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UPDATE 2018: IAS 39 is superseded for the periods starting on or after 1 January 2018 and you have to apply IFRS 9 Financial Instruments.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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