A few weeks ago, we published the article about How to Implement IFRS 9 to assist you with the adoption of the major forthcoming IFRS update.
Many accountants and CFOs are worried about IFRS 9, there are numerous discussions going on about it, but not everybody has the clear vision about WHAT is a financial instrument.
Indeed, some items are crystal clear to identify – yes or no.
But, some other transactions require careful assessment of the terms in the contract to conclude whether we deal with the financial instruments and IFRS 9 rules apply.
In today’s article, Mr. Spark Wang and Silvia explain:
- What the financial instruments are (with a few illustrative examples);
- The main features of the financial instruments;
- Where IFRS 9 applies and where it does NOT apply.
What is a financial instrument?
Before we explain what the financial instrument is, we would like to point out that the definitions of financial instruments are prescribed in IAS 32 Financial Instruments: Presentation.
Despite clear definitions in IAS 32 Financial Instruments: Presentation, it’s still quite difficult to apply IFRS 9, because of the complexity in different scenarios.
For example, it is very tricky to differentiate the perpetual bonds from the preferred stock, which triggers completely different accounting treatments subsequently.
So, what is it?
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. (IAS 32 par.11)
Please note that unlike other assets or liabilities, financial instruments arise from the CONTRACT.
Here, the equity instrument is the investment in another entity, so entity’s own shares are excluded, as well as the interests in the reporting entity’s joint venture or subsidiary.
Therefore, the financial instrument is a bridging tool between the assets or rights on one side, and liabilities or equity instruments of another entity on the other side.
What is a financial asset?
Financial assets are:
- Cash,
- Equity instruments of another entity (e.g. shares),
- Contractual right
- To receive cash or another financial asset of another entity (e.g. trade receivable);
- To exchange financial assets or financial liabilities with another entities under potentially favorable conditions (e.g. foreign currency forward contract with positive outcome – derivative asset)
- Contract settled with variable amount of own equity instruments (very simplified). If this would be settled with fixed amount of own equity instruments, then it would have been an equity instrument, not a financial asset.
Please note that the contractual rights to receive an asset other than cash or a financial asset of another entity is NOT a financial instrument.
Example – financial instrument or not?
Imagine you ordered XY barrels of petrol with delivery in 3 months at market price valid at the time of delivery. You have 2 options:
- You can take physical delivery (=petrol)
- Instead of physical delivery, you settle in cash (pay or receive the difference in market prices between the date of the contract and the time of delivery).
If you intend to take physical delivery, then it’s NOT a financial instrument (if you have no history of similar contracts settling in cash). It’s a regular trading contract, because you will NOT receive a cash or a financial asset of another entity.
But, if you intend to settle in cash, then here we go, it’s a financial instrument and you need to recognize a derivative from the day 1.
What is a financial liability?
Financial liability is:
- A contractual obligation
- To deliver cash or another financial asset to another entity (e.g. loan taken, ,trade payable), or
- To exchange financial assets or financial liabilities other than the entity’s own equity under potentially unfavorable conditions.
- Contract settled with variable amount of own equity instruments (very simplified). If this would be settled with fixed amount of own equity instruments, then it would have been an equity instrument, not a financial liability.
Why variable amount, not fixed?
Why is the fixed amount of own equity instruments excluded when defining the financial assets and liabilities?
It is probably because the nature of such transactions is very close to equity issuance or repurchase.
Example – liability or equity?
Your company writes 2 options to deliver your own shares:
- The first option is to deliver your own shares for total value of CU 1 000;
- The second option is to deliver 100 pieces of your own shares.
Which one is an equity?
Well, clearly option n. 2, because you will deliver fixed amount of your own shares.
Under option n.1, you deliver variable amount, because precise amount will depend on the market price of your shares at the time of delivery (CU 1 000 divided by the unit price). Therefore, it’s a financial liability.
What are the main Features of Financial Instruments
According to the characteristics of risks and rewards associated with the financial instruments, there are three types:
- Derivatives,
- Equities (e.g. shares) and
- Debt instruments (including receivables).
In addition to the three basic instruments, there are hybrid or compound financial instruments with more complicated features.
The following matrix depicts the main features of the financial instruments in three dimensions:
- How to define the Rights and Obligations,
- Who recognizes Assets or Liabilities for each category of the financial instruments, and
- Various subtypes available for the category.
Derivatives
Derivatives are the contracts with negligible or zero initial net value and subsequent fair value changes depending on the mark to market value of the underlying assets.
Derivatives can be either asset or liability depending on whether there is a mark to market gain or loss from the contract.
In addition, the future settlement of derivatives is normally in cash or other types of financial assets, instead of physical delivery.
Forward, futures, swaps and options are four basic types of the derivatives. Moreover, there are advanced or exotic derivatives.
Equity instruments
Equity represents both the residual rights of the holders and the issuers’ limited obligation to stakeholders after total assets deducting total liabilities during solvency.
However, the residual rights and limited obligations are applicable only during the issuers’ solvency, which means the issuer of ordinary shares has no obligation to pay the holder in daily operations.
As per previous discussion, only the equity holder needs to book it under the IFRS 9 as the financial assets, while the equity on the issuer’s side is out of scope of IFRS 9.
Debt instruments
Debt instruments are the contractual rights and obligations with defined terms for amount and timing to pay.
It must be reminded that the receiver of the debt contract, or the rights owner should book the debt as assets; while the payer of debt contract should book the debt as liabilities.
Unlike the equity where the payment by the issuer is only be expected during the solvency, the debt must be paid when due as prescribed by the debt contracts. Normally the debts are in the form of deposits, loan, bonds, payables and receivables.
According to IFRS 9, the debts should be further split into SPPI (Solely Payments of Principal & Interest) and Non-SPPI, where the interest of the former is mainly based on time value, credit risk and liquidity risk.
Scope of the IFRS 9 Assets and Liabilities
Until now, we discussed and explain which items ARE within the scope of IFRS 9.
Now, let’s try to list a few items what are NOT within the scope of IFRS 9 and you should apply some other standard to these items:
- Contract to deliver physical goods or services that is not settled by cash, cash equivalent, and financial instruments (see the example above).
- Constructive obligations such as deferred income, warranty, or impairment provision; and statutory obligations such as tax payables; which are all not contractual.
- Special items with its own standards, such as insurance contracts under IFRS 4, finance lease under IAS 17 , share-based payment under IFRS 2, contract assets under IFRS 15, and contingent events and provisions under IAS 37.
- Certain loan commitments and finance guarantees that is not booked at the FVPL. However, potential credit losses are subject to the ECL model like the finance lease.
Finally, we would like to stress that even if the above items are NOT within the scope of IFRS 9, this standard can still have some impact on their accounting.
For example, you should account for leases under IAS 17 / IFRS 16, but any potential impairment of the net investment in the lease in the lessor’s accounts is still subject to the IFRS 9 expected credit loss model.
About the author
His expertise also includes Basel III reporting, Capital Adequacy Ratio, Liquidity and Funding Risk.
Spark is a CICPA (China Institute of Certified Public Accountants), FCCA (fellow of the Chartered Association of Certified Accountants), CMA (Certified Management Accountant), and a panel of the Expert committee of ESNAI (Electronic Shanghai National Accounting Institute).
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