Financial Instrument:IAS 32, 39 & IFRS 7

‘Financial Instrument’

• IAS 39: Recognition and Measurement
• IAS 32 Presentation-discussed in another post
• IFRS 7: Disclosure- discussed in another post

IAS 39: Financial Instruments: Recognition and Measurement

Application

1. Recognition, derecognition and classification of financial assets and financial liabilities.
2. Initial measurement and subsequent measurement of financial assets and financial liabilities.
3. Definition of hedge accounting.
4. criteria and rules for hedge accounting.

Scope

1. This standard should be applied by all entities to the recognition and measurement of all financial instruments except for financial instruments that are dealt with by other standards, i.e.

a. interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27, IAS 28 and IAS 31 respectively;

This standard does not change the requirements relating to accounting by a parent for investments in subsidiaries, associates or joint ventures in the parent’s separate financial statements as set out in IAS 27, 28 and 31.

o Rights and obligations under leases, to which IAS 17 applies;

o Employers’ assets and liabilities under employee benefit plans, to which IAS 19 applies;

o Financial instruments issued by the entity that meet the definition of an equity instrument (IAS 32) including options and warrant;

However, the holder of such equity instruments applies IAS 39 to those instruments, unless they meet the exception relating to IAS 27, IAS 28 or IAS 31.

• Contracts for contingent consideration in a business combination under IFRS 3 (only applies to acquirer);
• Contracts between an acquirer and a vendor in a business combination to buy or sell an acquire at a future date; and
• Financial instruments, contracts and obligation under share-based payment transaction to which IFRS 2 applies.

Definition

Derivatives

A derivative is a financial instrument:

· Whose value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices, or rates, credit rating or credit index, or other variable (sometimes called the “underlying”);

· That requires little or no initial investment relative to other types of contracts that would be expected to have a similar response to changes in market conditions and

· that is settled at a future date.

Categories of financial assets

1) A financial asset or financial liability at “fair value through profit or loss” is a financial asset or financial liability that is either:

a) Classified as held for trading: or

b) Designed initially at fair value through profit or loss.

2) Held-to maturity investments are non derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intent and ability to hold to maturity other than those:

a) Designed as at fair value through profit or loss on initial recognition:

b) Designed as available for sale; or

c) Meeting the definition of loans and receivables.

3) Loans and Receivables are non derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than those:

a) Intended for immediate sale (classified as held for trading);

b) Designed initially as fair value through profit or loss or available for sale; or

c) Where repayment of the initial loan is in doubt (other than where there is a fall in credit rating), in which case they will be classed as available for sale.

d) Available-for-sale financial assets are those non-derivative financial assets that are designed available-for-sale or are not classified as:

i) Loans and receivables;

ii) Held to maturity investments; or

iii) Financial assets at fair value through profit or loss.

Recognition and measurement

• Amortized cost of financial assets or financial liability is:
• The amount at which it was measured at initial recognition;

Minus

• Principal repayments

Plus or minus

• The cumulative amortization of any difference between that initial amount and the maturity amount; and

Minus

• Any write down (directly or through the use of an allowance account) for impairment or uncollectability.
• The effective interest method is a method of calculating the amortized cost of a financial asset or a financial liability, using the effective interest rate and of allocating the interest.
• The effective interest rate that exactly discounts estimated future cash payments or receipts through the expected useful life of the financial instrument to the net carrying amount of the asset (or financial liability). The computation includes all cash flows ( e.g. fees, transactions cost, premiums or discounts) between the parties to the contract.
• Transaction costs are incremental costs that are directly attributable to the acquisition, issue of disposal of a financial asset (or financial liability).

IAS 21The effects of changes in Foreign Echange rates

1. Accounting issues

1.1 Introduction

A company may engage in foreign currency operations in two ways:

• By entering directly into transactions which are denominated in foreign currencies;
• By conducting foreign operations through a foreign entity (subsidiary, associate or joint venture).

Resultant transactions and balances must be translated into the functional currency of the entity for inclusion in financial statements.

1.2 Key Issues

1. Which exchange rate should be used for translation of the transaction or balance?
2. How to treat any exchange difference that arises – should they be taken to the income statement or equity?

1.3 Objectives

1. To report results which reflect impact of exchange rates on cash flows.
2. To fairly present the results of management’s actions.

1.4 Key Definitions

1. Functional currency is the primary economic environment in which the entity operates.
2. Presentation currency is the currency in which the financial statements are presented.
3. Closing rate is the spot exchange rate at the balance sheet date.
4. Foreign currency is a currency other than the functional currency of the entity.
5. Net investment in a foreign entity is the amount of the reporting entity currency.
• Monetary items include trade receivables, cash, trade payables and loans.
• Non monetary items comprise non current assets, investments and inventory.

2.Functional and Presentation currency

2.1 Functional Currency

• The functional currency of an entry will be dictated by the primary economic environment in which the entity operates.

• An entity should consider the following in determining its functional currency:

1. the currency that mainly influences the selling price of goods or services (and currency of the country whose regulations mainly determine the selling price of goods and services):
2. the currency in which monies from operating activities are kept.

• Other factors to be considered in determining the functional currency of a foreign operation and whether that currency is the reporting entity include:

• Whether activities are carried out as an extension of the reporting entity or with a significant degree of autonomy by the foreign operations;
• Whether transactions between the reporting entity and foreign operation are a high percentage of total transaction;
• Whether cash flows of the foreign operation impact directly on the cash flows of the reporting entity
• Whether the foreign operation is dependent upon the reporting entity to help service current and future debt obligations.

• If the functional currency is not obvious management must use their judgment in identifying the currency that most faithfully represents the economic effects of the underlying transactions.
• Once a functional currency has been identified it should only be changed if there is a change to the economic climate in which it was initially identified.

2.2 Presentation currency

• The financial statement of a foreign operation is translated into the presentation currency of the parent entity.
• Assets and liabilities are translated, at each balance sheet date, at the clsing exchange rate.
• Income and expenses are translated using exchange rates when the transaction occurred.
• The parent’s share of any exchange difference will be included as a separate component of equity, and recycled thorough profit and loss when the foreign operation is disposed.

3. Individual entities

3.1 Accounting treatment –basic transactions

3.1.1 Initial recognition

• Initially a foreign currency transaction is recorded in an entity’s functional currency using the spot exchange rate on the date of the transaction.
• Exchange difference arising on settlement of a foreign currency transaction in the same reporting period are recognised in profit and loss for the period.

3.1.2Subsequent recognition

• At each balance sheet date, any foreign currency monetary item is re-translated using the closing exchange rate.
• Exchange difference arising on re-translation of a foreign currency balance is recognised in profit and loss for the period.
• Non –monetary items measured at historical cost are translated at the exchange rate at the date of the transaction.
• Non-monetary items measured at fair value are translated using the exchange rate when the fair value was determined.

3.2 Exceptions to the basic rules

3.2.1 Net investment in a foreign currency

1. An entity may have a monetary item that is receivable from or payable to a foreign operation.
2. Such monetary items where settlement is neither planned nor likely to occur in the foreseeable future is in substance part of a ‘net investment in the operation’.
3. Exchange difference on such items shall be included in profit and loss in the separate financial statements of the reporting entity or foreign operations.

4 Disclosures

4.1 Exchange differences

1. The amount of exchange differences included in profit or loss for the period.
2. Net exchange difference classified in equity as a separate component of equity, and a reconciliation of the amount of such exchange difference at the beginning and end of the period.
3. When presentation currency is different to the functional currency, that fact shall be stated along with the the functional currency is and the reason for using a different reporting currency.
4. Any changes in functional currency, and the reasons for the change.

IFRS 2 : Share Based Payment

IFES 2 Share Based Payments

1. Key issues

· Recognition: When to recognize the charge for share based payments?

· Measurement: How much expense to recognize.

2. Objectives of IFRS 2

· To specify the financial reporting of share based payment transactions.

· In particular, to show the effects of such transactions (including associated expenses) on profit of loss and financial position.

3. Scope

· All share based payment transactions. Transaction may be:

i. Settled in cash, other assets, or equity instruments of the entity; and

ii. With employees or parties

· There are no exceptions, other than for transactions to which more specific standards apply, for example:

i. shares issued as consideration in a business combination (IFRS 3 ‘’Business Combination’’) and

ii. certain contract transaction failing within IAS 32 “ Financial Instruments: Disclosure and Presentation” or IAS 39 “Financial Instruments: Recognition and Measurement”

4. Definitions

· Share based payment transaction arrangement

An agreement between the entity and employee (or other party) to enter into a share based payment transaction which entitles the employee to receive:

o Equity instruments (including shares) of the entity: or

o Cash (or other assets) for amounts based on the price of entity’s instruments.

Provided any specified vesting conditions are met.

· Share based payment transactions: A transaction in which the entity:

o Requires goods or services as consideration for equity instruments of the entity (including shares or share options) or

o Acquires goods or services by incurring liabilities (to the supplier of those goods or services) for amounts based on the price of the entity’s equity instruments

· Equity Instruments: A contract that gives a residual interest in the assets of an entity after deducting all its liabilities

· Share Option: A contract that gives the holder the right but not the obligation to subscribe to the entity’s shares at a fixed (or determinable) price for a specified period of time.

· Vesting conditions: The condition that must be specified for person to become entitle to receive cash, other assets or equity instrument under Share based payment arrangement.

5. Types of transactions

The standard identifies three types of share based payment transactions:

• Equity settled share based payment transactions
• Cash settled share based payments transactions; and
• Share based payment transactions with cash alternatives.

6. Recognition

On receipt or acquisition

• Normal recognition rules apply in respect of the goods or services received:

Dr Expenses (e.g. purchase, labor)

• If settlement by equity settled share-based payment then increase equity:

Cr Equity

• If settlement by cash settled share-based payment then recognize a liability:

Cr Trade (or other) payables

7. Measurement

7.1 Fair Value

• Goods or services are measured at fair value.

7.2 Equity –settled transactions

1. The fair value of the services received (and the corresponding increase in equity) is measured either:

a. directly, at fair value of the services received: or

b. Indirectly, by reference to the fair value of the equity instruments granted.

2. Direct measurement is at the date the entity receives the services (or obtains the goods).

3. Indirect measurement, as a surrogate, is at the grant date.

1. Employee’s remuneration
• Direct measurement of services received for particular components of an employee’s remuneration package (e. g. cash, shares and other employee benefits) may not be possible.
• Also, it may not be possible to measure the fair value of a total remuneration package, without measuring directly the fair value of the equity instruments granted.
• Granting equity instrument is paying additional remuneration to obtain additional benefits is likely to be more difficult than measuring the fair value of the equity instruments granted.
2. Transactions with others

· For transactions with parties other than employees, there is a rebut table

Presumption that the fair value of the goods or services received can be estimated reliably.

· That fair value is measured at the date the goods are obtained or the supplier renders the service.

8.3 Granting of equity instruments

1. without vesting conditions
• When equity instruments granted vest immediately, employees (executives or other suppliers) are not required to complete a specified period of service before becoming unconditionally entitled to those equity instrument.
• Unless there is evidence to the contrary, the entity presumes that services rendered by the employee have been received. So on grant date the entity recognizes:

1. the services received in full; and

2. a corresponding increase in equity.

2. With vesting conditions

· If the equity instrument granted do not vest until a specified period of service has been completed, it id presumed that the services to be rendered as consideration will be received over the future vesting period.

· Services must then be accounted for as they are rendered by the employee during the vesting period, with a corresponding increase in equity.

3. Expected vesting period

· The expected vesting period at grant date is estimated based on the most likely outcome of the performance condition.

· A performance condition may be a market condition (i.e. a condition upon which the exercise price, vesting or exercisable of an equity instrument is related price, vesting or exercisability of an equity instrument is related to the market price of the entity’s equity instrument).

· If the performance condition is a market condition, the estimate of length of vesting period will be consistent with the assumptions used in estimating the fair vale of the options granted.

· If the performance condition is not a market condition, the entity revises its estimate of the length of the vesting period, if necessary.

8.4 Indirect measurement

• Fair value of equity instruments granted is based on:

1. market prices, if available; otherwise
2. Valuation techniques.

• Vesting conditions other than market conditions are not taken into account when estimating fair value.
• Services received measured at the grant date fair value of equity instruments granted is the minimum amount recognized (unless the equity instrument does not vest due to forfeiture).

8.5 Valuation technique

• It is highly unlikely that market prices will be available for employee share options because the terms and conditions under which they are granted do not apply to options that are actively traded.
• Where similar traded options do not exist, the fair value of options granted is estimated by applying an options pricing model.
• As a minimum, an option-pricing model should reflect:

1. Exercise price of option;

2. Life of option;

3. Current price of underlying;

4. Expected volatility of share price;

5. Expected dividends;

6. Risk free interest rate over life of option.

8.6 Cash –settled transactions

· For cash-settled transactions, the goods or services acquired and the liability incurred are measured at the fair value of the liability.

· The liability is re-measured to fair value at each reporting date, with any changes in value recognized in profit or loss, until it is settled.

· Where either the entity or supplier may choose whether the entity settles the transaction in cash or by issuing equity instruments, it is accounted for as:

a. cash-settled if the entity has a liability to settle in cash; or

b. Equity – settled if no such liability has been incurred.

9. Disclosures

1. Purpose

To enable users of financial statement to understand:

• The nature and the extent of share Based payment that existed during the period;
• How the fair value of goods or services, or the fair value of the equity instruments granted, during the period was determined; and
• The effect of expenses arising from share-based payment transactions on the equity’s profit or loss and financial position.

2. Nature and extent of schemes in place

A description of each type of scheme that existed at any time during the period, including:

1. general terms and conditions (e.g. vesting requirements):

2. the maximum term of options granted; and

3. The settlement method (i.e. cash or equity).

The number and weighted average exercise prices of share options:

1. Outstanding at the beginning of the period;

2. granted, forfeited, exercised and expired during the period;

3. Outstanding & exercisable at the end of the period.

For share options exercised during the period, the weighed average share price at the date of exercise.

For share options outstanding at the end of the period, the range of exercise prices and weighted average remaining contractual life.

3. How fair value was determined

1. Share options
• The weighted average fair value of share options granted during the period at the measurement date and information on how that fair value was measured:

a. the option pricing model used and the inputs to that model;

b. how expected volatility was determined, including an explanation of the extent to which it is based on historical volatility; and

c. Whether and how any features of the option grant were taken account of.

2. Other equity instruments

The number and weighted average fair value of other equity instrument at the measurement date, and information on how that fair value was measured, including:

· How fair value determined if not measured on the basis of an observable market price;

· Whether and how expected dividends (and any other features) were incorporated into the fair value.

3. Modifications

· For schemes that were modified during the period:

a. an explanation of the modifications;

b. the incremental fair value granted and

c. Information on how the incremental fair value granted was measured.

4. Direct measurement

Where the fair vale of goods or services received during the period has been measured directly, disclose how that fair value was determined (e.g. whether at a market price).

4. Effect of expenses arising

· The total expenses recognized for the period where the goods or services received did not qualify for recognition as assets.

· Separate disclosure of that portion of the total expenses that arises from equity-settled transaction.

· For liabilities arising from cash-based transactions:

The total carrying amount at the end of the period; and

Any vested share appreciation rights.

5. IFRIC 11 deals with two issues:

1. Rights of employees to equity instruments

Issue: When employees are granted rights to an entity’s own equity instruments (e.g. share options), should they be accounted for as equity-settled or as cash-settled?

Consensus: When an entity receives services as consideration for its own equity instruments, the transaction shall be accounted for as equity-settled.

This is regardless of whether:

1. the entity chooses or is required to buy the equity instruments from another party;
2. the entity or its shareholders grant to the employees; or
3. the arrangement is settled by the entity or by its shareholders.

2. Arrangements involving more than one group entity

Issue:

a) Share-based payment arrangement may involve two or more entities within the same group. For example, employees of a subsidiary (or other providers of services to a subsidiary) may be granted rights to equity instruments of its parent.

b) How should such share-based payment arrangements be accounted for in the financial statement of the subsidiary that receives services from the employees?

Consensus:

a) When the parent has the obligation to deliver equity instruments to the employees of its subsidiary, the subsidiary measures the services received consistent with the transaction being accounted for as equity-settled, and so recognize a capital contribution from the parent in equity.

b) When a subsidiary grants rights to the equity instruments of its parent it accounts for the transaction as cash-settled regardless of how the subsidiary obtains the equity instrument required settling the obligation.

IAS 18 Revenue

1. Scope :-

Sources of Revenue

1. Sale of Goods
2. Rendering of Services
3. Use of entity assets yielding interest, royalties and dividends

2. Definitions :-

1. Revenue: Gross inflow of economic benefits arising in the course of ordinary activities when those inflows result in increases in equity, other then increases relating to contributions from equity participants.
2. Fair Value: The amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

3 Measurement of revenue:-

· Revenue should be measured at the fair value of the consideration received or receivable (taking into account trade discounts and volume rebates allowed).

· When consideration is deferred the difference between the fair value and the nominal amount of consideration is recognized to be) as interest revenue.

· When goods or services are swapped revenue is only generated if the exchange is for dissimilar goods or services.

4 Sale of goods:-

· Revenue recognition criteria

o Significant risks and rewards are transferred to the buyer:

o Neither continuing managerial involvement nor effective control over goods sold are retained:

o The amount of revenue can be measured reliably:

o It is probable that economic benefits associated with the transaction will flow to the entity: and

o Costs (to be) incurred in respect of the transaction can be measured reliably.

If legal title passes but risk and rewards are retained, no sale should be recognized. For example, where:

o The entity retains obligation for unsatisfactory performance not covered by normal warranty provisions: or

o The receipt of revenue is contingent on the buyer selling the goods on ; or

o Goods are to be installed and installation is a significant part of the contract and remains uncompleted; or

o The buyer has the right to rescind and the seller is uncertain about the outcome.

If legal title does not pass but the risk and rewards do then the transaction should be recognized as a sale.

· Cost recognition

o Usually revenue and expenses are to be recognized simultaneously (and so ‘’matched in the same accounting period).

o Expenses can normally be measured reliably when other conditions for revenue recognition have been satisfied (i.e. costing goods is normally a perquisite for setting a selling price).

o Revenue can not be recognized when the related cost cannot be measured reliably. In such cases proceeds should be recognized as a liability not a sale.

5 Rendering of services :-

· Revenue is recognized by reference to the stage of completion of the transaction at the balance sheet date (but only if the outcome can be estimated reliably).

· Stage of completion should be estimated using the method that measures reliably the services performed. This ay includes:-Surveys of work completed, Services performed as a percentage of total services, Proportion of costs to total estimated costs.

· If outcome cannot be measured reliably recognize the revenue only to the extent of the expenses recognized that are recoverable.

· Reliable estimate of outcome is subject to the following conditions (all must be satisfied)

o The amount of revenue can be measured reliably.

o It is probable that the economic benefits associated with the transaction will flow to the entity.

o The stage if completion of the transaction can be measured reliably.

o Costs to complete can be measured reliably.

6 Interest, royalties and dividends:-

· Revenue recognition criteria:

o It Is probable that economic benefits will flow to the entity:

o The amount of the revenue can be measured reliably:

· Recognition bases:

o Interest – a time proportion basis:

o Royalties – an actual basis in accordance with the substance of the agreement:

o Dividends – when the share holder’s right to receive payment is established.

7 Disclosures:-

· Accounting policies adopted for revenue recognition.

· Amount of each significant category of revenue recognized during the period.

Treatment of some specific cases in Banking industry:-

Financial Services Fees:

1. Introduction –
• Recognition of revenue for financial services fees depends on the purpose for which the fees are assessed and the basis of accounting for any associated financial instrument.
• The description of fees for financial services may not be indicative of the nature and substance of the services provided.
• Therefore it is necessary to distinguish between fees which are –

i. An integral part of the effective yield of a financial instrument:

1. Such fees are generally treated as an adjustment to the effective yield.
2. However when the financial instruments to be measured at fair vale subsequent to its initial recognition the fees are recognized as revenue when the instrument is initially recognized.

ii. Earned as services are provided:

a. Fees charged for servicing a loan – recognize as revenue as the services are provided.

b. Commitment fees to originate or purchase a loan – recognize as revenue on a time proportion basis over the commitment period.

iii. Earned on execution of a significant act.

a. Commission of allotment of shares to a client – recognize as revenue when the shares have been allotted.

b. Placement fees for arranging a loan between a borrower and an investor should be recognized as revenue when the loan has been arranged.

How many IFRSs & IASs till date

There are total 9 IFRS, 41 IAS, and 19 IFRICs have been issued till date. For a complete study of IFRS, one has to thoroughly read and understand these all. Though some of the IASs are now reconstituted and new IASs and IFRSs are issued on the same topics.

IAS 1 Presentation of Financial Statement

IAS 1 Presentation of Financial Statement:
Objectives--Provide information about Financial Position, Performance & Cash Flow of the entity.

Components--complete set inclusive of :-

1. Balance Sheet
2. Income Statement
   
3. A separate Statement of changes in Equity
4. Cash Flow Statement
5. Accounting Policies and explanatory Notes
   

While preparing the Financial Statements one should always consider following :-

• Applying appropriate Accounting Policies and compliance with IFRS
• Going Concern Assumption
  
• Accrual Basis of Accounting
  
• consistency of presentation (unless it will result in more appropriate presentation or required by a standard
• Materiality concept
• Comparative Information : previous period info should be mentioned unless a statement requires otherwise