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9 Interest, dividends, losses and gains

9 Interest, dividends, losses and gains

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(b)



Distributions to holders of a financial instrument classified as an equity instrument should be

debited directly to equity by the issuer.



(c)



Transaction costs of an equity transaction shall be accounted for as a deduction from equity

(unless they are directly attributable to the acquisition of a business, in which case they are

accounted for under IFRS 3).



You should look at the requirements of IAS 1 Presentation of financial statements for further details of

disclosure, and IAS 12 Income taxes for disclosure of tax effects.



2.10 Offsetting a financial asset and a financial liability

A financial asset and financial liability should only be offset, with the net amount reported in the statement

of financial position, when an entity:

(a)



Has a legally enforceable right of set off, and



(b)



Intends to settle on a net basis, or to realise the asset and settle the liability simultaneously, ie at

the same moment.



This will reflect the expected future cash flows of the entity in these specific circumstances. In all other

cases, financial assets and financial liabilities are presented separately.



2.11 Puttable financial instruments and obligations arising on

liquidation

IAS 32 requires that if the holder of a financial instrument can require the issuer to redeem it for cash it

should be classified as a liability. Some ordinary shares and partnership interests allow the holder to 'put'

the instrument (that is to require the issuer to redeem it in cash). Such shares might more usually be

considered as equity, but application of IAS 32 results in their being classified as liabilities.

IAS 32 requires entities to classify such instruments as equity, so long as they meet certain conditions.

The standard further requires that instruments imposing an obligation on an entity to deliver to another

party a pro rata share of the net assets only on liquidation should be classified as equity.



2.12 Section summary





Financial instruments issued to raise capital must be classified as liabilities or equity.







The substance of the financial instrument is more important than its legal form.







The critical feature of a financial liability is the contractual obligation to deliver cash or another

financial instrument.







Compound instruments are split into equity and liability parts and presented accordingly.







Interest, dividends, losses and gains are treated according to whether they relate to an equity

instrument or a financial liability.



3 Recognition of financial instruments

FAST FORWARD



IFRS 9 issued in final form in July 2014, replaced IAS 39 Financial instruments: recognition and

measurement. It will come into force on 1 January 2018.

IFRS 9 Financial instruments establishes principles for recognising and measuring financial assets and

financial liabilities.



Part B Accounting standards  7: Financial instruments



191



3.1 Background

It had been the IASB's intention to replace IAS 39 with a principles-based standard for some time, due to

criticism of the complexity of IAS 39, which is difficult to understand, apply and interpret.

The replacement of IAS 39 became more urgent after the financial crisis. The IASB and US FASB set up a

Financial Crisis Advisory Group (FCAG) to advise on how improvements in financial reporting could help

enhance investor confidence in financial markets.

IFRS 9 was published in stages: new classification and measurement models (2009 and 2010) and a new

hedge accounting model (2013). The version of IFRS 9 issued in 2014 supersedes all previous versions

and completes the IASB’s project to replace IAS 39. It covers recognition and measurement, impairment,

derecognition and general hedge accounting. It does not cover portfolio fair value hedge accounting for

interest rate risk (‘macro hedge accounting’), which is a separate IASB project, currently at the discussion

paper stage.



3.1.1 Effective date

IFRS 9 is mandatorily effective for periods beginning on or after 1 January 2018 with early adoption

permitted. For a limited period, previous versions of IFRS 9 may be adopted early if not already done so

provided the relevant date of initial application is before 1 February 2015.



3.2 Scope

IFRS 9 applies to all entities and to all types of financial instruments except those specifically excluded,

as listed below.

(a)



Investments in subsidiaries, associates, and joint ventures that are accounted for under IFRS 10,

IAS 27 or IAS 28



(b)



Leases covered in IAS 17



(c)



Employee benefit plans covered in IAS 19



(d)



Equity instruments issued by the entity eg ordinary shares issued, or options and warrants



(e)



Insurance contracts and financial guarantee contracts



(f)



Contracts for contingent consideration in a business combination, covered in IFRS 3



(g)



Loan commitments that cannot be settled net in cash or another financial instrument



(h)



Financial instruments, contracts and obligations under share based payment transactions,

covered in IFRS 2.



(i)



Rights to reimbursement under IAS 37



(j)



Rights and obligations within the scope of IFRS 15 Revenue from contracts with customers



3.2.1 Financial contracts and executory contracts

IFRS 9 applies 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. However, contracts that allow net settlement in cash can be entered into for satisfying the

normal sales and purchases requirements of the two parties. Such contracts would be executory

contracts. (An executory contract is a contract in which something remains to be done by one or both

parties.)



3.3 Initial recognition

Financial instruments should be recognised in the statement of financial position when the entity becomes

a party to the contractual provisions of the instrument.



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7: Financial instruments  Part B Accounting standards



Point to

note



An important consequence of this is that all derivatives should be in the statement of financial position.

Notice that this is different from the recognition criteria in the Conceptual Framework and in most other

standards. Items are normally recognised when there is a probable inflow or outflow of resources and the

item has a cost or value that can be measured reliably.



3.4 Example: initial recognition

An entity has entered into two separate contracts:

(a)



A firm commitment (an order) to buy a specific quantity of iron.



(b)



A forward contract to buy a specific quantity of iron at a specified price on a specified date,

provided delivery of the iron is not taken.



Contract (a) is a normal trading contract. The entity does not recognise a liability for the iron until the

goods have actually been delivered. (Note that this contract is not a financial instrument because it

involves a physical asset, rather than a financial asset.)

Contract (b) is a financial instrument. Under IFRS 9, the entity recognises a financial liability (an

obligation to deliver cash) on the commitment date, rather than waiting for the closing date on which the

exchange takes place.

Note that planned future transactions, no matter how likely, are not assets and liabilities of an entity – the

entity has not yet become a party to the contract.



3.5 Derecognition of financial assets



6/12



Derecognition is the removal of a previously recognised financial instrument from an entity's statement of

financial position.

An entity should derecognise a financial asset when:

(a)



The contractual rights to the cash flows from the financial asset expire, or



(b)



The entity transfers the financial asset or substantially all the risks and rewards of ownership of

the financial asset to another party.



IFRS 9 gives examples of where an entity has transferred substantially all the risks and rewards of

ownership. These include:

(a)



An unconditional sale of a financial asset



(b)



A sale of a financial asset together with an option to repurchase the financial asset at its fair value

at the time of repurchase



The standard also provides examples of situations where the risks and rewards of ownership have not

been transferred:

(a)



A sale and repurchase transaction where the repurchase price is a fixed price or the sale price plus

a lender's return



(b)



A sale of a financial asset together with a total return swap that transfers the market risk exposure

back to the entity



(c)



A sale of short-term receivables in which the entity guarantees to compensate the transferee for

credit losses that are likely to occur



It is possible for only part of a financial asset or liability to be derecognised. This is allowed if the part

comprises:

(a)

(b)



Only specifically identified cash flows; or

Only a fully proportionate (pro rata) share of the total cash flows.



Part B Accounting standards  7: Financial instruments



193



For example, if an entity holds a bond it has the right to two separate sets of cash inflows: those relating to

the principal and those relating to the interest. It could sell the right to receive the interest to another party

while retaining the right to receive the principal.

On derecognition, the amount to be included in net profit or loss for the period is calculated as follows.



Formula to

learn



$

Carrying amount (measured at the date of derecognition) allocated to the part

derecognised

Less consideration received for the part derecognised (including any

new asset obtained less any new liability assumed)

Difference to profit or loss



$

X



X

(X)

X



The following flowchart, taken from the appendix to the standard, will help you decide whether, and to

what extent, a financial asset is derecognised.



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7: Financial instruments  Part B Accounting standards



Source: IFRS 9



3.6 Derecognition of financial liabilities

A financial liability is derecognised when it is extinguished – ie when the obligation specified in the

contract is discharged or cancelled or expires.

(a)



Where an existing borrower and lender of debt instruments exchange one financial instrument for

another with substantially different terms, this is accounted for as an extinguishment of the original

financial liability and the recognition of a new financial liability.



(b)



Similarly, a substantial modification of the terms of an existing financial liability or a part of it

should be accounted for as an extinguishment of the original financial liability and the recognition

of a new financial liability.



Part B Accounting standards  7: Financial instruments



195



(c)



For this purpose, a modification is 'substantial' where the discounted present value of cash flows

under the new terms, discounted using the original effective interest rate, is at least 10% different

from the discounted present value of the cash flows of the original financial liability.



(d)



The difference between the carrying amount of a financial liability (or part of a financial liability)

extinguished or transferred to another party and the consideration paid, including any non-cash

assets transferred or liabilities assumed, shall be recognised in profit or loss.



3.7 Classification of financial assets



6/12



FAST FORWARD



IFRS 9 requires that financial assets are classified as measured at either:





Amortised cost, or







Fair value through other comprehensive income, or







Fair value through profit or loss



There is an option to designate a financial asset at fair value through profit or loss to reduce or

eliminate an ‘accounting mismatch’ (measurement or recognition inconsistency).

On recognition, IFRS 9 requires that financial assets are classified as measured at either:









Amortised cost, or

Fair value through other comprehensive income, or

Fair value through profit or loss



3.7.1 Basis of classification

The IFRS 9 classification is made on the basis of both:

(a)

(b)



The entity's business model for managing the financial assets, and

The contractual cash flow characteristics of the financial asset.



Amortised cost

A financial asset is classified as measured at amortised cost where:

(a)



The objective of the business model within which the asset is held is to hold assets in order to

collect contractual cash flows and



(b)



The contractual terms of the financial asset give rise on specified dates to cash flows that are solely

payments of principal and interest on the principal outstanding.



Fair value through other comprehensive income

A financial asset must be classified and measured at fair value through other comprehensive income

(unless the asset is designated at fair value through profit or loss under the fair value option) if it meets

both the following criteria:

(a)



The financial asset is held within a business model whose objective is achieved by both collecting

contractual cash flows and selling financial assets.



(b)



The contractual terms of the financial asset give rise on specified dates to cash flows that are solely

payments of principal and interest on the principal amount outstanding.



This business model is new to the July 2014 version of IFRS 9.

Fair value through profit or loss

All other debt instruments must be measured at fair value through profit or loss.

Fair value through profit or loss option to avoid an ‘accounting mismatch’

Even if an instrument meets the above criteria for measurement at amortised cost or fair value through

other comprehensive income, IFRS 9 allows such financial assets to be designated, at initial recognition,

196



7: Financial instruments  Part B Accounting standards



as being measured at fair value through profit or loss if a recognition or measurement inconsistency

(an ‘accounting mismatch’) would otherwise arise from measuring assets or liabilities or recognising the

gains and losses on them on different bases.

Equity instruments

Equity instruments may not be classified as measured at amortised cost and must be measured at fair

value. This is because contractual cash flows on specified dates are not a characteristic of equity

instruments. However, if an equity instrument is not held for trading, an entity can make an irrevocable

election at initial recognition to measure it at fair value through other comprehensive income with only

dividend income recognised in profit or loss.

This is different from the treatment of debt instruments, where the fair value through other

comprehensive income classification is mandatory for assets meeting the criteria, unless the fair value

option through profit or loss option is chosen.



3.7.2 Business model test in more detail

IFRS 9 introduces a business model test that requires an entity to assess whether its business objective

for a debt instrument is to collect the contractual cash flows of the instrument as opposed to realising

its fair value change from sale prior to its contractual maturity. Note the following key points:

(a)



The assessment of a 'business model' is not made at an individual financial instrument level.



(b)



The assessment is based on how key management personnel actually manage the business, rather

than management’s intentions for specific financial assets.



(c)



An entity may have more than one business model for managing its financial assets and the

classification need not be determined at the reporting entity level. For example, it may have one

portfolio of investments that it manages with the objective of collecting contractual cash flows and

another portfolio of investments held with the objective of trading to realise changes in fair value.

It would be appropriate for entities like these to carry out the assessment for classification

purposes at portfolio level, rather than at entity level.



(d)



Although the objective of an entity’s business model may be to hold financial assets in order to

collect contractual cash flows, the entity need not hold all of those assets until maturity. Thus an

entity’s business model can be to hold financial assets to collect contractual cash flows even when

sales of financial assets occur.



3.7.3 Business model test examples: collecting contractual cash flows

The following examples, from the Application Guidance to IFRS 9, are of situations where the objective of

an entity’s business model may be to hold financial assets to collect the contractual cash flows.

Example 1

A Co holds investments to collect their contractual cash flows but would sell an investment in particular

circumstances, perhaps to fund capital expenditure, or because the credit rating of the instrument falls

below that required by A Co’s investment policy.

Analysis

Although A Co may consider, among other information, the financial assets' fair values from a liquidity

perspective (ie the cash amount that would be realised if A Co needs to sell assets), A Co’s objective is to

hold the financial assets and collect the contractual cash flows. Some sales would not contradict that

objective. If sales became frequent, A Co might be required to reconsider whether the sales were

consistent with an objective of collecting contractual cash flows.

Example 2

B Co has a business model with the objective of originating loans to customers and subsequently to sell

those loans to a securitisation vehicle. The securitisation vehicle issues instruments to investors.



Part B Accounting standards  7: Financial instruments



197



B Co, the originating entity, controls the securitisation vehicle and thus consolidates it. The securitisation

vehicle collects the contractual cash flows from the loans and passes them on to its investors in the

vehicle.

It is assumed for the purposes of this example that the loans continue to be recognised in the

consolidated statement of financial position because they are not derecognised by the securitisation

vehicle.

Analysis

The consolidated group originated the loans with the objective of holding them to collect the contractual

cash flows.

However, B Co has an objective of realising cash flows on the loan portfolio by selling the loans to the

securitisation vehicle, so for the purposes of its separate financial statements it would not be considered

to be managing this portfolio in order to collect the contractual cash flows.

Example 3

C Co’s business model is to purchase portfolios of financial assets, such as loans. Those portfolios may or

may not include financial assets that are credit impaired. If payment on the loans is not made on a timely

basis, C Co attempts to extract the contractual cash flows through various means – for example, by

contacting the debtor through mail, telephone, and so on.

In some cases, C Co enters into interest rate swaps to change the interest rate on particular financial

assets in a portfolio from a floating interest rate to a fixed interest rate.

Analysis

The objective of C Co’s business model is to hold the financial assets and collect the contractual cash

flows. The entity does not purchase the portfolio to make a profit by selling them.

The same analysis would apply even if C Co does not expect to receive all of the contractual cash flows (eg

some of the financial assets are credit impaired at initial recognition).

Moreover, the fact that C Co has entered into derivatives to modify the cash flows of the portfolio does not

in itself change C Co’s business model.



3.7.4 Contractual cash flow test in more detail

The requirement in IFRS 9 to assess the contractual cash flow characteristics of a financial asset is based

on the concept that only instruments with contractual cash flows of principal and interest on principal

may qualify for amortised cost measurement. By interest, IFRS 9 means consideration for the time value

of money and the credit risk associated with the principal outstanding during a particular period of time.



Question



Contractual cash flows



Would an investment in a convertible loan qualify to be measured at amortised cost under IFRS 9?



Answer

No, because of the inclusion of the conversion option which is not deemed to represent payments of

principal and interest



Measurement at amortised cost is permitted when the cash flows on a loan are entirely fixed (eg a fixed

interest rate loan or zero coupon bond), or where interest is floating (eg a GBP loan where interest is

contractually linked to GBP LIBOR), or combination of fixed and floating (eg where interest is LIBOR plus

a fixed spread).



198



7: Financial instruments  Part B Accounting standards



3.7.5 Examples of instruments that pass the contractual cash flows test

The following instruments satisfy the IFRS 9 criteria.

(a)



A variable rate instrument with a stated maturity date that permits the borrower to choose to pay

three-month LIBOR for a three-month term or one-month LIBOR for a one-month term



(b)



A fixed term variable market interest rate bond where the variable interest rate is capped



(c)



A fixed term bond where the payments of principal and interest are linked to an unleveraged

inflation index of the currency in which the instrument is issued



3.7.6 Examples of instruments that do not pass the contractual cash flows test

The following instruments do not satisfy the IFRS 9 criteria.

(a)

(b)



A bond that is convertible into equity instruments of the issuer (see question above)

A loan that pays an inverse floating interest rate (eg 8% minus LIBOR)



3.7.7 Business model test examples: both collecting contractual cash flows and

selling financial assets

The following examples, from the Application Guidance to IFRS 9, are of situations where the objective of

an entity’s business model is achieved by both collecting contractual cash flows and selling financial

assets.

Example 4

D Co expects to incur capital expenditure in a few years’ time. D Co invests its excess cash in short and

long-term financial assets so that it can fund the expenditure when the need arises. Many of the financial

assets have contractual lives that exceed D Co’s anticipated investment period.

D Co will hold financial assets to collect the contractual cash flows and, when an opportunity arises, it will

sell financial assets to re-invest the cash in financial assets with a higher return.

The remuneration of the managers responsible for the portfolio is based on the overall return generated by

the portfolio.

Analysis

The objective of the business model is achieved by both collecting contractual cash flows and selling

financial assets. D Co decides on an ongoing basis whether collecting contractual cash flows or selling

financial assets will maximise the return on the portfolio until the need arises for the invested cash.



Question



Business model objective



E Co expects to pay a cash outflow in ten years to fund capital expenditure and invests excess cash in

short-term financial assets. When the investments mature, E Co reinvests the cash in new short-term

financial assets. E Co maintains this strategy until the funds are needed, at which time E Co uses the

proceeds from the maturing financial assets to fund the capital expenditure. Only sales that are

insignificant in value occur before maturity (unless there is an increase in credit risk).

Required

How is the business model of E Co achieved under IFRS 9?



Answer

The objective of E Co’s business model is to hold financial assets to collect contractual cash flows. Selling

financial assets is only incidental to E Co’s business model.



Part B Accounting standards  7: Financial instruments



199



Example 5

F Bank holds financial assets to meet its everyday liquidity needs. The bank actively manages the return on

the portfolio in order to minimise the costs of managing those liquidity needs. That return consists of

collecting contractual payments as well as gains and losses from the sale of financial assets.

To this end, F Bank holds financial assets to collect contractual cash flows and sells financial assets to

reinvest in higher yielding financial assets or to better match the duration of its liabilities. In the past, this

strategy has resulted in frequent sales activity and such sales have been significant in value. This activity

is expected to continue in the future

.Analysis

The objective of the business model is to maximise the return on the portfolio to meet everyday liquidity

needs and F Bank achieves that objective by both collecting contractual cash flows and selling financial

assets. In other words, both collecting contractual cash flows and selling financial assets are integral

to achieving the business model’s objective.



3.8 Classification of financial liabilities

On recognition, IFRS 9 requires that financial assets are classified as measured at either:

(a)

(b)



At fair value through profit or loss, or

Financial liabilities at amortised cost.



A financial liability is classified at fair value through profit or loss if:

(a)



It is held for trading, or



(b)



Upon initial recognition it is designated at fair value through profit or loss. This is permitted when

it results in more relevant information because:

(i)



It eliminates or significantly reduces a measurement or recognition inconsistency

(‘accounting mismatch’), or



(ii)



It is a group of financial liabilities or financial assets and liabilities and its performance is

evaluated on a fair value basis, in accordance with a documented risk management or

investment strategy.



Derivatives are always measured at fair value through profit or loss.



3.9 Re-classification of financial assets

Although on initial recognition financial instruments must be classified in accordance with the

requirements of IFRS 9, in some cases they may be subsequently reclassified. IFRS 9 requires that when

an entity changes its business model for managing financial assets, it should reclassify all affected

financial assets. This reclassification applies only to debt instruments, as equity instruments must be

classified as measured at fair value.

The application guidance to IFRS 9 includes examples of circumstances when a reclassification is required

or is not permitted.



3.9.1 Examples: Reclassification permitted

Reclassification is permitted in the following circumstances, because a change in the business model

has taken place:

(a)



200



An entity has a portfolio of commercial loans that it holds to sell in the short term. The entity

acquires a company that manages commercial loans and has a business model that holds the loans

in order to collect the contractual cash flows. The portfolio of commercial loans is no longer for sale,

and the portfolio is now managed together with the acquired commercial loans and all are held to

collect the contractual cash flows.



7: Financial instruments  Part B Accounting standards



(b) A financial services firm decides to shut down its retail mortgage business. That business no longer

accepts new business and the financial services firm is actively marketing its mortgage loan portfolio

for sale.



3.9.2 Examples: Reclassification not permitted

Reclassification is not permitted in the following circumstances, because a change in the business model

has not taken place.

(a)



A change in intention related to particular financial assets (even in circumstances of significant

changes in market conditions)



(b)



A temporary disappearance of a particular market for financial assets



(c)



A transfer of financial assets between parts of the entity with different business models.





Reclassification of financial liabilities is not permitted.







Reclassification of equity instruments is not permitted. Investments in equity instruments

are always held at fair value and any election to measure them at fair value through other

comprehensive income is an irrevocable one.



3.9.3 Gains and losses on reclassification of financial assets

If a financial asset is reclassified from amortised cost to fair value, any gain or loss arising from a

difference between the previous carrying amount and fair value is recognised in profit or loss.

If a financial asset is reclassified from fair value to amortised cost, fair value at the date of

reclassification becomes the new carrying amount.



3.10 Section summary









All financial assets and liabilities should be recognised in the statement of financial position,

including derivatives.

Financial assets should be derecognised when the rights to the cash flows from the asset expire

or where substantially all the risks and rewards of ownership are transferred to another party.







Financial liabilities should be derecognised when they are extinguished.







On recognition, IFRS 9 requires that financial assets are classified as measured at either:









Amortised cost, or

Fair value through other comprehensive income, or

Fair value through profit or loss



4 Measurement of financial instruments

Exam focus

point

FAST FORWARD



6/11 – 12/15



IFRS 9 has been examined in part for several years now, but the sections on impairment and hedging are

new, so these areas are likely to be tested.



Financial assets should initially be measured at cost = fair value.

Transaction costs increase this amount for financial assets classified as measured at amortised cost, or

where an irrevocable election has been made to take all gains and losses through other comprehensive

income and decrease this amount for financial liabilities classified as measured at amortised cost.

Subsequent measurement of both financial assets and financial liabilities depends on how the instrument

is classified: at amortised cost or fair value.



Part B Accounting standards  7: Financial instruments



201



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