1. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 1 Chapter 17 Financial Liabilities and Derecognition

2. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 2 Agenda 1.Subsequent Measurement of Financial Liabilities 2.Classification of Financial Liabilities 3.Reclassification 4.Derecognition of a Financial Asset 5.Derecognition of a Financial Liability

3. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 3 1. Sub. Measurement of Financial Liab. After initial recognition, an entity is required to measure all financial liabilities at amortised cost using the effective interest method, –except for: 1.Financial liabilities at fair value through profit or loss; 2.Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies; 3.Financial guarantee contracts; and 4.Commitments to provide a loan at a below-market interest rate. Similar to financial assets, financial liabilities are subsequently measured in accordance with the entity’s classification of the financial liabilities.

4. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 4 2. Classification of Financial Liabilities

5. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 5 2. Classification of Financial Liabilities The classification of financial liabilities also determines how their gains and losses are recognised –For a financial liability classified as at fair value through profit or loss that is not part of hedging relationship, a gain or loss arising from a change in its fair value is, as its name describes, recognised in profit or loss. IAS 39 requires such changes be fully presented in P/L, IFRS 9 requires the changes for financial liabilities designated at fair value be divided into two parts (changes in the credit risk of the financial liability and other changes) and requires the changes in the credit risk be presented in other comprehensive income, see Section 17.2.2.1. –For financial liabilities carried at amortised cost, a gain or loss is recognised in profit or loss when the financial liability is derecognised and through the amortisation process. –The recognition of gains and losses on other categories are explained in the respective categories below.

6. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 6 2. Classification of Financial Liabilities Financial Liabilities Measured at Amortised Cost All financial liabilities, except for those categories of financial liabilities as discussed later, –are subsequently measured at amortised cost –using the effective interest method. The effective interest method, the effective interest rate and the amortised cost in measuring financial assets are explained in Chapter 16 and they are the same for financial liabilities.

7. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 7 2. Classification of Financial Liabilities Financial Liabilities at Fair Value through P/L A financial liability at fair value through profit or loss is defined as the same as a financial asset at fair value through profit or loss (see Chapter 16). A financial liability is also classified as at fair value through profit or loss when it meets either: 1.It is held for trading; or 2.Upon initial recognition, it is designated by the entity as at fair value through P/L as allowed under IFRS 9 and IAS 39.

8. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 8 2. Classification of Financial Liabilities Financial Liabilities at Fair Value through P/L IFRS 9 further imposes an exception for this category of financial liability. –If the financial liability within this category is financial liability designated as at fair value through profit or loss (i.e. not including the financial liability held for trading), an entity is required to present the effects of changes in the liability’s credit risk in other comprehensive income (IFRS 9.5.7.1).

9. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 9 2. Classification of Financial Liabilities Financial Liabilities Resulted from Derecognition Issues Arise from two derecognition issues of financial assets: 1.when a transfer of a financial asset does not qualify for derecognition, or 2.when the continuing involvement approach applies. Specific requirements are set out in IAS 39 to address the measurement of the above financial liabilities which are resulted from the two derecognition issues. Section 4 (later) further explains the derecognition issues of financial assets and the associated liabilities arising from the issues.

10. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 10 2. Classification of Financial Liabilities Financial Guarantee Contracts Financial guarantee contract is one kind of financial liabilities within the scope of IAS 39 and has the following definition: A financial guarantee contract is defined as: –a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.

11. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 11 2. Classification of Financial Liabilities Financial Guarantee Contracts An issuer is permitted to elect to apply either IAS 39 or IFRS 4 to its financial guarantee contact if the issuer has met the following two conditions. ‒ The issuer has previously asserted explicitly that it regards a financial guarantee contract as an insurance contract; and ‒ The issuer has used accounting applicable to insurance contracts. IFRS 4 requires a financial guarantee contract to be disclosed as a contingent liability and a liability is only recognised if payment for the contract becomes probable.

12. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 12 2. Classification of Financial Liabilities Financial Guarantee Contracts By using IAS 39, ‒ at initial recognition, a financial guarantee contract, as one kind of financial liabilities, is recognised at fair value plus transaction cost, unless it is classified as at fair value through profit or loss. ‒ after initial recognition, unless a financial guarantee contract is classified as a financial liability at fair value through profit or loss or a financial liability resulted from derecognition issue, an issuer of such a contract is required to measure the contract at the higher of: 1.the amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets; and 2.the amount initially recognised (i.e. fair value plus transaction costs) less, when appropriate, cumulative amortisation recognised in accordance with IAS 18 Revenue.

13. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 13 2. Classification of Financial Liabilities Example Knut Holdings Limited adopted similar policy as Recruit Holdings Limited (Real-life Case 17.7) in accounting for its financial guarantee contracts. On 4 July 2007, Knut issued two 3-year guarantee contracts of $100,000 each to a third party and a related party. While Knut estimated that the fair value of each contract was $1,500, it only demanded $1,500 from the third party but nothing from the related party. On 30 June 2008, Knut’s balance sheet date, it was probable that a holder of its guarantee may demand Knut to pay $20,000 for the guarantee to the third party. Knut estimated that there were no other probable liabilities in respect of the guarantees at that date. Discuss and suggest the journal entries for the year ended 30 June 2008.

14. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 14 On 4 July 2008, Knut issued two financial guarantee contracts and the fair value of the guarantees of $3,000 in total should be initially recognised as financial liabilities. Since only the third party was demanded for payment, the fair value of guarantee issued to the related party should be recognised as an immediate expense. DrCash$1,500 Profit or loss1,500 CrFinancial guarantee contracts$3,000 On 30 June 2008, Knut measured the financial guarantee contract at the higher of the amount determined in accordance with IAS 37 and the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with IAS 18. On 4 July 2008, Knut issued two financial guarantee contracts and the fair value of the guarantees of $3,000 in total should be initially recognised as financial liabilities. Since only the third party was demanded for payment, the fair value of guarantee issued to the related party should be recognised as an immediate expense. DrCash$1,500 Profit or loss1,500 CrFinancial guarantee contracts$3,000 On 30 June 2008, Knut measured the financial guarantee contract at the higher of the amount determined in accordance with IAS 37 and the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with IAS 18. 2. Classification of Financial Liabilities Example

15. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 15 For the financial guarantee contract granted to the related party, as no probable liability was expected, Knut measured it at the amount initially recognised (i.e. $1,500) less cumulative amortisation recognised in accordance with IAS 18 ($1,500 ÷ 3 years = $500). Thus, the following journal entry should be made: Dr Financial guarantee contracts$500 CrProfit or loss$500 For the financial guarantee contract granted to the related party, as it was probable that a holder of its guarantee may demand Knut to pay $20,000 for the guarantee, the financial guarantee contract should be measured at the amount determined in accordance with IAS 37, i.e. $20,000. Thus, the following journal entry should be made: Dr Profit or loss$18,500 CrFinancial guarantee contracts ($20,000 -$1,500)$18,500 For the financial guarantee contract granted to the related party, as no probable liability was expected, Knut measured it at the amount initially recognised (i.e. $1,500) less cumulative amortisation recognised in accordance with IAS 18 ($1,500 ÷ 3 years = $500). Thus, the following journal entry should be made: Dr Financial guarantee contracts$500 CrProfit or loss$500 For the financial guarantee contract granted to the related party, as it was probable that a holder of its guarantee may demand Knut to pay $20,000 for the guarantee, the financial guarantee contract should be measured at the amount determined in accordance with IAS 37, i.e. $20,000. Thus, the following journal entry should be made: Dr Profit or loss$18,500 CrFinancial guarantee contracts ($20,000 -$1,500)$18,500 2. Classification of Financial Liabilities Example

16. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 16 2. Classification of Financial Liabilities Commitments to Provide a Loan at a Below-Market Interest Rate At initial recognition, an issuer is required to measure such commitments at fair value plus transaction cost. After initial recognition, an issuer is required to measure such commitments at the higher of: 1.the amount determined in accordance with IAS 37; and 2.the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with IAS 18.

17. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 17 3. Reclassification While IFRS 9 specifically states that an entity shall not reclassify any financial liability, IAS 39 has no such requirements.

18. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 18 3. Reclassification However, in IAS 39, the reclassification of a financial liability between different categories is still infrequent or rare. –On one hand, an entity is not allowed to reclassify a financial liability (as a financial asset) into or out of the fair value through profit or loss category while it is issued. –On the hand, different categories of the financial liabilities represent the different nature and circumstances of the financial liabilities. –Unless there are changes in such nature and circumstances, it is impossible to have reclassification between other categories. In rare circumstance, a reliable measure of fair value of financial liability may be no longer available, it becomes appropriate to carry such financial liability at amortised cost. Alternatively, when a reliable measure becomes available for a financial liability for which such a reliable measure was previously not available, the financial liability will then be measured at fair value.

19. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 19 4. Derecognition of a Financial Asset The derecognition rules are identical in both IFRS 9 and IAS 39. Derecognition is the removal of a previously recognised financial asset or financial liability from an entity’s balance sheet. –Derecognition of an asset or a liability is originally a simple concept. Practically, it is not that simple for financial assets and financial liabilities. –Even a financial asset or a financial liability had been transferred, either or both the risk and reward and control of the financial asset or the obligation of the financial liability might have not been transferred. –IAS 39 sets out detailed derecognition criteria and requirements on financial assets and financial liabilities separately.

20. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 20 4. Derecognition of a Financial Asset The general derecognition criteria in accordance with IAS 39 require an entity to derecognise a financial asset when, and only when: 1.the contractual rights to the cash flows from the financial asset expire; or 2.the entity transfers the financial asset that meet the conditions set out in IAS 39 (i.e. “asset transfer test”) and the transfer qualifies for derecognition in accordance with IAS 39 (i.e. the “risks and rewards test” and the “control test”).

21. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 21 4. Derecognition of a Financial Asset

22. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 22 4. Derecognition of a Financial Asset The derecognition criteria –are applied consolidated level when an entity is a holding company –consider whether, and to what extent, the derecognition is appropriate on all or only a part of a (or group of) financial asset(s) One critical criterion to qualify for derecognition in IAS 39 is the expiry of contractual rights to receive cash flows from a financial asset. If the rights to receive cash flows from a financial asset have expired, the financial asset should be derecognised. The second criterion for derecognition includes two (or three) tests, namely –asset transfer test, risks and rewards test and control test, as discussed below

23. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 23 4. Derecognition of a Financial Asset In order to meet the “asset transfer test”, i.e. a financial asset is regarded as transferred, an entity either: 1.transfers the contractual rights to receive the cash flows of the financial asset; or 2.retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients (the “eventual recipients”) in an arrangement that meets the conditions set out in IAS 39.

24. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 24 4. Derecognition of a Financial Asset When an entity transfers a financial asset (i.e. fulfilled the “asset transfer test”), –the entity is required to evaluate the extent to which it retains the risks and rewards of ownership of the financial asset before it can derecognise the financial asset. (i.e. the “risks and rewards test”)

25. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 25 4. Derecognition of a Financial Asset If an entity concludes that it neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset, –it will be required to determine whether it has retained control of the financial asset (i.e. the “control test”).

26. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 26 4. Derecognition of a Financial Asset To determine whether the control of the transferred asset is retained, an entity ascertains whether the transferee has ability to sell the asset. –If the transferee has the practical ability to sell the asset in its entirety to an unrelated third party and is able to exercise that ability unilaterally and without needing to impose additional restrictions on the transfer, the entity has not retained control. –Because the entity does not control the transferee’s use of the asset. –In all other cases, the entity has retained control. IAS 39 clarifies that the evaluation of the transfer of risks and rewards of ownership (i.e. the risks and rewards test) precedes the evaluation of the transfer of control (i.e. the control test) for all derecognition transactions.

27. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 27 4. Derecognition of a Financial Asset Findings of risks & rewards test and control test Corresponding accounting treatments 1.Transfers substantially all the risks and rewards of ownership Transfer qualified for derecognition (section 4.5.1) To derecognise the financial asset To recognise separately as assets/liabilities any rights & obligations created/retained in the transfer 2.Retains substantially all the risks and rewards of ownership Transfer not qualified for derecognition (section 4.5.2) To continue to recognise the financial asset 3.Neither transfers nor retains substantially all the risks and rewards of ownership and not retained control Transfer qualified for derecognition (section 4.5.1) To derecognise the financial asset To recognise separately as assets/liabilities any rights & obligations created/retained in the transfer 4.Neither transfers nor retains substantially all the risks and rewards of ownership but retained control Continuing involvement (section 4.5.3) The entity is required to continue to recognise the financial asset to the extent of its continuing involvement in the financial asset. By applying the risks and rewards test together with the control test on a derecognition transaction:

28. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 28 4. Derecognition of a Financial Asset

29. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 29 4. Derecognition of a Financial Asset Requirements for All Transfers If a transferred asset continues to be recognised, –the asset and the associated liability cannot be offset. Similarly, the entity is not allowed to offset any income arising from the transferred asset with any expense incurred on the associated liability. If a transferor provides non-cash collateral (such as debt or equity instruments) to the transferee, –the accounting for the collateral by the transferor and the transferee depends on whether the transferee has the right to sell or repledge the collateral and on whether the transferor has defaulted.

30. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 30 4. Derecognition of a Financial Asset Circumstances for the collateral Requirements for the transferor Requirements for the transferee 1.The transferee has the right by contract or custom to sell or repledge the collateral To continue to carry the collateral as its asset To reclassify that asset in its balance sheet separately from other assets Not to recognise the collateral as an asset 2.The transferee sells collateral pledged to it To continue to carry the collateral as its asset Not to recognise the collateral as an asset To recognise the proceeds from the sale and a liability measured at fair value for its obligation to return the collateral 3.The transferor defaults under the terms of the contract and is no longer entitled to redeem the collateral To derecognise the collateral To recognise the collateral as its asset initially measured at fair value, or If it has already sold the collateral, to derecognise its obligation to return the collateral

31. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 31 5. Derecognition of a Financial Liability An entity is required to remove a financial liability (or a part of a financial liability) from its balance sheet (i.e. derecognise a financial liability) when, and only when, it is extinguished. –IAS 39 explains that a financial liability is extinguished when the obligation specified in the contract is discharged or cancelled or expires. A financial liability or part of it is extinguished when the debtor either: 1.discharges the liability or part of it by paying the creditor, normally with cash, other financial assets, goods or services; or 2.is legally released from primary responsibility for the liability (or part of it) either by process of law or by the creditor.

32. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 32 5. Derecognition of a Financial Liability When there is an exchange between an existing borrower and lender of debt instruments with substantially different terms or a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor), –such an exchange of debt instruments or substantial modification of terms is accounted for as: an extinguishment of the original financial liability and the recognition of a new financial liability.

33. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 33 5. Derecognition of a Financial Liability The recognition of a new financial liability –implies that the new liability is measured at fair value plus transaction costs at the date of extinguishment. The difference between –the carrying amount of a financial liability (or part of it) extinguished or transferred to another party and –the consideration paid, including any non-cash assets transferred or liabilities assumed, is recognised in profit or loss.

34. © 2008-11 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 17) - 34 Chapter 17 Financial Liabilities and Derecognition