What are the common difficulties in studying financial assets and liabilities?

Transcription

1 HKICPA Module A Financial Reporting Agenda Financial Assets and Liabilities What are the common difficulties in studying financial assets and liabilities? In today s seminar, we will discuss the following: Update on HKFRS 9 development Recognition and de-recognition including derivatives Measurement Impairment of financial assets Disclosure Note: The MPS is not to give candidates any tips as to which topic may come out in the coming examination HKCA All for you to PASS!

2 aa HKICPA Module A Financial Reporting 1. Basics and Development of HKFRS 9 References: HKAS 32 Financial Instruments: Presentation (Revised July 2012) HKAS 39 Financial Instruments: Recognition and Measurement (Revised July 2013) HKFRS 9 Financial Instruments (2014) Arguably financial instrument is currently the most dynamic area in financial reporting. It is intended that HKFRS 9 is to replace HKAS 39 in its entirety by phases (the process has taken longer than it was first intended and this underlines why this area of financial reporting is problematic). When it was first issued, the effective date of IFRS 9 (and thus HKFRS 9) was originally scheduled to be 1 January However, this effective date was subsequently deferred to 1 January As complicated as it can be, in November 2013 the IASB (International Accounting Standards Board) removed the 1 January 2015 effective date of IFRS 9. Finally, in July 2014, the IASB issued IFRS 9 (2014) as a complete standard following the completion of the final phase (impairment of financial assets). As a result, HKICPA issued HKFRS 9 (2014) in September HKFRS 9 (2014) will be mandatorily effective for annual periods beginning on or after 1 January 2018 with early adoption permitted. Before touching on the details of accounting requirements, it is important to understand the basic terms which will frequently be referred to throughout today s seminar. HKCA All for you to PASS! - 3 -

3 HKICPA Module A Financial Reporting Definitions: 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: cash an equity instrument of another entity a contractual right: (i) to receive cash or another financial asset from another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or a contract that will or may be settled in the entity's own equity instruments and is: (i) 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. (For this purpose the entity's own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments.) (ii) puttable instruments classified as equity or certain liabilities arising on liquidation classified by HKAS 32 as equity instruments HKCA All for you to PASS!

4 aa HKICPA Module A Financial Reporting A financial liability is any liability that is: a contractual obligation: (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or a contract that will or may be settled in the entity s own equity instruments and is: (i) 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 (ii) 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. (For this purpose the entity's own equity instruments do not include: instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments; puttable instruments classified as equity or certain liabilities arising on liquidation classified by HKAS 32 as equity instruments.) An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. 2. Issuer: Financial Liability or Equity? When the entity issues a financial instrument, there is a question as to where should the credit entry go (i.e. should it go to share capital or debt )? In some cases, it may be a straightforward classification in the case of issuance ordinary shares (i.e. share capital ). However, the classification can be complex when the instrument issued is not as plain as an ordinary share (e.g. redeemable or non-redeemable preference share). [Note: a mis-classification would distort the financial position, e.g. ratio analysis] The below table summarises the key classification requirements from the issuer s perspective: HKCA All for you to PASS! - 5 -

5 HKICPA Module A Financial Reporting Aspects Principle [HKAS 32 para 15] Basic Rule [HKAS 32 para 16] Remarks A financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract rather than its legal form. [see also the definitions of financial liability and equity instrument] A financial instrument is an equity instrument only if: the instrument includes no contractual obligation to deliver cash or another financial asset to another entity; and if the instrument will or may be settled in the issuer's own equity instruments, it is either: a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. [In layman s terms, the focus is whether the issuer has an unconditional right to avoid delivering cash or another financial asset to settle to the holder (e.g. redemption). This is the critical feature that distinguishes financial liability from equity. An instrument is classified as equity when it represents a residual interest in the issuer s net assets.] Puttable Instruments [HKAS 32 para 16A] However, there is an exception to the above rule: An instrument that meets the definition of a financial liability would still be classified as equity when it is a puttable instrument that meets specific criteria and certain obligations arising on liquidation. [See below box] A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. Put it in another way, a puttable financial instrument includes a contractual obligation for the issuer to repurchase or redeem that instrument for cash or another financial asset on exercise of the put HKCA All for you to PASS!

6 aa HKICPA Module A Financial Reporting As an exception to the definition of a financial liability, an instrument that includes a contractual redemption/repurchase obligation is classified as an equity instrument if it has all the following features: It entitles the holder to a pro rata share of the entity s net assets in the event of the entity s liquidation. The instrument is in the class of instruments that is subordinate to all other classes of instruments. All financial instruments in the class of instruments that is subordinate to all other classes of instruments have identical features. Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset, the instrument does not include any 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, and it is not a contract that will or may be settled in the entity s own equity instruments. The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the FV of the recognised and unrecognised net assets of the entity over the life of the instrument (excluding any effects of the instrument). Treatment of Interest, Dividends, Losses and Gains of instruments issued [HKAS 32 para 35] The treatment of interest, dividends, losses and gains should follow the classification of the related instrument. For example, if a preference share is classified as financial liability, then its coupon is shown as interest in profit or loss. But if the preference share is classified as equity, the coupon is treated recognised equity is shown as distribution. This also explains why standard dividends to ordinary shareholders are recognised in equity but not in profit or loss as an expense. HKCA All for you to PASS! - 7 -

7 HKICPA Module A Financial Reporting Examples Preference Shares A preference share provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount. In this case, the preference share is a financial liability. If, however, this preference share does not have a fixed maturity, and the issuer does not have a contractual obligation to make any payment, the preference share should then be equity. In other words, even though the preference share is legally termed share, any difference in its contractual terms (i.e. substance) would lead to different classification. 2.1 Compound Instruments Some instruments may contain elements of both financial liability and equity in a single contract (i.e. compound instrument). A typical example is convertible bond. Effectively, a convertible bond contains two components: Financial liability - the issuer's contractual obligation to pay cash Equity - the holder's option to convert into ordinary shares Aspects Principle [HKAS 32 para 29 & 30] Basic Rule [HKAS 32 para 31 & 32] Remarks The financial liability and equity components should be split and accounted for separately. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices, or other event that changes the likelihood that the conversion option will be exercised. The initial carrying amount of a compound financial instrument should be allocated to its equity and liability components. The equity component is assigned the residual amount after deducting from the FV of the instrument as a whole the amount separately determined for the liability component HKCA All for you to PASS!

8 aa HKICPA Module A Financial Reporting In practice, the step is as follows: Step 1: Determine the FV of the Financial Liability component Typically, the FV can be determined by discounted cash flow. Step 2: Deduce the FV Equity component as balancing figure Effectively: Proceed received on issuance - FV of Financial Liability component = FV of Equity component Effectively: Dr. Cash Cr. Financial Liability (convertible instrument) Cr. Equity Reserve (convertible option) On Conversion of Convertible Instrument [HKAS 32 AG 32] On conversion of a convertible instrument, the entity derecognises the liability component and recognises it as equity. The original equity component remains as equity (although it may be transferred from one line item within equity to another). There is no gain or loss on conversion at maturity. In practice, the step is as follows: Step 1: Determine the Carrying Amount of the Financial Liability component at conversion date Typically, this is future value of the financial liability at conversion date. HKCA All for you to PASS! - 9 -

9 HKICPA Module A Financial Reporting Step 2: Derecognise the Financial Liability and Equity Option previously recognised On initial recognised, a financial liability (now at future value) and equity reserve (convertible option) were recognised which now must be derecognised. At the same time, shares are issued and should be recognised. Effectively: Dr. Financial Liability (convertible instrument) Dr. Equity Reserve (convertible option) Cr. Share Capital (and premium if applicable) Amendment of Terms [HKAS 32 AG 35] The entity may amend the terms of a convertible instrument to induce early conversion (e.g. offering a more favourable conversion ratio or paying other additional consideration in the event of conversion before a specified date). The difference (at the date the terms are amended) between: the FV of the consideration the holder receives on conversion of the instrument under the revised terms; and the FV of the consideration the holder would have received under the original terms is recognised as a loss in profit or loss. Effectively: Dr. Expense Cr. Equity Reserve (convertible option) To record the incentive for early conversion Dr. Financial Liability (convertible instrument) Dr. Equity Reserve (convertible option) Cr. Share Capital (and premium if applicable) To record the early conversion [Note: Logically, the issuer should give in some benefits to the holder so that the holder would have an incentive to convert early.] HKCA All for you to PASS!

10 aa HKICPA Module A Financial Reporting 3. Holder: Recognition and Derecognition of Financial Assets and Financial Liabilities We now look into the basic requirements on recognition and derecognition criteria from the holder s perspective. Readers are reminded that as of the time of writing this area is covered by both HKAS 39 and HKFRS 9. Nevertheless, it can be interpreted the requirements of HKAS 39 and HKFRS 9 are consistent. Aspects Recognition of Financial Asset and Financial Liability Remarks Financial asset or a financial liability is recognised when, and only when, the entity becomes a party to the contractual provisions of the instrument, subject to the following provisions in respect of regular way purchases. [HKAS 39 para 14]; [HKFRS 9 para 3.1.1] Regular way purchases or sales of a financial asset [HKAS 39 para 38]; [HKFRS 9 para 3.1.2] Offsetting of Financial Assets and Financial Liabilities [HKAS 32 para 42] Derecognition of Financial Asset [HKAS 39 para 17-20]; [HKFRS 9 para ] A regular way purchase or sale of financial assets is recognised and derecognised using either trade date or settlement date accounting. The method used is to be applied consistently for all purchases and sales of financial assets that belong to the same category. A financial asset and a financial liability should be offset (i.e. only the net amount is presented) when and only when, an entity: has a legally enforceable right to set off the amounts; and intends either to: settle on a net basis, or realise the asset and settle the liability simultaneously. The entity should derecognise a financial asset when, and only when: the contractual rights to the cash flows from the financial asset expire; or it transfers the financial asset (see below). HKCA All for you to PASS!

11 HKICPA Module A Financial Reporting An entity transfers a financial asset if, and only if, it either: transfers the contractual rights to receive the cash flows of the financial asset; or retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients in an arrangement that meets the following conditions: the entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the original asset the entity is prohibited from selling or pledging the original asset (other than as security to the eventual recipient) the entity has an obligation to remit those cash flows without material delay Once an entity has determined that the asset has been transferred, it then determines whether or not it has transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of the asset is precluded. Derecognition of a financial liability [HKAS 39 para 39]; [HKFRS 9 para 3.3.1] A financial liability should be removed from the balance sheet when, and only when, it is extinguished (i.e. when the obligation specified in the contract is either discharged or cancelled or expires) HKCA All for you to PASS!

12 aa HKICPA Module A Financial Reporting Specific Consideration - Modification of Loan Term [HKAS 39 para 40 & 41]; [HKFRS 9 para 3.3.1] Sometimes the terms of the loan may be modified (e.g. changes in repayment period or interest rates). The issue is whether the updated loan represents a new financial liability (i.e. the original financial liability should then be derecognised). Basic Principle: An exchange between an existing borrower and lender of debt instruments with substantially different terms should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. The difference between: the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party; and the consideration paid, including any non-cash assets transferred or liabilities assumed should be recognised in profit or loss. See Note 1 below. Note 1: Modification of Loan Terms If modification of terms is substantial If modification of terms is not substantial Derecognise original financial liability and calculate any gain/loss Recognise a new financial liability Continue to recognise the existing financial liability using the modified terms Modification is substantial if: Discounted PV of Cash Flows under New Terms (including any fees paid net of any fees received) Discounted PV of Remaining Cash Flows under Original Terms > 10% *Original Effective Interest Rate should be used in both cases* [HKAS 39 AG 42]; [HKFRS 9 para B3.3.6] HKCA All for you to PASS!

13 HKICPA Module A Financial Reporting 4. Classification of Financial Instruments We will now move on to look at the classification of financial instruments from the holder s perspective. It should be noted that the classification of financial assets under HKAS 39 and HKFRS 9 are fundamentally different. 4.1 Financial Assets Classification and Accounting Treatment under HKAS 39 Essentially, HKAS 39 classifies financial assets into 4 categories. It is important that they are carefully distinguished because of the different subsequent accounting treatments. Types of Financial Assets Financial Assets at Fair Value Through Profit or Loss ( FAFVPL ) [HKAS 39 para 9, 46, 50 & 55(a)] Held-To-Maturi ty ( HTM ) [HKAS 39 para 9, 46 & 52] Criteria Classified as Held For Trading Designated as FAFVPL Derivatives Fixed or determinable payment Fixed maturity Positive intention and ability to hold to maturity Non-derivatives Subsequent Measurement Measured at FV Change in FV recognised in profit or loss Measured at Amortised Cost Interests go to profit or loss Reclassification Into this category: Cannot be reclassified Out of this category Cannot be reclassified if designated or derivative May reclassify if held for trading (but very rare) May be reclassified to AFS Loans and Receivables [HKAS 39 para 9 & 46] Available-For- Sale ( AFS ) Cannot classify as HTM if the entity has sold or reclassified more than insignificant amount of HTM during current year or the past 2 years Fixed and determinable payments that are not quoted in active market Non-derivatives Designated as AFS Not classified as other categories Non-derivatives Measured at Amortised Cost Interest goes to profit or loss Measured at FV Change in FV recognised in OCI Not common to reclassify out of this category May be reclassified to loans and receivables [HKAS 39 para 9, 46 & 55(b)] All categories are initially measured at FV plus transaction costs, except for FAFVPL where transaction costs should be expensed as incurred HKCA All for you to PASS!

14 aa HKICPA Module A Financial Reporting 4.2 Financial Assets Classification and Accounting Treatment under HKFRS 9 HKFRS 9 simplifies the classification model under HKAS 39 by having only two categories: FV and amortised cost. In essence, the classification under HKFRS 9 is primarily based on the nature of the financial asset whether it is a debt instrument or an equity instrument. The key accounting treatment is summarised in the below table. Circumstance Accounting Treatment If it is a debt instrument [HKFRS 9 para 4.1.1, 4.1.2, 4.1.3, 4.1.4, 4.1.5, 4.4.1] A debt instrument that meets the following two conditions should be measured at amortised cost (net of any write down for impairment): The financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows; and The asset s contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Otherwise, the financial asset should be measured at fair value through profit or loss. [Note additional classification in compete HKFRS 9 (2014): The finalised standard introduces one more category which is Financial Asset at Fair Value through Other Comprehensive Income ( FVTOCI ) para 4.1.2A A debt instrument that meets the following two conditions must be measured at FVTOCI: The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets; and The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Otherwise, the financial asset should be measured at fair value through profit or loss.] HKCA All for you to PASS!

15 HKICPA Module A Financial Reporting Even if both tests are met, the management may still irrevocably designate the financial asset as fair value through profit or loss if f doing so reduces or eliminates a measurement or recognition inconsistency ( accounting mismatch ). Financial assets are reclassified only when the entity changes in business model. If it is an equity instrument [HKFRS 9 para 4.1.4, 5.7.5, 5.7.6, B5.7.1] The FV model should always be used. Equity instruments that are held for trading (including derivatives) are required to be classified as at FV through profit or loss. For all other equity instruments, the entity may make an irrevocable election on initial recognition (on an instrument-by-instrument basis) to recognise the changes in FV in OCI. If this election is made, all FV changes, excluding dividends that are a return on investment, will be reported in OCI. There is no subsequent transfer of amounts from OCI to profit and loss (e.g. on sale of an equity investment) nor are there any impairment requirements. However, the entity may transfer the cumulative gain or loss within equity. The above requirements can be summarised in the following flow chart: (see next page) HKCA All for you to PASS!

16 aa HKICPA Module A Financial Reporting HKFRS 9 - Classification of Financial Assets Is the Financial Instrument a Debt Instrument or Equity Instrument? Debt Instrument Equity Instrument The objective of the entity s business model is to hold the asset to collect the contractual cash flows? No Held for Trading? No - Measure at FV - Changes in FV go to P/L - But can make irrevocable election to recognise changes in FV in OCI [Note: In complete HKFRS 9:- additional test for FVTOCI: "business model to both collect contractual cash flows and sell financial assets"] Yes The contractual terms give rise to cash flows on specified dates? Yes The asset s contractual cash flows represent only payments of principal and interest? No No Yes (no choice) Once election is made: - no recycling of amounts from OCI to P/L - no impairment requirements However, the entity may transfer the cumulative gain or loss within equity. Yes Does management decide to designate the Financial Asset as FV through Profit or Loss? No Measure at Amortised Cost; Interest in Profit or Loss Yes Measure at FV; Changes in FV go to P/L Derivatives (no choice) [Note: In complete HKFRS 9:- additional classification as FVTOCI] HKCA All for you to PASS!

17 HKICPA Module A Financial Reporting 4.3 Financial Liabilities Classification and Accounting Treatment under HKAS 39 HKAS 39 classifies financial liabilities into 2 categories: Types of Financial Liabilities Financial liabilities at fair value through profit or loss ( FLFVPL ) Criteria Classified as Held For Trading Designated as FLFVPL Derivatives Subsequent Measurement Measure at FV Change in FV recognised in profit or loss Reclassification Reclassificatio n is prohibited [HKAS 39 para 9, 47, 50 & 55(a)] Other liabilities [HKAS 39 para 9, 47] Liabilities other than FLFVPL Measure at Amortised Cost Interest go to profit or loss Reclassificatio n is prohibited FLFVPL are initially measured at FV (transaction costs are not included). Other liabilities are initially measured at FV less transaction costs HKCA All for you to PASS!

18 aa HKICPA Module A Financial Reporting 4.4 Financial Liabilities Classification and Accounting Treatment under HKFRS 9 It can be interpreted that there is no wholesale change made by HKFRS 9. The classification and measurement of financial liabilities under HKFRS 9 remains the same. The exception is that when the entity has chosen to measure a liability at fair value through profit or loss, changes in FV related to changes in own credit risk (i.e. fluctuations in value due to changes in the liability s credit risk) are presented separately in OCI. No reclassification of financial liabilities is allowed. The key accounting treatment is summarised in the below table. Measurement Measured at Amortised Cost Measured at FV Accounting Treatment Interest go to P/L Required to be measured at FV: Held for trading Derivatives Changes in FV go to P/L Irrevocably designated to be measured at FV Changes in FV should be separated into: Gain or loss resulting from own credit risk goes to OCI. However, if this would create an accounting mismatch in profit or loss then all movements go to P/L) Other gain or loss goes to profit or loss [HKFRS 9 para 4.2.1, 4.2.2, 5.7.1, 5.7.7] HKCA All for you to PASS!

19 HKICPA Module A Financial Reporting Note on Amortised Cost using Effective Interest Method For financial instruments that are measured at amortised cost, the interest expense (for financial liabilities) or income (for financial assets) is calculated by using the effective interest rate method. In essence, this method calculates the rate of interest that is necessary to discount the estimated stream of principal and interest cash flows through the expected life of the financial instrument to equal the amount recognised at initial recognition. The rate is then applied to the carrying amount at each reporting date to determine the interest expense or revenue for the period. Concept Check What are the journal entries for initial recognition and subsequent measurement of: FAFVPL FAFVOCI AFS? How do you calculate the changes in fair value? HKCA All for you to PASS!

20 aa HKICPA Module A Financial Reporting 5. Derivatives Definition: A derivative is a financial instrument or other contract with all three of the following characteristics: Its value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index; it requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and it is settled at a future date. Common derivatives include: Type Options Forwards Futures Interest Rate Swaps and Forward Rate Agreements Caps and Floors Remarks Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. They can be individually written or exchange-traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option. Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual delivery of the item specified in the contract, or by a net cash settlement. Futures are similar to forwards but with the following differences: Futures are exchange-traded, whereas forwards are usually OTC (over-the-counter). Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash settlement. Contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates. They are sometimes referred to as interest rate options. An interest rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall below a predetermined rate. By all means, derivatives are treated as held-for-trading and should be treated as fair value through profit or loss. However, under specific circumstance the derivatives are accounted for different when hedge accounting applies. HKCA All for you to PASS!

21 HKICPA Module A Financial Reporting 6. Impairment of Financial Assets HKAS 36 scopes out the impairment of financial assets which is covered by HKAS 39 and HKFRS 9. The final phase of HKFRS 9 saw the introduction of a new expected loss impairment model. We shall consider the requirements under HKAS 39 and HKFRS 9 separately. 6.1 Impairment under HKAS 39 The entity should assess at each balance sheet date whether there is any objective evidence of impairment. If any such evidence exists, the entity is required to do a detailed impairment calculation to determine whether an impairment loss should be recognised. [HKAS 39 para 58] It should be noted that impairment loss is recognised for loss event that has taken place but not those that are expected to take place. The below table summarises the impairment requirements on specific types of financial assets: Types FAFVPL HTM Loans and Receivables Accounting Treatment Technically speaking any impairment loss has already been reflected in FV re-measurement exercise. (Apply for Financial Assets Measured at Amortised Cost under HKFRS 9) Assets that are individually assessed and for which no impairment exists are grouped with financial assets with similar credit risk statistics and assessed for impairment collectively. [HKAS 39 para 64] Recognition of Impairment Loss: Impairment Loss = Carrying Amount PV of estimate future cash flows discounted at original effective interest rate Impairment loss is recognised in profit or loss [HKAS 39 para 63] HKCA All for you to PASS!

22 aa HKICPA Module A Financial Reporting Reversal of Impairment Loss: Impairment Loss may be subsequently reversed either directly or adjusting an allowance account The reversal should not result in a carrying amount that exceeds what the amortised cost would have been. [HKAS 39 para 65] AFS (For HKAS 39 only) Indication for impairment of AFS in equity instruments: significant or prolonged (Note HKAS 39 is silent on the threshold) Recognition of Impairment Loss: Impairment loss is to reclassified from OCI to profit or loss as a reclassification adjustment (i.e. as if the AFS is derecognised) [HKAS 39 para 67] Reversal of Impairment Loss: Impairment Loss of AFS in Equity instrument cannot be reversed through profit or loss Impairment Loss of AFS in Debt instrument should reversed through profit or loss [HKAS 39 para 69 & 70] Note: According to HK(IFRIC) Int 10, The entity should not reverse an impairment loss recognised in a previous interim period in respect an investment in either an equity instrument or a financial asset carried at cost. See Chapter for details. 6.2 Impairment under HKFRS 9 The impairment model in HKFRS 9 is based on the premise of providing for expected losses. The scope of impairment covers: Financial assets measured at amortised cost Financial assets mandatorily measured at FVTOCI (i.e. not by irrevocable election) Loan commitments when there is a present obligation to extend credit (except where these are measured at FVTPL) Financial guarantee contracts to which HKFRS 9 is applied (except those measured at FVTPL) Lease receivables within the scope of HKAS 17 [HKFRS 9 para 5.5.1] HKCA All for you to PASS!

23 HKICPA Module A Financial Reporting The key accounting treatment is summarised in the below table. Circumstance Accounting Treatment General Approach [HKFRS 9 para & 5.5.5] Loss Allowance for full lifetime expected credit losses [HKFRS 9 para 5.5.3, & ] An entity shall recognise a loss allowance for expected credit losses. In other words, it is forward-looking. Except for purchased or originated credit-impaired financial assets (see below), expected credit losses are required to be measured through a loss allowance at an amount equal to: the 12-month expected credit losses (expected credit losses that result from those default events on the financial instrument that are possible within 12 months after the reporting date); or full lifetime expected credit losses (expected credit losses that result from all possible default events over the life of the financial instrument). [see application criteria below] It is required for a financial instrument if: the credit risk of that financial instrument has increased significantly since initial recognition; or contract assets or trade receivables that do not constitute a financing transaction in accordance with HKFRS 15. Nevertheless, the entity may elect an accounting policy to recognise full lifetime expected losses for all contract assets and/or all trade receivables that do constitute a financing transaction in accordance with HKFRS 15. Significant Increase in Credit Risk: The assessment of whether there has been a significant increase in credit risk is based on an increase in the probability of a default occurring since initial recognition. Credit risk is low if there is a low risk of default (i.e. the borrower has a strong capacity to meet its contractual cash flow obligations in the near term). Investment grade rating might be an indicator for a low credit risk. [HKFRS 9 para B B5.5.24] There is a rebuttable presumption that the credit risk has increased significantly when contractual payments are more than 30 days past due. An entity can rebut this presumption if the entity has reasonable and supportable information that is available without undue cost or effort, that demonstrates that the credit risk has not increased significantly since initial recognition even though the contractual payments are more than 30 days past due. [HKFRS 9 para ] 12-month expected credit losses [HKFRS 9 para 5.5.5] For all other financial instruments, expected credit losses are measured at an amount equal to the 12-month expected credit losses HKCA All for you to PASS!

24 aa HKICPA Module A Financial Reporting Purchased or originated credit-impaired financial assets [HKFRS 9 para & ] Measurement of Expected Credit Loss [HKFRS 9 para ] Purchased or originated credit-impaired financial assets are treated differently because at initial recognition they were not 100% clean. An entity shall only recognise the cumulative changes in lifetime expected credit losses since initial recognition as a loss allowance for purchased or originated credit-impaired financial assets. An entity shall recognise favourable changes in lifetime expected credit losses as an impairment gain, even if the lifetime expected credit losses are less than the amount of expected credit losses that were included in the estimated cash flows on initial recognition. A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired include observable data about the following events: significant financial difficulty of the issuer or the borrower; a breach of contract, such as a default or past due event; the lenders for economic or contractual reasons relating to the borrower s financial difficulty granted the borrower a concession that would not otherwise be considered; it is becoming probable that the borrower will enter bankruptcy or other financial reorganisation; the disappearance of an active market for that financial asset because of financial difficulties; or the purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses. [HKFRS 9 Appendix A] Expected credit losses are defined as the weighted average of credit losses with the respective risks of a default occurring as the weights An entity shall measure expected credit losses of a financial instrument in a way that reflects: an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes; the time value of money; and reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions. Time Value of Money: To reflect time value, expected losses should be discounted to the reporting date using the effective interest rate of the asset (or an approximation thereof) that was determined at initial recognition. A credit-adjusted effective interest rate should be used for expected credit losses of purchased or originated credit-impaired financial assets. In contrast to the effective interest rate (calculated using expected cash flows that ignore expected credit losses), the credit-adjusted effective interest rate reflects expected credit losses of the financial asset. [HKFRS 9 para B & ] HKCA All for you to PASS!

25 HKICPA Module A Financial Reporting 7. Disclosures of Financial Instruments Reference: HKFRS 7 Financial Instruments: Disclosures (Revised February 2012) applicable for annual periods beginning on or after 1 January 2007 earlier application is encouraged HKFRS 7 aims at providing disclosures that enable the F/S users to evaluate: the significance of financial instruments for the entity s financial position and performance; and the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks. 7.1 Significance of Financial Instruments for Financial Position and Performance The below table summarises the key disclosure requirements: Aspects Statement of Financial Position Remarks The carrying amounts of each category of financial assets and financial liabilities (as covered by HKAS 39 and HKFRS 9) should be disclosed either in the statement of financial position or in the notes. [HKFRS 7 para 8] Other disclosures include: special disclosures about financial assets and financial liabilities designated to be measured at FV through profit and loss, including disclosures about credit risk and market risk, changes in FV attributable to these risks and the methods of measurement. [HKFRS 7 para 9-11] reclassifications of financial instruments from one category to another (e.g. from FV to amortised cost or vice versa) [HKFRS 7 para 12&12A] information about financial assets pledged as collateral and about financial or non-financial assets held as collateral [HKFRS 7 para 14&15] reconciliation of the allowance account for credit losses by class of financial assets [HKFRS 7 para 16] information about compound financial instruments with multiple embedded derivatives [HKFRS 7 para 17] breaches of terms of loan agreements [HKFRS 7 para 18&19] HKCA All for you to PASS!

26 aa HKICPA Module A Financial Reporting Statement of Comprehensive Income Items of income, expense, gains, and losses from each category of financial assets and financial liabilities should be disclosed either in the statement of comprehensive income or in the notes. [HKFRS 7 para 20(a)] Other disclosures include: total interest income and total interest expense for those financial instruments that are not measured at fair value through profit and loss [HKFRS 7 para 20(b)] fee income and expense for those financial instruments that are not measured at FV through profit and loss [HKFRS 7 para 20(c)] amount of impairment losses by class of financial assets [HKFRS 7 para 20(e)] interest income on impaired financial assets [HKFRS 7 20(d)] Other Disclosures Summary of significant accounting policies for financial instruments [HKFRS 7 para 21] Information about hedge accounting, including: description of each hedge, hedging instrument, and FV of those instruments, and nature of risks being hedged [HKFRS 7 para 22] Hedge ineffectiveness recognised in profit and loss (separately for cash flow hedges and hedges of a net investment in a foreign operation) [HKFRS 7 para24(b)&(c)] For cash flow hedges, disclose: the periods in which the cash flows are expected to occur when they are expected to affect profit or loss a description of any forecast transaction for which hedge accounting had previously been used but which is no longer expected to occur the amount recognised in OCI during the period the amount that was reclassified from equity to profit or loss for the period [HKFRS 7 para 23] For fair value hedges, disclose: information about the FV changes of the hedging instrument and the hedged item [HKFRS 7 para 24(a)] HKCA All for you to PASS!

27 HKICPA Module A Financial Reporting Fair Value Information about the FV of each class of financial asset and financial liability, and: comparable carrying amounts description of how FV was determined the level of inputs used in determining FV (see Note below) reconciliations of movements between levels of FV measurement hierarchy; and additional disclosures for financial instruments whose FV is determined using level 3 inputs including impacts on profit and loss, OCI and sensitivity analysis information if FV cannot be reliably measured [HKFRS 7 para 25-30] Note on FV measurement hierarchy HKFRS 7 adopts a 3-level hierarchy with reference to the nature of input which is similar to that of HKFRS 13, please refer to Chapter and HKCA All for you to PASS!

28 aa HKICPA Module A Financial Reporting 7.2 Nature and Extent of Risks arising from Financial Instruments The below table summarises the key disclosure requirements: Aspects Qualitative Disclosures [HKFRS 7 para 33] Quantitative Disclosures [HKFRS 7 para 34] Credit Risk Liquidity Risk Remarks For each type of risk arising from financial instruments, disclose: the exposures to risk and how they arise its objectives, policies and processes for managing the risk and the methods used to measure the risk changes from the prior period For each type of risk arising from financial instruments, disclose: summary quantitative data about exposure to each risk at the reporting date disclosures about credit risk, liquidity risk, and market risk and how these risks are managed concentrations of risk Credit risk is the risk that one party to a financial instrument will cause a loss for the other party by failing to pay for its obligation. Disclosures about credit risk include: maximum amount of exposure (before deducting the value of collateral), description of collateral, information about credit quality of financial assets that are neither past due nor impaired [HKFRS 7 para 36] an analysis of the age of financial assets that are past due as at the end of the reporting period but not impaired; and an analysis of financial assets that are individually determined to be impaired as at the end of the reporting period [HKFRS 7 para 37] information about collateral or other credit enhancements obtained or called [HKFRS 7 para 38] Liquidity risk is the risk that an entity will have difficulties in paying its financial liabilities. Disclosures about liquidity risk include: a maturity analysis for non-derivative financial liabilities that shows the remaining contractual maturities (analysed by time bands showing the contractual undiscounted cash flows) a maturity analysis for derivative financial liabilities which include the remaining contractual maturities for those derivative financial liabilities for which contractual maturities are essential for an understanding of the timing of the cash flows description of approach to risk management (i.e. how the entity manages the liquidity risk inherent in the items disclosed in the maturity analysis) [HKFRS 7 para 39] HKCA All for you to PASS!

29 HKICPA Module A Financial Reporting Market Risk Market risk is the risk that the fair value or cash flows of a financial instrument will fluctuate due to changes in market prices. Market risk reflects interest rate risk, currency risk and other price risks. Disclosures about market risk include: a sensitivity analysis of each type of market risk to which the entity is exposed, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date the methods and assumptions used in preparing the sensitivity analysis changes from the previous period in the methods and assumptions used, and the reasons for such changes an explanation of the main parameters and assumptions underlying the data provided in the sensitivity analysis [HKFRS 7 para 40 & 41] 7.3 Fair Value Measurement and Disclosure HKFRS 13 Reference: HKFRS 13 Fair Value Measurement (Issued June 2011) applicable for annual periods beginning on or after 1 January 2013 earlier application is encouraged prospective application However, because the respective HKFRSs were developed over many years, the requirements for measuring FV and for disclosing information about FV measurements may be dispersed. As a result, HKFRS 13 was issued to standardise. HKFRS 13 applies when another HKFRS requires or permits FV measurements or disclosures about FV measurements, except for: share-based payment transactions (see HKFRS 2) leasing transactions (see HKAS 17) measurements that have some similarities to FV but are not FV (e.g. NRV in HKAS 2 or VIU in HKAS 36) In other words, HKFRS 13 applies to both financial and non-financial instrument items HKCA All for you to PASS!

30 aa HKICPA Module A Financial Reporting Fair Value Measurement First and foremost, HKFRS 13 clarifies the meaning of FV. Definition: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price). The above definition implies that FV is a market-based measurement, not an entity-specific measurement. Therefore, when measuring FV, the entity uses the assumptions that market participants would use under current market conditions, including assumptions about risk. HKFRS 13 is a lengthy standard. The below table summarises the key guidance on the measurement of FV: Aspects Consider the Characteristics of Asset or Liability being measured [HKFRS 13 para 11] Orderly Transaction under Current Market Conditions [HKFRS 13 para 15 & 16] Remarks The entity should take into account the characteristics of the asset or liability that a market participant would take into account when pricing the asset or liability at measurement date. For example: the condition and location of the asset any restrictions on the sale and use of the asset FV measurement assumes an orderly transaction between market participants at the measurement date under current market conditions. In essence, the transaction is assumed to take place either: in the principal market for the asset or liability; or (in the absence of a principal market) in the most advantageous market for the asset or liability. Principal market is the market with the greatest volume and level of activity for the asset or liability. Most advantageous market is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs. HKCA All for you to PASS!

31 HKICPA Module A Financial Reporting Non-Financial Asset - Highest and Best Use [HKFRS 13 para 27] Liability or the Entity s Own Equity Instruments [HKFRS 13 para 34] Liability - Non-Performance Risk [HKFRS 13 para 42] Exception to Financial Assets and Liabilities with Offsetting Positions [HKFRS 13 para 48 & 96] The FV measurement of a non-financial asset takes into account a market participant s ability to generate economic benefits by using the asset in its highest and best use. Highest and Best Use is the use of a non-financial asset by market participants that would maximise the value of the asset or the group of assets and liabilities (e.g. a business) within which the asset would be used. The FV measurement of liability or an entity's own equity instruments assumes that they are transferred to a market participant without settlement, extinguishment, or cancellation at the measurement date. The FV of a liability reflects the effect of non-performance risk (i.e. the risk the entity will not fulfil an obligation). Non-performance risk includes, but may not be limited to, an entity s own credit risk. Non-performance risk is assumed to be the same before and after the transfer of the liability. The entity may hold a group of financial assets and financial liabilities is exposed to market risks and to the credit risk of each of the counterparties. If the entity manages that group of financial assets and financial liabilities on the basis of its net exposure to either market risks or credit risk, the entity is permitted to apply an exception for measuring FV under HKFRS 13. This exception permits the entity to measure FV of a group of financial assets and financial liabilities on the basis of the price that would be received to sell a net long position (i.e. an asset) for a particular risk exposure or to transfer a net short position (i.e. a liability) for a particular risk exposure. Bid and Ask Prices [HKFRS 13 para 70 & 71] If the entity makes an accounting policy decision to use the above exception, it should disclose that fact. Certain asset or liability (e.g. listed shares) may have a bid price and an ask price. The price within the bid-ask spread that is most representative of FV in the circumstances shall be used to measure FV. In other words, HKFRS 13 permits, but does not require, to use bid prices for asset positions and ask prices for liability positions. The use of mid-market pricing may also be used HKCA All for you to PASS!

32 aa HKICPA Module A Financial Reporting Valuation Techniques While the valuation for listed securities is typically straightforward, there are circumstances where valuation techniques are necessary, especially for unlisted assets and liabilities. HKFRS 13 [para 62] outlines 3 widely used valuation techniques: Valuation Technique Market Approach Cost Approach Income Approach Remarks Uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities (e.g. a business). Reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost). Converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts. HKFRS 13 [para 61 & 67] states that the entity should use valuation techniques that: Are appropriate in the circumstances for which sufficient data are available, thereby maximising the use of relevant observable inputs and minimising the use of unobservable inputs HKCA All for you to PASS!

33 HKICPA Module A Financial Reporting Fair Value Hierarchy To increase consistency and comparability in FV measurements and related disclosures, HKFRS 13 establishes a FV hierarchy that categorises the inputs used in valuation techniques into 3 levels: [Note: This FV hierarchy is similar to what HKFRS 7 requires for financial instruments but HKFRS 13 extends the FV hierarchy requirement to non-financial instruments.] Level of Inputs 1 [HKFRS 13 para 76 & 77] Remarks Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted price in an active market provides the most reliable evidence of FV. A quoted price should be used without adjustment whenever available, except: when an entity holds a large number of similar (but not identical) assets or liabilities (e.g. debt securities) at FV and a quoted price in an active market is available but not readily accessible for each of those assets or liabilities individually (i.e. given the large number of similar assets or liabilities held by the entity, it would be difficult to obtain pricing information for each individual asset or liability at the measurement date). when a quoted price in an active market does not represent FV at the measurement date when measuring the FV of a liability or the entity s own equity instrument using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset HKCA All for you to PASS!

34 aa HKICPA Module A Financial Reporting 2 [HKFRS 13 para 81-83] Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. For example: Receive-fixed, pay-variable interest rate swap based on the LIBOR swap rate. A Level 2 input would be the LIBOR swap rate if that rate is observable at commonly quoted intervals for substantially the full term of the swap. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following: (a) quoted prices for similar assets or liabilities in active markets (b) quoted prices for identical or similar assets or liabilities in markets that are not active (c) inputs other than quoted prices that are observable for the asset or liability, for example: (i) interest rates and yield curves observable at commonly quoted intervals (ii) implied volatilities (iii) credit spreads (d) inputs that are derived principally from or corroborated by observable market data by correlation or other means ( market-corroborated inputs ) Adjustments may be made on Level 2 inputs. 3 [HKFRS 13 para 86-89] Unobservable inputs for the asset or liability. For example: Interest rate swap. A Level 3 input would be an adjustment to a mid-market consensus (non-binding) price for the swap developed using data that are not directly observable and cannot otherwise be corroborated by observable market data. Unobservable inputs are used to measure FV to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little (if any) market activity for the asset or liability at the measurement date. An entity develops unobservable inputs using the best information available in the circumstances (e.g. the entity's own data), taking into account all information about market participant assumptions that is reasonably available. The FV hierarchy gives the highest priority to Level 1 inputs and the lowest priority to Level 3 inputs. [HKFRS 13 para 72] If the inputs used to measure FV are categorised into different levels of the FV hierarchy, the FV measurement is categorised in its entirety in the level of the lowest level input that is significant to the entire measurement (based on judgement). [HKFRS 13 para 73] HKCA All for you to PASS!

35 HKICPA Module A Financial Reporting Disclosures of Fair Value Measurement The entity should disclose, at a minimum, the following information for each class of assets and liabilities measured at FV after initial recognition: [HKFRS 13 para 93] Aspects Remarks Overall the FV measurement at the end of the reporting period the level of the FV hierarchy within which the FV measurements are categorised in their entirety (Level 1, 2 or 3) Non-Recurring FV the reasons for the measurement measurements Recurring FV the amounts of any transfers between Level 1 Measurements and Level 2 the reasons for those transfers the entity's policy for determining when transfers between Level 2 and Level 3 only levels are deemed to have occurred a description of the valuation technique(s) the inputs used in the FV measurement any change in the valuation techniques and the reason(s) for making such change Level 3 only a description of the valuation processes used by the entity quantitative information about the significant unobservable inputs used a reconciliation from the opening balances to the closing balances: total gains or losses for the period recognised in profit or loss, separately out any unrealised gains or losses total gains or losses for the period recognised in other comprehensive income purchases, sales, issues and settlements the amounts of any transfers into or out of Level 3 the reasons for those transfers the entity's policy for determining when transfers between levels are deemed to have occurred a narrative description of the sensitivity of the FV measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower FV measurement For financial assets and financial liabilities: If changing one or more of the unobservable inputs to reflect reasonably possible alternative assumptions would change FV significantly, the entity should: state that fact disclose the effect of those changes Highest and Best Use of a Non-financial Asset If the highest and best use of a non-financial asset differs from its current use, the entity should: disclose that fact why the non-financial asset is being used in a manner that differs from its highest and best use HKCA All for you to PASS!

36 aa HKICPA Module A Financial Reporting Appendix Illustrative Disclosure Example (Source: Value Partners Group Annual Report 2014 Extract) HKCA All for you to PASS!

37 HKICPA Module A Financial Reporting HKCA All for you to PASS!

38 aa HKICPA Module A Financial Reporting HKCA All for you to PASS!

39 HKICPA Module A Financial Reporting HKCA All for you to PASS!

40 aa HKICPA Module A Financial Reporting HKCA All for you to PASS!

41 HKICPA Module A Financial Reporting HKCA All for you to PASS!

42 aa HKICPA Module A Financial Reporting HKCA All for you to PASS!

43 HKICPA Module A Financial Reporting Past Paper Practice Question 1 > QP MA Feb 10 Q HKCA All for you to PASS!

44 aa HKICPA Module A Financial Reporting Answer 1 > QP MA Feb 10 Q4 HKCA All for you to PASS!

45 HKICPA Module A Financial Reporting Answer 1 > QP MA Feb 10 Q HKCA All for you to PASS!

46 aa HKICPA Module A Financial Reporting Question 2 > QP MA Dec 10 Q4 HKCA All for you to PASS!

47 HKICPA Module A Financial Reporting Answer 2 > QP MA Dec 10 Q HKCA All for you to PASS!

48 aa HKICPA Module A Financial Reporting Question 3 > QP MA Jun 11 Q4 HKCA All for you to PASS!

49 HKICPA Module A Financial Reporting Answer 3 - QP MA Jun 11 Q HKCA All for you to PASS!

50 aa HKICPA Module A Financial Reporting Question 4 > QP MA Jun 14 Q4 HKCA All for you to PASS!

51 HKICPA Module A Financial Reporting Answer 4 > QP MA Jun 14 Q HKCA All for you to PASS!