1 Financial Assets and Financial Liabilities (HKAS 39) Date: December 20, 2008

2 Contents Initial Recognition and Measurement Classification of Financial Assets Measurement of Financial Assets Reclassification of Financial Assets

3 Financial instrument is any contract that gives rise to financial asset of one entity and a financial liability or equity instrument of another entity Definition

4 Recognition Recognise a financial assets or financial liabilities on its balances sheet when and only when it becomes a party to the contractual provision of the instrument. e.g. trade receivable, forward contract, financial options

5 The entity can use “ trade date accounting ” or “ settlement date accounting ” to recognise the financial assets if it is a “ regular way ” purchase or sale of financial assets The method used shall be applied consistently “ Regular way ” purchase or sale contract is a purchase or sale of financial assets that requires delivery of the assets within the time frame generally established by regulation or convention in the market place concerned

6 Example On June 28, 20x1, Z company commits to purchase 1,000 share for HK$2,000 (including transaction costs). On July 3, 20x1 (settlement date), the fair value of the shares HK$2,100. The shares are classified as “held for trading”. Z company has 31 Dec. accounting year ends. Trade date accounting June 28, 20x1 Dr. Investment in sharesHK$2,000 Cr. Accounts payableHK$2,000 July 3, 20x1 Dr. Accounts payableHK$2,000 Cr. Bank/CashHK$2,000 Dr. Investment in sharesHK$100 Cr. Unrealised gainHK$100 Settlement date accounting June 28, 20x1 No entry required July 3, 20x1 Dr. Investment in sharesHK$2,100 Cr. Bank/CashHK$2,000 Cr. Unrealised gainHK$100

7 Initial Measurement Financial assets or liabilities shall be measured at its fair value upon initial recognition However, financial assets or liabilities not “ at fair value through profit or loss ” shall be measured at fair value plus transaction cost that are directly attributable to the acquisition or issue of the financial assets or liabilities (e.g. fee and commission paid to brokers; levied by regulatory agencies and securities exchange)

8 Classification of Financial Assets For the purpose of measuring a financial asset subsequent to initial recognition, HKAS 39 classifies financial assets into 4 categories -financial assets “ at fair value through profit or loss ( “ FVPL ” ) -held to maturity ( “ HTM ” ) -loans and receivables -available for sales financial assets ( “ AFS ” )

9 Financial assets at fair value through profit or loss (a) Financial assets at fair value through profit or loss -Financial assets classified as held for trading -initial recognition financial assets are designated by the entity as at fair value through profit and loss

10 Held to maturity investment (b) Held to maturity investment are -non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity other than 1. those that the entity upon initial recognition designates as at “FVPL” 2. those that the entity designates as “available for sale” 3. those that meet the definition of “loans and receivable”

11 Loans and receivable (c) Loans and receivable are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than: 1.those that the entity intends to sell immediately or in the near term, which shall be classified as “ held for trading ”, and those that the entity upon initial recognition designates as at “ FVPL ” 2. those that the entity upon initial recognition designates as “ available for sales ” 3. those for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which shall be classified as “ AFS ”

12 Both loans and receivables and HTM investments are non-derivative financial assets with fixed or determinable payments, their differences are that - Fixed maturity is required for HTM investment but not required for loans and receivable - Position intention and ability to hold to maturity investments is required for HTM investments but not required for loans and receivable - Loans and receivables cannot be a financial assets for which the holder may not recover substantially all of is initial investment, other than because of credit deterioration - Loans and receivables must not be quoted in an active market but such requirement is not imposed on HTM investment - Loans and receivables are not subject to tainting rule, which is applied to HTM

13 Available for sale financial assets (d)Available for sale financial assets are those non- derivative financial assets that are designated as available for sale or all the other non-derivative financial assets that are not classified as 1. FVPL 2. HTM 3. Loans and receivable

14 Tainting Rule The rule for classification as HTM is tainted when 1. There is an change in the intention or ability to hold the investment until maturity date; or 2. A more than insignificant amount HTM has been disposed of. Once the rule is tainted, all HTM investment have to be re-classified as AFS investments and the entity is not allowed to classify any investment as HTM for next 2 accounting periods, both at the company level as well as group level.

15 Subsequent Measurement HKAS 39 provides that after initial recognition 1. Financial assets at FVPL and AFS financial assets (including derivatives that are assets) shall be measured at their fair value 2. Loans and receivable and HTM shall be measured at amortised cost, using the effective interest rate method 3. Investment in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured which shall be measured at cost

16 Example 1 X Ltd acquires the following shares in the HKSEx on 1/11/20x1, which it intends to sell the early 20x2 to take advantage of the expected changes in the share prices a) 100,000 ordinary shares of ABC Ltd at HK$2 per share plus transaction costs of HK$3,000; and b) 200,000 ordinary shares of DEF Ltd at HK$3 per share plus transaction costs of HK$5,000 At its accounting year end on 31/12/x1, the shares are quoted at the HKSEx at the following prices - Ordinary shares of ABC Ltd : HK$1.5 per share - Ordinary shares of DEF Ltd : HK$4 per share

17 Example 1 In this case, the shares will be classified as “held for trading”, and the accounting treatment required under HKAS 39 will be as follow 1/11/x1 Dr. FVPLHK$800,000 Dr. ExpensesHK$8,000 Cr. Bank/Cash HK$808,000 31/12/x1 Dr. FVPLHK$150,000 Cr. Unrealised gainHK$150,000 In the balance sheet as at 31/12/x1, the FVPL will be presented at its fair value of HK$950,000 In the income statement for the year ended 31/12/x1, the unrealised gain on FVPL of HK$150,000 and the expenses of HK$8,000 will be recognised in income statement for the year.

18 Example 2 Refer to previous example. Assume that the shares were acquired as long term investments, and therefore are classified as “ Available for Sales ” Assuming further that at its accounting year ended on 31/12/x2, the shares are quoted at the HKSEx at the following prices a) Ordinary shares of ABC Ltd : HK$1.3 per share b) Ordinary shares of DEF Ltd : HK$3.1 per share 15/11/20x1 Dr. AFSHK$808,000 Cr. Bank/CashHK$808,000 31/12/20x1 Dr. AFSHK$142,000 Cr. ReservesHK$142,000

19 Example 2 31/12/20x2 Dr. ReservesHK$200,000 Cr. AFSHK$200,000 In its 20x1 financial statements a)AFS will be presented at its fair value of HK$950,000 in the balance sheet b)the gain in AFS of HK$142,000 will be presented as part of shareholder ’ s equity in the balance sheet In its 20x2 financial statements a) AFS will be presented at its fair value of HK$750,000 in the balance sheet b)the loss in AFS of HK$58,000 will be presented as part of shareholders ’ equity in the balance sheet.

20 Example 3 On Jan 1, 20x1, MH Ltd pays HK$104,330 to acquire a bond which has a nominal value of HK$100,000, a coupon rate of 6% interest payable on Dec 31 each year and matures on Dec 31, 20x5. MH Ltd has intended and has the ability to hold the bond until maturity date and therefore classifies the bond as “ HTM ” investment. The effective interest rate in this case is 5 % InterestInterestCarrying incomereceivedamount 1/1/x1104,330 31/12/x15,2166,000103,546 31/12/x25,1776,000102,723 31/12/x35,1366,000101,859 31/12/x45,0936,000100,952 31/12/x55,0486,000100,000

21 Example 3 The relevant journal entries are as follows 1/1/x1 Dr.HTM104,330 Cr.Bank/Cash104,330 31/12/x1 Dr.Bank/Cash6,000 Cr.HTM Bond784 Cr.Interest income5,216 31/12/x2 Dr.Bank/Cash6,000 Cr.HTM Bond823 Cr. Interest Income5,177 31/12/x3 Dr.Bank/Cash 6,000 Cr. HTM Bond 864 Cr. Interest income 5,136 31/12/x4 Dr.Bank/Cash6,000 Cr. HTM Bond 907 Cr. Interest income 5,093 31/12/x5 Dr.Bank/Cash106,000 Cr. HTM Bond 952 Cr. Interest income 5048

22 Financial Assets - Impairment HKAS 39 provides that all financial assets, except those measured at fair value through profit or loss, are subject to impairment test. A financial asset is impaired if its carrying amount is greater than its estimated recoverable amount. The recoverable amount of the various categories of financial assets are determined as follows: -for a financial asset carried at amortised cost, it ’ s recoverable amount is the present value of expected future cash flows discounted at the financial asset ’ s original effective interest rate -for unquoted equity instrument that is not carried at fair value because its fair value cannot be reliably measured, its recoverable amount is the present value of expected future cash flows discount at the current market rate of return for a similar financial assets -for available for sale financial assets, its recoverable amount is the current fair value.

23 If in a subsequent period, the amount of the impairment loss decreases and the decrease can be objectively related to an event occurring after the write-down, such as improvement in the debtor ’ s crediting, HKAS 39 requires reversal of the impairment loss to be accounted for as follows: - for financial assets carried at amortised cost, the write-down for impairment loss shall be reversed and recognised in profit and loss for the period; however, the reversal shall not result in a carrying amount of the financial asset that exceeds what the amortised cost would have been, had the impairment not been recognised at the date the write-down of the financial asset is reversed -for financial assets carried at cost, HKAS 39 specifically prohibits the reversal of impairment losses -for financial assets classified as “ available for sale ”, the reversal of impairment loss is accounted for differently depending on whether the financial asset is a debt or equity instrument a) for debt instrument, the reversal of impairment loss shall be recognised in the profit or loss for the period b) for equity instrument, the reversal should not be accounted through profit or loss, instead it should be accounted for through the reserve.

24 Financial Assets - Impairment Refer to example 3 Assume that after paying the second interest payment on Dec 31, 20x2, the issuer of the bond announced that, due to financial difficulty, the coupon rate of the bond is to be reduced to 1% (instead of 6%) for each of the next three years, with no change to the face value of HK$100,000. In this case, there is an impairment loss The recoverable amount is to be calculated as the present value of the expected future cash flows discounted at the original effective interest rate of 5%, which yields a figure of HK$89,107 InterestEffective interestPresent incomeratevalue 31/12/x31,0005%952 31/12/x41,0005%907 31/12/x5101,0005%87,248 89,107

25 Given that the carrying amount of the bond as at Dec 31, 2002 is HK$102,723, MH Ltd has to change an impairment loss of HK$13,616 to its 20x2 income statement, as follows: 31/12/x2 Dr.Impairment loss13,616 Cr.HTM 13,616 The journal entry for each of the next three years will be as follows 31/12/x3 Dr. Bank/Cash1,000 Dr. HTM3,455 Cr. Interest income4,455 31/12/x4 Dr.Bank/Cash1,000 Dr. HTM3,628 Cr.Interest income4,628 31/12/x5 Dr. Bank/Cash101,000 Cr. HTM96,190 Cr.Interest income4,810

26 On Oct 15, 20x1, MH Ltd acquires 100,000 ordinary shares of CS Ltd at HK$2 per share plus transaction costs of HK$3,000. The shares are acquired as long term investments and classified as “ available for sale ” investments. CS Ltd ’ s ordinary shares are quoted at HK$1.8 per share on Dec 31, 20x1 and at HK$1.5 per share on Dec 31, 20x2. On Dec 31, 20x3, CS Ltd ’ s factory and production facilities are destroyed in a fire, uninsured, and its ordinary shares are quoted at HK$0.8 per share. Assume further that in late 20x4, it was found that the fire was the work of an arsonist, the CS Ltd is able to recover the fire loss from the arsonist. The share price recovers and is quoted at HK$1.6 per share at Dec 31, 20x4.

27 In this case, the relevant journal entries required under HKAS 39 are as follows: 15/10/x1 Dr. AFS203,000 Cr. Bank/Cash203,000 31/12/x1 Dr. Reserve23,000 Cr. AFS23,000 31/12/x2 Dr. Reserve30,000 Cr. AFS30,000 31/12/x3 Dr. Impairment loss on AFS53,000 Cr. Reserve53,000 Dr. Impairment loss on AFS70,000 Cr. AFS70,000 31/12/x4 Dr. AFS80,000 Cr. Reserve80,000 If the AFS is a debt security, the journal entry as 31/12/x4 will be as follow: Dr. AFS 70,000 Cr. Recovery of impairment 70,000 Dr. AFS 10,000 Cr. Reserve 10,000

28 Reclassification of Financial Assets Fair Value through Profit or Loss An entity shall not reclassify a financial instrument into or out of the fair value through profit or loss category while it is held or issued. On Oct 13, 2008, the IASB issued amendments to IAS 39 and IFRS 7 that permit the reclassification of some financial assets. On Oct 14, 2008, the HKICPA announced to issue equivalent amendments. (Discuss later)

29 Available for sales (recl. to loans and receivable) For financial assets met the definition of loans and receivable A financial asset classified as available for sale that would have met the definition of loans and receivable maybe reclassified out of the available for sale category to the loans and receivables category If the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity Reclassification of Financial Assets

30 Available for sales (recl. to held to maturity) In case of 1) A change intention or ability; 2) In the rare circumstance, a reliable measure of fair value is no longer available; or 3) Tainting rule expires Then, it becomes appropriate to carry a financial asset at cost or amortised cost rather than at fair value The fair value carrying amount of the asset on that date becomes its new cost or amortised cost, as applicable Any previous gain or loss on that asset that has been recognised directly in equity shall be accounted for as follows: a) in case of a financial asset with a fixed maturity The gain or loss shall be amortised to P/L over the remaining life of the HTM investment using the effective interest method b) in case of a financial asset that does not have a fixed maturity the gain or loss shall remain in equity until the financial asset is sold or otherwise disposed of, when it shall be recognised in P/L Activity 1 Reclassification of Financial Assets

31 Activity 1: Reclassification of Debt Instrument On January 2, 2008, Bonnie Singapore Limited reclassified its investment in 6% debt instrument with a cost of $105,998 and a fair value of $113,815 from available-for-sale financial assets to held-to-maturity investment. The debt instrument pays 6% interest annually on June 30 and has a maturity value of $120,000 on December 31, 2010 Question: Discuss the implication of the reclassification and suggest journal entries.

32 Held to maturity (recl. to available for sale) A change in intention or ability 1) reclassified as AFS financial assets 2) re-measured at fair value 3) the difference between its carrying amount and fair value shall be recognised directly in equity Tainting rule Any remaining HTM investments shall be reclassified as AFS financial assets On such reclassification, the difference between their carrying amount and fair value shall be recognised directly in equity Reclassification of Financial Assets

33 Amendment of HKAS 39 for the reclassification of financial instrument (FI) published in October 2008 Effective from July 1, 2008

34 An entity shall not reclassify a derivative out of the fair value through profit or loss category while it is held or issue shall not reclassify any financial instrument out of the fair value through profit or loss category if upon initial recognition it was designated by the entity as at fair value through profit or loss; and May, if a financial asset is no longer held for the purpose of selling or repurchasing it in the near term, reclassify that financial asset out of the fair value though profit or loss category if the requirements in HKAS39.50B or 50D are met An entity shall not reclassify any financial instrument into the fair value through profit or loss category after initial recognition Amendment of HKAS 39 for the reclassification of financial instrument

35 Implication An entity is permitted to reclassify non-derivative financial assets held for trading out of the fair value through profit or loss category in particular circumstances; to transfer from the available for sale category to the loans and receivables category a financial asset that would have met the definition of loans and receivable, if the entity has the intention and ability to hold that financial asset for the foreseeable future Amendment of HKAS 39 for the reclassification of financial instrument

36 Amendment of HKAS 39 for the reclassification of financial instrument Reclassification of financial assets held for trading A non-derivative financial asset held for trading may be reclassified out of the fair value through profit or loss category only in rare circumstances

37 Measurement on the reclassification date If an entity reclassified a financial asset out of the fair value through profit or loss category The financial asset shall be reclassified at its fair value on the date of reclassification Any gain or loss already recognised in profit or loss shall not be reversed The fair value of the financial asset on the date of reclassification becomes its new cost or amortised cost, as applicable For financial assets met the definition of loan and receivable A financial asset to be reclassified that would have met the definition of loans and receivables may be reclassified out of the fair value through profit or loss category if the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity Amendment of HKAS 39 for the reclassification of financial instrument

38 Is the FI a derivative a liability or financial asset designated at FVTPL at initial recognition? Is the financial asset classified at Held for trading No Reclassification amendment is not “permitted” Is the financial asset classified at Available for Sale? No Could the financial asset be classified as LaR at date of reclassification Yes Could the financial asset be classified as LaR at date of reclassification Yes Does the entity intend and have the ability to hold the financial asset in the foreseeable future or until maturity Yes Is the situation rare? No Reclassification amendment of HKAS is relevant Disclosure requirement of HKFRS 7.12 Fair Value at reclassification date is the new (amortised) cost Subsequent increases in future cash receipts as a result of increased recoverability will be spread over the life of the instrument (revised HKAS 39 AG8) Yes Reclassification amendment is not “relevant” Reclassification amendment of HKAS is relevant The asset may be reclassified to any category, provided the instrument meets the definition of that category per HKAS 39.9 Yes The asset may be reclassified to LaR No

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