IFRS 9 & IAS 32 notes and class examples 2021 PDF

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FINANCIAL ACCOUNTING 300IAS 32, Financial Instruments: Presentation IFRS 7, Financial Instruments: Disclosure IFRS 9, Financial InstrumentsNotes and class examplesWM BadenhorstDEPARTMENTOFACCOUNTINGUP1. IFRS and financial instrumentsInternational Financial Reporting Standards (IFRS) deal with financ...

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1 FINANCIAL ACCOUNTING 300 IAS 32, Financial Instruments: Presentation IFRS 7, Financial Instruments: Disclosure IFRS 9, Financial Instruments Notes and class examples

DEPARTMENT OF ACCOUNTING

UP

WM Badenhorst

1. IFRS and financial instruments International Financial Reporting Standards (IFRS) deal with financial instruments in several standards, each of which address specific aspects related to financial instruments (IAS 32, par 2 – 3 & AG2). The main focus of each financial instrument standard is the following: IAS 32

IFRS 9

IFRS 7

Classification

Recognition and measurement

Disclosure

 IAS 32 The specific matters dealt with in IAS 32 are set out in IAS 32, par 2. The most important point to note from this paragraph is that IAS 32 addresses the classification of financial instruments as financial assets, financial liabilities and equity instruments from the perspective of the issuer thereof.  IFRS 9 If an entity has classified a financial instrument as a financial asset or financial liability in accordance with the principles in IAS 32, IFRS 9 determines how the financial instrument should be recognised and measured (IFRS 9, par 1.1). Note that entities can also transact in foreign financial instruments (i.e. financial instruments with foreign currency exposure). While the principles of IFRS 9 apply to these instruments, their accounting treatment also requires consideration of IAS 21, Foreign Currency Transactions, which is discussed in separate handouts.  IFRS 7 IFRS 7 is only addressed on FRK 300 in respect of the risks of financial instruments and the definitions relevant to IFRS 9.

2 2. Definitions of financial instruments Refer to IAS 32, par 11, for the definitions of the following: 

Financial instrument (also refer to IAS 32, par 13, for the definition of a “contract”)



Financial asset



Financial liability



Equity instrument

Note that there are always at least two parties involved in any financial instrument (with the exception of physical cash, such as petty cash for example). A financial asset of one entity is always represented by a financial liability / equity instrument of another entity, for example, a debtor of one entity will be a creditor of another entity (IAS 32, par AG 4). 3. Further analysis and discussion of the financial instrument definitions The definitions of financial instruments are supported by further details that you must study, before you attempt the class examples that follow. Work through the additional guidance provided in IAS 32, par AG 3 – AG 12. Note the following: 

The most important elements of a financial asset or liability are that there: (i) (ii)



must be a contract (definition: IAS 32, par 13) (with the exception of cash on hand); and must be cash flows in accordance with the contract even if they are not a direct result of the contract (e.g. an exchange of financial assets).

Perpetual debt instruments (IAS 32, par AG 6) represent a unique situation. The capital amount of a perpetual debt instrument will never be repaid by a going concern. However, par AG 6 shows that the present value of the cash outflows of the instrument (the interest thereon) is equal to the fair value of the capital amount. Since there is an obligation to pay the interest, the present value of the interest payments (the fair value of the capital amount) is in fact a financial liability.

The following two class examples illustrate the principles in IAS 32, par AG 3 – AG 12: Class example 1 - definitions of financial instruments Consider each of the following items in the statement of financial position of Finin Limited in isolation and indicate, with brief reasons, whether the items should be classified as financial assets, financial liabilities or equity instruments of the company. You need not refine the classification further.

3 a.

An investment in the shares of another company, Spectra Limited. These shares were acquired for speculative purposes.

b.

An interest-bearing debenture issued by Finin Limited, which will be redeemed in four years’ time.

c.

The ordinary shares issued by Finin Limited upon its incorporation to finance its operations.

d.

A prepayment in respect of an insurance policy premium.

e.

A motor vehicle, which is leased by Finin Limited and used every day.

f.

A large computer installation leased by Finin Limited to Compu Limited under a finance lease. The lease was correctly accounted for in accordance with IFRS 16, Leases.

g.

An option to acquire 25 000 ordinary shares in Minute Limited at R10 each. The current share price of Minute Limited is R15 per share.

SUGGESTED SOLUTION: a.

Financial asset as it is an equity instrument of another entity.

b.

Financial liability as Finin Limited has a contractual obligation (in accordance with the debenture deed) to deliver cash to the debenture holders for the interest and the capital amounts at settlement.

c.

Equity instrument as these are Finin Limited’s own shares. These shares represent a residual interest in the net assets of Finin Limited itself.

d.

Not a financial asset, a financial liability or an equity instrument. The prepaid insurance amount represents a right to receive insurance services in the future. It is not a contractual right to receive cash or another financial asset.

e.

A motor vehicle is a right-of-use asset under IFRS 16, which is not a financial asset (IAS 32, AG 10). The lease obligation which arises is a financial liability as it represents a contractual obligation (under the lease agreement) to deliver cash or another financial asset to the lessor.

f.

In terms of IFRS 16, the computer equipment is no longer an asset in the books of Finin Limited, so it is not considered. However, the lease receivable (debtor) that arises is a financial asset, as it represents a contractual right (under the lease agreement) to receive cash or another financial asset from the lessee (Compu Limited).

g.

The option is a financial asset as it represents the right to exchange one financial asset (cash) for another financial asset (shares) under conditions that are potentially favourable. Finin Limited would pay R10 per share for shares that currently have a market value of R15 per share.

4 Class example 2 – definitions of financial instruments Discuss whether the following items are financial assets, financial liabilities or equity instruments: a.

Inventories, property, plant and equipment, and intangible assets;

b.

Accrued interest on a loan account; and

c.

Current tax owing owing to the South African Revenue Service (SARS) and Value Added Tax (VAT) payable.

SUGGESTED SOLUTION: a.

Inventories, property, plant and equipment and intangible assets Tangible assets (such as these) and intangible assets are not financial assets since they are physical assets and do not represent a right to receive cash or another financial asset from another party. Assets such as inventories, that will be sold for the immediate or future receipt of cash, are physical assets and are not financial assets since they are not a present right to receive cash or another financial asset from another party. However, unpaid amounts arising on the acquisition of such assets are obligations to deliver cash and are thus financial liabilities.

b.

Accrued interest on a loan account If the loan account represents a liability, the accrued interest expense is a financial liability since it represents a contractual obligation to deliver cash or another financial asset to the lender. If the loan account represents an asset, the accrued interest income is a financial asset since it represents a contractual right to receive cash or another financial asset from the borrower.

c.

Current tax owing to South African Revenue Service (SARS) and Value Added Tax (VAT) payable Current tax and VAT payable meet the definition of liabilities since they are present obligations arising from past events and the entity has no option to avoid paying them. However, they do not arise from a contract between the parties, but rather by legislation and hence they are not financial liabilities as defined in terms of IAS 32.

5 4. Classification of financial instruments by the issuer The issuer of the financial instrument classifies the financial instrument … on initial recognition in accordance with: (i) The substance of the contractual agreement; and (ii) The definitions of a financial asset, financial liability and equity instrument as a financial asset, financial liability or equity instrument (IAS 32, par 15). IAS 32 provides guidance on the application of the above with regard to the classification of financial instruments from the perspective of the issuer, that is: whether an item is a financial liability or an equity instrument. 

When is a financial instrument an equity instrument? Refer to IAS 32, par 16. Note that it is implied in this paragraph that a financial instrument is only an equity instrument if it does not meet any of the elements of the definition of a financial liability (refer IAS 32, par 5). The most important characteristic of an equity instrument is that there is no contractual obligation to pay cash or deliver other financial assets to another party (IAS 32, par 17). Note that dividends on shares are not a compulsory payment. Accordingly, issued share capital is often an equity instrument.



When is a financial instrument a financial liability? Refer to IAS 32, par 19. When an entity does not have an unconditional right to avoid the delivery of cash or another financial asset, the entity has a financial liability. What does an unconditional right mean? A contract must not stipulate that the entity can only avoid the delivery of cash or another financial asset under specific circumstances. For example, if the contract determines that the entity only has to pay interest if the Rand/Dollar exchange rate is less than R15/Dollar, the entity still has a financial liability, as the entity’s contractual obligation under the contract is not removed. Under such a contract the entity will still have to pay interest if the Rand/Dollar exchange rate is more than R15/Dollar. For an entity to have an unconditional right, it must be able to avoid the delivery of cash or another financial asset at all times. IAS 32, par 19(a) and (b) provide additional examples where the delivery of cash / other financial assets is subject to conditions, but still represent a financial liability. Note that in both cases the entity does not have an unconditional right to avoid the delivery of cash or another financial asset to the counterparty.



The substance of the contract or the legal form Classification of a financial instrument is based on the substance of the contract even if this differs from its legal form (IAS 32, par 18).

6 

Does it make sense to ignore the legal form of a financial instrument for classification purposes? Consider the definition of a liability in accordance with the Conceptual Framework for Financial Reporting: A liability is a present obligation of the entity to transfer an economic resource as a result of past events. Par 4.43 of the Conceptual Framework states “if an entity has already obtained economic benefits or taken an action; and as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer”, a liability exists. Par 4.37 of the Conceptual Framework also states “It is only necessary that the obligation already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource.” The fact that the legal form of the instrument is an equity instrument, does not affect the actual obligation. Also consider the definition of an equity instrument in accordance with the Conceptual Framework: Equity is the residual interest in the assets of the entity after deducting all its liabilities. If the entity does not have a contractual obligation to deliver cash or another financial asset in respect of a financial instrument that it has issued, that financial instrument is an equity instrument. This is because the holders of the instrument are dependent on the decisions made by the entity to receive repayment of their investment. The definition in the Conceptual Framework does not require that the instrument must have the legal form of an equity instrument.

5. Scope of IFRS 9 and IAS 32 From the above sections, you should now be able to identify financial instruments and classify them as financial assets, financial liabilities and equity instruments. Note, however, that even if an instrument meets the definition of a financial instrument, this does not necessarily imply that it should be accounted for in accordance with IAS 32 and/or IFRS 9:  IAS 32 Refer to IAS 32, par 4, for the details related to the scope of IAS 32.  IFRS 9 Refer to IFRS 9, par 2.1 and 2.2, for the details related to the scope of IFRS 9. Note, that in contrast to IAS 32, IFRS 9, par 1.1, makes it clear that only financial assets and financial liabilities are addressed. This means that the principles in IFRS 9 do not apply to an entity’s own equity instruments! [IFRS 9, par 2.1(d)].

7 6. IAS 32, IFRS 9 and the line items in the financial statements Example Limited Statement of financial position as at ………..

R

Assets Non-current assets Property, plant and equipment Investment property Goodwill Other intangible assets Financial assets Current assets Inventories Trade receivables Financial assets Cash and cash equivalents Total assets Equity and liabilities Total equity (#) Ordinary share capital NOT affected by IFRS 9! (##) Retained earnings Other components of equity (###) Non-current liabilities Long-term borrowings Other financial liabilities Deferred tax Current liabilities Trade and other payables Short-term borrowings Short-term portion of long-term borrowings Other financial liabilities Current tax payable Short-term provisions Bank overdraft Total equity and liabilities #

The impact of IAS 32 on the financial statements is primarily on the classification of financial instruments from the perspective of the issuer, that is: whether an item is a financial liability or an equity instrument.

##

IFRS 9 only applies to the measurement of financial assets and liabilities, NOT the entity’s own equity [IFRS 9, par 2.1(d)]

### Other components of equity are affected by the application of IFRS 9’s measurement requirements to financial assets and financial liabilities, and by applying IAS 32’s requirements to compound financial instruments. Note: Offsetting of financial assets and financial liabilities is not often permitted. Refer to the discussion on offsetting of financial assets and liabilities later in this material.

8 Example Limited Statement of profit or loss and other comprehensive income for the year ended ………..

R

Revenue Cost of sales Gross profit Other income # Distribution costs Administrative expenses Other expenses # Net impairment losses on financial assets  Profits and losses arising on the derecognition of financial assets at amortised cost $ Finance costs *** Finance income using the effective interest method  *** Other finance income  *** Profit before tax Income tax expense Profit for the period Other comprehensive income Items that will not be reclassified to profit or loss: Revaluation surplus on property, plant and equipment (N1) Gross amount Income tax expense Mark-to-market reserve on equity instruments (N2) Fair value adjustment Items that will be reclassified to profit or loss: Foreign currency translation reserve (N2) Mark-to-market reserve on debt instruments (N2) Fair value adjustment Reclassification to profit or loss arising on derecognition Expected credit losses reserve (N2) Net impairment losses on financial assets recognised in expected credit losses reserve Reclassification of expected credit loss reserve to profit or loss on derecognition of financial assets

AAA

BBB

CCC

Total comprehensive income for the period # Fair value adjustments that are recognised in profit or loss, will be presented as part of other income or other expenses. Dividend income forms part of other income for most entities.  IAS 1, par 82(ba), requires that net impairment losses on financial assets must be presented as a separate line item on the face of the statement of profit or loss and other comprehensive income. $ The objective with financial assets at amortised cost is not to dispose of them. Therefore, if this should occur, IAS 1, par 82(aa), requires prominent presentation thereof.

9  IAS 1, par 82(a)(i), requires that finance income calculated using the effective interest method be disclosed in a separate line item on the face of the statement of profit or loss and other comprehensive income. Furthermore, ONLY finance income on financial assets classified as at amortised cost or as a debt instrument at fair value through other comprehensive income is included in this line item. All other finance income (whether on financial instruments or from other standards) is included in the line item “Other finance income”. Also note that a bank balance is a financial asset at amortised cost and the interest on bank accounts may therefore be included in this line item. *** Finance income and finance costs may not be offset! N1 In FRK 300, we only consider the presentation option whereby each item in other comprehensive income is presented with its own income tax effect on the face of the statement of profit or loss and other comprehensive income. N2 The income tax consequences of these items fall outside the scope of FRK 300. Additional notes: 

A financial instrument classified as a financial liability in terms of IAS 32 will have finance cost in the statement of profit or loss and other comprehensive income.



A video presentation about items in other comprehensive income that will / will not be reclassified to profit or loss is available on ClickUP. Also refer to the prescribed work handout.

Example Limited Statement of changes in equity for the year ended ……….. Mark-tomarket reserve on equity instruments R

Mark-tomarket reserve on debt instruments R

Expected credit losses reserve

AAA

BBB

CCC

R

Balance at beginning of the year Total comprehensive income - Profit for the year - Other comprehensive income Transfer to retained earnings

(#)

Balance at the end of the year (#)

In accordance with IFRS 9, an entity can choose to transfer the mark-to-market reserve for equity instruments to retained earnings directly in equity. Some entities may therefore choose to never to make such a transfer. This choice is not available for any of the other reserves illustrated!!

Note: 

Only the reserves affected by IFRS 9 and discussed in this material are illustrated. The application of IAS 32 can give rise to a component of equity (equity component of convertible debentures) which is illustrated in examples later in this document.

10 

The impact on the line items of the statement of cash flows will be addressed in the lecture material of IAS 7, Statement of Cash Flows, later in the year.

7. Initial recogn...