2.2.1 The need for a contract

The terms ‘contract’ and ‘contractual’ are important to the definitions and refer to ‘an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law’. Such contracts may take a variety of forms and need not be in writing. [IAS 32.13].

The Interpretations Committee examined the question of what constitutes a contract in the context of gaming transactions. This is because, in some jurisdictions, a wager does not give rise to a contract that is enforceable under local contract law. The Interpretations Committee staff noted that a gaming transaction constitutes an agreement between two or more parties that has clear economic consequences for both. Furthermore, in most countries, gambling is heavily regulated and only parties acting within a regulated framework are licensed to operate gaming institutions, so that such entities cannot realistically fail to pay out on a good wager and therefore the gaming institution will have little or no discretion as to whether it pays out on the bet. Consequently, the Interpretations Committee agreed that a wager should be treated as a contract.¹

Whilst this seems an entirely plausible analysis in context, it is a little difficult to reconcile with the conclusions of the Interpretations Committee and the IASB concerning the existence (or otherwise) of a contractual obligation to make payments on certain preference shares and similar securities. In those cases, terms of an instrument that effectively force the issuer to transfer cash or other financial assets to the holder although not legally required to do so (often referred to as ‘economic compulsion’), are not taken into account (see Chapter 47 at 4.5.6).

A contractual right or contractual obligation to receive, deliver or exchange financial instruments is itself a financial instrument. A chain of contractual rights or contractual obligations meets the definition of a financial instrument if it will ultimately lead to the receipt or payment of cash or to the acquisition or issue of an equity instrument. [IAS 32.AG7].

Assets and liabilities relating to non-contractual arrangements that arise as a result of statutory requirements imposed by governments, such as income taxes or levies are not financial liabilities or financial assets because they are not contractual. [IAS 32.AG12]. Accounting for income taxes is dealt with in more detail in another standard, IAS 12 – Income Taxes (see Chapter 33), while levies are covered by IFRIC 21 – Levies (see Chapter 26 at 6.8).

Similarly, constructive obligations as defined in IAS 37 – Provisions, Contingent Liabilities and Contingent Assets (see Chapter 26 at 3.1.1) do not arise from contracts and are therefore not financial liabilities. [IAS 32.AG12].

2.2.2 Simple financial instruments

Currency (or cash) is a financial asset because it represents the medium of exchange and is therefore the basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability. [IAS 32.AG3].

The following common financial instruments give rise to financial assets representing a contractual right to receive cash in the future and corresponding financial liabilities representing a contractual obligation to deliver cash in the future:

1. trade accounts receivable and payable;
2. notes receivable and payable;
3. loans receivable and payable; and
4. bonds receivable and payable.

In each case, one party's contractual right to receive (or obligation to pay) cash is matched by the other party's corresponding obligation to pay (or right to receive). [IAS 32.AG4].

Another type of financial instrument is one for which the economic benefit to be received or given up is a financial asset other than cash. For example, a note payable in government bonds gives the holder the contractual right to receive, and the issuer the contractual obligation to deliver, government bonds, not cash. The bonds are financial assets because they represent obligations of the issuing government to pay cash. The note is, therefore, a financial asset of the note holder and a financial liability of the note issuer. [IAS 32.AG5].

Perpetual debt instruments (such as perpetual bonds, debentures and capital notes) normally provide the holder with the contractual right to receive payments on account of interest at fixed dates extending indefinitely, either with no right to receive a return of principal or a right to a return of principal under terms that make it very unlikely or very far in the future. For example, an entity may issue a financial instrument requiring it to make annual payments in perpetuity equal to a stated interest rate of 8% applied to a stated par or principal amount of $1,000. Assuming 8% is the market rate of interest for the instrument when issued, the issuer assumes a contractual obligation to make a stream of future interest payments having a net present value (or fair value) of $1,000 on initial recognition. The holder and issuer of the instrument have a financial asset and a financial liability, respectively. [IAS 32.AG6].

2.2.3 Contingent rights and obligations

The ability to exercise a contractual right or the requirement to satisfy a contractual obligation may be absolute (as in the examples at 2.2.2 above), or it may be contingent on the occurrence of a future event. A contingent right or obligation, e.g. to receive or deliver cash, meets the definition of a financial asset or a financial liability. [IAS 32.AG8].

For example, a financial guarantee is a contractual right of the lender to receive cash from the guarantor, and a corresponding contractual obligation of the guarantor to pay the lender, if the borrower defaults. The contractual right and obligation exist because of a past transaction or event (the assumption of the guarantee), even though the lender's ability to exercise its right and the requirement for the guarantor to perform under its obligation are both contingent on a future act of default by the borrower. [IAS 32.AG8].

However, even though contingent rights and obligations can meet the definition of a financial instrument, they are not always recognised in the financial statements as such. For example, contingent rights and obligations may be insurance contracts within the scope of IFRS 4 – Insurance Contracts (see Chapter 55 at 3.3) or IFRS 17 – Insurance Contracts (see Chapter 56 at 3.3) or may otherwise be excluded from the scope of IFRS 9 (see 3 below). [IAS 32.AG8].

2.2.4 Leases

A lease typically creates an entitlement of the lessor to receive, and an obligation of the lessee to make, a stream of payments that are substantially the same as blended payments of principal and interest under a loan agreement. The lessor accounts for its investment in the amount receivable under a finance lease rather than the underlying asset itself. Accordingly, a lessor regards a finance lease as a financial instrument. In contrast, a lessor does not recognise its entitlement to receive lease payments under an operating lease. The lessor continues to account for the underlying asset itself rather than any amount receivable in the future under the contract. Accordingly, a lessor does not regard an operating lease as a financial instrument, except as regards individual payments currently due and payable by the lessee. [IAS 32.AG9].

IFRS 16 – Leases – requires a lessee to recognise a lease liability (with corresponding right-of-use asset) at the commencement date at the present value of the lease payments that are not paid at that date. [IFRS 16.22, 26]. Accordingly, under IFRS 16, a lessee regards a lease as giving rise to a financial liability. IFRS 16 was effective for periods beginning on or after 1 January 2019. Nevertheless, as discussed in more detail at 3.2 below, financial instruments arising from leases are not always accounted for under IFRS 9.

2.2.5 Non-financial assets and liabilities and contracts thereon

Physical assets (such as inventories, property, plant and equipment), right-of-use assets and intangible assets (such as patents and trademarks) are not financial assets. Control of such physical assets, right-of-use assets and intangible assets creates an opportunity to generate an inflow of cash or another financial asset, but it does not give rise to a present right to receive cash or another financial asset. [IAS 32.AG10]. For example, whilst gold bullion is highly liquid (and perhaps more liquid than many financial instruments), it gives no contractual right to receive cash or another financial asset, and so is therefore a commodity, not a financial asset. [IFRS 9.B.1].

Assets such as prepaid expenses, for which the future economic benefit is the receipt of goods or services rather than the right to receive cash or another financial asset, are not financial assets. Similarly, items such as deferred revenue and most warranty obligations are not financial liabilities because the outflow of economic benefits associated with them is the delivery of goods and services rather than a contractual obligation to pay cash or another financial asset. [IAS 32.AG11].

Contracts to buy or sell non-financial items do not meet the definition of a financial instrument because the contractual right of one party to receive a non-financial asset or service and the corresponding obligation of the other party do not establish a present right or obligation of either party to receive, deliver or exchange a financial asset. For example, contracts that provide for settlement only by the receipt or delivery of a non-financial item (e.g. an option, future or forward contract on silver and many similar commodity contracts) are not financial instruments. However, as set out at 4 below, certain contracts to buy or sell non-financial items that can be settled net or by exchanging financial instruments, or in which the non-financial item is readily convertible into cash are included within the scope of IAS 32 and IFRS 9, essentially because they exhibit similar characteristics to financial instruments. [IAS 32.AG20].

In some industries, e.g. brewing and heating gas, entities distribute their products in returnable containers. Often, these entities will collect a cash deposit for each container delivered which they have an obligation to refund on return of the container. The Interpretations Committee found itself in November 2007 addressing the classification of these obligations, in particular whether they met the definition of a financial instrument.² It is easy to jump to the conclusion (as the Interpretations Committee did initially)³ that such an arrangement represents a contract to exchange a non-financial item (the container) for cash and is therefore outside the scope of IFRS 9. However, the Interpretations Committee recognised that this analysis holds true only if, in accounting terms, the container ceases to be an asset of the entity when the sale is made, i.e. it is derecognised. If the container is not derecognised, the entity cannot be regarded as receiving the non-financial asset because the accounting treatment regards the entity as retaining the asset. Instead, the deposit simply represents an obligation to transfer cash and is therefore a financial liability.⁴

Some contracts are commodity-linked, but do not involve settlement through the physical receipt or delivery of a commodity. Instead they specify settlement through cash payments that are determined according to a formula in the contract. For example, the principal amount of a bond may be calculated by applying the market price of oil prevailing at the maturity of the bond to a fixed quantity of oil, but is settled only in cash. Such a contract constitutes a financial instrument. [IAS 32.AG22].

Financial instruments also include contracts that give rise to a non-financial asset or non-financial liability in addition to a financial asset or financial liability. Such arrangements often give one party an option to exchange a financial asset for a non-financial asset. For example, an oil-linked bond may give the holder the right to receive a stream of fixed periodic interest payments and a fixed amount of cash on maturity, with the option to exchange the principal amount for a fixed quantity of oil. The desirability of exercising this option will vary over time depending on the fair value of oil relative to the exchange ratio of cash for oil (the exchange price) inherent in the bond, but the intentions of the bondholder do not affect the substance of the component assets. The financial asset of the holder and the financial liability of the issuer make the bond a financial instrument, regardless of the other types of assets and liabilities also created. [IAS 32.AG23].

2.2.6 Payments for goods and services

Where payment on a contract involving the receipt or delivery of physical assets is deferred past the date of transfer of the asset, a financial instrument arises at the date of delivery. In other words, the sale or purchase of goods on trade credit gives rise to a financial asset (a trade receivable) and a financial liability (a trade payable) when the goods are transferred. [IAS 32.AG21]. This is the case even if an invoice is not issued at the time of delivery.

IAS 32 does not explain whether the same logic should apply to the delivery of other, less tangible, non-financial items, e.g. construction or other services. IFRIC 12 – Service Concession Arrangements – provides guidance on how operators of service concessions over public infrastructure assets should account for these arrangements. Where an operator obtains an unconditional contractual right to receive cash from the grantor in exchange for construction or other services, the accrued revenue represents a financial asset. This is the case even if payment is not due immediately and even if it is contingent on the operator ensuring that the underlying infrastructure meets specified quality or efficiency requirements (see Chapter 25 at 4.2). [IFRIC 12.16].

2.2.7 Equity instruments

Equity instruments include non-puttable ordinary shares, some puttable and similar instruments, some types of preference shares and warrants or written call options that allow the holder to subscribe for or purchase a fixed number of non-puttable ordinary shares in the issuing entity, in exchange for a fixed amount of cash or another financial asset. [IAS 32.AG13]. The definition of equity instruments is considered in more detail in Chapter 47 at 3.

2.2.8 Derivative financial instruments

In addition to primary instruments such as receivables, payables and equity instruments, financial instruments also include derivatives such as financial options, futures and forwards, interest rate swaps and currency swaps. Derivatives normally transfer one or more of the financial risks inherent in an underlying primary instrument between the contracting parties without any need to transfer the underlying instruments themselves (either at inception of the contract or even, where cash settled, on termination). [IAS 32.AG15, AG16].

There are important accounting consequences for financial instruments that are considered to be derivatives, and the defining characteristics of derivatives are covered in more detail in Chapter 46 at 2.

As noted at 2.2.5 above, certain derivative contracts on non-financial items are included within the scope of IAS 32 and IFRS 9, even though they are not, strictly, financial instruments as defined. These contracts are covered in more detail at 4 below.

On inception, the terms of a derivative financial instrument generally give one party a contractual right (or obligation) to exchange financial assets or financial liabilities with another party under conditions that are potentially favourable (or unfavourable). Some instruments embody both a right and an obligation to make an exchange and, as prices in financial markets change, those terms may become either favourable or unfavourable. [IAS 32.AG16].

A put or call option to exchange financial assets or financial liabilities gives the holder a right to obtain potential future economic benefits associated with changes in the fair value of the underlying instrument. Conversely, the writer of an option assumes an obligation to forgo such potential future economic benefits or bear potential losses associated with the underlying instrument. The contractual right (or obligation) of the holder (or writer) meets the definition of a financial asset (or liability). The financial instrument underlying an option contract may be any financial asset, including shares in other entities and interest-bearing instruments. An option may require the writer to issue a debt instrument, rather than transfer a financial asset, but the instrument underlying the option would constitute a financial asset of the holder if the option were exercised. The option-holder's right (or writer's obligation) to exchange the financial asset under potentially favourable (or unfavourable) conditions is distinct from the underlying financial asset to be exchanged upon exercise of the option. The nature of the holder's right and of the writer's obligation (which characterises such contracts as a financial instrument) are not affected by the likelihood that the option will be exercised. [IAS 32.AG17].

Another common type of derivative is a forward contract. For example, consider a contract in which two parties (the seller and the purchaser) promise in six months' time to exchange $1,000 cash (the purchaser will pay cash) for $1,000 face amount of fixed rate government bonds (the seller will deliver the bonds). During those six months, both parties have a contractual right and a contractual obligation to exchange financial instruments (cash in exchange for bonds). If the market price of the government bonds rises above $1,000, the conditions will be favourable to the purchaser and unfavourable to the seller, and vice versa if the market price falls below $1,000. The purchaser has a contractual right (a financial asset) similar to the right under a call option held and a contractual obligation (a financial liability) similar to the obligation under a put option written. The seller has a contractual right (a financial asset) similar to the right under a put option held and a contractual obligation (a financial liability) similar to the obligation under a call option written. As with options, these contractual rights and obligations constitute financial assets and financial liabilities separate and distinct from the underlying financial instruments (the bonds and cash to be exchanged). Both parties to a forward contract have an obligation to perform at the agreed time, whereas performance under an option contract occurs only if and when the holder of the option chooses to exercise it. [IAS 32.AG18].

Many other types of derivative also embody a right or obligation to make a future exchange, including interest rate and currency swaps, interest rate caps, collars and floors, loan commitments, note issuance facilities and letters of credit. An interest rate swap contract may be viewed as a variation of a forward contract in which the parties agree to make a series of future exchanges of cash amounts, one amount calculated with reference to a floating interest rate and the other with reference to a fixed interest rate. Futures contracts are another variation of forward contracts, differing primarily in that the contracts are standardised and traded on an exchange. [IAS 32.AG19].

2.2.9 Dividends payable

As part of its project to provide authoritative accounting guidance for non-cash distributions (see Chapter 8 at 2.4.2), the Interpretations Committee found itself debating the seemingly simple question of how to account for a declared but unpaid cash dividend (or, more accurately, which standard applies to such a liability). Although there are clear indicators within IFRS that an obligation to pay a cash dividend is a financial liability, [IAS 32.AG13], the Interpretations Committee originally proposed that IAS 37 should be applied to all dividend obligations,⁵ a decision that appeared to have been made more on the grounds of expediency rather than using any robust technical analysis. By the time IFRIC 17 – Distributions of Non-cash Assets to Owners – was published in November 2008, the Interpretations Committee had modified its position slightly. Aside from those standards dealing with the measurement of liabilities that are clearly not relevant (e.g. IAS 12), they considered that others, except IAS 37 or IFRS 9, were simply not applicable because they addressed liabilities arising only from exchange transactions, whereas IFRIC 17 was developed to deal with non-reciprocal distributions. [IFRIC 17.BC22]. Finally, IFRIC 17 simply specifies the accounting treatment to be applied to distributions without linking to any individual standard. [IFRIC 17.BC27]. The Interpretations Committee concluded that it was not appropriate to conclude that all dividends payable are to be regarded as financial liabilities.

3.3.1 Weather derivatives

Contracts which require a payment based on climatic variables (often referred to as ‘weather derivatives’) or on geological or other physical variables are within the scope of IFRS 9 unless they fall within the scope of IFRS 4 or IFRS 17. [IFRS 9.B2.1]. Generic or standardised contracts will rarely meet the definition of insurance contracts because the variable is unlikely to be specific to either party to the contract. [IFRS 4.B18(l), B19(g), IFRS 17.B26(k), B27(g)]. This is illustrated in the following example.

3.3.2 Contracts with discretionary participation features

IFRS 4 and IFRS 17 are clear that investment contracts that have the legal form of an insurance contract but do not expose the insurer to significant insurance risk (see Chapters 55 and 56) are financial instruments and not insurance contracts. [IFRS 4.B19(a), IFRS 17.B27(a)]. Investment contracts (normally taking the form of life insurance policies) which contain what are called discretionary participation features, essentially rights of the holder to receive additional benefits whose amount or timing is, contractually, at the discretion of the issuer, are accounted for under IFRS 4. [IFRS 4 Appendix A]. Accordingly, IFRS 9 and the parts of IAS 32 dealing with the distinction between financial liabilities and equity instruments (see Chapter 47 at 4) do not apply to such contracts, although the disclosure requirements of IFRS 7 do apply. [IAS 32.4(e), IFRS 9.2.1(e), IFRS 4.2(b), IFRS 7.3]. When IFRS 17 is applied, such contracts would fall within its scope if (and only if) the entity also issues insurance contracts as the IASB believes that applying IFRS 17 to these contracts in these circumstances would provide more relevant information about the contracts than would be provided by applying other standards. [IFRS 17.3(c), BC65(a)]. In rare cases where an entity issues contracts with a discretionary participation feature but does not issue any insurance contracts, those contracts would fall within the scope of IAS 32 and IFRS 9.

3.3.3 Separating financial instrument components including embedded derivatives from insurance contracts

IFRS 9 applies to derivatives that are embedded in insurance contracts or contracts containing discretionary participation features (see 3.3.2 above) if the derivative itself is not within the scope of IFRS 4. [IFRS 9.2.1(e)]. When IFRS 17 is applied, entities will use IFRS 9 to determine whether a contract contains an embedded derivative to be separated and apply IFRS 9 to those components that are separated. [IFRS 17.11(a)]. IFRS 7 applies to all embedded derivatives that are separately accounted for. [IFRS 7.3(d)].

In addition, IFRS 17 requires an entity to separate the investment component (the amount an insurance contract requires the entity to repay to the policyholder even if an insured event does not occur [IFRS 17.BC108]) from a host insurance contract if the component is ‘distinct’ (see Chapter 56 at 11.2). The separated component is accounted for in accordance with IFRS 9. [IFRS 17.11(b)].

3.4.1 Definition of a financial guarantee contract

A financial guarantee contract is defined as 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 4 Appendix A, IFRS 9 Appendix A].

3.4.2 Issuers of financial guarantee contracts

In general, issuers of financial guarantees contracts should apply IAS 32, IFRS 9 and IFRS 7 to those contracts even though they meet the definition of an insurance contract in IFRS 4 (or IFRS 17) if the risk transferred is significant. [IFRS 9.B2.5(a)]. However, if an entity has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply either IFRS 9 or IFRS 4 (see Chapter 55 at 2.2.3.D) or IFRS 17 when applicable (see Chapter 56 at 2.3.1.E). That election may be made contract by contract, but the election for each contract is irrevocable. [IAS 32.4(d), IFRS 4.4(d), IFRS 7.3(d), IFRS 9.2.1(e), IFRS 17.7(e)]. This concession does not extend to contracts that are similar to financial guarantee contracts but are actually derivative financial instruments (see 3.4.1.A above).

The IASB was concerned that entities other than credit insurers could elect to apply IFRS 4 to financial guarantee contracts and consequently (if their accounting policies permitted) recognise no liability on inception. Consequently, it imposed the restrictions outlined in the previous paragraph. [IFRS 9.BCZ2.12]. The application guidance contains further information on these restrictions where it is explained that assertions that an issuer regards contracts as insurance contracts are typically found throughout the issuer's communications with customers and regulators, contracts, business documentation as well as in their financial statements. Furthermore, insurance contracts are often subject to accounting requirements that are distinct from the requirements for other types of transaction, such as contracts issued by banks or commercial companies. In such cases, an issuer's financial statements would typically include a statement that the issuer had used those accounting requirements, i.e. ones normally applied to insurance contracts. [IFRS 9.B2.6]. Nevertheless, other companies do consider it appropriate to apply IFRS 4 rather than IFRS 9 to these contracts. Rolls Royce disclosed the following accounting policy in respect of guarantees that it provides.

Accounting for the revenue associated with financial guarantee contracts issued in connection with the sale of goods is dealt with under IFRS 15 – Revenue from Contracts with Customers (see Chapters 27 to 32). [IFRS 9.B2.5(c)].

3.4.3 Holders of financial guarantee contracts

As discussed in Chapter 51 at 5.8.1, certain financial guarantee contracts held will be accounted for as an integral component of the guaranteed debt instrument. Financial guarantee contracts held that are accounted for separately are not within the scope of IFRS 9 because they are insurance contracts (see 3.3 above). [IFRS 9.2.1(e)]. However, IFRS 4 does not apply to insurance contracts that an entity holds (other than reinsurance contracts) either. [IFRS 4.4(f)]. Accordingly, as explained in the guidance on implementing IFRS 4, the holder of a financial guarantee contract will need to develop its accounting policy in accordance with the ‘hierarchy’ in IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors. The IAS 8 hierarchy specifies criteria to use if no IFRS applies specifically (see Chapter 3 at 4). [IFRS 4.IG2 Example 1.11, IFRS 17.BC66].

In selecting their policy, entities may initially look to the requirements of IAS 37 dealing with contingent assets (see Chapter 26 at 3.2.2) or reimbursement assets (see Chapter 51 at 5.8.1.B), at least as far as recoveries under the contract are concerned. In certain situations it may also be possible for the holder of a financial guarantee contract to account for it as an asset at fair value through profit or loss. This might be considered appropriate if it was acquired subsequent to the initial recognition of a guaranteed asset that had itself been classified as at fair value through profit or loss.

It should, however, be noted that IFRS 9 has been amended by IFRS 17. The scope exclusion for financial guarantee contracts will change from those contracts that meet the definition of insurance contracts to those that are in the scope of IFRS 17. As the accounting by the holder of the guarantee is not in the scope of IFRS 17, it will, by default, be in the scope of IFRS 9. This is discussed in more detail in Chapter 51 at 5.8.1.B.

3.4.4 Financial guarantee contracts between entities under common control

There is no exemption from the measurement requirements of IFRS 9 for guarantees issued between parents and their subsidiaries, between entities under common control nor by a parent or subsidiary on behalf of a subsidiary or a parent (unlike an exemption under US GAAP). [IFRS 9.BCZ2.14].

Therefore, for example, where a parent guarantees the borrowings of a subsidiary, the guarantee should be accounted for as a standalone instrument in the parent's separate financial statements. However, for the purposes of the parent's consolidated financial statements, such guarantees are normally considered an integral part of the terms of the borrowing (see Chapter 47 at 4.8) and therefore should not be accounted for independently of the borrowing.

3.6.1 Equity instruments issued

Financial instruments (including options and warrants) that are issued by the reporting entity and meet the definition of equity instruments in IAS 32 (see 2.1 above and Chapter 47 at 3 and 4) are outside the scope of IFRS 9. [IFRS 9.2.1(d)].

In principle, IFRS 7 applies to issued equity instruments except for those that are derivatives based on interests in subsidiaries, associates or joint ventures (see 3.1 above). [IFRS 7.3(a)]. However, this is of largely academic interest because IFRS 7 specifies no disclosure requirements for issued equity instruments.

In fact, the scope of IFRS 7 for these types of instrument is even more curious. Firstly, it is explained that derivatives over subsidiaries, associates and joint ventures that are equity instruments from the point of view of the issuer are excluded from the scope of IFRS 7 because equity instruments are not remeasured and hence do not expose the issuer to statement of financial position and income statement risk. Also, the disclosures about the significance of financial instruments for financial position and performance are not considered relevant for equity instruments. [IFRS 7.BC8]. Given the reasons quoted, it is not entirely clear why the IASB did not exclude all instruments meeting the definition of equity in IAS 32 from the scope of IFRS 7, e.g. non-puttable ordinary shares issued by the reporting entity. Secondly, it is very difficult to see how a derivative over a reporting entity's associate or joint venture could ever meet the definition of equity from the perspective of the reporting entity.

3.6.2 Equity instruments held

From the point of view of the holder, equity instruments are within the scope of IFRS 7 and IFRS 9 (unless they meet the exception at 3.1 above). [IFRS 9.2.1(d)].

3.7.1 Contingent consideration in a business combination

3.7.2 Contracts between an acquirer and a vendor in a business combination

IFRS 9 does not apply to forward contracts between an acquirer and a selling shareholder to buy or sell an acquiree that will result in a business combination at a future acquisition date. In order to qualify for this scope exclusion, the term of the forward contract should not exceed a reasonable period normally necessary to obtain any required approvals and to complete the transaction, for example to accommodate the completion of necessary regulatory and legal processes. [IFRS 9.2.1(f), BCZ2.39].

It applies only when completion of the business combination is not dependent on further actions of either party. Option contracts allow one party to control the occurrence or non-occurrence of future events depending on whether the option is exercised. Consequently, option contracts that on exercise will result in the reporting entity obtaining control of another entity are within the scope of IFRS 9, whether or not they are currently exercisable. [IFRS 9.BCZ2.40, BCZ2.41].

It was suggested that ‘in-substance’ or ‘synthetic’ forward contracts, e.g. the combination of a written put and purchased call where the strike prices, exercise dates and notional amounts are equal, or a deeply in- or out-of-the-money option, should be excluded from the scope of IFRS 9. However, the IASB staff did not agree with the notion that synthetic forward contracts (which do provide optionality to one or both parties) are substantially identical to forward contracts (which commit both parties). The IASB staff accepted that in normal financial instrument transactions, the economics of a synthetic forward will be favourable to one party to the contract and should therefore result in its exercise, but a similar assumption does not necessarily hold true in business combination transactions because one party may choose not to exercise the option due to other factors. Therefore, it is not possible to assert that the contracts will always result in a business combination.⁸

The acquisition of an interest in an associate represents the acquisition of a financial instrument, not an acquisition of a business. Therefore the scope exclusion should not be applied by analogy to contracts to acquire investments in associates and similar transactions. [IFRS 9.BCZ2.42].

Another related issue is the treatment of contracts, whether options or forwards, to purchase an entity that owns a single asset such as a ship or building which does not constitute a business. The reason a contract for a business combination is normally considered to be a financial instrument seems to be because it is a contract to purchase equity instruments. Consequently, a contract to purchase all of the shares in a single asset company would also meet the definition of a financial instrument, yet on the face of it such a contract would not be excluded from the scope of IFRS 9 if the asset did not represent a business. The IASB staff disagreed with this analysis and argued that such a contract should be analysed as a contract to purchase the underlying asset which would normally be outside the scope of IFRS 9.⁹ Although forward contracts between an acquirer and a vendor in a business combination are scoped out of IFRS 9 and hence are not accounted for as derivatives, they are still within the scope of IFRS 7.

4.2.1 Net settlement of similar contracts

If the terms of a contract do not explicitly provide for net settlement but an entity has a practice of settling similar contracts net, that contract should be considered as capable of being settled net (see 4.1 above). Net settlement could be achieved either by entering into offsetting contracts with the original counterparty or by selling the contract before its maturity. In these circumstances the contract cannot be considered a normal sale or purchase and is accounted for in accordance with IFRS 9 (see 4.1 above). [IAS 32.9, IFRS 9.2.4, BCZ2.18].

The standard contains no further guidance on what degree of past practice would be necessary to prevent an entity from treating similar contracts as own use. We do not believe that any net settlement automatically taints an entity's ability to apply the own use exception, for example where an entity is required to close out a number of contracts as a result of an exceptional disruption arising from external events at a production facility. However, judgement will always need to be applied based on the facts and circumstances of each individual case.

Read literally, the reference to ‘similar contracts’ could be particularly troublesome. For example, it is common for entities in, say, the energy sector to have a trading arm that is managed completely separately from their other operations. These trading operations commonly trade in contracts on non-financial assets, the terms of which are similar, if not identical, to those used by the entity's other operations for the purpose of physical supply. Accordingly, the standard might suggest that the normal purchase or sale exemption is unavailable to any entity that has a trading operation. However, we believe that a more appropriate interpretation is that contracts should be ‘similar’ as to their purpose within the business (e.g. for trading or for physical supply) not just as to their contractual terms.

4.2.2 Commodity broker-traders and similar entities

IFRS 9 contains no further guidance on what degree of net settlement (or trading) is necessary to make the normal sale or purchase exemption inapplicable, but in many cases it will be reasonably clear. For example, in our view, the presumption must be that contracts entered into by a commodity broker-trader that measures its inventories at fair value less costs to sell in accordance with IAS 2 – Inventories (see Chapter 22 at 2) falls within the scope of IFRS 9. However, there will be situations that are much less clear-cut and the application of judgement will be necessary. Factors to consider in making this assessment might include:

• how the entity manages the business and intends to profit from the contract;
• whether value is added by linking parties which are normal buyers and sellers in the value chain;
• whether the entity takes price risk;
• how the contract is settled; and
• the entity's customer base.

Again the reference in the standard to ‘similar contracts’ in this context may be troublesome for certain entities. However, as noted at 4.2.1 above, we believe contracts should be ‘similar’ as to their purpose within the business (e.g. for trading or for physical supply) not just as to their contractual terms.

4.2.3 Written options that can be settled net

The IASB does not believe that a written option to buy or sell a non-financial item that can be settled net can be regarded as being for the purpose of receipt or delivery in accordance with the entity's expected sale or usage requirements. Essentially, this is because the entity cannot control whether or not the purchase or sale will take place. Accordingly, IAS 32, IFRS 7 and IFRS 9 apply to written options that can be settled net according to the terms of the contract or where the underlying non-financial item is readily convertible to cash (see (a) and (d) at 4.1 above). [IAS 32.10, IFRS 9.2.7, BCZ2.18].

4.2.4 Electricity and similar ‘end-user’ contracts

There have been problems in determining whether or not IAS 32, IFRS 7 and IFRS 9 apply to contracts to sell non-financial items (for example electricity or natural gas) to ‘end-users’ such as retail customers. The non-financial items will often be considered readily convertible to cash (see 4.1 above), at least by the supplier. Accordingly, contracts to supply such items might be considered contracts that can be settled net.

Furthermore, end-user contracts often enable the customer to purchase as much of the non-financial item as needed at a given price to satisfy its usage requirements, i.e. the supplier does not have the contractual right to control whether or not the sale will take place. This might suggest that, from the perspective of the supplier, the contract is a written option with the consequence that it could not regard it as meeting the normal sale and purchase exemption (see 4.2.3 above).

However, many argued that this was not necessarily the case, particularly in the following circumstances:

• the non-financial item is an essential item for the customer;
• the customer does not have access to a market where the non-financial item can be resold;
• the non-financial item is not easily stored in any significant amounts by the customer; and
• the supplier is the sole provider of the non-financial item for a certain period of time.

In circumstances such as these, the apparent optionality within the contract is not exercisable by the retail customer in any economic sense. The customer will purchase volumes required whether the terms in the contract are advantageous or not and would not have the practical ability to sell any excess amounts purchased. Such a contract can have both a positive value and a negative value for the supplier when compared with market conditions and therefore fails to exhibit one of the key characteristics of an option, i.e. that it has only a positive value for the holder (the customer) and only a negative value for the writer (the supplier). In many respects the positive value stems from an intangible, rather than financial, aspect of the contract, being the likelihood that the customer will exercise the option. Accordingly, it was often argued that such contracts should not be considered written options (and therefore not within the scope of IFRS 9).

Even if contracts such as these are considered to be within the scope of IFRS 9, it is common for the supplier to have the ability to increase the price charged at relatively short notice. Also, the customer may be able to cancel the contract without penalty and switch to another supplier. Features such as these are likely to reduce any fair value that the contract can have.

Only a small number of energy suppliers appeared to regard these contracts as falling within the scope of IFRS 9. The Interpretations Committee noted that the guidance already explains what constitutes a written option, essentially confirming that in this context a written option arises where a supplier does not have the contractual right to control whether or not a sale will take place.¹³

The Interpretations Committee also noted that ‘in many situations these contracts are not capable of net cash settlement’, and therefore would not be within the scope of IFRS 9. No detailed explanation was provided of why the ability of the supplier to readily realise the non-financial item for cash does not enable it to settle the contract net (as that term is used in IFRS 9).¹⁴ However, we understand the reason underlying the comment to be the inability of the counterparty to realise the non-financial item (and hence the contract) for cash. This establishes a useful principle that may be applied in similar situations, i.e. a contract is not capable of net settlement if the contract is an option and the option holder cannot readily realise the non-financial item for cash.

4.2.5 Other contracts containing volume flexibility

It is not uncommon for other sales contracts, such as those with large industrial customers, to contain volume flexibility features. For example, a supplier might enter into a contract requiring it to deliver, say, 100,000 units at a given price as well as giving the counterparty the option to purchase a further 20,000 units at the same price. The customer might well have access to markets for the non-financial item and, following the guidance of the Interpretations Committee, the supplier might consider such a contract to be within the scope of IFRS 9 as it contains a written option.

However, the supplier could split the contract into two separate components for accounting purposes: a forward contract to supply 100,000 units (which may qualify as a normal sale) and a written option to supply 20,000 units (which would not). Arguments put forward include:

• the parties could easily have entered into two separate contracts, a forward contract and a written option; and
• it is appropriate to analogise to the requirements for embedded derivatives and separate a written option from the normal forward sale or purchase contract because it is not closely related (see Chapter 46 at 5).

The Interpretations Committee was asked to consider the appropriate treatment of such contracts but in spite of noting significant diversity in practice the issue has not been addressed. In our view, entities may apply either of these interpretations as an accounting policy choice.

4.2.6 Fair value option

Own use contracts are accounted for as normal sales or purchase contracts (i.e. executory contracts), with the idea that any fair value change of the contract is not relevant given that the contract is used for the entity's own use. However, participants in several industries often enter into similar contracts both for own use and for trading purposes and manage all the contracts together with derivatives on a fair value basis (so as to manage the fair value risk to close to nil). In such a situation, own use accounting leads to an accounting mismatch, as the fair value change of the derivatives and the trading positions cannot be offset against fair value changes of the own use contracts.

To eliminate the accounting mismatch, an entity could apply hedge accounting by designating own use contracts as hedged items in a fair value hedge relationship. However, hedge accounting in these circumstances is administratively burdensome and often produces less meaningful results than fair value accounting. Furthermore, entities enter into large volumes of commodity contracts and, within the large volume of contracts, some positions may naturally offset each other. An entity would therefore typically hedge on a net basis. [IFRS 9.BCZ2.24].

Alternatively, IFRS 9 provides a ‘fair value option’ for own use contracts. At inception of a contract, an entity may make an irrevocable designation to measure an own use contract at fair value through profit or loss in spite of it being entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the entity's expected purchase, sale or usage requirement. However, such designation is only allowed if it eliminates or significantly reduces an accounting mismatch that would otherwise arise from not recognising that contract because it is excluded from the scope of IFRS 9. [IFRS 9.2.5].

On transition to IFRS 9, entities can apply the fair value option on an ‘all-or-nothing’ basis for similar types of (already existing) own use contracts (see Chapter 53 at 11.2). [IFRS 9.7.2.14A].