IFRS 9 FINANCIAL INSTRUMENTS AND IAS 39 FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT

1 INTRODUCTION

IAS 39 sets out the requirements for recognizing and measuring financial assets and financial liabilities. However, the IASB is currently developing a new standard (IFRS 9) that will ultimately replace IAS 39 in its entirety. The IASB divided that project to replace IAS 39 into three main phases (IFRS 9.IN1 and 9.IN5–9.IN6):

• Classification and measurement of financial assets and financial liabilities
• Impairment methodology
• Hedge accounting

As the IASB completes each phase, the relevant portions of IAS 39 will be deleted and new chapters will be created in IFRS 9 that replace the requirements in IAS 39.

In November 2009, the Board issued the chapters of IFRS 9 that relate to the classification and measurement of financial assets. In October 2010, the IASB added the requirements to IFRS 9 for classifying and measuring financial liabilities. At the same time, the requirements in IAS 39 related to the derecognition of financial assets and financial liabilities were carried forward unchanged to IFRS 9 (IFRS 9.IN7–IN8). By amending IFRS 9 in October 2010, the Board completed the first main phase of its project to replace IAS 39. However, currently the IASB intends to make limited modifications to the already existing rules of IFRS 9.

IFRS 9 (2010) has to be applied for annual periods beginning on or after Jan 01, 2015. However earlier application is permitted (IFRS 9.7.1.1). In the European Union, new IFRSs have to be endorsed by the European Union before they can be applied. Since there has been no endorsement with regard to IFRS 9 until now, the new rules cannot be applied in the European Union at the moment.

The remaining part of this chapter of the book is subdivided as follows:

• In Section 2, financial instruments accounting is explained on the basis of IFRS 9 (as issued in October 2010) and its consequential amendments to IAS 39.
• In Section 3, the differences between financial instruments accounting prior to IFRS 9 and the requirements applicable when applying IFRS 9 (2010) early are illustrated.
• Each of these two sections closes with a subsection that includes examples.

2 FINANCIAL INSTRUMENTS ACCOUNTING ACCORDING TO IFRS 9 (AS ISSUED IN 2010) AND ITS CONSEQUENTIAL AMENDMENTS TO IAS 39

2.1 Scope1

Generally speaking, IFRS 9 (as issued in October 2010) is applied for recognizing, derecognizing, and measuring financial assets and financial liabilities (IFRS 9.2.1), whereas IAS 39 still sets out the requirements for impairment testing and hedge accounting that are not yet addressed by IFRS 9. Some aspects of financial instruments accounting are not covered by IFRS 9 and IAS 39. These are dealt with in the chapters on IAS 32 (“Financial Instruments: Presentation”) and IFRS 7 (“Financial Instruments: Disclosures”).

In the investor's consolidated financial statements, equity instruments are generally not in the scope of IFRS 9 if they are interests in subsidiaries, joint ventures or associates (IAS 39.2 and IFRS 9.2.1).

2.2 Initial Recognition

As a general principle, a financial asset or a financial liability is recognized in the statement of financial position when the entity becomes a contracting party (IFRS 9.3.1.1). As a consequence, positive and negative fair values of financial derivatives are recognized in that statement (IFRS 9.B3.1.1).

However, receivables and liabilities that are the result of a firm commitment to purchase or sell goods or services are generally not recognized until at least one of the parties has completed their side of the agreement. For example, an entity that receives an order generally does not recognize a trade receivable (and the entity that places the order does not recognize a trade payable) at the time of the commitment but, rather, delays recognition until the ordered goods or services have been shipped, delivered or rendered (IFRS 9.B 3.1.2b).

2.3 Measurement

2.3.1 Derivatives and Financial Instruments Held for Trading

When discussing the measurement of financial instruments, it is first necessary to understand the terms “derivative” and “held for trading:”

• A derivative is a financial instrument or other contract within the scope of IFRS 9 that meets all three of the following criteria (IFRS 9.Appendix A):
  • Its value changes in response to the change of an underlying. Examples of underlyings are interest rates, financial instrument prices, commodity prices, foreign exchange rates, indices of prices or rates, credit ratings or credit indices. In the case of a non-financial underlying (e.g. weather conditions), the contract is only considered a derivative if the variable is not specific to a party to the contract. Non-financial variables that are not specific to a party to the contract include an index of earthquake losses in a particular region and an index of temperatures in a particular city. Non-financial variables specific to a party to the contract include the occurrence or non-occurrence of a fire that damages or destroys an asset of a party to the contract (IFRS 9.BA5).
  • No initial net investment is necessary or the initial net investment is smaller than would be required for other types of contracts that have a similar response to changes in market factors.
  • Settlement is at a future date.
• A financial asset or financial liability meets the definition of held for trading if one of the criteria below is met (IFRS 9.Appendix A):
  • It is acquired or incurred principally for the purpose of selling or repurchasing it in the near term or it is part of a portfolio managed in this way.
  • It is a derivative that is neither a designated and effective hedging instrument nor a financial guarantee contract.

2.3.2 Initial Measurement

Financial assets and financial liabilities are initially recognized at fair value (IFRS 9.5.1.1). This is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction (IFRS 9.Appendix A).

Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. The accounting treatment of transaction costs depends on the subsequent measurement2 of the financial asset or financial liability (IFRS 9.5.1.1, IFRS 9.IG E.1.1, and IAS 39.9):

• If subsequent measurement is at fair value through profit or loss, transaction costs are immediately recognized in profit or loss.
• If subsequent measurement is not at fair value through profit or loss, transaction costs of a financial asset are capitalized and transaction costs of a financial liability are deducted from the carrying amount of the liability.

Transaction price is the fair value of the consideration given or received. Normally, the fair value of a financial instrument on initial recognition is the transaction price (IFRS 9.B5.1.1 and 9.B5.4.8). Hence, normally, measurement on initial recognition is actually at cost, when disregarding transaction costs.

2.3.3 Subsequent Measurement of Financial Assets

With regard to financial assets, IFRS 9 is based on a mixed measurement model in which some financial assets are measured at fair value and others at amortized cost after recognition. The distinction between the amortized cost and fair value category is principle-based.

IFRS 9 requires that financial assets are classified at initial recognition into the categories “amortized cost” or “fair value” which are relevant for the assets' subsequent measurement (IFRS 9.3.1.1 and 9.4.1.1–9.4.1.4). This classification is effected on the basis of both (IFRS 9.4.1.1):

• the entity's business model for managing the financial assets, and
• the contractual cash flow characteristics of the financial asset.

A financial asset is classified into the category “amortized cost” if both of the following conditions are met (IFRS 9.4.1.2):

• Subjective condition: The objective of the business model for the group of assets to which the asset under review belongs is to hold assets in order to collect contractual cash flows.
• Objective condition: The contractual terms of the financial asset give rise on specified dates to cash flows which are solely payments of interest and principal on the principal amount outstanding.

If a financial asset does not meet both of these criteria it has to be measured at fair value (IFRS 9.4.1.4).

The objective of the business model is the objective determined by the entity's key management personnel within the meaning of IAS 24 (IFRS 9.B4.1.1).

The business model does not depend on management's intentions for an individual financial asset. This condition should be determined on a higher level of aggregation, i.e. for portfolios of financial assets. A single entity may have one or more such portfolio. For example, an entity may hold a portfolio of financial assets that it manages in order to collect contractual cash flows and another portfolio of financial assets that it manages in order to trade to realize fair value changes (IFRS 9.B4.1.2).

The objective of an entity's business model may be to hold financial assets in order to collect contractual cash flows, even though not all of the assets are held until maturity. However, if more than an infrequent number of sales are made out of a particular portfolio, it is necessary to assess whether and how such sales are consistent with an objective of collecting contractual cash flows (IFRS 9.B4.1.3 and 9.B4.1.4, Example 1).

The classification of a financial asset into the category “amortized cost” requires objectively that the contractual terms of the asset give rise on specified dates to cash flows that are solely payments of interest and principal on the principal amount outstanding (IFRS 9.4.1.2b). For the purpose of IFRS 9, interest is consideration for the time value of money (i.e. for the provision of money to another party over a particular period of time) and for the credit risk associated with the principal amount outstanding (IFRS 9.4.1.3), which may include a premium for liquidity risk (IFRS 9.BC4.22).

The assessment of this criterion is based on the currency in which the financial asset is denominated (IFRS 9.B4.1.8).

Leverage is a characteristic of the contractual cash flows of some financial assets. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest within the meaning of IFRS 9. Therefore, such contracts cannot be measured at amortized cost. Stand-alone options, forward and swap contracts are examples of financial assets that include leverage (IFRS 9.B4.1.9). A variable interest rate does not preclude contractual cash flows that are solely payments of interest and principal on the principal amount outstanding. However, the variable interest rate has to be consideration for the time value of money (i.e. for the provision of money to another party over a particular period of time) and for the credit risk associated with the principal amount outstanding (IFRS 9.B4.1.12).

In spite of the classification criteria described above, it is possible to designate a financial asset as measured at fair value through profit or loss (fair value option) at initial recognition. This requires that doing so eliminates or significantly reduces a measurement or recognition inconsistency (accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases (IFRS 9.4.1.5).3

2.3.4 Subsequent Measurement of Financial Liabilities

With regard to financial liabilities, IFRS 9 is also based on a mixed measurement model in which some financial liabilities are measured at fair value and others at amortized cost after recognition.

Normally, financial liabilities are measured at amortized cost. Exceptions to this rule are, among others, financial liabilities at fair value through profit or loss (see below) and financial guarantee contracts4 (IFRS 9.4.2.1).

The category “financial liabilities at fair value through profit or loss” consists of two sub-categories (IFRS 9.Appendix A):

• Financial liabilities that meet the definition of “held for trading.”5
• Financial liabilities for which the fair value option is exercised, i.e. which are designated upon initial recognition by the entity as “at fair value through profit or loss.” The fair value option may be exercised with respect to a financial liability if one of the following conditions is met (IFRS 9.4.2.2 and IFRS 9.4.3.5):
  • Exercising the option eliminates or significantly reduces an inconsistency (accounting mismatch).
  • A group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis according to a documented risk management or investment strategy and information about that group is provided internally on that basis to the entity's key management personnel.
  • Under certain circumstances, a contract that contains at least one embedded derivative (hybrid or combined instrument) may be designated as at fair value through profit or loss.

2.3.5 Measurement at Amortized Cost: Determining the Effective Interest Rate

Measurement of financial assets or financial liabilities at amortized cost according to IFRS 9 means application of the effective interest method (IAS 39.9 and IFRS 9.4.2.1). Effective interest includes, for example, the contractual interest, premiums, discounts, and transaction costs. The effective interest rate is the rate that discounts the cash payments or receipts of the financial asset or financial liability to the net carrying amount of the asset or liability at initial recognition. When calculating the effective interest rate, the estimated future cash payments or receipts of the financial instrument through its expected life (or, when appropriate, a shorter period) are used. However, future credit losses are not included in this calculation (IAS 39.9).

2.3.6 Determining Fair Values After Recognition

IFRS 9 establishes a fair value hierarchy (IFRS 9.5.4.1, 9.5.4.2, and IFRS 9.B5.4.1–9.B5.4.17):

• The best evidence of fair value is quoted prices in an active market.
• If there is no active market, fair value is determined on the basis of recent transactions or by reference to the current fair value of another instrument that is substantially the same.
• If it is not possible to determine fair value as described previously, valuation models are used (in particular discounted cash flow analysis and option pricing models).
• In the case of investments in unquoted equity instruments (and contracts on those investments that must be settled by delivery of the unquoted equity instruments) cost may be an appropriate estimate of fair value, in limited circumstances.

2.3.7 Presentation of Fair Value Gains and Losses

Changes in fair value of financial assets or financial liabilities measured at their fair values and that are not part of a hedging relationship (see IAS 39.89–39.102) are generally recognized in profit or loss.

Exercising the fair value option for financial assets6 means that the changes in fair value are presented in profit or loss (IFRS 9.4.1.5).

If the fair value option is exercised for financial liabilities,7 fair value changes have to be presented as follows (IFRS 9.5.7.1 and 9.5.7.7–9.5.7.8):

• The amount of change in the fair value of the liability that is attributable to changes in the liability's credit risk is presented in other comprehensive income.
• The remaining amount of change in the fair value of the liability is presented in profit or loss.
• However, an exception is applicable if presentation of the changes in the liability's credit risk in other comprehensive income (see above) would create or enlarge an accounting mismatch in profit or loss. In such cases, all fair value changes of that liability (including the effects of changes in the liability's credit risk) have to be presented in profit or loss.

If the fair value option has been exercised for financial liabilities, amounts presented in other comprehensive income must not be subsequently transferred to profit or loss. However, the cumulative gain or loss may be transferred within equity, e.g. to retained earnings (IFRS 9.B5.7.9).

It is possible to recognize the change in the fair value of an equity instrument (e.g. a share) within the scope of IFRS 9 that is not held for trading in other comprehensive income instead of recognizing it in profit or loss. In order to avoid the so-called “cherry picking” (i.e. in order to avoid entities recognizing changes in fair value in profit or loss or in other comprehensive income selectively), this choice can only be made at initial recognition of the equity instrument and is irrevocable in the future (IFRS 9.5.7.5 and IFRS 9.BC5.25d).

Amounts presented in other comprehensive income for such equity instruments must not be subsequently transferred to profit or loss, i.e. not even when the equity instrument is derecognized. However, the entity may transfer the cumulative gain or loss within equity, e.g. to retained earnings (IFRS 9.B5.7.1).

2.3.8 Impairment Losses and Reversals of Impairment Losses

In the case of financial assets measured at fair value, all fair value changes are recognized either in profit or loss or in other comprehensive income (IFRS 9.5.7.1). Amounts recognized in other comprehensive income must not be subsequently transferred to profit or loss (IFRS 9. B5.7.1). Consequently, according to the systematics of IFRS 9, assessing whether financial assets are impaired and recognizing impairment losses is only necessary for financial assets carried at amortized cost. In this respect, the rules of IAS 39 apply because IFRS 9 does not yet contain such rules (IFRS 9.5.2.2).

At the end of each reporting period, it has to be assessed whether there is any objective evidence of impairment (loss events) in respect of financial assets measured at amortized cost (IAS 39.58). IAS 39 includes a list of examples of loss events that relate to financial difficulties of the debtor (e.g. it becoming probable that the borrower will enter bankruptcy) (IAS 39.59).

If there is objective evidence that an impairment loss on these financial assets has been incurred, the following amounts have to be compared with each other (IAS 39.63):

• The asset's carrying amount as at the end of the reporting period determined according to the effective interest method.
• The present value of the asset's estimated future cash flows (excluding future credit losses that have not been incurred). These cash flows are discounted at the financial asset's original effective interest rate (i.e. the effective interest rate computed at initial recognition).

If the asset's carrying amount exceeds its present value, an impairment loss is recognized in profit or loss (IAS 39.63). It is important to note that this present value does not correspond with fair value because the cash flows are not discounted at a market interest rate. This results in moderate impairment losses which reflect financial difficulties of the debtor, but not market risks.

An entity first assesses whether an impairment exists individually for financial assets that are individually significant. If there is objective evidence of impairment, the impairment loss has to be determined and recognized for the financial asset under review. Assessing impairment on the basis of a group of financial assets is possible for insignificant financial assets instead of an assessment on an individual basis. Moreover, assessment on a group basis is necessary in the case of financial assets tested individually for impairment, for which no impairment has been determined on an individual basis and for which statistical credit risks exist (IAS 39.64).

If the amount of an impairment loss recognized in a previous period decreases and the decrease can be related objectively to an event occurring after the impairment was recognized, a reversal of the impairment loss has to be recognized in profit or loss. The reversal must not result in a carrying amount of the asset that exceeds what the amortized cost would have been at the date the impairment is reversed had the impairment not been recognized (IAS 39.65).

2.4 Hybrid Contracts

2.4.1 Introduction

Hybrid or combined instruments consist of a host contract (e.g. a bond) that is supplemented with additional rights or obligations. A simple example is a convertible bond. A convertible bond consists of a bond (host) which is redeemed at maturity if the conversion right is not exercised. However, if the conversion right (embedded derivative) is exercised, the holder of the convertible bond receives shares of the issuer instead of cash.

A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty is not an embedded derivative, but a separate financial instrument (IFRS 9.4.3.1).

If a hybrid contract contains a liability component as well as an equity component (e.g. in the case of a convertible bond from the perspective of the issuer), these components are separated according to the rules of IAS 32 in the issuer's financial statements (IFRS 9.2.1, IAS 39.2d, and IAS 32.28–32.32) which differ from the rules of IFRS 9 illustrated in Sections 2.4.2 and 2.4.3 below.8 However, the holder of such contracts classifies them in accordance with IFRS 9.

2.4.2 Hybrid Contracts with Financial Asset Hosts

When the hybrid contract contains a host that is an asset within the scope of IFRS 9, the hybrid contract is classified either into the category “amortized cost” or into the category “fair value” in its entirety according to the classification rules of IFRS 9 (IFRS 9.4.3.2, 9.B5.2.1, and 9.4.1.1–9.4.1.5).

2.4.3 Other Hybrid Contracts

A hybrid contract may contain a host that is not an asset within the scope of IFRS 9. In such a case it is necessary to determine whether the embedded derivative has to be separated from the host. Separate accounting of an embedded derivative under IFRS 9 is necessary if all of the following criteria are met (IFRS 9.4.3.3):

• The hybrid instrument is not measured at fair value through profit or loss.
• The economic characteristics and risks of the embedded derivative are not closely related to those of the host contract.
• A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.

If separation of an embedded derivative is necessary, the host is accounted for in accordance with the appropriate IFRSs (IFRS 9.4.3.4) and the embedded derivative is measured at fair value at initial recognition and subsequently (IFRS 9.B4.3.1).

If an entity is unable to determine reliably the fair value of an embedded derivative on the basis of its terms and conditions, the fair value of the embedded derivative is the difference between the fair value of the hybrid contract and the fair value of the host if those can be determined according to IFRS 9. If separate accounting of an embedded derivative from its host is necessary, but the entity is unable to measure the embedded derivative separately either at acquisition or at the end of a subsequent period, the entire hybrid contract has to be designated as at fair value through profit or loss (IFRS 9.4.3.6–9.4.3.7).

Assessment of whether an embedded derivative is required to be separated is made when the entity first becomes a party to the contract. Subsequent reassessment is prohibited unless there is a change in the terms of the contract that significantly modifies the cash flows, in which case reassessment is necessary (IFRS 9.B4.3.11–9.B4.3.12).

There is extensive case history with regard to embedded derivatives (IFRS 9.B4.3.1–9.B4.3.8 and IFRS 9.IG C.1–9.IG C.10). The analysis may be complex depending on the circumstances and the requirements may result in less reliable measures than measuring the entire instrument at fair value through profit or loss. Hence, it is possible to measure the entire hybrid instrument at fair value through profit or loss if certain criteria are met (IFRS 9.4.3.5 and 9.B4.3.9–9.B4.3.10).9 If this form of the fair value option is exercised, separating the embedded derivative becomes unnecessary and is prohibited (IFRS 9.4.3.3c).

2.5 Derecognition of Financial Assets

IFRS 9 contains extensive rules relating to the issue of when and how a previously recognized financial asset has to be removed from the statement of financial position (derecognition) (IFRS 9.Appendix A). Apart from situations in which financial assets (e.g. receivables) are extinguished (e.g. statute of limitation or redemption) and apart from consolidation rules, the following chart applies (IFRS 9.B3.2.1):

Remarks to Step 1

At first it is necessary to investigate whether the financial asset has been transferred. This is the case in each of the following situations:

• The rights to receive the cash flows have been transferred (IFRS 9.3.2.4a) (e.g. a receivable has been sold).
• The entity retains the contractual rights to receive the cash flows of the financial asset but assumes an obligation to pay the cash flows to one or more recipients in an arrangement that meets the conditions specified in IFRS 9.3.2.5 (IFRS 9.3.2.4b).

Remarks to Step 2

If the financial asset has been transferred (see Step 1), it is necessary to investigate whether the entity has retained or substantially transferred all the risks and rewards of ownership of the financial asset. In the case of receivables, the relevant risk is the credit risk, whereas in the case of securities, the relevant risk is the risk of fluctuations in market prices. Three situations are possible:

• The entity has transferred substantially all the risks and rewards (IFRS 9.3.2.6a). In this case, the financial asset has to be derecognized. Moreover, any rights and obligations created or retained in the transfer are recognized separately as assets or liabilities.
• The entity retains substantially all the risks and rewards (IFRS 9.3.2.6b). In this case, the financial asset continues to be recognized. If the entity has, for instance, sold a receivable and already received the consideration therefor, the receivable continues to be recognized in the statement of financial position and the consideration is recognized via the entry “Dr Cash Cr Financial liability” (IFRS 9.3.2.15).
• The entity neither transfers nor retains substantially all the risks and rewards (IFRS 9.3.2.6c). For this situation, we refer to Step 3.

Remarks to Step 3

Step 3 requires determination as to whether control of the asset has been retained (IFRS 9.3.2.9 and IFRS 9.B3.2.7–9.B3.2.9). This involves an assessment as to whether the transferee has the practical ability to sell the transferred asset. If this is the case, the transferor has lost control.

• If control has not been retained, the financial asset is derecognized (IFRS 9.3.2.6(c)(i)). Any rights and obligations created or retained in the transfer are recognized separately as assets or liabilities.
• If control has been retained, the transferor continues to recognize the financial asset to the extent of its continuing involvement in the asset (IFRS 9.3.2.6(c)(ii) and IFRS 9.3.2.16–9.3.2.21).

The gain or loss on derecognition of a financial asset is calculated on the basis of the carrying amount measured at the date of derecognition (IFRS 9.3.2.12, 9.3.2.13, and 9.3.2.20).

2.6 Financial Guarantee Contracts From the Issuer's Perspective

A financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument (IFRS 9.Appendix A). This chapter focuses on the typical accounting treatment of liabilities from co-signing in the financial statements of industrial and mercantile enterprises.

Under certain circumstances, a co-signer can apply IFRS 4. In other situations (these are the normal situations for industrial and mercantile enterprises) application of IFRS 9 is mandatory. Subsequently, only the accounting treatment according to IFRS 9 is illustrated.

Financial guarantees are measured initially at fair value (IFRS 9.5.1.1).

Two different types of financial guarantees that are issued against consideration have to be distinguished:

• The issuer receives a one-time payment in advance when issuing the guarantee.
• The issuer receives payments on an ongoing basis.

The remaining part of this section focuses on contracts with ongoing payments. In the case of such a contract, the initial fair value of the financial guarantee is the present value of the ongoing payments. In our view, in this case, the entry “Dr Receivable (right to receive commission payments) Cr Liability (obligation from co-signing)” is necessary at initial recognition.

Liabilities from co-signing against consideration are normally measured subsequently at amortized cost in the financial statements of industrial and mercantile enterprises. Two different situations have to be distinguished:

• A default is not expected: In this case, commission income is recognized over the duration of the obligation from co-signing. The entry is “Dr Liability (obligation from co-signing) Cr Commission income” (IFRS 9.4.2.1c). The receivable (right to receive commission payments) is reduced by the ongoing commission payments.
• A default is expected: If risk assessments deteriorate when the liability from co-signing is subsequently measured with the result that the amount of the liability from co-signing under IAS 37 exceeds the amount initially recognized and reduced by the appropriate amount of revenue, this higher amount is the new carrying amount of the liability (IFRS 9.4.2.1c). This means that the carrying amount is increased to the expected value of the obligation (which is the amount co-signed for, multiplied by the probability of default) (“Dr Expense Cr Liability”). Thereby, in our view, only the measurement rules and not the recognition rules of IAS 37 apply. This means that the liability is measured at expected value, even if the default risk is below 50%. This new carrying amount of the liability is amortized according to IAS 18 in subsequent periods. In the case of a deteriorated risk assessment, the carrying amount is again increased to the expected value of the obligation according to IAS 37.

2.7 Hedge Accounting

2.7.1 Introduction

The application of IFRS 9 may lead to measurement or recognition inconsistencies (accounting mismatches). These are sometimes due to the fact that IFRS 9 is based on a mixed measurement model in which some financial assets and financial liabilities are measured at fair value and others at amortized cost after recognition.10

Example 1: Entity E is the creditor of a fixed interest rate loan. An increase (a reduction) in the market interest rate leads to a reduction (an increase) in fair value (calculated as present value) of the loan. Assume that E intends to hedge the risk of changes in fair value. Hence, E enters into an interest rate swap (derivative) under which E pays fixed interest and receives variable interest. This means that in essence, E receives variable interest on the loan instead of fixed interest due to the effect of the derivative. In other words, E receives variable interest from the combination of the loan and the swap, which means that E has eliminated the risk of changes in fair value (hedging strategy). This applies under the presumption that hedge effectiveness is 100%, i.e. if fair value of the loan decreases (increases) by CU 5, fair value of the derivative improves (deteriorates) by CU 5. If E measures the loan at amortized cost (i.e. according to the effective interest method), an increase in fair value above amortized cost must not be recognized in E's financial statements. Only decreases in fair value attributable to the debtor's credit risk (impairment losses) are recognized by E. By contrast, the interest rate swap has to be measured at fair value through profit or loss (IFRS 9.4.2.1(a) and IFRS 9.B4.1.9). Consequently, E has to recognize all changes in fair value of the swap in profit or loss. For example, if fair value of the loan increases by CU 5 above amortized cost, E must not recognize this increase in its financial statements. However, the corresponding deterioration of CU 5 in the fair value of the derivative has to be recognized. This results in an incorrect illustration of the hedging relationship in E's financial statements (inconsistency or accounting mismatch) because the loan and the derivative are measured on different bases, after recognition.

Example 2: Entity E is the creditor of a variable interest rate loan, which is measured at amortized cost. An increase (a reduction) in the market interest rate leads to an increase (a reduction) in the interest payments that E receives on the loan. Assume that E intends to hedge the risk of changes in interest payments. Hence, E enters into an interest rate swap (derivative) under which E receives fixed interest and pays variable interest. This means that in essence, E receives fixed interest on the loan instead of variable interest due to the effect of the derivative. In other words, E receives fixed interest from the combination of the loan and the swap, which means that E has eliminated the risk of changes in cash flows (hedging strategy). This applies under the presumption that hedge effectiveness is 100%. In this situation, applying the general requirements of IFRS 9 results in an inconsistency (accounting mismatch): the interest rate swap has to be measured at fair value through profit or loss (IFRS 9.4.2.1(a) and IFRS 9.B4.1.9). Consequently, E has to recognize all changes in fair value of the swap (present value of the future interest payments arising under the swap) in profit or loss. However, the future cash flows (i.e. the future interest payments) arising on the loan measured at amortized cost that are hedged must not be recognized by E (because they have not yet occurred). Consequently, an inconsistency arises because the hedging derivative affects E's financial statements, whereas the hedged position does not.

In order to avoid such inconsistencies, an entity may – under certain circumstances – (see Section 2.7.2) depart from the general requirements of IFRS 9 and apply the hedge accounting rules of IAS 39 (IFRS 9.5.2.3 and 9.5.3.2). Basically, there are two different types of hedge accounting:

• In the case of a fair value hedge, the accounting treatment of the hedged item (e.g. of the loan of a creditor) is changed so that the inconsistency is eliminated. This means that the hedged item is measured at fair value (with respect to the hedged risk) through profit or loss (which corresponds to the accounting treatment of the hedging derivative) instead of being measured at amortized cost. Thus, the effect of the changes in fair value of the hedged item and of the hedging derivative on profit or loss is zero (if hedge effectiveness is 100%). Consequently, reality is correctly portrayed in the financial statements, meaning the false presentation of results is avoided. In Example 1, application of the concept of fair value hedge would mean that changes in fair value of the loan (caused by changes in market interest rates) would also be recognized in profit or loss. For example, if fair value of the loan increases by CU 5 above amortized cost, this increase would be recognized in profit or loss. The corresponding deterioration of CU 5 in the fair value of the derivative would also be recognized in profit or loss. This results in a correct illustration of reality in E's financial statements.
• In the case of a cash flow hedge, the accounting treatment of the hedging derivative is changed. This means that the hedging derivative is measured at fair value through other comprehensive income instead of being measured at fair value through profit or loss. Thus, the effect of the hedging relationship on profit or loss is zero (if hedge effectiveness is 100%). This is because the future cash flows arising on the hedged item are not recognized by E (because they did not yet occur) and the fair value changes of the hedging derivative are generally recognized in other comprehensive income. This means that neither the future cash flows arising on the hedged item nor the hedging instrument affect profit or loss. Consequently, there is no inconsistency with regard to profit or loss. However, applying cash flow hedge accounting does not eliminate all inconsistencies in the financial statements because the fair value changes of the hedging derivative affect other comprehensive income (and consequently also equity), whereas the hedged future cash flows do not. These considerations can be applied to Example 2.

2.7.2 The Rules in More Detail

As illustrated above, there may be different types of hedging strategies which are implemented in practice. In order to avoid inconsistencies, the hedge accounting rules allow an entity to depart from the general requirements of IFRS 9 if certain criteria are met (see next) in order to correctly present reality in the financial statements.

If a transaction, which has already been recognized in the financial statements, is hedged (e.g. a bond acquired by the entity), fair value hedge accounting (e.g. if a fixed interest rate loan is hedged against the risk of fair value changes with an interest rate swap) or cash flow hedge accounting (e.g. if a variable interest rate loan is hedged against the risk of changes in future interest payments with an interest rate swap) may be applied. Also a firm commitment can be hedged. A firm commitment is a binding agreement for the exchange of a specified quantity of resources on a specified future date or dates at a specified price (IAS 39.9). For example, entity E may enter into a contract in Nov 01 for the purchase of 10 tons of a specified raw material for 1 million CAD, which will be delivered on Feb 01, 02. On Dec 31, 01 (E's end of the reporting period 01) this transaction is a firm commitment. Generally, a hedge of a firm commitment is accounted for as a fair value hedge. However, a hedge of the foreign currency risk of a firm commitment may be also be accounted for as a cash flow hedge (IAS 39.87). A forecast transaction is an uncommitted but anticipated future transaction (IAS 39.9). In contrast to a firm commitment, no contract has been entered into in the current reporting period. Hedges of forecast transactions may only be accounted for as cash flow hedges.

Hedge accounting can only be applied if restrictive criteria are met. For example, hedge accounting can only be applied if the hedging instrument is a derivative. An exception to this rule only applies in the case of a hedge of the risk of changes in foreign currency exchange rates (IAS 39.9 and 39.72).

In addition to further restrictions, it is necessary that all of the following conditions are met (IAS 39.88):

• Documentation of the hedging relationship.
• Hedge effectiveness has to be demonstrated on a retrospective basis (i.e. relating to the past) as well as on a prospective basis (i.e. effectiveness is expected for the future).
• For cash flow hedges, the occurrence of a forecast transaction must be highly probable.

In some hedging relationships, hedge effectiveness is not 100%. For example, fair value of the hedging instrument may improve by CU 96 if fair value of the hedged item deteriorates by CU 100 due to the hedged risk. In this case, the changes are within the boundaries of 80% and 125%, prescribed by IAS 39,11 which means that continuing hedge accounting is possible (96 : 100 = 96% and 100 : 96 = 104.17%), although the changes in value are not compensated by each other in full.

In the case of hedging relationships that are effective within the meaning of IAS 39, any ineffectiveness is treated as follows:

• In the case of a fair value hedge, the fair value changes of the hedging derivative and the fair value changes of the hedged item that are attributable to the hedged risk are recognized in profit or loss. Due to this procedure, any ineffectiveness is automatically recognized in profit or loss.
• In the case of a cash flow hedge, the hedged future cash flows (IAS 39.AG103) are not recognized in the financial statements in the current reporting period. The hedging derivative is measured at fair value through other comprehensive income. The last principle has to be stated more precisely (IAS 39.95–39.96):
  • First, the carrying amount of the hedging derivative is adjusted to fair value.
  • The separate component of equity (i.e. the amount of other comprehensive income accumulated in equity) relating to the hedging relationship at the balance sheet date is always the lower of the following amounts:
    • The cumulative gain or loss on the hedging derivative from inception of the hedge.
    • The cumulative change in fair value (present value) of the expected future cash flows on the hedged item from inception of the hedge.
  • After the change in the carrying amount of the hedging derivative and the appropriate amount of other comprehensive income have been recognized, the amount that has to be recognized in profit or loss is the remaining amount.

In the case of cash flow hedge accounting, there are two possibilities for the subsequent accounting treatment of the separate component of equity (hedging reserve) (i.e. the amount of other comprehensive income accumulated in equity):

If the forecast transaction subsequently results in the recognition of a non-financial asset (e.g. a machine or raw materials) or a non-financial liability, or a forecast transaction for a non-financial asset or non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, then the entity applies either (a) or (b) above. In all other cases, alternative (a) is mandatory (IAS 39.97–39.100).

Among others, the entity has to discontinue hedge accounting prospectively if the criteria for applying hedge accounting (IAS 39.88 – see above) are no longer met. Moreover, an entity may discontinue hedge accounting voluntarily by revoking the designation (IAS 39.91 and 39.101).

2.8 Examples with solutions

Example 3

Measurement at fair value through other comprehensive income

On Oct 15, 01, entity E acquires shares. The purchase price of CU 99 as well as transaction costs (incremental costs that are directly attributable to the acquisition) of CU 1 are paid at the same date.

The stock market price of the shares develops as follows:

Version (a)

Dec 31, 01	110
Dec 31, 02	75
Dec 31, 03	70
Dec 31, 04	120

Version (b)

Dec 31, 01	97
Dec 31, 02	90
Dec 31, 03	85

Required

Prepare any necessary entries in the financial statements of E as at Dec 31 for the years 01–04 (version a) and for the years 01–03 (version b). Assume that the shares do not meet the definition of “held for trading” (IFRS 9. Appendix A) and that they are in the scope of IFRS 9. E always measures shares at fair value through other comprehensive income, if possible.

Hints for solution

In particular Sections 2.3.2, 2.3.3, and 2.3.7.

Solution (general remarks)

Shares do not meet the criterion “solely payments of principal and interest,” which means that they have to be measured at fair value. Fair value changes of financial assets are generally recognized in profit or loss. However, it is also possible to recognize the fair value changes of the shares held by E in other comprehensive income, because the shares are equity instruments within the scope of IFRS 9 and they do not meet the definition of “held for trading.” Such an election can only be made at initial recognition and is irrevocable (IFRS 9.4.1.2(b), 9.4.1.4, 9.5.7.1(b), and 9.5.7.5). Since the election is possible, E recognizes the fair value changes of the shares in other comprehensive income. This means that impairment losses are also recognized in other comprehensive income (fair value reserve) instead of profit or loss. The subsequent transfer of amounts recognized in other comprehensive income to profit or loss is prohibited (IFRS 9.B5.7.1). At initial measurement, the transaction costs of CU 1 are capitalized since measurement is not at fair value through profit or loss (IFRS 9.5.1.1).

Solution (a)

Solution (b)

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Example 4

Financial assets held for trading

Required

Prepare any necessary entries for version (a) of Example 3, but presume that the shares meet the definition of “held for trading.” Presume that increases and decreases in fair value of E's financial instruments held for trading are material.

Hints for solution

In particular Sections 2.3.2, 2.3.3, and 2.3.7.

Solution

The shares held for trading do not qualify for measurement at amortized cost because they do not meet the business model criterion (IFRS 9.4.1.2(a) and 9.B4.1.6) and because shares do not meet the criterion “solely payments of principal and interest” (IFRS 9.4.1.2(b)). This means that the shares have to be measured at fair value (IFRS 9.4.1.4). The fair value changes (fair value gains and fair value losses) have to be presented in profit or loss because in the case of shares held for trading, fair value changes must not be presented in other comprehensive income (IFRS 9.5.7.1(b) and 9.5.7.5).

The transaction costs of CU 1 are recognized in profit or loss because subsequent measurement of the shares is at fair value through profit or loss (IFRS 9.5.1.1).

Since increases and decreases in fair value of E's financial instruments held for trading are material, the gains and losses have to be presented separately (IAS 1.35).

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Example 5

Effective interest method – introductory example (financial liability)

On Jan 01, 01, entity E takes up a loan. According to the loan, E receives CU 100 on the same date. No interest is explicitly stipulated with respect to the loan. However, E has to pay CU 121 on Dec 31, 02 in order to settle its obligations under the loan.

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01 and 02. The loan is measured at amortized cost, i.e. according to the effective interest method.

Hints for solution

In particular Section 2.3.5.

Solution

No interest is explicitly stipulated with respect to the loan. However, E has to pay an amount of CU 121 on Dec 31, 02 although E receives only CU 100 on Jan 01, 01. The difference of CU 21 is the consideration for E's creditor and E's cost for the loan. These costs have to be allocated by E over the years 01 and 02 according to the effective interest method.

The difference of CU 21 (from CU 121 and CU 100) corresponds to an effective interest rate of 10% p.a. (CU 121: 1.12 = CU 100 or CU 100 · 1.12 = CU 121). Thus, effective interest is CU 10 for 01 (= carrying amount as at Jan 01, 01 of CU 100 · 10%).

On Jan 01, 02, the carrying amount of the liability is CU 110 (= CU 100 + CU 10). Thus, effective interest is CU 11 for 02 (= carrying amount as at Jan 01, 02 of CU 110 · 10%).

On Dec 31, 02 (before derecognition of the liability), the carrying amount of the liability corresponds with redemption amount.

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Example 6

Effective interest method – financial liability

On Jan 01, 01, entity E takes up a loan. According to the loan agreement, E receives CU 100 on the same date. The maturity of the loan is two years. At the end of each year, E has to pay CU 56.

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01 and 02. The loan is measured at amortized cost, i.e. according to the effective interest method.

Hints for solution

In particular Section 2.3.5.

Solution

The effective interest rate is 7.90%:12

Date	Cash inflow (+) and cash outflows (–)	Effective interest rate
Jan 01, 01	100	7.9%
Dec 31, 01	−56
Dec 31, 02	−56

The amortization table is presented below. As in Example 5, effective interest results from multiplying the carrying amount as at Jan 01 by the effective interest rate. The amount presented in the column “redemption” is calculated by deducting the amount shown in the column “interest” from the amount presented in the column “installment.” The amount shown in the column “redemption” reduces the carrying amount of the liability.

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Example 7

Effective interest method – financial asset

On Jan 01, 01, entity E acquires a fixed interest rate bond for CU 89.69. The redemption amount, which is payable on Dec 31, 03, is CU 100. At the end of each year, E receives interest of 4% on the redemption amount.

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01–03. Assume that the bond has to be measured at amortized cost according to IFRS 9.

Hints for solution

In particular Section 2.3.5.

Solution

Acquisition of the bond:

At first, the financial asset has to be classified either into the category “amortized cost” or into the category “fair value.” In this example, it is presumed that the bond has to be measured at amortized cost, according to the classification criteria (IFRS 9.4.1.1–9.4.1.4). Measurement at amortized cost according to IFRS 9 requires application of the effective interest method (IFRS 9.Appendix A refers to IAS 39.9 regarding the definition of the terms “amortized cost” and “effective interest method”).

From the bond, E receives fixed interest of 4% p.a. Moreover, E receives additional consideration of CU 10.31 because it acquires the bond for CU 89.69 whereas the redemption amount is CU 100. Consequently, not only an amount of CU 4 (= CU 100 · 4%) is recognized as interest income in 01. Instead, effective interest income, which is a higher amount, has to be recognized. Effective interest income for 01 also includes an allocation of the additional consideration of CU 10.31. The effective interest rate is 8.00%:13

Date	Cash inflows (+) and cash outflow (–)	Effective interest rate
Jan 01 01	−89.69	8.0%
Dec 31, 01	–4.00
Dec 31, 02	–4.00
Dec 31, 03	104.00

At first, the contractual interest of 4%, which is received on Dec 31, 01, is recognized:

However, it is necessary to recognize the effective interest income of CU 7.18 (= CU 89.69 · 8%) in 01, which also includes an allocation of the additional consideration of CU 10.31 and not only the contractual interest. Thus, the remaining amount of interest income of CU 3.18 (= CU 7.18 – CU 4.00) has to be additionally recognized.

E will receive the additional consideration of CU 10.31 on Dec 31, 03 (when the redemption amount of CU 100 is paid). Therefore, E has to recognize its right to receive this additional consideration in its statement of financial position to the extent that the additional consideration has been allocated to 01 (CU 3.18).

These considerations are useful in understanding the table and the entries below:

Alternatively, the carrying amounts as at Dec 31 can also be explained as the present value of the future payments (e.g. CU 92.87 = CU 104 : 1.082 + CU 4 : 1.08 and CU 96.30 = CU 104: 1.08).

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Example 8

Effective interest method – impairment loss

The situation is the same as in Example 7. However, on Dec 31, 01, E expects that due to significant financial difficulties of the debtor, it will receive the redemption amount of CU 100 on Dec 31, 03 but will not receive the interest payments. In the following years, it turns out that this assumption was correct.

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01–03. Assume that the bond has to be measured at amortized cost according to IFRS 9.

Hints for solution

In particular Sections 2.3.5 and 2.3.8.

Solution

The rules of IAS 39 relating to impairment losses still apply to financial assets accounted for at amortized cost in accordance with IFRS 9 (IFRS 9.5.2.2) because IFRS 9 does not yet contain its own rules in this respect.

In 01, the same entries are made as in Example 7. However, on Dec 31, 01, the significant financial difficulties of the debtor are an indication that the financial asset (bond) is impaired (IAS 39.59a). For this reason, E expects that it will not receive part of the payments and determines the amount of the impairment loss (IAS 39.58 and 39.63). The impairment loss is calculated as the difference between the carrying amount and the lower present value of the expected future cash flows, discounted by the original effective interest rate of 8% p.a. (which is the interest rate determined at initial recognition of the asset, i.e. on Jan 01, 01, as illustrated in Example 7).

In the following years, effective interest is recognized although E does not receive contractual interest (IAS 39.AG93). Effective interest for 02 is CU 6.86 (= CU 85.73 · 8% or carrying amount of CU 92.59 as at Dec 31, 02 – carrying amount of CU 85.73 as at Dec 31, 01 after recognition of the impairment loss). The increased carrying amount as at Dec 31, 02 results from the fact that the payment of CU 100 is only discounted for one period.

The above considerations are applied along the same lines for 03.

Until Dec 31, 03, the carrying amount has been increased to CU 100, which corresponds to the redemption amount.

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Example 9

Effective interest method – reversal of an impairment loss

The situation is the same as in Example 8. However, on Dec 31, 02, the reason for the impairment does not exist anymore. E expects to receive the redemption amount as well as the last interest payment on Dec 31, 03. However, E does not expect to receive the interest payment for the year 02. Finally, it turns out that these assumptions were correct.

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01–03. Assume that the bond has to be measured at amortized cost according to IFRS 9.

Hints for solution

In particular Sections 2.3.5 and 2.3.8.

Solution

The rules of IAS 39 relating to impairment losses and reversals of impairment losses still apply to financial assets accounted for at amortized cost in accordance with IFRS 9 (IFRS 9.5.2.2) because IFRS 9 does not yet contain its own rules in this respect.

In 01 and 02, the same entries are made as in Example 8. Hence, the carrying amount of the bond as at Dec 31, 02 is CU 92.59.

On Dec 31, 02, E expects to receive the redemption amount as well as the last interest payment on Dec 31, 03, i.e. an amount of CU 104 in total. Present value of these payments is CU 96.30 (= CU 104 : 1.08), which corresponds with the carrying amount of the bond as at Dec 31, 02 in Example 7 (in which no impairment loss occurs). The carrying amount of the bond is increased to this amount:

In 03, the same entries are made as in Example 7.

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Example 11

Derecognition of financial assets – introductory example

Entity E is creditor of a bond. The carrying amount of the bond of CU 100 as at Jan 01,01 corresponds with its redemption amount. The redemption amount has to be paid on Dec 31, 01. The contractual interest rate and the effective interest rate are 7% p.a. Contractual interest for the year always has to be paid on Dec 31. On Jan 01, 01, E sells the bond to entity F at its fair value. On the same date, the market interest rate is 5% p.a.

Required

Prepare any necessary entries in E's financial statements as at Dec 31, 01. Assume that the bond is measured at amortized cost, according to IFRS 9.

Hints for solution

In particular Section 2.5.

Solution

Fair value of the bond is calculated by discounting the future cash flows of the bond by the current market interest rate. Thus, on Jan 01, 01, fair value is CU 101.90 (= CU 107 : 1.05). The bond is sold to F for this amount. On Jan 01, 01, the carrying amount of the bond (amortized cost) is CU 100 (= CU 107 : 1.07). The difference of CU 1.90 has to be recognized in profit or loss (IFRS 9.3.2.12).

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Example 12

Derecognition of financial assets – factoring

E owns a group of short-term receivables which are measured at amortized cost. Their carrying amount as at Dec 31, 01 is CU 80. E sells this group of receivables on Dec 31, 01 to bank B for CU 70. The sales price is settled on the same date. After this sale, the debtors of the receivables are instructed to make their outstanding payments to B. Due to experience, credit losses of CU 8 are expected relating to this group of receivables. The following is stipulated:

(a) B assumes the risk of credit losses completely.

(b) E retains the risk of credit losses completely.

(c) E and B each bear 50% of the credit losses. There are no restrictions in respect of the transfer of the receivables to B. This means that B has the ability to resell or to pledge the receivables.

(d) E and B each bear 50% of the credit losses. There are restrictions relating to the transfer of the receivables to B. This means that B does not have the ability to resell or to pledge the receivables.

Required

Prepare any necessary entries in E's financial statements as at Dec 31, 01. E has already made its consolidation entries (IFRS 9.3.2.1 and 9.B3.2.1).

Hints for solution

In particular Section 2.5.

Solution

After the consolidation entries have been made (IFRS 9.3.2.1), it has to be determined whether the derecognition principles are applied to the whole group of receivables or to a part of the group of receivables (IFRS 9.3.2.2). In this example, all of the cash flows of the group of receivables are transferred to B. Hence, the derecognition principles are applied to the whole group of receivables.

The next question is whether the contractual rights to the cash flows from the group of receivables have expired (IFRS 9.3.2.3a). Although, E sells the group of receivables, the acquirer (B) is entitled to receive cash flows from the receivables because the receivables have not yet been settled, they have not yet become time-barred, etc. Consequently, the rights to the cash flows have not yet expired.

The next matter is whether E has transferred the contractual rights to receive the cash flows from the receivables (IFRS 9.3.2.4a). In this example, it is presumed that the transfer is irrevocable and unalienable and that the transfer is also valid in the case of bankruptcy. This is necessary for the existence of a transfer within the meaning of IFRS 9. Consequently, E has transferred the contractual rights to receive the cash flows.

In this situation, the accounting treatment of the receivables depends on the question to which extent the risks and rewards with respect to the receivables are transferred from E to B (IFRS 9.B3.2.1). In the case of receivables, the relevant risk is the risk of credit losses. When all of these risks are shared substantially by E and B (version (c) and (d) of this example), it is necessary to determine whether E has retained control of the group of receivables.

Version (a)

Since B assumes the risk of credit losses completely, substantially all risks and rewards are transferred from E to B. Hence, E has to derecognize the receivables (IFRS 9.3.2.6a and IFRS 9.B3.2.1):

Version (b)

Credit losses of CU 8 are expected. E retains the risk of these credit losses completely. Therefore, E retains substantially all risks and rewards, which means that E continues to recognize the receivables (IFRS 9.3.2.6b, IFRS 9.B3.2.5e, and 9.B3.2.1). E has to recognize the consideration received of CU 70 as a financial liability (IFRS 9.3.2.15).

Version (c)

In this version, E does not retain control of the receivables (IFRS 9.3.2.9 and 9.B3.2.7–9. B3.2.9). Hence, the receivables are derecognized (IFRS 9.3.2.6(c)(i) and 9.B3.2.1):

The agreement that E has to bear 50% of the credit losses (remaining risk) is a guarantee that is measured at fair value of CU 4 (= 50% of CU 8) (IFRS 9.3.2.6(c)(i)):

Version (d)

In this version, E retains control of the receivables (IFRS 9.3.2.9 and IFRS 9.B3.2.7–9. B3.2.9). Hence, the receivables continue to be recognized to the extent of E's continuing involvement. This is to reflect E's continuing exposure to the risks and rewards of the receivables (IFRS 9.3.2.6(c)(ii), 9.B3.2.1, and 9.BCZ3.27). The receivables continue to be recognized to the extent of the maximum risk of CU 40 (= 50% of CU 80) and are derecognized to the extent of CU 40. Since receivables in the amount of CU 40 remain in E's statement of financial position, a liability has to be recognized to that extent. Moreover, a liability of CU 4 (= 50% of CU 8) has to be recognized for the part of the receivables already derecognized (IFRS 9.3.2.17):

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Example 13

Co-signing

On Jan 01, 01, debtor D takes out a loan at bank B. The loan is to be redeemed on Dec 31, 02.

On Jan 01, 01, entity E co-signs D's loan. From E's perspective, D is an unrelated third party.

It is stipulated that E will receive consideration of CU 72.60 for co-signing on Dec 31, 01 as well as on Dec 31, 02.

From the end of 01 until Dec 31, 02, D's creditworthiness is excellent.

Required

Prepare any necessary entries in the co-signer's (i.e. in E's) financial statements as at Dec 31, for the years 01 and 02. The interest rate is 10% p.a.

Hints for solution

In particular Section 2.6.

Solution

On Jan 01, 01, E recognizes a liability (which represents E's obligation from co-signing), as well as a receivable (which represents E's right to receive commission payments). The present value of the ongoing commission payments is CU 126 (= CU 72.6 : 1.1 + CU 72.6 : 1.12).

On Dec 31, 01, the carrying amount of the liability and of the receivable are increased by the interest of CU 12.6 (= CU 126 · 10%) for 01.

After that, income of CU 72.6 is recognized. The liability is reduced by the same amount:

The carrying amount of the receivable has to be reduced because E receives a commission payment:

Thus, on Dec 31, 01, the carrying amounts of the liability and of the receivable are CU 66 each (CU 126 + CU 12.6 – CU 72.6). On Dec 31, 02, the carrying amount of the liability and of the receivable are increased by the interest of CU 6.6 (= CU 66 · 10%) for 02.

On Dec 31, 02, the carrying amounts of the liability and of the receivable are CU 0 each (CU 66 + CU 6.6 – CU 72.6).

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Example 14

Hedge accounting – forecast transaction

Entity E's own currency is the CNY. On Nov 30, 03, E plans to purchase a machine in country Z on Mar 31, 04 for 10 m units of foreign currency F. It is highly probable that this purchase will take place. However, no contract of purchase has been entered into until the end of the reporting period 03.

On Nov 30, 03, E enters into a forward contract in order to hedge against the foreign exchange risk (currency risk) arising on the forecast transaction. Under this contract, E is obliged to buy 10 m units of foreign currency F on Mar 31, 04 at an exchange rate of 10 (1 unit of F = 10 CNY) from bank B.14

The following table shows the development of the exchange rate (1 unit of F = x CNY):15

Nov 30, 03	10
Dec 31, 03	8
Mar 31, 04	9

On Mar 31, 04, the machine is purchased, delivered, and paid. On Apr 01, 04, the machine is available for use. The machine's useful life is five years.

Required

Prepare any entries in E's financial statements that are necessary from Nov 30, 03 until Dec 31, 04. E's reporting periods end on Dec 31. E applies the hedge accounting rules of IAS 39.

Hints for solution

In particular Section 2.7.

Solution

Measurement of the hedging derivative on Dec 31, 03:

The negative fair value of –20 m CNY results from the fact that E could purchase 10 m units of F for 80 m CNY without existence of the forward contract, but has to pay 100 m CNY due to the forward contract.

Conversely, fair value of the forecast transaction has improved. On Nov 30, 03, E would have had to pay 100 m CNY in order to buy the machine. On Dec 31, 03, E would have to pay only 80 m CNY. Hence, fair value of the forecast transaction is positive (+20 m CNY).

In reality, the fair value changes of the forecast transaction and of the derivative offset each other. However, on Dec 31, 03, the expected purchase of the machine cannot be recognized in the financial statements. Nevertheless, E would have to recognize the derivative at its negative fair value (“Dr Profit or loss Cr Liability 20 m CNY”). Consequently, profit or loss for 03 would deteriorate by –20 m CNY although the fair value changes actually offset each other. In order to avoid this, IAS 39 permits the application of cash flow hedge accounting.

Under the cash flow hedge accounting technique, the fair value change of the derivative of –20 m CNY is recognized in other comprehensive income (hedging reserve). Thus, neither the forecast transaction nor the hedging derivative affect profit or loss, i.e. the effect on profit or loss is zero. This corresponds with reality (see above).

The change in the hedging reserve during the period is presented in other comprehensive income (IAS 1.7e).

It should be noted that the cash flow hedge accounting technique avoids a distortion of profit or loss but not of other comprehensive income, total comprehensive income or equity as a whole.

Year 04

Measurement of the hedging derivative on Mar 31, 04:

The reduction in the carrying amount of the liability from –20 m CNY to –10 m CNY is recognized in other comprehensive income (hedging reserve):

On Mar 31, 04, the machine is purchased for 10 m units of F, converted at the current exchange rate (= 10 m units of F · 9 = 90 m CNY). Moreover, the forward contract (fair value as at Mar 31, 04 = –10 m CNY) is settled. Therefore, in total, an amount of 100 m CNY has to be paid. This corresponds with the purchase price that E intended to fix by securing the rate of 10 (10 m units of F · 10 = 100 m CNY).

After this entry, the question arises of how to treat the carrying amount of the hedging reserve of –10 m CNY. A machine represents a non-financial asset. Consequently, IAS 39.98 has to be applied, which permits two different ways of treating the hedging reserve.

IAS 39.98(a): Derecognition of the hedging reserve is effected in the same periods during which the machine affects profit or loss. In 04, the machine is depreciated for nine months (90 m CNY : 5 years : 12 months · 9 months = 13.5 m CNY). Derecognition of the hedging reserve is effected to the same extent (10 m CNY : 5 : 12 · 9 = 1.5 m CNY).

IAS 39.98(b): On Mar 31, 04, the hedging reserve is derecognized and included in the carrying amount of the machine. This entry does not affect E's OCI for the year 04.

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Example 15

Hedge accounting – firm commitment

Entity E's own currency is the CNY. On Nov 30, 03, E orders a machine in country Z for 10 m units of foreign currency F. The machine will be delivered on Mar 31, 04.

On Nov 30, 03, E enters into a forward contract in order to hedge against the foreign exchange risk (currency risk) arising from the firm commitment. According to this contract, E is obliged to buy 10 m units of foreign currency on Mar 31, 04 at an exchange rate of 10 (1 unit of F = 10 CNY) from bank B.16

The following table shows the development of the exchange rate (1 unit of F = x CNY):17

Nov 30, 03	10
Dec 31, 03	8
Mar 31, 04	9

On Mar 31, 04, the machine is delivered and paid. On Apr 01, 04, the machine is available for use. The machine's useful life is five years.

Required

Prepare any entries in E's financial statements that are necessary from Nov 30, 03 until Dec 31, 04. E's reporting periods end on Dec 31. E applies the hedge accounting rules of IAS 39. E treats hedges of foreign currency risks arising from firm commitments as fair value hedges (IAS 39.87).

Hints for solution

In particular Section 2.7.

Solution

Measurement of the hedging derivative on Dec 31, 03:

The negative fair value of –20 m CNY results from the fact that E could purchase 10 m units of foreign currency for 80 m CNY without existence of the forward contract, but has to pay 100 m CNY due to the forward contract.

Conversely, fair value of the firm commitment has improved. On Nov 30, 03, E would have had to pay 100 m CNY for the machine. On Dec 31, 03, E would have to pay only 80 m CNY. Hence, fair value of the firm commitment is positive (+20 m CNY).

In reality, the fair value changes of the firm commitment and the derivative offset each other. E has to recognize the negative fair value of the derivative (“Dr Profit or loss Cr Liability 20 m CNY”). However, the positive fair value of the firm commitment must not be recognized in the financial statements according to IFRS. Consequently, profit or loss for 03 would deteriorate by –20 m CNY, although the fair value changes actually offset each other. In order to avoid this, IAS 39 permits the application of fair value hedge accounting.

Under the fair value hedge accounting technique, the positive fair value of E's firm commitment is recognized as an asset. The fair value increase is recognized in profit or loss. Thus, the effect of the total of the fair value changes of the firm commitment and of the derivative on the amount of profit or loss for the year is zero. This corresponds with reality (see above).

Year 04

Measurement of the hedging derivative on Mar 31, 04:

Fair value of the firm commitment deteriorates to +10 m CNY:

The following entry shows the settlement of the derivative (fair value as at Mar 31, 04 = –10 m CNY):

Regarding the acquisition of the machine, the exchange rate as at Mar 31, 04 is relevant. The acquisition of the machine results in a payment of 90 m CNY (= 10 m units of F · 9):

The positive fair value of the asset recognized relating to the firm commitment is derecognized and included in the carrying amount of the machine (IAS 39.94):

Thus, the machine is recognized at an amount of 100, which corresponds to the exchange rate, hedged on Nov 30, 03 (10 m units of F · 10 or 90 m CNY + 10 m CNY).

Finally, the machine is depreciated for nine months (100 m CNY : 5 years : 12 months · 9 months):

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3 FINANCIAL INSTRUMENTS ACCOUNTING PRIOR TO IFRS 9

This section generally describes financial instruments accounting prior to IFRS 9 only to the extent that it differs from IFRS 9 as issued in October 2010 (and its consequential amendments to IAS 39). Subsequently, references to IAS 39 refer to the “old” version of that Standard, i.e. to IAS 39 before any consequential amendments resulting from IFRS 9.

3.1 Scope18

IAS 39 sets out the requirements for recognizing and measuring financial instruments. However, the scope of IAS 39 does not include all financial instruments. For example, equity instruments are not within the scope of IAS 39 from the issuer's perspective. In the holder's consolidated financial statements, equity instruments are not in the scope of IAS 39 if they are interests in subsidiaries, joint ventures or associates (IAS 39.2).

3.2 Subsequent Measurement

IAS 39 is based on a mixed measurement model in which some financial assets and financial liabilities are measured at fair value and others at amortized cost after recognition. The method of subsequent measurement depends on the measurement category to which the financial asset or financial liability is assigned.

3.2.1 Assigning a Financial Asset or a Financial Liability to a Measurement Category

Loans and receivables This category comprises non-derivative financial assets with fixed or determinable payments that are not quoted in an active market (IAS 39.9). An active market is a market that meets all the following conditions (IAS 36.6):

• The items traded within the market are homogeneous.
• Willing buyers and sellers can normally be found at any time.
• Prices are available to the public.

Held-to-maturity investments This category includes non-derivative financial assets with fixed or determinable payments and fixed maturity. However, they have to be quoted in an active market (e.g. bonds quoted on the stock exchange). Moreover, classification into this category requires that the entity has the positive intention and ability to hold the financial assets to maturity.

In the case of sales of financial assets classified as “held to maturity” that do not meet specified conditions, the entity must not classify any financial assets into this category for a specified period of time. Moreover, any remaining financial assets of the category “held to maturity” have to be reclassified into the category “available for sale” (IAS 39.9 and 39.52).

Financial assets available for sale Available-for-sale financial assets represent primarily a residual category: All financial assets not falling into one of the other categories belong to this category (IAS 39.9).

Financial assets or financial liabilities at fair value through profit or loss This category includes financial assets as well as financial liabilities and consists of two sub-categories (“held for trading” and “fair value option”).

• Financial assets or financial liabilities that meet the definition of “held for trading.” The terms “held for trading” and “derivative” have the same meaning as in IFRS 9 (IFRS 9. Appendix A).19
• Financial assets or financial liabilities for which the fair value option is exercised (i.e. which are designated as at fair value through profit or loss). Exercising that option is possible if one of the following conditions (which correspond with the eligibility criteria for financial liabilities according to IFRS 920) is met and the asset's or liability's fair value can be determined reliably (IAS 39.9 and 39.11 A):
  • Exercising the option eliminates or significantly reduces an inconsistency (accounting mismatch). For example, an entity may own a fixed-interest bond (classified as “available for sale”) that is refinanced by a fixed-interest financial liability (measured at amortized cost). Without exercising the option, fair value changes of the bond due to changes in the market interest rate would be recognized outside profit or loss and fair value changes of the financial liability due to changes in the market interest rate would not be recognized at all. Exercising of the option eliminates this inconsistency by recognizing the fair value changes of the asset as well as the fair value changes of the liability in profit or loss.
  • A group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis according to a documented risk management or investment strategy and information about that group is provided internally on that basis to the entity's key management personnel.
  • Under certain circumstances (IAS 39.11 A), a contract that contains at least one embedded derivative (hybrid or combined instrument) may be designated as at fair value through profit or loss.

Financial liabilities measured at amortized cost Normally, financial liabilities are measured at amortized cost, i.e. according to the effective interest method.21 Exceptions to this rule are, among others, financial liabilities at fair value through profit or loss (see previous) and financial guarantee contracts (IAS 39.47).

3.2.2 Gains and Losses and Technical Aspects

Loans and receivables, held-to-maturity investments, and most financial liabilities are measured at amortized cost, i.e. according to the effective interest method (IAS 39.9 and 39.46–39.47).22

Available-for-sale financial assets are measured at fair value. Changes in fair value are generally recognized in other comprehensive income and accumulated in a separate component of equity (fair value reserve). However, in the case of debt instruments of this category, interest is first calculated using the effective interest method and recognized in profit or loss. Only the change in the difference between amortized cost calculated according to the effective interest method and fair value is recognized in other comprehensive income. Impairment losses arising from available-for-sale financial assets are recognized in profit or loss. When the financial asset is derecognized, the cumulative gain or loss previously recognized in other comprehensive income is reclassified to profit or loss. Impairment losses also lead to the derecognition of amounts previously recognized in other comprehensive income (IAS 39.46, IAS 39.55b, IAS 1.7, and 1.95).23

Financial assets and financial liabilities held for trading or for which the fair value option has been exercised are measured at their fair values. Changes in fair value are recognized in profit or loss (IAS 39.46–39.47 and 39.55a).

3.2.3 Determining Fair Values After Recognition

For debt instruments, there is an irrefutable presumption that fair value can be measured reliably. By contrast, for equity instruments that do not have a quoted market price in an active market, there is a presumption which can be rebutted in certain cases that fair value can be measured reliably. If the presumption is rebutted in the case of equity instruments, they are measured at cost, less any impairment losses. There are also exceptions from fair value measurement for derivatives under certain circumstances (IAS 39.46, 39.66, and 39.AG80–39.AG81).

3.2.4 Impairment Losses and Reversals of Impairment Losses

Financial assets at fair value through profit or loss are not tested for impairment because their fair value changes are recognized in profit or loss. However, all other financial assets are subject to review for impairment (IAS 39.46). This means that it has to be assessed at the end of each reporting period whether there is any objective evidence of impairment (loss events) (IAS 39.58).

IAS 39 includes a list of examples of loss events that relate to financial difficulties of the debtor (e.g. it becoming probable that the borrower will enter bankruptcy) (IAS 39.59).

In the case of equity instruments (e.g. shares), a significant or prolonged decline in fair value below cost is also objective evidence of impairment (IAS 39.61). We believe that it is appropriate to interpret the terms “significant” and “prolonged” as follows:

• A decline is prolonged if the market price of equity instruments – which are quoted in an active market – remains below cost for more than nine months. This criterion of nine months has to be applied retrospectively from the end of the reporting period.
• A decline is significant if the market price of equity instruments is at least 20% below cost. This applies irrespective of the change in value in a certain period of time before or after the end of the reporting period.

It is important to note that IAS 39.61 uses cost as reference point and not the carrying amount as at the end of the previous reporting period.

Three categories of financial assets have to be distinguished with regard to the calculation and accounting treatment of impairment losses and reversals of impairment losses.

Financial assets carried at amortized cost (i.e. loans and receivables as well as held-to-maturity investments)24 The procedure is the same as for financial assets measured at amortized cost according to IFRS 9.25

Financial assets carried at cost If there is objective evidence that an equity instrument carried at cost instead of fair value (because its fair value cannot be reliably measured26) is impaired, the following amounts have to be compared (IAS 39.66):

• Carrying amount of the instrument.
• Present value of the estimated future cash flows discounted at the current market rate of return for a similar financial asset.

If present value is below the instrument's carrying amount, an impairment loss is recognized. In this category, impairment losses must not be reversed (IAS 39.66).

Available-for-sale financial assets If an equity instrument classified as “available for sale” is impaired for the first time, the following applies (IAS 39.67–39.68):

• The cumulative amount previously recognized in other comprehensive income (i.e. the fair value reserve) is derecognized.
• The asset's carrying amount is reduced to fair value.
• An impairment loss (being the difference between cost and fair value) is recognized in profit or loss.

Reversals of impairment losses for equity instruments classified as “available for sale” are recognized in other comprehensive income (IAS 39.69).

3.3 Hybrid Contracts

According to the old version of IAS 39 the separation rules that apply to hybrid contracts with financial liability hosts under IFRS 927 applied to both hybrid contracts with financial asset hosts and hybrid contracts with financial liability hosts.

3.4 Examples with Solutions

Example 16

Solution of Example 3 according to the “old” version of IAS 39

The situation is the same as in Example 3. With regard to version (b), the following additional information is available in respect of the fair value changes:

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01–04 (version a) and for the years 01–03 (version b). E still applies the “old” version of IAS 39. Assume that E classifies the shares as “available for sale” (IAS 39.9). With respect to impairment losses, E interprets the terms “significant” and “prolonged” (IAS 39.61) as described in Section 3.2.4.

Hints for solution

In particular Sections 3.2.1, 3.2.2, and 3.2.4.

Solution (a)

The shares are initially measured at fair value, which normally corresponds to the purchase price at that time. Since subsequent measurement of the shares is not at fair value through profit or loss (because the shares are classified as “available for sale”), transaction costs are capitalized (IAS 39.43).

The shares classified as available for sale are subsequently measured at fair value. Fair value changes are generally recognized in other comprehensive income (IAS 39.46 and 39.55b).

The decline in fair value to CU 75 until Dec 31, 02 is significant within the meaning of IAS 39.61 because CU 75 is below CU 80 (20% below cost of CU 100). Hence, the shares are impaired. This means that the carrying amount of the shares decreases from CU 110 to CU 75 and that the fair value reserve previously recognized with respect to the shares is derecognized. Moreover, the reduction from CU 100 (cost of the shares) to fair value of CU 75 is recognized in profit or loss as an impairment loss.

Since the decline to CU 75 in 02 was significant within the meaning of IAS 39.61, the further decrease from CU 75 to CU 70 is also significant, which means that it represents an impairment loss. That is because the decrease from CU 75 to CU 70 is a further decrease below the threshold of CU 80.

Reversals of impairment losses of equity instruments (e.g. shares) classified as “available for sale” must not be recognized in profit or loss (IAS 39.69). Consequently, the increase in the stock market price from CU 70 to CU 120 is recognized in OCI.

Solution (b)

The decrease from CU 100 to CU 97 is not significant (because it is not a decrease below the threshold of CU 80 – see version (a)). The criterion “prolonged” is not met, either because on Dec 31, 01, the stock market price is below cost since one month and not since more than nine months. Thus, there is no impairment loss, which means that the decrease is recognized in other comprehensive income.

The decrease in the stock market price to CU 90 does not meet the criterion “significant.” However, it is prolonged because on Dec 31, 02 the stock market price is below cost since it is more than nine months. Hence, the carrying amount of the shares is reduced from CU 97 to CU 90, the fair value reserve is derecognized, and the reduction from cost to fair value is recognized in profit or loss as an impairment loss.

The decrease in the stock market price to CU 85 does not meet the criterion “significant.” However, it meets the criterion “prolonged.” It is only relevant that the nine month criterion is met with regard to cost.

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1 The terms “financial instrument,” “financial asset,” “financial liability,” and “equity instrument” are defined in IAS 32.11 (see the chapter on IAS 32, Section 1 and Example 1).

2 See Sections 2.3.3 and 2.3.4.

3 Example 1 in Section 2.7.1 illustrates an accounting mismatch.

4 See Section 2.6.

5 See Section 2.3.1.

6 See Section 2.3.3.

7 See Section 2.3.4.

8 See the chapter on IAS 32, Section 3

9 See Section 2.3.4.

10 See Sections 2.3.3 and 2.3.4.

11 The boundaries of 80% and 125% apply when testing hedge effectiveness on a prospective, as well as on a retrospective basis (IAS 39.BC136–39.BC137).

12 The effective interest rate is calculated by applying the formula “IRR” in the English version of Excel to the payments shown below.

13 The effective interest rate is calculated by applying the formula “IRR” in the English version of Excel to the payments shown below.

14 In this example the exchange rates are presented as “1 unit of foreign currency F = x CNY” (e.g. 1 unit of F = 10 CNY).

15 For simplification purposes, differences between the spot exchange rate and the forward exchange rate are ignored in this example.

16 In this example the exchange rates are presented as “1 unit of foreign currency F = x CNY” (e.g. 1 unit of F = 10 CNY).

17 For simplification purposes, differences between the spot exchange rate and the forward exchange rate are ignored in this example.

18 The terms “financial instrument,” “financial asset,” “financial liability,” and “equity instrument” are defined in IAS 32.11 (see the chapter on IAS 32, Section 1 and Example 1).

19 See Section 2.3.1.

20 See Section 2.3.4.

21 See Section 2.3.5 with regard to the effective interest method.

22 See Section 2.3.5 with regard to the effective interest method.

23 Impairment losses and reversals of impairment losses from available-for-sale financial assets are discussed in Section 3.2.4 in more detail.

24 See Sections 3.2.1 and 3.2.2.

25 See Section 2.3.8.

26 See Section 3.2.3.

27 See Section 2.4.3.