IAS 39 Financial Instruments: Recognition and Measurement
IAS 39 is a standard fully replaced by the new standard on financial instruments IFRS 9 applicable from 1 January 2018. If you would like to know more about this process, please read our article IAS 39 vs. IFRS 9: Clarifying the Confusion.
UPDATE 2018: IAS 39 is superseded for the periods starting on or after 1 January 2018 and you have to apply IFRS 9 Financial Instruments. I leave this summary here for your information.
IAS 39 prescribes rules for accounting and reporting of almost all types of financial instruments. Typical examples include cash, deposits, debt and equity securities (bonds, treasury bills, shares…), derivatives, loans and receivables and many others.
IAS 39 also explicitly lists what is outside its scope and thus you should look to other standards for guidance, for example interests in subsidiaries, associates etc.
Due to overall complexity of IAS 39, I decided to split this summary into several logical blocks. So let’s proceed.
Classification of financial assets and financial liabilities
IAS 39 classifies financial assets into 4 main categories:
- Financial asset at fair value through profit or loss:a financial asset that is either
- classified as held for trading, or
- upon initial recognition it is designated by the entity as at fair value through profit or loss
- Held-to-maturity financial investments:non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention to hold to maturity, other than:
- those designated at fair value through profit or loss upon initial recognition
- those designated as available for sale and
- those that meet the definition of loans and receivables
- Loans and receivables: non-derivative financial assets with fixed or determinable payments that are not quoted in an active market other than:
- those that entity intends to sell immediately or in the near term (held for trading)
- those designated at fair value through profit or loss upon initial recognition
- those designated as available for sale
- those for which the holder may not recover substantially all of its investment, other than
because of credit deterioration (available for sale)
- Available-for-sale financial assets: non-derivative financial assets designated as available for sale
or are not classified in any other of 3 above categories.
Financial liabilities are classified into 2 main categories:
- Financial liabilities at fair value through profit or loss:a financial liability that is either
- classified as held for trading, or
- upon initial recognition it is designated by the entity as at fair value through profit or loss
- Other financial liabilities measured at amortized cost using the effective interest method
However, no matter how the financial instrument would be initially classified, IAS 39 permits entities to initially designate the instrument at fair value through profit or loss (but fair value must be reliably measured).
Initial classification of financial assets and financial liabilities is critical due to their subsequent measurement.
Embedded derivatives
Embedded derivatives became a big thing among all auditors and accountants several years ago as people started to realize that these can be found almost everywhere.
Embedded derivative is simply a component of a hybrid instrument that also includes a non-derivative host contract. Typical example is rental contract concluded for several years in advance with rental price adjustments according to inflation measured as consumer price index in European Union.
Non-derivative part in this case is a rent of some property or facility. An embedded derivative part is then forward contract indexed to the consumer price index in EU.
IAS 39 requires separation of embedded derivative from the host contract when the following conditions are fulfilled:
- the economic risks and characteristics of the embedded derivative are not closely related to the economic risks and characteristics of the host contract (here, you would assess whether rent of property is somehow dependent on changes in EU consumer price index)
- a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative
- the hybrid instrument (whole rental contract in our example) is not measured at fair value with changes in fair value recognized in the income statement
Separation means that you account for embedded derivative separately in line with IAS 39 and the host contract (rent in this case) in line with other appropriate standard. If an entity is not able to do this, then the whole contract must be accounted for as a financial asset at fair value through profit or loss.
Initial recognition
IAS 39 requires recognizing a financial asset or a financial liability in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument.
It seems obvious, but the important thing is that also derivatives shall be recognized in the statement of financial position. I stress this point, because many countries do not require recognizing the derivatives as they usually have zero or very small initial costs. But—as the time passes, fair value of derivatives changes and this can have significant impact on the profit or loss and the statement of financial position, too.
Initial measurement
Financial asset or financial liability shall be initially measured at its fair value. When financial asset or financial liability are NOT measured at fair value through profit or loss, then directly attributable transaction costs shall be included in the initial measurement.
Subsequent measurement
As written above, subsequent measurement and the method of accounting for gains or losses from subsequent measurement strongly depend on the category of financial asset or financial liability. Subsequent measurement is summarized in the following table:
Category – WHAT | Subsequent measurement – HOW MUCH | Gains and losses – WHERE |
---|---|---|
Financial assets | ||
Financial assets at fair value through profit or loss | Fair value | Profit or loss |
Held-to-maturity financial investments | Amortized cost using the effective interest method | Profit or loss |
Loans and receivables | Profit or loss | |
Available-for-sale financial investments except below | Fair value | Other comprehensive income (except for impairment and foreign exchange gain/loss) |
Investments in equity instruments with no reliable fair value measurement and derivatives linked to them | Cost | Impairment to profit or loss |
Financial assets designated as hedged items | See Hedge Accounting | See Hedge Accounting |
Derivative financial assets | Fair value | Profit or loss |
Financial liabilities | ||
Financial liabilities at fair value through profit or loss | Fair value | Profit or loss |
Other financial liabilites | Amortized cost using the effective interest method | Profit or loss |
Financial liabilities designated as hedged items | See Hedge Accounting | See Hedge Accounting |
Derivative financial liabilities | Fair value | Profit or loss |
Financial liabilities arising when transfer of financial asset does not qualify for derecognition or is accounted using continuing-involvement method | Measured in line with specific IAS 39 provisions related to transfers / continuing involvement | Profit or loss |
In fact, derivative financial assets and liabilities belong to category “at fair value through profit or loss”, but I show them separately for your convenience.
Impairment
An entity shall assess at the end of each reporting period whether there is any objective evidence that a financial asset is impaired. If there is such evidence, then an entity must calculate the amount of impairment loss.
Impairment loss is calculated as a difference between asset’s carrying amount and the present value of estimated cash flows discounted at the financial asset’s original effective interest rate. Impairment loss shall be recognized to profit or loss account.
Reversal of the impairment loss is possible, but only if in a subsequent period the impairment loss decreases and the decrease directly relates to some event occurring after the recognition of impairment loss. Reversal shall be re recognized in profit or loss.
Derecognition of a financial asset
Standard IAS 39 provides extensive guidance on derecognition of a financial asset. Before deciding on derecognition, an entity must determine whether derecognition is related to:
- a financial asset (or a group of similar financial assets) in its entirety, or
- a part of a financial asset (or a part of a group of similar financial assets). The part must fulfill
the following conditions (if not, then asset is derecognized in its entirety):- the part comprises only specifically defined cash flows from a financial asset (or group)
- the part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset (or group)
- the part comprises only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or group)
An entity shall derecognize the financial asset when:
- the contractual rights to the cash flows from the financial asset expire, or
- an entity transfers the financial asset and the transfer qualifies for the derecognition
Transfers of financial assets are discussed in more details. First of all, an entity must decide whether the asset was transferred or not. Then, if the financial asset was transferred, the entity must determine whether also risks and rewards from the financial asset were transferred.
Was the financial asset transferred?
An entity transfers a financial asset if either the entity transfers the contractual rights to receive the cash flows from a financial asset, or the entity retains the contractual rights to receive the cash flows from the asset, but assumes a contractual obligation to pass those cash flows on (or to pay these cash flows to one or more recipients) under an arrangement that meets the following conditions:
- the entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the original asset
- the entity is prohibited from selling or pledging the original asset (other than as security to the eventual recipient)
- the entity has an obligation to remit any cash flows it collects on behalf of eventual recipients without material delay
Were the risks and rewards from the financial assets transferred?
If substantially all the risks and rewards have been transferred, the asset is derecognized. If substantially all the risks and rewards have been retained, the entity must continue recognizing the asset in its financial statements.
If the entity has neither retained nor transferred substantially all of the risks and rewards of the asset, then the entity must assess whether it has retained control of the asset or not.
If the entity does not control the asset then it must derecognize the asset. But if the entity has retained control of the asset, then the entity continues to recognize the asset to the extent of its continuing involvement in the asset.
Transfers of financial assets are then discussed in much greater detail in IAS 39 and also, application guidance in paragraph 36 summarizes derecognition steps in a simple decision tree. You can familiarize yourself with the decision tree in the video below this summary.
Derecognition of a financial liability
An entity shall derecognize a financial liability when it is extinguished. It is when the obligation specified in the contract is discharged, cancelled or expires.
Hedge accounting
In this short summary I do not intend to explain what hedging is and how it works. But I can promise to do it with some good example in some future article. Here, I just want to sum up what IAS 39 says about hedging.
IAS 39 allows hedge accounting only if all the following conditions are met:
- hedging relationship is at its inception formally designated and documented, together with entity’s risk management objective and strategy for undertaking the hedge
- the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk (consistently with the documentation)
- for cash flow hedges: a forecast transaction must be highly probable and must present exposure to variations in cash flows (which can affect profit or loss)
- the effectiveness of the hedge can be reliably measured
- the hedge is assessed on an ongoing bases and determined actually to have been highly effective
IAS 39 then describes the rules for 3 types of hedging: fair value hedges, cash flow hedges and hedges of a net investment in a foreign operation.
A fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset, liability or a previously unrecognized firm commitment that is attributable to particular risk and can affect profit or loss. The gain or loss from the change in fair value of the hedging instrument is recognized immediately in profit or loss. Also, an entity should adjust the carrying amount of the hedged item for corresponding gain or loss from the hedged risk—this adjustment shall be recognized to profit or loss, too.
A cash flow hedge is a hedge of the exposure to variability in cash flows that could affect profit or loss and is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction. Here, that portion of the gain or loss on the hedging instrument that is determined to be an effective shall be recognized to other comprehensive income. Ineffective portion shall be recognized to profit or loss. IAS 39 then prescribes rules for accounting when a forecast transaction subsequently results in recognition of a financial or non-financial asset or liability.
A hedge of a net investment in a foreign operation is accounted in the similar way as a cash flow hedge.
IAS 39 also specifies when hedge accounting shall be discontinued prospectively:
- when the hedging instrument expires or is sold, terminated, or exercised, or
- when the hedge no longer meets the criteria for hedge accounting, or
- when the forecast transaction is no longer expected to occur, or
- when the entity revokes the hedge designation
Standard IAS 39 addresses all issues in a greater detail and contains application guidance, because it really is very complex and tough standard. I have summarized it also in the following video:
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The recognition for financial instruments including financial asset, financial liabilities, and equity instruments according to relevant ICAP standards
How should my company account for investments in non-consolidated subsidiaries, following IAS 39?
A company xyz has fixed deposit with the bank which was used to secure a loan facility from the bank, what is the treat of the fixed deposit in respect to IFRS 39
Hi Silvia
Trust you are well
I currently in a situation where a a company within the group finance a investment for a other company within the group by means of a loan. The company is just writing of the loan without impairing the original investment. According to me this is not correct. Can you share some light regarding this
How to account reclassify from AFS to held to maturity according IAS 39.
My Company has an investments in XYZ company and the investment classifies as AFS and measured at cost since there is no market value for such instrument. XYZ Company decided to pay dividends by giving 1:1 share for each investor. How i should recognize the new shares?
How can we calculate current and non current portion of loans and receivables (amortized cost) as per IAS 39.
Hay Silvia:
I really appreciate your dedication to teach IFRS to the whole world. We are benefiting from your illustrations and examples of IFRS Standards organized and presented in an understandable manner.
I want to you to clarify on the interest recognition of credit impaired financial asset whose collateral(future cash flows) can sufficiently recover the total outstanding loan(IAS 39 par. AG.93 taking an example?
Best Regards,
Giragn
Hi Silvia,
My company recognize financial liabilities – (payables to parent company of advance payments to subsidiary – “loan”) using fair value by calculating NPV of the loan free of interest which will be only repaid after 5 years. My point of view is that this should be recognized at amortized cost because the total cash will be paid in full by then. please help.
Juliao, unless you categorize the loan at FVTPL, then initially it must be measured at fair value plus transaction cost. Only then, subsequently, you apply amortized cost. So if your company recognize the loan at fair value initially, when the loan was generated (0 transaction cost), then it’s OK.
How do you treat treasury bill purchased with cash
Hi Silvia,
I am currently residing in Pakistan. In our jurisdiction, IFRS 9 is applicable from Annual period begining on or after July 1, 2018. Therefore IAS 39 (2009 edition) is applicable now.
My question is that whether investment in shares of a single listed company can be classified in both categories i.e. Held for trading as well as available for sale as intention to hold 50% percent shares for long term (AFS) and remaining 50% for short term gains under held for trading at the time of purchasing.
Kindly clarify as per IAS 39. Appreciate your reply.
Dear Sylvia,
My client (Parent entity) had HTM portfolio, they have sold few of those, before well in advance to it’s maturity. therefore entire HTM is re-classified to AFS, due to tainting rule. Now two year period is elapsed. IAS 39 para 54 says, it becomes appropriate to reclassify back
1. is it must to re-classify back to HTM or is it optional ?
2. If so, should subsidiaries also follow ? or can they do different treatment, depends on their intention.
3. At the initial point, if parent applies tainting rule, should subsidiary also follow it ?
Kindly clarify. Appreciate your reply.
Hi Kavinda,
interesting question.
1. It is a must, but only in theory. The reason is that the investments are not designated as HTM, but they must be included in this category if they meet the conditions. But, in practice, it is too easy to break the rules and trigger reclassification to AFS.
2. Yes, absolutely. This is very strict rule and if it is broken, then all instruments must be reclassified (not by classes, but the whole category).
3. Yes.
Hope it helps, S.
Hi silvia,
if impairment loss arises consecutively in two years after that there is gain.then which loss would be reversed???either loss for current year in which gain arise or both years loss commulatively????
Hi Silvia,
Can you sharing with me about ifrs 9 “financial Asset Loans and receivables”?, what your advice about “deposit rent”?
Thaks Very Much Before…
Dear Sylvia,
a company bought receivables, that were secured by a collateral. The fair value of the collateral is much higher than the price the company paid for receivables. How to account for the transaction? And what if the receivables were not paid when due, and the company has to sell collateral for the price much higher than the receivables were paid for?
Thank you!
Dear Sylvia,
how to account for a loan discharge? Loan had a collateral, and with the discharge, collateral has been removed (buildings), so there is no obligation toward the bank and the property is not pledged anymore.
Thanks!
can an investment in subsidiary be classified in investments but valued at FVTPL? only asset of sub company is investment in a fund.
In individual investor’s financial statements – yes. However, unless the investor is an investment entity and meets the exception criteria as per IFRS 10, then you need to consolidate.
I wanted to find a Company gave its employees house loans some years back at a Lower interest rate that was prevailing over time. However the rates have changed in the market as they have drastically increased. What should they do. Should the Loans be revalued to show fair value to current rates being used by the Banks.
If an investment is measured at FVTPL I see transaction costs on measurement are not capitalised.
How about transaction costs upon sale? Would these reduce the realised gain? Or would they be expenses separately in P/L?
Thanks
Hi Seb, yes, they reduce the gain on sale. S.
Dear Silvia,
My Company borrowed funds from a financial institution and the contract stipulates that some fees would be paid upon maturity of the facility. I have not treated it as a transaction cost as I could not find any reference in the standard to fees paid in arrears. The Auditor is insisting that the payable fees is a transaction cost and has factored it into the amortised cost computation.
What is your view on this treatment?
For assets and liabilities at FVTPL, each period they are revalued to unrealized gains/losses. Then in the period sold , there will be a realized gain for the difference between the most recent fair value and proceeds. So assume that the last several periods recorded an unrealized gain each period on this particular asset when it’s sold, do those unrealized gains somehow get reclassified to realized gains ? Like debit unrealized gain(to clear previous P&L entries) and then credit realized gain? That seems more like OCI accounting. But I guess I just thought that the “realized gain” on P&L should somehow be proceeds less original cost ?
Dear Brenna,
I need to say that these “unrealized” differences in the past periods were recognized in profit or loss – it means, that they were in fact realized. As a result, when you sell an asset, any gain or loss is recognized in P/L, an asset is derecognized and that’s it. S.
Hi Silvia. Great post.
Speaking on Amortised Cost Measurement, I would like to know specific examples of transaction fees that are required and not required to be amortised when carrying out the valuation of the financial instruments. I am aware that there are one-off fees and there are periodic fees paid or received (which arose as a result of the creation of the instrument). Is the amortised required on only one-off fees or periodic fees or both? Can you give specific examples of fees required or not required to be taken into consideration when carrying out such measurement?
Thanks
Hi Silvia. Great post.
Speaking on Amortised Cost Measurement, I would like to know specific examples of transaction fees that are required and not required to be amortised when carrying out the valuation of the financial instruments. I am aware that there are one-off fees and there are periodic fees paid or received (which arose as a result of the creation of the instrument). Is the amortised required on only one-off fees or periodic fees or both? Can you give specific examples of fees required or not required to be taken into consideration when carrying out such measurement?
Thanks.
It depends of the nature of the investment and its category.
Regarding the part that will be invested next year, no recognision should be made in current year but a disclosure note will be enough i think.
Hi, Silvia
We have invested in foreign operation (in shares ) and we have entered into agreement in this financial year. But we made our investment partially and one part will be invested in next FY.
1.How do we record this in current Financial year ?
2.Can we revalue this end of current FY
Hi Bandara,
it depends precisely on the contract conditions, but let’s say that you gain a control over your shares when you pay (shares are transferred after payment). Then you account for this as 2 acquisitions. If it’s in a foreign currency, then it’s a non-monetary asset. The subsequent measurement depends on the classification of your assets, but in most cases, yes, you do revalue at fair value. S.
Thanks for the wonderful video, I want to understand whether the de recognition mechanism has changed under IFRS 9 or is it the same as IAS 39. Also can you give me an example of how recognising a financial asset has changed from IAS 39 to IFRS 9 for all the 3 classifications.
Thanks a lot in advance
Jain, that would require more elaborate answer than in one comment 🙂 S.
Hi,
Is there any guidance, as to if we can chose not to use the Effective Interest Method for calculation of interest income on Assets Held under Fair Value Through PL (FVTPL)
Mohamed, once you select FVTPL, you do NOT apply the effective interest method. You do fair value changes. S.
How is deposit for shares treated in the financial statements