Financial instruments clearly explained

Financial instruments clearly explained provides the explanations on all aspects of IAS 32, IAS 39, IFRS 7 and IFRS 9 in this website. The need for so many Standards and their regular withdrawal and/or revisions may show the difficulty in regulating the financial reporting of financial assets, financial liabilities and equity instruments!

History of financial instruments in IAS and IFRS

Financial instruments are important across all reporting entities and even more so in the financial services industry (banks, insurance companies, investment vehicles). But is took until 1995 when IAS 32 (now revised to Financial instruments: Presentation) was issued!

In 1999 IAS 39 was issued for recognition and measurement at a time that was known for increasingly volatile financial markets and more widespread use of innovative and complex financial products.

Various revisions have been made, IAS 32 was partly replaced by IFRS 7 in 2005 and IAS 39 was replaced by IFRS 9 in a phased approach from 2009 to 2015. The phased approach included classification and measurement of financial assets and financial liabilities, hedge accounting, derecognition and impairment, resulting in IFRS 9 replacing IAS 39 for annual reporting periods beginning on or after 1 January 2018.

Introduction financial instruments

(from a financial industry 1 perspective)

Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world’s investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.

Key points:

  • A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value.
  • Financial instruments may be divided into two types: cash instruments and derivative instruments.
  • Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.
  • Foreign exchange instruments comprise a third, unique type of financial instrument.

Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and derivative instruments.

Cash Instruments

  • The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable.
  • Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.

Derivative Instruments

  • The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
  • These can be over-the-counter (OTC) derivatives or exchange-traded derivatives.

Objectives

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IAS 32 Financial Instruments Presentation

1 [Deleted]

2 The objective of this Standard is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interestdividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset.

3 The principles in this Standard complement the principles for recognising and measuring financial assets and financial liabilities in IFRS 9 Financial Instruments, and for disclosing information about them in IFRS 7 Financial Instruments: Disclosures.

Overview:

IAS 32 Financial Instruments: Presentation outlines the accounting requirements for the presentation of financial instruments, particularly as to the classification of such instruments into financial assets, financial liabilities and equity instruments. The standard also provide guidance on the classification of related interest, dividends and gains/losses, and when financial assets and financial liabilities can be offset.

IAS 32 was reissued in December 2003 and applies to annual periods beginning on or after 1 January 2005.

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IAS 39 Financial Instruments Recognition and Measurement

No objectives left anymore!

Overview:

IAS 39 Financial Instruments: Recognition and Measurement outlines the requirements for the recognition and measurement of financial assets, financial liabilities, and some contracts to buy or sell non-financial items. Financial instruments are initially recognised when an entity becomes a party to the contractual provisions of the instrument, and are classified into various categories depending upon the type of instrument, which then determines the subsequent measurement of the instrument (typically amortised cost or fair value). Special rules apply to embedded derivatives and hedging instruments.

IAS 39 was reissued in December 2003, applies to annual periods beginning on or after 1 January 2005, and will be largely replaced by IFRS 9 Financial Instruments for annual periods beginning on or after 1 January 2018.

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IFRS 7 Financial Instruments Disclosures

Objective

1 The objective of this IFRS is to require entities to provide disclosures in their financial statements that enable users to evaluate:

  1. the significance of financial instruments for the entity’s financial position and performance; and
  2. the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks.

2 The principles in this IFRS complement the principles for recognising, measuring and presenting financial assets and financial liabilities in IAS 32 Financial InstrumentsPresentation and IFRS 9 Financial Instruments.

Overview:

IFRS 7 Financial Instruments: Disclosures requires disclosure of information about the significance of financial instruments to an entity, and the nature and extent of risks arising from those financial instruments, both in qualitative and quantitative terms. Specific disclosures are required in relation to transferred financial assets and a number of other matters.

IFRS 7 was originally issued in August 2005 and applies to annual periods beginning on or after 1 January 2007.

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IFRS 9 Financial instruments

Objective

1.1 The objective of this Standard is to establish principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows.

Overview:

IFRS 9 Financial Instruments issued on 24 July 2014 is the IASB’s replacement of IAS 39 Financial Instruments: Recognition and Measurement. The Standard includes requirements for recognition and measurement, impairment, derecognition and general hedge accounting. The IASB completed its project to replace IAS 39 in phases, adding to the standard as it completed each phase.

The version of IFRS 9 issued in 2014 supersedes all previous versions and is mandatorily effective for periods beginning on or after 1 January 2018 with early adoption permitted (subject to local endorsement requirements). For a limited period, previous versions of IFRS 9 may be adopted early if not already done so provided the relevant date of initial application is before 1 February 2015.

IFRS 9 does not replace the requirements for portfolio fair value hedge accounting for interest rate risk (often referred to as the ‘macro hedge accounting’ requirements) since this phase of the project was separated from the IFRS 9 project due to the longer term nature of the macro hedging project which is currently at the discussion paper phase of the due process. In April 2014, the IASB published a Discussion Paper Accounting for Dynamic Risk management: a Portfolio Revaluation Approach to Macro Hedging. Consequently, the exception in IAS 39 for a fair value hedge of an interest rate exposure of a portfolio of financial assets or financial liabilities continues to apply.

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Introduction

The way to IFRS 9 Financial instruments
Example IFRS 9 – Applying the ‘own use’ scope exemption
IAS 32 Financial instruments: Presentation

Nature and characteristicsFinancial instruments clearly explained

Descriptions of financial instruments
Description of derivatives
Held for trading
Instruments with stepped interest payments
Gross carrying amount calculation financial assets
Perpetual debt instruments – decreasing interest rate
Perpetual debt instruments – variable rate
Option to put a non-financial asset
Practice of settling net: forward contract to purchase a commodity
Cross-currency swap

Embedded derivatives in host contracts

Embedded derivatives: separation of option
Embedded derivatives: separation of host
Embedded derivatives: synthetic instruments
Embedded derivatives: equity kicker
Recovery of recognised investment
Embedded foreign currency derivatives – currency of international commerce
Embedded foreign currency derivatives – unrelated foreign currency provision
Purchases and sales in FX Instruments

Classification of financial contracts

IFRS 9 Financial asset classification
Classification of financial assets

IFRS 9-The SPPI test explained by example!!!Financial instruments clearly explained
IFRS 9 The Solely Payments of Principal and Interest Test
What is the SPPI test?

IFRS 9 The Business Model Test
What is a Business Model?

Cash flows identification- Not-Only Principal and interest
Cash flows identification- Only Principal and interest

Classification and measurement of financial liabilities
IFRS 9 – Reclassification of financial instruments
Classification of crypto-assets
Determination of separable assets

Business model:
– Examples hold assets and collect cash

– Examples collecting cash and selling assets
– Other business models

Financial liabilities and equity instruments

Classification and measurement of financial liabilities
Measurement of equity
What is a debt instrument?

Recognition and derecognition

Share purchase by call option 
Regular way contracts: forward contract 
Regular way contracts: no established market 
Customary settlement provisions 
Settlement date accounting 
Trade and settlement date Sale 
Trade or settlement date Financial asset 
Trade date or settlement date accounting 
Modifications and Write-offs

Measurement of financial assets and financial liabilities

Measurement categories

Summary impairment of financial assets 
IFRS 9 Impairment of Financial instruments

The general approach 
The simplified approach 
Determining significant increases in credit risk 
Possible indicators for ‘Lifetime Expected Credit Loss’ 
Indicators of a possible default 
Impairment – Expected credit losses on financial assets 
When and how to recognise Expected Credit Losses 
Measurement of Expected Credit Losses 
Collateral in measurement of expected credit losses 
Recognition of cash collateral 
Impairment of investments and loans

The credit-adjusted approach 
Simplified approach – Trade receivables 
Loan commitments and financial guarantee contracts 
Group managed and performance evaluated on a fair value basis 

Step-by-step measure expected credit losses 

Classification and measurement of financial liabilities 
Initial measurement: transaction costs 
Interaction between IFRS 9 and IAS 21 
FX translation of foreign entities 
Separation of currency component 
Claims against an entity with different seniority 
Purchased and originated credit-impaired financial assets 
Change in the fair value of a bond

Hedge accounting

Presentation and disclosure

Management of credit risk for financial instruments 
IFRS 32 Financial instruments: Presentation 
IFRS 7 Disclosures for IFRS 9 Financial instruments 
Presentation and disclosure of crypto-assets 
Off-setting of financial assets and financial liabilities 
Costs of issuing and reacquiring equity instruments
Financial instruments Basic risks

IFRS 9 Classification and measurement

IFRS 9 Classification and measurement of financial instruments

See also: The IFRS Foundation

Financial instruments clearly explained

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