Financial Instruments: Classification, Measurement, and
Disclosure
Introduction
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
Financial instruments are contracts that give rise to a financial asset of one
entity and a financial liability or equity instrument of another entity. Financial
instruments play a very important role in the modern economy as they are
used by companies and individuals to raise funding, invest surplus funds,
and manage financial risks. Due to their widespread use and importance, it is
essential that financial instruments are properly accounted for and disclosed
in the financial statements of entities.
This assignment discusses the different types of financial instruments, how
they should be classified, measured, and disclosed in the financial
statements according to relevant accounting standards. It is organized as
follows:
- Classification of financial instruments
- Measurement of financial instruments
- Impairment of financial instruments
- Hedge accounting
- Disclosure requirements
Classification of Financial Instruments
The first step in accounting for financial instruments is to classify them into
appropriate categories. The main classification used as per International
Financial Reporting Standard (IFRS) 9 Financial Instruments is:
- Amortized cost
- Fair value through other comprehensive income (FVOCI)
- Fair value through profit or loss (FVTPL)
Amortized Cost
A financial asset shall be measured at amortized cost if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Examples of financial assets that normally qualify for amortized cost
measurement include:
- Loans to customers
- Held-to-maturity investments
- Trade receivables
Fair Value through Other Comprehensive Income (FVOCI)
A debt instrument shall be measured at FVOCI if both of the following
conditions are met:
- The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling financial
assets.
- The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
For example, certain bonds that an entity intends to hold for medium term
and realizes its objective through both interest income and capital gains
would qualify for FVOCI measurement.
Fair Value through Profit or Loss (FVTPL)
All financial assets that do not meet the criteria for amortized cost or FVOCI
shall be measured at FVTPL. Some common examples include:
- Trading securities or assets held for sale in the near term
- Derivative financial assets that are not designated as hedging instruments
- Equity investments for which an entity has not elected to recognize fair
value changes through OCI
It is to be noted that an entity can also elect to designate a financial asset at
FVTPL even if the asset would otherwise meet the criteria for amortized cost
or FVOCI measurement. This is known as the fair value option and is normally
done to reduce an accounting mismatch.
Classification of Financial Liabilities
There are only two categories for classifying financial liabilities as per IFRS 9:
1. Amortized cost
2. Fair value through profit or loss (FVTPL)
Almost all financial liabilities fall under amortized cost category unless the
entity has elected the fair value option or the liability contains an embedded
derivative that must be separated. Examples of financial liabilities measured
at amortized cost are:
- Trade payables
- Bank loans
- Commercial papers
- Callable bonds
Derivatives embedded in financial liabilities are separated and measured at
FVTPL, unless they are closely related to the host contract. Contingent
consideration payables by an acquirer in a business combination are also
measured at FVTPL.
Measurement of Financial Instruments
Once classified, financial instruments are measured using various
measurement techniques depending on the category they fall under:
Amortized Cost Measurement
For financial assets and liabilities measured at amortized cost, the amount at
which they are initially recognized is their fair value plus or minus directly
attributable transaction costs. Subsequently, they are measured using the
effective interest method whereby interest income/expense are recognized
using the (adjusted) carrying amount and effective interest rates.
Examples:
- Loans are initially recognized at fair value including direct costs, and
subsequently interest is recognized using effective interest rate method.
- Trade payables are initially recognized at fair value and subsequently
carried at amortized cost using effective interest method.
Fair Value through Profit or Loss Measurement
Financial assets and liabilities classified at FVTPL are measured at their fair
values at each reporting date with changes in fair value recognized in profit
or loss.
Fair value is generally the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market
participants at the measurement date. A number of valuation techniques can
be used depending on availability of data including market comparables,
discounted cash flows, and Black-Scholes model for options/derivatives.
Examples:
- Quoted equity shares are measured using their market prices at reporting
date
- Unquoted investment funds are measured using their net asset values
- Derivatives are valued using option pricing or discounted cash flow models
Fair Value through Other Comprehensive Income Measurement
Debt instruments measured at FVOCI are initially recognized at fair value
plus transaction costs. Subsequently, they are measured at fair value with
interest income, impairment gains/losses, and foreign exchange gains/losses
recognized in profit or loss using effective interest method.
Other changes in fair value are recognized in other comprehensive income
and accumulated in a separate reserve rather than profit or loss. On
derecognition, the cumulative gain/loss previously reported in OCI is
reclassified from the FVOCI reserve to profit or loss.
For example, certain bonds held by an entity for both collecting cash flows
and selling are measured at fair value through OCI with interest income in
profit/loss and other fair value changes in OCI reserve.
Impairment of Financial Assets
IFRS 9 requires recognizing impairment allowances for expected credit losses
(ECL) on financial assets measured at amortized cost or FVOCI rather than
incurred losses. The general 3-stage model is:
Stage 1: 12-month ECL - financial assets that have not had a significant
increase in credit risk since initial recognition would have a loss allowance
measured at an amount equal to 12-month ECL.
Stage 2: Lifetime ECL - financial assets that have had a significant increase in
credit risk since initial recognition would have a loss allowance measured at
an amount equal to lifetime ECL.
Stage 3: Lifetime ECL (credit impaired financial assets) - financial assets that
are credit impaired would have a loss allowance measured at an amount
equal to lifetime ECL.
Lifetime ECL is the ECL that results from all possible default events over the
expected life of a financial instrument. Significant increase in credit risk is
assessed by comparing credit risk at reporting date versus initial recognition.
Simplified approaches are available for trade receivables and lease
receivables without significant financing component. ECL must be estimated
using reasonable and supportable past and forward-looking information.
Hedge Accounting
Hedge accounting allows an entity to offset the accounting effects of
changes in the fair values of hedging instruments with corresponding
changes in fair values or cash flows of hedged items/transactions. It aims to
recognize gains/losses arising from hedging activities in profit or loss in the
same period(s) as the hedged item/transaction affects profit or loss.
IFRS 9 includes three types of hedging relationships:
- Fair value hedge: Hedges exposure to changes in fair value of recognized
assets/liabilities or firm commitments.
- Cash flow hedge: Hedges exposure to variability in cash flows of recognized
assets/liabilities or forecast transactions.
- Hedges of a net investment in a foreign operation: Hedges foreign currency
risk arising from a net investment in a foreign operation.
At inception of a hedge, the entity formally designates the hedging
relationship and documents the risk management objectives and strategy.
The hedging relationship qualifies for hedge accounting if it meets hedge
effectiveness requirements. Hedging gains/losses are recognized as follows:
- Fair value hedges: Changes in fair value of hedging instrument and hedged
item offset in profit or loss.
- Cash flow hedges: Effective portion of changes in hedging instrument’s fair
value recognized in OCI. Ineffective portion in profit or loss. Amounts in OCI
reclassified to profit or loss when hedged item affects profit or loss.
- Net investment hedges: Effective portion of changes in hedging
instrument’s fair value recognized in OCI. Ineffective portion in profit or loss.
Amount in OCI reclassified to profit or loss on disposal of foreign operation.
Disclosure Requirements
IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value
Measurement mandate extensive disclosures related to financial instruments
in the financial statements. Some of the key disclosure requirements include:
- Significance of financial instruments for financial position and performance
- Information about balance sheet line items containing financial instruments
- Carrying amounts of financial instruments by measurement category
- Fair values of each class of financial asset and liability including judgments
made
- Nature and extent of risks arising from financial instruments and how they
are managed
Specific disclosures for items measured at fair value including fair value
hierarchy, valuation techniques used including significant unobservable
inputs, and sensitivity analysis. Extensive disclosures for items at amortized
cost including credit quality, aging, collateral and other credit enhancements.
Disclosures around hedge accounting including hedging strategy,
assessment of hedge effectiveness, and potential sources of hedge
ineffectiveness. Any prior period errors or changes in classification or
measurement are also required to be disclosed.
The level and extent of disclosures aim to provide users with a
comprehensive understanding of the significance of financial instruments for
the entity as well as associated risks. All relevant qualitative and quantitative
information is needed to comply with the disclosure requirements.
Conclusion
In conclusion, this report has discussed the various aspects of accounting
and reporting for financial instruments as per relevant accounting standards.
Financial instruments play a key role in modern business and economies.
Their proper classification, measurement and disclosure in financial
statements is of utmost importance to provide useful information to
stakeholders. While standards give broad guidelines, management needs to
exercise judgment in many areas. Overall compliance with IFRS requirements
ensures transparency and comparability regarding entity's different types of
financial instruments.
