FINANCIAL INSTRUMENTS

1.
2. 3.
Overview &
Presentation Recognition
Definitions

9.
4.
Hedge
Derecognition
Accounting Financial
Instruments
8. 5.
Derivatives Classification

7. Fair Value 6.
Measurement Measurement
1. Overview & Definitions
Financial Instruments

IAS 32 IAS 39 IFRS 9 IFRS 7 IFRS 13

Financial Financial Financial Financial Fair Value
Instruments: Instruments: Instruments Instruments: Measurement
Presentation Recognition and Disclosures
Measurement

- Definitions - Recognition - Recognition - Disclosure - Framework

requirements for fair value
- Derecognition - Derecognition measurement
- Debt vs. equity - Classification - Classification
- Applies
- Measurement - Measurement across IFRS

- Hedge accounting - Replaces IAS 39

1. Overview & Definitions

June 1995: IAS 32 Financial Instruments:

Disclosure and Presentation

Minor modifications

2003: Revised IAS 32 Issued

August 2005:

IFRS 7 Financial IAS 32 Financial

Instruments: Disclosures Instruments: Disclosures
1. Overview & Definitions

2005: IAS 39 in its current form

Too complicated People confused

2008: Project “IFRS 9: Financial

Instruments (replacement of IAS 39)”

Phase 1:
Phase 2: Phase 3:
Classification and
Impairment Methodology Hedge Accounting
Measurement
1. Overview & Definitions

Financial Instruments
IFRS 9 IAS 39

- Classification FA + FL - Classification FA + FL
- Measurement FA + FL - Measurement FA + FL

- Recognition FA + FL - Recognition FA + FL

- Derecognition FA + FL - Derecognition FA + FL

- Hedge accounting - Hedge accounting

- Impairment of FA Choice until 1 January 2018 - Impairment of FA

IAS 32 IFRS 7 IFRS 13

Presentation Disclosure FV measurement

1. Overview & Definitions

Financial Instruments

= any contract that gives rise to both:

Clear economic consequences

Financial asset Financial liability OR Equity instrument

of one entity of another entity

1. Overview & Definitions

Financial Assets

Cash Equity instrument Contractual right to: Contract settled in the entity’s
of another entity own equity instruments and is:
• receive cash / another • a non-derivative => obligation to
financial asset receive a variable number of
• exchange FI with another entity’s own equity instruments
• entity (favorable conditions) • a derivative => settled OTHER
than by the exchange of fixed
amount of cash / another FA /
own EI
Cash Shares Trade receivables
Loan receivable
Purchased call options Transactions in own equity
Purchased put options
1. Overview & Definitions

Financial Liability

Contractual obligation to: Contract settled in the entity’s

own equity instruments and is:

• a non-derivative => obligation to

deliver cash / another exchange FI with another deliver a variable number of
entity’s own equity instruments
financial asset entity (unfavorable
conditions) • a derivative => settled OTHER
than by the exchange of fixed
amount of cash / another FA /
own EI
Trade payables Written call options

Written put options

Transactions in own equity
1. Overview & Definitions

Equity Instrument

= any contract that evidences a residual interest in the assets of an entity

after deducting all of its liabilities

EQUITY

negative

entity’s shares = equity instrument

shares Derivatives
shares in another entity = financial asset
 1. Overview & Definitions

Derivatives

= a financial instrument or other contract with all three of the following characteristics:

1. Its value changes in response to the change in an underlying variable

2. No initial investment / initial net investment <

3. Settled at a future date

FORWARD FUTURES SWAPS

OPTIONS
CONTRACT CONTRACT

Fixed price, fixed future date Standardized, traded Rights (not obligations) Swapping cash flows
1. Overview & Definitions

Financial Instrument

Physical assets Intangible assets Leased assets

Prepaid expenses / Contracts to buy/sell Liabilities / assets not

deferred revenue non-financial items contractual in nature
1. Overview & Definitions
Example 1:
Financial Instrument?

Q: ABC entered in the several contracts during 20X3. Help ABC’s managers to determine
whether these contracts are financial instruments within IFRS 9 or not.

1. On 2 March 20X3, ABC ordered 2 tons of aluminum which will be delivered

on 12 July 20X3 for the fixed price.

2. On 3 March 20X3, ABC entered into a fixed-price forward contract to purchase 3 tons
of aluminum in 6 months. According to terms of the contract, ABC can either take physical
delivery at the end of 6 months, or to pay or receive a net settlement in cash based on
the change in market price of aluminum.
1. Overview & Definitions
Example 1:
Financial Instrument?

1. On 2 March 20X3, ABC ordered 2 tons of aluminum that will be delivered

on 12 July 20X3 for the fixed price.

VALUE = FIXED SETTLEMENT = PHYSICAL DELIVERY

Trading Financial
contract instrument
1. Overview & Definitions
Example 1:
Financial Instrument?

2. On 3 March 20X3, ABC entered into a fixed-price forward contract to purchase 3

tons of aluminum in 6 months. According to terms of the contract, ABC can either
take physical delivery at the end of 6 months, or to pay or receive a net settlement in
cash based on the change in market price of aluminum.

SETTLEMENT = CASH SETTLEMENT = PHYSICAL DELIVERY

Financial Trading
instrument contract
2. Presentation

IAS 32: Presentation

LIABILITIES EQUITY

Trade payables Ordinary shares

??? Preference shares ??? ??? Convertible debt ???

2. Presentation
Classification as
liabilities or equity

SUBSTANCE DEFINITIONS

Is there a contractual obligation to transfer economic benefit?

YES NO
On initial
recognition
LIABILITIES EQUITY

 LEGAL FORM ≠ SUBSTANCE !

2. Presentation
Example 2:
Classification as liabilities or equity

Q: Raiser plc. intends to raise some additional finance by issuing 2 types of shares:

1. Preference shares paying interest of 5% p.a. and shares are mandatorily

redeemable at the fixed date.
2. Ordinary shares. Raiser intends to buy these shares back at the fixed date.

A: Raiser should classify the shares as follows:

1. Preference shares => obligation exists => LIABILITY

2. Ordinary shares => obligation does not exist => EQUITY

2. Presentation
Example 2:
Classification as liabilities or equity

Accounting entries:

DEBIT CREDIT

1. Preference shares Cash/ receivable Liability – preference shares

2. Ordinary shares Cash/ receivable Equity – ordinary shares

2. Presentation
Example 3:
Classification as liabilities or equity

Q: Instead of mandatorily redeemable shares at the fixed date, Raiser plans to issue
10 mil. preference shares paying 5% interest p.a., with the following options:

1. Shares will be redeemable at the option of Raiser (who intends to redeem).

2. Shares will be redeemable with ordinary shares for the value of 10 mil.

A: Raiser should classify the shares as follows:

1. Shares optionally redeemable
=> obligation to redeem does not exist => EQUITY COMPOUND
FINANCIAL
=> obligation to pay dividends exists => LIABILITY INSTRUMENT
2. Presentation
Example 3:
Classification as liabilities or equity

2. Shares will be redeemable with ordinary shares for the value of 10 mil.

10 mil. CU = ??? Shares ??? X current market price / 1 share

FL =contract settled in entity’s own equity instruments and is a non-derivative for which
the entity is / may be obliged to deliver a variable number of entity’s own equity
instruments

Shares redeemable with ordinary shares at 10 mil. => definition of a liability => LIABILITY
2. Presentation

Contingent settlement provisions

Settlement depends on

Uncertain future events Outcome of uncertain circumstances

Fixed amount of shares => EQUITY

Preference shares redeemable at OR

Cash if shares < XY => LIABILITY

LIABILITY
2. Presentation

Settlement options: derivatives

Issuer OR holder can CHOOSE to settle in

Cash Shares Or other instruments

LIABILITY OR ASSETS

If all options result in equity instrument => EQUITY

2. Presentation

Compound financial instruments

= non-derivative financial instrument with both LIABILITY and EQUITY element

Example: Convertible bond Conventional loan Call option to shares

1. Set FV of the whole instrument

CLASSIFY + PRESENT SEPARATELY 2. Calculate the FV of the liability component
At the issuance + not revised! 3. FV of equity = 1. – 2.
2. Presentation

Transactions in own equity

LIABILITY EQUITY

• settled by the entity receiving or delivering • exchanging a fixed number of its own shares for
a fixed number of its own shares for no a fixed amount of cash or other financial assets
future consideration

LIABILITY LIABILITY EQUITY

≠ own shares own shares for 100 own shares
€100K

Any consideration paid / received Deducted / added directly to equity

Changes in FV Deducted / added directly to equity
2. Presentation

Treasury shares

= own shares of an entity

ASSETS Deducted directly from equity

DEBIT CREDIT

Deducted directly from equity Equity Cash/ payable

2. Presentation

Interest, dividends, gains and losses

LIABILITIES EQUITY

Profit or loss Equity

Example: - dividends payable on mandatorily - dividends payable on

redeemable preference shares ordinary shares

DEBIT CREDIT

Dividends – preference shares P/L Financial expenses Cash/ payable

Dividends – ordinary shares Equity Cash/ payable
2. Presentation

Offsetting a financial asset and a financial liability

= presenting the LIABILITY and ASSETS as 1 single net amount

Self goods
Receivable to B Payable to A

Payable to B
A Bills listing fees
B Receivable to A

Legally enforceable right of set off Intends to settle on a net basis /

Realize asset + settle liability simultaneously

MUST OFFSET
2. Presentation

Puttable financial instruments

If the holder requires to redeem in cash LIABILITY EQUITY

Deducted directly from equity

Obligations arising on liquidation

To deliver another party pro-rata share on the net assets EQUITY

2. Recognition

Initial recognition

= when the entity becomes a party to the contractual provisions of the instrument

On the commitment date

BUY
100 barrels of
petrol
on 31/12/20X8
for 10 000 CU
On the settlement date
3. Recognition

Initial recognition

Regular way transactions

Trade date accounting Settlement date accounting

At the settlement date At the settlement date

As the asset
4. Derecognition

Derecognition

When should financial instrument be removed from the financial statements?

OFF-BALANCE SHEET
FINANCING
LOTS OF RULES

Offsetting against rules Items excluded from FS

Why Profits included in FS

Collapse
ENRON in 2001
Losses transferred to SPE
4. Derecognition

Derecognition of financial assets

An entity should derecognize a financial asset when:

Contractual rights to the cash flows

from the financial asset expire The entity transfers

financial asset risks and rewards of ownership

DECISION TREE

+ transfer qualifies for de-recognition

Substance over Form

4. Derecognition

Derecognition of financial assets

CONSOLIDATE

Entire asset or part?

YES

Rights to Obliga- Risks/ Risks /

NO Transfer NO YES NO NO Control
cash tion rewards rewards
of retained
flows to transfer retained
rights? ?
expired? pay CF? ? ?

YES NO YES YES YES NO

DERECOGNIZE DERECOGNIZE DERECOGNIZE

CONTINUE TO RECOGNIZE CONTINUE TO RECOGNIZE

4. Derecognition
Derecognition of financial assets:
Factoring of receivables

Retailer A Retailer B Retailer C FACTORING

Non-recourse Recourse

Derecognize Keep recognizing

Food producer

Factoring company
4. Derecognition
Derecognition of financial assets:
Continuing involvement

TRANSFERRED ASSET LIABILITY

At the lower of: Guarantee amount

CA of asset Guarantee amount FV of guarantee

4. Derecognition
Derecognition of financial assets:
Continuing involvement

Are rewards and risks transferred to and buyer / transferee?

• Sale + repurchase at the fixed price

• Unconditional sale of financial or at the sale’s price + return
asset • Sale + total return swap that
• A sale of financial asset + option transfers market risk exposure back
to repurchase the asset at its FV to the seller
at the time of repurchase • Sale of short-term receivables in
• A sale of financial asset + deeply which the entity guarantees to
out of money put/call option compensate the transferee for the
credit losses that are likely to occur
Option to sell at 20
share trades at 30 Keep recognizing
+ short maturity
Derecognize
4. Derecognition
Derecognition of financial assets:
Securitization

Originator Charitable
trust

Equity
Makes
Loans

Issues notes
Special Purpose Entity INVESTORS

CASH
Mortgagors

STOP PAYING => TOXIC ASSETS?

4. Derecognition
Derecognition of financial
liabilities

An entity should derecognize a financial liability when:

It is extinguished

Discharged Cancelled Expires

= asset delivered = entity legally released from = due to passage of time

obligation
4. Derecognition

Derecognition of financial liabilities

Exchange / modification of debt by original lender

LIABILITY I.

Bank LIABILITY II. Bank

- extinguishment of financial liability I. + recognition of financial liability II.

Substantial modification:

= discounted PV of CF under new terms ⇒ at least 10% different from discounted PV

Original effective interest rate of CF under original terms

CA of original FL -consideration paid => Profit or loss

5. Classification

Classification of Financial Instruments

= sorting of financial instruments according to some characteristics

At FVTPL => Changes to P/L

Accounting treatment depends on the category of FI => shares

AFS => Changes to OCI

IAS 39 IFRS 9

• 4 categories of FA • 3 categories of FA
• 2 categories of FL • 2 categories of FL
5. Classification
Classification of Financial Assets
(IFRS 9)

Business Model Contractual Cash Flow Characteristics

⇒ Objective = hold assets to collect ⇒ Cash flows on specified dates

contractual cash flows (+sell) that are solely principal + interest

I. MEASURED AT AMORTIZED COST  Business model + Contractual CF 

II. MEASURED AT FAIR VALUE through P/L All other financial assets

III. MEASURED AT FAIR VALUE through OCI Choice: equity investments not held for trading
Business model + contractual CF test
5. Classification
Classification of Financial Assets
(IFRS 9)

Contractual cash flows solely NO Equity instrument: FVOCI option

for principal and interest? selected?
YES

Business Model: Held to NO Business Model: Held to collect

collect contractual CF only? contractual CF AND for sale?
YES YES NO YES
NO FVTPL Option NO
FVTPL Option Used?
Used?
NO YES
YES
I. AMORTIZED COST II. FAIR VALUE through P/L III. FAIR VALUE through OCI

Reclassifications possible!
5. Classification

Business Model Test

Debt
Realizing fair value change from sale prior contractual maturity

Assessment:

1. Not individual level => but portfolio level

2. How key management manages the business => not intentions

3. More than one business model => Test on the portfolio level => Not on entity level

4. Sale of financial asset needs not to have an impact on the business model
5. Classification

Example 11:
Business Model Test

1. Q: Raiser sells goods to customers on credit and typically gives up to 30 days

for making a full payment.
1. A: Raiser collects the cash in accordance with the contractual cash flows
+ no intention to dispose of receivables => MET

2. Q: Raiser holds bonds to collects their contractual cash flows, but sometimes,
Raiser sells bonds in urgent cash shortage before their maturity.
2. A: Raiser’s objective is to hold bonds until maturity and collect the contractual
cash flows + if sales are infrequent=> MET
5. Classification

Example 11:
Business Model Test

3. Q: BeeBank provides mortgages to its clients and sells the mortgages to SPE.
SPE pays for mortgages with the cash from investors and collects contractual
cash flows from mortgages. BeeBank consolidates SPE.

Sells Loans Issues notes

BeeBank SPE Investors

Pay loans

Group level Entity level

5. Classification

Example 11:
Business Model Test

4. Q: SPE purchases mortgages from BeeBank and collects payments of principal

and interest from mortgagors. If payment is not made on time, SPE tries to
collect cash by contacting mortgagors, etc. Sometimes, SPE enters into interest
rate swaps to change the interest rate from floating to fixed.

Sells Loans
BeeBank

Pay loans
5. Classification

Contractual Cash Flow Test

Debt ⇒ Cash flows on specified dates that are solely principal + interest

INTEREST = consideration for the time value credit risk

of money

On instrument by instrument basis + in the denomination currency

 x x x
• Fixed rate loan => 10 mil.; 4% • Inverse floating rate loan => can be converted to equity

• Floating rate loan => 10 mil.; 3M LIBOR+1% • Some inflation-linked loans => 10 mil.; 6%-3M LIBOR

• Zero coupon bond => At discount; coupon 0%

• Capped variable rate loan => 10 mil., 3M LIBOR+1%, max. 5%

• Convertible bond => 10 mil. USD, linked to US inflation

5. Classification

Classification of Financial Liabilities

I. FL at fair value through profit or loss II. FL at amortized cost

Held for trading Designated at FVTPL

• repurchasing in near-term • reduces accounting mismatch All other liabilities

• portfolio with short-term • group managed on FV basis
profit taking • embedded derivative
• derivative

Liabilities related to failed de-recognition of assets Continuing involvement

Financial guarantee contracts Provision IAS 37

At fair value Higher of
Some loan commitments Initial
measurement