In terms of initial recognition of a financial asset or a financial liability, IAS 39 requires that this is done when, and only when, the entity becomes a party to contractual provision of the instrument. With this, the company becomes sub- ject to provisions in respect of regular handling of a commodity. The rules spec- ify that:
● All financial assets and liabilities must be recognized on the balance sheet, and this includes all derivatives.
● A financial asset is recognized (or derecognized), following purchase (or sale) using either trade date or settlement date accounting.
Two groups of financial liabilities are recognized by IAS 39. The first (which has been introduced in section 2, in its incarnation as ‘assets’) is a group of liabili- ties to be recognized at fair value through profit and loss; the second includes financial liabilities measured at amortized cost using the effective interest method. Like financial assets, financial liabilities at fair value through profit or loss have two subclasses:
● Designated, and
● Held for trading.
A financial liability is designatedby the entity as a liability at fair value through profit or loss, upon initial recognition. An example of financial liability charac- terized as held for trading are securities borrowed in the short term, which have to be returned. As we have already seen, according to IAS 39 initially financial assets and liabilities should be measured at fair value, including transactions costs.
If a market for a financial instrument is not active, an entity must establish fair value of its recognized instruments, by using valuation techniques employing a maximum of direct market inputs. If there is no active market to provide an input, or the range of reasonable fair value estimates is significant, then the entity should measure the instrument at cost less impairment.
A financial asset is impaired, and impairment losses are incurred, only ifthere is objective evidence, as a result of one or more events that occurred after the initial recognition of the asset. In this case, the amount of the loss is measured as the dif- ference between the asset’s carrying amount and the present value of estimated cash flows discounted at the financial asset’s original effective interest rate.
The basic premise in IAS 39 for derecognitionof a financial asset is to determine whether the subject under consideration for derecognition is an asset in its entirety, with specifically identified cash flows, or a fully proportionate share of specifically identified cash flows from a financial asset. Once the issue of dere- cognition has been determined, an assessment is made as to whether the asset has been transferred. If so, it must be judged whether the transfer of that asset is eligible for derecognition.
An asset is transferred if either the entity has transferred the contractual rights to receive the cash flows, or it has retained the contractual rights to receive the cash flows from the asset but has assumed a contractual obligation to pass those cash flows on. This is specified, in IAS 39, as an arrangement that meets the condi- tions that the company:
● Is obliged to remit those cash flows without material delay to their lawful owner,
● But has no obligation to pay amounts to the eventual recipient, unless it collects equivalent amounts on the original asset, and
● Is prohibited from selling or pledging the original asset, other than as security to the eventual recipient.
Next to determining that the asset has been transferred, the entity must establish whether or not it has transferred substantially all of the risks and rewards result- ing from ownership of the asset. If it has neither retained nor transferred all of the risks and rewards associated to that asset, then the entity must assess whether it has relinquished control of the asset or not.
● Ifthe entity does not control the asset, thenderecognition is appropriate.
● But, if the entity has retained control of the asset, thenit must continue to recognize it to the extent to which it has a continuing involvement in the asset.
Similarly, a financial liability should be removed from the balance sheet when, and only when, it is extinguished. This means when the obligation specified in the contract is discharged, cancelled, or has expired. If so, gains and losses from
the extinguishment of the original financial liability must be recognized in the profit and loss statement.
Where there has been an exchange between an existing borrower and lender of debt instruments with substantially different terms, or important modification of terms of an existing financial liability, this transaction must be accounted for as:
● An extinguishment of the original financial liability, and
● Recognition of a new financial liability.
Notice that, with only a few exceptions, IAS 39 applies to all types of financial instruments. Among the exceptions are interests in subsidiaries, associates, and joint ventures (accounted for under IAS 27, IAS 28, or IAS 31). However, excep- tions are void ifthere is a derivative instrument present, on an interest in a sub- sidiary, associate, or joint venture.
Among the exceptions are: employers’ rights and obligations under employee benefit plans (to which applies IAS 39); financial instruments that meet the def- inition of own equity (under IAS 32); contracts requiring payment based on cli- matic, geological, or other physical variables, again except in the case where derivatives are embedded in such contracts; contracts for contingent considera- tion in a business combination; rights and obligations under insurance contracts, except if insurance (or reinsurance) contracts involve the transfer of:
● Financial risks, and
● Embedded derivatives (see Chapter 5).
Within the scope of IAS 39, financial guarantees provide for payments to be made in response to changes in a specified variable such as price, rate, or index, and derivative financial instruments. Those guarantees are not derivatives, and therefore are excluded from IAS 39, ifthey provide for specified payments to be made to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due.
The rules of IAS 39 ensure that such excluded guarantees must be initially rec- ognized at fair value and subsequently at the higher of the amount determined under IAS 37 and the amount initially recognized under IAS 39 minus amounts amortized as revenue. No doubt, plenty of learning will be necessary to fine-tune these rules and iron out problems associated to their implementation. Not every- thing with an impact on good governance can be engineered in advance; much must evolve through practice.