The International Financial Reporting Standards, most particularly IAS 32 and IAS 39, define a financial instrumentas a contract giving rise to a financial asset (or equity) and a financial liability (or equity) of another entity. This is fairly sim- ilar to the definition by FASB – and, therefore, US GAAP. A financial assetis:
● Cash
● Demand and time deposit
● Commercial paper
● Equity of another entity
● A contractual right, and more.
This ‘more’ is accounts, notes, loans, receivables and payables, leases, rights and obligations with insurance risk under insurance contracts, employers’ rights and obligations under pension contracts, and so on. Debt and equity securities are financial instruments from the perspectives of both the holder and the issuer, including investments in subsidiaries and joint ventures.
Asset-backed securities, such as collateralized mortgage obligations (CMOs), repurchase agreements, and securitized packages of receivables are also assets.
The same is true of a long list of derivatives, including options, rights, warrants, futures, forward, and swaps, provided that they have a positive value (they are in the money) and not a negative value (they are out of the money) for the holder.
Ifthey have a negative value, thenthey are financial liabilities. A financial lia- bilityis:
● A contractual obligation to deliver cash or other financial asset to another entity
● A contract that will, or may, be settled in the entity’s own equity instru- ments, or
● An obligation to exchange financial assets or financial liabilities with another entity, under conditions that are potentially unfavourable to the holder.
Under IFRS, some of what is currently shareholder funds will be classified as lia- bilities. For instance, if a bond pays no cash but compensates its holder in shares, it will belong to the liabilities column. This changes significantly the method of meeting T-1 regulatory capital requirements. Like SFAS 133 in the United States, IAS 39 expands the use of fair value for measuring and reporting on assets,
liabilities, and derivative instruments. It provides for limited use of hedge accounting (see Chapter 5), but sets criteria for:
● Recognition, and
● Derecognition.
The definitions just given come beyond IAS 32, which requires compound instruments such as embedded derivatives to be split into their components and accounted for accordingly (see Chapter 3).
Most of the examples given in the preceding paragraphs represent contractual rights and contractual obligation. By definition, a contractual right (obligation) is the legally supported right (obligation) to receive (pay) cash or another finan- cial asset from another entity; or, to exchange financial assets or financial liabil- ities with another entity under conditions that are:
● Potentially favourable to the holder, in the case of right, and
● Potentially unfavourable to the holder, in the case of obligation.
A contractual right may also be a contract that will, or may, be settled in the entity’s own equity instruments. It is a non-derivative for which the entity is, or may be, obliged to receive a variable number of the entity’s own equity. Ifit is a derivative thenthis contractual right will, or may, be settled by means 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.
An important part of the new accounting standards, specifically of IAS 39, is the classification of financial assets which guides management’s hand in reporting on financial assets and liabilities. Critical is the classification of an instrument as a liability or as equity. IAS 39 requires financial assets to be classified in one of four categories:
● Financial assets at fair value, through profit or loss
● Available-for-sale financial assets
● Loans and receivables, and
● Investments held to maturity.
Among themselves, these four classes help to determine how a particular finan- cial asset is recognized and measured in financial statements that are made pub- lic, and are used by investors in their decisions. As previous chapters have brought to the reader’s attention, homogeneity in definitions, and in account classifications, helps in creating a level field for all players.
Financial assets at fair value, through profit or loss, has two groups: (i) desig- nated and (ii) held for trading. Designatedincludes any financial asset specified on initial recognition to be measured at fair value, with fair value changes reflected in profit or loss (more on this in section 3). The held for tradingclass includes all derivatives, except those designated hedging instruments. It also includes financial assets:
● Acquired or held for the purpose of selling in the short term, or
● For which there is a recent pattern of short-term profit taking.
Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on initial recognition as being available for sale. Loans and receivables are non-derivative financial assets originated or acquired with fixed or deter- minable payments, that are neither quoted in an active market, nor held for trad- ing except in case of securitization. (More on AFS financial assets in section 4.) The held-to-maturityinvestments, that do not meet the definition of loans and receivables, are non-derivative financial instruments with fixed or determinable payments that an entity intends, and is able, to hold to maturity. Held-to- maturity is an a priori management decision. Its nature is well-defined in SFAS 133 by the Financial Accounting Standards Board as management intent (see also Chapter 1).
Several experts say that, in many aspects, IAS 39 is close to US financial report- ing rules on financial instruments. In particular, they point to the fact that finan- cial assets are to be classified into categories, some of which require fair value measurement. As has been explained in Chapter 3, there is nothing really nega- tive about this – while there are several positive points. But there is a major
‘plus’ in the likelihood that IFRS and US GAAP might be converging.
Nevertheless, as should be expected, the outlook of the different industries varies. According to the Geneva Association, in jurisdictions where insurance liabilities are measured at amortized cost, IAS 39 will cause asset and liability mismatches and imbalances that affect the financial results of insurers. This is an argument that is worth paying attention to, but it is not a reason for leaving IAS 39 aside. (See also the case study on insurance in Chapter 2.)
In its brief review of the seminal work by Luca Paciolo, Chapter 2 made the point that the advent of balance sheets has been a most important novelty in the accounting profession. But as Chapters 13 and 14 will document, because of rapid innovation in financial instruments, balance sheet do not balance any- more. Trying to show they are balanced is a deformation of financial reporting,
generally inherent in today’s balance sheets. All that IAS 39 does is to bring this inconsistency into the open. Always remember the dictum of US Supreme Court Judge Louis Brandeis, ‘Sunshine is the best disinfectant’.