The IFRS for SMEs 1 Topic 2.1 Section 11 Basic Financial Instruments Section 12 Other Fin. Inst. Issues Section 22 Liabilities and Equity
This PowerPoint presentation was prepared by IFRS Foundation education staff as a convenience for others. It has not been approved by the IASB. The IFRS Foundation allows individuals and organisations to use this presentation to conduct training on the IFRS for SMEs. However, if you make any changes to the PowerPoint presentation, your changes should be clearly identifiable as not part of the presentation prepared by the IFRS Foundation education staff and the copyright notice must be removed from every amended page. This presentation may be modified from time to time. The latest version may be downloaded from: http://www.ifrs.org/ifrs+for+smes/sme+workshops.htm The accounting requirements applicable to small and medium sized entities (SMEs) are set out in the International Financial Reporting Standard (IFRS) for SMEs, which was issued by the IASB in July 2009. The IFRS Foundation, the authors, the presenters and the publishers do not accept responsibility for loss caused to any person who acts or refrains from acting in reliance on the material in this PowerPoint presentation, whether such loss is caused by negligence or otherwise. 2
Sections 11-12 Introduction 3 Financial instruments split into two sections: Sec. 11 Basic Financial Instruments Sec. 12 Other Financial Instruments Issues Together the two sections cover recognising, derecognising, measuring, and disclosing financial assets and financial liabilities
Sections 11-12 Introduction 4 Section 11 is relevant to all SMEs Section 12 is relevant If: SME owns or issues exotic financial instruments instruments that impose risks or rewards that are not typical of basic financial instruments SME wants to do hedge accounting
Sections 11-12 Accounting choice 5 Entity may choose to apply either: Sections 11 and 12 in full, or Recognition and measurement provisions of IAS 39 and the disclosure requirements in Sec 11 & 12 No option to use IFRS 9 The option chosen applies to all financial instruments (not individually) To change option, follow Section 10
Sections 11-12 Basic principles Basic principle of Section 11: Amortised cost model for all basic FI except investments in ordinary or preference shares that are publicly traded or whose fair value can be measured reliably these are fair value through profit or loss (FVTPL). Basic principle of Section 12: FI not covered by Section 11 are at FVTPL 6
Section 11 Scope 7 All basic financial instruments except those covered by other sections of IFRS for SMEs: Investments in sub, associate, JV (see Sections 9, 14, 15) Entity s own equity (see Sec 22, 26) Leases (see Section 20) Employee benefit assets and liabilities (see Section 28)
Sections 11-12 Definitions Financial instrument Contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity Includes cash But commodities that are near cash like gold are not financial instruments 8
Sections 11-12 Definitions Basic financial instrument* Cash Debt instrument (accounts, notes, and loans receivable and payable) that meet conditions on next slide Ordinary and preference shares that are not convertible and not puttable 9 *These notes do not discuss loan commitments
Section 11 Basic debt instruments 10 Debt instruments are in Section 11 if: Returns to holder are fixed, variable referenced to an observable rate, or combination of fixed and variable No special provision could cause holder to lose principal Prepayment conditions are not contingent on a future event No special conditional returns
Section 11 Basic debt instruments Examples of basic debt instruments: Trade accounts and notes receivable and payable Loans from banks and other 3rd parties Accounts payable in foreign currency Loans to/from subsidiaries or associates that are due on demand Debt instrument that becomes immediately due if issuer defaults All of these measured at amortised cost 11
Section 11 Basic debt instruments Examples of NOT basic debt instruments: Investment in convertible or puttable shares or debt Swaps, forwards, futures, options, rights, and other derivatives Loans with unusual prepayment conditions (based on tax change, accounting change, linked to company performance) All of these are FVTPL under Section 12 12
Section 11 Recognition and measurement 13 Initial recognition: When entity becomes a party to the contractual provisions of the instrument IFRS for SMEs allows judgement regarding trade date vs settlement date accounting, but be consistent
Section 11 Recognition and measurement 14 Initial measurement: At transaction price Include transaction costs except for FI that will be measured at FVTPL Impute interest if payment is deferred beyond normal terms or below-market interest
Section 11 Recognition and measurement 15 Initial recognition-measurement examples: Loan made to another entity: Measure at PV of interest and principal payments Goods sold to customer (purchased from supplier) on normal credit terms: Measure receivable (payable) at undiscounted invoice price
Section 11 Recognition and measurement Initial recognition-measurement examples: Goods sold (purchased) on 2-year interest free credit: Measure at current cash sale price or PV of receivable or payable Example: We sell goods for 1,000, payment due 2 years, interest-free. Cash price = 857. IRR = 8%. Journal entries Debit Credit At time of sale Receivable 857 Sales Revenue 857 End of year 1 Receivable 69 8% x 857 = 69 Interest Revenue 69 16
Section 11 Recognition and measurement 17 Subsequent measurement: Debt instruments in the scope of Section 11 (even if publicly traded): Amortised cost using the effective interest method Equity instruments in scope of Section 11: If publicly traded or FV can be measured reliably: FVTPL All others: cost less impairment
Section 11 Recognition and measurement 18 What is amortised cost? Amount measured at initial recognition Minus repayments of principal Plus or minus cumulative amortisation of any difference between initial measurement and maturity amount (using effective interest method) Minus (for assets) reduction for impairment or uncollectibility
Section 11 Recognition and measurement What is effective interest method? Effective interest is rate that exactly discounts future cash payments (receipts) to the carrying amount Also called Internal Rate of Return Amortised cost = PV of future cash receipts (payments) discounted at effective interest rate Interest expense (income) = carrying amount at beginning of period x effective interest rate 19
Section 11 Effective interest example 1/1/X0 buy 5-year bond for 900, transaction cost = 50, cash interest = 40/year, mandatory redemption at 1,100 at 31/12/X4. Year Carrying amount beginning Int. income at 6.9583%* Cash inflow 20 Carrying amt ending X0 950.00 66.10 (40) 976.11 X1 976.11 67.92 (40) 1,004.03 X2 1,004.03 69.86 (40) 1,033.89 X3 1,033.89 71.94 (40) 1,065.83 X4 1,065.83 74.16 (40) 1,100.00 *6.9583% is the rate that exactly discounts the cash flows to 950.00
Section 11 Recognition and measurement 21 What is fair value? Amount for which FI could be sold or settled in an arm s length transaction Best: Quoted market price in an active market (bid price) Next: Price in a recent transaction for identical asset (unless circumstances have changed) Estimate using a valuation technique (a model)
Section 11 Impairment 22 Impairment only applies to FI measured at cost or amortised cost At each reporting date, look for evidence that FV is below carrying amount Significant financial difficulty of issuer Default or delinquency Abnormal concession granted to debtor by creditor Probable debtor bankruptcy or reorg.
Section 11 Impairment 23 Impairment assessment: Individually for all equity instruments Individually for debt instruments that are individually significant For other debt instruments, either individually or grouped based on similar risk characteristics Impairment recognition: Write-down is recognised in P&L
Section 11 Impairment Measurement of the impairment loss: Debt instruments: Difference between carrying amount and current PV of estimated cash flows discounted at asset s original effective interest rate. (Use current rate if variable.) Equity instruments: Difference between carrying amount and best estimate (approximation) of the amount (might be zero) that entity would receive if asset were sold at reporting date. 24
Section 11 Impairment Reversal of an impairment loss: Required if the problem causing the original impairment reduces Write up but not to more than what carrying amount would have been had no impairment been recognised (ie not to FV but to new amortised cost ) Reversal recognised in P&L 25
Section 11 Derecognition Derecognition of a financial asset: Derecognition = remove from balance sheet Only when: a. Rights to cash flows expire or settled b. Substantially all risks and rewards (cash flows) transferred to other entity c. Transferred some but not substantially all risks and rewards, and physical control of asset transferred to another party who has the right to sell the asset to an unrelated third party. 26
Section 11 Derecognition 27 Derecognition of a financial asset: In case (c) above: Derecognise old asset entirely, and Recognise separately any rights and obligations retained or created in the transfer (measure at fair value) If transfer does not result in derecognition, keep transferred asset on books and recognise financial liability for the consideration received Do not offset
Section 11 Derecognition Derecog. of financial asset examples: Must derecognise: Sell receivables to bank but we continue to collect and remit, for a handling fee. Bank assumes credit risk. May not derecognise: Same facts except entity agrees to buy back any receivables in arrears for more than 120 days. Entity continues to recognise the receivables until collected or writeoff as uncollectible. 28
Section 11 Derecognition Derecognition of a financial liability: Only when extinguished, that is: a. Discharged b. Cancelled c. Expired If existing debt is replaced with new one with substantially different terms (or there is a significant modification of terms): Treat as new liability and extinguishment of original liability 29
Section 11 Disclosure 30 Disclose accounting policies for FI Disclose financial assets and liabilities by categories in the balance sheet: Equity or debt at FVTPL Debt at amortised cost Equity measured at cost less impairment Liabilities at FVTPL Liabilities at amortised cost
Section 11 Disclosure Terms, conditions, and restrictions of financial assets and liability For those at FVTPL, details of how FV was determined Details of transfer of financial asset that did not qualify for derecognition Details of financial assets pledged as collateral Details of defaults and breaches on loans payable continued next slide... 31
Section 11 Disclosure Items of income, expense, gains and losses: Changes in FV for instruments measured at FVTPL Total interest income and total interest expense on FI not measured at FVTPL Impairment loss by class of financial asset 32
The IFRS for SMEs 33 Topic 2.1 Section 11 Basic Financial Instruments Section 12 Other Fin. Inst. Issues Section 22 Liabilities and Equity
Section 12 Recognition and measurement Initial recognition: When entity becomes a party to the contractual provisions of the instrument Initial measurement: At FV (normally the transaction price) Transaction costs are charged to expense 34
Section 12 Recognition and measurement Subsequent measurement: At FVTPL except: Equity instrument that is not publicly traded and cannot get FV reliably, then measure at cost less impairment Also measure a contract linked to such equity instrument at cost less impairment If previously at FVTPL, but now a reliable FV measure is no longer available, treat most recent FV measure as cost going forward. 35
Section 12 Hedge accounting Hedging and hedge accounting are two different things What is hedging? Managing risks by using one financial instrument ( hedging instrument ) purposely to offset the variability in FV or cash flows of a recognised asset or liability, firm commitment, or future cash flows ( hedged item ) 36
Section 12 Hedge accounting What is hedge accounting? Matching the change in FV of the hedging instrument and the hedged item in the same income statement Hedge accounting is only an issue when normal accounting would put the two FV changes in different periods sometimes referred to as an accounting mismatch 37
Section 12 Hedge accounting 38 The hedger s accounting dilemma: I have a risk in an asset or liability measured at amortised cost Any change in FV or cash flows from that asset or liability is recognised only when realised in cash (asset is sold, liability is settled, cash flows occur) To hedge, I buy a derivative, which is measured at FVTPL at each reporting date I need special hedge accounting to fix this mismatch
Section 12 Hedge accounting 39 The hedger s accounting dilemma an illustration: Entity has note payable at a fixed rate of interest due in 3 years. Note measured at amortised cost. Buys swap to convert receive fixed interest to pay variable. Swap is measured at FVTPL. End of year 1, interest rate declines. Therefore loss on derivative immediately recognised but an offsetting gain (not yet recognised) because we will be paying the lower variable rate of interest in future.
Section 12 Hedge accounting Hedge accounting matching the gain (loss) on the derivative with the loss (gain) on the hedged item. Hedge accounting is optional. 40
Section 12 Hedge accounting 41 To qualify for hedge accounting: Designate and document hedging relationship up front Clearly identify the hedged risk Hedged risk is listed in 12.17 Hedging instrument is listed in 12.18 Entity expects hedging instrument to be highly effective in offsetting the designated hedged risk.
Section 12 Hedge accounting Hedged risk must be (12.17): Interest rate risk in debt measured at cost FX or interest rate risk in firm commitment or highly probable forecast transaction Price risk in a commodity owned or to be acquired in a firm commitment or highly probable forecast transaction FX risk in a net investment in a foreign operation 42
Section 12 Hedge accounting 43 Hedged risk must be (12.17): FX risk in debt instrument measured at cost is not in this list. Why? Under 30.10 (FX) the debt is translated at spot rate and FX gain or loss is recognised in profit or loss Change in FV of the swap (hedging instrument) is also recognised in profit or loss (measured using forward rate) Natural hedge
Section 12 Hedge accounting Hedging instrument must be (12.18): Interest rate swap, FX swap, FX forward, commodity forward Entered into with external party Notional amount = principal or notional amount of hedged item Specified maturity not later than maturity or settlement of hedged item Cannot be prepaid or terminated early 44
Section 12 Hedge accounting 45 Hedge of fixed interest rate risk or commodity price risk of commodity held Recognise hedging instrument as asset or liability Change in FV of hedging instrument in P&L Change in FV of hedged item in P&L and adjustment of carrying amount of hedged item even though hedged item is otherwise measured at cost This is called Fair Value Hedge in IAS 39.
Section 12 Hedge accounting Hedge of fixed interest rate risk or commodity price risk of commodity held (continued) If hedged risk was fixed interest in debt measured at cost, recognise in P&L the periodic net settlements from the derivative (interest rate swap) in the period in which the net settlements occur. 46
Section 12 Hedge accounting 47 Example Assumptions: Entity borrows 1,000, 3 years, 5% fixed rate, payable measured at amortised cost Hedged with a derivative whose value is linked to an interest rate index End of year 1, market rate = 6%. FV of 1,000 payable 2 years 6% = 1,000 x.889996 = 890, but this 110 gain is not recognised Value of the derivative declines to -112 Note there is small ineffectiveness = 2
Section 12 Hedge accounting 48 Balance sheet at time loan is made: Cash 1,000 Loan payable 1,000 Adjust loan end of year 1 to reflect rate change: Loan payable 110 P&L 2 Derivative (Liability) 112 Balance sheet end of year 1: Cash 1,000 Derivative (Liability) 112 Loan payable 890 Equity (2)
Section 12 Hedge accounting Conceptual question regarding the previous example: Does the 890 carrying amount of the loan payable at end of year 1 represent the Fair Value of the loan? Hint: Does the 890 reflect change in credit risk or prepayment risk? If 890 is not Fair Value, what is it? 49
Section 12 Hedge accounting 50 Hedge of fixed interest rate risk and commodity price risk (continued) Discontinue hedge accounting when: Hedging instrument expires Hedge no longer meets conditions Entity revokes designation Any gain or loss that was included in the carrying amount of the hedged item is amortised to P&L over remaining life of hedged item.
Section 12 Hedge accounting Hedge of variable interest rate risk, FX or commodity price risk of commodity held, highly probable forecast transaction, or net investment in foreign operation Recognise change in FV of hedging instrument in OCI (assuming it was effective; ineffectiveness reported in P&L) 'Recycle' amount recognised in OCI when hedged item hits P&L or hedging relationship ends. 51
Section 12 Hedge accounting 52 Hedge of variable interest rate risk, FX or commodity price risk of commodity held, highly probable forecast transaction, or net investment in foreign operation (continued) If hedged risk was variable interest in debt measured at cost, recognise in P&L the periodic net settlements from the interest rate swap in the period in which the net settlements occur. This is called Cash Flow Hedge in IAS 39.
Section 12 Hedge accounting Example Assumptions: Entity sells goods for 1,000 floating rate 3- year note receivable Interest rate risk managed with a derivative (interest rate swap) End of year 1 interest rates increase PV of cumulative cash flows increase by 100 But FV of swap decreases by 105 Note: Some hedge ineffectiveness 53
Section 12 Hedge accounting 54 Opening balance sheet: Receivable 1,000 Equity 1,000 Ineffective portion of hedge: P&L* 5* OCI (Equity) 100 Derivative (Liability) 105 *Ineffective portion of hedge example continued next slide...
Section 12 Hedge accounting 55 Closing balance sheet: Receivable 1,000 Equity (OCI)* 100* Derivative (Liability) 105 Equity 995 *Effective portion of the hedge (loss on derivative), which will be amortised to P&L as the higher floating rate interest payments are earned and recognised in P&L in years 2 & 3
Section 12 Hedge accounting Hedge of variable interest rate risk etc... Discontinue hedge accounting when: Hedging instrument expires Hedge no longer meets conditions Forecast transaction no longer probable Entity revokes designation Any prior gain or loss on forecast transaction that was recognised in OCI is recycled to P&L 56
Section 12 Hedge accounting Disclosures relating to hedge accounting For each type of hedge: Description of hedge (risk, hedged item, instrument) Special disclosures for hedge of fixed interest rate risk and commodity price risk of commodity held Special disclosures for hedge of variable interest rate risk, FX or commodity price risk of commodity held, highly probable forecast transaction, or net investment in foreign operation 57