Note: The IASB and the FASB have numerous projects with respect to financial instruments. In November 2009 the IASB issued ED/2009/12, Financial Instruments: Amortised Cost and Impairment, which would replace the current requirements with an expected loss model. In May 2010 the IASB issued ED/2010/4, Fair Value Option for Financial Liabilities, which retains the existing requirements for classification and measurement of financial liabilities, except for the effects of changes in own credit risk, which would be transferred to other comprehensive income.
In May 2010 the FASB issued proposed Accounting Standards Update (ASU), Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. The ASU proposes a
comprehensive approach to financial instruments accounting, including classification, measurement, impairment, and hedge accounting.
See the IASB and FASB websites for additional information on the current status of their financial instruments projects.
IFRS U.S. GAAP
Relevant guidance: IAS 32 and 39 Relevant guidance: ASC 310, 320, 815, 825, and 860
(SOP 01-6; SFAS 91,107, 114, 115, 133, 140, 155, 159, and 166; FSP FAS 115-2)
Introduction
IAS 39 addresses recognition and measurement of financial instruments, including financial assets. Financial assets comprise (IAS 32.11):
Cash
Rights to receive cash or another financial asset (i.e. receivables and loans made to others)
A contract to exchange financial instruments on potentially favourable terms
Equity instruments in another entity
A non-derivative contract to receive a variable number of the entity's own equity instruments
A certain type of complex derivative as specified in IAS 32 in respect of an entity's own equity
instruments
A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that both (ASC Master Glossary, “Financial Instrument”) (SFAS 107.3):
Imposes on one entity a contractual obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange other financial instruments on potentially unfavorable terms with the second entity
Conveys to that second entity a contractual right (1) to receive cash or another financial instrument from the first entity or (2) to exchange other financial instruments on potentially favorable terms with the first entity
IAS 39 has highly detailed requirements concerning derivatives, complex instruments (such as embedded derivatives) and hedging arrangements. Derivatives such as interest swaps, forward contracts, and currency options are carried at fair value.
Similar to IFRS. Derivatives and hedging arrangements are covered by ASC 815 (SFAS 133) (see Section 7.3, “Recognition and measurement of derivatives” and Section 7.4, “Hedge accounting”).
Categorisation of financial assets
Divide financial assets into the following categories (IAS 39.9):
Financial assets at fair value through profit or loss (see below for further details)
Loans and receivables (see below for further details)
Held to maturity – defined narrowly with strict conditions; covers only assets with fixed or determinable payments and fixed maturity that the enterprise has the positive intent and ability to hold to maturity, other than loans and receivables originated by the enterprise
Available-for-sale financial assets – all financial assets not falling under another category (any financial asset other than one that is held for trading may be designated into this category on initial recognition)
No explicit categorization scheme for financial assets. They could be categorized as follows:
Derivative financial instruments (see Section 7.3, “Recognition and measurement of derivatives”)
Hybrid financial instruments that would be required to be separated into a host and derivative component under ASC 815-15-25-1 (SFAS 133.12) which the entity has irrevocably elected to measure at fair value (ASC 815-15-25-4) (SFAS 155.4)
Eligible financial assets that the entity elects to measure at fair value – fair value option (ASC 825- 10-15-4) (SFAS 159.7 and .8)
Loans and receivables (see below for further details)
Debt and equity securities within the scope of ASC 320 (SFAS 115):
− Trading (see below for further details)
− Held-to-maturity – defined narrowly with strict conditions and covers only those debt securities that the enterprise has the positive intent and ability to hold to maturity
− Available-for-sale – debt and equity securities not classified as trading or held-to-maturity securities
An entity may not use the held to maturity category for two annual reporting periods (taint period) when it sells more than an insignificant amount of assets, with limited exceptions (IAS 39.9).
The length of the taint period under U.S. GAAP is not defined. The SEC uses a two year time frame.
Financial assets at fair value through profit or loss include (IAS 39.9):
Assets held for trading – includes all derivatives (see Section 7.2, “Presentation, recognition, and measurement of financial liabilities and equity” and Section 7.3, “Recognition and measurement of derivatives”) as well as other instruments acquired for the purpose of generating profit from short-term fluctuations in price or dealer's margin
Financial assets designated irrevocably into this category on initial recognition if they fall into one of the categories below. Note that the fair value option may not be applied to unquoted equity investments whose fair value cannot be measured reliably.
− The contract contains one or more embedded derivatives (IAS 39.11A)
Financial assets at fair value through earnings include:
Derivative financial instruments (see Section 7.2, “Presentation, recognition, and measurement of financial liabilities and equity” and Section 7.3, “Recognition and measurement of derivatives”)
Trading securities – securities that are bought and held principally for the purpose of selling them in the near term but may include securities held for a longer period (ASC 320-10-25-1) (SFAS 115.12a)
Hybrid financial instruments that would be required to be separated into a host and derivative component under ASC 815-15-25-1 (SFAS 133.12) which the entity has irrevocably elected to measure at fair value (ASC 815-15-25-4) (SFAS 155.4)
Eligible financial assets that the entity elects to measure at fair value – fair value option (ASC 825- 10-15-4) (SFAS 159.7 and .8)
− The designation results in more relevant financial information because it eliminates an accounting mismatch or a group of financial assets, financial liabilities, or both are managed and evaluated on a fair value basis
Transfers into or from the fair value through profit or loss
category are now similar to U.S. GAAP (IAS 39.50-.54). Transfers into or from the trading category should be rare (ASC 320-10-35-12) (SFAS 115.15). Loans and receivables are non-derivative financial
assets with fixed or determinable payments that are not quoted in an active market, other than (IAS 39.9):
Held-for-trading assets
Those designated on initial recognition as at fair value through profit or loss or as available-for-sale. An entity may reclassify out of fair value through profit or loss if certain criteria are met (see above).
Those where the holder may not recover
substantially all of its investment (other than due to credit deterioration), which are classified as available-for-sale
A loan is a contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor’s balance sheet (ASC Master Glossary, “Loan”) (SFAS 114.4).
Loans are not considered debt securities and hence may not be categorized in the trading, available-for-sale, or held-to-maturity categories provided by ASC 320 (SFAS 115).
Measurement on initial recognition
When a financial asset is recognised initially, an entity measures it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition of the financial asset (IAS 39.43).
Financial assets are recognized initially at fair value. This may lead to the recognition of premiums and discounts on loans and debt securities acquired.
Except for certain costs associated with certain lending activities and loan purchases, transaction costs that are directly attributable to the purchase of a financial asset are expensed as incurred (ASC 310-20-25-2 through 25- 3) (SFAS 91.5-.7).
Subsequent measurement
Subsequent treatment (IAS 39.46):
Remeasure financial assets at fair value through profit or loss at fair value with gains and losses going to the income statement
Carry held-to-maturity financial assets and loans and receivables at amortized cost (no similar special rules as under U.S. GAAP for deterioration in credit quality)
Remeasure available-for-sale financial assets to fair
Subsequent treatment:
Remeasure financial assets at fair value through earnings at fair value with gains and losses going to the income statement (derivatives see ASC 815-10- 35-1 (SFAS 133.17); hybrid financial instruments see ASC 815-15-25-4 (SFAS 155.4); trading securities see ASC 320-10-35-1 (SFAS 115.13))
Carry held-to-maturity securities, loans held for investment, and trade receivables at amortized cost. Special rules apply for certain acquired loans with deterioration in credit quality (ASC 320-10-25-3, ASC 310-10-35-41 through 35-42 and ASC 825-10-35-2 through 35-3, and ASC 310-30-35) (SFAS 115.7 and SOP 01-6.8 and SOP 03-3).
value and take gains or losses through equity (comprehensive income) until point of sale (when recycled to income statement)
Investments in equity instruments that do not have quoted prices in active markets and whose fair value cannot be reliably measured shall be measured at cost
Unrealized gains and losses are included (net of tax) in shareholder’s equity in other comprehensive income. All or a portion of the unrealized holding gain and loss of an available-for-sale security that is designated as being hedged in a fair value hedge is recognized in earnings during the period of the hedge. Realized gains and losses are reported in earnings (ASC 320-10-35-1) (SFAS 115.13-.14).
Derecognition
IAS 39 addresses derecognition specifically in relation to financial instruments. Assets are derecognised when the enterprise loses control of the contractual rights that comprise the financial assets. IAS 39's derecognition principles operate via a five-step process, which focuses on the transfer of risks and rewards as follows (there is no isolation in bankruptcy test) (IAS 39.15-37):
Financial assets are derecognised when an entity transfers substantially all the risks and rewards of ownership
Financial assets are not derecognised when an entity retains substantially all the risks and rewards of ownership
If the entity neither transfers nor retains
substantially all the risks and rewards of ownership it shall determine whether it has retained control
If it has not retained control, derecognise the financial assets and recognise as separate assets or liabilities any rights or obligations created or retained
If it has retained control, partially continue to recognise the asset to the extent of its continuing involvement
A transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset in which the transferor surrenders control over those financial assets shall be accounted for as a sale if and only if all of the following conditions are met (ASC 860-10-40-4 through 40-5) (SFAS 140.9):
Transferred assets have been isolated from the transferor – put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership
Transferee has the right to pledge or exchange the assets (or beneficial interests) received, without any constraints
Transferor does not maintain effective control over the transferred asset
Impairment
If there is objective evidence that a financial asset is impaired, its recoverable amount must be determined and any impairment loss recognised in the income statement. Where such evidence exists, impairment reviews are relevant to assets carried at amortised cost or assets categorised as available-for-sale (although carried at fair value, the gains or losses are included in equity) (IAS 39.58-.70).
For available-for-sale and held-to-maturity securities, if an entity determines that a decline in fair value below the amortized cost basis is other than temporary:
The cost basis of the individual security is written down to fair value and the write-down is included in earnings (i) for all equity securities and (ii) for debt securities for which the entity determines that it intends to sell the debt security or the entity determines that it is more likely than not will be required to sell the debt security before recovery of its
amortized cost basis (ASC 320-10-35-30 through 35- 33I) (SFAS 115.16 and FSP FAS 115-2).
If the entity does not intend to sell the debt security, or it is not more likely than not that it will be required to sell the debt security before recovery of its amortized cost basis, then it must separate the impairment into two components and recognize any impairment related to credit loss in earnings while the other component must be recognized in other comprehensive income, net of tax (ASC 320-10-35- 34C through 35-34D) (FSP FAS 115-2).
A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement (ASC 310-10-35-16) (SFAS 114.8). Reversal of impairment losses on receivables, loans,
and held-to-maturity and available-for-sale debt securities is required provided certain criteria are met. The reversal is recognised in the income statement (IAS 39.65 and .70).
Reductions of valuation allowances related to receivables and loans are recognized in the income statement. Reversals of impairment losses on held-to-maturity and available-for-sale debt securities are prohibited. Reversal of impairment losses on available-for-sale
equity securities is prohibited (IAS 39.69). Similar to IFRS.