Depth – Financial Instruments

Financial instruments

Accounting for financial instruments is perhaps the most challenging aspect of FRS 102 for many entities, who have been able to leave many of the more complex arrangements off balance sheet under old GAAP. Even for common instruments such as bank loans and intercompany loans, the new standard may mean more complex accounting.

Section 11 of FRS 102 applies to basic financial instruments and is relevant to all entities. Section 12 applies to other, more complex financial instruments and transactions. Together they deal with recognising, derecognising, measuring and disclosing financial instruments.

[[[Even for common instruments such as bank loans and intercompany loans, the new standard may mean more complex accounting]]]

If an entity enters into only basic financial instrument transactions then Section 12 is not applicable. However, even entities with only basic financial instruments must consider the scope of Section 12 to ensure they are exempt.

To account for all of its financial instruments, an entity shall choose to apply either:

  1. the provisions of both Section 11 and Section 12 in full; or
  2. the recognition and measurement provisions of IAS 39 Financial Instruments: Recognition and Measurement (as adopted for use in the EU) and the disclosure requirements of Sections 11 and 12; or
  3. the recognition and measurement provisions of IFRS 9 Financial Instruments and/ or IAS 39 (as amended following the publication of IFRS 9) and the disclosure requirements of Sections 11 and 12.        

Where an entity chooses (b) or (c) it applies the scope of the relevant standard to its financial instruments. Changing between (a), (b) and (c) is regarded as a change of accounting policy.        

What are financial instruments?

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

Sections 11 and 12 cover a broad range of contracts and arrangements, but some are specifically excluded as they are dealt with elsewhere in the standard. These exclusions are:

  • Investments in subsidiaries, associates and joint ventures (these are accounted for in accordance with Sections 9, 14 and 15 of FRS 102 respectively);
  • Financial instruments that meet the definition of an entity’s own equity and the equity component of compound financial instruments issued by the reporting entity that contain both a liability and an equity component (Section 22 – Liabilities and Equity applies);        
  • Leases (Section 20 applies);
  • Employers’ rights and obligations under employee benefit plans (Section 28 Employee Benefits applies);
  • Share-based payments (Section 26 applies);
  • Insurance contracts and financial instruments issued by an entity with a discretionary participation feature (see FRS 103 Insurance Contracts).
  • Reimbursement assets and financial guarantee contracts (Section 21 applies).

How are financial instruments classified between ‘basic’ and ‘other’?

Basic financial instruments typically include the following:

  • cash;
  • demand and fixed-term deposits when the entity is the depositor, e.g. bank accounts;
  • commercial paper and commercial bills held;
  • accounts, notes and loans receivable and payable;
  • bonds and similar debt instruments;
  • investments in non-convertible preference shares and non-puttable ordinary and preference shares; and
  • commitments to receive a loan and commitments to make a loan to another entity, that cannot be settled net in cash.

Examples of financial instruments that do not normally satisfy the conditions in Section 11, and are therefore within the scope of Section 12, include:

  • asset-backed securities, such as collateralised mortgage obligations, repurchase agreements and securitised packages of receivables;
  • options, rights, warrants, futures contracts, forward contracts and interest rate swaps that can be settled in cash or by exchanging another financial instrument;
  • financial instruments that qualify and are designated as hedging instruments in accordance with the requirements in Section 12; and
  • commitments to make a loan to another entity and commitments to receive a loan, if the commitment can be settled net in cash.

How are ‘basic’ financial instruments accounted for?

Initial recognition and measurement

A basic financial asset or liability is measured initially at the transaction price (including transaction costs except where financial assets and liabilities are measured at fair value through profit or loss) unless the arrangement constitutes, in effect, a financing transaction. A financing transaction may take place in connection with the sale of goods or services, for example, if payment is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate. 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.

[[[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]]]

Section 11 contains a number of examples of such initial measurement.

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. Ordinary and preference shares are measured at fair value (wherever available), or at cost less impairment if no fair value can be found. NB unlisted shares can in many cases be valued at fair value through comparison with recent transactions for identical instruments, or by using a valuation methodology. Guidance on fair value measurement is provided in section 11.
  2. Debt instruments are measured at amortised cost using the effective interest method.  However, debt instruments that are payable or receivable within one year shall be measured at the undiscounted amount of the cash or other consideration expected to be paid or received.
  3. If the arrangement constitutes a financing transaction, the entity shall measure the debt instrument at the present value of the future payments discounted at a market rate of interest for a similar debt instrument. As an alternative, in some cases debt instruments can instead be valued at fair value through profit or loss.        
  4. Commitments to receive a loan and to make a loan to another entity shall be measured at cost (which sometimes is nil) less impairment.

Note that if a reliable measure of fair value becomes unavailable for an asset measured at fair value, its carrying amount at the last date the asset was reliably measurable becomes its new cost (less impairment) until a reliable measure of fair value becomes available.

How are ‘other’ financial instruments accounted for?

Initial measurement

When a financial asset or financial liability is recognised initially, an entity shall measure it at its fair value, which is normally the transaction price (including transaction costs except in the initial measurement of financial assets and liabilities that are measured at fair value through profit or loss). If payment for an asset is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate, the entity shall initially measure the asset at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.        

Subsequent measurement

At the end of each reporting period, an entity shall measure all financial instruments within the scope of Section 12 at fair value and recognise changes in fair value in profit or loss, except as follows:

  1. investments in equity instruments that are not publicly traded and whose fair value cannot otherwise be measured reliably and contracts linked to such instruments that, if exercised, will result in delivery of such instruments, shall be measured at cost less impairment; and
  2. hedging instruments in a designated hedging relationship (see below).

Hedge accounting

The hedge accounting rules within section 12 allow entities to reduce volatility in profit or loss by accounting for a hedging instrument and a hedged item together. Section 12 outlines the permissible lists of hedging instruments and hedged items.

[[[The hedge accounting rules within section 12 allow entities to reduce volatility in profit or loss by accounting for a hedging instrument and a hedged item together]]]        

There are three types of hedging relationships:

  1. fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that are attributable to a particular risk and could affect profit or loss;
  2. cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss; and
  3. hedge of a net investment in a foreign operation.

Section 12 provides guidance on the accounting treatment for each of the three types, with examples.