Financial Instruments

Welcome to the Management
Development Programme
on
Accounting for Financial
Instruments

Accounting for Financial Instruments
Session 1 : Introduction to Financial Instruments [
9.30 – 11.00 AM]
• Introduction to financial instruments standards
• Definition of financial instruments
• Definition of financial asset, financial liability and
equity
• Puttable Instruments as equity
• Obligation for pro-rata distribution in liquidation as
equity
• Financial Guarantee

Session 2 Financial Assets & Financial Liabilities
[ 11.00 – 12.00 hrs]
• Classification of financial assets and financial liabilities
• Measurement of financial assets and liabilities at initial
recognition and subsequent measurement
• Fair value measurement issues
• Amortised cost accounting
• Reclassification
• Derecognition

• Session 3 : Compound financial Instruments &
Embedded Derivatives
[ 12.00-13.00 hrs]
• Separation of Convertible Debentures
• Separation of embedded derivatives

• Session 4 Hedge Accounting
[ 14.00 – 15.30 hrs & 15.45- 17.00 hrs]
Hedged item
Hedging Instruments
Hedging relationships
Fair value hedge , cash flow hedge and hedging
net investment in foreign operations

• Session 5 : Financial Instruments : Disclosures
[ 17.00- 17.30 hrs]

9.30 – 11.00 AM]
• Introduction to financial instruments
standards
equity
equity

Introduction of financial Instrument
standards
• Financial instruments standards evolved through a
sustained effort of the International Accounting
Standards Committee ( the IASC), the predecessor of
the International Accounting Standards Board ( the
IASB) which began a project, jointly with the Canadian
Institute of Chartered Accountants ( CICA) , to develop
a comprehensive Standard on the recognition,
measurement, and disclosure of financial instruments.
• The process began with the issuance of Exposure Draft
E40 Financial Instruments issued in September 1991.

Emergence of IAS 32
• Standards on financial instruments were
developed in different phases . The IASC (the
predecessor of the IASB) approved IAS 32
Financial Instruments : Presentation and
Disclosures in 1995.
• In August 2005, the IASB expanded the disclosure
aspects of IAS 32 by issuing a separate
International Financial Reporting Standard 7 (IFRS
7) Financial Instruments: Disclosures.
Consequently, the title of IAS 32 was changed to
Financial Instruments: Presentation.

Emergence of IAS 39
• IAS 39 was issued in December , 1998 which became
effective for annual periods beginning on or after 1
January, 2001.
• The International Accounting Standards Board (IASB)
succeeded the IASC in 2001. In 2002, in response to
practice issues identified by audit firms, national
standard- setters, regulators and others, and issues
identified in the IAS 39 implementation guidance
process, the IASB proposed changes to both IAS 32 and
IAS 39. It issued revised versions of both the standards
in December 2003.

IAS 39 Implementation Guidance
• In July 2001, Accounting for Financial
Instruments - Standards, Interpretations, and
Implementation Guidance was issued to assist
financial statement preparers, auditors,
financial analysts, and others to understand
IAS 39, and to ensure consistent application
of the Standard.

Project to Replace IAS 39
• The IASB intends to replace IAS 39 in phases by IFRS 9 . IAS 39
replacement project was adopted out of its joint project with FASB
“ Reducing Complexity in Reporting Financial Instruments” ( March
2008) , and noted deficiencies of IAS 39 to cope with the scenarios
arising out of economic recession. The replacement project is
dividend into three phases –
• Phase 1: Classification and measurement of financial assets and
financial liabilities
• This phase had been completed in 2010. IFRS 9 contains the
outcome of this phase.
• Phase 2: Impairment methodology ( work-in-progress)
• Phase 3: Hedge accounting ( work-in-progress).
• The latest version of IAS 39 only contains impairment and hedge
accounting.

Emergence of IFRS 9
• On 12 November 2009, the IASB published IFRS 9 Financial
Instruments which covers the classification and measurement of
financial assets. The Board finalised this phase in time to allow, but
not require, early application for 2009 year-end financial
statements.
• In October 2010, requirements relating to the classification and
measurement of financial liabilities were included to IFRS 9.
• This includes requirements on embedded derivatives and how to
account for own credit risks for financial liabilities that are
measured at fair value.
• Most of the ‘added requirements’ were carried forward unchanged
from IAS 39.
• In December 2011 the IASB deferred the effective date to January
2015.
•

IFRS 7
• IFRS 7 Financial Instruments: Disclosures was issued in
2005 relocating disclosure portion of IAS 32 ( 1995) and
including relevant disclosure issues contained in IAS
30 Disclosures in the Financial Statements of Banks and
Similar Financial Institutions (1990).
• IFRS 7 disclosures are intended to enable users of the
financial statements to evaluate:
- the significance of financial instruments for the entity’s
financial position and performance; and
- the nature and extent of risks arising from financial
instruments, and how the entity manages those risks.

Accounting standards in India
• In India , the following standards were issued:
AS 30 Financial Instruments : Recognition &
Measurement [Equivalent to IAS 39]
AS 31 Financial Instruments : Presentation [
Equivalent to IAS 32]
AS 32 Financial Instruments : Disclosures [
Equivalent to IFRS 7]
Application of these standards are deferred.

Accounting standards in India
• The following standards were issued in the
process of IFRS convergence:
Ind-AS 39 Financial Instruments : Recognition &
Measurement [Equivalent to IAS 39]
Ind-AS 32 Financial Instruments : Presentation [
Equivalent to IAS 32]
Ind-AS 107 Financial Instruments : Disclosures [
Equivalent to IFRS 7]
India has to initiate the process of upgrading Ind-AS
39 to Ind-AS 109 in the line of the developments of
IFRS.

Purpose of IAS 32
• IAS 32 Financial Instruments : Presentation
defines financial assets , financial liabilities and
equity and sets out principles for -
• distinguishing financial liabilities and equity
instruments;
• recognition of compound financial instruments;
• presentation of treasury shares ;
• recognition of interest , dividend , losses or gains
; and
• offsetting financial assets and financial liabilities.

Purpose of IAS 39
(i) definition of derivatives ;
(ii) classification of financial instruments into four categories ,
namely , held for trading, held to maturities , loans and
receivables , and available for sale.
(iii) principles to be followed for recognition and de-
recognition of various categories of financial instruments ;
(iv) trade date and settlement date accounting;
(v) accounting for embedded derivatives ;
(vi) reclassification of financial assets and financial liabilities;
(vii) impairment and uncollectibility of financial assets ; and
(viii) hedge accounting

Purpose of IFRS 9
• IASB intends to replace IAS 39 in its entirety by
IFRS 9 . Till date only Phase I is complete

Purpose of IFRS 7
• Categories of financial assets and financial liabilities ;
• Financial assets or financial liabilities at fair value through profit or
loss ;
• Financial assets measured at fair value through other
comprehensive income;
• Reclassification ;
• Offsetting financial assets and financial liabilities ;
• Collateral ;
• Allowance account for credit losses ;
• Compound financial instruments with multiple embedded
derivatives;
• Defaults and breaches;
• Items of income, expenses, gain or losses;
• Disclosures regarding hedge accounting.

9.30 – 11.00 AM]
equity
equity

Meaning of Financial Instruments
• Financial Instrument is a contract that gives rise to a
financial asset to one entity, and a financial liability or an
equity instrument to another entity.
• Financial instruments include primary financial
instruments like receivables , payables, loans and advances,
debentures and bonds , investments in equity instruments,
cash and bank balances, derivative instruments like options
, futures, forwards , swaps, cap , collar, floor , forward rate
agreement ( FRA) , etc.
• A derivative with a positive value is financial asset and with
negative value is financial liability.
• In certain cases even a contract to buy or sell non-financial
item may give rise to a financial asset or a financial liability.

Contractual Characteristics
• Liabilities or assets that are not contractual (such as
income taxes that are created as a result of statutory
requirements imposed by governments) are not
financial liabilities or financial assets. Accounting for
income taxes is dealt with in accordance with IAS 12
Income Taxes. For example, tax liability and related
advance payment of tax do not arise out of contract.
Rather they arise out of legal requirements. So they
are not treated as financial instruments.
• Constructive obligations, as defined in IAS 37
Provisions, Contingent Liabilities and Contingent
Assets, do not arise from contracts and are not
financial liabilities.

Financial Instruments - analysed
• Contractual right – absolute or contingent
• Potential cash flows
• Lease contracts

Contracts to buy or sell non-financial
items treated as financial instruments
• A contract to buy or sell financial items is treated as
financial instrument when there is net settlement
instead of giving or taking delivery. The primary
identification criteria are –
- net settlement by exchange of cash or another financial
instruments ;
Net settlement may be explicit in the contract or by
practice followed by an entity while settling such
contracts;
- practice of short term profit taking by an entity ; and
- ready convertibility of the non-financial items into
cash.

9.30 – 11.00 AM]
• Definition of financial asset, financial
liability and equity
equity

Meaning of Financial Assets
(a) Cash – examples currency cash and bank deposit ; bank deposit reflects a
contractual right to receive cash; but gold bullion is a commodity.
(b) An equity instrument of another entity - example, investment in equity shares of
another company ;
(c) A contractual right -
(i) to receive cash or another financial asset from another entity , or
(ii) to exchange financial assets or financial liabilities with another entity for terms
which are potentially favourable ; and
(d) a contract that will or may be settled in the entity’s own equity instruments and is -
(i) non – derivative for which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments , or
(ii) a derivative which will or may be settled other than by exchange of a fixed
amount of cash or another financial asset for a fixed number of entity’s own equity
instruments.

Financial Liability
(a) a contractual obligation :
(i) to deliver cash or any other financial asset to another enterprise, and
(ii) to exchange financial instruments with another enterprise for terms which
are potentially unfavourable ,
(b) a contract that will or may be settled in the entity’s own equity instruments
and is –
(i) non – derivative for which the entity is or may be obliged to receive a
variable number of the entity’s own equity instruments , or
(ii) a derivative which will or may be settled other than by exchange of a fixed
amount of cash or another financial asset for a fixed number of entity’s own
equity instruments.
• Examples are accounts payable , bills payable , loans and advances payable ,
bank overdraft , debentures payable , outstanding expenses.

Note payable
• Example A note payable in government bonds gives
the holder the contractual right to receive and the
issuer the contractual obligation to deliver government
bonds, not cash. Is note payable a financial asset in the
hands of the holder , and financial liability in the hands
of the issuer.
• Analysis : In one type of financial instrument the
economic benefit to be received or given up is a
financial asset other than cash. In the given example ,
the bonds are financial assets because they represent
obligations of the issuing government to pay cash. The
note is, therefore, a financial asset of the note holder
and a financial liability of the note issuer.

Equity Instruments
• An Equity instrument is a contract that evidences a residual
interest in the assets of an entity after deducting all of its
liabilities.
• To be classified as an equity instrument, an instrument
must satisfy two conditions stated in Paragraph 16 (a) and
(b)
– (a) no contractual obligation to deliver cash , other financial
instruments to other entity or exchnage of financial
instruments in unfavourable terms to the issuer , and
- (b) settlement of any contract that requires exchange of
own equity must be a contract to exchange fixed number of
own equity.

Equity Instruments…
• No contractual obligation condition : To be classified as
equity , the instrument includes no contractual
obligation:
(i) to deliver cash or another financial asset to another
entity; or
(ii) to exchange financial assets or financial liabilities
with another entity under conditions that are potentially
unfavourable to the issuer. [ Paragrph 16(a), IAS32]
• An instrument that contains contractual dividend
clause, repayment clause or put option to the holder is
not an equity instrument.

Settlement of contract in fixed number of entity’s
equity : In case an instrument will or may be
settled in the issuer’s own equity instruments, and
it is :
(i) a non-derivative that includes no contractual
obligation for the issuer to deliver a variable
number of its own equity instruments; or
(ii) a derivative that will be settled only by the
issuer exchanging a fixed amount of cash or another
financial asset for a fixed number of its own equity
instruments. [Paragraph 16 (b), IAS 32].

Examples of equity instruments include -
• non-puttable ordinary shares,
• some puttable instruments (see paragraphs 16A and 16B of IAS
32),
• some instruments that impose on the entity an obligation to deliver
to another party a pro rata share of the net assets of the entity only
on liquidation (see paragraphs 16C and 16D of IAS 32),
• some types of preference shares (see paragraphs AG25 and AG26 of
IAS 32), and
• Warrants or written call option that allow the holder to subscribe
for or purchase a fixed number of non-puttable ordinary shares in
the issuing entity in exchange for a fixed amount of cash or another
financial asset.

Case Analysis 1
• A contractual right can be derivative as well. For
example , under a futures contract X Ltd. has
entered into 4 lots of Feb 2013 Futures contract
in MCX to buy 100 MT ( lot size 25 MT) of
Steelflat at an agreed price of Rs. 6,500 per MT.
There is a practice of settling the transaction net
based on settlement price of commodity
exchange futures . On 31 December , 2012 X Ltd.
finalises 3rd quarter accounts. As on that date
settlement price is Rs. 6,600 per MT. Should this
contract be classified as financial asset?

Solution to Case Analysis 1
• A commodity derivative contract that contains
a net settlement caluse is a financial
instrument. Derivative with a positive value is
financial asset. Under the contract, the
carrying amount of the financial asset was
Rs. 10,000 [ 100×(6600-6500)].

Financial Asset
• [ Advance payment to buy financial asset] Is
advance payment to acquire debentures of
another entity or Government T-Bills or equity
shares / preferences of another entity is a
financial asset?

• Analysis : Yes. Under Paragraph 11 ( c) (ii) of IAS
32 , advance payment signifies a contractual
right of the entity to receive a financial asset , so
it is a financial asset.

Case Analysis 2
• [ Contractual right to receive cash or another financial asset from another entity
- Investment in perpetual debt ]

Akash Investment Ltd. invested in 8% Perpetual debt of face value Rs. 10,000 issued
by Delhi Auto Ltd. . How should this instrument be evaluated as an item of financial
asset ?

Analysis : This instrument gives a contractual right to the holder ( Akash Investment)
to get a perpetuity of Rs. 800. It is measured in terms of present value applying
current market yield. Assuming current market yield of that type of perpetual debt
instrument is 7% , then it is valued at -
Rs. 800
------------- = Rs. 11,429.
7%

Similarly for Delhi Auto Ltd. it is a financial liability.

Case Analysis 3
• Redeemable shares - a fixed redemption date or
redemption at the holder's  discretion typically
results in liability classification
• A Ltd. issues 1,000 shares with a par value of Rs.
10 each. The holder of the shares has the option
to require the company to redeem the shares at
par at any given time. Whether these shares are
classified as equity or liability ? How would the
answer be different if the entity has the option to
redeem the shares ?

• These shares are classified as liabilities unless classified
as puttable instruments as equity under Paragraphs
16A & 16B , IAS 32. This is because A Ltd. does not
have the ability to avoid the obligation to redeem the
shares for cash should the holder exercise his option to
redeem the shares.
• If the option to redeem the entity's shares had instead
been at the discretion of the issuer, the shares would
have been classified as equity. In this case, the issuer
has a right to pay cash to buy back the shares but no
obligation to do so.

Case Analysis 4
• Shares with mandatory dividend payments
• B Ltd. issues preference shares with a par value of Rs.
100 each. The preference shares are non-redeemable
but require the entity to make annual dividend
payments @ 9 % on the par value. Are the preference
shares classified as equity ?
• Solution : No. Paragraph AG 26 , IAS 32 explains that
non-redeemable preference shares are classified as
equity if the dividend is optional but cumulative or
non-cumulative. In the given case, dividend payment is
mandatory so the preference shares are classified as
liability.

Case Analysis 5
• Financial instruments with payments based on profits
of the issuer
• X Ltd. issues 1,00,000 perpetual shares of Rs. 100 each
on which it is liable to pay a 10% of its profits in each
annual accounting period. Profit for this purpose
means PAT of the company. Are these shares classified
as equity ?
• Solution : No. An instrument which contains an
obligation to pay mandatory payments either on the
amount of par value of shares or as a percentage of
profit is classified as a financial liability.

Case Analysis 6
• X Ltd. has issued 1,00,000 non-redeemable
preference shares. The instruments contain a
condition that the issuer has to transfer a
property to the holder of the instrument if it
fails to make dividend payments. Should the
instrument be classified as an equity or a
financial liability?

• The instrument contains a contractual
obligation to pay dividend. As per Paragraph
20(a) , IAS 32 if the entity can avoid a transfer
of cash or another financial asset only by
settling the non-financial obligation, the
financial instrument is a financial liability. In
the given case, obligation to settle by transfer
of property creates an indirect obligation to
make the dividend payments, and the
instrument is therefore classified as a liability.

Preference shares
• Preference shares having mandatory
redemption by the issuer for a fixed or
determinable amount at a fixed or
determinable future date is a financial liability.
Similarly , preference shares which have
attached put option by which the holders
enjoy the right to require the issuer to
redeem the instrument at or after a particular
date for a fixed or determinable amount is
also classified as financial liability.

Preference shares
• Potential inability to redeem : Sometime it may
appear that issuer will be unable to meet the
redemption condition attached to preference
shares . There may be many reasons for this
inability important of which are insufficient
project cash flows , a statutory restriction ,
insufficient profits. However, the potential
redemption inability does not negate the
obligation.
• Despite of potential inabilities the preference
shares shall be classified as financial liability.

Preference shares
• Call option of the issuer : The preference
shares may have attached call option such
that the issuer can buy back those shares .
This call feature does not make the preference
shares automatically redeemable. This kind of
preference shares are classified as equity until
the issuer notifies its intention to call those
shares. Once the intention is notified , then
the preference shares are re-classified as
financial liability.

Preference shares
• Distribution feature : A compulsory
distribution of dividend at a fixed rate would
make the preference a financial liability. But if
the distribution ( cumulative or non-
cumulative) is to be approved by the Board it
loses the compulsory distribution feature and
classified as equity.

Classification of Equity
• Fixed test for non-derivative contract
• Fixed to Fixed test for derivative contracts

The fixed test for non-derivative
instruments
• A non-derivative contract that is to be settled by
delivering fixed number of entity’s own equity
instruments is an equity. A contract to deliver a
variable number of own equity instruments equal in
value to a fixed monetary amount on the settlement
date is classified as a financial liability.
• The underlying principle behind the fixed test is that
using a variable number of own equity instruments to
settle a contract can be similar to using own shares as
'currency' to settle what in substance is a financial
liability. Such a contract does not evidence a residual
interest in the entity's net assets. Equity classification is
therefore inappropriate.

Case Analysis 7
• [ Shares used as currency]
• Entity A issues a debt instrument for which it
receives Rs. 100,000. Under the terms of the
issue, Entity A will repay the debt in 3 years time
by delivering ordinary shares to the value of Rs.
145,000. Should this instrument be classified as
equity ?
• Solution : Entity A is using its own shares as
currency, and the instrument should therefore be
classified as a financial liability.

Case Analysis 8
• [ Shares to the value of a commodity]
• Entity B issues preference shares for Rs. 1,00,000. The
shares pay no dividend and will be settled in three years
time by Entity A delivering a number of its own ordinary
shares (which are correctly classified as equity) as are equal
to the value of 100 ounces of gold. Can the preference
shares be classified as equity under the fixed for fixed test?
• Solution : No. The shares must be classified as financial
liabilities as the delivery of ordinary shares to the value of
100 ounces of gold represents an amount that fluctuates in
part or in full in response to changes in a variable other
than the market price of the entity's own equity
instruments. [ IAS 32.21].

The Fixed for fixed test for derivative
instruments
• In the case of a derivative financial instrument which is to
be settled by an entity issuing its own equity instruments, it
is classified as equity if and only if the 'fixed for fixed' test is
satisfied.
• The fixed for fixed test is therefore typically crucial when an
entity issues (i) a convertible bond or (ii) share warrants or
options.
• Fixed for fixed test is satisfied in the derivative contracts
presented in the Table below. In case of the option
contracts , strike price indicates fixed cash to be exchanged
and lot size of the contracts specifies fixed number of own
equity to be exchanged in return. Similarly, forward /
futures price and lot size of forward/ futures contracts
satisfy fixed for fixed test.

9.30 – 11.00 AM]
equity
• Obligation for pro-rata distribution in
liquidation as equity

Puttable Instruments as Equity

• Generally, a puttable instrument is classified
as a financial liability not as an equity
instrument. Exceptions are set out in
Paragraphs 16A & 16 B of IAS 32.

Puttable Instruments as Equity..
• Conditions to be satisfied for classifying a
puttable instruments for classification as an
equity instrument ( Paragraphs 16A & 16B ,
IAS 32 ) are instrument specific and issuer
specific .

Instrument specific conditions
• Pro-rata distribution of net assets on
liquidation
• The puttable instrument is sub-ordinated to
all other classes of instrument. It has no prior
claim on the assets of the issuer on liquidation
before any other category of instrument nor it
is to be converted to reach the status of sub-
ordinated instrument.

Issuer specific Conditions

i. The issuer has no other financial instrument
which has expected cash flow that can be
attributable to the instrument over its life are – (a)
profit or loss , (b) change in recognised net assets
and (c ) fair value change in recognised and
unrecognised net asset of the entity ; and
ii The issuer has no other financial instrument
which has the effect of substantially restricting or
fixing the residual return to the puttable instrument
holders.

Example of puttable instruments as equity

• Example : An open-ended mutual fund issues units to the
unitholders which contains a repurchase feature , i.e. the unit
holders can offer their units for repurchase. Therefore , these units
are puttable instruments. Can they be classified as equity ?

• Solution : It is to be verified that whether (i) the open ended
mutual fund can issue only one class of units that ensures pro-rata
distribution of its net assets in the eventuality of liquidation of the
fund ; all units will then carry same features , (ii) such units are sub-
ordinated to all other liabilities of the fund , (iii) the obligation of
the issuer relates to only to repurchase or redeem the units and
(iv) expected return on units depends on the profit / loss of the
funds. If all the above-mentioned conditions are fulfilled , then by
virtue of IAS 32.16A and IAS 32.16B units of mutual funds having
repurchase feature can be classified as equity instruments.

Obligation to Pro-rata Distribution
• Instruments, or components of instruments,
that impose on the entity an obligation to
deliver to another party a pro rata share of
the net assets of the entity only on
liquidation are classified as equity on the
fulfilment of (i) instrument specific and (ii)
issuer specific conditions.

Instrument specific conditions
[ Paragraph 16 C, IAS 32]
i. The holder of the instrument is entitled to a pro rata share of the entity’s net assets
in the event of the entity’s liquidation. The entity’s net assets are those assets that
remain after deducting all other claims on its assets.

Net assets in event of entity’s liquidation
A pro-rata share in net asset per unit = ------------------------------------------------------
No of shares / units outstanding

This is multiplied by the number of units which a holder possesses.

ii. The instrument is sub-ordinated to all other classes of instrument. It has no prior
claim on the assets of the issuer on liquidation before any other category of
instrument nor it is to be converted to reach the status of sub-ordinated instrument.

iii. All instrument belonging to this class must have an identical contractual obligation
for the issuing entity to deliver a pro rata share of its net assets on liquidation.

Issuer specific Conditions
[ Paragraph 16D , IAS 32]
i. The issuer has no other financial instrument which has
expected cash flow that can be attributable to the
instrument over its life are – (a) profit or loss , (b) change
in recognised net assets and (c) fair value change in
recognised and unrecognised net asset of the entity; and
ii The issuer has no other financial instrument which has
the effect of substantially restricting or fixing the residual
return to the e instrument holders.

In case the entity cannot carry the tests under Paragraph
16D , the instrument having obligation to pro-rata
distribution is classified a financial liability.

Financial Guarantee
• A financial guarantee is a contract that requires the issuer to
make specified payments to reimburse the holder for a loss
that it incurs because a specified debtor fails to make a
payment when due in accordance with the original or
modified terms of a debt instrument.
• The issuer of such a financial guarantee would account for it
initially at fair value under IAS 39, and subsequently at the
higher of that amount initially recognised less cumulative
amortisation recognised in accordance with IAS 18 or the
amount determined in accordance with IAS 37.
• Guarantees based on an underlying price or index are
derivatives within the scope of IAS 39.

Financial Guarantee…
• The issuer has the choice to elect a financial guarantee
contract as an insurance contract and account for the same in
accordance with the accounting applicable to insurance
contracts.
• Therefore, the issuer may elect to apply either IAS 39 or IFRS 4
to such financial guarantee contracts.

Financial Guarantee : Case Analysis
• If a $10,000 loan is drawn down so that the borrower can acquire
machinery from a dealer, and a third party agrees to guarantee this
debt to the bank for a onetime premium of $250, for a loan term of
four years, that amount probably represents the fair value of the
loan guarantee, which should be recorded accordingly. If it qualifies
under IAS 18 for recognition as revenue on a straight-line basis, it
would be amortized to income at the rate of $62.50 per year.
• Assume that, subsequently, the machinery purchaser’s
creditworthiness is impaired by a severe downturn in its industry
segment performance, so that, by the end of the second year, the
fair value of this guarantee (which has two more years to run) is
$200. That could be measured, among other ways, by the onetime
premium that would be charged to transfer this risk to another
arm’s-length guarantor.

Financial Guarantee : Example 1 contd
• Since the carrying value of the liability is $125 after two years’
amortization has occurred, the higher of the amount determined under
IAS 37 or the carrying value, $200 must be reported in the statement of
financial position as the guarantee obligation. An expense of ($200 – $125
=) $75 must be recognized in the current (second) year as the cost of the
additional risk borne by the reporting entity (but note that $62.50 in fee
income is also being recognized in that year). The new book value, $200,
will be amortized over the remaining two years ratably, assuming that no
default occurs.
• Note that IAS 37 stipulates that the “best estimate” of the amount to be
reported as a provision is the amount that would rationally be offered to
eliminate the obligation. In general, this should match with the notion of
“fair value.” Both imply a probability-weighted assessment, which may be
made explicitly or implicitly depending upon the circumstances. Both also
imply a present value equivalent of future resource outflows, assuming
that the timing of such outflows could be estimated.

Sales inducement guarantee
• In case the guarantee is a sales inducement (e.g., when the
machinery dealer finds it must guarantee the buyer’s bank
loan in order to consummate the sale), and thus is
effectively a discount on the price otherwise obtainable for
the merchandise (or services).
• The full expense would be recognized at the date of the
transaction since this expense was incurred in order to
generate the sale; thus it is best “matched” against revenue
recognized in the current reporting period. The guarantee
liability is accounted for as set forth above (adjusted to the
higher of fair value or amortized original value, if
amortization is proper under IAS 18).

Financial Instruments

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