Introduction

Publication date: 08 Dec 2017


6.7A.1 An entity recognises a financial asset or a financial liability when it first becomes a party to the contractual rights and obligations in the contract. It is, therefore, necessary to measure those contractual rights and obligations on initial recognition. Under IAS 39, all financial instruments are measured initially by reference to their fair value, which is normally the transaction price, that is, the fair value of the consideration given or received. However, this will not always be the case.

6.7A.2 Subsequent to initial recognition, IAS 39’s measurement approach is best described as a ‘mixed attribute’ model with certain assets and liabilities measured at cost and others at fair value. The model depends upon an instrument’s classification into one of the four categories of financial assets or one of the two categories of financial liabilities discussed in chapter 6.4A. For example, depending on the nature of the instrument and management’s intentions, a fixed interest security intended to be held-to-maturity would be measured at amortised cost and not at fair value. Notwithstanding this, as explained in chapter 6.4A, the standard gives entities the option to classify financial instruments that meet certain special criteria at fair value with all gains and losses taken to profit and loss. The ability for entities to use the fair value option simplifies the application of IAS 39 by mitigating some anomalies that result from the use of the mixed measurement model.

6.7A.3 This chapter deals with IAS 39’s basic measurement requirements and addresses the concepts of fair value and amortised cost, including the use of the effective interest method and the standard’s impairment model. Detailed guidance on fair value measurement is included in chapter 5, and the special form of accounting that applies when a financial asset or liability is designated by management in a hedging relationship is covered in chapter 6.8A.

6.7A.4 It is the IASB’s intention that IFRS 9 will ultimately replace IAS 39 in its entirety. IFRS 9 now includes requirements for classification and measurement of financial instruments (both financial assets and financial liabilities), impairment of financial assets and general hedge accounting. IFRS 9 is dealt with in chapter 42.

6.7A.5 In May 2011 the IASB issued IFRS 13. The standard provides a single source of fair value measurement guidance. It clarifies the definition of fair value, provides a framework for measuring fair value and requires disclosures for all assets and liabilities measured at fair value, on recurring (for example some financial instruments) or non-recurring (for example intangible assets acquired in a business combination) basis. The standard does not determine when fair value measurements are required. The measurement guidance in IFRS 13 applies to all fair value measurements except for those within the scope of IFRS 2 or IAS 17, and certain other measurements that are required by other standards and are similar to, but are not, fair value. Disclosures are required for assets and liabilities measured at fair value with some exceptions. IFRS 13 amended IAS 39 and IFRS 9 to remove their guidance on fair value measurement. IFRS 13 is effective for annual periods beginning on or after 1 January 2013 and it is applied prospectively as of the beginning of the annual period in which it is initially applied. IFRS 13 is dealt with in chapter 5.

Initial measurement - Initial fair value

Publication date: 08 Dec 2017


6.7A.6 When a financial asset or financial liability is recognised initially, IAS 39 requires the entity to measure it at its ‘fair value’ plus, in certain situations, transaction costs (see para 6.7A.13 below). [IAS 39 para 43]. The standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. [IAS 39 para 9]. The concept of fair value and requirements for determining the fair value of financial instruments are discussed in detail from paragraph 6.7A.94 below.

6.7A.7 Given that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, it follows that a financial instrument’s initial fair value will normally be the transaction price, that is, the fair value of the consideration given or received. [IAS 39 para AG 64].

6.7A.8 In some circumstances the consideration given or received (say the face amount) may not necessarily be the financial instrument’s fair value. For example, the fair value of a long-term note receivable that carries no interest is not equal to its face amount and, therefore, part of the consideration received is something other than its fair value. As the note receivable would have to be recorded initially at its fair value, its fair value has to be estimated. The instrument’s fair value may be evidenced by a quoted price in an active market for an identical asset or liability (that is, a Level 1 input) or based on a valuation technique that uses only data from observable markets. [IAS 39 para AG 76]. For a long-term loan or receivable with no stated interest, the fair value is normally arrived at by using a discounted cash flow valuation method. Under this method, the fair value can be estimated as the present value of all future cash receipts discounted using the prevailing market rate of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating issued at the same time. Any additional amount lent is an expense or a reduction of income, unless it qualifies for recognition as some other type of asset. [IAS 39 para AG 64].

6.7A.9 Short-term receivables and payables are commonly measured at the original invoice amount if the effect of discounting is immaterial. This is consistent with the requirements of IAS 8 which permit an entity not to apply accounting policies where the effect is not material. The IFRS IC also considered the accounting for extended payment terms, such as six months interest-free credit, and concluded that the accounting treatment under IAS 39 was clear. In such circumstances, the effect of the time value of money should be reflected where this is material. [IFRIC Update July 2004].

Example 1 – Interest free loan to a company
 
Entity A lends C1,000 to entity B for 5 years and classifies the asset under loans and receivables. The loan carries no interest. Instead, entity A expects other future economic benefits, such as an implicit right to receive goods or services at favourable prices.
 
On initial recognition, the market rate of interest for a similar 5 year loan with payment of interest at maturity is 10% per year. The loan’s initial fair value is the present value of the future payment of C1,000 discounted using the market rate of interest for a similar loan of 10% for 5 years, that is, C621.
 
In this example, the consideration given of C1,000 is for two things – the fair value of the loan of C621 and entity A’s right to obtain other future economic benefits that have a fair value of C379 (the difference between the total consideration given of C1,000 and the consideration given for the loan of C621).
 
Entity A recognises the loan at its initial fair value of C621 that will accrete to C1,000 over the term of the loan using the effective interest method (see further para 6.7A.67 below).
 
The difference of C379 is not a financial asset, since it is paid to obtain expected future economic benefits other than the right to receive payment on the loan asset. Entity A recognises that amount as an expense unless it qualifies for recognition as an asset under, say, IAS 38, or as part of the cost of investment in subsidiary, if entity B is a subsidiary of entity A.

Example 2 – Interest free loan to an employee
 
An entity grants an interest free loan of C1,000 to an employee for a period of two years. The market rate of interest to this individual for a two year loan with payment of interest at maturity is 10%.
 

The consideration given to the employee consists of two assets:

   
The fair value of the loan, that is C1,000/(1.10)2 = C826.
The difference of C174 that is accounted for as employee compensation in accordance with IAS 19.
   

Example 3 – Interest free loan received from a government agency
 
An entity is located in an enterprise zone and receives an interest free loan of C500,000 from a government agency. The loan carries no interest and is repayable at the end of year three.
 
Loans received from a government that have a below-market rate of interest should be recognised and measured in accordance with IAS 39. The benefit of the below-market rate of interest should be measured as the difference between the initial carrying value of the loan determined in accordance with IAS 39 and the proceeds received. [IAS 20 para 10A].
 
So if the fair value is estimated at C450,000 under IAS 39, the loan would be recorded initially at its fair value of C450,000. The difference between the consideration received and the fair value of the loan, that is, C50,000, would fall to be accounted for as a government grant in accordance with IAS 20.
 
However, the IASB noted that applying IAS 39 to loans retrospectively may require entities to measure the fair value of loans at a past date. So the IASB decided that the amendment should be applied prospectively to government loans received in periods beginning on or after 1 January 2009.

6.7A.10 In some circumstances, instead of originating an interest free loan, an entity may originate a loan that bears an off-market interest rate (for example, a loan that carries a higher or lower rate than the prevailing current market rate for a similar loan) and pays or receives an initial fee as compensation. In that situation, the entity still recognises the loan at its initial fair value, that is, net of the fee paid or received as illustrated below. The fee paid or received is amortised to profit or loss using the effective interest method. [IAS 39 para AG 65]. A similar requirement is included in IAS 18, where fees that are an integral part of a financial instrument’s effective interest rate are generally treated as an adjustment to the effective interest rate. [IAS 18 para IE 14(a)].

6.7A.11 A further exception to the general rule that the transaction price is not necessarily the financial instrument’s initial fair value is of particular relevance to banking and insurance entities. Such entities often originate structured transactions and use models to estimate their fair values. Such models may show a ‘day 1’ gain (that is, the fair value exceeds the transaction price). However, IFRS permits departure from the transaction price only if fair value is evidenced by observable current market transactions in the same instrument or a valuation technique whose variables include only data from observable markets. As a result, an immediate ‘day 1’ gain is rarely recognised on initial recognition. This issue is considered further in paragraph 6.7A.148 below.

Example – Off-market loan with origination fee
 
An entity originates a loan for C1,000 that is repayable in 5 years’ time. The loan carries interest at 6%, which is less than the market rate of 8% for a similar loan. The entity receives C80 as compensation for originating a below market loan.
 
The entity should recognise the loan at its initial fair value of C920 (net present value of C60 of interest for 5 years and principal repayment of C1,000 discounted at 8%). This is equal to the net cash received (loan of C1,000 less origination fee of C80). The net amount of the loan of C920 accretes to C1,000 over the 5 year term using an effective interest of 8%.
 
In this example, the upfront fee received of C80 exactly compensates the entity for interest short fall of C20 for each of the next 5 years discounted at the market rate of 8%. Hence, no gain or loss arises on initial recognition.

Initial measurement - Transaction costs

Publication date: 08 Dec 2017


6.7A.12 Transaction costs are incremental costs that are directly attributable to the acquisition or issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument. [IAS 39 para 9].

6.7A.13 Transaction costs include fees and commissions paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs. [IAS 39 para AG 13].

6.7A.14 The standard defines transaction costs to include internal costs, provided they are incremental and directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. [IAS 39 para BC222(d)]. However, in practice, other than payments made to employees acting as selling agents (common in insurance contracts that fall to be accounted for under IAS 39 as financial instruments), salary costs of employees that would be incurred irrespective of whether the loan was granted are not incremental, nor are allocated indirect administrative costs or overheads.

6.7A.15 The appendix to IAS 18 sets out a number of examples of financial services fees. IAS 18 distinguishes such fees between those that are an integral part of generating an involvement with the resulting financial instrument, those that are earned as services are provided and those that are earned on the execution of a significant act. Such fees may fall into two categories: fees associated with origination of a loan (loan origination fees) and fees associated with commitment to lend (commitment fees).

6.7A.16 Loan origination fees may consist of:

Fees that are charged to the borrower as ‘pre-paid’ interest or to reduce the loan’s nominal interest rate (explicit yield adjustments).
Fees to compensate the lender for origination activities such as evaluating the borrower’s financial condition, evaluating and recording guarantees, collateral and other security arrangements, negotiating the instrument’s terms, preparing and processing documents and closing the transaction.
Other fees that relate directly to the loan origination process (for example, fees that are paid to the lender as compensation for granting a complex loan or agreeing to lend quickly).

6.7A.17 Commitment fees are fees that are charged by the lender for entering into an agreement to make or acquire a loan. Sometimes they are referred to as facility fees for making a loan facility available to a borrower. The accounting treatment depends on whether or not it is probable that the entity will enter into a specific lending arrangement and whether the loan commitment is within IAS 39’s scope. If it is probable that the entity will enter into the lending agreement and the loan commitment is not within IAS 39’s scope, the commitment fee received is regarded as compensation for an ongoing involvement with the acquisition of a financial instrument and, together with the transaction costs (as defined in IAS 39), is deferred and recognised as an adjustment to the effective interest rate. If the commitment expires without the entity making the loan, the fee is recognised as revenue on expiry. [IAS 18 App para 14(a)(ii)]. On the other hand, if it is unlikely that a specific lending arrangement will be entered into and the loan commitment is outside IAS 39’s scope, the commitment fee is recognised as revenue on a time proportion basis over the commitment period. Loan commitments that are within IAS 39’s scope are accounted for as derivatives and measured at fair value. [IAS 18 App para 14(b)(ii); IAS 39 para 9].
 
6.7A.18 The borrower’s accounting mirrors that of the lender as discussed above. Therefore, to the extent there is evidence that it is probable that some or all of the facility will be drawn down, the facility fee is accounted for as a transaction cost under IAS 39. Where this is the case, the facility fee is deferred and treated as a transaction cost when draw-down occurs; it is not amortised prior to the draw-down. For example, draw-down might be probable if there is a specific project for which there is an agreed business plan. If a facility is for C20 million and it is probable that only C5 million of the facility will be drawn down, a quarter of the facility fee represents a transaction cost of the C5 million loan and is deferred until draw-down occurs. To the extent there is no evidence that it is probable that some or all of the facility will be drawn down, the facility fee represents a payment for liquidity services – that is, to secure the availability of finance on pre-arranged terms over the facility period. As such, to the extent draw down is not probable, the facility fee is capitalised as a prepayment for services and amortised over the period of the facility to which it relates. The availability of finance on pre-arranged terms provides benefit to an entity in a similar way to an insurance policy. If finance is needed in the future due to unforeseen events, the facility in place ensures that an entity can obtain this finance on known terms regardless of the economic environment in the future.

6.7A.18.1 An entity might enter into a loan commitment for which it charges a fee that is directly related to the undrawn portion of the loan commitment and which changes based on the portion of the unused commitment at that time. In such circumstances, the fee is not related to the amount being lent, and so would not be deferred and included as part of the effective interest rate when the commitment is drawn (as discussed above). The fee relates to a service being provided by the lender and, as such, should be accounted for as a service in accordance with IAS 18 (see above). The borrower’s accounting would mirror that of the lender.

6.7A.19 Direct loan origination costs relate to costs incurred by the entity for undertaking activities set out in the second bullet point of paragraph 6.7A.16 above. Internal costs directly related to those activities should include only that portion of employee cost directly related to time spent performing those activities (see para 6.7A.16 above).

6.7A.20 It is apparent from the nature of the above fees that they are an integral part of generating an involvement with the resulting financial instrument and together with the related direct origination costs, are accounted for in a financial instrument’s initial measurement as follows:

When a financial asset or financial liability is recognised initially and not designated as at fair value through profit or loss, transaction costs (net of fees received) that are directly attributable to the acquisition or issue are added to the initial fair value. For financial assets, such costs are added to the amount originally recognised. For financial liabilities, such costs are deducted from the amount originally recognised. This applies to financial instruments carried at amortised cost and available-for-sale financial assets. [IAS 39 para 43].
For financial instruments that are measured at fair value through profit or loss, transaction costs (net of any fees received or paid) are not added to or deducted from the initial fair value, but are immediately recognised in profit or loss on initial recognition.
Transaction costs expected to be incurred on a financial instrument’s transfer or disposal are not included in the financial instrument’s measurement.
[IAS 39 para IG E1.1].

Example 1 – Initial measurement – transaction cost
 
An entity acquires an equity available-for-sale financial asset at its fair value of C100. Purchase commission of C2 is also payable. At the end of the entity’s financial year, the asset’s quoted market price is C105. If the asset were to be sold, a commission of C4 would be payable.
 
As the asset is not classified initially at fair value through profit or loss, the entity recognises the financial asset at its fair value that includes the purchase commission, that is, at C102. At the end of the entity’s financial year, the asset is recorded at C105 without regard to the commission of C4 payable on sale. The change in fair value of C3 recognised in other comprehensive income includes the purchase commission of C2 payable at the acquisition date.

Example 2 – Allocation of transaction costs to a convertible instrument that contains a conversion option as an embedded derivative
 
An entity, with functional currency of C, issues a 5 year, euro-denominated convertible bond for C100. Transaction costs of C2 were incurred by the issuer. The host liability is to be accounted for at amortised cost. The fair value of the embedded derivative on initial recognition was C20.
 
Transaction costs relating to issuance of a convertible instrument for which the conversion feature is classified as an embedded derivative should be allocated to the host liability and the embedded conversion option in either of the following ways (that is, there is an accounting policy choice):
   
■  Approach 1 – The convertible bond represents a liability in its entirety, as the conversion feature fails the fixed-for-fixed requirement for equity classification (see chapter 43). On initial recognition, the financial liability (that is, the entire instrument) should be recognised at fair value less transactions costs that are directly attributable to its issuance since the instrument is not at fair value through profit or loss. As the embedded derivative’s fair value at initial recognition is C20, the host liability is initially recognised at C78 (C100 – C20 – C2) and there is no impact on profit or loss.
■  Approach 2 – Under this approach, transaction costs are allocated to each component in proportion to the allocation of proceeds. Therefore, costs allocated to the embedded derivative are charged to profit or loss on initial recognition, and those allocated to the host contract are deducted from its initial carrying amount. Accordingly, the embedded derivative is recognised initially at C20, with (20/100) of the transaction costs (that is, C0.4) being recognised in profit or loss. The host liability is recognised initially at C78.4 (C100 – C20 – (80/100) × C2).

6.7A.21 Entities may also receive fees for the provision of a service, such as loan servicing fee, or for the execution of a significant act such as placement fees for arranging a loan between two third parties and loan syndication fees. These fees are not integral to lending or borrowing and, therefore, cannot form part of the financial instrument’s measurement.

6.7A.22 The treatment of transaction costs on the subsequent measurement of available-for-sale financial assets is considered in paragraph 6.7A.33 below and those carried at amortised cost are considered in paragraph 6.7A.75 below.

Initial measurement - Settlement date accounting for regular way transactions

Publication date: 08 Dec 2017


6.7A.23 When an entity uses settlement date accounting for an asset that is subsequently measured at cost or amortised cost, the asset is recognised initially at settlement date, but measured at the fair value on trade date. [IAS 39 para 44]. This is an exception to the general rule in paragraph 6.7A.6 above that a financial asset should be recognised at its fair value on initial recognition. The accounting for regular way trades is considered in chapter 44.

Subsequent measurement of financial assets - General

Publication date: 08 Dec 2017


6.7A.24 As set out in chapter 6.4, financial assets are classified in one of four categories. Following their initial recognition, the classification determines how the financial asset is subsequently measured, including any profit or loss recognition. The following table summarises the requirements that are considered in detail in the remainder of this chapter.

Classification Financial asset Measurement basis Changes in carrying amount Impairment test (if objective evidence)
At fair value through profit or loss Debt Fair value Profit or loss No 5
Equity 1 Fair value Profit or loss No 5
Derivatives not designated as effective hedging instruments Fair value Profit or loss No 5
Loans and receivables Debt Amortised cost Profit or loss 3 Yes
Held-to-maturity investments Debt Amortised cost Profit or loss 3 Yes
Available-for-sale financial assets   Debt Fair value OCI 2
Profit or loss 3
Yes
Equity 1 Fair value OCI 2
Profit or loss 4
Yes
1 Equity instruments that do not have any quoted market price in an active market and whose fair value cannot be reliably measured and derivative assets that are linked to and must be settled by delivery of such unquoted equity instruments are measured at cost.
2 Change in fair value including related foreign exchange differences other than those noted in note 3 or 4 below where relevant.
3 Interest calculated using the effective interest method, foreign exchange differences resulting from changes in amortised cost, impairment and reversal of impairment, where relevant, are taken to profit or loss.
4 Dividends and impairment are taken to profit or loss. Foreign exchange difference on (non-monetary) equity AFS investments taken to equity and recycled to profit or loss on disposal or impairment.
5 Any impairment will be taken though profit or loss as part of the change in fair value and so separate impairment testing is not necessary.

6.7A.25 Financial assets that are designated as hedged items are subject to measurement under the hedge accounting requirements. These requirements apply in addition to, and may modify, the general accounting requirements that are discussed below. Hedge accounting is covered in chapter 6.8.

Subsequent measurement of financial assets - Financial assets at fair value through profit or loss

Publication date: 08 Dec 2017


6.7A.26 After initial recognition, financial assets falling within this category (including assets held-for-trading and derivative assets not designated as effective hedging instruments and assets designated on initial recognition at fair value through profit or loss) are measured at fair value, without the deduction of transaction costs that the entity may incur on sale or other disposal. [IAS 39 para 46]. Such transaction costs are future costs that relate to the sale or the disposal and have no relevance to determining fair value. Therefore, they are properly included in the period in which the sale or the disposal takes place.

6.7A.27 The standard’s requirements for determining the fair value of instruments that fall to be measured on this basis are considered from paragraph 6.7A.94 below. Investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured and derivatives that are linked to and must be settled by delivery of such unquoted equity instruments, are measured at cost (see further para 6.7A.145 below). [IAS 39 para 46(c)].

6.7A.28 All gains and losses arising from changes in fair value of financial assets falling within this category are recognised, not surprisingly, in profit or loss. [IAS 39 para 55(a)]. This means that assets falling within this category are not subject to review for impairment as losses due to fall in value (including impairment) would automatically be reflected in profit or loss.

Subsequent measurement of financial assets - Loans and receivables

Publication date: 08 Dec 2017


6.7A.29 Loans and receivables, as defined in chapter 6.4A, are measured at amortised cost using the effective interest method. [IAS 39 para 46(a)]. They are measured on this basis whether they are intended to be held-to-maturity or not. [IAS 39 para AG 68]. The amortised cost method of accounting is discussed from paragraph 6.7A.67 below.

6.7A.30 Gains and losses are recognised in profit or loss when loans and receivables are derecognised or impaired and throughout the amortisation process. Special rules apply for gain or loss recognition when loans and receivables are designated as hedged items. [IAS 39 para 56].

Subsequent measurement of financial assets - Held-to-maturity investments

Publication date: 08 Dec 2017


6.7A.31 Held-to-maturity investments are also measured at amortised cost using the effective interest method. Gains and losses are accounted for in the same way as loans and receivables. [IAS 39 para 46(b)].

Subsequent measurement of financial assets - Available-for-sale assets

Publication date: 08 Dec 2017


6.7A.32 Available-for-sale financial assets are measured at fair value. As with assets designated as at fair value through profit or loss, transaction costs that will be incurred on the sale or disposal of such assets are not deducted from the fair value. However, there is an exemption from measurement at fair value of an available-for-sale asset if its fair value cannot be measured reliably (see para 6.7A.27 above). This exemption only applies to equity instruments that do not have a quoted price in an active market for an identical instrument and derivative contracts based on those instruments. These instruments are measured at cost. [IAS 39 para 46(c)].

6.7A.33 As explained in paragraph 6.7A.20 above, transaction costs that are directly attributable to the acquisition of an available-for-sale financial asset are added to the initial fair value. For available-for-sale financial assets, transaction costs are recognised in other comprehensive income as part of a change in fair value at the subsequent measurement. If an available-for-sale financial asset has fixed or determinable payments and does not have an indefinite life, the transaction costs are amortised to profit or loss using the effective interest method (see para 6.7A.68 below). If an available-for-sale financial asset does not have fixed or determinable payments and has an indefinite life, the transaction costs are recognised in profit or loss when the asset is derecognised or becomes impaired and the cumulative gain or loss, including transaction costs, deferred in other comprehensive income is reclassified to profit or loss. [IAS 39 para AG 67].

6.7A.34 All gains and losses arising from changes in fair value of available-for-sale financial assets are recognised directly in other comprehensive income except as follows:

Interest calculated using the effective interest method is recognised in profit or loss (see further para 6.7A.67 below). Dividends on an available-for-sale equity instruments are recognised in profit or loss when the entity’s right to receive payment is established. [IAS 18 para 30(c)].
Foreign exchange gains and losses on monetary financial assets are recognised in profit or loss (see further para 6.7A.212 below).
Impairment losses are recognised in profit or loss (see further para 6.7A.201 below ). Reversals of impairment of a debt instrument are also recognised in profit or loss, but reversals of impairment on equity instruments are not (see further para 6.7A.204 below).
[IAS 39 para 55(b)].

6.7A.35 When an available-for-sale financial asset is derecognised as a result of sale or is impaired, the cumulative gain or loss previously recognised in other comprehensive income is reclassified to profit or loss. [IAS 39 paras 55(b), 67]. For example, assume that an entity acquires an equity security for C500 that has a fair value at the end of the year of C600. A gain of C100 is recognised in other comprehensive income. In the following year, the entity sells the security for C550. In the year of sale, a profit of C50, being the difference between proceeds of C550 and original cost of C500 is recognised. This represents the difference between proceeds of C550 and previous carrying value of C600 (C50 loss) and the recycling to profit or loss of C100 gain previously recognised in other comprehensive income.

6.7A.36 In the above example, a single security is used to illustrate the accounting for recycling. In practice, the entity may have acquired the same security in tranches at different dates and at different prices over a period of time. IAS 39 does not specify whether such fungible assets (or indeed any other fungible financial assets) should be considered individually or in aggregate, and, if in aggregate, which measurement basis (weighted average, first in first out (FIFO), specific identification) is appropriate for calculating the gain or loss on a partial disposal. This is in contrast to IAS 2, which specifies the use of weighted average or FIFO in most circumstances. In practice, entities may opt, as an accounting policy choice, for any one of the methods. The method used should be applied consistently for both impairment and disposal and disclosed.

6.7A.37 It is conceivable that within a group, portfolios have a different nature − for example, an available-for-sale portfolio held for liquidity purposes versus an available-for-sale portfolio held for long-term strategic investment purposes. In this instance, it may be possible to justify using different cost formulae within an entity for the same securities. However, whatever cost formula is used, it should be used for both impairment and measurement of gains and losses on disposal.

6.7A.38 The subsequent measurement of available-for-sale financial assets with fixed and determinable payments is complicated by the fact that fair value changes are recognised in other comprehensive income, but interest income is recognised in each period in profit or loss using the effective interest method. In order to ensure that the change in fair value is correctly calculated at the measurement date, it would be necessary to compare the instrument’s clean price (the fair value of the instrument less accrued interest) with its amortised cost, also excluding accrued interest, at that date. Therefore, although the instrument is measured at fair value, the amortised cost must still be calculated using the effective interest method in order to determine interest income.

Example – Debt security classified as available-for-sale investment
 
On 1 January 20X5, an entity purchases 10% C10 million 5 year bonds with interest payable on 1 July and 1 January each year. The bond’s purchase price is C10,811,100. The premium of C811,100 is due to market yield for similar bonds being 8%. Assuming there are no transaction costs, the effective interest rate is 8% (the effective interest method is discussed further in para 6.7A.68 below).
 
The entity classifies the bond as available-for-sale. The entity prepares its financial statements at 31 March. On 31 March 20X5, the yield on bonds with similar maturity and credit risk is 7.75%. At that date, the fair value of this bond calculated by discounting 10 semi-annual cash flows of C500,000 and principal payment of C10 million at maturity at the market rate of 7.75% amounted to C11,127,710.
 
Since the bond is classified as available-for-sale, the bond will be measured at fair value with changes in fair value recognised in other comprehensive income.
 
At 1 January 20X5, the fair value of the bond is the consideration paid of C10,811,100 and the entry to record this is as follows:
 
  Dr Cr
 
C
C
At 1 January 20X5    
Available-for-sale investment 10,811,100  
Cash   10,811,100
     
On 31 March 20X5, the entity will record interest income for the 3 months at the effective interest rate of 8%, that is, C10,811,100 × 8% × 3/12 = C216,222. Since the next coupon of C500,000 is due on 1 July 20X5, the entity will record a half-year interest accrual of C250,000. The difference of C33,778 between the interest income accrued and that recognised in the profit or loss represents the amortisation of the premium. The entry to record the interest income on 31 March 20X6 is as follows:
 
  Dr Cr
 
C
C
At 31 March 20X5    
Available-for-sale investment (accrued interest) 250,000  
Available-for-sale investment (premium)   33,778
Profit or loss – interest income   216,222
     
The bond’s amortised cost at 31 March 20X5 is, therefore, C10,777,322 (10,811,100 – 33,778)
     
The fair value of the bond at 31 March 20X5 is C11,127,710. This includes the accrued interest of C250,000. To calculate the clean price of the bond, the accrued income is deducted from the fair value. Therefore, the clean price of the bond is C10,877,710.
     
A comparison of the clean price of the bond and its amortised cost at 31 March 20X5 results in a gain as follows:
   
C
Fair value of bond at 31 March 20X5 – clean price   10,877,710
Amortised cost of bond at 31 March 20X5   10,777,322

Change in value – Unrealised gain   100,388

The entry to record the gain at 31 March 20X5 is as follows:
  Dr Cr
 
C
C
At 31 March 20X5    
Available-for-sale investments 100,388  
Other comprehensive income   100,388
   
  C
The movement in available-for-sale asset is shown below:
At 1 Jan 20X5 – Fair value (inclusive of premium)   10,811,100
Accrued income (reflected in fair value)   250,000
Amortisation of premium   (33,778)
Fair value adjustment - gain   100,388

At 31 Mar 20X5 – Fair value   11,127,710

     
    C
Recognised in profit or loss – income   216,222
Recognised in other comprehensive income – gain   100,388

Total change in fair value   316,610


6.7A.39 As stated in paragraph 6.7A.34 above, dividends on an available-for-sale equity instrument are recognised in profit or loss when the entity’s right to receive payment is established. The right to receive payment is established when the equity instrument’s issuer declares a dividend or in the case of quoted equity securities, at the ex-dividend date. When a share goes ex-dividend shortly before the dividend payment is actually due, the price will drop (other things being equal) by the amount of the dividend. Therefore, depending upon the ex-dividend date (when the dividend income is recognised) and the payment date (when the receivable is settled), the realisation of part of the fair value through dividend payment will affect both profit or loss and equity as illustrated below.

Example – Dividend on available-for-sale investments
 
An entity acquires 1,000 quoted equity shares in another entity for C20,000. The shares are classified as available-for-sale. Just prior to the entity’s year end of 31 December 20X5, the security goes ex-dividend following declaration of a dividend of C1.50 per share. At 31 December 20X5, the quoted ex-dividend price of the shares amounts to C21 per share. The entity receives payment of the dividend on 6 January 20X6.
 
At 31 December 20X5, the entity will recognise the dividend income in profit or loss and the change in the fair value of the shares in other comprehensive income as noted below:
  Dr Cr
 
C
C
Dividend receivable 1,500  
Profit or loss – dividend income – 1,000 @ 1.50   1,500
     
Available-for-sale financial asset 1,000  
Other comprehensive income – 1,000 @ (21-20)   1,000
     
The shares’ quoted price prior to the dividend adjustment would have been C22.50 giving a total fair value change of C2,500. However, as part of this change (C1,500) is realised as a result of the dividend income recognised in profit or loss; there is an equal and offsetting change in other comprehensive income.

Subsequent measurement of financial assets - Designation as hedged items

Publication date: 08 Dec 2017


6.7A.40 Financial assets that are designated as hedged items are subject to measurement under IAS 39’s hedging accounting requirements. [IAS 39 para 46]. These special accounting rules generally override the normal accounting rules for financial assets. Hedge accounting is covered in chapter 6.8A.

Subsequent measurement of financial assets - Reclassifications between categories

Publication date: 08 Dec 2017


6.7A.41 The amendment to IAS 39 issued in October 2008 allows reclassification of certain financial assets after initial recognition out of a category measured at fair value (that is, held-for-trading or available-for-sale) and into another category under limited circumstances (see chapter 6.4A and IAS 39 para 50 A-E). The tainting rules applicable to the held-to-maturity category remain unchanged.

6.7A.42 When a financial asset is reclassified, the fair value at the date of reclassification becomes its new cost or amortised cost. [IAS 39 para 50 C and F]. Any gains or losses already recognised in profit or loss are not reversed. The new ‘cost’ is also used as the basis for assessing impairment in the future.

6.7A.43 On reclassification, the effective interest rate is recalculated using the fair value at the date of reclassification. This new effective interest rate will be used to calculate interest income in future periods and considered as the original effective interest rate when measuring impairment.

6.7A.44 For a financial asset denominated in a foreign currency that is reclassified to loans and receivables, the ‘amortised cost’ of the financial asset at the date of reclassification is calculated in the foreign currency and then translated at the spot rate to the functional currency at the date of reclassification. [IAS 39 para IG E3.4].

6.7A.45 When an available-for-sale financial asset with fixed maturity is reclassified as held-to-maturity investment or loans and receivables, the fair value of the financial asset on that date becomes its new amortised cost. Any previous gain or loss on that asset that has been recognised directly in other comprehensive income is amortised to profit and loss over the investment’s remaining life using the effective interest method. Any difference between the new amortised cost and the amount payable on maturity is also amortised in a similar manner, akin to the amortisation of a premium or a discount. If the financial asset is subsequently impaired, any gain or loss that has been recognised directly in other comprehensive income is recognised in profit or loss. [IAS 39 para 54(a)]. Essentially, interest income should not change as a result of reclassification and should continue to be based on the original amortisation schedule (that is, prior to reclassification). This is because the combination of the amortisation of the difference between the new amortised cost on the reclassified financial asset and the amount payable on maturity and the gain or loss to be amortised from other comprehensive income will result in the same net effective interest rate as originally determined prior to reclassification.

Example – Available-for-sale debt security reclassified to loans and receivables
 
On 1 January 20X9, an entity reclassifies a C9m bond from available-for-sale to loans and receivables. On the date of the reclassification, the bond’s amortised cost is C9,198,571 and the original effective interest rate is 8.75%. The bond’s fair value is C9,488,165, which becomes its new amortised cost. The excess of the new carrying amount over the amount receivable at maturity on 31 December 2X10 (that is C488,165) is amortised to profit or loss over the remaining term to give a new effective rate of 7% including interest coupons receivable, as shown below.
 
In addition, the cumulative gain of C289,594 in other comprehensive income as at 31 December 20X8 (that is, the difference between the fair value of C9,488,165 and the amortised cost of C9,198,571) is also amortised to profit or loss during the remaining two years to maturity. The effect in profit or loss is the same as if the bond was classified as loans and receivables, as illustrated below:

 

   

 

 
Cash received
Interest income @ 7%
New amortised co
 
C
C
C

1 Jan 20X9

   

9,488,165

31 Dec 20X9

900,000
664,172

9,252,337

31 Dec 2 X10
9,900,000
647,663
− 

 

 
1,311,835

 

Amortisation of gain in other comprehensive income in 20X9 and 2X10  
289,594
 

Total amount recognised in profit or loss  
1,601,429
 

       
If the C9m bonds had not been reclassified as available-for-sale, the total amount recognised in profit or loss would have been as follows:
       
 
Cash received
Interest income @ 8.75%
Amortised cost
 
C
C
C
31 Dec 20X8    
9,198,571
31 Dec 20X9
900,000
804,876
9,103,447
31 Dec 20X10
9,900,000
796,553
 

Total income from date of reclassification to maturity  
1,601,429
 


6.7A.46 When a held-to-maturity investment is reclassified as available-for-sale, it should be remeasured at fair value at the date of reclassification. The difference between its previous carrying amount and fair value should be recognised in other comprehensive income. [IAS 39 paras 51, 52].

Example – Held-to-maturity investment reclassified as available-for-sale financial asset

On 1 January 20X0, an entity purchases 10% C10m 10 year bonds with interest payable annually on 31 December each year. The bond’s purchase price is C10,811,100. This results in a bond premium of C811,100 and an effective interest rate of 8.75%. The bonds were classified by the entity as held-to-maturity.

On 31 December 20X5, when the bonds amortised cost and fair value amounted to C10,407,192 and C10,749,395 respectively, the entity sells C1m bonds and realises a gain as shown below:
  C
Fair value of C1m bond (10% of C10,749,395) 1,074,940
Carrying value of C1m bond (10% of C10,407,192) 1,040,719

Profit on disposal recognised in profit or loss 34,221

 
Since the entity has sold more than an insignificant amount of its held-to-maturity investments, the portfolio is tainted. As a result, the entity has to reclassify the remaining C9m bonds as available-for-sale assets. The difference between the carrying value of C9m bonds and their fair value is recognised in other comprehensive income as shown below:
   
  C
Fair value of C9m bond (90% of C10,749,395) 9,674,455
Carrying value of C9m bonds (90% of C10,407,192) 9,366,473

Gain on reclassification recognised in other comprehensive income 307,982

 
Even though the remaining investment is classified as available-for-sale, the entity will continue to recognise the interest income and the amortisation of the premium using the effective interest method in profit or loss and fair value changes in other comprehensive income, as illustrated in the example in paragraph 6.7A.45. After the tainting period is over, the entity may reinstate the bonds again to held-to-maturity. This will happen after 31 December 20X7 (two full financial years following the partial disposal).

Subsequent measurement of financial assets - Settlement date accounting for regular way transactions

Publication date: 08 Dec 2017


6.7A.47 As stated in paragraph 6.7A.23 above, when an entity uses settlement date accounting for an asset that is subsequently measured at cost or amortised cost, the asset is recognised initially at its fair value at trade date. Any subsequent change in fair value between trade date and settlement date is not recognised (other than impairment losses). For assets that are subsequently measured at fair value, any change in fair value between trade date and settlement date is recognised:

In profit or loss for assets classified as at FVTPL.
In other comprehensive income for assets classified as available-for-sale.

6.7A.48 When assets measured at fair value are sold on a regular way basis, the change in fair value between trade date (the date the entity enters into the sales contract) and settlement date (the date proceeds are received) is not recorded because the seller’s right to changes in fair value ceases on the trade date (see further chapter 6).

Subsequent measurement of financial assets - Negative fair values

Publication date: 08 Dec 2017


6.7A.49 The standard clarifies that if a financial instrument that was previously recognised as a financial asset is measured at fair value and its fair value falls below zero, it becomes a financial liability that should be measured as considered below. [IAS 39 para AG 66].

Subsequent measurement of financial liabilities

Publication date: 08 Dec 2017


6.7A.50 After initial recognition, an entity should measure financial liabilities, other than those described in paragraphs 6.7A.52 to 6.7A.66 below, at amortised cost using the effective interest method as discussed from paragraph 6.7A.67 below. [IAS 39 para 47].

6.7A.51 Where a financial liability is carried at amortised cost, a gain or loss is recognised in profit or loss when the financial liability is derecognised or through the amortisation process. [IAS 39 para 56].

Subsequent measurement of financial liabilities - Financial liabilities at fair value through profit or loss

Publication date: 08 Dec 2017


6.7A.52 After initial recognition, financial liabilities falling within this category (including liabilities held-for-trading and derivative liabilities not designated as hedging instruments) are measured at fair value. However, a derivative liability that is linked to and must be settled by delivery of an unquoted equity instrument whose fair value cannot be reliably measured should be measured at cost. [IAS 39 para 47(a)].

6.7A.53 A change in a financial liability’s fair value in this category that is not part of a hedging relationship should be recognised in the profit or loss for the period. [IAS 39 para 55]. The standard’s requirements for determining the fair value of instruments that fall to be measured on this basis are considered from paragraph 6.7A.94 below.

Subsequent measurement of financial liabilities - Financial liabilities arising on transfers of financial assets

Publication date: 08 Dec 2017


6.7A.54 Certain financial liabilities may arise when a transfer of a financial asset does not qualify for derecognition, or is accounted for using the continuing involvement approach. For example, a sale of an asset that is accompanied by the seller giving a guarantee of the asset’s future worth may, depending on the substance, give rise to the asset’s derecognition and recognition of a liability in respect of the guarantee or it may result in the asset not being derecognised and the proceeds being shown as a liability. Special rules apply for the measurement of the transferred asset and the associated liability so that these are measured on a basis that reflects the rights and obligations that the entity has retained. [IAS 39 paras 29, 31, 47(b)]. See further chapter 6.6.

Subsequent measurement of financial liabilities - Financial guarantee contracts

Publication date: 08 Dec 2017


6.7A.55 Financial guarantee contracts are defined in chapter 6.1. Financial guarantee contracts that are accounted for as financial liabilities under IAS 39 by the issuer are initially recognised at fair value. If the financial guarantee contract was issued to an unrelated party in a stand-alone arm’s length transaction, its fair value at inception would likely be to equal the premium received, unless there was evidence to the contrary. [IAS 39 para AG4(a)]. 

6.7A.56 In some circumstances, an issuer expects to receive recurring future premiums from an issued financial guarantee contract (for example, it issues a five year guarantee with annual premiums due at the start of each year). In that situation, an issue arises as to whether the issuer should recognise a receivable for the discounted value of the expected future premiums or should it recognise only the initial cash received (if any). As stated above, IAS 39 requires the financial guarantee contract to be initially recorded at fair value; that is likely to equal the premium received. By analogy with derivative contracts the fair value will take into account any future cash flows on the instrument including those relating to premiums receivable.

6.7A.57 IAS 39 does not explicitly prohibit the recognition of a separate receivable for future premiums not yet due. This is evidenced by the basis for conclusions, paragraph BC 23D, which states that the IAS 39 requirement for initial recognition at fair value is consistent with US GAAP as represented by FIN 45 (FIN 45 requires recognition of a liability for the guarantee and a separate receivable for future premiums). Accordingly, entities are permitted to recognise a separate receivable. The entity should select a presentation policy and apply it consistently to all issued financial guarantee contracts.

6.7A.58 Subsequent to initial recognition, an issuer accounts for financial guarantee contracts at the higher of:

the amount determined in accordance with IAS 37; and
the amount initially recognised (fair value) less, when appropriate, cumulative amortisation of the initial amount recognised in accordance with IAS 18.
[IAS 39 para 47(c)].

6.7A.59 However, the above requirements do not apply:

if the financial guarantee contract was designated at fair value through profit or loss at inception. A contract designated at inception as at fair value through profit or loss is measured at fair value subsequently; or
if the financial guarantee contract was entered into or retained on transferring financial assets or financial liabilities to another party and prevented derecognition of the financial asset or resulted in continuing involvement (see chapter 6.6).
[IAS 39 para 47(a)(b), AG 4].

6.7A.60 From the perspective of the purchaser of the financial guarantee, who could be either the borrower or the lender, the contract is outside the scope of IAS 39. The purchaser’s accounting treatment depends on whether the cost of the guarantee is considered to be an integral part of the effective interest rate of the guaranteed debt instrument. In accordance with the definition of transaction costs in IAS 39 paragraph 9, the financial guarantee is an integral part of the guaranteed financial instrument when purchased in the context of the origination or purchase of a debt instrument, for example, when the loan agreement or related documents or legislation require the financial guarantee.  However, the cost of a financial guarantee obtained over pre-existing debt instruments is not an integral part of generating an involvement with the guaranteed debt instrument. In such circumstances, the cost is recognised as a prepayment asset and amortised over the shorter of the life of the guarantee and the expected life of the guaranteed debt instruments. The prepayment asset is tested for impairment under IAS 36. Lenders classify the amortisation and impairment charges as a reduction of interest income whilst borrowers treat it as an additional finance cost.

6.7A.60.1 A lender may obtain a financial guarantee from a third party to mitigate its credit risk at the origination of the debt instrument, even though the loan agreement and related documents or legislation do not explicitly refer to a financial guarantee contract.  In such cases, there is an accounting policy choice.  The cost of the financial guarantee contract obtained at the origination of the debt instrument can be either recognised as part of the effective interest rate of the guaranteed loan or accounted for separately from the loan as a prepayment asset.  The accounting policy adopted should be applied consistently to similar guarantee arrangements. FAQ 45.52.1 gives further guidance about whether a financial guarantee is integral to the guaranteed financial instrument for different scenarios.

Subsequent measurement of financial liabilities - Intra-group financial guarantee contracts

Publication date: 08 Dec 2017


6.7A.61 As stated in chapter 6.1, intra-group financial guarantee contracts are not exempted from IAS 39’s requirements and, on a stand-alone basis, will have to be measured in accordance with the standard. On a consolidation basis, the financial guarantee is not recognised as a separate contract, but is part of the group’s liability to a third party (for example, a guarantee given by the parent to a subsidiary’s bankers in the event the subsidiary fails to repay a loan to the bank when due). In the individual financial statements, the financial guarantee is recognised initially at fair value in accordance with IAS 39 (unless IFRS 4 applies).

6.7A.62 Establishing such a fair value may be difficult if the financial guarantee contracts between related parties were not negotiated at arm’s length and there are no comparable observable transactions with third parties. Given that intra-group guarantees are unlikely to be negotiated in a ‘stand-alone arm’s length transaction’, fair value would have to be estimated. Chapter 5 provides guidance on how to measure the fair value of intra-group financial guarantees.

6.7A.63 As the fair value of an intra-group guarantee is unlikely to be equal to the fee charged, if any, the issuer would need to determine whether any difference should be treated as an expense or a capital contribution via an increase in investments in the subsidiary. This is an accounting policy choice. The method used should reflect the transaction’s economic substance, be applied consistently to all similar transactions and be clearly disclosed in the financial statements. While each entity within a group can choose its own accounting policies, those policies must be aligned on consolidation.

6.7A.64 Where a parent entity provides a guarantee to a bank that has advanced a loan to one of its subsidiaries, the subsidiary has obtained a benefit in that it would pay a lower rate of interest on the loan than it would have otherwise paid for an unguaranteed loan. The subsidiary could fair value the loan from the bank by reference to a normal market rate of interest it would pay on a similar but unguaranteed loan and take the benefit of the interest differential to equity as a capital contribution from the parent. Alternatively, the subsidiary could view the unit of account as being the guaranteed loan and therefore the fair value would be expected to be the face value of the proceeds the subsidiary receives. IAS 39 does not address the accounting for financial guarantees by the beneficiary and there is no requirement in IAS 24 to fair value non-arm’s length related party transactions. Therefore, there is an accounting policy choice as to whether a capital contribution is recognised in equity by the subsidiary for the benefit of the lower rate of interest on the loan than it would have otherwise paid for an unguaranteed loan. In practice, there is diversity on which accounting policy is applied, however, the majority of subsidiaries do not take the capital contribution to equity approach and instead recognise the fair value of the guaranteed loan.

Subsequent measurement of financial liabilities - Commitments to provide off-market loans

Publication date: 08 Dec 2017


6.7A.65 An entity may enter into a commitment to provide a loan at a below-market rate. After initial recognition at fair value, such a commitment is subsequently measured in the same way as a financial guarantee contract stated above. [IAS 39 para 47(d)].

Subsequent measurement of financial liabilities - Designation as hedged items

Publication date: 08 Dec 2017


6.7A.66 Financial liabilities that are designated as hedged items are subject to measurement under IAS 39’s hedging accounting requirements. [IAS 39 para 47]. These special accounting rules generally override the normal accounting rules for financial liabilities. Hedge accounting is covered in chapter 6.8.

Amortised cost and the effective interest method - General

Publication date: 08 Dec 2017


6.7A.67 The amortised cost of a financial asset or financial liability is defined as the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the ‘effective interest method’ of any difference between that initial amount and the amount payable at maturity and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility. [IAS 39 para 9].

6.7A.68 The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The method’s principal features are as follows:

The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the financial instrument’s expected life or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability (see para 6.7A.76 below). The effective interest rate is sometimes termed the level yield to maturity or to the next repricing date and is the internal rate of return of the financial asset or liability for that period. The internal rate of return can be calculated using a financial calculator, or the IRR function in a spreadsheet.
When calculating the effective interest rate, an entity should estimate cash flows considering all the financial instrument’s contractual terms (for example, pre-payment, call and similar options), but should not consider future credit losses.
The calculation should include all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts.
[IAS 39 para 9].

6.7A.69 The effective interest rate method is grounded in historical transaction values, because its determination is based on the initial carrying amount of the financial asset or liability. Therefore, once determined it is not recalculated to reflect fair value changes in financial assets, for example, interest bearing available-for-sale assets due to changes in market interest rates. The effective interest method produces a periodic interest income or expense equal to a constant percentage of the carrying value of the financial asset or liability as illustrated in the example given in paragraph 6.7A.78.

Amortised cost and the effective interest method - Estimation of cash flows

Publication date: 08 Dec 2017


6.7A.70 As noted in paragraph 6.7A.68 above, the effective interest method uses a set of estimated future cash flows through the expected life of the financial instrument using all the financial instrument’s contractual terms, rather than contractual cash flows. However, the financial instrument’s expected life cannot exceed its contracted life. This applies not only to individual financial instruments, but to groups of financial instruments as well to achieve consistency of application. As the cash flows are often outlined in a contract or linked in some other way to the financial asset or financial liability in question, there is a presumption that the future cash flows can be reliably estimated for most financial assets and financial liabilities, in particular for a group of similar financial assets and similar financial liabilities. [IAS 39 para 9]. For example, for a portfolio of pre-payable mortgage loans, financial institutions often estimate pre-payment patterns based on historical data and build the cash flows arising on early settlement (including any pre-payment penalty) into the effective interest rate calculation.

6.7A.71 However, in some rare cases it might not be possible to estimate reliably the cash flows of a financial instrument (or group of financial instruments). In those rare cases, the entity should use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments). [IAS 39 para 9].

6.7A.72 The standard requires that in estimating the future cash flows all the instrument’s contractual terms, including pre-payment, call and similar options should be considered. [IAS 39 para 9]. Such pre-payment, call and put options, which are often embedded in the debt instruments, are derivatives. Therefore, as explained, in chapter 6.3A, the entity must first determine whether such options need to be separately accounted for as embedded derivatives. Separate accounting for the embedded derivative will not be necessary if the option’s exercise price is approximately equal to the instrument’s amortised cost on each exercise date, or the exercise price reimburses the lender for an amount up to the approximate present value of the lost interest for the remaining term of the host contract, because in that situation the embedded derivative is regarded as closely related to the debt host. [IAS 39 para AG 30(g)].

6.7A.72.1 As discussed in chapter 6.3A, an extension option held by a borrower may be considered to be a loan commitment or an embedded derivative. If it is considered to be a loan commitment and the loan is subsequently extended with an interest step up, the change in interest rate should either be accounted for as an IAS 39 AG 8 adjustment due to a change in the expected cash flows on an existing loan, reflected as an adjustment to carrying amount or the extension should be accounted for prospectively as a draw down of a new loan. This is further discussed in chapter 6.3A.

6.7A.73 Where a pre-payment, call or put option falls to be separately accounted for, its impact on estimating the future cash flows for the purposes of determining the effective interest rate should be ignored. Although this is not explained in the standard, it is rather obvious as to do otherwise would result in double counting the effects of the embedded derivative in profit or loss – first through the option’s fair value movement and, secondly, through its effect on the effective interest rate. In practice, this means that if the option is regarded as closely related and not separately accounted for, the entity, in determining the instrument’s expected life, needs to assess whether the option is likely to be exercised in estimating the future cash flows at inception. Furthermore, this assessment should continue in subsequent periods until the debt instrument is settled, because the likelihood of the option being exercised will affect the timing and amount of the future cash flows and will have an immediate impact in profit or loss. On the other hand, if the option is accounted for as a separate derivative, such considerations are not necessary as the likelihood of the option being exercised will be reflected in its fair value. In that situation, the effective interest rate is based on the instrument’s contractual term. See further paragraph 6.7A.84 below.

6.7A.74 The standard also makes it clear that expected or future credit losses (defaults) should not be included in estimates of cash flows, because this would be a departure from the incurred loss model for impairment recognition. However, in some cases, financial assets are acquired at a deep discount that reflects incurred losses (for example, purchase of impaired debt). As such losses are already reflected in the price, they should be included in the estimated cash flows when computing the effective interest rate. [IAS 39 para AG 5]. Accordingly, the effective interest rate of the acquired distressed loan would be the discount rate that equates the present value of the expected cash flows (this would be less than the contractual cash flows specified in the loan agreement because of incurred credit losses) with the purchase price of the loan. The alternative of not including such credit losses in the calculation of the effective interest rate means that the entity would recognise a higher interest income than that inherent in the price paid.

Amortised cost and the effective interest method - Transaction costs and fees

Publication date: 08 Dec 2017


6.7A.75 Transaction costs and fees are discussed from paragraph 6.7A.12 above. To the extent that they are integral to generating an involvement with a financial instrument, such costs and fees are included in the financial instrument’s initial measurement. For financial instruments that are carried at amortised cost, such as held-to-maturity investments, loans and receivables, and financial liabilities that are not at fair value through profit or loss, transaction costs and fees are, therefore, included in calculating amortised cost using the effective interest method. This means that, in effect, they are amortised through profit or loss over the instrument’s life (see para 6.7A.68 above).

Amortised cost and the effective interest method - Amortisation period

Publication date: 08 Dec 2017


6.7A.76 Consistent with the estimated cash flow approach outlined from paragraph 6.7A.70 above, the standard requires fees, points paid or received, transaction costs and other premiums or discount that are integral to the effective interest rate to be amortised over the instrument’s expected life or, when applicable, a shorter period. A shorter period is used when the variable (for example, interest rates) to which the fee, transaction costs, discount or premium relates is repriced to market rates before the instrument’s expected maturity. In such a case, the appropriate amortisation period is the period to the next such repricing date. [IAS 39 AG6]. The application of this requirement in the context of a floating rate instrument is considered in paragraph 6.7A.84 below.

6.7A.77 There is a presumption that the expected life of a financial instrument (or group of similar financial instruments) can be estimated reliably. However, in those rare cases when it is not possible to estimate reliably the expected life, the entity should use the full contractual term of the financial instrument (or group of financial instruments) as the amortisation period. [IAS 39 para 9]. The expected life cannot exceed the contractual term.

Amortised cost and the effective interest method - Illustrations of the effective interest rate method of amortisation - Fixed interest instruments

Publication date: 08 Dec 2017


6.7A.78 The examples that follow illustrate the application of the effective interest rate method of amortisation to fixed interest loans. In example 1, the fixed rate loan asset is repayable only at maturity (a similar example is given in IAS 39 para IG B26). In example 2, the fixed rate loan asset is repayable in equal annual instalments. In example 3, the loan’s pre-determined rate of interest increases over the instrument’s term (‘stepped interest’).

Example 1 – Fixed interest loan asset repayable at maturity

On 1 January 20X5, entity A originates a 10 year 7% C1m loan. The loan carries an annual interest rate of 7% payable at the end of each year and is repayable at par at the end of year 10. Entity A charges a 1.25% (C12,500) non-refundable loan origination fee to the borrower and also incurs C25,000 in direct loan origination costs.

The contract specifies that the borrower has an option to pre-pay the instrument and that no penalty will be charged for pre-payment. At inception, the entity expects the borrower not to pre-pay.

The initial carrying amount of the loan asset is calculated as follows:
 
  C
Loan principal 1,000,000
Origination fees charged to borrower (12,500)
Origination costs incurred by lender 25,000

Carrying amount of loan 1,012,500

   
As explained in paragraph 6.7A.72 above, it is first necessary to determine whether the pre-payment option should be separately accounted for. In this example, as the loan’s principal amount is likely to be approximately equal to the loan’s amortised cost at each exercise date, the borrower’s option to pre-pay is closely related and not separately accounted for.
 
As the entity expects the borrower not to pre-pay, the amortisation period is equal to the instrument’s full term. In calculating the effective interest rate that will apply over the term of the loan at a constant rate on the carrying amount, the discount rate necessary to equate 10 annual payments of C70,000 and a final payment at maturity of C1 million to the initial carrying amount of C1,012,500 is approximately 6.823%.

The carrying amount of the loan over the period to maturity will, therefore, be as follows:
 
  Cash in flows
(coupon)
Interest income @ 6.823% Amortisation of net fees Carrying amount
 
C
C
C
C
1 Jan 20X5       1,012,500
31 Dec 20X5 70,000 69,083 917 1,011,588
31 Dec 20X6 70,000 69,025 975 1,010,613
31 Dec 20X7 70,000 68,959 1,041 1,009,572
31 Dec 20X8 70,000 68,888 1,112 1,008,460
31 Dec 20X9 70,000 68,812 1,188 1,007,272
31 Dec 20Y0 70,000 68,731 1,269 1,006,003
31 Dec 20Y1 70,000 68,644 1,356 1,004,647
31 Dec 20Y2 70,000 68,552 1,448 1,003,199
31 Dec 20Y3 70,000 68,453 1,547 1,001,652
31 Dec 20Y4 70,000 68,348 1,652 1,000,000

  700,000 687,500 12,500  

31 Dec 20Y4 Repayment of principal (1,000,000)

31 Dec 20Y4 Carrying value of loan Nil

     
As can be seen from the above, the effective interest income for the period is calculated by applying the effective interest rate of 6.823% to the loan’s amortised cost at the end of the previous reporting period. The annual interest income decreases each year to reflect the decrease in the asset’s carrying value as the initial net fee is amortised. Thus the difference between the calculated effective income for a given reporting period and the loan’s coupon is the amortisation of the net fees during that reporting period. The loan’s amortised cost at the end of the previous period plus amortisation in the current reporting period gives the loan’s amortised cost at the end of the current period. By maturity date, the net fees received are fully amortised and the loan’s carrying amount is equal to the face amount, which is then repaid in full.

Example 2 – Fixed interest loan asset repayable in equal annual instalments

On 1 January 20X5, entity A originates a 10 year 7% C1 million loan. The loan is repaid in equal annual payments of C142,378 through to maturity date at 31 December 20Y4. Entity A charges a 1.25% (C12,500) non-refundable loan origination fee to the borrower and also incurs C25,000 in direct loan origination costs.

The contract specifies that the borrower has an option to pre-pay the instrument and that no penalty will be charged for pre-payment. At inception, the entity expects the borrower not to pre-pay.

The initial carrying amount of the loan is calculated as follows:
  C
Loan principal 1,000,000
Origination fees charged to borrower (12,500)
Origination costs incurred by lender 25,000

Carrying amount of loan 1,012,500

 
As in the previous example, the pre-payment option will not be separately accounted for. In calculating the effective interest rate that will apply over the term of the loan at a constant rate on the carrying amount, the discount rate necessary to equate 10 annual payments of C142,378 to the initial carrying amount of C1,012,500 is approximately 6.7322%. The carrying amount of the loan over the period to maturity will, therefore, be as follows:
 
        Cash in flows Interest Income @ 6.7322% Carrying amount
        C C C
1 Jan 20X5          
1,012,500
31 Dec 20X5       142,378 68,164
938,286
31 Dec 20X6       142,378 63,167
859,075
31 Dec 20X7       142,378 57,835
774,531
31 Dec 20X8       142,378 52,143
684,296
31 Dec 20X9       142,378 46,068
587,987
31 Dec 20Y0       142,378 39,584
485,193
31 Dec 20Y1       142,378 32,664
375,479
31 Dec 20Y2       142,378 25,278
258,379
31 Dec 20Y3       142,378 17,395
133,396
31 Dec 20Y4       142,378 8,982

        1,423,780 411,280  


Example 3 – Fixed interest loan asset with interest step-up

On 1 January 20X5, entity A originates a 5 year debt instrument for C1million loan that is repayable at maturity. The contract provides for 5% interest in year 1 that increases by 2% in each of the following 4 years. Entity A also receives C25,000 in loan origination fees.

The loan’s initial carrying amount is calculated as follows:
  C
Loan principal 1,000,000
Origination fees charged to borrower (25,000)

Carrying amount of loan 975,000

 
In calculating the effective interest rate that will apply over the term of the loan at a constant rate on the carrying amount, the discount rate necessary to equate 5 annual step-up payments and a final payment at maturity of C1 million to the initial carrying amount of C975,000 is approximately 9.2934 %.
 
      Interest income @ 9.2934% Cash in flows (coupon) Carrying amount
     
C
C
C
1 Jan 20X5         975,000
31 Dec 20X5     90,610 50,000 1,015,610
31 Dec 20X6     94,385 70,000 1,039,995
31 Dec 20X7     96,651 90,000 1,046,646
31 Dec 20X8     97,268 110,000 1,033,914
31 Dec 20X9     96,086 130,000 1,000,000

      475,000 450,000  

     
If the borrower were to repay the entire loan of C1 million early, say in 20X9, when the loan asset’s carrying value is C1,033,914, the excess amount of C33,914 would have to be recognised in profit or loss. This effectively represents the excess income recognised in earlier periods that is now written back as shown below:
   
 
C
Total income recognised to 31 Dec 20X8 378,914
Amortisation of fees (25,000)
Cash received to 31 Dec 20X8 (320,000)

Excess income recognised prior to pre-payment by borrower in 20X9 33,914

Amortised cost and the effective interest method - Illustrations of the effective interest rate method of amortisation - Changes in estimated cash flows

Publication date: 08 Dec 2017


6.7A.79 As explained above, the cash flows that are discounted to arrive at the effective interest rate are estimated cash flows that are expected to occur over the instrument’s expected life. However, in practice, actual cash flows rarely occur in line with expectations. There is usually variation in the amount, timing or both. Differences from the original estimates present a problem for the effective interest rate. If the variation is ignored, either the asset or liability will amortise before all of the cash flows occur, or a balance may remain after the last cash flow.

6.7A.80 The standard, therefore, requires an entity to adjust the carrying amount of the financial asset or financial liability (or group of financial instruments) to reflect actual and revised estimated cash flows whenever it revises its cash flow estimates. The entity recalculates the carrying amount by computing the present value of estimated future cash flows at the financial instrument’s original effective interest rate, or, when applicable, the revised effective interest calculated in accordance with paragraph 92 of IAS 39 (see chapter 6.8A). The adjustment is recognised in profit or loss as income or expense. [IAS 39 para AG 8].

Example – Changes in estimates of cash flows
 
The facts are the same as in example 1 in paragraph 6.7A.78 above, except that on 1 January 20Y1, entity A revises its estimates of cash flows as it now expects that, because of a significant fall in interest rates during the previous period, the borrower is likely to exercise its option to pre-pay. Accordingly, entity A anticipates that 40% of the loan is likely to be repaid by the borrower in 20Y1, with the remaining 60% progressively at 20% in the following three years to maturity.
 
The revised cash flows are shown below. In accordance with paragraph 6.7A.80 above, the opening balance at 1 January 20Y1 is adjusted. The adjusted amount is calculated by discounting the amounts the entity expects to receive in 20Y1 and subsequent years using the original effective rate of 6.823%. This results in the adjustment shown below. The adjustment is recognised in profit or loss in 20Y1.
 
          Carrying amount
1 Jan 20Y1 Opening amortised carrying amount before revision 1,006,003
  Adjustment for changes in estimate – profit or loss 2,563

1 Jan 20Y1 Adjusted amortised carrying amount after revision 1,003,440

           
    Opening amortised carrying amount Interest income @ 6.823% Cash in flows
(coupon+ repayment of principal)
Closing amortised carrying amount
    C C C C
31 Dec 20Y1   1,003,440 68,465 70,000 + 400,000 601,905
31 Dec 20Y2   601,905 41,068 42,000 + 200,000 400,973
31 Dec 20Y3   400,973 27,358 28,000 + 200,000 200,331
31 Dec 20Y4   200,331 13,669 14,000 + 200,000

6.7A.81 For financial assets reclassified in accordance with IAS 39 paragraphs 50B, D and E (see para 6.7A.41), any increase in the estimates of expected future cash flows arising from recoveries is reflected by adjusting the effective interest rate prospectively, rather than as an adjustment to the carrying amount. Any increased recoverability of cash receipts is, therefore, spread over the debt instrument’s remaining life. [IAS 39 para AG 8]. A decrease in the estimate of expected cash flows would be recorded as an impairment loss.

6.7A.82 An increase in estimates of future cash receipts can be determined on a discounted or undiscounted basis. It is an accounting policy choice and should be applied consistently to all reclassified financial assets. Entities may determine whether there is a change in recoverable cash receipts on an undiscounted basis. In such a case, an entity adjusts effective interest rate for any increase in the total amount of undiscounted cash receipts it expects to recover, but not for a change in recoverable amount (that is, discounted) due only to changes in the timing or pattern of cash receipts. Entities may alternatively determine whether there is a change in recoverable cash receipts on a discounted basis. In such circumstances, an entity adjusts the effective interest rate if there is a change in the present value of the estimated cash receipts, thus taking into account timing and pattern of receipt as well as quantum. In both cases, the reference to ‘recoverability’ indicates that such cash receipts arise from a reversal of credit losses.

Example 1 – Increase in expected future cash flows arising from recoveries
 
An entity has reclassified a floating-rate financial asset to loans and receivables on 1 July 20X8. The loan was originally purchased for C100. At the date of reclassification, the fair value of the instrument had decreased substantially as a result of a decline in the creditworthiness of the counterparty to C80, and the entity expects to get undiscounted cash receipts of C90. At 31 December, the credit rating of the counterparty has increased (for example, because of government backing) and the entity now expects to get undiscounted cash receipts of C100. The entity should recalculate its effective interest rate prospectively to reflect those new cash receipts. The increase in expected future cash receipts should be reflected in a new effective interest rate.

Example 2 – Decrease in expected future cash flows arising from recoveries
 
An entity reclassified a fixed rate asset to loans and receivables on 1 July 20X8. The loan was originally purchased for C100. At the date of reclassification, the fair value of the instrument had decreased substantially as a result of a decline in the creditworthiness of the counterparty to C60, and the entity expects to get undiscounted cash receipts of C75. At 31 December 20X8, the recoverability of cash receipts has decreased further to C50. The amendment to paragraph AG 8 requires the effective interest rate to be adjusted only where there are increases in the estimates of future cash receipts. Decreases in estimates of future cash receipts do not result in a downwards adjustment to the effective interest rate. The reduction in estimated cash receipts at 31 December 20X8 will be reflected as an impairment loss in profit or loss measured in accordance with paragraph 63 of IAS 39 (see further para 6.7A.173).

Example 3 – Increase in expected future cash flows arising from recoveries after impairment
 
An entity reclassified a fixed rate debt instrument to loans and receivables on 1 July 20X8. The loan was originally purchased for C100. At the date of reclassification, the instrument’s fair value had decreased substantially as a result of a decline in the counterparty’s creditworthiness to C60. At 31 December 20X8, the recoverability of cash receipts has decreased to C50, and the entity records an impairment loss. At 31 March 20X9, the recoverability of cash receipts has increased to C60. The entity should account for the increase in expected cash receipts as a reversal of the impairment recorded at 31 December 20X8 (see para 6.7A.198).

6.7A.83 When, subsequent to a reclassification, there is an increase in the cash flows expected to be recovered followed by a decrease in those expected cash flows, but the expected cash flows remain above the amount expected when the asset was reclassified (that is, there is not an impairment subsequent to reclassification), we consider that either of the following approaches would be acceptable:

■  Only increases in cash flows are dealt with by amending the effective interest rate prospectively. Any decreases, even those after an increase and still above the cash flows expected at the reclassification date, are accounted for by means of a cumulative catch up in accordance with paragraph AG8 of IAS 39 (using, as the discount rate, the effective interest rate on the reclassified instrument that was determined after the prospective change in the effective interest rate due to an increase in the cash flows).
■  Increases and decreases above the level of cash flows expected on the reclassification date are dealt with prospectively by amending the effective interest rate. Any decreases below the cash flows expected on the reclassification date are accounted for by means of a cumulative catch-up in accordance with paragraph AG8 of IAS 39, or as an impairment.

Amortised cost and the effective interest method - Illustrations of the effective interest rate method of amortisation - Issuer call option in debt instruments

Publication date: 08 Dec 2017


6.7A.84 The terms of a debt instrument may include an issuer call option, that is, a right of the issuer (but not the investor) to redeem the instrument early and pay a fixed price (generally at a premium over the par value). There may also be other pre-payment features that cause the whole or part of the outstanding principal to be repaid early. Adding call options and/or other pre-payment options should make the instrument less attractive to investors, since it reduces the potential upside on the bond. As market interest rates go down and the bond price increases (reflecting its above market interest rate), the bonds are likely to be called back. As explained in paragraph 6.7A.72 above, such a call option embedded in the debt host is a derivative and would fall to be separately accounted for if its exercise price is not approximately equal to the debt host’s amortised cost at each exercise date. Consider the example given below.

Example – Issuer call option in debt instrument

Entity A issues a fixed rate loan for C1m and incurs issue costs of C30,000 resulting in an initial carrying value of C970,000. The loan carries an interest rate of 8% per annum and is repayable at par at the end of year 10. However, under the contract, entity A can call the loan at any time after year 4 by paying a fixed premium of C50,000.

As explained in paragraph 6.7A.72 above, it is first necessary to determine whether the call option is closely related to the host debt instrument. As the fixed premium is required to be paid whenever the call option is exercised after year 4, it may or may not be equal to the present value of any interest lost during the remaining term after exercise of the option. Furthermore, as the call option’s exercise price is C1,050,000 (inclusive of the premium), it is unlikely to be approximately equal to the debt instrument’s amortised cost in year 4, or at any time subsequently. Therefore, the call option has to be separated from the host debt contract and accounted for separately. This assumes that the expected life of the instrument is the full 10 year term. However, if the expected life is assumed to be 4 years, the 10 year loan with a call option after 4 years is economically equivalent to a 4 year loan with a 6 year extension option. Since there is no concurrent adjustment to the interest rate after 4 years, the term extension option would not be closely related and would need to be accounted for separately (see chapter 6.3A). Therefore, in this case whatever way the loan and option are viewed, the embedded derivative is separated.

Even though the option is out of the money at inception, because the option’s exercise price is greater than the debt instrument’s carrying value, it has a time value. Suppose the option’s fair value is C20,000 at inception. Since the value of a callable bond is equal to the value of a straight bond less the value of the option feature, the accounting entries at inception would be as follows:
     
  Dr Cr
  C C
Embedded option (derivative asset) 20,000  
Cash 970,000  
Debt instrument (host)   990,000
 
Since the call option will be fair valued and accounted for separately with fair value movements taken to profit or loss, it has no impact on the entity’s estimate of future cash flows as explained in paragraph 6.7A.73 above and, accordingly, the amortisation period will be the debt host’s period to original maturity. On this basis, the effective interest rate amounts to 8.15%. The amortisation schedule is shown below.
         
  Opening amortised cost Interest expense @ 8.15% Cash payments Closing amortised cost
  C C C C
Year 1 990,000 80,685 80,000 990,685
Year 2 990,685 80,741 80,000 991,427
Year 3 991,427 80,802 80,000 992,228
Year 4 992,228 80,867 80,000 993,095
Year 5 993,095 80,938 80,000 994,033
Year 6 994,033 81,014 80,000 995,047
Year 7 995,047 81,097 80,000 996,144
Year 8 996,144 81,186 80,000 997,330
Year 9 997,330 81,283 80,000 998,613
Year 10 998,613 81,387 1,080,000
         
The entity would recognise interest expense in profit or loss and the loan’s amortised cost in the balance sheet each year in accordance with the above amortisation schedule.
         
In years 1 and 2, there is no change in interest rate since inception for an instrument of similar maturity and credit rating. The option’s fair value (time value) at the end of year 2 is C10,000. The decrease in fair value of C10,000 since inception will be reported in profit and loss and the option will be recorded at C10,000 at the end of year 2.

At the end of year 3, interest rates have fallen and the option’s fair value increases to C18,000. The increase in value of C8,000 will be recorded in profit or loss and the option will be recorded at its fair value of C18,000 at the end of year 3.

At the end of year 4, interest rates have fallen further. The option’s fair value increases to C30,000 and the company decides to repay the loan at the end of year 4.

The accounting entries to reflect the change in the option’s fair value and the loan’s early repayment at the end of year 4 are as follows:
  Dr Cr
  C C
Embedded Option 12,000  
Profit or loss   12,000
     
Early repayment of loan    
Debt instrument (host) 993,095  
Embedded option (derivative asset)   30,000
Cash   1,050,000
Loss on derecognition of liability 86,905  
 
The loss of C86,905 in profit or loss reflects the fact that the fair value of the host contract has gone up in value as interest rates have fallen compared to its carrying value at amortised cost. The fair value of the host contract is actually C1,080,000, which is the option’s fair value plus the fair value of the consideration given. The market rate of interest that discounts the interest payments of C80,000 for the next 6 years plus the principal repayment of C1,000,000 at maturity to the fair value of the host is 6.95%, indicating a significant fall in value compared to the instrument’s stated interest rate of 8%.
 
Suppose that instead of an additional premium or penalty payable on early exercise, the option’s exercise price is the fair value of the loan at each exercise date. In other words, the exercise price of the pre-payment option is a ‘market adjusted value’. A market adjusted value is calculated by discounting the contractual guaranteed amount payable at the end of the specified term to present value using the current market rate that would be offered on a new loan with a similar credit rating and having a maturity period equal to the remaining maturity period of the current loan. As a result, the market adjusted value may be more or less than the loan principal, depending upon market interest rates at each option exercise date.

In that situation, the pre-payment option enables the issuer simply to pay off the loan at fair value at the pre-payment date. Since the holder receives only the market adjusted value, which is equal to the loan’s fair value at the date of pre-payment, the pre-payment option (the embedded derivative) has a fair value of zero at all times. Since the pre-payment option, on a stand-alone basis, would not meet the definition of a derivative, it cannot be an embedded derivative, the loan is simply carried at its amortised cost as above, on the assumption that the loan is not going to be pre-paid. If, however, the entity expects to pre-pay the loan, the loan would be amortised over its expected life.

Amortised cost and the effective interest method - Illustrations of the effective interest rate method of amortisation - Floating rate instruments

Publication date: 08 Dec 2017


6.7A.85 As will be apparent from the above illustrations, the application of the effective interest rate method is relatively straight forward for fixed interest instruments with fixed terms. Indeed, it appears to be specifically designed for such instruments. However, the analysis is more complicated in the case of a financial instrument that provides for future cash flows that are determinable rather than fixed. Floating rate interest on a financial instrument that is linked to a reference rate such as LIBOR and a principal amount linked to a price index are examples of determinable cash flows. The apparent complication arises because, unlike fixed interest instruments where the effective interest rate generally stays constant over the instrument’s term, for floating rate instruments, the periodic re-estimation of determinable cash flows to reflect movements in market rates of interest alters the instrument’s effective yield.

6.7A.86 However, although fluctuations in interest rates result in a change in the effective interest rate, there is usually no change in the instrument’s fair value. Accordingly, where a floating rate instrument is acquired or issued and the amount at which it is recognised initially is equal to the principal receivable or payable at maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or liability. [IAS 39 para AG 7]. This means that the effective yield will always equal the rate under the interest rate formula (for example, LIBOR + 1%) in the instrument. The effect is that the carrying amount remains unchanged by the process, illustrated in paragraph 6.7A.81 above, of re-estimating future cash flows and the effective interest rate. The result is that changes in LIBOR are reflected in the period in which the change occurs.

6.7A.87 However, if a floating rate instrument is issued or acquired at a discount or premium, or the entity receives or incurs loan origination fees or costs, the question arises as to whether the premium or discount and other transaction fees or costs should be amortised over the period to the next repricing date, or over the instrument’s expected life. The answer depends upon the nature of the premium or discount and its relationship with market rates.

An amortisation period to the next repricing date should be used if the premium or discount on a floating rate instrument reflects interest that has accrued on the instrument since interest was last paid, or changes in market interest rate since the floating interest rate was reset to market rates. This is because the premium or discount relates to the period to the next interest reset date as, at that date, the variable to which the premium or discount relates (that is interest rates) is reset to market rates. In this case, the loan’s fair value at the next repricing date will be its par value. This is illustrated in example 1 below.
The instrument’s expected life should be used as the amortisation period if the premium or discount results from changes in the credit spread over the floating rate specified in the instrument, or other variables that are not reset to market rates. In this situation, the date the interest rate is next reset is not a market-based repricing date of the entire instrument, since the variable rate is not adjusted for changes in the credit spread for the specific issue. This is illustrated in example 2 below.
[IAS 39 para AG 6].

Example 1 – Amortisation of discount over the period to the next repricing date

On 15 May 20X6, an entity acquires a C100 nominal 5 year floating rate bond that pays quarterly interest at 3 month LIBOR + 50 basis points for C99.25. LIBOR at the last reset date on 30 March 20X6 was 4.50% which determines the interest that would be paid on the bond on 30 June 20X6. On the purchase date, LIBOR was 4.75%. The discount of 0.75 (5.25% − 4.50%) is amortised to the next repricing date, that is, 30 June 20X6.

Example 2 – Amortisation of discount over the expected life of the instrument
 
A 20 year bond is issued at C100, has a principal amount of C100, and requires quarterly interest payments equal to current 3 month LIBOR plus 1% over the instrument’s life. The interest rate reflects the market-based rate of return associated with the bond issue at issuance. Subsequent to issuance, the loan’s credit quality deteriorates resulting in a rating downgrade. Therefore, the bond trades at a discount. Entity A purchases the bond for 95 and classifies it as held-to-maturity. In this case, the discount of C5 is amortised to net profit or loss over the period to the bond’s maturity and not to the next date interest rate payments are reset, as there is no adjustment to the variable rate as a result of the credit downgrade.

6.7A.88 There is no specific guidance in the standard as to how transaction costs incurred in originating or acquiring a floating rate instrument should be amortised. Since such costs are sunk cost and are not subject to repricing, they will be amortised over the instrument’s expected life. Any methodology that provides a reasonable basis of amortisation may be used. For example, entities may find it appropriate to amortise the fees and costs by reference to the interest rate at inception ignoring any subsequent changes in rates or to simply adopt a straight-line amortisation method.

Amortised cost and the effective interest method - Illustrations of the effective interest rate method of amortisation - Floating rate instruments - Inflation linked bond

Publication date: 08 Dec 2017

6.7A.89 Entities sometimes issue or invest in debt instruments whose payments (principal and interest) are linked to the change in an inflation index of the period. Such an inflation-linked bond needs to be assessed to determine if the inflation-linking mechanism is a closely related embedded derivative that does not need to be recognised and measured separately under IAS 39. There are two possible approaches to account for changes in estimated future cash flows for an inflation-linked bond where the inflation linking mechanism has been found to be closely related.

Applying the guidance in paragraph AG7 of IAS 39, under which the bond is treated as a floating-rate debt instrument with the inflation link being part of the floating-rate mechanism. The EIR at initial recognition is determined as the rate that sets the estimated future cash flows to be paid on the bond, based on the expected level of the inflation index over the expected term of the bond to equal the fair value of the bond (usually the issue proceeds). However, if in subsequent periods there is a change in inflation expectations, the entity reflects these changes by adjusting both the expected future cash flows on the debt and the EIR. It follows that such changes in the entity’s expectations of future inflation result in no adjustment to the carrying amount of the debt and no gain or loss.
■  Applying the guidance in paragraph AG8 of IAS 39, under which the EIR is determined at inception in the same way as above. However, if in subsequent periods there is a change in the level of the inflation expectations for the bond’s remaining term, the entity revises its estimates of the future cash flows to be paid on the bond accordingly. It recalculates the bond’s carrying amount by discounting the revised estimated cash flows using the original EIR. The resulting adjustment to the bond’s carrying amount is recognised immediately in the income statement as a gain or loss. The result is that a gain or loss is recognised in the current period for changes in the entity’s expectations of the future level of the inflation index.

6.7A.90 Given that the standard is not clear as to how the EIR method applies for instruments with variable cash flows, the IFRIC was asked to provide guidance on how to apply the effective interest rate method to a financial instrument whose cash flows are linked to changes in an inflation index. [IFRIC update July 2008]. The IFRIC noted that paragraphs AG6-AG8 of IAS 39 provide the relevant application guidance. Judgement is required to determine whether an instrument is a floating rate instrument within the scope of paragraph AG7 or an instrument within the scope of paragraph AG8. In view of the existing application guidance in IAS 39, the IFRIC decided not to add this issue to its agenda. However, since the application of the effective interest rate method has widespread application in practice, the IFRIC has decided to refer the matter to the IASB.
 
6.7A.91 Until such time as the IASB provides clarification, we believe an entity should make an accounting policy choice as to which method is acceptable and apply this method to all similar instruments. The way in which the above guidance should be applied is illustrated in the example given below.

Example – Inflation-linked bond

On 1 January 20X5, an entity invests in an inflation-linked bond for C100,000. The term of the bond is 5 years. The bond pays a fixed coupon of 5% per annum (real) at the end of each year on principal that is adjusted annually by the applicable year’s percentage change in the consumer price index. The principal repayable at the end of year 5 is similarly adjusted for inflation.
 
Terms of the bond
Proceeds received on 1 Jan 20X5 100,000
Fixed coupon @ 5% per annum (real interest rate) 5,000
Term 5 years
Principal and real interest adjusted annually for changes in the consumer price index  
   

Following are data of actual inflation rates and annual expected inflation rates on various dates
Annual expected percentage change in consumer price index
  1 Jan 20X5 1 Jan 20X6 1 Jan 20X7 1 Jan 20X8 1 Jan 20X9 Actual change
20X5 0.70%         1.20%
20X6 2.60% 1.40%       2.40%
20X7 2.80% 1.90% 1.70%     0%
20X8 2.80% 3.50% 2.10% 1.20%   3.40%
20X9 2.80% 3.50% 2.60% 1.60% 2.50% 2.50%
 
The expected inflation adjusted interest payments at the end of each year and the principal payment at the end of year 5 are shown below. The expected cash flows at the end of a year are calculated by multiplying the principal of C100,000 by the expected change in the consumer price index in that year. So at the beginning of 20X5, the principal at the end of 20X5 is expected to be C100,000 × 1.007 = C100,700. As the nominal coupon rate is 5%, the interest expected to be paid for 20X5 would be C5,035 (C100,700 @ 5%). Similarly, at 1 Jan 20X6, the expected inflated adjusted principal at the end of year 20X6 would be C100,000 × 1.012 (the opening amount as adjusted by the actual increase in inflation during 20X5) × 1.014 (expected increase during 20X6) = C102,617 and the expected adjusted interest would be C5,131 (C102,617 @ 5%).

Annual expected interest and principal cash flows Actual inflation adjusted cash flows
               
  1 Jan 20X5 1 Jan 20X6 1 Jan 20X7 1 Jan 20X8 1 Jan 20X9 Interest Principal
20X5 5,035         5,060  
20X6 5,166 5,131       5,181  
20X7 5,311 5,228 5,270     5,181  
20X8 5,459 5,411 5,380 5,244   5,358  
               
20X9 – interest 5,612 5,601 5,520 5,328 5,492 5,492  
Principal 112,242 112,014 110,401 106,550 109,831   109,831

20X9 117,854 117,615 115,921 111,878 115,323 26,272 109,831

 
Note that the principal expected to be paid at the end of 20X9 is adjusted for expected changes in the index since 1 Jan 20X5. For example, the expected principal payable in 20X9 estimated at 1 Jan 20X5 = 100,000 × 1.007 × 1.026 × 1.028 × 1.028 × 1.028 = 112,242.
 
There are essentially two ways in which the bond could be amortised in accordance with the guidance provided in paragraph AG7 of IAS 39.

The first method views the EIR as a ‘floating inflation adjusted rate’ – similar to LIBOR. In this method, the finance cost recognised in profit or loss is the actual inflation adjusted interest paid during the year plus the actual increase in principal as adjusted for inflation during the year. So the carrying amount is equal to the inflation adjusted amount at the end of the period. This method is simple and is often used in practice.

Amortisation of bond based on AG7 – Method 1
             
    Opening balance   Finance cost Cash flow Closing balance
31 Dec 20X5   100,000   6,260 5,060 101,200
31 Dec 20X6   101,200   7,610 5,181 103,629
31 Dec 20X7   103,629   5,181 5,181 103,629
31 Dec 20X8   103,629   8,881 5,358 107,152
31Dec 20X9   107,152   8,171 115,323 0

        36,103 136,103  

 
The second method complies strictly with the guidance in paragraph AG7. In this method, the finance cost in each period is based on an adjusted EIR, calculated by discounting the expected cash flows to equal to the carrying amount at the beginning of each period. No further gain or loss arises.
 
Amortisation of bond based on AG7 – Method 2
    Opening balance   Finance cost @ adjusted EIR (see below) Cash flow Closing balance
31 Dec 20X5   100,000   7,408 5,060 102,348
31 Dec 20X6   102,348   7,496 5,181 104,662
31 Dec 20X7   104,662   7,172 5,181 106,653
31 Dec 20X8   106,653   5,235 5,358 106,530
31Dec 20X9   106,530   8,793 115,323 0

        36,103 136,103  

 
Calculation of adjusted EIR based on expected cash flows

  EIR % 1 Jan 20X5 31 Dec 20X5 31 Dec 20X6 31 Dec 20X7 31 Dec 20X8 31 Dec 20X9
20X5 7.408 -100,000 5,035 5,166 5,311 5,459 117,854
20X6 7.324   -102,348 5,131 5,228 5,411 117,615
20X7 6.853     -104,662 5,270 5,380 115,921
20X8 4.908       -106,653 5,244 111,878
20X9 8.254         -106,530 115,323
               
The original effective interest rate at inception is 7.408%
 
The way in which the bond would be amortised in accordance with the guidance provided in paragraph AG8 of IAS 39 is shown below. As the finance cost in each period is based on the original EIR at inception, the carrying value at the end of each period is adjusted to the present value of the expected cash flows discounted at the original EIR. This gives rise to a further adjustment that is recognised as part of the finance cost in each period.

Amortisation of bond based on AG8  
  Opening balance Finance cost @ 7.408% Cash flow Closing balance AG8 adjustment Adjusted closing balance (see below) Total finance cost
31 Dec 20X5 100,000 7,408 5,060 102,348 -297 102,050 7,110
31 Dec 20X6 102,050 7,559 5,181 104,428 -1,305 103,123 6,255
31 Dec 20X7 103,123 7,639 5,181 105,581 -3,720 101,860 3,919
31 Dec 20X8 101,860 7,545 5,358 104,048 3,321 107,369 10,866
31 Dec 20X9 107,369 7,953 115,323 0 0 0 7,953

      136,103       36,103


           
Present value of expected cash flows based on original discount rate
           
  31 Dec 20X6 31 Dec 20X7 31 Dec 20X8 31 Dec 20X9 PV @7.408%
31 Dec 20X5 5,131 5,228 5,411 117,615 102,050
31 Dec 20X6   5,270 5,380 115,921 103,123
31 Dec 20X7     5,244 111,878 101,860
31 Dec 20X8       115,323 107,369

Comparison between AG7 and AG8
  AG7 – Method 1 AG7 – Method 2 AG8
  Finance cost Loan balance Finance cost Loan balance Finance cost Loan balance
31 Dec 20X5 6,260 101,200 7,408 102,348 7,110 102,050
31 Dec 20X6 7,610 103,629 7,496 104,662 6,255 103,123
31 Dec 20X7 5,181 103,629 7,172 106,653 3,919 101,860
31 Dec 20X8 8,881 107,152 5,235 106,530 10,866 107,369
  8,171 0 8,793 0 7,953 0

  36,103   36,103   36,103  

             
The comparisons between the two methods indicate that the finance cost calculated in accordance with AG7 is consistent with the trend in the actual inflation rate.

Amortised cost and the effective interest method - Illustrations of the effective interest rate method of amortisation - Perpetual debt instruments

Publication date: 08 Dec 2017


6.7A.92 It is not uncommon for entities to issue debt instruments on terms with no redemption date, but on which interest payments are made, usually at a fixed rate or a variable market based rate (for example, a fixed margin over LIBOR) in perpetuity. At initial recognition, assuming there are no transaction costs, the debt instrument will be recorded at its fair value, which is the amount received. The difference between this initial amount and the maturity amount, which is zero if the interest rate at inception is the market rate for that instrument, will never be amortised, as there is no repayment of principal. This means that at each reporting date the debt instrument will be recorded at its principal amount, which is also its amortised cost. This is because the amortised cost, which is the present value of the stream of future cash payments discounted at the effective interest rate (fixed for fixed rate instruments or variable for floating rate instruments) equals the principal amount in each period. [IAS 39 para IG B24]. If, on the other hand, the entity incurs transaction costs, the debt instrument will be recorded in each reporting period at its initial amount, which is the amount received less transaction costs. The result is that the transaction costs are never amortised, but reflected in the carrying amount indefinitely.

6.7A.93 Sometimes perpetual debt instruments are repackaged in such a way that the principal amount is effectively repaid. One way of achieving this is to pay a high rate of interest for a number of years (the primary period) which then falls to a negligible amount. If the interest were simply charged to profit or loss, the company would bear an artificially high interest expense during the primary period and little or no interest expense thereafter to perpetuity. Such treatment might reflect the form of the loan agreement, but not its substance. From an economic perspective, some or all of the interest payments are repayment of principal as illustrated in the example below. A similar example is included in paragraph IG B25 of IAS 39.

Example – Perpetual debt instrument with decreasing interest

An entity issues a perpetual bond for C100,000 on which interest at 14% is paid annually for the first 10 years and thereafter at a nominal rate of 0.125%.

It is clear that at the end of the ten year period, the bond has little or no value. The principal amount is repaid, in effect, over the initial 10 year primary period. Consequently, the interest payments during the primary period represent a payment for interest and repayment of capital. The effective interest rate calculated on the basis of C14,000 for 10 years followed by C125 to perpetuity is 6.84%.

  Opening amortised cost Interest expense @ 6.84% Cash payments Closing amortised cost
 
C
C
C
C
Year 1 100,000 6,840 14,000 92,840
Year 2 92,840 6,350 14,000 85,190
Year 3 85,190 5,827 14,000 77,017
Year 4 77,017 5,268 14,000 68,285
Year 5 68,285 4,671 14,000 58,956
Year 6 58,956 4,033 14,000 48,989
Year 7 48,989 3,351 14,000 38,340
Year 8 38,340 2,622 14,000 26,962
Year 9 26,962 1,844 14,000 14,806
Year 10 14,806 1,013 14,000 1,819

    41,819 140,000  

 
Although the carrying value at the end of year 10 is small, an amount of C100,000 may fall to be repayable should the entity go into liquidation. In practice, however, there will usually be arrangements to enable the entity to repurchase the debt instrument for a nominal amount and, therefore, extinguish any liability on it.

Fair value measurement considerations - General

Publication date: 08 Dec 2017


6.7A.94 The IASB believes that fair value is the most relevant measure for financial instruments and is the only relevant measure for derivative assets and liabilities. As a result, IAS 39 gives entities an option to measure all financial assets and liabilities that meet certain qualifying criteria at fair value. The importance of fair value in the measurement process arises because it is a market-based notion that is unaffected by the history of the asset or liability, the specific entity that holds the asset or the liability and the future use of the asset or the liability. Thus, it represents an unbiased measure that is consistent from year to year, within an entity and between entities. As a result, if an investor knows a financial instrument’s fair value and has information about its essential terms and risks, it has all the information it needs to make decisions about that instrument. IFRS 13 amended IAS 39 and IFRS 9 to remove their guidance on fair value measurement. For entities still applying IAS 39, the guidance on ‘day 1’ gain or loss and unquoted equity investments and related derivatives continues to be applicable and is included below. The guidance on fair value measurements under IFRS 13 is included in chapter 5.

[The next paragraph is 6.7A.145.]

Fair value measurement considerations - Unquoted equity instruments and related derivatives

Publication date: 08 Dec 2017


6.7A.145 Normally it is possible to estimate an equity instrument’s fair value that does not have a quoted price in an active market for an identical instrument (that is, a ‘Level 1 input’), as well as derivatives that are linked to (and must be settled by delivery of) such an equity instrument with sufficient reliability by applying valuation techniques based on reasonable assumptions. The fair value of such an instrument is deemed to be reliably measurable if:

the variability in the range of reasonable fair value measurements is not significant for that instrument; or
the probabilities of the various estimates within the range can be reasonably assessed and used when measuring fair value.
[IAS 39 para AG 80].

6.7A.146 There are many situations in which the variability in the range of reasonable fair value measurements is likely not to be significant and, hence, the fair value is reasonably measurable. However, if the range of reasonable fair value measurements is significantly wide and the probabilities of the various estimates cannot be reasonably assessed, an entity is precluded from measuring the instrument at fair value. In that situation, such instruments are measured at cost, less impairment. [IAS 39 paras 46(c), AG81]. It is not permissible for the entity to measure the equity instrument at fair value, for instance, by judgementally picking a fair value estimate within a range.

6.7A.147 A similar dispensation applies to derivative financial instruments that can only be settled by physical delivery of an equity instrument that does not have a quoted price in an active market for an identical instrument. It does not apply to derivative instruments in any other situations, as illustrated in the following example.

Example – Reliability of fair value measurement

An entity acquires a complex stand-alone derivative that is based on several underlying variables, including commodity prices, interest rates and credit indices. There is no active market or other price quotation for the derivative and no active markets for some of its underlying variables. The entity contends that the derivative’s fair value cannot be reliably measured.

Notwithstanding the entity’s contention, there is a presumption that the fair value of derivatives can be determined reliably by reference to appropriate market prices, or prices of similar instruments, or discounted cash flow or other pricing models or by reference to prices/rates for components, with the exception only of derivatives that are linked to and must be settled by delivery of such an equity instrument (see para 6.7A.147 above). This is not the situation here and, therefore, the entity cannot measure the derivative at cost or amortised cost.

Fair value measurement considerations - ‘day 1’ gain or loss

Publication date: 08 Dec 2017


6.7A.148 The best evidence of the instrument’s fair value on initial recognition is normally the transaction price. However, it is possible for an entity to determine that the instrument’s fair value is not the transaction price. The only exception to using the transaction price is if the fair value is evidenced by a quoted price in an active market for an identical asset or liability (that is, a ‘Level 1 input’) or based on a valuation technique that uses only data from observable markets. An entity recognises the difference between the fair value at initial recognition and the transaction price as a gain or loss. In all other cases, an entity recognises the instrument at fair value, adjusted to defer the difference between the fair value at initial recognition and the transaction price. After initial recognition, the entity recognises that deferred difference as a gain or loss only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability. [IAS 39 para AG 76]. The IASB concluded that these conditions were necessary and sufficient to provide reasonable assurance that this fair value was genuine for the purposes of recognising up-front gains or losses. In all other cases, the transaction price gives the best evidence of fair value, and ‘day 1’ gain recognition is precluded. [IAS 39 para BC104].

Example – ‘day 1’ gain or loss recognition
 
Entity A acquires a financial asset for C110, which is not quoted in an active market. The asset’s fair value based on the entity’s own valuation technique amounted to C115. However, that valuation technique does not solely use observable market date, but relies on some entity-specific factors that market participants would not normally consider in setting a price.
 
The entity cannot recognise a ‘day 1’ profit of C5 and record the asset at C115. The use of unobservable entity-specific inputs to calculate a fair value that is different from transaction price on ‘day 1’ is so subjective that its reliability is called into question. Hence, recognition of a ‘day 1’ gain or loss is not appropriate. Accordingly, the entity restricts its valuation to the transaction price and the asset is recorded at C110.

6.7A.149 A question arises as to whether and how any gain or loss not recognised on ‘day 1’ should be recognised subsequently, or at all. An unrecognised ‘day 1’ gain or loss should be recognised after initial recognition only to the extent that it arises from a change in a factor (including time) that market participants would consider in setting a price. [IAS 39 para AG 76]. It is not clear how the phrase “a change in a factor (including time) that market participants would consider in setting a price” should be interpreted. One interpretation is that a gain or loss should remain unrecognised until all market inputs become observable. Another interpretation is that it permits the recognition of ‘day 1’ gain or loss in profit or loss on a systematic basis over time, even in the absence of any observable transaction data to support such a treatment. Indeed, some constituents asked the Board to clarify whether straight-line amortisation was an appropriate method of recognising the difference. The Board decided not to do this. It concluded that although straight-line amortisation may be an appropriate method in some cases, it will not be appropriate in others. [IAS 39 para BC222(v)(ii)]. This would appear to suggest that an unrecognised ‘day 1’ gain or loss could be amortised either on a straight line basis or on another rational basis that reflects the nature of the financial instrument (for example, a non-linear amortisation for some option-based derivatives).

6.7A.150 It should be noted that an unrecognised ‘day 1’ gain or loss is not separately identified in the balance sheet. However, IFRS 7 requires disclosure of the unrecognised amount, together with the change in the amount previously deferred, and the entity’s accounting policy for determining when amounts deferred are recognised in profit or loss (see chapter 6.9A).

[The next paragraph is 6.7A.156.]

Impairment of financial assets

Publication date: 08 Dec 2017


6.7A.156 A financial asset measured at amortised cost is impaired when its carrying value exceeds the present value of the future cash flows discounted at the financial asset’s original effective interest rate. A financial asset that is carried at fair value through profit or loss does not give rise to any impairment issues as diminution in value due to impairment is already reflected in the fair value and, hence, in profit or loss. It follows that impairment issues are only relevant to financial assets that are carried at amortised cost and available-for-sale financial assets whose fair value changes are recognised in other comprehensive income.

6.7A.157 IAS 39 deals with impairment of financial assets through a two-step process. First, an entity must carry out an impairment review of its financial assets at each balance sheet date. The aim of this review is to determine whether there is objective evidence that impairment exists for a financial asset. [IAS 39 para 58]. This is considered from paragraph 6.7A.162 below.

6.7A.158 Secondly, if there is objective evidence of impairment, the entity should measure and record the impairment loss in the reporting period. [IAS 39 para 58]. The measurement of impairment losses differs between financial assets carried at amortised cost (see para 6.7A.173 below), financial assets carried at cost (see para 6.7A.200 below) and available-for-sale financial assets (see para 6.7A.201 below). There is also a difference on whether impairment losses can be reversed depending on whether the available-for-sale instrument is debt or equity (see para 6.7A.204 below).

Impairment of financial assets - Incurred versus expected losses

Publication date: 08 Dec 2017


6.7A.159 Under IAS 39, a financial asset or a group of financial assets is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the asset’s initial recognition (a ‘loss event’). It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. In addition, the loss event must have a reliably measurable effect on the present value of estimated future cash flows and be supported by current observable data. [IAS 39 para 59].

6.7A.160 Losses expected as a result of future events, no matter how likely, are not recognised. Possible or expected future trends that may lead to a loss in the future (for example, an expectation that unemployment will rise or a recession will occur) are also not taken into account. The standard states that to recognise impairment on the basis of expected future transactions and events would not be consistent with an amortised cost model.

6.7A.161 As the impairment model in IAS 39 is based on the ‘incurred loss’ model and not on an ‘expected loss’ model, an impairment loss is not recognised at the time an asset is originated, that is, before a loss event can have occurred as illustrated in the following example:

Example – Recognition of an impairment loss on origination

Entity A lends C1,000 to a group of customers. Based on historical experience, entity A expects that 1% of the principal amount of loans given to the customers will not be collected.

Entity A is not permitted to reduce the carrying amount of a loan asset by C10 on initial recognition through the recognition of an immediate impairment loss.

Under the incurred loss model of IAS 39, an impairment loss is recognised only if there is objective evidence of impairment as a result of a past event that occurred after initial recognition. Furthermore, recognition of an immediate impairment loss based on future expectation would be inconsistent with the general rule that a financial asset should be initially measured at fair value. For a loan asset, the fair value is the amount of cash lent adjusted for any fees and costs (unless a portion of the amount lent is compensation for other stated or implied rights or privileges). [IAS 39 para IGE4.2]. In practice, however, the expectation of loss is built in to the credit spread for the customer.

Impairment of financial assets - Objective evidence of impairment

Publication date: 08 Dec 2017


6.7A.162 IAS 39 provides examples of factors that may, either individually or taken together, provide sufficient objective evidence that an impairment loss has been incurred in a financial asset or group of financial assets. They include observable data that comes to the attention of the holder of the asset about the following loss events:

Significant financial difficulty of the issuer or obligor.
A breach of contract, such as a default or delinquency in interest or principal payments.
The lender, for economic or legal reasons relating to the borrower’s financial difficulty, granting to the borrower a concession that the lender would not otherwise consider.
It becomes probable that the borrower will enter bankruptcy or other financial reorganisation.
The disappearance of an active market for that financial asset because of financial difficulties.
Observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group, including:
  adverse changes in the payment status of borrowers in the group (for example, an increased number of delayed payments or an increased number of credit card borrowers who have reached their credit limit and are paying the minimum monthly amount); or
  national or local economic conditions that correlate with defaults on the assets in the group (for example, an increase in the unemployment rate in the geographical area of the borrowers, a decrease in property prices for mortgages in the relevant area, a decrease in oil prices for loan assets to oil producers, or adverse changes in industry conditions that affect the borrowers in the group).
[IAS 39 para 59].

6.7A.163 A downgrade of an entity’s credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. Other factors that an entity considers in determining whether it has objective evidence that an impairment loss has been incurred include information about:

The debtors’ or issuers’ liquidity.
Solvency, business and financial risk exposures.
Levels of and trends in delinquencies for similar financial assets.
National and local economic trends and conditions.
The fair value of collateral and guarantees.
   
These and other factors may, either individually or taken together, provide sufficient objective evidence that an impairment loss has been incurred in a financial asset or group of financial assets. [IAS 39 para 60, IG para E4.1].

6.7A.164 A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of an investment in a debt instrument that results from an increase in the risk-free interest rate). Also, in contrast with the fifth bullet point mentioned in paragraph 6.7A.162 above, the disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment. [IAS 39 para 60].

Impairment of financial assets - Objective evidence of impairment - Evidence of impairment for equity instruments

Publication date: 08 Dec 2017


6.7A.165 The standard provides additional guidance about impairment indicators that are specific to investments in equity instruments. They apply in addition to the impairment indicators described above, which focus on the assessment of impairment in debt instruments.

6.7A.166 The additional impairment indicators that may indicate that the equity investment’s cost may not be recovered are:

Significant adverse changes in the technological, market, economic or legal environment in which the issuer operates. For example, such changes include but are not limited to:
  Structural changes in the industry or industries in which the issuer operates, such as changes in production technology or the number of competitors.
  Changes in the level of demand for the goods or services sold by the issuer resulting from factors such as changing consumer tastes or product obsolescence.
  Changes in the political or legal environment affecting the issuer’s business, such as enactment of new environment protection, tax or trade laws.
  Changes in the issuer’s financial condition evidenced by changes in factors such as its liquidity, credit rating, profitability, cash flows, debt/equity ratio and level of dividend payments.
A ‘significant’ or ‘prolonged’ decline in the fair value of an investment in an equity instrument below its cost.
[IAS 39 para 61].

6.7A.167 In the context of the last bullet point above, the IFRIC confirmed that a significant decline in fair value should be evaluated against the original cost at initial recognition and ‘prolonged’ should be evaluated against the period in which the fair value of the investment has been below that original cost. In May 2009 the IFRIC tentatively decided, that a significant or prolonged decline cannot be considered only an indicator of possible impairment in determining whether there is objective evidence. When such a decline exists, recognition of an impairment loss is required. Furthermore, any further declines in value after an impairment loss has been recognised in profit or loss should be recognised immediately in profit or loss. [IAS 39 para IG E4.9]. IAS 39 refers to original cost on initial recognition of an equity instrument and does not permit a prior impairment to establish a new deemed cost against which subsequent declines in fair value are evaluated. [IFRIC Update April 2005]. However, no guidance is provided on what is a ‘significant’ or ‘prolonged’ decline in the fair value of an equity instrument. Consequently, judgement is required.

6.7A.168 Whether a decline in fair value below cost is considered as ‘significant’ must be assessed on an instrument-by-instrument basis. In our view, the assessment of significant should be based on both qualitative and quantitative factors. An entity should develop an accounting policy for assessing a ‘significant’ decline in fair value.

6.7A.169 The expected level of volatility for an instrument may also be a factor that entities should take into consideration when assessing what is ‘significant’. Volatility is a tendency of a stock’s value to fluctuate. Stocks with higher volatility are considered riskier because their value changes more from day to day. Stocks with a lower volatility are more stable and, therefore, viewed as less risky. For example, a company may hold listed shares in an established supermarket chain whose share price changes by 3% over a period of time and listed shares in a speculative mining enterprise whose share price fluctuates by 10% over the same period. In this case, a larger decline in the mining company’s shares might be tolerated before an entity records an impairment loss, given its greater volatility compared with the supermarket chain. It is also important to note that where volatility is taken into account in a company’s assessment of whether a decline is significant, the volatility is considered relative to the instrument’s fair value at the date impairment is being considered, not its original cost. In addition, that volatility should be determined over a relatively long period. For example, a market downturn due to decline in the overall economy over a short period of time would not be considered adequate to establish an estimate of expected future volatility.

6.7A.170 What is a ‘prolonged’ decline in fair value will also require judgement and a policy will need to be established. In general, a period of 12 months or greater below original cost is likely to be a ‘prolonged’ decline. However, the assessment of ‘prolonged’ should not be compared to the entire period that the investment has been or is expected to be held. For example, if a security’s fair value has been below cost for 12 months, whether that security has been held or is intended to be held for two or 20 years is irrelevant. The assessment is whether the period of 12 months accords with the entity’s chosen policy.

6.7A.171 Following the amendment to IAS 39 described in paragraph 6.7A.41, on reclassification of an equity instrument out of a category measured at fair value (that is, held-for-trading or available-for-sale) and into another category, the fair value at the date of reclassification becomes its new cost or amortised cost. [IAS 39 paras 50C, 50F]. This new cost or amortised cost is the basis against which future ‘significant’ or ‘prolonged’ declines in fair value should be assessed.

6.7A.172 In practice, an entity may have purchased securities in a company on multiple dates and at different prices. IAS 39 does not provide guidance on this point. By analogy to IAS 2, in our view the basis for measuring the cost for calculating impairment could be a specific identification method, weighted average cost or FIFO method. The basis should be the same as the basis for calculating realised gains or losses upon disposal and should remain consistent across periods. This is an accounting policy choice and should be applied consistently.

Impairment of financial assets - Financial assets carried at amortised cost - General requirements

Publication date: 08 Dec 2017


6.7A.173 Financial assets carried at amortised cost are those that are classified as either loans and receivables or held-to-maturity. If there is objective evidence that an impairment loss on such an asset has been incurred, the amount of the loss should be measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows. The expected cash flows should exclude future credit losses that have not been incurred and should be discounted at the financial asset’s original effective interest rate (that is, the effective interest rate computed at initial recognition). [IAS 39 para 63].

6.7A.174 The standard allows the carrying amount of the asset to be reduced either directly by writing it down or through use of an allowance account such as a loan loss provision or provision for bad and doubtful debts. However, the amount of the loss should be recognised in profit or loss. [IAS 39 para 63]. The asset’s carrying amount in the entity’s balance sheet is stated net of any related allowance. [IAS 39 para AG 84].

6.7A.175 In some circumstances, it may not be practicable to make a reasonably reliable direct estimate of the present value of future cash flows expected from an impaired financial asset measured at amortised cost. As a practical expedient, the carrying amount of the impaired asset may be determined in these circumstances on the basis of an instrument’s fair value using an observable market price. [IAS 39 para AG 84].

6.7A.176 A loan’s observable market price is the loan’s quoted price that can be obtained from reliable market sources. For example, loans with an active secondary market could be measured based on the observable market price. Similarly, an entity that has a viable plan to dispose of loans in a bulk sale could measure impairment by comparison to the net proceeds received on similar loan sales. However, it is likely that the use of the observable market price will be infrequent, because either there may not be a market for the loans or the market may be illiquid.

6.7A.177 The expected future cash flows that are included in the calculation are the contractual cash of the instrument itself, reduced or delayed based on the current expectations of the amount and timing of these cash flows as a result of losses incurred at the balance sheet date. In circumstances where the amount outstanding is expected to be collected in full, but the collection period is delayed, an impairment loss must still be recognised, unless the creditor receives full compensation (for example, in the form of penalty interest) for the period of the delinquency, as illustrated in the example below.

Example – Impairment arising from changes in the amount and timing of cash flows
 
Entity A is concerned that, because of financial difficulties, customer B will not be able to make all principal and interest payments due on a loan in a timely manner. It negotiates a restructuring of the loan. Entity A expects that customer B will be able to meet its obligations under the restructured terms in any of the 5 scenarios indicated below.
 
■  Customer B will pay the original loan’s full principal amount 5 years after the original due date, but none of the interest due under the original terms.
■  Customer B will pay the original loan’s full principal amount on the original due date, but none of the interest due under the original terms.
■  Customer B will pay the original loan’s full principal amount on the original due date with interest only at a lower interest rate than the interest rate inherent in the original loan.
■  Customer B will pay the original loan’s full principal amount 5 years after the original due date and all interest accrued during the original loan term, but no interest for the extended term.
■  Customer B will pay the original loan’s full principal amount 5 years after the original due date and all interest, including interest for both the loan’s original term and the extended term.
[ IAS 39 para IG E4.3].
 
Given that customer B is in financial difficulties, an impairment loss has been incurred, as there is objective evidence of impairment. The amount of the impairment loss for a loan measured at amortised cost is the difference between the loan’s carrying amount and the present value of future principal and interest payments discounted at the loan’s original effective interest rate.
 
In the first four scenarios above, the present value of the future principal and interest payments discounted at the loan’s original effective interest rate will be lower than the loan’s carrying amount. Therefore, an impairment loss is recognised in those cases.
 
In the final scenario, even though the timing of payments has changed, the lender will receive interest on interest, and the present value of the future principal and interest payments discounted at the loan’s original effective interest rate will equal the carrying amount of the loan. Therefore, there is no impairment loss. However, this fact pattern is unlikely given customer B’s financial difficulties.

6.7A.178 Where an impaired financial asset is secured by collateral, the calculation of the present value of the estimated future cash flows of the collateralised financial asset should reflect the cash flows that may result from foreclosure less costs for obtaining and selling the collateral, whether or not foreclosure is probable. [IAS 39 para AG 84]. As the measurement of the impaired financial asset reflects the collateral asset’s fair value, the collateral is not recognised as an asset separately from the impaired financial asset, unless it meets the recognition criteria for an asset in another standard. [IAS 39 IG para E4.8].

6.7A.179 For financial assets reclassified to another category following the amendment to IAS 39 in October 2008, see paragraph 6.7A.45.

Impairment of financial assets - Financial assets carried at amortised cost - Appropriate discount rate

Publication date: 08 Dec 2017


6.7A.180 As stated above, impairment of a financial asset carried at amortised cost is measured by discounting the expected future cash flows using the financial instrument’s original effective interest rate. Since impairment reflects a fall in the asset’s carrying amount, which is evidenced by a decrease in the estimate of expected cash flows to be received from the financial asset, discounting at a rate of interest that reflects a current market rate of interest would impose fair value measurement on the financial asset. This would not be appropriate for assets that are measured at amortised cost. [IAS 39 para AG 84]. The historical effective rate should be used as the discount rate even where it is lower or higher than the rate on current loans originated by the entity. In other words, loan impairments are based solely on the reduction in estimated cash flows rather than on changes in interest rates. This approach ensures that a financial asset carried at amortised cost that becomes impaired continues to be carried at an amount that considers the present value of all expected future cash flows, in a manner consistent with the asset’s measurement before it became impaired.

Example – Impairment of fixed rate loan
 
The facts are the same as in example 2 in paragraph 6.7A.78 above, except that at 31 December 20X9 it became clear that as a result of structural changes in the industry in which the borrower operates, the borrower was in financial difficulties and its credit rating had been downgraded. At that date, the loan’s amortised carrying value, calculated at the original effective rate of 6.7322%, amounted to C583,435.
 
Faced with this objective evidence, the entity believes that the borrower will be unable to make all the remaining 5 annual scheduled repayments of C142,378. Accordingly, the entity restructures the loan under which the annual payment due on 31 December 20Y0 is waived followed by three annual payments of C175,000 until 31 December 20Y3. The interest on the outstanding loan under the revised payment schedule is reduced to 6.3071%.
 
The present value of the annual payments of C175,000 due on 31 December 20Y1, Y2 and Y3, discounted at the original effective interest rate of 6.7322% amounts to C432,402. Accordingly, the entity recognises an impairment loss of C151,033 (C583,435 – C432,402) in profit or loss on 31 December 20X9. Therefore, the carrying amount is written down by the amount of the impairment loss.

6.7A.181 Even if the terms of a loan, receivable or held-to-maturity investment are renegotiated or otherwise modified because of financial difficulties of the borrower, impairment is measured using the original effective interest rate before the terms were modified. [IAS 39 para AG 84]. However, in some situations, significant modification of the terms may result in derecognition of the existing asset and recognition of a new asset.

6.7A.182 There are three specific instances where the original discount rate is not used to measure impairment losses.

For variable rate loans and variable rate held-to-maturity investments, the discount rate for measuring any impairment loss is the current variable rate determined under the contract. [IAS 39 para AG 84].
   
 
Example – Discount rate for loan impairment calculation

Entity A has provided a loan of GBP1m to entity B. In entity A’s financial statements, the loan is classified as ‘loans and receivables’ in accordance with IAS 39. The loan was originally priced at three month GBP Libor + 300bp. However, entity B has run into financial difficulty and following renegotiations the loan has been re-priced at three month GBP Libor + 100bp.

Objective evidence that an impairment loss on the loan has been incurred is provided by the fact that the terms of the loan have been re-negotiated (that is, the price of the loan was reduced) in response to the counterparty being in financial difficulties.

The impairment loss should be measured as the difference between the carrying amount of the loan and the present value of estimated future cash flows. Estimated future cash flows should be based on the revised terms of the loan – that is, GBP three month Libor + 100bp. These estimated future cash flows should then be discounted at the loan’s effective interest rate, which in this case is the current GBP three month Libor + 300bp, according to the terms of the original loan. The amount of the loss should be recognised in profit and loss. It is the current GBP three month Libor plus the original spread of 300bp that should be used to measure any impairment loss.

In addition, following any impairment, management should consider whether the contractual rights to the financial asset have in substance expired – that is, whether the terms of the loan have been modified to such a large extent that it is in substance a new loan. If they have, the financial asset is derecognised under paragraph 17(a) of IAS 39, and a new asset is recognised for the new loan at its fair value. Derecognition is considered in chapter 6.6.
   
For financial assets reclassified out of held-for-trading or available-for-sale, the effective interest rate will be recalculated using the fair value at the date of reclassification (see para 6.7A.43). This new effective interest rate will be used to calculate interest income in future periods and considered as the original effective interest rate when measuring impairment. Subsequent to reclassification, an increase in the recoverability of cash flows would also result in an adjusted effective interest rate (see para 6.7A.81).
For a fixed rate loan that is designated as a hedged item in a fair value hedge of interest rate risk, the loan’s carrying amount is adjusted for any changes in its fair value attributable to interest rate movements. The loan’s original effective interest rate before the hedge, therefore, becomes irrelevant and the effective interest rate is recalculated using the loan’s adjusted carrying amount. The adjusted effective rate is used as the rate for discounting the estimated future cash flows for measuring the impairment loss on the hedged loan. [IAS 39 para IG E4.4]. Hedge accounting is considered in chapter 6.8.

6.7A.183 Consistent with the initial measurement requirements set out in paragraph 6.7A.9 above, cash flows relating to short-term receivables are not discounted if the effect of discounting is immaterial. [IAS 39 para AG 84].

Impairment of financial assets - Financial assets carried at amortised cost - Evaluation of impairment on a portfolio basis

Publication date: 08 Dec 2017


6.7A.184 IAS 39 contains specific guidance for assessing and measuring the impairment losses of a group of financial assets that is carried at amortised cost. The assessment process is as follows:

First, financial assets that are considered to be individually significant are assessed for impairment individually based on whether objective evidence of impairment exists.
Secondly, all other assets that are not individually significant are assessed for impairment. They may be assessed either individually or collectively on a group basis as indicated below.
Thirdly, all assets that have been individually assessed for impairment, whether significant or not, but for which there is no objective evidence of impairment, are included within a group of assets with similar credit risk characteristics and collectively assessed for impairment.
Fourthly, assets that are individually assessed for impairment and for which an impairment loss is (or continues to be) recognised are not included in a collective assessment for impairment.
[IAS 39 para 64].

6.7A.185 It seems perhaps illogical and superfluous to subject individual loans that have been reviewed individually for impairment and found not to be impaired to be included again in a portfolio of similar loans for collective assessment. The Basis for Conclusions sets out in extensive detail the arguments for and against this requirement and concludes that impairment that cannot be identified with an individual loan may be identifiable on a portfolio basis. [IAS 39 paras BC111 to BC117].

6.7A.186 There is no guidance in the standard as to what is meant by ‘individually significant’. What is significant for one entity may not be significant to another, so each entity should assess what is significant based on its own facts and circumstances.

Example – Individual versus collective assessment

An entity has a portfolio of similar receivables amounting to C100m. The entity considers that within this portfolio are C30m of loans that are individually significant. It assesses these loans for impairment on an individual basis and determines that C20m of loans are impaired. Of the remaining C70m loans that are not significant, the entity selects C15m for individual assessment and finds them all to be individually impaired. The rest of the portfolio is subject to an impairment review on a collective basis.

The result of this assessment means that loans amounting to C35m that have been assessed for impairment on an individual basis, whether significant or not, and found to be impaired will not be included for collective assessment. The remaining C65m of loans (C10m of individually significant loans that are found not to be impaired) and C55m that were not assessed for impairment on an individual basis) are included in the collective assessment.

However, loss probabilities and other loss statistics differ at a portfolio level between the C10m of individually evaluated loans that are found not to be impaired and the C55m of loans that were not individually evaluated for impairment. This means that a different amount of impairment may be required for these sub-portfolios. [IAS 39 AG 87].

6.7A.187 For the purpose of a collective evaluation of impairment, financial assets should be grouped on the basis of similar credit risk characteristics that are indicative of the debtors’ ability to pay all amounts due according to the contractual terms. This may be done on the basis of a credit risk evaluation or grading process that considers asset type, industry, geographical location, collateral type, past-due status and other relevant factors. If an entity does not have a group of assets with similar risk characteristics, it does not make the additional assessment. [IAS 39 para AG 87]. In that case, such assets are individually assessed for impairment.

6.7A.188 It should be noted that as soon as information is available that specifically identifies losses on individually impaired assets in a group, those assets should be removed from the group. [IAS 39 para AG 88].

6.7A.189 The Basis for Conclusions in IAS 39 provides detailed guidance on how to perform impairment assessments within groups of financial assets. Most of the detailed guidance will be highly relevant to banks and financial institutions that have large portfolios of loans and receivables. The following elements are critical to an adequate process:

Future cash flows in a group of financial assets should be estimated on the basis of historical loss experience for assets with credit risk characteristics similar to those in the group.
Entities that have no entity-specific loss experience or insufficient experience should use peer group experience for comparable groups of financial assets.
Historical loss experience should be adjusted on the basis of current observable data to reflect the effects of current conditions.
Changes in estimates of future cash flows should be directionally consistent with changes in underlying observable data (such as changes in unemployment rates, property prices, payment status, or other factors indicative of changes in the probability of losses in the group and their magnitude).
The methodology and assumptions used for estimating future cash flows should be reviewed regularly to reduce any differences between loss estimates and actual loss experience.
[IAS 39 para BC124].

6.7A.190 Applying the above process ensures that the collective assessment of impairment for a group of financial assets is still an ‘incurred’ and not an ‘expected’ loss model that aims to reflect the loss events that have occurred with respect to individual assets in the group, but have not yet been identified on an individual asset basis. IAS 39 provides an example of an entity that determines, on the basis of historical experience, that one of the main causes of default on credit card loans is the death of the borrower. Although the death rate is unchanged from one year to the next, some of the borrowers in the group may have died in that year. This indicates that an impairment loss has occurred on those loans, even if, at the year-end, the entity is not yet aware which specific borrowers have died. It would be appropriate for an impairment loss to be recognised for these ‘incurred but not reported’ (IBNR) losses. However, it would not be appropriate to recognise an impairment loss for deaths that are expected to occur in a future period, because the necessary loss event (the death of the borrower) has not yet occurred. [IAS 39 para AG 90].

6.7A.191 The standard allows the use of formula-based approaches or statistical methods to determine impairment losses in a group of financial assets as long as they:

Do not give rise to an impairment loss on a financial asset’s initial recognition.
Are consistent with the general requirements outlined above.
Incorporate the effect of the time value of money.
Consider the cash flows for all of the remaining life of an asset (not only the next year).
Consider the age of the loans within the portfolio.
[IAS 39 para AG 92].

Impairment of financial assets - Financial assets carried at amortised cost - Measurement difficulties in the absence of observable data

Publication date: 08 Dec 2017


6.7A.192 Making a reasonably reliable estimate of the amount and timing of future cash flows from an impaired financial asset is a matter of judgement. The best estimate is based on reasonable and supportable assumptions and observable data concerning the ability of a debtor to make payments in relation to circumstances existing at the impairment measurement date.

6.7A.193 However, sometimes observable data required to estimate the amount of an impairment loss on a financial asset may be limited or no longer fully relevant to current circumstances. For example, this may be the case when a borrower is in financial difficulties and there is little available historical data relating to similar borrowers. In such cases, an entity should use its judgement to estimate the amount of any impairment loss and to adjust observable data for a group of financial assets to reflect current circumstances. The use of reasonable estimates is an essential part of the financial statement’s preparation and does not undermine their reliability. [IAS 39 para 62].

Impairment of financial assets - Financial assets carried at amortised cost - General provisions for bad and doubtful debts

Publication date: 08 Dec 2017


6.7A.194 It has not been uncommon for entities under previous GAAPs to determine bad debt provisions for non-performing loans based on a provision matrix or similar formula that specifies fixed provision rates for the number of days a loan or a debt is overdue. For example, the provisioning rates could be 0% if less than 90 days overdue, 20% if 90-180 days, 50% if 181-365 days and 100% if more than 365 days. Such a method of provisioning would not be acceptable under IAS 39, unless it produces a result that is sufficiently close to the one obtained by following a discounted cash flow methodology required by the standard, which is considered highly unlikely. [IAS 39 para IG E4.5].

6.7A.195 Similarly, it was fairly common for entities under previous GAAPs to make a general provision for bad and doubtful debts on the grounds of prudence and set aside sums that are not specifically related to losses in a group of assets, but intended to cover unplanned and unexpected losses. Such provisioning methods are not allowed under IAS 39 as it results in impairment or bad debt losses that are in excess of those that can be attributed to incurred losses. Accordingly, amounts that an entity might want to set aside for additional possible impairment in financial assets, such as reserves that cannot be supported by objective evidence about impairment, are not recognised as impairment or bad debt losses under IAS 39. [IAS 39 para IG E4.6]. This does not prevent an entity designating part of its reserves in equity to cover such ‘prudence’ or related losses.

Impairment of financial assets - Financial assets carried at amortised cost - Recognition of interest on impaired assets

Publication date: 08 Dec 2017


6.7A.196 Once a financial asset or a group of similar financial assets has been written down as a result of an impairment loss, interest income is thereafter recognised using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss. [IAS 39 para AG 93]. That is the discount in the carrying amount is unwound. This would be the original effective rate for fixed rate instruments carried at amortised cost and current interest rate for floating rate instruments.

6.7A.197 An entity should not stop accruing interest on loans that are non-performing. When non-performing loans are reviewed for impairment, the collection or non-collection of the future interest payments would be taken into account in the estimation of future cash flows for the purposes of the impairment calculation. Interest income would be recognised as the discount unwinds.

Example – Income recognition on impaired loans
 
The facts are the same as in the example in paragraph 6.7A.182 above. Following recognition of the impairment loss at 31 December 20X9, the amortised cost amounted to C432,402.

On the assumption that cash inflows will occur as restructured, the amortisation schedule based on the revised cash flows and the original discount rate is shown below. In accordance with paragraph 6.7A.196 above, interest income is recognised at the rate of discount used to the measure the impairment.
 
  Cash in flows Interest income @ 6.7322% Carrying amount
1 Jan 20Y0     432,402
31 Dec 20Y0   29,110 461,512
31 Dec 20Y1 175,000 31,070 317,582
31 Dec 20Y2 175,000 21,380 163,962
31 Dec 20Y3 175,000 11,038

  525,000 92,598  

Impairment of financial assets - Financial assets carried at amortised cost - Reversal of impairment losses on assets held at amortised cost

Publication date: 08 Dec 2017


6.7A.198 As stated in paragraph 6.7A.157 above, an impairment review should be carried out at each reporting date. If, in a subsequent period, the amount of the impairment loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognised (such as an improvement in the debtor’s credit rating), the previously recognised impairment loss should be reversed either directly or by adjusting an allowance account. The reversal should not result in a carrying amount of the financial asset that exceeds what the amortised cost would have been had the impairment not been recognised at the date the impairment is reversed. The amount of the reversal should be recognised in profit or loss. [IAS 39 para 65]. This is in contrast with an equity instrument where an impairment loss is specifically not reversed (see para 6.7A.204).

6.7A.199 If a financial asset has been reclassified out of a category measured at fair value (that is, held-for-trading or available-for-sale) and into a category measured at amortised cost, an increase in cash flows would be a reversal of impairment only if the impairment loss was recognised after the date of reclassification. Any other increase in cash flows will be a change in expected cash flows and adjusted cumulatively in accordance with paragraph AG 8 of IAS 39 (see para 6.7A.81).

Impairment of financial assets - Financial assets carried at cost

Publication date: 08 Dec 2017


6.7A.200 As set out in paragraph 6.7A.145 above, an unquoted equity instrument that is not carried at fair value because its fair value cannot be reliably measured, or on a derivative asset that is linked to and must be settled by delivery of such an unquoted equity instrument, are measured at cost. For such instruments, if there is objective evidence that an impairment loss has been incurred, the amount of the impairment loss is measured as the difference between the carrying amount of the financial asset and the present value of estimated future cash flows discounted at the current market rate of return for a similar financial asset. Such impairment losses are not permitted to be reversed. [IAS 39 para 66].

Impairment of financial assets - Available-for-sale financial assets

Publication date: 08 Dec 2017


6.7A.201 When a decline in the fair value of an available-for-sale financial asset has been recognised directly in other comprehensive income and there is objective evidence that the asset is impaired, the cumulative loss that had been recognised directly in other comprehensive income should be reclassified from equity and recognised in profit or loss even though the financial asset has not been derecognised. [IAS 39 para 67]. It is not appropriate to allocate part of the reduction below cost to impairment and part to a fair value movement through other comprehensive income.

6.7A.202 The amount of cumulative loss that is recycled to profit or loss is the difference between the acquisition cost (net of any principal repayment and amortisation) and current fair value, less any impairment loss on that financial asset previously recognised in profit or loss. [IAS 39 para 68]. Any portion of the cumulative net loss that is attributable to foreign currency changes on that asset that had been recognised in equity is also recognised in profit or loss (see para 6.7A.213 below). Subsequent losses, including any portion attributable to foreign currency changes, are also recognised in profit or loss until the asset is derecognised. [IAS 39 para IG E4.9].

6.7A.203 For financial assets reclassified out of a category measured at fair value (that is, held-for-trading or available-for-sale) and into another category, see paragraph 6.7A.41.

Example – Impairment of available-for-sale debt security
 
On 1 January 20X3, an entity purchased C10 million 5 year bond with semi-annual interest of 5% payable on 30 June and 31 December each year. The bond’s purchase price was C10,811,100, which resulted in a bond premium of C811,100 and an effective interest rate of 8% (4% on a semi-annual basis). The entity classified the bond as available-for-sale.
 
The entity received all the interest due in 20X3 and 20X4 on a timely basis. At 31 December 20X4, the amortised cost of the loan amounted to C10,524,226. The cumulative amount recognised in equity to that date was a loss C266,322.
 
The entity did not receive the half-yearly interest due on 30 June 20X5 and it soon became clear that the issuer was in financial difficulties. At 31 December 20X5, the entity reviews the issuer’s financial condition and prospects for repayment of the loan and determines that the bond is impaired. On the basis of the information available at the time, the entity’s best estimate of future cash flows (on a yearly basis) is cash receipts of C2m on 31 December 20X6 and C7m on 31 December 20X7, the scheduled repayment date.
 
Although the bond is non-performing, the entity recognises the interest income for the period to 31 December 20X5 at the original effective interest rate. On this basis, the bond’s amortised cost at 31 December 20X5 amounts to C11,383,002.
 
As the bond is classified as available-for-sale, it is necessary to determine the bond’s fair value at 31 December 20X5. As there is no observable market price for the bond, the bond’s fair value, can only be obtained by discounting the expected cash flows at the current market rate. As a market rate for a comparable bond may not exist, it would be necessary to derive a current market rate for the bond. One way of estimating the current rate for a comparable bond with terms and credit risk profiles similar to the existing bond is by reference to a benchmark rate or the risk-free rate, which is part of the bond’s effective rate of interest of 8%, and amending that rate by the original credit risk premium of the existing bond.
 
Assume that when the bond was purchased on 1 January 20X3, the risk-free rate was 6% for a debt instrument with the same terms as the one purchased by the entity. Thus, the credit risk premium of the bond is 200 basis points. At 31 December 20X5, the risk-free rate for a similar type of instrument is 8%. Therefore, using the bond’s credit risk premium of 200 basis points, the current interest rate for discounting the expected cash flows is 10% (8% + 200 basis point). Using this rate of 10%, the present value of the expected cash flow of C2m and C7m arising on 31 December 20X6 and 31 December 20X7 amounts to C7,603,305.
 
Therefore, the impairment loss recognised in profit or loss is as follows:
   
Amortised cost at 31 December 20X4 10,524,226
Accrual of half-yearly interest to 30 June 20X5 @ 4% 420,969

  10,945,195
Accrual of half-yearly interest to 31 December 20X5 @ 4% 437,808

Amortised cost at 31 December 20X5 before impairment 11,383,003
Fair value of bond at 31 December 20X5 (7,603,305)

Impairment arising during 20X5 3,779,698
Recycling of loss recognised in equity 266,322

Impairment recognised in profit or loss 4,046,020

Bond stated in the balance sheet at 31 December 20X5 7,603,305

   
On 31 December 20X6, the holder received the expected cash flow of C2m. The amortised cost of the bond at 31 December 20X6 amounts to:
   
Amortised cost at 31 Dec 20X5 7,603.305
Accrual of interest to 31 Dec 20X6 @10% 760,330

  8,363,635
Less cash received at 31 Dec 20X6 2,000,000

Amortised cost at 31 Dec 20X6 6,363,635

   
Note that once the bond has been written down as a result of an impairment loss, interest income is thereafter recognised using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss. (See para 6.7A.196.) This rate is 10% as stated above.
 

During the year to 31 December 20X6, interest rates increased and as a result the bond’s fair value at 31 December 20X6 fell to C6.0m. There was no further change in the credit status/rating of the issuer and there is no evidence of any further credit-related impairment since the original assessment of impairment was made during 20X5. At 31 December 20X6, there is a difference between the bond’s amortised cost and its fair value as shown below:

 
Amortised cost at 31 Dec 20X6 as above 6,363,635
Fair value at 31 Dec 20X6 6,000,000

Further reduction 363,635

   

The further reduction of C363,635 is also the difference between the fair value of C7,603, 305 at 31 December 20X5 after adjusting for interest income of 10% and the cash of £2m received and the fair value of C6,000,000 at 31 December 20X6.

The question arises as to whether the further decrease of C363,635 should be taken to the AFS reserve in equity or recognised as a further impairment loss in profit or loss for the period to 31 December 20X6.

There are two acceptable views. An entity makes an accounting policy choice as to which view it accepts and applies this view to all similar transactions. If material, an entity discloses this policy in its financial statements.

View A – AFS reserve in equity

Without any further objective evidence of impairment, no further impairment charge is recognised in profit or loss. Hence, the change in fair value is recognised in equity. 

This view is consistent with paragraph 58 of IAS 39, which requires an entity to assess at each balance sheet date whether there is any objective evidence that a financial asset is impaired. If such evidence exists, the entity should apply the requirement for available-for-sale financial asset considered in paragraphs 6.7A.201 and 6.7A.202 above. In this situation, at 31 December 20X6, as there is no new evidence of a further credit impairment, the requirements of those paragraphs do not apply and the further decrease of C363,635 is recognised in equity. In addition, IAS 39 paragraph IG E4.10 acknowledges that the AFS reserve in equity can be negative – for example, because of a decline in the fair value of an investment in a debt instrument that results from an increase in the basic risk free interest rate.

Similarly, had interest rates decreased resulting in an increase in fair value, it would be appropriate to recognise that change in the AFS reserve in equity. This would not be considered a reversal of impairment as for a reversal to occur there should be an increase in fair value attributable to an improvement in the issuer’s credit standing.

View B – impairment/reversal of impairment in profit or loss

This view is that, at the reporting date, there is still objective evidence of impairment since acquiring the asset and, therefore, a further decline in fair value is recognised in profit or loss as further impairment. Any changes in fair value (gains or losses) subsequent to impairment are reflected in profit or loss up to the asset’s amortised cost and afterwards in equity. 

This view interprets paragraph 58 of IAS 39 as referring to evidence of impairment since acquiring the asset. This view is also consistent with the treatment in a period in which objective evidence of impairment first arises on an asset where the entire change in fair value (IAS 39 para 68) is recognised in profit or loss, even if some of that change in fair value is market related (for example, due to an increase in interest rates). This is a broader reading of the term event in paragraph 70 of IAS 39 to mean any event rather than only a credit-related event.

This view is also consistent with paragraph IG E4.9 of IAS 39. It states that for non-monetary AFS financial assets that became impaired in a previous period, any subsequent losses including the portion attributable to foreign exchange losses (that are also not additional impairments) are also recognised in profit or loss until the asset is derecognised.

Similarly, had interest rates decreased resulting in an increase in fair value and the increase can be objectively related to an event occurring after the impairment loss was recognised in profit or loss, it would be appropriate to recognise the change in profit or loss as a reversal of the previous impairment in accordance with IAS 39 paragraph 70

Impairment of financial assets - Available-for-sale financial assets - Reversal of impairment losses

Publication date: 08 Dec 2017


6.7A.204 It is possible that after an impairment loss has been recognised for an available-for-sale financial asset circumstances change in a subsequent period such that the fair value of the available-for-sale financial instrument increases. In those circumstances, the treatment required by the standard for reversals of impairment losses on available-for-sale debt instruments is different from those on available-for-sale equity instruments as noted below:

For available-for-sale debt instruments (monetary assets), past impairment losses should be reversed through the profit or loss when fair value increases and the increase can be objectively related to an event occurring after the impairment loss was recognised in profit or loss. [IAS 39 para 70].
For available-for-sale equity investments (non-monetary assets), past impairment losses recognised in profit or loss should not be reversed through profit or loss when fair value increases. [IAS 39 para 69]. This means that subsequent increases in fair value, including those that have the effect of reversing earlier impairment losses, are all recognised in equity.

6.7A.205 The inability to reverse impairment losses recognised in profit or loss on available-for-sale equity instruments raises a particular issue for entities that have recognised such impairment losses in their interim reports. This is because, at the subsequent reporting or balance sheet date, conditions may have changed to such an extent that a loss would not have been recognised, or a smaller loss would have been recognised, if the impairment review were first carried out at that date.

6.7A.206 The confusion arises because paragraph 28 of IAS 34 requires an entity to apply the same accounting policies in its interim financial statements as are applied in its annual financial statements. This suggests that an impairment loss recognised in the interim period should not be reversed at the subsequent balance sheet date. On the other hand, the same paragraph states that ‘the frequency of an entity’s reporting (annual, half-yearly, or quarterly) should not affect the measurement of its annual results. To achieve this objective, measurement for interim reporting purposes should be made on a ‘year-to-date’ basis. This suggests that an impairment loss recognised in one interim period can be reversed at the subsequent balance sheet date.

6.7A.207 The IFRS IC considered the matter and issued IFRIC 10 in July 2006. The IFRS IC concluded that the prohibitions on reversals of recognised impairment losses on investments in equity instruments in IAS 39 should take precedence over the more general statement in IAS 34 regarding the frequency of an entity’s reporting not affecting the measurement of its annual results. Therefore, any impairment losses that are recognised in a previous interim period in respect of an investment in an equity instrument may not be reversed in a later interim periods or when preparing the annual financial statements. [IFRIC 10 para 8].

Foreign currency financial instruments - General

Publication date: 08 Dec 2017


6.7A.208 Financial instruments are often denominated in foreign currencies. The way in which changes in foreign exchange rates in foreign currency financial assets and liabilities should be dealt with is covered in IAS 21. The measurement principles of IAS 39 generally do not override these rules, except in the area of hedge accounting which is considered in chapter 6.8A.

6.7A.209 Under IAS 21, all transactions in foreign currencies are initially recognised at the spot exchange rate at the date of the transaction. The spot exchange rate is the exchange rate for immediate delivery. It follows that on initial recognition, all foreign currency financial instruments are translated at the spot rate into the entity’s functional currency, irrespective of whether the instrument is carried at cost, amortised cost or fair value.

6.7A.210 Gains and losses associated with financial instruments, such as interest income and expense and impairment losses, are recognised at the spot exchange rate at the dates on which they arise. Dividends should be recognised in profit or loss when the shareholder’s right to receive payment is established. [IAS 18 para 30(c)]. The exchange rate ruling at that date, which is normally the dividend declaration date, is used to record the income. Entities are permitted to use an average rate where it represents an approximation to the spot rate in that period.

Foreign currency financial instruments - Subsequent measurement

Publication date: 08 Dec 2017


6.7A.211 The subsequent measurement of foreign currency financial assets and liabilities will depend on whether the assets and liabilities are monetary or non-monetary in nature. Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. [IAS 21 para 8]. It follows that financial assets and liabilities that are debt instruments are monetary items. Derivative financial instruments are also monetary items as they are settled at a future date, even though the underlying may be non-monetary. Non-monetary items are all items other than monetary items. In other words, the right to receive (or an obligation to deliver) a fixed or determinable number of units of currency is absent in a non-monetary item. This is the case for financial assets that are equity instruments.

Foreign currency financial instruments - Subsequent measurement - Monetary financial assets

Publication date: 08 Dec 2017


6.7A.212 IAS 21 requires that an entity should translate its foreign currency monetary items outstanding at the balance sheet date using the closing spot rate at that date. [IAS 21 para 23(a)]. Exchange differences arising on translating monetary items or on the settlement of monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements, are recognised in profit or loss in the period in which they arise. [IAS 21 para 28]. However, exchange differences on monetary items that are designated as hedging instruments in cash flow hedges or net investments in foreign entities are recognised in equity. [IAS 39 para AG 83].

6.7A.213 For the purpose of recognising foreign exchange gains and losses under IAS 21, a foreign currency monetary available-for-sale financial asset is treated as if it were carried at amortised cost in the foreign currency. Accordingly, for such a financial asset, exchange differences arising from changes in amortised cost, such as interest calculated using the effective interest method and impairment losses are recognised in profit or loss. All other gains and losses are recognised in equity. [IAS 39 para 55(b)]. An example illustrating the above treatment is included as example E3.2 in the Implementation Guidance to IAS 39. A similar example is given below.

Example – Available-for-sale debt security denominated in foreign currency

On 1 January 20X1, an entity whose functional currency is the local currency (LC) purchases a foreign currency (FC) denominated bond for its fair value of FC1,000. The bond has 5 years remaining to maturity and a principal amount of FC1,250. Interest is payable annually at 4.7% (that is, FC59) on 31 December each year. Assuming there are no transaction costs, the effective interest rate is 10%. The entity classifies the bond as available-for-sale.

The relevant foreign exchange rates are as follows:
 
  Average rate Closing rate
  FC = FC=
1 January 20X1   LC 1.50
31 December 20X1 LC 1.75 LC 2.00
31 December 20X2 LC 2.25 LC 2.50
31 December 20X3 LC 2.35 LC 2.20
31 December 20X4 LC 2.05 LC 1.90
31 December 20X5 LC 2.10 LC 2.30
 
For the purpose of this illustrative example, it is assumed that the use of the average exchange rate provides a reliable approximation of the spot rates applicable to the accrual of interest income during the year.

The cumulative gain or loss that is recognised in equity is the difference between the amortised cost (adjusted for impairment, if any) and the fair value of the available-for-sale financial asset in the entity’s functional currency.
 
At 1 January 20X1, the fair value of the bond (FC1,000) translated in the entity’s functional currency is LC1,500 and the entry to record this is as follows:

       
At 1 January 20X1  
Dr
Cr
   
LC
LC
Available-for-sale financial asset  
1,500
 
Cash    
1,500
       
The amortisation schedule in foreign currency (FC) is as follows:      
       
Date Interest income @ 10% Cash inflow Amortised cost
1 Jan 20X1     1,000
31 Dec 20X1
100
59
1,041
31 Dec 20X2 104 59 1,086
31 Dec 20X3
109
59
1,136
31 Dec 20X4
113
59
1,190
31 Dec 20X5
119
59
1,250
 
As the entity classifies the bond as an available-for-sale investment, the asset is treated as an asset measured at amortised cost in foreign currency for the purposes of applying IAS 21. Therefore, the amortisation schedule in the entity’s functional currency (LC) shown below is calculated from the above amounts at the appropriate exchange rates as follows:

       
  Interest income @ 10% (average rate) Cash inflow @ 4.7% (actual rate) Amortised cost
  LC LC LC
1 Jan 20X1     1,500
31 Dec 20X1 175 118 1,557
31 Dec 20X2 234 148 1,643
31 Dec 20X3 256 130 1,769
31 Dec 20X4 232 112 1,889
31 Dec 20X5 250 136 2,003
 
 
  1,147 644  
 
 

  Amortised cost as above Amortised cost translated at year end rate Carrying amount as determined above Cumulative exchange difference Exchange difference recognised in profit or loss
  FC LC LC LC LC
31 Dec 20X1 1,041 2,082 1,557 525 525
31 Dec 20X2 1,086 2,715 1,643 1,072 547
31 Dec 20X3 1,136 2,498 1,769 729 (342)
31 Dec 20X4 1,190 2,261 1,889 372 (358)
31 Dec 20X5 1,250 2,875 2,003 872 500
           
As the debt instrument is classified as an available-for-sale investment, it is necessary to determine the bond’s fair value at each balance sheet date. The bond’s fair value at each balance sheet date is given below. The difference between the amortised cost and asset’s fair value is the cumulative gain or loss that is recognised in equity. This difference will include exchange differences that would not be separated out from the overall movement recognised in equity. All other changes in foreign exchange rates are recognised in profit or loss as shown above.

Fair value Fair value at year end rate Amortised cost at year end rate as above Cumulative difference Gain or loss recognised in equity
  FC LC LC LC LC
31 Dec 20X1 1,060 2,120 2,082 38 38
31 Dec 20X2 1,070 2,675 2,715 (40) (78)
31 Dec 20X3 1,140 2,508 2,499 9 49
31 Dec 20X4 1,200 2,280 2,261 19 10
31 Dec 20X5 1,250 2,875 2,875 0 (19)
           
The movements in the fair value of the bond can be summarised as follows:
           

  Fair value at the beginning of the period Interest income Cash received Exchange difference recognised in profit or loss Gain or loss recognised in equity Fair value at the end of the period
  LC LC LC LC LC LC
31 Dec 20X1 1,500 175 (118) 525 38 2,120
31 Dec 20X2 2,120 234 (148) 547 (78) 2,675
31 Dec 20X3 2,675 256 (130) (342) 49 2,508
31 Dec 20X4 2,508 232 (112) (358) 10 2,280
31 Dec 20X5 2,280 250 (136) 500 (19) 2,875

Foreign currency financial instruments - Subsequent measurement - Monetary financial assets - Dual currency bond

Publication date: 08 Dec 2017

6.7A.214 Dual currency bonds are bonds that are denominated in one currency, but pay interest in another currency at a fixed exchange rate. For example, an entity with pound sterling as a functional currency may issue a debt instrument that provides for the annual payment of interest in euros and the repayment of principal in pound sterling. Sometimes both the interest payments and the principal repayments may be denominated in currencies that are different from the entity’s functional currency. For example, an entity with pound sterling functional currency may issue a euro denominated bond that pays interest in US dollars. Such a foreign currency bond can be viewed as a host debt instrument with principal and interest payments denominated in pound sterling and two embedded swaps that convert the pound sterling interest payments into US dollars and the pound sterling principal payments into euros. However, as explained in chapter 6.3A, IAS 39 does not permit such embedded foreign currency derivatives to be separated from the host debt instrument, because IAS 21 requires foreign currency gains and losses to be recognised in profit or loss. [IAS 39 para AG33(c)].

6.7A.215 We believe the most appropriate accounting treatment would be to analyse the bond into its two components – the interest component that exposes the entity to US dollar exchange rate risk and the principal component that exposes the entity to euro exchange rate risk. Each component would be recognised at its fair value at initial recognition, being the present value of the future payments to be made on the respective components. This means that the entity would have an instalment bond with annual payments denominated in US dollars for the US dollar interest payments and a zero coupon bond denominated in euros for the euro principal payment. The carrying amount of each component would be translated to pound sterling at each period end using the closing exchange rate and the resulting exchange differences recognised in the income statement in accordance with paragraph 28 of IAS 21.

6.7A.216 Analysing the dual currency bond into its two components for measurement purposes reports the foreign currency risk on the principal on a discounted basis, recognising that the euro payment is not due until redemption and also captures the foreign exchange risk associated with the dollar interest cash flows inherent in the bond. The analysis is consistent with the rationale given in paragraph AG 33(c) of IAS 39 for not separating the foreign currency embedded derivative.

 Example – Dual currency bond
 
On 1 January 20X5, an entity with pound sterling functional currency issued a €5m bond repayable in 3 years’ time. The bond pays fixed interest at 6% per annum in US dollars, calculated on a notional dollar equivalent of the proceeds raised in euros. There is no issue cost. 
 
The following exchange rates are relevant:

    01 Jan 20X5 31 Dec 20X5 31 Dec 20X6 31 Dec 20X7
£1= Spot rate €1.4142 €1.4530 €1.4852 €1.3571
Average rate   €1.4627 €1.4673 €1.4621
           
£1 = Spot rate $1.9187 $1.7208 $1.9591 $1.9973
Average rate   $1.8207 $1.8429 $2.0018
           
€1 = Spot rate $1.3569      
 

In accordance with the treatment discussed above, the amounts that should be recognised in the income statement and the balance sheet at the end of each period are shown below:
 
  £ US$
Proceeds received   5,000,000 6,784,500
Interest payable @ 6% pa on USD amount     407,070
Zero Coupon Bond = PV of € principal repayment at the end of year 3 discounted 6% 2,968,531 4,198,096  
Instalment Bond = PV of 3 yearly USD interest payments discounted at 6% 567,104   1,088,103

Proceeds received for the single bond 3,535,635    


Note that the discounting is carried out at 6% assuming a flat yield curve. The actual proceeds of €5,000,000 translated at the spot rate at 1 January 20X5 are actually £3,535,568. The small difference of 67 is due to the effect of discounting and cross exchange rate and is ignored.
 
Amortisation of instalment bond
  Balance brought forward Finance cos @ 6% Cash Payments Balance carried forward
  US$ US$ US$
       
31/12/20X5 1,088,103 65,286 407,070 746,319
31/12/20X6 746,319 44,779 407,070 384,028
31/12/20X7 384,028 23,042 407,070 0

  Balance brought forward Finance cost at average rate Payment at spot rate Balance carried forward Retranslated US$ @ year end rate Exchange difference
  £ £ £ £ £ £
31 Dec 20X5 567,104 35,858 236,559 366,403 433,705 67,301
31 Dec 20X6 433,705 24,298 207,784 250,219 196,023 -54,196
31 Dec20X7 196,023 11,510 203,810 3,723 0 -3,723

    71,666 648,153     9,382

 

Amortisation of zero coupon bond
  Balance brought forward Finance cost @ 6% Cash Payments Balance carried forward
 
       
31/12/20X5 4,198,096 251,886   4,449,982
31/12/20X6 4,449,982 266,999 0 4,716,981
31/12/20X7 4,716,981 283,019 5,000,000 0

  Balance brought forward Finance cost at average rate Payment at spot rate Balance carried forward Translated US$ @ year end rate Exchange difference
  £ £ £ £ £ £
31/12/20X5 2,968,531 172,206   3,140,737 3,062,617 -78,120
31/12/20X6 3,062,617 181,966   3,244,583 3,175,991 -68,592
31/12/20X7 3,175,991 193,570 3,684,327 -314,766 0 314,766

    547,742 3,684,327     168,054


Amortisation of single bond
  Opening balance sheet Income statement Cash payments  
    Finance cost Exchange gain/(loss)    
  £ £ £ £ £
31/12/20X5 3,535,635 208,064 -10,819 236,559 3,496,322
31/12/20X6 3,496,322 206,264 -122,788 207,784 3,372,013
31/12/20X7 3,372,013 205,081 311,043 3,888,137 0

    619,409 177,436 4,332,480  

   
These amounts are calculated by adding the bonds two components together.

Foreign currency financial instruments - Subsequent measurement - Non-monetary financial assets

Publication date: 08 Dec 2017


6.7A.217 Translation of non-monetary items depends on whether they are recognised at historical cost or at fair value. Items recognised at historical cost are not retranslated at subsequent balance sheet dates. This would apply to foreign currency denominated unquoted equity instruments that are measured at cost, because their fair values cannot be reliably determined. However, most non-monetary financial instruments, such as equity instruments, are measured at fair value. Non-monetary assets that are measured at fair value in a foreign currency are translated using the exchange rates at the date when the fair value was determined. [IAS 21 para 23(c)]. When a gain or loss on a non-monetary item is recognised directly in equity, any exchange component of that gain or loss should also be recognised directly in equity. Therefore, for available-for-sale equity instruments remeasured through equity the entire change in fair value is recognised in equity. [IAS 39 para AG 83].

Foreign currency financial instruments - Subsequent measurement - Financial assets held in foreign operations

Publication date: 08 Dec 2017


6.7A.221 An entity may have both financial assets that are classified as at fair value through profit or loss and available-for-sale investments. When such an entity is a foreign operation that is a subsidiary, its financial statements are consolidated with those of its parent. In that situation, IAS 39 applies to the accounting for financial instruments in the financial statements of the foreign operation and IAS 21 applies in translating the financial statements of a foreign operation for incorporation in the reporting entity’s consolidated financial statements. Under IAS 21, all exchange differences resulting from translating the financial statements of a foreign operation are recognised in equity until disposal of the net investment. This would include exchange differences arising from financial instruments carried at fair value, which would include both financial assets classified as at fair value through profit or loss and financial assets that are available-for-sale as illustrated in the example below.
 
Example – Financial instruments held in a foreign entity – Interaction of IAS 39 and IAS 21
 
Entity A is domiciled in the UK and its functional currency and presentation currency is pound sterling. Entity A has a foreign subsidiary, entity B, in France whose functional currency is the euro. Entity B is the owner of a debt instrument, which is held-for-trading and, therefore, carried at fair value under IAS 39. [IAS 39 para IE 3.3].
 
In entity B’s financial statements for year 20X5, the fair value and carrying amount of the debt instrument is €400. In entity A’s consolidated financial statements, the asset is translated into pound sterling at the spot exchange rate applicable at the balance sheet date, say €1 = £0.50. Thus, the carrying amount in the consolidated financial statements is £200.
 
At the end of year 20X5, the fair value of the debt instrument has increased to €440. Entity B recognises the trading asset at €440 in its balance sheet and recognises a fair value gain of €40 in its income statement. During the year, the spot exchange rate has increased from €1 = £0.50 to €1 = £0.75, resulting in an increase in the instrument’s fair value from £200 to £330 (€440 @ 0.75). Therefore, entity A recognises the trading asset at £330 in its consolidated financial statements.
 
Since entity B is a foreign entity, entity A translates the income statement of entity B in accordance with IAS 21 “at the exchange rates at the dates of the transactions”. Since the fair value gain has accrued through the year, entity A uses the average rate of €1 = £0.625 as a practical approximation. Therefore, while the fair value of the trading asset has increased by £130 (£330 − £200), entity A recognises only £25 (€40 @ 0.625) of this increase in consolidated profit or loss. The resulting exchange difference, that is, the remaining increase in the debt instrument’s fair value £105 (£130 − £25) is classified as equity until the disposal of the net investment in the foreign operation.
 
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