Financial Instruments: IFRS 9

Initial Measurement of Financial Assets (IFRS 9)

  • According to IFRS 9 5.1, at initial recognition, a financial asset is measured at its fair value.
  • The classification of a financial asset determines how transaction costs are treated and the basis for subsequent measurement.

Classification Categories for Financial Assets

  • Amortized Cost:
    • Objective: The business model objective is to hold the financial asset to collect contractual cash flows.
    • Initial Measurement: Calculated as Fair Value plus Transaction Costs (Fair Value+Transaction Costs\text{Fair Value} + \text{Transaction Costs}).
    • Perspective: These are typically viewed as long-term investments.
  • Fair Value Through Other Comprehensive Income (FVTOCI):
    • Objective: The business model objective is achieved by both gathering contractual cash flows and selling financial assets.
    • Initial Measurement: Calculated as Fair Value plus Transaction Costs (Fair Value+Transaction Costs\text{Fair Value} + \text{Transaction Costs}).
    • Perspective: These are typically viewed as long-term investments.
  • Fair Value Through Profit or Loss (FVTPL):
    • Objective: This is the default classification option when the criteria for Amortized Cost or FVTOCI are not met.
    • Initial Measurement: Measured at Fair Value only. Transaction costs are expensed immediately and are not capitalized.
    • Perspective: These are viewed as short-term investments or assets "held for trading."

Subsequent Measurement Framework

  • The method for subsequent measurement depends entirely on the initial classification of the asset.
  • Amortized Cost:
    • Measured using the Effective Interest Method.
  • FVTOCI:
    • Changes in Fair Value are recognized through Other Comprehensive Income (OCI). These represent the unrealized gains or losses.
    • Interest Revenue or Dividend Income is recognized in Profit or Loss (P&L) using the effective interest method.
  • FVTPL:
    • Changes in Fair Value (unrealized gains/losses) are recognized directly through Profit or Loss (P&L).
    • Interest Revenue or Dividend Income is recognized in Profit or Loss (P&L) using the effective interest method.

Impairment of Financial Assets

  • Impairment rules apply only to financial assets classified as Amortized Cost or FVTOCI.
  • Impairment generally concerns long-term investments and debt instruments because these instruments promise fixed cash flows. Equity instruments do not promise fixed cash flows.
  • Amortized Cost Impairment:
    • Since the investment is not carried at Fair Value, an impairment exists if the Present Value (PV) of expected cash flows is less than the Carrying Amount.
    • Accounting Entry: Debit Impairment Loss, Credit Investment.
  • FVTOCI Impairment:
    • Because the investment is already held at Fair Value, market fluctuations are already accounted for.
    • An impairment adjustment is only required when there are expected credit losses.
    • Accounting Entry: Debit Credit Loss, Credit Investment.

Reclassification and Derecognition

  • Reclassification:
    • An entity is required to reclassify financial assets only when its business model or intent for managing those assets changes.
    • Reclassification applies only to debt instruments.
    • Investments in equity designated at FVTOCI are irrevocable.
    • All reclassifications are handled on a prospective basis, starting from the reclassification date.
  • Derecognition - Amortized Cost:
    • The gain or loss is determined by the difference between the Carrying Value and the consideration received (Fair Value).
    • If a bond is held until it matures, there is generally no gain or loss recognized upon derecognition.
  • Derecognition - FVTOCI:
    • Calculated as the difference between Carrying Value and consideration received.
    • For Equity: The resulting gain or loss is recognized in Retained Earnings.
    • For Debt: The resulting gain or loss is recognized through Profit or Loss (Net Income).
  • Derecognition - FVTPL:
    • The difference between the Carrying Value and consideration received is recognized in Profit or Loss.

Procedures for Calculating Amortized Cost

  • Step 1: Determine the Effective Interest Rate:
    • The effective interest rate usually differs from the coupon rate.
    • Equation parameters: Rate(Nper,PMT,−PV,FV,Type)\text{Rate}(\text{Nper}, \text{PMT}, -\text{PV}, \text{FV}, \text{Type}).
    • Nper\text{Nper}: The number of payment periods.
    • PMT\text{PMT} (Payment): The cash received each period, calculated as Face Value×Coupon RateNumber of compounding periods\frac{\text{Face Value} \times \text{Coupon Rate}}{\text{Number of compounding periods}}.
    • FV\text{FV} (Face Value): The total sum to be received at the bond's maturity.
    • PV\text{PV} (Present Value): The initial cost of the investment plus any transaction costs (entered as a negative value).
  • Step 2: Calculate Interest Revenue:
    • Interest Revenue=Effective Interest Rate×Carrying Value of Investment at the beginning of the period\text{Interest Revenue} = \text{Effective Interest Rate} \times \text{Carrying Value of Investment at the beginning of the period}.
  • Step 3: Amortize the Investment:
    • The amortization amount is the difference between the actual cash payment received (Face Value×Coupon Rate\text{Face Value} \times \text{Coupon Rate}) and the calculated Interest Revenue.

Illustrative Example: Amortized Cost

  • Scenario: On January 1, Year 1, Ontario Co. purchased bonds with a face value of $2,000,000\$2,000,000 and a coupon rate of 4.5%4.5\%. The bonds were purchased for $2,044,518\$2,044,518 and mature in five years. Interest is payable annually on December 31. Ontario plans to hold the bonds to maturity.
  • Initial Recognition:
    • Value: Fair Value+Transaction Costs=$2,044,518\text{Fair Value} + \text{Transaction Costs} = \$2,044,518.
    • Debit: Investment in Bond $2,044,518\$2,044,518.
    • Credit: Cash $2,044,518\$2,044,518.
  • Subsequent Measurement (Step 1 - Rate Calculation):
    • Nper=5\text{Nper} = 5
    • \text{PMT} = \2,000,000 \times 4.5\% = \90,00090,000
    • PV=−$2,044,518\text{PV} = -\$2,044,518
    • FV=$2,000,000\text{FV} = \$2,000,000
    • Calculated Effective Rate: 4%4\%
  • Subsequent Measurement (Step 2 - Interest Calculation):
    • Interest Revenue=4%×$2,044,518=$81,780.72\text{Interest Revenue} = 4\% \times \$2,044,518 = \$81,780.72
  • Subsequent Measurement (Step 3 - Amortization Entry):
    • Debit: Cash Received $90,000\$90,000
    • Credit: Interest Revenue $81,780.72\$81,780.72
    • Credit: Investment in Bond $8,219.28\$8,219.28 (The difference representing the amortization of the premium).

Illustrative Example: FVTOCI

  • Scenario: Ontario Co. purchased 1,000 shares of Investco on July 10, Year 1, for $23\$23 per share. Brokerage fees (transaction costs) were $450\$450. On December 15, Year 1, Investco declared a dividend of $3\$3 per share, to be paid on January 10, Year 2. On December 31, Year 1, shares were trading at $25\$25 per share. Management designates these as FVTOCI.
  • Initial Recognition:
    • Total Cost: (1,000×$23)+$450=$23,450(1,000 \times \$23) + \$450 = \$23,450.
    • Debit: Investment - Investco $23,450\$23,450.
    • Credit: Cash $23,450\$23,450.
  • Dividend Recognition (Year 1):
    • Dividend Amount: \3 \times 1,000 = \3,0003,000.
    • Debit: Dividend Receivable $3,000\$3,000.
    • Credit: Dividend Income $3,000\$3,000.
  • Fair Value Adjustment (December 31, Year 1):
    • Ending Fair Value: 1,000×$25=$25,0001,000 \times \$25 = \$25,000.
    • Current Carrying Value: $23,450\$23,450.
    • Required Adjustment: $25,000−$23,450=$1,550\$25,000 - \$23,450 = \$1,550.
    • Debit: Investment - Investco $1,550\$1,550.
    • Credit: Other Comprehensive Income (OCI) $1,550\$1,550.