Financial instruments take on a particular significance in the economic and financial structure of CIR and for this reason, in order to give a better and clearer understanding of financial issues, it was considered useful to devote a special section to the accounting treatment of IAS 32, IAS 39 and IFRS 7.
According to IAS 32 financial instruments are classified into four categories:
a) Financial instruments that are valued at fair value through profit and loss (FVTPL) in application of the fair value option, which are held for trading purposes;
b) Investments held to maturity (HTM);
c) Loans and receivables (L&R);
d) Available-for-sale financial assets (AFS).
Classification depends on Financial Management’s intended use of the financial instrument in the business context and each involves a different measurement for accounting purposes. Financial transactions are recognized on the basis of their value date.
Financial instruments at fair value through profit and loss
Instruments are classified as such if they satisfy one of the following conditions:
- They are held for trading purposes;
- They are a financial asset designated on adoption of the fair value option, the fair value of which can be reliably determined.
Trading generally means frequent buying and selling with the aim of generating profit on price movements in the short term.
Derivatives are included in this category unless they are designated as hedge instruments.
The initial designation of financial instruments, other than derivatives and those held for trading, as instruments at fair value through profit and loss in adoption of the fair value option is limited to those instruments that meet the following conditions:
a) Designation according to the fair value option eliminates or significantly reduces accounting mismatches;
b) A group of financial assets, financial liabilities or both are managed and their performance is measured on the basis of their fair value following a documented investment risk strategy, and
c) An instrument contains an implicit derivative which meets particular conditions.
The designation of an individual instrument to this category is definitive, is made at the moment of initial recognition and cannot be modified.
Investments held to maturity
This category includes non-derivative instruments with fixed payments or payments that can be determined and that have a fixed maturity, and which it is intended and possible to hold until maturity.
These instruments are measured at amortized cost and constitute an exception to the general measurement principle of fair value.
Amortized cost is determined by applying the effective interest rate of the financial instrument, taking into account any discounts or premiums received or paid at the moment of purchase, and recognizing them throughout the whole life of the instrument until its final maturity.
Amortized cost represents the initial recognition value of a financial instrument, net of any capital repayments and of any impairment, plus or minus the cumulated amount of the differences between its initial value and its value at maturity calculated using the effective interest rate method.
The effective interest rate method is a calculation criterion used to assign financial expenses to their appropriate time period.
The effective interest rate is the rate that gives a correct present value to expected future cash flows until maturity, so as to obtain the net present carrying value of the financial instrument.
If even one single instrument belonging to this category is sold before maturity, for a significant amount and where there is no special justification for this, the tainting rule is applicable and requires that the whole portfolio of securities classified as Held To Maturity be reclassified and measured at fair value, and this category cannot then be used in the two following years.
Loans and receivables
This refers to financial instruments which are not derivatives, have payments that are either fixed or can be determined, which are not quoted on an active market and which are not intended to be traded.
This category includes trade receivables (and payables).
The measurement of these instruments, with the exception of those classified as current assets (up to twelve months) is made by applying the method of amortized cost, using the effective interest rate and taking into account any discounts or premiums obtained or paid at the moment of acquisition and recognizing them throughout the whole life of the instrument until its final maturity.
Available-for-sale financial assets
This is a “residual” category which includes non-derivative financial instruments that are designated as available for sale and are not included in any of the previous categories.
Financial instruments held for trading are recognized at their fair value plus any transaction costs.
Gains and losses are recognized to a separate item of equity until the financial instruments are sold or have been impaired. In such cases the profit or loss accumulated under shareholders’ equity is released to the income statement.
Fair value is the price at which an asset can be traded, or a liability may be extinguished in a free transaction between independent parties at arm’s length.
In the case of securities listed on regulated markets, the fair value is the bid price at the close of trading on the last day of the accounting period.
Where no market prices are available, fair value is determined either on the basis of the fair value of another financial instrument that is substantially similar or by using appropriate financial techniques (for example the discounted cash flow method).
Investments in financial assets can be eliminated from the balance sheet, or derecognized, only when the contractual rights to receive their respective financial cash flows have expired or when the financial asset is transferred to third parties together with all its associated risks and rewards.