e-IFRSline May 06 - IAS 39: Financial Instruments - Grant Thornton

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1 OverviewMany companies have ignored IAS 39 (AC133) under the misconception that the standard onlyapplies to financial institutions such as banks and insurance companies. This is incorrect as thedefinition of a financial instrument includes balance sheet items such as investments in equity sharesof another entity, cash, loans and receivables, trade debtors, trade creditors and derivatives, such asshare or currency options, currency forward contracts, commodity forward contracts or interest ratesswaps.2 What instruments does IAS 39 cover?IAS 39 applies to the recognition and measurement of financial instruments, except for certainspecifically excluded items. The basic definitions are set out in IAS 32 and apply also to IAS 39.What are financial instruments?A financial instrument is any contract that gives rise to a financial asset of one entity and a financialliability or equity instrument of another. This definition therefore contains three key terms.A "financial asset" is any asset that is:• cash• an equity instrument of another entity• a non-derivative contract to receive a variable number of the entity's own equity instruments• a contractual right to receive cash or another financial asset or to exchange financial assets orfinancial liabilities on potentially favourable terms• a certain type of complex derivative as specified in IAS 32.A "financial liability" is any liability that is:• a contractual obligation to deliver cash or another financial asset to another entity, or toexchange financial assets or financial liabilities with another entity under conditions that arepotentially unfavourable to the entity• a non-derivative contract to deliver a variable number of the entity's own equity instruments, or• certain types of derivative obligation to deliver the entity's own equity instruments.An "equity instrument" is any contract that evidences a residual interest in the assets of an entity afterdeducting all of its liabilities, e.g. ordinary shares or most share options.A "derivative" is a financial instrument whose value changes in response to the change in anunderlying variable (e.g. interest rate, exchange rate, price index). A derivative requires relativelylittle initial investment and is settled at a future date.Financial assets and liabilities include, for example, investments in equity shares of another entity,cash, loans and receivables, trade debtors, trade creditors and derivatives, such as share or currencyoptions, currency forward contracts, commodity forward contracts or interest rates swaps.What instruments are excluded from IAS 39's scope?The main financial instruments excluded from IAS 39 are:• investments in subsidiaries, associates and joint ventures (as dealt with by IASs 27, 28 and 31)although derivatives relating to these investments remain within the scope of IAS 39• an issuer's own equity instruments, as defined by IAS 32• leases (accounted for under IAS 17) although IAS 39 applies to derecognition, impairment oflease receivables and embedded derivatives, e.g. prepayment options within leases• employee benefit plans (covered by IAS 19)• share-based payments (dealt with under IFRS 2) unless they fall within the criteria noted belowfor certain contracts to buy or sell non-financial items• obligations under insurance contracts• contingent consideration in business acquisitions in respect of the acquirer (dealt with by IFRS 3)• loan commitments (although IAS 39 includes rules for provisions in respect of commitments toissue loans at less than market value). This exclusion does not apply where the commitment canbe settled net (such as where loan assets are sold shortly after origination) or where thecompany designates commitments as at fair value through profit or loss.
3 Distinguishing between financial liabilities and own equityIAS 32 addresses the distinction between a financial liability and an entity's own equity. IAS 39 doesnot address measurement of an entity's own equity instruments. Where there are obligations todeliver the entity's own equity instruments, detailed consultation of IAS 32 is required to determinewhether that item is a financial liability (and so within IAS 39's scope) or an equity instrument.Examples of classifications as liabilities or equity include:• an entity's own ordinary shares with no redemption rights and no fixed dividends are equity• preference shares with fixed dividends or redemption rights are financial liabilities (and so withinIAS 39) to the extent that they are comparable to a similar debt instrument• convertible bonds issued that convert (at holder's option) into a fixed number of shares arecompound financial instruments and are split into a liability component for the bond and an equitycomponent for the conversion option• an option issued to a third party to allow it to purchase a fixed amount of the entity's own sharesfor a fixed amount of cash is an equity instrument.Note that the distinction between equity and liabilities for IFRS purposes may not be the same as forlegal purposes. A classic example of this situation is the preference share. Preference shares thatare redeemable at a specified date for cash are classified as equity for legal purposes, howeverbecause the is a contract (term of the preference shares stated in the articles of association)specifying that the company has the obligation to redeem those shares at a future date for cash is aliability under IFRS principles.4 Categorisation and measurement of financial assetsEach financial asset should be allocated to one of the following four categories identified in IAS 39:• at fair value through profit or loss• held to maturity• loans and receivables• available for sale.Financial assets at fair value through profit or lossFinancial assets in this category are carried at fair value, with fair value changes going through theprofit and loss account. This category covers:• financial assets held for trading − these include all derivatives which are financial assets (apartfrom those designated as hedging instruments) and other financial assets held principally for salein the short term• financial assets designated as being at fair value through profit or loss. An entity may opt todesignate a financial asset into this category but this must be on initial recognition and may notbe changed subsequently. The IAS 39 "fair value option" amendment limits such designation tocases where it eliminates or reduces an accounting mismatch, it relates to a group of assetswhich are managed and their performance evaluated on a fair value basis, or where theinstrument is a hybrid contract containing an embedded derivative.Held-to-maturity investmentsThese are assets that have fixed or determinable payments that the entity has a positive intentionand ability to hold to maturity. They are measured at amortised cost. Financial assets may not beincluded in this category where a previous asset was so categorised in the last two years but wassold before its redemption date."Amortised cost" means the amount recognised initially less principal repayments plus or minuscumulative amortisation using the effective interest method of the difference between initial amountand maturity amount. Reductions for impairment or uncollectibility are made where necessary.Loans and receivablesThese are non-derivative financial assets with fixed or determinable payments. They are measuredat amortised cost (as defined above for held-to-maturity investments). To be included in thiscategory, the item must not be quoted on an active market and the entity must not have elected toclassify it as being at fair value through profit or loss. In addition, there must be no intention to sell inthe short term (otherwise the asset would be categorised as held for trading instead).
Page 1: Issue 2May 2006By Jeanette Hern, Pa
Page 5 and 6: 8 Embedded derivativesIn some cases

e-IFRSline May 06 - IAS 39: Financial Instruments - Grant Thornton

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