Financial instrument: A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Financial asset: Any asset that is: cash; an equity instrument of another entity; a contractual right: to receive cash or another financial asset from another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity; or a contract that will or may be settled in the entity's own equity instruments and is: 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 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 instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments.
Financial liability: Any liability that is: a contractual obligation: to deliver cash or another financial asset to another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or a contract that will or may be settled in the entity's own equity instruments
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.
Embedded Derivatives
§An embedded derivative is a feature within a contract, such that the cash flows associated with that feature behave in a similar fashion to a stand-alone derivative. In the same way that derivatives must be accounted for at fair value on the balance sheet with changes recognised in the income statement, so must some embedded derivatives. IAS 39 requires that an embedded derivative be separated from its host contract and accounted for as a derivative when:
§the economic risks and characteristics of the embedded derivative are not closely related to those of the host contract;
§a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
§the entire instrument is not measured at fair value with changes in fair value recognised in the income statement.
§If an embedded derivative is separated, the host contract is accounted for under the appropriate standard (for instance, under IAS 39 if the host is a financial instrument). Appendix A to IAS 39 provides examples of embedded derivatives that are closely related to their hosts, and of those that are not.
Classification as Liability or Equity Since IAS 39 does not address accounting for equity instruments issued by the reporting enterprise but it does deal with accounting for financial liabilities, classification of an instrument as liability or as equity is critical.
Classification of Financial Assets
§Financial assets at fair value through profit or loss. This category has two subcategories:
1. Designated. The first includes any financial asset that is designated on initial recognition as one to be measured at fair value with fair value changes in profit or loss.
2. Held for trading. The second category includes financial assets that are held for trading. All derivatives (except those designated hedging instruments) and financial assets acquired or held for the purpose of selling in the short term or for which there is a recent pattern of short-term profit taking are held for trading.
§Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on initial recognition as available for sale. AFS assets are measured at fair value in the balance sheet. Fair value changes on AFS assets are recognised directly in equity, through the statement of changes in equity, except for interest on AFS assets (which is recognised in income on an effective yield basis), impairment losses, and (for interest-bearing AFS debt instruments) foreign exchange gains or losses. The cumulative gain or loss that was recognised in equity is recognised in profit or loss when an available-for-sale financial asset is derecognised.
§Loans and receivables are non-derivative financial assets with fixed or determinable payments, originated or acquired, that are not quoted in an active market, not held for trading, and not designated on initial recognition as assets at fair value through profit or loss or as available-for-sale. Loans and receivables for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, should be classified as available-for-sale. Loans and receivables are measured at amortised cost
§Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments that an entity intends and is able to hold to maturity and that do not meet the definition of loans and receivables and are not designated on initial recognition as assets at fair value through profit or loss or as available for sale. Held-to-maturity investments are measured at amortised cost. If an entity sells a held-to-maturity investment other than in insignificant amounts or as a consequence of a non-recurring, isolated event beyond its control that could not be reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years
Classification of Financial Liabilities :-AS 39 recognises two classes of financial liabilities:
§Financial liabilities at fair value through profit or loss.
§Other financial liabilities measured at amortised cost using the effective interest method.
The category of financial liability at fair value through profit or loss has two subcategories:
Designated. A financial liability that is designated by the entity as a liability at fair value through P/L upon initial recognition.
Held for trading. A financial liability classified as held for trading, such as an obligation for securities borrowed in a short sale, which have to be returned in the future.
Initial Recognition:-IAS 39 requires recognition of a financial asset or a financial liability when, and only when, the entity becomes a party to the contractual prov. of the instrument, subject to the following provisions in respect of regular way purchases
Initial Measurement :-Initially, financial assets and liabilities should be measured at fair value (including transaction costs, for assets and liabilities not measured at fair value through profit or loss).
Measurement Subsequent to Initial Recognition :-Subsequently, financial assets and liabilities (including derivatives) should be measured at fair value, with the following exceptions;
§Loans and receivables, held-to-maturity investments, and non-derivative financial liabilities should be measured at amortised cost using the effective interest method.
§Investments in equity instruments with no reliable fair value measurement (and derivatives indexed to such equity instruments) should be measured at cost.
§Financial assets and liabilities that are designated as a hedged item or hedging instrument are subject to measurement under the hedge accounting requirements of the IAS 39.
§Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition, or that are accounted for using the continuing-involvement method, are subject to particular measurement requirements.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument:
§Quoted market prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial instrument.
§If a market for a financial instrument is not active, an entity establishes f.v by using a valuation technique that makes maximum use of market inputs and includes recent arm's length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models. An acceptable valuation technique incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments.
§If there is no active market for an equity instrument and the range of reasonable fair values is significant and these estimates cannot be made reliably, then an entity must measure the equity instrument at cost less impairment.
§Amortised cost is calculated using the effective interest method. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. Financial assets that are not carried at fair value though profit and loss are subject to an impairment test. If expected life cannot be determined reliably, then the contractual life is used.
Derecognition of a Financial Asset
§The basic premise for the derecognition model in IAS 39 is to determine
whether the asset under consideration for derecognition is:
§an asset in its entirety; or
§specifically identified cash flows from an asset; or
§a fully proportionate share of the cash flows from an asset; or
§a fully proportionate share of specifically identified cash flows from F.A.
§Once the asset under consideration for derecognition has been determined, an assessment is made as to whether the asset has been transferred, and if so, whether the transfer of that asset is subsequently eligible for derecognition.
§An asset is transferred if either the entity has transferred the contractual rights to receive the cash flows, or the entity has retained the contractual rights to receive the cash flows from the asset, but has assumed a contractual obligation to pass those cash flows on under an arrangement that meets the following three conditions: [IAS 39.17-19]
§the entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the original asset,
§the entity is prohibited from selling or pledging the original asset (other than as security to the eventual recipient), and
§the entity has an obligation to remit those cash flows without material delay.
§Once an entity has determined that the asset has been transferred, it then determines whether or not it has transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of the asset is precluded.
§If the entity has neither retained nor transferred substantially all of the risks and rewards of the asset, then the entity must assess whether it has relinquished control of the asset or not. If the entity does not control the asset then derecognition is appropriate; however if the entity has retained control of the asset, then the entity continues to recognise the asset to the extent to which it has a continuing involvement in the asset
Derecognition of a Financial Liability
§A financial liability should be removed from the balance sheet when, and only when, it is extinguished, that is, when the obligation specified in the contract is either discharged, cancelled, or expired. Where there has been an exchange between an existing borrower and lender of debt instruments with substantially different terms, or there has been a substantial modification of the terms of an existing financial liability, this transaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. A gain or loss from extinguishment of the original financial liability is recognised in the income statement
Hedge Accounting :-IAS 39 permits hedge accounting under certain circumstances provided that the hedging relationship is: formally designated and documented, including the entity's risk management objective and strategy for undertaking the hedge, identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity will assess the hedging instrument's effectiveness; and expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk as designated and documented, and effectiveness can be reliably measured.
Hedging Instruments :-All derivative contracts with an external counterparty may be designated as hedging instruments except for some written options. An external non-derivative financial asset or liability may not be designated as a hedging instrument except as a hedge of foreign currency risk. A proportion of the derivative may be designated as the hedging instrument. Generally, specific cash flows inherent in a derivative cannot be designated in a hedge relationship while other cash flows are excluded. However, the intrinsic value and the time value of an option contract may be separated, with only the intrinsic value being designated. Similarly, the interest element and the spot price of a forward can also be separated, with the spot price being the designated risk.
Categories of Hedges
§A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or a previously unrecognised firm commitment to buy or sell an asset at a fixed price or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss. The gain or loss from the change in fair value of the hedging instrument is recognised immediately in profit or loss. At the same time the carrying amount of the hedged item is adjusted for the corresponding gain or loss with respect to the hedged risk, which is also recognised immediately in net P/L
§A cash flow hedge is a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profit or loss. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity and recycled to the income statement when the hedged cash transaction affects profit or loss. If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a financial liability, any gain or loss on the hedging instrument that was previously recognised directly in equity is 'recycled' into profit or loss in the same period(s) in which the financial asset or liability affects profit or loss.
Discontinuation of Hedge Accounting
Hedge accounting must be discontinued prospectively if:
§the hedging instrument expires or is sold, terminated, or exercised;
§the hedge no longer meets the hedge accounting criteria -
§for cash flow hedges the forecast transaction is no longer expected to occur;
§the entity revokes the hedge designation.
§For the purpose of measuring the carrying amount of the hedged item when fair value hedge accounting ceases, a revised effective interest rate is calculated.
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