Classification and its importance
All financial assets, including derivatives, are
recognised on the balance sheet under IFRS . They are initially measured
at fair value plus, in the case of a financial asset
not at fair value through profit or loss, transaction
costs that are directly attributable to the acquisition
of the asset [IAS39R.43] . The accounting treatment of financial assets,
subsequent to initial recognition, depends on how
they are classified.
An entity should recognise a financial asset on
its balance sheet, when, and only when, it becomes
a party to the contractual provisions of the instrument
[IAS39R.14] . The purchase or sale
of a financial asset in accordance with the time
frame generally established by market convention
(a 'regular way' transaction), should be recognised
using either trade date or settlement date accounting
[IAS39R.38] [IAS39R.IG.D.2.2.]. The method used
should be applied consistently for all transactions
that belong in the same category of financial assets
[IAS39R.AG53-54] .
Most financial assets, subsequent to initial recognition,
are re-measured to fair value at each balance sheet
date. There are two classes of assets that are carried
at amortised cost subject to a test for impairment.
These are loans and receivables and held-to-maturity
investments. There is also an exception to the fair
value measurement requirement for investments in
equity instruments that do not have a quoted market
price in an active market that cannot be reliably
measured and for derivatives that are linked to
and must be settled by delivery of such unquoted
equity instruments. These instruments are measured
at cost, subject to a test for impairment. This
exception is expected to be used rarely - in most
cases an entity will be able to reliably measure
the fair value of unquoted equity instruments and
derivatives on them [IAS39R.46] .
Categories of financial assets
There are four categories of financial assets:
fair value through profit or loss (which includes
trading), loans and receivables, held-to-maturity
and -sale [IAS39R.45]. All financial
assets not covered in the exclusions in section
80.1 above, must be classified into one of the four
categories. Classification is not necessarily a
free choice but is based on facts and circumstances
and the intent of management at the date of purchase.
Transfers between categories after initial recognition
are restricted.
Financial assets at fair value through profit or loss
A financial asset at fair value through profit or
loss is one that either
| a) |
is classified as
held for trading, which means that it is |
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(i) acquired principally for the
purpose of selling it in the near term ; |
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(ii) part of a portfolio of identified
financial instruments that are managed together
and for which there is evidence of a recent
actual pattern of short-term profit-taking;
or |
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(iii) a derivative (except for one that is
designated and effecting hedging instrument);
or |
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| b) |
upon initial recognition it is
designated as at fair value through profit or
loss. An entity may use this designation when
doing so results in more relevant information,
because either |
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(i) it eliminates or significantly
reduces a measurement or recognition inconsistency
(an 'accounting mismatch') that would otherwise
arise from measuring assets or liabilities or
recognising the gains and losses on them on
different bases; or |
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(ii) a group of financial assets
and/or 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 assets and/ or liabilities is provided
internally to the entity's key management personnel
(as defined in IAS 24). |
An entity may also use this designation for a contract
that contains one or more embedded derivatives,
unless;
| (a) |
that embedded
derivative does not significantly modify the
cash flows that otherwise would be required
by the contract, or |
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| (b) |
it is clear with little or no analysis
that separation of the embedded derivative
is prohibited. |
Subsequent measurement
Financial assets at fair value through profit or
loss are re-measured to fair value at each subsequent
balance sheet date until the assets are de-recognised
[IAS39R.46] . The gains and losses
arising from changes in fair value are included
in the income statement in the period in which they
occur [IAS39R.55] . Gains and losses
will include both realised gains and losses arising
on the disposal of these financial assets and unrealised
gains and losses arising from changes in the fair
value of the assets still held.
Loans and receivables
Loans and receivables are financial assets with
fixed or determinable payments that are not quoted
in an active market, that are not intended for trading,
that are not initially designated as available for
sale or where the holder may not recover substantially
all of its initial investment other than because
of credit deterioration (e.g. interest only strip)
.
An interest acquired in a pool of assets that are
not loans or receivables (for example, an interest
in a mutual fund or a similar fund) is not a loan
or receivable [IAS39R.9] .
Loan origination fees and costs
Loan origination fees are deferred and recognised
as an adjustment to the effective yield of a loan
[IAS18Appendix.14(a)(i)]. A portfolio basis can
be adopted if it is not possible to adjust the effective
yield on an individual loan basis.
Origination fees are an integral part of generating
an ongoing involvement with the resultant financial
asset, and together with the related direct costs,
are deferred and recognised as an adjustment to
the effective yield, except when the financial asset
is classified as at fair value through profit or
loss [IAS18Appendix.14(a)(i)].
Loan origination costs attributable to unsuccessful
loans are expensed. An entity should therefore have
a system for distinguishing successful from unsuccessful
loans and for determining the related incremental
and directly attributable origination costs.
Transaction costs are incremental costs that are
directly attributable to the acquisition of a financial
asset [IAS39R.9] and include costs such as fees
and commissions paid to agents, advisers, brokers
and dealers; levies by regulatory agencies and securities
exchanges; and transfer taxes and duties. Transaction
costs do not include debt premium or discounts,
financing costs, or internal administrative or holding
costs [IAS39R.AG13] .
Subsequent measurement
Loans and receivables are subsequently measured
at amortised cost using the effective interest method,
and are subject to impairment testing [IAS39R.46].
Amortised cost is assumed to approximate the original
invoice amount for short-term receivables with no
stated interest rate if the impact of discounting
would not be significant [IAS39R.AG79].
The effective interest method is a method of calculating
the amortised cost of a financial asset and of allocating
the interest income over the relevant period.
The effective interest rate is the rate that exactly
discounts estimated future cash receipts through
the expected life of the asset or, when appropriate,
a shorter period to its net carrying amount. When
calculating the effective interest rate, an entity
estimates cash flows considering all contractual
terms of the financial instrument (for example,
prepayment, call and similar options) but does not
consider future credit losses [IAS39R.9].
Entities are not permitted to use an expected life
that is longer than the contractual life of the
asset when determining the effective interest rate
as that would take future credit losses (due to
time value) into consideration [IAS39R.9].
Some prepayment penalty fees are included in the
effective interest rate. Where a fee is charged
in order to compensate the lender for the increased
margin that would have been earned had the loan
continued to the end of the period during which
a penalty must be paid, this is considered as part
of the effective interest calculation.
Where the penalty fees are included in the calculation
of effective interest and thus in the amortised
cost balance, the prepayment option will be closely
related to the loan and is not separated as an embedded
derivative. This is because the amortised cost balance
will always approximate the amount to be repaid
if the prepayment option is exercised [IAS39R.AG30(g)].
The expected life of the loan is generally used
to determine the effective interest rate. The effective
interest calculation is a method of spreading any
fees, costs, premiums or discounts over the asset's
expected life. However, effective interest calculations
do not change the nature of fixed and floating contract
terms of loans. For example, when a fixed rate loan
reverts to a standard variable rate before the end
of its expected life, fees and costs are spread
over this expected life, but the effective interest
calculation does not blend fixed and floating rate
cash flows to produce a single combined effective
interest rate. When the interest rate changes from
fixed to floating, it impacts the calculation of
interest income at that time as the effective interest
rate will change. Therefore interest changes are
not anticipated by recalculating effective interest
rates .
Held-to-maturity investment
Held-to-maturity investments are financial assets
with fixed or determinable payments and fixed maturity
that an entity has the positive intention and ability
to hold to maturity [IAS39R.9] .
Fixed or determinable payments and fixed maturity
means a contractual arrangement that defines the
amounts and dates of payments to the holder, such
as interest and principal payments on debt [IAS39R.AG17].
Floating rate debt is considered to have determinable
payments and can therefore be included in the held-to-maturity
category [IAS39R.AG17].
Held-to-maturity is a restrictive category because
it is an exception from the general requirement
to measure financial assets at fair value. There
are strict criteria that an asset and the entity
must meet before assets can be categorised as held-to-maturity.
IFRS requires 'a positive intent and ability' to
hold a financial asset to maturity. The intent and
ability must be assessed when an asset is acquired
and at each subsequent balance sheet date [IAS39R.AG25]
. A positive intent to hold the
assets is a much higher hurdle than the absence
of intent to sell the asset.
Positive intent cannot be demonstrated if [IAS39R.AG16]:
| a) |
the entity intends
to hold the financial asset for an undefined
period; |
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| b) |
the entity stands ready to sell the financial
asset in response to changes in market interest
rates or risks, liquidity needs, changes in
the availability of and the yield on alternative
investments, changes in financing sources
or terms, or changes in foreign currency risk;
or |
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| c) |
the issuer has a right to settle
the financial asset at an amount significantly
below its amortised cost. |
The ability to hold the financial asset to maturity
cannot be demonstrated if the entity [IAS39R.AG23]:
| a) |
does not have the
financial resources available to continue to
finance the investment until maturity ; or |
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| b) |
is subject to legal or other
constraints that could frustrate its intention
to hold the financial asset to maturity. |
Tainting of held-to-maturity
When an entity's actions cast doubt on its intent
or ability to hold investments to maturity, the
entity is prohibited from using the held-to-maturity
category for a reasonable period of time [IAS39R.AG20]
. A penalty is therefore effectively
imposed for a change in management's intention.
The entity is forced to reclassify all its held-to-maturity
investments as -sale and measure them
at fair value until it is able, through subsequent
actions, to restore faith in its intentions (i.e.
"cleansed") [IAS39R.IG.B.19].
More specifically, an entity shall not classify
any financial assets as held to maturity if it has,
during the current financial year or the two preceding
financial years sold or reclassified more than an
insignificant amount of held-to-maturity investment
before maturity. However, this tainting does not
occur if the sales are: (a) so close to maturity
that changes in the market rate of interest would
not have a significant effect on the financial asset's
fair value; (b) occur after the entity has collected
substantially all of the asset's original principal;
or (c) are attributable to an isolated event that
is beyond the entity's control, is non-recurring
and could not have been reasonably anticipated by
the entity [IAS39R.9].
Tainting affects all assets in the held-to-maturity
category. Segregation of assets into separate portfolios
does not 'protect' assets held in other portfolios
[IAS39R.IG.B.20]. Similarly, holding assets in different
legal entities within one group does not prevent
the tainting of assets held by other entities. Sale
of any held-to-maturity assets will call into question
management's intention and ability to hold all assets
to maturity not just assets of a similar type or
within the same portfolio [IAS39R.9] .
Subsequent measurement
Held-to-maturity assets are subsequently carried
[IAS39.46].
Available-for-sale assets
Available-for-sale (AFS) financial assets are those
financial assets that are designated as available
for sale or are not classified as (a) loans and
receivables, (b) held-to-maturity investments or
(c) financial assets at fair value through profit
or loss [IAS39R.9]. Thus, AFS is a residual category.
The AFS category will include all equity securities
except those classified as fair value through profit
or loss.
Subsequent measurement
Available-for-sale financial assets are carried
at fair value subsequent to initial recognition
[IAS39R.46]. There is a presumption that fair value
can be readily determined for most financial assets
either by reference to an active market or by a
reasonable estimation process. The only exemption
to this is equity securities that do not have a
quoted market price in an active market and for
which a reliable fair value cannot be reliably measured.
.
Most gains or losses on an available-for-sale financial
asset shall be recognised directly in equity until
the financial asset is derecognised. The cumulative
gain or loss previously recognised in equity is
recognised in profit or loss when the asset is derecognised.
However, impairment losses, foreign exchange gains
and losses (on AFS debt securities) and interest
(on AFS debt investments) calculated using the effective
interest method are recognised in profit or loss.
Dividends on an available-for-sale equity instrument
are recognised in profit or loss when the entity's
right to receive payment is established [IAS39R.55].
Changes in classification of financial assets
Reclassifications between categories are relatively
uncommon in IAS 39 and are prohibited into and out
of the fair value through profit or loss category,
with the exception of the following:
| a) |
derivatives that become
part of a hedging relationship and are therefore
reclassified out of held-for-trading; |
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| b) |
derivatives that are no longer part of a
hedging relationship and are therefore reclassified
into held-for-trading; and |
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| c) |
a portfolio of assets on which
there is evidence that short-term profit-taking
has begun, which should be reclassified into
held-for-trading. |
The most common reason for a reclassification out
of the HTM category is when the whole category is
tainted and has to be reclassified as available-for-sale
for two years. In such circumstances the assets
are re-measured to fair value with any difference
recognised in equity.
An instrument may be reclassified into the HTM
category where the tainted held-to-maturity portfolio
has been "cleansed". In this case the
financial asset's carrying value at the date of
reclassification is recharacterised as amortised
cost. Any unrealised gains and losses recognised
in equity remain in equity until the asset is impaired
or derecognised .
Fair value measurement considerations
All assets classified at fair value through profit
or loss (including all derivatives) and available
for sale are measured at fair value. Unquoted equity
investments and derivatives on unquoted equity investments
whose fair value cannot be reliably measured are
not measured at fair value. IAS 39 defines fair
value as the amount for which an asset could be
exchanged or a liability settled, between knowledgeable,
willing parties in an arm's length transaction [IAS39R.9].
The presumption that an entity is a going concern
without any intention or need to liquidate, or to
undertake a transaction on adverse terms underpins
the definition of fair value. Fair value is not
therefore the amount that an entity would receive
or pay in a forced transaction, involuntary liquidation
or distress sale. However, fair value does reflect
the credit quality of the instrument.
There is a general presumption that fair value
can be reliably measured for all financial instruments.
IAS 39R provides the following hierarchy for determining
an instrument's fair value:
Active market - quoted market price: The existence
of published price quotations in an active market
is the best evidence of fair value and, when they
are available, they must be used to measure fair
value . The phrase "quoted
in an active market" means that quoted prices
are readily and regularly available from an exchange,
dealer, broker, industry group, pricing service
or regulatory agency. Those prices represent actual
and regularly occurring market transactions on an
arm's length basis. The price can be taken from
the most favourable market readily available to
the entity even if that was not the market in which
a transaction would occur [IAS39R.AG71]. The quoted
market price cannot be adjusted for "blockage"
or "liquidity" factors. The fair value
of a portfolio of financial instruments is the product
of the number of units of each instrument and its
quoted market prices. The appropriate quoted market
price for an asset held or a liability to be issued
is the current bid price and for an asset to be
acquired or liability held, is the asking price.
When an entity has assets and liabilities with offsetting
risk positions, it may use mid-market prices and
apply the bid or asking price to the net open position
as appropriate. When current bid prices are unavailable,
the price of the most recent transaction provides
evidence of the current fair value [IAS39R.AG72].
No active market - valuation techniques: If the
market for a financial instrument is not active,
fair value is established by using a valuation technique.
The objective of a valuation technique is to establish
what the transaction price would have been on the
measurement date in an arm's length transaction
motivated by normal business considerations [IAS39R.AG75].
Valuation techniques that are well established in
financial markets include reference to a transaction
that is substantially the same with adjustment for
the differences, discounted cash flows and option
pricing models. An acceptable valuation technique
incorporates all factors that market participants
would consider in setting a price, and should be
consistent with accepted economic methodologies
for pricing financial instruments. Entities are
also required to periodically calibrate the valuation
technique and test it for validity using prices
from any observable current market transactions
in the same instrument or based on any available
observable market data. An entity obtains market
data consistently in the same market where the instrument
was originated or purchased [IAS39R.AG76]. Normally
the amount paid or received for a financial instrument
is the best estimate of fair value at inception.
However, where all data inputs to a valuation technique
are obtained from observable market transactions,
the resulting calculation of fair value can be used
for initial recognition .
No active market - equity instruments: Normally
it is possible to estimate the fair value of an
equity instrument that an entity has acquired from
an outside party. However, if the range of reasonable
fair value estimates is significant, and no reliable
estimate can be made, an entity is permitted, as
a last resort, to measure the instrument at cost
less impairment. A similar dispensation applies
to derivative financial instruments that can only
be settled by physical delivery of such unquoted
equity instruments.
Day 1 profit recognition: It might be possible
in some circumstances to recognise a gain on initial
recognition of a financial instrument. However,
the circumstances in which this is permitted are
very tightly controlled. Entities will have to demonstrate
that the fair value is evidenced by actual current
market transactions in the same instrument (i.e.
without modification or repackaging) or based on
a valuation technique whose variables include only
observable market data .
Presentation and Disclosure
An entity must disclose the accounting policies
and methods adopted, including the criteria for
recognition and the basis of measurement applied
[IAS32R.60]
.
In the notes to the financial statements an entity
must also disclose the information required by IAS
32R.51-94 including the following:
| a) |
risk management
and hedging policies [IAS32R.56] |
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| b) |
information about the extent and nature
of the financial instruments including any
significant terms and conditions [IAS32R.60] |
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| c) |
information about its exposure
to interest rate risk including contractual
repricing or maturity dates, whichever dates
are earlier and effective interest rates [IAS32R.67] |
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| d) |
information about its exposure
to credit risk including the amount that best
represents the maximum credit risk exposure
and significant concentrations of credit risk
[IAS32R.76] |
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| e) |
fair values for those financial
assets not already measured at fair value [IAS32R.87] |
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| f) |
methods and significant assumptions
applied in determining fair values of all financial
assets [IAS32R.92] |
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| g) |
details of derecognition transactions
that either fail to qualify for derecognition
or are accounted for using the continuing involvement
approach[IAS32R.94(a)] |
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| h) |
details of collateral pledged
and accepted [IAS32R.94(b)] |
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| i) |
details of compound financial
instruments with multiple embedded derivatives
[IAS32.94(d)] |
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| j) |
details about financial assets
and financial liabilities designated at fair
value through profit or loss [IAS32R.94(e)-(f)] |
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| k) |
reasons for reclassification
of assets measured at cost or amortised cost
from fair value [IAS32R.94(g)] |
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| l) |
material items of income and
expense and gains and losses from financial
assets [IAS32R.94(h)] |
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| m) |
nature and amount of any impairment
losses [IAS32R.94(i)] |
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