Classification as liability or equity
Since IAS 39 does not address accounting for equity instruments issued by the reporting enterprise but it does deal with accounting for financial liabilities, classification of an instrument as liability or as equity is critical. IAS 32 Financial Instruments: Presentation addresses the classification question.
Classification of financial assets
IAS 39 requires financial assets to be classified in one of the following categories: [IAS 39.45]
Financial assets at fair value through profit or loss Available-for-sale financial assets Loans and receivables Held-to-maturity investments
Those categories are used to determine how a particular financial asset is recognised and measured in the financial statements.
Financial assets at fair value through profit or loss. This category has two subcategories:
Designated. The first includes any financial asset that is designated on initial recognition as one to be measured at fair value with fair value changes in profit or loss. Held for trading. The second category includes financial assets that are held for trading. All derivatives (except those designated hedging instruments) and financial assets acquired or held for the purpose of selling in the short term or for which there is a recent pattern of short-term profit taking are held for trading. [IAS 39.9]
Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on initial recognition as available for sale or any other instruments that are not classified as as (a) loans and receivables, (b) held-to-maturity investments or (c) financial assets at fair value through profit or loss. [IAS 39.9] AFS assets are measured at fair value in the balance sheet. Fair value changes on AFS assets are recognised directly in equity, through the statement of changes in equity, except for interest on AFS assets (which is recognised in income on an effective yield basis), impairment losses and (for interest-bearing AFS debt instruments) foreign exchange gains or losses. The cumulative gain or loss that was recognised in equity is recognised in profit or loss when an available-for-sale financial asset is derecognised. [IAS 39.55(b)]
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than held for trading or designated on initial recognition as assets at fair value through profit or loss or as available-for-sale. Loans and receivables for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, should be classified as available-for-sale.[IAS 39.9] Loans and receivables are measured at amortised cost. [IAS 39.46(a)]
Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments that an entity intends and is able to hold to maturity and that do not meet the definition of loans and receivables and are not designated on initial recognition as assets at fair value through profit or loss or as available for sale. Held-to-maturity investments are measured at amortised cost. If an entity sells a held-to-maturity investment other than in insignificant amounts or as a consequence of a non-recurring, isolated event beyond its control that could not be reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years. [IAS 39.9] Held-to-maturity investments are measured at amortised cost. [IAS 39.46(b)]
Classification of financial liabilities
IAS 39 recognises two classes of financial liabilities: [IAS 39.47]
Financial liabilities at fair value through profit or loss Other financial liabilities measured at amortised cost using the effective interest method
The category of financial liability at fair value through profit or loss has two subcategories:
Designated. a financial liability that is designated by the entity as a liability at fair value through profit or loss upon initial recognition Held for trading. a financial liability classified as held for trading, such as an obligation for securities borrowed in a short sale, which have to be returned in the future
IAS 39 requires recognition of a financial asset or a financial liability when, and only when, the entity becomes a party to the contractual provisions of the instrument, subject to the following provisions in respect of regular way purchases. [IAS 39.14]
Regular way purchases or sales of a financial asset. A regular way purchase or sale of financial assets is recognised and derecognised using either trade date or settlement date accounting. [IAS 39.38] The method used is to be applied consistently for all purchases and sales of financial assets that belong to the same category of financial asset as defined in IAS 39 (note that for this purpose assets held for trading form a different category from assets designated at fair value through profit or loss). The choice of method is an accounting policy. [IAS 39.38]
IAS 39 requires that all financial assets and all financial liabilities be recognised on the balance sheet. That includes all derivatives. Historically, in many parts of the world, derivatives have not been recognised on company balance sheets. The argument has been that at the time the derivative contract was entered into, there was no amount of cash or other assets paid. Zero cost justified non-recognition, notwithstanding that as time passes and the value of the underlying variable (rate, price, or index) changes, the derivative has a positive (asset) or negative (liability) value.
Initially, financial assets and liabilities should be measured at fair value (including transaction costs, for assets and liabilities not measured at fair value through profit or loss). [IAS 39.43]
Measurement subsequent to initial recognition
Subsequently, financial assets and liabilities (including derivatives) should be measured at fair value, with the following exceptions: [IAS 39.46-47]
Loans and receivables, held-to-maturity investments, and non-derivative financial liabilities should be measured at amortised cost using the effective interest method. Investments in equity instruments with no reliable fair value measurement (and derivatives indexed to such equity instruments) should be measured at cost. Financial assets and liabilities that are designated as a hedged item or hedging instrument are subject to measurement under the hedge accounting requirements of the IAS 39. Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition, or that are accounted for using the continuing-involvement method, are subject to particular measurement requirements.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. [IAS 39.9] IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument: [IAS 39 Appendix A, paragraphs AG69-82]
Quoted market prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial instrument. If a market for a financial instrument is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs and includes recent arm's length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models. An acceptable valuation technique incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments. If there is no active market for an equity instrument and the range of reasonable fair values is significant and these estimates cannot be made reliably, then an entity must measure the equity instrument at cost less impairment.
Amortised cost is calculated using the effective interest method. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. Financial assets that are not carried at fair value though profit and loss are subject to an impairment test. If expected life cannot be determined reliably, then the contractual life is used.
IAS 39 fair value option
IAS 39 permits entities to designate, at the time of acquisition or issuance, any financial asset or financial liability to be measured at fair value, with value changes recognised in profit or loss. This option is available even if the financial asset or financial liability would ordinarily, by its nature, be measured at amortised cost – but only if fair value can be reliably measured.
In June 2005 the IASB issued its amendment to IAS 39 to restrict the use of the option to designate any financial asset or any financial liability to be measured at fair value through profit and loss (the fair value option). The revisions limit the use of the option to those financial instruments that meet certain conditions: [IAS 39.9]
the fair value option designation eliminates or significantly reduces an accounting mismatch, or a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis by entity's management.
Once an instrument is put in the fair-value-through-profit-and-loss category, it cannot be reclassified out with some exceptions. [IAS 39.50] In October 2008, the IASB issued amendments to IAS 39. The amendments permit reclassification of some financial instruments out of the fair-value-through-profit-or-loss category (FVTPL) and out of the available-for-sale category – for more detail see IAS 39.50(c). In the event of reclassification, additional disclosures are required under IFRS 7 Financial Instruments: Disclosures. In March 2009 the IASB clarified that reclassifications of financial assets under the October 2008 amendments (see above): on reclassification of a financial asset out of the 'fair value through profit or loss' category, all embedded derivatives have to be (re)assessed and, if necessary, separately accounted for in financial statements.
IAS 39 available for sale option for loans and receivables
IAS 39 permits entities to designate, at the time of acquisition, any loan or receivable as available for sale, in which case it is measured at fair value with changes in fair value recognised in equity.