Accounting for financial instruments is governed by:

• IAS 32, ‘Financial instruments: presentation’;
• IAS 39, ‘Financial instruments: recognition and measurement’;
• IFRS 9, ‘Financial instruments’; and
• IFRS 7, ‘Financial instruments: disclosures.

An entity should apply IFRS 9 in full (unless it is an insurance company that qualifies for the temporary exemption), with the exception of certain transitional adjustments such as macro-hedging. IFRS 9 provides an accounting policy choice with respect to hedge accounting: entities can either continue to apply the hedge accounting requirements of IAS 39, pending the macro hedging project being finalised, or they can apply IFRS 9.

IFRS 13 provides the relevant guidance for financial instruments measured or disclosed at fair value.

What future developments are expected to the financial instruments standards? The IASB has initiated other financial instrument-related projects that have not yet been finalised. These include: ·        The IASB issued a discussion paper on dynamic macro portfolio hedging in 2014. Further analysis is being carried out on this topic. Since then, the Board has been exploring whether it can develop an accounting model that will enable investors to understand a company’s dynamic risk management activities and to evaluate the effectiveness of those activities. The Board plans to start outreach on a ‘core model’ in late 2019. ·        The IASB published a discussion paper on ‘Financial instruments with characteristics of equity’ (‘FICE’) in June 2018. The Board is in the process of discussing the future direction of the FICE project in the light of the feedback received on the discussion paper.

Objectives

IAS 32 establishes principles for presenting financial instruments as financial liabilities or equity, and for offsetting financial assets and financial liabilities. It applies to:

• the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments;
• the classification of related interest, dividends, losses and gains; and
• the circumstances in which financial assets and liabilities should be offset.

IAS 39 establishes principles for:

• Recognising and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.
• De-recognition of financial assets and financial liabilities.
• Hedge accounting.

IFRS 9, which has now replaced IAS 39, establishes principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows. Insurance companies applying IFRS 4, and that meet certain conditions, may continue to apply IAS 39 until IFRS 17 comes into effect.

IFRS 7 requires entities to provide disclosures that enable users to evaluate:

• The significance of financial instruments for the entity’s financial position and performance.
• The nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks.

Definitions relating to financial instruments

The definitions of ‘financial instruments’ that appear in paragraph 11 of IAS 32 are common to IAS 32, IAS 39, IFRS 9 and IFRS 7.

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

A financial asset is any asset that is:

• An equity instrument of another entity.
• A contractual right:
• to receive cash or another financial asset from another entity; or
• to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity.
• A contract that will or may be settled in the entity’s own equity instruments and is:
• a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
• a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. The entity’s own equity instruments do not include puttable instruments and obligations arising on liquidation that are classified as equity, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.

A financial liability is any liability that is:

• A contractual obligation:
• to deliver cash or another financial asset to another entity; or
• to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.
• A contract that will or may be settled in the entity’s own equity instruments and is:
• a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
• a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

What is meant by exchange under potentially favourable or unfavourable terms? Scenario A Entity A holds an option to purchase equity shares in a listed entity, B, for C5 per share at the end of a 90-day period. The call option gives entity A a contractual right to exchange cash of C5 for an equity share in another entity, and it will be exercised if the market value of the share exceeds C5 at the end of the 90-day period (favourable terms to entity A at the end of term). Entity A will gain if the call option is exercised and the exchange is potentially favourable to the entity. Therefore, the option is a derivative financial asset from the time when the entity becomes a party to the option contract. Scenario B Entity A writes an option under which the counterparty can force the entity to sell equity shares in the listed entity, B, for C5 per share at any time in the next 90 days. Entity A has a contractual obligation to exchange equity shares in another entity for cash of C5 per share on potentially unfavourable terms if the holder exercises the option, because the market price per share exceeds the exercise price. Entity A stands to lose if the option is exercised and the exchange is potentially unfavourable. The option is a derivative financial liability from the time when the entity becomes a party to the option contract.

A puttable instrument that meets the definition of a financial liability is classified as an equity instrument if it has certain features and meets certain conditions.

An equity instrument is any contract that evidences a residual interest in an entity’s assets after deducting all of its liabilities. The term ‘entity’ includes individuals, partnerships, incorporated bodies and government agencies.

What are typical examples of equity instruments? Examples of equity instruments include non-puttable ordinary shares, some types of preference shares, and share warrants or written call options that allow the holder to subscribe for or purchase a fixed number of non-puttable ordinary shares in the issuing entity in exchange for a fixed amount of cash or another financial asset.

Key features of the definitions

Contractual basis

All financial instruments are defined by contracts. The terms ‘contract’ and ‘contractual’ refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts defining financial instruments may take a variety of forms and need not be in writing.

An item that would not meet the definition of a financial instrument is an entity’s tax liability, as it is not based on a contract between the entity and the tax authority, but arising through statute. Similarly, constructive obligations, as defined in IAS 37, do not arise from contracts and are not financial liabilities.

A provision for an onerous contract arises from the unavoidable cost of meeting the obligations under the contract. Such provisions are outside the scope of IAS 39/IFRS 9 and are accounted for in accordance with IAS 37.

A contractual right or contractual obligation to receive, deliver or exchange financial instruments is itself a financial instrument. A chain of contractual rights or contractual obligations meets the definition of a financial instrument if it will ultimately lead to the receipt or payment of cash or to the acquisition or issue of an equity instrument.

All financial instruments are required to be contracts under IAS 32. Cash is not necessarily a contract, but it is a financial asset, because it represents the medium of exchange and is therefore the basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset, because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability.

Is a gold bullion a financial instrument (similar to cash) or is it a commodity? A gold bullion is not a financial instrument, similar to cash; it is a commodity. Although the bullion market is highly liquid, there is no contractual right to receive cash or another financial instrument inherent in a bullion. Contracts to exchange commodities might fall within the scope of the standard.

Common examples of financial instruments giving rise to financial assets or liabilities from a contractual right or obligation to receive/deliver cash are detailed in IAS 32. One party’s contractual right to receive (or obligation to pay) cash is always matched by the other party’s corresponding obligation to pay (or right to receive).

What is an example of a non-financial contract that typically falls outside the financial instruments definition? Examples of non-financial contracts that typically fall outside of the financial instrument definition are commitments to purchase or sell inventory, property, plant and equipment, real estate and identifiable intangibles. This is because they require physical delivery of the specific item and are not capable of net settlement.

Another type of financial instrument is one for which the economic benefit to be received or given up is a financial asset other than cash. For example, a note payable in government bonds gives the holder the contractual right to receive and the issuer the contractual obligation to deliver government bonds, and not cash. The bonds are financial assets because they represent obligations of the issuing government to pay cash. The note is, therefore, a financial asset of the noteholder and a financial liability of the note issuer.

Conditional (contingent) rights and obligations

The ability to exercise a contractual right or the requirement to satisfy a contractual obligation may be absolute, or contingent on the occurrence of a future event. An example of this is a financial guarantee contract, which is a conditional financial instrument, because it results in a contractual right of the lender to receive cash from the guarantor and a corresponding contractual obligation of the guarantor to pay the lender, if the borrower defaults. A contractual right and an obligation exist as a result of a past transaction or event (the assumption of the guarantee), even though the lender’s ability to exercise its right and the requirement for the guarantor to perform under its obligation are both contingent on a future act of default by the borrower.

Are contingent events which might require the payment of cash but not yet contractual, classified as financial instruments? A contingency requiring the payment of cash which does not yet arise from a contract (for example, a contingent payable or receivable for a court judgment) is not a financial instrument. It becomes a financial instrument when it is enforced by a government or a court of law and the parties agree to payment terms as part of a contract. A fine is not contractual.

A contingent right or obligation can meet the definition of a financial asset or a financial liability, but it is not always recognised in the financial statements. Some of these contingent rights and obligations may be insurance contracts within IFRS 4’s scope.

Comparison with non-financial assets and liabilities

Financial instruments arise from contractual rights or obligations. Non-financial items have a more indirect, non-contractual relationship to future cash flows. Control of non-financial assets creates an opportunity to generate an inflow of cash or another financial asset, but does not give rise to a present right to receive cash or another financial asset.

What is the nature of a non-financial asset? The non-financial assets of a business (such as inventories, property, plant and equipment and intangibles) are inputs to some productive process. They are expected to contribute, along with other inputs, to the production and sale of goods or services. They must be used in a productive activity, and effectively transformed into goods or services, which must be sold, before there is any right to receive cash. If physical assets, such as properties, are held as investments rather than as inventories, they are not financial assets.

A contract to acquire or sell a non-financial asset at a specified price at a future date is not a financial instrument, because the contractual right of one party to receive a non-financial asset and the corresponding obligation of the other party do not establish a present right or obligation of either party to receive, deliver or exchange a financial asset. Contracts to buy or sell non-financial items that can be settled net or by exchanging financial instruments are treated as if they are financial instruments.

For the same reasons, a firm commitment that involves the receipt or delivery of a physical asset is not a financial instrument. [

A contract that involves the receipt or delivery of physical assets does not give rise to a financial asset of one party and a financial liability of the other party, unless any corresponding payment is deferred past the date on which the physical assets are transferred. Such is the case with the purchase or sale of goods on trade credit.

An asset is not a financial asset where the future economic benefit is the receipt of goods or services (rather than the right to receive cash or another financial asset). Examples of this include pre-paid expenses. Liabilities (such as deferred revenue and most warranty obligations) are not financial liabilities where they result in an outflow of economic benefits which are goods or services. This differs to a contractual obligation to pay cash or another financial asset.

For a lessor, an operating lease is not regarded as a financial instrument (except as regards individual payments currently due and payable). It is regarded as an uncompleted contract committing the lessor to provide the use of an asset in future periods in exchange for consideration similar to a fee for a service. The lessor continues to account for the leased asset itself, rather than any amount receivable in the future under the contract.

For a lessor, a finance lease is regarded as a financial instrument. It is regarded as an entitlement of the lessor to receive, and an obligation of the lessee to pay, a stream of payments that are substantially the same as a loan agreement. The lessor accounts for its investment in the amount receivable under the lease contract, rather than the leased asset itself.

Derivative financial instruments

Definition

A derivative is a financial instrument or other contract with all of the following characteristics: its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable – provided, in the case of a non-financial variable, that the variable is not specific to a party to the contract (sometimes called the ‘underlying’); it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contract that would be expected to have a similar response to changes in market factors; and it is settled at a future date.

What are the typical characteristics of a derivative? Derivatives are financial instruments that derive their value from an underlying price or index, such as an interest rate, foreign exchange rate or commodity price. Their primary purpose is to create rights and obligations that transfer one or more of the financial risks in an underlying primary instrument between the parties to the instrument. They are used either for trading purposes, to generate profits from risk transfers, or as a hedging instrument for managing risks. Many derivatives do not involve the transfer of the underlying instrument between the parties, either at inception or at maturity. Terms of the exchange are determined at inception. As variables in the financial markets change, the terms might become favourable or unfavourable. Derivative instruments can be either free-standing or embedded in a financial instrument or in a non-financial contract. The definition of a derivative is wide, and the concepts associated with a derivative need to be analysed to determine whether an instrument meets the definition of a derivative. Examples include contracts such as loan commitments, certain contracts to buy or sell a non-financial item, and regular way trades, as well as forwards, swaps, futures and options.

Note that contracts qualifying for the ‘own use’ exemption are not in the scope of IAS 39/IFRS 9.

A derivative usually has a notional amount, which together with the underlying determines the settlement amount under a derivative instrument.

Does there need to be a notional amount to meet the definition of a derivative? Notional amount vs. payment provisions. A derivative usually has a notional amount (which is an amount of currency), a number of shares, a number of units of weight or volume, or other units specified in the contract. However, a derivative instrument does not require the holder or writer to invest or receive the notional amount at the inception of the contract. The interaction of the notional amount and the underlying determines the settlement amount under a derivative instrument. The interaction might consist of a simple multiplication (for example, price × number of shares), or it might involve a formula that has leverage factors or other constants (for example, notional amount × interest rate where interest rate = 2.5 × LIBOR, by which the effect of any change in LIBOR is magnified by two and a half times). A derivative could contain a ‘payment provision’ specifying a fixed payment or payment of an amount that can change (but not proportionally with a change in the underlying) as a result of some future event that is unrelated to a notional amount. For example, a contract might require a fixed payment of C1,000 if six-month LIBOR increases by 100 basis points. Such a contract is a derivative, even though a notional amount is not specified. Another example is where an entity receives C10 million if the share price of another entity decreases by more than 5% during a six-month period, but pays C10 million if the share price increases by more than 5% during the same six-month period. No payment is made if the share price is less than 5% up or down. This is a derivative contract where there is no notional amount to determine the settlement amount. Instead, there is a payment provision that is based on changes in the underlying.

Specific examples of derivative instruments This table provides typical examples of contracts that normally qualify as derivatives, together with the relevant underlying, and notional and settlement features. Derivative Underlying Notional amount Settlement amount Stock options Market price of share Number of shares (Market price at settlement − strike price) × number of shares Currency forward Currency rate Number of currency units (Spot rate at settlement − forward rate) × number of currency units Commodity future Commodity price per unit Number of commodity units Net settlement occurs daily and is determined by the change in the futures price and is discounted to reflect the time to maturity Interest rate swap Interest rate index (receive 5% fixed and pay LIBOR) Amounts in C Net settlement occurs periodically throughout the contract’s term based on the formula: (current interest rate index − fixed rate specified in the contract) × amounts in C Fixed-payment contract 6-month LIBOR increases by 100 basis points Not specified Settlement amount based on payment provision in the contract

Key features of the definition

Underlying

The value of a derivative changes in response to an underlying. A derivative can have more than one underlying or variable. Examples include: A cross-currency interest rate swap that has one underlying based on a foreign exchange rate and another underlying based on an interest rate. A complex option with two variables, one based on an interest rate and the other based on the price of a commodity, such as oil.

What is meant by an underlying An underlying is a variable, such as: ·        An interest rate (for example, LIBOR). ·        A security price (for example, the price of an entity’s equity share listed on a regulated market). ·        A commodity price (for example, the price of a bushel of wheat). ·        A foreign exchange rate (for example, €/$ spot rate). ·        An index (for example, FTSE 100 or a retail price index). ·        A credit rating or a credit index (for example, Moody’s credit rating). ·        An insurance index or catastrophe-loss index. ·        Non-financial variable (for example, a climatic or geological condition, such as temperature, rainfall or earthquake severity, or sales volume indices specifically created for settlement of derivatives). An underlying might be any variable whose changes are observable or otherwise objectively verifiable. The underlying will generally be the referenced index that determines whether or not the derivative instrument has a positive or a negative value.

An underlying that is a non-financial variable should not be specific to a party to the contract in order for it to meet the definition of a derivative. Such variables might include an index of earthquake losses in a particular region or an index of temperatures in a particular city.

What are typical examples of non-financial variables which are specific to a party to the contract? Examples of non-financial variables that are specific to a party to the contract, and hence do not give rise to a derivative, include: ·        the occurrence or non-occurrence of a fire that damages or destroys an asset of a party to the contract; ·        EBITDA; ·        revenue; or ·        a measure of regulatory capital of a financial institution (for example, core tier 1 capital of a bank), including non-viability clauses included in some debt instruments issued by banks.

Derivatives with more than one underlying or variable: foreign currency contract based on sales volume Entity XYZ, whose functional currency is the US dollar, sells products in France denominated in euros. It enters into a contract with an investment bank to convert euros to US dollars at a fixed exchange rate. The contract requires entity XYZ to remit euros, based on its sales volume in France, in exchange for US dollars at a fixed exchange rate of €1: $1.20. The contract has two underlying variables (the foreign exchange rate and the volume of sales), no initial net investment − or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors − and a payment provision. If a contract has two or more underlyings, and at least one of those underlyings is not a non-financial variable specific to a party to a contract, the entire contract is accounted for as a derivative (assuming that the rest of the definition of a derivative is met). The contact is a derivative, even though one of the variables (sales volume) is a non-financial variable that is specific to a party to the contract. IAS 39/IFRS 9 does not exclude from its scope derivatives that are based on sales volume.

A change in the fair value of a non-financial asset is specific to the owner if the fair value reflects not only changes in market prices for such assets (a financial variable) but also the condition of the specific nonfinancial asset held (a non-financial variable). These contracts might be treated as insurance contracts.

Initial net investment

A derivative instrument must have no initial net investment, or one that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. Professional judgement is required in interpreting ‘smaller’. Smaller does not necessarily mean insignificant in relation to the overall investment. It is a relative measure, and it needs to be interpreted with care. This characteristic reflects the inherent leverage features typical of derivative instruments compared to the underlying instruments.

Forward contract with no initial net investment; does this meet the definition of a derivative? Forward-based derivative contracts (such as forward foreign exchange contracts and interest rate swaps) are derivative instruments that typically do not require an initial net investment. This is because they are priced at the-money at inception, which means that the fair value of the contracts is zero. If the fair value of the contract is not zero at inception (for example, because they are ‘off market’ transactions), the contract is recognised as an asset or liability. Under a forward foreign exchange contract, the two parties agree to purchase or sell a foreign currency at a specified price, with delivery or settlement at a specified future date. Although the forward contract has a notional amount equal to the amount of the foreign currency, it does not require the holder or the writer to invest or receive the notional amount at the inception of the contract. Forward contracts do not have cash flows during the contract term, and settlement takes place at maturity of the contract. An interest rate swap might be viewed as a variation of a forward contract, in which the two parties agree to exchange one set of interest cash flows (calculated with reference to a fixed interest rate) for another set of interest cash flows (calculated with reference to a floating interest rate). No exchange of principal takes place. Typically, the rates are set so that the fair values of the fixed and floating legs are equal and opposite at inception, with the result that the fair value of the swap on initial recognition is nil. Because no money changes hands at inception, there is no initial net investment. Swap cash flows occur at regular intervals over the life of the swap contract, based on a notional principal amount and fixed and floating rates specified in the swap.

Option contract with an initial net investment less than the notional amount; does this meet the definition of a derivative? Option contracts are derivative instruments that do require an initial net investment. An option is a contractual agreement that gives the buyer the right, but not the obligation, to purchase (call) or sell (put) a specified security, currency or commodity (the underlying) at a specified price (exercise price) during a specified period of time (or on a specified date). For this right, the buyer pays a premium, which is the amount that the seller requires to take on the risk involved in writing the option. This premium can be significant, but it is often less than the amount that would be required to buy the underlying financial instrument to which the contract is linked. The option fulfils the initial net investment criterion. If the option premium is so deep in-the-money at inception that the premium paid is close to making an investment in the underlying, the option contract will fail the initial net investment criterion and will not be accounted for as a derivative, but rather as an investment in the underlying asset itself.

Is an exchange of currency seen as an initial net investment? Some contracts might require a mutual exchange of currencies or other assets, in which case the net investment is the difference between the fair values of the assets exchanged. An example is a currency swap that requires the exchange of currencies at both inception and at maturity. The initial exchange of currencies at fair values in those arrangements (zero net investment) is not seen as an initial net investment. Instead, it is an exchange of one kind of cash for another kind of cash.

If a party pre-pays its obligation under a pay-fixed, receive-variable interest rate swap at inception, is the swap a derivative financial instrument? Yes. Entity S enters into a C100 million notional amount five-year pay fixed, receive-variable interest rate swap with counterparty C. The interest rate of the variable part of the swap is reset, on a quarterly basis, to three-month LIBOR. The interest rate of the fixed part of the swap is 10% per year. Entity S pre-pays its fixed obligation under the swap of C50 million (C100 million × 10% × 5 years) at inception, discounted using market interest rates, while retaining the right to receive interest payments on the C100 million reset quarterly, based on three-month LIBOR, over the life of the swap. The initial net investment in the interest rate swap is significantly less than the notional amount on which the variable payments under the variable leg will be calculated. The contract requires an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, such as a variable-rate bond. Therefore, the contract fulfils the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ provision of IAS 39/IFRS 9. Even though entity S has no future performance obligation, the ultimate settlement of the contract is at a future date, and the value of the contract changes in response to changes in the LIBOR index. Accordingly, the contract is regarded as a derivative contract. Would the answer change if the fixed-rate payment obligation is pre-paid subsequent to initial recognition? If the fixed leg is pre-paid during the term, that would be regarded as a termination of the old swap and an origination of a new instrument that is evaluated under IAS 39/IFRS 9.

If a party pre-pays its obligation under a pay-variable, receive-fixed interest rate swap at inception of the contract or subsequently, is the swap a derivative financial instrument? No. A pre-paid pay-variable, receive-fixed interest rate swap is not a derivative if it is pre-paid at inception, and it is no longer a derivative if it is pre-paid after inception, because it provides a return on the pre-paid (invested) amount comparable to the return on a debt instrument with fixed cash flows. The pre-paid amount fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ criterion of a derivative. Entity S enters into a C100 million notional amount five-year pay-variable, receive-fixed interest rate swap with counterparty C. The variable leg of the swap is reset, on a quarterly basis, to three-month LIBOR. The fixed interest payments under the swap are calculated as 10% times the swap’s notional amount (that is, C10 million per year). Entity S pre-pays its obligation under the variable leg of the swap at inception at current market rates, while retaining the right to receive fixed interest payments of 10% on C100 million per year. The cash inflows under the contract are equivalent to those of a financial instrument with a fixed annuity stream, since entity S knows that it will receive C10 million per year over the life of the swap. Therefore, all else being equal, the initial investment in the contract should equal that of other financial instruments that consist of fixed annuities. Thus, the initial net investment in the pay-variable, receive-fixed interest rate swap is equal to the investment required in a non-derivative contract that has a similar response to changes in market conditions. For this reason, the instrument fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ criterion of IAS 39/IFRS 9. Although the initial net investment value would be the same as for a pay-fixed, receive-variable swap, relative to other instruments providing the same variability in cash flows, the initial net investment is not considered small. Therefore, the contract is not accounted for as a derivative under IAS 39/IFRS 9. By discharging the obligation to pay variable interest rate payments, entity S in effect provides a loan to counterparty C.

Is a forward pre-paid at inception a derivative? An entity enters into a forward contract to purchase shares of stock in one year at the forward price. Its pre-pays at inception, based on the current price of the shares. Is the forward contract a derivative? No. The forward contract fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ test for a derivative. Entity XYZ enters into a forward contract to purchase one million ordinary shares in entity T in one year. The current market price of entity T is C50 per share; the one-year forward price of entity T is C55 per share. Entity XYZ is required to pre-pay the forward contract at inception with a C50 million payment. The initial investment in the forward contract of C50 million is less than the notional amount applied to the underlying (that is, one million shares at the forward price of C55 per share, totalling C55 million). However, the initial net investment approximates the investment that would be required for other types of contracts that would be expected to have a similar response to changes in market factors, because entity T’s shares could be purchased at inception for the same price of C50. Accordingly, the pre-paid forward contract does not meet the initial net investment criterion of a derivative instrument.

Settlement at a future date

All derivatives are settled at a future date. Forward contracts are settled at a specified date in the future, whilst settlement of an interest rate swap occurs at regular intervals over the swap’s life.

Is the criterion ‘settled at a future date’ met if an option is expected not to be exercised (for example, because it is out of the money)? Yes. An option is settled on exercise or at its maturity. Expiry at maturity is a form of settlement, even though there is no additional exchange of consideration.

A derivative can be settled net in cash (that is, the entity has the right to receive or the obligation to pay a single net amount) or gross in cash and/or another financial asset (exchange of cash and/or other financial asset).

What is an example of a gross-settled derivative? Settlement of a derivative might also occur gross through physical delivery of the underlying financial item. An example is a forward contract to purchase C100 million of a 5% fixed-rate bond at a specified fixed date in the future. In this situation, at settlement date the entity would exchange cash for physical delivery of the bond (the underlying financial item), whose nominal value is equal to the notional amount of the contract, and the market interest rate is the underlying.

For the purpose of determining whether an interest rate swap is a derivative financial instrument under IAS 39/IFRS 9, does it make a difference whether the parties pay the interest payments to each other (gross settlement) or settle on a net basis? No. The definition of a derivative does not depend on gross or net settlement. Entity ABC enters into an interest rate swap with a counterparty (entity XYZ) that requires entity ABC to pay a fixed rate of 8% and receive a variable amount based on three-month LIBOR, reset on a quarterly basis. The fixed and variable amounts are determined on the basis of a C100 million notional amount. Entities ABC and XYZ do not exchange the notional amount. Entity ABC pays or receives a net cash amount each quarter, based on the difference between 8% and three-month LIBOR. Alternatively, settlement might be on a gross basis. The contract meets the definition of a derivative, regardless of whether there is net or gross settlement, because its value changes in response to changes in an underlying variable (LIBOR), there is no initial net investment, and settlements occur at future dates.

Contracts that are, in substance, derivatives

It is generally inappropriate to treat two or more separate financial instruments (such as an investment in a floating-rate debt instrument and a floating-to-fixed interest rate swap with different counterparties) as a single combined instrument (‘synthetic instrument’ accounting). An exception to this is non-derivative transactions which should be aggregated and treated as a derivative if the transactions result in a derivative instrument in substance. Indicators of this would include circumstances where the transactions: are entered into at the same time and in contemplation of one another; have the same counterparty; relate to the same risk; have no substantive business purpose, or there is no apparent economic need for structuring the transactions separately that could not also have been accomplished in a single transaction.

When would two loans between two counterparties be classified as in-substance derivatives? Entity A makes a five-year fixed rate loan to entity B, while entity B at the same time makes a five-year variable-rate loan for the same amount to entity A. There are no transfers of principal at inception of the two loans, since entities A and B have a netting agreement. The contractual effect is that the loans are, in substance, equivalent to an interest rate swap arrangement that meets the definition of a derivative – there is an underlying variable, no initial net investment and future settlement. The same answer would apply if entities A and B did not have a netting agreement, because the definition of a derivative instrument does not require net settlement.

Regular way contracts

A regular way contract is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned. Such contracts give rise to a fixed price commitment between trade date and settlement date that meets the definition of a derivative. However, it is not recognised as a derivative financial instrument due to the commitment’s short duration. IAS 39/IFRS 9 provides for special accounting for such regular way.

Accounting for derivatives

All derivatives in the scope of IAS 39/IFRS 9 are required to be measured at fair value through profit or loss. Different rules apply for derivatives that qualify as effective hedging instruments.

Scope exclusions from the financial instrument standards

IAS 32, IAS 39/IFRS 9 and IFRS 7 have to be applied by all entities preparing financial statements in accordance with IFRS, and are applied to all types of financial instruments, except for those specifically excluded from their scope.

The scope of the standards is wide-ranging but not identical. This is summarised below:

Scope interaction between IAS 32, IAS 39/IFRS 9 and IFRS 7

In scope of IAS 32? In scope of IAS 39/IFRS 9? In scope of IFRS 7?

Recognised financial instruments ✓ ✓ ✓

Unrecognised financial instruments ✗ ✗ ✓

There are more extensive scope exclusions within IAS 39/IFRS 9 compared to IFRS 7 and IAS 32. Items are scoped out of all the three standards if another standard is more prescriptive.

Interests in subsidiaries, associates and joint ventures

IAS 39/IFRS 9 do not apply to those interests in subsidiaries, associates and joint ventures that are accounted for in accordance with IFRS 10, IAS 27 or IAS 28. However, in specific circumstances, IFRS 10, IAS 27 or IAS 28 requires or permits an entity to account for an interest in a subsidiary, associate or joint venture in accordance with some or all of the requirements of IAS 39/IFRS 9.

Separate financial statements

An entity preparing separate financial statements has the option of accounting for its investments in subsidiaries, joint ventures and associates at cost, in accordance with IAS 39/ IFRS 9, or using the equity method as described in IAS 28.

If IAS 39/IFRS 9 is chosen, the interest in a subsidiary, associate or joint venture also falls within the scope of IAS 32, IFRS 7 and IFRS 13.

Consolidated financial statements

Entities generally apply the equity method when accounting for their interests in associates and joint ventures in their consolidated financial statements. IAS 39/IFRS 9 does not apply to such interests. However, the equity method is not applied in the various circumstances detailed below.

Interests in instruments which contain potential voting rights in an associate or a joint venture but do not, in substance, currently give access to the returns associated with an ownership interest in an associate or a joint venture are generally accounted for in accordance with IAS 39/IFRS 9.

Entities should apply IAS 39/IFRS 9 to derivatives on an interest in a subsidiary, associate or joint venture, unless the derivative meets the definition of an equity instrument of the entity under IAS 32, in which case it is accounted for as equity in accordance with IAS 32. It is also outside the scope of IFRS 7. An example of this is an option over an interest in a subsidiary in the consolidated financial statements of an entity.

An entity that qualifies as a venture capital organisation can elect to measure investments in those associates and joint ventures at fair value through profit or loss in accordance with IAS 39/IFRS 9. Relevant disclosures under IFRS 7, IFRS 12 and IFRS 13 apply in this case.

If the election to measure at fair value through profit or loss is taken in the consolidated accounts, an entity should also account for the investments at fair value through profit or loss in the separate financial statements. Relevant disclosures under IFRS 7, IFRS 13 and IAS 27 should be applied in this case.

If an entity holds an investment in an associate, a portion of which is held by a venture capital organisation, the entity can elect to measure the that portion of the investment in the associate at fair value through profit or loss, in accordance with IAS 39/IFRS 9, in its consolidated financial statements.

Investments meeting the criteria of ‘held-for-sale’ in the consolidated financial statements

An investment, or a portion of an investment, in an associate or a joint venture may meet the criteria to be classified as held for sale under IFRS 5. In cases where the portion ‘held for sale’ has been disposed of and the investor has lost joint control or significant influence, any retained interest is accounted for in accordance with IAS 39/IFRS 9.

Investment entities; consolidated and separate financial statements

An entity that meets the definition of an investment entity is prohibited from consolidating its subsidiaries, with one exception. It is required to measure its investments in subsidiaries at fair value through profit or loss, in accordance with IAS 39/IFRS 9, in both its consolidated and its separate financial statements.

Other equity holdings

An equity interest not sufficient to meet the definition of a subsidiary, associate or joint venture is a financial instrument, and would be classified and measured in line with IAS 39/IFRS 9.

Business combinations

Contracts for contingent consideration usually fall within the scope of IAS 32, IAS 39/IFRS 9 and IFRS 7. These contracts are measured at fair value with changes in value reported in profit or loss. Certain obligations to pay contingent consideration may qualify as equity under IAS 32; these are not remeasured and their subsequent settlement is accounted for within equity.

From the seller’s perspective, contracts for contingent consideration normally fall within the scope of IAS 39/IFRS 9 as a financial asset.

Forward contracts between an acquirer and a vendor in a business combination, to buy or sell an acquiree at a future date, are outside the scope of IAS 39/IFRS 9, but not IFRS 7, for both the acquirer and the seller. The scope exemption: applies to forward contracts entered into before the date when the acquirer obtains control of the acquiree; and applies to forward contracts where the term does not exceed a reasonable period normally necessary to obtain any required approvals and to complete the transaction; does not apply by analogy, to investments in associates and other similar transactions, nor to combinations of put and call options that are in some ways similar to a forward (‘synthetic forwards’). applies to forward contracts.

Own equity instruments

Own equity instruments are financial instruments issued by an entity, including options and warrants, that meet the definition of an equity instrument in IAS 32, or puttable instruments that are required to be classified as equity. Own equity is not remeasured subsequent to issue and is outside the scope of IAS 39/IFRS 9. Own equity instruments are within the scope of IFRS 7 (for example, disclosure about compound financial instruments in) however puttable instruments that are required to be classified as equity are outside the scope of IFRS 7.

Employee benefit plans and share-based payments

Employee rights and obligations under employee benefit plans are financial instruments and are contractual rights or obligations that will result in the flow of cash to the past and present employees. They are outside the scope of IAS 39/IFRS 9, IAS 32 and IFRS 7.

Generally, share-based payment transactions are outside the scope of IAS 32, IFRS 7 and IAS 39/IFRS 9, except for certain contracts to buy or sell non-financial items in share-based payment transactions that can be settled net. For example, if an entity enters into a contract to purchase a fixed quantity of a particular commodity in exchange for issuing a fixed number of own equity instruments that could be settled net in cash. Such contract would fall within IAS 39/IFRS 9’s scope unless it qualifies for the ‘own use’ exception. Own use contracts are outside the scope of IAS 39/IFRS 9.

Treasury shares that are purchased, sold, issued or cancelled in connection with employee share option plans, employee share purchase plans and all other share-based payment arrangements are in the scope of IAS 32.

Rights and obligations under lease contracts 40.65 Lease liabilities for lessees and finance lease receivables for lessors are financial instruments that are specifically dealt with in IFRS 16. They fall within the scope of IAS 32 and IFRS 7, but outside the scope of IAS 39/IFRS 9, except as follows: Finance lease receivables for the lessor are included in IAS 39/IFRS 9’s scope for de-recognition and impairment purposes only. Lease liabilities for the lessee are subject to IAS 39/IFRS 9’s derecognition provisions. Any derivatives embedded in lease contracts are within IAS 39/IFRS 9’s scope.

Rights and obligations under insurance contracts

Rights and obligations under insurance contracts are accounted for under IFRS 4/IFRS 17, because the policyholder transfers to the insurer significant insurance rather than financial risk. A financial instrument which takes the form of an insurance contract, but involves the transfer of financial risks, would fall within IAS 39/IFRS 9, IAS 32 and IFRS 7.

Financial risk is the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable, that the variable is not specific to a party to the contract.

Contracts with discretionary participation features

A discretionary participation feature is a contractual right to receive significant additional benefits, as a supplement to guaranteed benefits. The amount or timing of the benefits is at the issuer’s discretion and are contractually based on the performance of a specified pool of contracts, investment returns or profit or loss of the company, fund or other entity that issues the contract. Financial instruments within IFRS 4’s scope, because they contain a discretionary participation feature, are outside the scope of the IAS 39/IFRS 9 but are in IFRS 7’s scope. Under IFRS 17, investment contracts with discretionary participation features it issues are in scope of this standard, provided the entity also issues insurance contracts. The classification and presentation distinctions of IAS 32 do not apply to these instruments; however, all other requirements of IAS 32 do.

Derivatives embedded in insurance contracts

Derivatives embedded in insurance contracts, or in contracts containing discretionary participation features, are within the scope of IAS 32, IFRS 7 and IAS 39/IFRS 9 if they require separation in accordance with IAS 39/IFRS 9

Separate accounting would be required where contractual payments embedded in a host insurance contract that is indexed to the value of equity instruments are not related to the host instrument, because the risks inherent in the host and the embedded derivative are dissimilar.

No separation is required if the embedded derivative itself is an insurance contract.

Weather derivatives

Some contracts require a payment based on climatic variables (sometimes described as ‘weather derivatives’) or on geological or other physical variables. Such contracts are accounted for as follows: Contracts that require a payment only if a particular level of the underlying climatic, geological or other physical variable adversely affects the contract holder are insurance contracts, because payment is contingent on changes in a physical variable that is specific to a party to the contract. Contracts that require a payment based on a specified level of the underlying variable, regardless of whether there is an adverse effect on the contract holder, are derivatives and are within IAS 39/IFRS 9’s scope.

Distinguishing between a weather derivative and an insurance contract? A farming entity in Punjab, a State in India, relies on the prospect of a good monsoon that would favourably impact on its earnings for the season. A good monsoon in Punjab involves an average rainfall of about 400 millimetres during the months of June, July and August. The entity enters into a contract with a counterparty that would pay a fixed sum of Rs1 million if the entity suffers loss due to poor production caused by below average rainfall during the monsoon months. The premium paid on the contract is Rs50,000. This is an example of a highly tailored or customised policy that provides the entity with protection against an adverse impact on earnings due to poor production caused by a poor monsoon in Punjab, irrespective of whether the rest of India has a good monsoon or not. Hence, the contract is an insurance contract and is outside the scope of IAS 39/IFRS 9. It should be noted that, even if the farming entity’s loss due to poor production is less than Rs1 million, the entity would receive Rs1 million, as stipulated in the contract. The definition of an insurance contract does not limit the payment by the insurer to an amount equal to the financial impact of the adverse event. If, on the other hand, the sum of Rs1 million was paid if the average rainfall was below 400 millimetres during the months of June, July and August, and it would be payable irrespective of whether the farming entity in Punjab had suffered any damage, the contract would be accounted for as a derivative instrument. This is because payment is made following the change in average rainfall, which is a non-financial variable that is not specific to the holder of the contract, and hence one of the variables considered in the definition of financial risk.

Financial guarantee contracts

Financial guarantee contracts (sometimes known as ‘credit insurance’) require the issuer to make specified payments to reimburse the holder for a loss that it incurs if a specified debtor fails to make payment when due under a debt instrument’s original or modified terms.

The accounting treatment of a financial guarantee contract does not depend on its legal form (for example, letter of credit, credit default contracts) or whether it is issued by an insurance or non-insurance company. There is no detailed guidance on accounting for financial guarantee contracts from the holder’s perspective under IAS 39/IFRS. For the issuer, all contracts that meet the definition of a financial guarantee fall within IAS 39/IFRS 9’s scope and are accounted for by the issuer as financial liabilities, unless an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting that is applicable to an insurance contract. The issuer may elect to apply either IFRS 9 or IFRS 4/IFRS 17.

Credit-related guarantees which do not, as a precondition for payment, require that the holder is exposed to, and has incurred a loss on, the failure of the debtor to make payments on the guaranteed asset, when due, are not financial guarantee contracts, and they are not insurance contracts as defined in IFRS 4/IFRS 17. Such guarantees are derivatives that must be accounted for under IAS 39/IFRS 9. However, a contract that requires an entity to make payments when the counterparty to a derivative contract fails to make a payment, when due, is considered to meet the definition of a financial guarantee contract. It is not the risk inherent in the derivative that is being guaranteed; it is the counterparty’s credit risk that is being guaranteed in the event that the counterparty defaults.

When is the definition of a financial guarantee met? For the definition to be met, the amount of reimbursement must be either less than the amount of the loss incurred or equal to the amount incurred in order to reimburse some or all of the loss that the holder suffered because the debtor defaulted. A contract that compensates the holder for more than the loss incurred does not meet the definition of a financial guarantee contract. Contracts that provide compensation if another party fails to perform a contractual obligation (such as an obligation to construct a building) are performance guarantees. They do not meet the definition of a financial guarantee, because they do not transfer credit risk. These types of guarantees are accounted for under IFRS 4 as insurance contracts.

Is there an option available to insurers to account for financial guarantee contracts under IFRS 4? An option is available to insurers to continue to account for these contracts under IFRS 4 if they had met two conditions, before the amendment of IAS 39 to include financial guarantees in its scope. The issuer must have: ·        previously asserted explicitly that it regards such contracts as insurance contracts; and ·        used accounting applicable to insurance contracts. If these conditions are met, the issuer can elect to apply either IFRS 4 or IAS 39/IFRS 9 to such financial guarantee contracts. The issuer can make the election on a contract-by-contract basis, but the election for each contract is irrevocable. Assertions that the issuer regards contracts as insurance can typically be found in business documentation, contracts, accounting policies, financial statements and communications with customers and regulators. When accounted for in accordance with IAS 39/IFRS 9, financial guarantee contracts also fall within the scope of IAS 32 and IFRS 7. If the issuer elects to apply IFRS 4 to those contracts, the disclosure requirements of IFRS 4 and not IFRS 7 apply.

What is the distinction between a credit related guarantee and a financial guarantee contract? A bank issues a credit-related guarantee contract (sometimes referred to as credit derivative) that provides for payment if the credit rating of a debtor falls below a particular level. This credit-related contract will be accounted for as a derivative financial instrument under IAS 39/IFRS 9, because the contract holder is not required to suffer a loss on a specified debt instrument – the bank will pay for the decrease in the creditworthiness of the debtor, even if the debtor does not actually default. However, if the contract provides for payment only in the event that the entity suffers loss as a result of non-payment by the debtor, the contract would be a financial guarantee contract. Holders and issuers of credit derivatives will always account for them under IAS 39/IFRS 9.

What is a residual value guarantee? A residual value guarantee contract is one where an insurer is required to make payments to the insured party based on the fair value of a nonfinancial asset at a future date. In this situation, the risk of changes in the fair value of the non-financial asset is not a financial risk, because the fair value reflects not only changes in market prices for such assets (a financial variable), but also the condition of the specific asset held (a non-financial variable). Because the change in fair value of the non-financial asset is specific to the owner, it is not a derivative instrument, and so the contract will be accounted for as an insurance contract by the issuer in accordance with IFRS 4. However, if the contract compensates the insured party only for changes in market prices, and not for changes in the condition of the specific non-financial asset held, the contract is a derivative and within IAS 39/IFRS 9’s scope.

Is a parent providing a comfort letter to its subsidiary a financial guarantee contract? A subsidiary of a group takes out a loan with a bank. The parent provides a comfort letter to the subsidiary such that, if the subsidiary fails to repay the loan to the bank when due, the parent will pay on its behalf. The comfort letter simply constitutes an undertaking given by the parent to its subsidiary that, if the subsidiary fails to repay the loan to the bank when due, the parent will step in and discharge the subsidiary’s debt. This is not a financial guarantee contract, because the parent has not provided any guarantee to the bank (nor would the bank be able to enforce payment under what is, effectively, a private arrangement between the parent and its subsidiary) to repay the loan if the subsidiary defaults.

Are intra-group guarantees over obligations such as pension plan contributions and taxes within the scope of IAS 39/IFRS 9? Intra-group guarantees cover other obligations, such as pension plan contributions and taxes. It should be determined whether the financial instrument falls in the scope of the insurance standard or of the financial instrument’s standard. The risk transferred, in these other obligations, is the risk that the subsidiary (or joint venture or associate) will not make a payment when due. The reasons for non-payment could vary widely and, whilst they might include some financial risk variables, a significant part of the risk transferred might be operational (for example, cash flow difficulties or, at the extreme, bankruptcy). Hence, it appears that the significant risk transferred in a typical guarantee of pension plan contributions and taxes will be insurance risk. It is arguable, therefore, that such guarantees should be treated as insurance contracts and accounted for accordingly. Even though guarantees of pension plan contributions and taxes are insurance contracts within IFRS 4’s scope, it is still necessary to consider whether they meet the definition of financial guarantee contracts within IAS 39/IFRS 9’s scope. We have considered the definition of a financial guarantee contract under IAS 39/IFRS 9, which refers specifically to the terms of a debt instrument. The term ‘debt instrument’ is not specifically defined in IFRS, but it is clear (from the various references made in IAS 32) that a debt instrument is a type of loan, involving a borrower and a lender. It can be concluded, therefore, that pension plan contributions and tax liabilities are not debt instruments.

Are there exemptions available under IAS 39/IFRS 9 for financial guarantee contracts between group companies? Unlike in US GAAP FIN 45, there is no exemption under IAS 39/IFRS 9 for financial guarantee contracts issued between members of a group, or entities under common control. In the individual financial statements of the group member issuing the guarantee, the guarantee contract will need to be accounted for in accordance with IAS 39/IFRS 9. However, on a consolidated 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).

Are guarantees over leases a financial guarantee contract under IFRS 16? For lessors under IFRS 16, paragraph AG9 of IAS 32 states that: “A lease typically creates an entitlement of the lessor to receive, and an obligation of the lessee to pay, a stream of payments that are substantially the same as blended payments of principal and interest under a loan agreement. The lessor accounts for its investment in the amount receivable under a finance lease rather than the underlying asset itself that is subject to the finance lease. Accordingly, a lessor regards a finance lease as a financial instrument. Under IFRS 16, a lessor does not recognise its entitlement to receive lease payments under an operating lease. The lessor continues to account for the leased underlying asset itself rather than any amount receivable in the future under the contract. Accordingly, a lessor does not regard an operating lease as a financial instrument, except as regards individual payments currently due and payable by the lessee.” For lessees under IFRS 16, leases are recognised as a liability on balance sheet (unless the lessee elects to apply a recognition exemption). Lessees under IFRS 16 do not classify leases between operating and finance leases. When deciding whether a guarantee over lease payments is a guarantee of a debt instrument, the entity providing the guarantee has an accounting policy choice whether to: ·        refer to lessee accounting, in which case all leases create a debt instrument; under this approach, all guarantees over leases are financial guarantee contracts within the scope of IAS 39 / IFRS 9 (unless the guarantor applies IFRS 4 / IFRS 17 to its financial guarantee contracts); or ·        refer to lessor accounting, in which case there are only debt instruments for finance leases, or for individual payments currently due and payable under operating leases; under this approach, only such guarantees over leases are financial guarantee contracts within the scope of IAS 39 / IFRS 9; guarantees which are not within the scope of IAS 39 / IFRS 9 might instead be within the scope of IFRS 4/ IFRS 17. This is an accounting policy choice that should be applied consistently by the entity.

Loan commitments

Loan commitments are firm commitments to provide credit under pre-specified terms and conditions. They are usually entered into by financial institutions for providing loans to third parties at a specified rate of interest during a fixed period of time. Such a commitment is a derivative, since it has no initial net investment, it has an underlying variable (interest rate), and it will be settled at a future date. In effect, the lender has written an option that allows the potential borrower to obtain a loan at a specified rate.

The following loan commitments are within IAS 39/IFRS 9’s scope and therefore accounted for at fair value with changes in value recorded in profit or loss: Loan commitments that the entity designates as financial liabilities at fair value through profit or loss. This might be appropriate, for example, if the entity manages risk exposures related to loan commitments on a fair value basis. For an entity that has a past practice of selling the assets resulting from its loan commitments shortly after origination, IAS 39/IFRS 9 should be applied to all of its loan commitments in the same class. Loan commitments that can be settled net in cash or by delivering or issuing another financial instrument. These loan commitments are derivatives. A loan commitment is not regarded as settled net merely because the loan is paid out in instalments (for example, a mortgage construction loan that is paid out in instalments, in line with the progress of construction). Commitments to provide a loan at a below-market interest rate.

What does the term ‘same class’ mean in the context of loan commitments? The term ‘same class’ is not explained in the standard, but we believe that a commitment to provide borrowing facilities to a corporate entity is not in the same class as a commitment to provide residential mortgage loans, because of differing risk return profiles.

Loan commitments that are not within IAS 39’s scope should be accounted for in accordance with IAS 37 if events make such a loan commitment an onerous contract and a liability should be recognised.

Loan commitments which are not within the scope of IFRS 9, are however subject to the impairment requirements of IFRS 9. All loan commitments, whether in or out of the scope of IAS 39/IFRS 9, are subject to IAS 39/IFRS 9’s de-recognition provisions and IFRS 7’s disclosure requirements.

Contracts to buy or sell non-financial items

It is necessary to analyse contracts to buy or sell non-financial items to determine if they are financial instruments.

Contracts that can be settled net in cash or another financial instrument, or by exchanging another financial instrument, fall within the scope of the financial instruments standard.

Exchange-traded commodities and certain over the counter commodity contracts (for example, gold and oil) are accounted for as derivatives at fair value through profit or loss (that is, in scope of IAS 39/IFRS 9) unless the contracts were entered into and continue to be held for the purpose of receipt or delivery of non-financial items to meet the entity’s expected purchase, sale or usage requirements (often referred to as ‘own use’ purchase or sale exception). For example, ‘own use’ might be met if the contract will result in physical delivery of the commodity. If the ‘own use’ exception is met, the contract must not be accounted for as a derivative under IAS 39 (the application of the ‘own use’ exception is not a choice) although it may be accounted for at fair value under IFRS 9 if doing so removes an accounting mismatch.

Even if the contract itself meets own use, contracts to buy or sell non-financial items also need to be reviewed for embedded derivatives (indexed features such as interest or inflation, currency, credit etc.).

Contracts that can be settled net

There are various ways in which a contract to buy or sell a nonfinancial asset can be settled net in cash, including: Where the terms of the contract permit either party to settle net in cash or another financial instrument or by exchanging financial instruments. Net settlement means that the entity will pay or receive cash (or an equivalent value in other financial assets) to and from the counterparty, equal to the net gain or loss on the contract on exercise or settlement. Where the ability to settle the contract net is not explicitly stated in the contract, but the entity has a practice of settling similar contracts net in cash (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse). For example, a futures exchange permits an entity to enter into offsetting contracts that relieve the entity of its obligation to make or receive delivery of the non-financial asset. Where, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it, within a short period after delivery, to generate a profit from short-term fluctuations in price or dealer’s margin. An example is an exchange that offers a ready opportunity to sell the contract. Where the non-financial asset that is the subject of the contract is readily convertible into cash.

The entity’s activities may make it clear that the contracts cannot qualify for ‘normal’ purchase or sale exception, and such contracts are within the scope of IAS 39/IFRS 9, IAS 32 and IFRS 7. An example is contracts that are exchange-traded or routinely net settled as described. Other contracts that can be settled net should be evaluated to determine if they qualify for the exception.

What is the distinction between a contract meeting the ‘own use’ exception and a contract being treated as a derivative? Commodity price and foreign exchange price movements between the date of order and settlement might expose an entity to risks when purchasing inventories. Commodity price risk arises where an entity enters into a contract to purchase a commodity which varies. Foreign exchange risk arises where the entity pays for the inventory in a foreign currency. To mitigate or hedge commodity price risk, the entity could enter into a forward contract to buy the commodity at a fixed price at a future date. If the contract is entered into and continues to be held for the purpose of the delivery of the commodity in accordance with the entity’s expected purchase or usage requirements, the entity does not recognise the forward contract as a derivative. If the entity has a practice of settling net (either with the counterparty or by entering into offsetting contracts or by taking delivery of the commodity and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin), the forward contract will have to be recognised as a derivative. This is because such a contract to buy or sell non-financial items (for example, inventory) would be within the scope of IAS 39/IFRS 9. In practice, many contracts to buy or sell a commodity fall within IAS 39/IFRS 9’s scope. Some commodity contracts are standardised in form and traded on organised markets, in much the same fashion as some derivative financial instruments. For example, a commodity futures contract could be bought and sold readily for cash, because it is listed for trading on an exchange and might change hands many times. However, the parties buying and selling the contract are, in effect, trading the underlying commodity. The ability to buy or sell a commodity contract for cash, the ease with which it could be bought or sold, and the possibility of negotiating a cash settlement of the obligation to receive or deliver the commodity do not alter the fundamental character of the contract in a way that creates a financial instrument.

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What does ‘own-use’ mean in practice? To qualify for the exception, a contract’s terms must be consistent with the terms of an entity’s normal purchases or sales (the quantity specified in the contract must be expected to be used or sold by the entity over a reasonable period in the normal course of business). Other factors to consider in determining whether or not the contract qualifies for the exception include the locations to which delivery of the items will be made, the period of time between entering into the contract and delivery, and the entity’s prior practices with regard to such contracts.

Is the ‘own use’ exemption met in a contract to sell copper where an entity has no history of net settlement? Background Entity A owns a copper mine and enters into a fixed-price forward contract to sell one million kilograms of copper in accordance with a counterparty’s expected usage requirements. The contract permits physical delivery of the copper at the end of the 12 months, or payment of a net settlement in cash based on the change in the fair value of copper during the 12-month period. The counterparty cannot choose to refuse delivery. Entity A intends to settle the contract by delivering the copper, has no history of settling similar contracts net in cash, and has sufficient production capacity to provide the required quantity of copper to meet the delivery requirements. From entity A’s perspective, is this contract an ‘own use’ contract? Solution The ‘own use’ criteria are likely to be met. There is an embedded derivative (being the net settlement provision based on the change in the fair value of copper), but it does not require separation. Although the contract allows net settlement, it will still qualify as ‘own use’ as long as it has been entered into and continues to be held for the expected counterparties’ sales/usage requirements.

Is the ‘own use’ exemption met in a contract to purchase oil where an entity has an established pattern of settling net before delivery? An entity enters into a forward contract to purchase oil. The entity has an established pattern of settling such contracts net, before delivery, by contracting with a third party. The entity settles any market value difference for the contract price directly with the third party. The forward contract to purchase oil is recognised as a derivative. IAS 39/IFRS 9 applies to a contract to purchase a non-financial asset if the contract meets the definition of a derivative and it does not qualify for the exemption for delivery in accordance with the entity’s expected purchase or usage requirements. The entity does not expect to take delivery. A pattern of entering into offsetting contracts that effectively accomplishes settlement on a net basis means that the transaction does not qualify for the exemption for delivery in accordance with the entity’s expected purchase or usage requirements.

What factors should be considered when determining whether a contract meets the ‘own use’ exemption? Do both counterparties have to reach the same conclusion? Entity XYZ enters into a fixed-price forward contract to purchase one million kilograms of copper in accordance with its expected usage requirements. The contract permits entity XYZ to take physical delivery of the copper at the end of 12 months, or to pay or receive a net settlement in cash based on the change in fair value of copper. This contract needs to be evaluated to determine whether it falls within the scope of the financial instruments standards. The contract is a derivative instrument, because there is no initial net investment, the contract is based on the price of copper, and it is to be settled at a future date. However, if entity XYZ intends to settle the contract by taking delivery, and has no history (for similar contracts) of settling net in cash or of taking delivery of the copper and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin, the contract is not accounted for as a derivative under IAS 39/IFRS 9. Instead, it is accounted for as an executory contract. It is possible for entity XYZ and the counterparty to reach different conclusions about whether the contract falls within IAS 39/IFRS 9’s scope. For example, a ‘normal’ sale by the counterparty might not be a ‘normal’ purchase by entity XYZ, that would treat the contract as a derivative. This is one of the few areas of IAS 39/IFRS 9 where a contract might be treated as a derivative by one party, but not be treated as a derivative by the other party.

Written options

A written option to buy or sell a non-financial item that can be settled net cannot be considered to be entered into for the purpose of the receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. Exercise by the holder of an option written by the entity is outside the entity’s control. Therefore, such contracts are always within the scope of IAS 32 and IAS 39/IFRS 9.

How do you determine whether you have/do not have a written option? The following cumulative factors should be considered to ascertain whether an interest rate collar, or other derivative instrument that includes a written option is not a net written option: a. no net premium is received either at inception or over the life of the combination of options. The distinguishing feature of a written option is the receipt of a premium to compensate the writer for the risk incurred; and where relevant b. except for the strike prices, the critical terms and conditions of the written option component and the purchased option component are the same (including underlying variable or variables, currency denomination and maturity date). The notional amount of the written option component is not greater than the notional amount of the purchased option component. If no premium can be identified, other terms of the contract need to be examined to determine whether the contract contains a written option (in particular, whether the buyer is able to secure economic value from the option’s presence).

Long-term commodity contracts may offer the counterparty flexibility in relation to the quantity of the commodity to be delivered under the contract. Volume flexibility such that a party can choose not to take any volume and instead pay a penalty is referred to as a ‘Take or pay’ contract. Such flexibility may prevent the supplier from claiming the ‘own use’ exemption.

Is the ‘own-use’ exemption met in a contract to buy electricity where there is volume flexibility? Question Entity B, an electricity supplier in the United Kingdom (where there is an active electricity market), enters into a contract to buy electricity from entity A. The contract provides for entity A to supply 100 units of electricity at a specified future date to entity B at a fixed price per unit. Entity B has the option to take between 90% and 110% of the contract quantity. Entity B can monetise the contract’s value by selling on any excess power into the market (that is, it can readily convert the electricity contract to cash). Does the contract meet the own use requirements? Solution Entity B is not able to take the own use exemption if the quantity specified in the contract is more than the entity’s normal usage requirement and the entity intends to net settle part of the contract that it does not need in the normal course of business or has a practise to net settle similar contract. The entity could take all of the quantities specified in the contract and sell the excess, or it could enter into an offsetting contract for the excess quantity. In such a case the entire contract falls within IAS 39/IFRS 9’s scope as a derivative for entity B. If the quantity specified in the contract is less than the entity’s normal usage requirement and the entity entered into the contract and continues to hold the contract for the purpose of the receipt of the electricity for the entities expected normal usage requirements, it will not be classified as a derivative. It is important in this situation the client also has no practise of net settling similar contract or have a practise to take delivery and selling the electricity immediately (that is, make a profit from market price fluctuations).

Accounting for take or pay contract; do these violate the ‘own-use’ requirements? Question Many contracts for the supply of goods oblige the buyer to take a minimum quantity of goods. If the buyer does not take the minimum amount of goods the contract requires a penalty which can either be based on a fixed price, the market value of the goods or some other variable. Do these take or pay feature violate the own use requirements? Solution A minimum quantity commitment might create a derivative where the entity does not expect to purchase all of the guaranteed volume for its ‘own use’. If it becomes likely that the entity will not take physical delivery of the product and will, instead, pay a penalty under the contract, it accounts for the contract as follows: ·        If the penalty is dependent on changes in the market price of the goods. The contract might meet the definition of a derivative and is measured at fair value through profit and loss. Changes in market price will affect the carrying value until the penalty is paid. ·        If the amount of the penalty payable is fixed or pre-determined, there is no derivative. Such a payment of the contractual amount for the volume that was not taken is not considered a net settlement, because there is no payment based on the difference between contract price and market price. In other words, the entity will need to provide for the penalty payable once it becomes clear that non-performance is likely. If the quantity specified in the contract is less than the entity’s normal usage requirement and the entity entered into the contract and continues to hold the contract for the purpose of the receipt of the goods for the entities expected normal usage requirements, it will not be classified as a derivative. It is important in this situation the client also has no practise of net settling similar contract or have a practise to take delivery and selling the goods immediately (that is, make a profit from market price fluctuations)

Volume adjustment feature with a written option with no premium; is the ‘own-use’ exemption met? Question Entity A, a car manufacturer, enters into a contract to sell cars to entity B that is engaged in renting cars. The contracts provide for entity A to supply 50 cars of a specific model at a specified future date at a fixed price. Entity B has the option to take between 90% and 110% of the contract quantity. Available market information indicates that a similar contract for 50 cars but without volume flexibility would also be priced at the same fixed price specified in the contract. Entity B cannot monetise the value of the contract by selling on any excess cars in the market. Does the volume flexibility comprise a written option? Solution The supply contract would not be considered a written option, because the pricing of the contract is the same as that for a similar contract with no volume flexibility. There is, therefore, no premium associated with the contract. Entity B cannot exercise any value from the option’s presence, so the contract is not a written option and qualifies for the own use exemption.

Electricity supply contract containing a written option; is the ‘own-use’ exemption met? Question Entity A, an electricity producer in the United Kingdom (where there is an active electricity market), enters into a contract to sell electricity to entity B. The contract provides for entity A to supply 100 units of electricity at a specified future date to entity B at a fixed price per unit. Entity B has the option to take between 90% and 110% of the contract quantity. The total quantity taken will be priced at C0.21 per unit. Available market information indicates that a similar contract for 100 units of electricity but without volume flexibility would be priced at C0.20 per unit. Entity B is also a supplier of electricity and can, therefore, monetise the contract’s value by selling on any excess power into the market (that is, it can readily convert the electricity contract to cash). Does the volume flexibility comprise a written option? Solution The pricing of the contract is not the same as that for a similar contract without volume flexibility. The price per unit includes a premium for the additional risk accepted by entity A in offering volume flexibility. So, the contract is a written option, and entity A cannot claim the own use exemption. In that situation, the contract will be marked-to-market in accordance with IAS 39/IFRS 9. Entity A can view the contract in two ways: ·        as a written option in its entirety, and hence entity A cannot claim the own use exemption, with the effect that the contract will be marked to-market in accordance with IAS 39/IFRS 9; or ·        as a fixed volume contract for 90 units of electricity for C0.20 per unit, for which the own use exemption could be claimed, and a written option for 20 units at C0.21 per unit, which is within IAS 39/IFRS 9’s scope.

Royalty agreements

Royalty agreements that are based on the volume of sales or service revenues are accounted for in accordance with IAS 18/IFRS 15. However, derivative contracts that are based on both sales volume and a financial variable (such as an exchange rate) are not excluded from IAS 39/IFRS 9’s scope.

Rights to reimbursement receipts

An entity may have the right to receipts that reimburse expenditure required to settle a liability, or a provision for which is, or has been, made in accordance with IAS 37. These assets are outside the scope of IAS 39/IFRS 9 and within the scope of IAS 32 and IFRS 7. IAS 37 prescribes the required accounting.

Practical aid for identifying whether an item meets the definition of a financial instrument

Practical aid detailing common balance sheet items and whether an item meets the definition of a financial instrument Balance sheet item Financial instrument? Included within the scope of IAS 32 and IFRS 7 Included within the scope of IAS 39/ IFRS 9 Yes (✓) or No (✗) Yes (✓) or No (✗) Yes (✓) or No (✗) Intangible assets ✗ n/a n/a Property, plant and equipment ✗ n/a n/a Investment property ✗ n/a n/a Interests in subsidiaries (in separate financial statements), associates and joint ventures – accounted for under IAS 27 or IAS 28 respectively ✓ ✗ ✗ Interests in subsidiaries (in separate financial statements), associates and joint ventures – held for sale under IFRS 5 ✓ ✗ ✗ Interests in subsidiaries, associates and joint ventures – accounted for under IAS 39/IFRS 9 in separate financial statements (in accordance with para 10 of IAS 27) ✓ ✓ ✓ Inter-company trading balances with subsidiaries, associates and joint ventures ✓ ✓ ✓ Other investments in other entities ✓ ✓ ✓ Inventories ✗ n/a n/a Gross amount due from customers for construction contract work ✓ ✓ ✓ IFRS 15 contract assets ✗ note 3 ✓ note 3 ✓ note 3 Trade receivables ✓ ✓ ✓ Pre-payments – goods and services ✗ n/a n/a Cash and cash equivalents ✓ ✓ ✓ Trade payables ✓ ✓ ✓ Contingent consideration in a business combination ✓ ✓ ✓ Accruals – goods and services (settlement in cash) ✓ ✓ ✓ Deferred income ✗ n/a n/a Debt instruments ✓ ✓ ✓ Derivative instruments ✓ ✓ ✓ Net-settled commodity-based contracts ✓ ✓ ✓ Retirement benefit obligations ✓ ✗ ✗ Provisions for constructive obligations (as defined in IAS 37) ✗ n/a n/a Warranty obligations (settled by delivery of goods or service) ✗ n/a n/a Warranty obligations (settled by delivery of cash or other financial asset) ✓ ✓ ✓ Financial guarantee contracts issued ✓ ✓ ✓ Financial guarantee contracts held ✓ ✗ ✗ Rights to reimbursement receipts ✓ ✓ ✗ Finance lease receivables (as a lessor) ✓ ✓ ✓ Operating leases (as a lessor) ✗ n/a n/a Lease liabilities (as a lessee) ✓ ✓ ✗ Dividend payable note 1 note 1 note 1 Current and deferred tax ✗ n/a n/a Redeemable preference shares (debt) ✓ ✓ ✓ Entity’s own equity shares ✓ ✓ ✗ Employee share options ✓ ✗ ✗ Other equity options over own equity shares ✓ ✓ ✗ Non-controlling interest ✓ ✓ note 2 note 2   Notes: 1 Dividend payable on the balance sheet is a financial liability when the dividend has been formally declared by the members in a general meeting and becomes a legal obligation of the entity to deliver cash to shareholders for the amount of the declared dividend. 2 The non-controlling interest that might arise on consolidating a subsidiary is presented in the consolidated balance sheet within equity, separately from the equity of the owners of the parent. However, where the parent or any fellow subsidiary undertaking has an obligation to deliver cash or another financial asset in respect of a subsidiary’s shares (for example, by virtue of a written put option), they are treated as financial liabilities in the consolidated financial statements under IAS 32 and are within the scope of IAS 39/IFRS 9. 3 Contract assets are only in scope of IFRS 9 impairment requirements. Contract assets are only in scope of IFRS 7 impairment disclosure requirements.