through the amortization process. A gain or loss on financial assets or financial liabilities that are hedged items and shall be recognized in Profit and Loss Account or Other Comprehensive Income If an entity recognizes 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 recognized for assets measured at amortized cost (other than impairment losses). For assets measured at fair value, however, the change in fair value shall be recognized in profit or loss or in other comprehensive income. Investments in equity instruments At initial recognition, an entity may make an irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument within the scope of this IFRS that is not held for trading. 17 P a g e

18 If an entity makes the election, it shall recognize in profit or loss dividends from that investment when the entity s right to receive payment of the dividend is established in accordance with IAS 18. Liabilities designated as at fair value through profit or loss An entity shall present a gain or loss on a financial liability designated as at fair value through profit or loss as follows: (a) The amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability shall be presented in other (b) comprehensive income, and the remaining amount of change in the fair value of the liability shall be presented in profit or loss unless the treatment of the effects of changes in the liability s credit risk described in (a) would create or enlarge an accounting mismatch in profit or loss. If the requirements in above paragraph would create or enlarge an accounting mismatch in profit or loss, an entity shall present all gains or losses on that liability (including the effects of changes in the credit risk of that liability) in profit or loss. Reclassifications An instrument s classification is made at initial recognition and is not changed subsequently, with one exception. Reclassifications between fair value and amortized cost (and vice versa) are required only when the entity changes how it manages its financial instruments (that is, changes its business model). Such changes are expected to be infrequent. The reclassification must be significant to the entity's operations and demonstrable to external parties. Any reclassification should be accounted for prospectively. Entities are not, therefore, allowed to restate any previously recognized gains or losses. The asset should be re-measured at fair value at the date of a reclassification of a financial asset from amortized cost to fair value; this value will be the new carrying amount. Any difference between the previous carrying amount and the fair value would be recognized in a separate line item in the income statement. At the date of a reclassification of a financial asset from fair value to amortized cost, its fair value at that reclassification date becomes its new carrying amount. Examples of change in the business model that would require reclassification include: An entity has a portfolio of commercial loans that it holds to sell in the short-term. Following an acquisition of an entity whose business model is to hold commercial loans to collect the contractual cash flows, that portfolio is managed together with the acquired portfolio to collect the contractual cash flows. An entity decides to close its retail mortgage business and is actively marketing its mortgage loan portfolio. The following are not changes in business model: A change in intention related to particular financial assets. A temporary disappearance of a particular market for financial assets. A transfer of financial assets between parts of the entity with different business models.

19 DE-RECOGNITION De-recognition principle can be applied to part when: - a) Part comprise identifiable cash flows b) Full proportionate share of cash flows of asset c) Proportionate share of identifiable cash flows The entity treats the transfer of asset when: - a) No obligation to pay until it received from the asset b) The entity cannot sell or pledge the asset c) The cash flows collected are immediately remitted to Buyer The transfer of risks and rewards are determined by the exposure of an entity to variability in cash flows before and after transfer Control is determined by the practical ability of the transferee to sell asset in entirety to a third party RECOGNITION OF GAIN LOSS ON DERECOGNITION Entire financial asset The gain or loss is charged to profit and loss account on de-recognition of the difference a) The carrying amount and b) Consideration received plus any new asset less any new liability assumed The entity transfer the financial asset but retains a servicing contract, which may result in servicing asset or servicing liability 19 P a g e