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IAS 32 Presentation of Financial Instruments

(First Issued 2005)

Instruments as defined by IAS 32:

To decide whether a transaction is a financial instrument (and how to classify it if it is a financial

instrument), it is important to have a good understanding of the instruments as defined by IAS

32:

Financial instrument: Any contract that gives rise to both a financial asset of one entity and a

financial liability or equity instrument of another entity.

Financial asset: Any asset that is:

(a) Cash.

(b) An equity instrument of another entity.

(c) A contractual right:

(i) To receive cash or another financial asset from another entity; or

(ii)To exchange financial assets or financial liabilities with another entity under conditions

that are potentially favorable to the entity; or

(d) A contract that will or may be settled in the entity’s own equity instruments.
Financial liability: Any liability that is:

(a) A contractual obligation:

(i) To deliver cash or another financial asset to another entity; or

(ii)To exchange financial assets or financial liabilities with another entity under conditions that are

potentially unfavorable to the entity; or

(b) A contract that will or may be settled in an entity’s own equity instruments.
Equity instrument: Any contract that evidences a residual interest in the assets of an entity after
deducting all its liabilities.
Derivative: A derivative has three characteristics:

(a) Its value changes in response to an underlying variable (e.g., share price, commodity price, foreign

exchange rate or interest rate).

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(b) It requires no initial net investment or an initial net investment that is smaller than would be

required for other types of contracts that would be expected to have a similar response to

changes in market factors; and

(c) It is settled at a future date.

Note: Instrument is only an equity instrument if neither (a) nor (b) in the definition of a financial

liability are met.

 A financial liability is the contractual obligation to deliver cash or another financial asset.

Compound Instruments

Where a financial instrument contains some characteristics of equity and some of financial liability
then its separate components need to be classified separately.

E.g., Convertible loan notes

 Method for separating the components:

(a) Determine the carrying amount of the liability component (by measuring the fair value of a

similar liability that does not have an associated equity component).

(b) Assign the residual amount to the equity component.

IFRS 9 Financial Instruments

Prior to the issue of IAS 32 and IAS 39 (the forerunner of IFRS 9), many financial instruments were

‘off balance sheet’, being neither recognized nor disclosed in the financial statements while still

exposing the shareholders to significant risks.

Recognition (IFRS 9)
Financial assets and liabilities are recognized in the statement of financial position when the entity

becomes a party to the contractual provisions of the instrument.

 Financial contracts:

Those contracts to buy or sell a non-financial item that can be settled net in cash or another

financial instrument, or by exchanging financial instruments as if the contracts were financial

instruments.

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 Executory contracts:

Contracts under which neither party has performed any of its obligations. (or both parties have

partially performed their obligations to an equal extent)

These contracts that were entered into for the entity’s expected purchase, sale or usage

requirements of non-financial items are outside the scope of IFRS 9.

Example:

Forward contract to purchase cocoa beans for use in making chocolate is an executory contract

which is outside the scope of IFRS 9.

The purchase is not accounted for until the cocoa beans are delivered.

Derecognition (IFRS 9)

Derecognition is the removal of a previously recognized financial instrument from an entity’s

statement of financial position. Derecognition happens:

Financial assets:

When the contractual rights to the cash flows expire

1. When the financial asset is transferred (e.g., sold), based on whether the entity has transferred

substantially all the risks and rewards of ownership of the financial asset

Financial liability:

2. When it is extinguished, i.e., when the obligation is discharged (e.g., paid off), cancelled or

expires

Where a part of a financial instrument meets the criteria above, that part is derecognized.

Classification And Measurement

Definitions:
Amortized cost: The amount at which the financial asset or financial liability is measured at initial

recognition minus the principal repayments, plus or minus the cumulative amortization using the

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effective interest method of any difference between that initial amount and the maturity amount

and, for financial assets, adjusted for any loss allowance.

Effective interest rate: The rate that exactly discounts estimated future cash payments or receipts

through the expected life of the financial asset or financial liability to the gross carrying amount

of a financial asset or to the amortized cost of a financial liability.

Held for trading: A financial asset or financial liability that:

(a) Is acquired or incurred principally for the purpose of selling or repurchasing it in the near term.

(b) On initial recognition is part of a portfolio of identified financial instruments that are managed

together and for which there is evidence of a recent actual pattern of short-term profit-taking; or
(c) Is a derivative (except for a derivative that is a financial guarantee contract or a designated

and effective hedging instrument).

Financial guarantee contract: A contract that requires the issuer to make specified payments to
reimburse the holder for a loss it incurs because a specified debtor fails to make payment when

due in accordance with the original or modified terms of the debt instrument.:

Business model approach relates to groups of debt instrument assets and the accounting
treatment depends on the entity’s intention for that group of assets:

a. If the intention is to hold the group of debt instruments until they are redeemed, then the

difference between initial and maturity value is recognized using the amortized cost

method.

b. If the intention is principally to hold the group of debt instruments until they are

redeemed, but they may be sold if certain criteria are met then changes in fair value are
recognized in other comprehensive income, but interest is still recognized in profit or loss

on the same basis as if the intention was not to sell if certain criteria are met.

Accounting Mismatch: is a measurement or recognition inconsistency that would otherwise arise

from measuring assets or liabilities or recognizing gains or losses on them on different bases. Any

financial asset can be designated at fair value through profit or loss if this would eliminate the

mismatch.

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Financial Assets:

a. Investments in debt instruments

1. Held to collect contractual cash flows; and cash flows are solely principal and interest

(Business model approach)

• Initial measurement: Fair value + transaction costs

• Subsequent measurement: Amortized cost.

2. Held to collect contractual cash flows and to sell; and cash flows are solely principal and

interest (Business model approach)

• Initial measurement: Fair value + transaction costs

• Subsequent measurement: Fair value through other comprehensive income (with

reclassification to profit or loss (P/L) on derecognition)

NB: interest revenue calculated on amortized cost basis recognized in P/L

b. Investments in equity instruments not ‘held for trading’ (optional irrevocable election on
initial recognition)

• Initial measurement: Fair value + transaction costs

• Subsequent measurement: Fair value through other comprehensive income (no

reclassification to P/L on derecognition) NB: dividend income recognized in P/L

c. All other financial assets:

• Initial measurement: Fair value (transaction costs expensed in P/L)

• Subsequent measurement: Fair value through profit or loss

Reclassification Of Financial Assets

• Reclassified under IFRS 9 when an entity changes its business model.

• It is applied prospectively from the reclassification date.

These rules only apply to investments in debt instruments as investments in equity instruments

are always held at fair value and any election to measure them at fair value through other

comprehensive income is an irrevocable one.

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Treatment Of Gain or Loss on Derecognition

On derecognition of a financial asset the difference between:

(a) The carrying amount (measured at the date of derecognition); and

(b) The consideration received is recognized in profit or loss

Financial Liabilities

(a) Most financial liabilities

▪ Initial measurement: Fair value less transaction costs

▪ Subsequent measurement: Amortized cost

(b) Financial liabilities at fair value through profit or loss

▪ ‘Held for trading’ (short-term profit making)

▪ Derivatives that are liabilities

▪ Designated on initial recognition at ‘fair value through profit or losses to

eliminate/significantly reduce an ‘accounting mismatch’)

▪ A group of financial liabilities (or financial assets and financial liabilities) managed, and

performance evaluated on a fair value basis in accordance with a documented risk

management or investment strategy

▪ Initial measurement: Fair value (transaction costs expensed in P/L)

▪ Subsequent measurement: Fair value through profit or loss (Changes in fair value due

to changes in the liability’s credit risk are recognized separately in other

comprehensive income)

(c) Financial liabilities arising when transfer of financial asset does not qualify for derecognition

• Initial measurement: Consideration received

• Subsequent measurement: Measure financial liability on same basis as transferred asset

(amortized cost or fair value)

(d) Financial guarantee contracts and commitments to provide a loan at a below-market

interest rate.

• Initial measurement: Fair value less transaction costs

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• Subsequent measurement:

Higher of:

i. Impairment loss allowance ii. Amount initially recognized

less amounts amortized to P/L

Offsetting Financial Assets and Financial Liabilities These

are required to be offset when:

(a) Has a legally enforceable right to set-off the recognized amounts; and

(b) Intends either to settle on a net basis or to realize the asset and settle the liability

simultaneously. Otherwise, presented separately.

Embedded Derivatives (IFRS 9)

• Characteristics of Derivatives:

– Settled at a future date

– Value changes in response to an underlying variable

– No/little initial net investment vs contracts for similar market response

▪ Some contracts may have derivatives embedded in them.

▪ Derivatives not used for hedging are treated as ‘held for trading’ and measured at fair value

through profit or loss.

▪ IFRS 9 requires embedded derivatives that would meet the definition of a separate derivative
instrument to be separated from the host contract (and therefore be measured at fair value

through profit or loss like other derivatives)

▪ Exception: IFRS 9 does not require embedded derivatives to be separated from the host

contract if:

▪ The economic characteristics and risks of the embedded derivative are closely related to

those of the host contract.

▪ The hybrid (combined) instrument is measured at fair value through profit or loss.

▪ The host contract is a financial asset within the scope of IFRS 9.

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▪ The embedded derivative significantly modifies the cash flows of the contract.

Impairment Of Financial Assets (IFRS 9)

IFRS 9 uses a forward-looking impairment model. Under this model future expected credit losses
are recognized. This is different to the impairment model used in IAS 36 Impairment of Assets in

which an impairment loss is only recognized when objective evidence of impairment exists.

Scope

IFRS 9’s impairment rules apply primarily to certain financial assets:

• Financial assets measured at amortized cost (business model: objective – to collect contractual

cash flows of principal and interest)

• Investments in debt instruments measured at fair value through other comprehensive income

(OCI) (business model: objective – to collect contractual cash flows of principal and interest

and to sell financial assets)

The impairment rules do not apply to financial assets measured at fair value through profit or loss

as subsequent measurement at fair value will already consider any impairment.

Recognition Of Credit Losses

On initial recognition of a financial asset and at each subsequent reporting date, a loss allowance

for expected credit losses must be recognized.

Terms:

• Loss allowance: The allowance for expected credit losses on financial assets.

• Expected credit losses: The weighted average of credit losses with the respective risks of a

default occurring as the weights.

• Credit loss: The difference between all contractual cash flows that are due to an entity…and all

the cash flows that the entity expects to receive, discounted.

• Initial recognition

A loss allowance equal to 12-month expected credit losses must be recognized.

12-month expected credit losses

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The portion of lifetime expected credit losses that result from default events on a financial

instrument that are possible within the 12 months after the reporting date’. They are calculated

by multiplying the probability of default in the next 12 months by the present value of the lifetime

expected credit losses that would result from the default.

Lifetime expected credit losses

The expected credit losses that result from all possible default events over the expected life of the

financial instrument’

At Subsequent Reporting Dates:

The loss allowance required depends on whether there has been a significant increase in credit

risk of that financial instrument since initial recognition.

Stage 1: No significant increase in credit risk since initial recognition:

▪ Recognize 12-month expected credit losses

▪ Effective interest calculated on gross carrying amount of financial asset

Stage 2: Significant increase in credit risk since initial recognition

▪ Recognize lifetime expected credit losses

▪ Effective interest calculated on gross carrying amount

▪ of financial asset

To determine whether credit risk has increased significantly, management should assess whether

there has been a significant increase in the risk of default. There is a rebuttable presumption that
the credit risk has increased significantly when contractual payments are more than 30 days past

due.

Stage 3: Objective evidence of impairment at the reporting date

▪ Recognize lifetime expected credit losses

▪ Effective interest calculated on net carrying amount of financial asset

Presentation

Credit losses are treated as follows:

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 Investments in debt instruments measured at amortized cost:

o Recognized • in profit or loss

o Credit losses held in a separate allowance account offset against the carrying

amount of the asset:

Financial asset X

Allowance for credit losses (X) Carrying amount

(net of allowance for credit losses) X

 Investments in debt instruments measured at fair value through other comprehensive

income:

o Portion of the fall in fair value relating to credit losses recognized in profit or

loss

o Remainder recognized in other comprehensive income

o No allowance account necessary because already carried at fair value (which is

automatically reduced for any fall in value, including credit losses)

Measurement
The measurement should reflect:

(a) An unbiased and probability-weighted amount that is determined by evaluating a range of

possible outcomes.

(b) The time value of money; and

(c) Reasonable and supportable information that is available without undue cost and effort at the
reporting date about past events, current conditions, and forecasts of future economic

conditions.

Impairment Loss Reversal

When the conditions are no longer met, it should revert to measuring the loss allowance at an

amount equal to 12-month expected credit losses.

The resulting impairment gain is recognized in profit or loss.

Trade Receivables, Contract Assets and Lease Receivables

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Trade receivables or contract assets that do not have a significant financing component under

IFRS 15, the loss allowance is measured at the lifetime expected credit losses, from initial

recognition.

For others, the entity can choose to apply the three-stage approach or to recognize an allowance

for lifetime expected credit losses from initial recognition.

Purchased Or Originated Credit-Impaired Financial Assets

In this case it is originally recognized as a single figure with no separate allowance for credit losses.
Any subsequent changes in lifetime expected credit losses are recognized as a separate allowance.

Hedge Accounting
Where an item in the financial statements is subject to potential fluctuations in value that could
be detrimental to the business, a hedging transaction may be entered.
So that overall risk is reduced as in where the item hedged makes a financial loss, the hedging

instrument would make a gain and vice versa.

 Accounted for as a hedge if hedging relationship:

– Only includes eligible items,

– Designated at inception as a hedge with full documentation, and – Is effective

(i) Economic relationship between hedged item and hedging instrument exists.

(ii) Change in FV due to credit risk does not distort hedge; and

(iii)Quantity of hedging instrument vs quantity of hedged item ('hedge ratio') designated as the

hedge is same as used.

Discontinues hedge accounting when the hedging relationship ceases to meet the qualifying

criteria.

Types Of Hedges:

Fair Value Hedges

These hedge the change in value of a recognized asset or liability that could affect profit or loss.

E.g.: hedging the fair value of fixed rate loan notes due to changes in interest rates.

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All gains and losses are recognized as follows:

(a) Immediately in profit or loss

(b) Immediately in other comprehensive income if the hedged item is an investment in an equity

instrument held at fair value through other comprehensive income

In both cases, the gain or loss on the hedged item adjusts the carrying amount of the hedged

item.

Cash Flow Hedges

These hedges the risk of change in value of future cash flows from a recognized asset or liability

that could affect profit or loss.

E.g.: hedging a variable rate interest income stream.

 Hedging instrument is accounted as:

(a) The portion of the gain or loss on the hedging instrument that is effective is recognized in
other comprehensive income (‘items that may be reclassified subsequently to profit or loss’)

and the cash flow hedge reserve.

(b) Any excess is recognized immediately in profit or loss.

 The amount accumulated in the cash flow hedge reserve is then accounted for as follows :

(a) If a hedged forecast transaction subsequently results in the recognition of a non-financial asset

or non-financial liability, the amount shall be removed from the cash flow reserve and be included

directly in the initial cost or carrying amount of the asset or liability.

(b) For all other cash flow hedges, the amount shall be reclassified from other comprehensive

income to profit or loss in the same period(s) that the hedged expected future cash flows affect

profit or loss.

IFRS 13 Fair Value Adjustment

Fair value:
It is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.

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 Fair value is after transport costs, but before transaction costs

 Market-based measure (i.e., use assumptions market participants would use), not entity

specific

IFRS 13 provides extensive guidance on how the fair value of assets and liabilities should be

established.

Scope:
It applies to all IFRS Standards where a fair value measurement is required except:

• Share-based payment transactions (IFRS 2)

• Leasing transactions (IFRS 16)

• Measurements which are like, but not the same as, fair value, e.g.:
- Net realizable value of inventories (IAS 2)

- Value in use (IAS 36)

This standard requires that the following are considered in determining fair value.

▪ The asset or liability being measured.

▪ The principal market (i.e., that where the most activity takes place) or where there is no

principal market, the most advantageous market (i.e., that in which the best price could be

achieved) in which an orderly transaction would take place for the asset or liability.

▪ The highest and best use of the asset or liability and whether it is used on a standalone

basis or in conjunction with other assets or liabilities.

▪ Assumptions that market participants would use when pricing the asset or liability

Having considered these factors, IFRS 13 provides a hierarchy of inputs for arriving at fair value. It

requires that level 1 inputs are used where possible. Incase following level 1 is not possible, and

then only the entity can switch to level 2. However, the last priority is level 3.

Level 1: Quoted prices in active markets for identical assets that the entity can access at the

measurement date.

Level 2: Inputs other than quoted prices those are directly or indirectly observable for the asset

Level 3: Unobservable inputs for the asset

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Active market: A market in which transactions for the asset or liability take place with sufficient

frequency and volume to provide pricing information on an ongoing basis

• Multiple markets, use FV in:

(1) Principal market (if there is one)

(2) Most advantageous market (i.e., the best one after both transaction and transport costs)

• Non-financial assets: highest and best use that is physically possible, legally permissible,

and financially feasible.

Fair Value of a Liability

The measurement of the fair value of a liability assumes that the liability remains outstanding

and the market participant transferee would be required to fulfil the obligation, rather than it

being extinguished

• FV of a liability (example):

Expected value of cash flows

Third-party contractor mark-up X
-----
X

Inflation adjustment X

------
X
Risk premium (Re diff cash flows) X

------

Discount to PV X
-------

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