IFRS 9 – Financial Instruments

Part 1: Introduction + Executive Summary
Part 2: Financial Instruments – Introduction
Part 3: Financial Instruments Standards – IAS 32/IAS 39/IFRS 7/IFRS 9, Recognition and Measurement

Part 4: Financial asset, Financial Liability

Part 5: Appendix

Read IFRS 9 Summary Online  IFRS 9 Test

4 Financial asset

4.1 Initial recognition

Financial asset is recognized in the statement of financial position when entity becomes party to the contract i.e. financial instrument.

Broadly financial assets can be of two types:

  1. Equity instrument e.g. shares in another entity mostly ordinary shares or any type of share with equity rights to the holder.
  2. Debt instrument e.g. debentures or bonds issued by another entity and holder has the right to receive interest income and cash (or another financial asset) on maturity.

4.2 Initial measurement

All financial assets are initially measured at fair value.

For financial assets, treatment of transaction cost depends upon subsequent measurement financial asset and are capitalized only if financial asset is subsequently measured at fair value through other comprehensive income (FVTOCI).

4.3 Subsequent measurement

Subsequent measurement of instruments depends on how entity would like to subsequently classify them.

4.3.1 Equity Instrument

Equity instrument can be subsequently measured at either of the following basis:

Fair value through profit or loss (FVTPL); if entity is holding these instruments for trading purposes i.e. intention is to benefit from sale or purchase of such instruments then any gains or losses as a result of revaluation of financial assets are reported in profit or loss i.e. income statement

Fair value through other comprehensive income (FVTOCI); if intention is to hold the instrument then any gain or loss arising as a result of revaluation of financial asset will be cycled through other comprehensive income and not profit or loss. However, once this measurement basis is selected, standard does not allow switching back to FVTPL basis.

Main difference of cycling gains or losses through other comprehensive income under FVTOCI basis is that gains (positive balance) and losses (negative balance) are reported as a reserve in equity and are not immediately recognized. They are recognized only when such financial asset is sold. However, entity may choose to transfer the reserve amount either to retained earnings or keep it as equity reserve.

Whereas under FVTPL the gains and losses are recognized immediately.

Making it simple
Selection of subsequent measurement is made at the time of acquisition especially if entity has incurred transaction costs. But how entities know which one to choose?

Shares are bought by entity get benefit either by receiving dividend or through capital gains by selling those shares. This is normally the situation almost all the time. That is why FVTPL is the default selection for equity instruments. In such situations transaction costs are expensed out immediately

However, under exception conditions entity may choose to hold the shares for longer term instead of trading it freely. This is usually the case with shares of subsidiary, preference shares, or shares held under a contractual arrangement. In this case, entity already knows in advance then shares won’t be traded for a good time in future. In such situations entity may make irrevocable selection to measure instruments through other comprehensive income. And if such selection is made then transaction costs are capitalized.

4.3.2 Debt instrument

Debt instrument can be subsequently measured at:

For this type of financial asset, determination of subsequent measurement depends upon the responses of two tests:

  1. [Test 1] Business model test: this test determines how entity would like to take benefit from the debt instrument. Entity has two choices:
    1. [Option 1] Hold the instrument till maturity and earn benefits principally through interest income and receiving cash at maturity
    2. [Option 2] Entity has no specific intention to hold the instrument. Entity may hold or sell the asset whatever feasible for it.
  2. [Test 2] Contractual cash flow test: applied to confirm if asset is a debt instrument under which entity can receive interest and principal payments on specified dates.

Here is the summary of subsequent measurement of debt instrument type of financial asset:

  1. A debt instrument is measured at amortized cost if it qualifies both:
    • [Option 1] of [Test 1]; and
    • [Test 2]

[Option 1 of Test 1] + [Test 2] = Amortized cost

  1. A debt instrument is measured at FVTOCI if it qualifies both:
    • [Option 2] of [Test 1]; and
    • [Test 2]

[Option 2 of Test 1] + [Test 2] = Fair value through other comprehensive income

  1. All other debt instruments not falling under any category mentioned above will be measured at FVTPL including those that entity has elected to measure at FVTPL at initial recognition.

5 Financial Liabilities

5.1 Initial recognition

Financial liability is recognized in the statement of financial position when entity becomes party to the contract i.e. financial instrument.

5.2 Initial measurement

All financial assets are initially measured at fair value minus any transaction cost except those that are classified as fair value through profit or loss.

5.3 Subsequent measurement

Financial liabilities are classified at amortized cost using an effective interest method except for:

  1. Financial liabilities at fair value through profit and loss (FVPL)
  2. Transfer of financial asset not qualifying for derecognition or continuing involvement approach applies
  3. Financial guarantee contracts
  4. Commitments to provide a loan at below market rate

Financial liabilities are measured at fair value through profit or loss if:

  1. Instrument is held essentially for trading instead of collecting cash flow at maturity.
  2. It is a derivative liability
  3. At initial recognition entity has specified instrument to be measured at fair value through profit or loss

5.4 Transfers not qualifying derecognition

If entity has not transferred substantially all the risks and rewards associated with the financial asset, then entity will continue to recognize it as asset and recognize liability for consideration received.

The entity shall recognize asset to the extent it has continuing involvement and also recognize associated liability where measurement is done as follows:

  1. If transferred asset is measured at amortized cost, then retained asset and associated liability is measured at amortized cost
  2. If transferred asset is measured at fair value, then retained asset and liability measured at value equal to fair value of right and liability.

5.5 Financial guarantee contracts

Such financial instruments shall be measured at a higher of:

  1. The amount determined as per the rule laid down in IAS 37
  2. The amount initially recognized less cumulative amortization recognized as per IAS 18 where appropriate.

5.6 Commitment to provide loan at below market rate

After the initial recognition issuer of such commitment shall subsequently measure it at higher of:

  1. The amount determined as per the rules laid down in IAS 37
  2. The amount initially recognized less cumulative amortization recognized as per IAS 18 where appropriate
Preference shares and return on Financial liability instruments
Preference shares can be of two types:

  • Irredeemable preference shares are not considered as a liability as entity not bound to make any payments at specified time entity agrees otherwise
  • Redeemable preference shares on the other hand are a financial liability and any dividend paid on such shares is part of liability therefore expensed out in the relevant period.

6 Derecognition of financial Instruments

Unlike usual assets and liabilities, financial assets and liabilities have somewhat different characteristics. Therefore, the derecognition itself require assessment of situation.

6.1 Derecognition of financial asset

Determine if asset to be derecognized is:

  1. Financial asset itself in totality
  2. Certain cash flows arising out of financial asset that can be identified specifically
  3. Portion of overall cash flows arising out of financial assets
  4. Portion of certain specified cash flows arising out of financial assets

Once determined, that financial asset or part of financial asset qualifies for derecognition of it is transferred to third party. Asset is said to have transferred if entity has transferred the right to receive cash or other financial asset to third party together with the control of the asset.

6.2 Derecognition of financial liabilities

Financial liability is derecognized if it is discharged, waved or expired.

If the holder and issuer of instrument agree to exchange a fresh liability instrument for old, then old financial liability stands discharged and will be derecognized and new instrument will be recognized. Any difference in values will give rise to a gain or loss that will be recognized in the income statement.