Basic Financial Instruments 2

Initial recognition of financial assets and liabilities

Recognition of a financial asset or a financial liability

An entity shall recognise a financial asset or a financial liability only when the entity becomes a party to the contractual provisions of the instrument.

Initial measurement

When a financial asset or financial liability is recognised initially, an entity shall measure it at the transaction price (including transaction costs except in the initial measurement of financial assets and liabilities that are subsequently measured at fair value through profit or loss) unless the arrangement constitutes, in effect, a financing transaction for either the entity (for a financial liability) or the counterparty (for a financial asset) to the arrangement. An arrangement constitutes a financing transaction if payment is deferred beyond normal business terms, for example, providing interest-free credit to a buyer for the sale of goods, or is financed at a rate of interest that is not a market rate, for example, an interest-free or below market interest rate loan made to an employee. If the arrangement constitutes a financing transaction, the entity shall measure the financial asset or financial liability at the present value of the future payments discounted at a market rate of interest for a similar debt instrument as determined at initial recognition.

Examples – financial assets

1 For a long-term loan made to another entity, a receivable is recognised at the present value of cash receivable (including interest payments and repayment of principal) from that entity.

2 For goods sold to a customer on short-term credit, a receivable is recognised at the undiscounted amount of cash receivable from that entity, which is normally the invoice price.

3 For an item sold to a customer on two-year interest-free credit, a receivable is recognised at the current cash sale price for that item. If the current cash sale price is not known, it may be estimated as the present value of the cash receivable discounted using the prevailing market rate(s) of interest for a similar receivable.

4 For a cash purchase of another entity’s ordinary shares, the investment is recognised at the amount of cash paid to acquire the shares.

Examples – financial liabilities

1 For a loan received from a bank, a payable is recognised initially at the present value of cash payable to the bank (for example, including interest payments and repayment of principal).

2 For goods purchased from a supplier on short-term credit, a payable is recognised at the undiscounted amount owed to the supplier, which is normally the invoice price.

Subsequent measurement

At the end of each reporting period, an entity shall measure financial instruments as follows, without any deduction for transaction costs the entity may incur on sale or other disposal:

  1. debt instruments that meet the conditions in Debt instrument accounted for as Basic financial instruments (b) shall be measured at amortised cost using the effective interest method. All sections in Amortised cost and effective interest method provide guidance on determining amortised cost using the effective interest method. Debt instruments that are classified as current assets or current liabilities shall be measured at the undiscounted amount of the cash or other consideration expected to be paid or received (ie net of impairment—see all sections in Impairment of financial assets measured at cost or amortised cost) unless the arrangement constitutes, in effect, a financing transaction (see Initial measurement).
  2. commitments to receive a loan that meet the conditions in Debt instrument accounted for as Basic financial instruments (c) shall be measured at cost (which sometimes is nil) less impairment.
  3. investments in non-convertible preference shares and non-puttable ordinary or preference shares shall be measured as follows (Fair value in Basic Financial Instruments – 3 provides guidance on fair value):
    1. if the shares are publicly traded or their fair value can otherwise be measured reliably without undue cost or effort, the investment shall be measured at fair value with changes in fair value recognised in profit or loss; and
    2. all other such investments shall be measured at cost less impairment.

Impairment or uncollectibility must be assessed for financial assets in (a), (b) and (c)(ii). The sections in Impairment of financial assets measured at cost or amortised cost provide guidance.

Amortised cost and effective interest method

Amortised cost of a financial asset or financial liability

The amortised cost of a financial asset or financial liability at each reporting date is the net of the following amounts:

  1. the amount at which the financial asset or financial liability is measured at initial recognition;
  2. minus any repayments of the principal;
  3. plus or minus the cumulative amortisation using the effective interest method of any difference between the amount at initial recognition and the maturity amount;
  4. minus, in the case of a financial asset, any reduction (directly or through the use of an allowance account) for impairment or uncollectibility.

Financial assets and financial liabilities that have no stated interest rate, that do not relate to an arrangement that constitutes a financing transaction and that are classified as current assets or current liabilities are initially measured at an undiscounted amount in accordance with Initial measurement. Consequently, (c) does not apply to them.

Effective interest method

The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or a group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period, to the carrying amount of the financial asset or financial liability. The effective interest rate is determined on the basis of the carrying amount of the financial asset or liability at initial recognition. Under the effective interest method:

  1. the amortised cost of a financial asset (liability) is the present value of future cash receipts (payments) discounted at the effective interest rate; and
  2. the interest expense (income) in a period equals the carrying amount of the financial liability (asset) at the beginning of a period multiplied by the effective interest rate for the period.

Estimate cash flows

When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument (for example prepayment, call and similar options) and known credit losses that have been incurred, but it shall not consider possible future credit losses not yet incurred.

Calculating the effective interest rate

When calculating the effective interest rate, an entity shall amortise any related fees, finance charges paid or received (such as ‘points’), transaction costs and other premiums or discounts over the expected life of the instrument, except as follows. The entity shall use a shorter period if that is the period to which the fees, finance charges paid or received, transaction costs, premiums or discounts relate. This will be the case when the variable to which the fees, finance charges paid or received, transaction costs, premiums or discounts relate is repriced to market rates before the expected maturity of the instrument. In such a case, the appropriate amortisation period is the period to the next such repricing date.

Variable rate financial assets and variable rate financial liabilities

For variable rate financial assets and variable rate financial liabilities, periodic re-estimation of cash flows to reflect changes in market rates of interest alters the effective interest rate. If a variable rate financial asset or variable rate financial liability is recognised initially at an amount equal to the principal receivable or payable at maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or liability.

Revisions of estimates of payments or receipts

If an entity revises its estimates of payments or receipts, the entity shall adjust the carrying amount of the financial asset or financial liability (or group of financial instruments) to reflect actual and revised estimated cash flows. The entity shall recalculate the carrying amount by computing the present value of estimated future cash flows at the financial instrument’s original effective interest rate. The entity shall recognise the adjustment as income or expense in profit or loss at the date of the revision.

Example of determining amortised cost for a five-year loan using the effective interest method

On 1 January 20X0, an entity acquires a bond for Currency Units (CU)900, incurring transaction costs of CU50. Interest of CU40 is receivable annually, in arrears, over the next five years (31 December 20X0–31 December 20X4).

The bond has a mandatory redemption of CU1,100 on 31 December 20X4.

Year

Carrying amount at beginning of period

Interest income at 6.9583%*

Cash inflow

Carrying amount at end of period

CU

CU

CU

CU

20X0

950.00

66.10

(40.00)

976.11

20X1

976.11

67.92

(40.00)

1,004.03

20X2

1,004.03

69.86

(40.00)

1,033.89

20X3

1,033.89

71.94

(40.00)

1,065.83

20X4

1,065.83

74.16

(40.00)

1,100.00

(1,100.00)

0

* The effective interest rate of 6.9583 per cent is the rate that discounts the expected cash flows on the bond to the initial carrying amount:

40/(1.069583)^1 + 40/(1.069583)^2 + 40/(1.069583)^3 + 40/(1.069583)^4 + 1,140/(1.069583)^5 = 950

Continue reading: Basic Financial Instruments – 3

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