Financial instruments: the devil is not so black? Part 2.

Piotr STASZKIEWICZ
Audit Partner at RSM Poland

In one of our latest articles we have presented several of the most popular financial instruments, both simple and more complex. As auditors, we quite often see doubts concerning their disclosures and measurement, and it is not just about the most popular ones like e.g. futures, finance lease or loan agreements, but also about those less common in business practice, like e.g. debt securities convertible into common shares, bonds and call options for shares of another entity.

Outline of classification of financial assets according to IFRS 9 on the example of bonds

Today we are going to take a closer look at the measurement of bonds, both those issued and purchased by the entity, in the light of a new model of classification and measurement presented in IFRS 9, focusing on the approach to financial instruments presented in IFRS. What we must have in mind, however, is that according to the Accounting Act (and the Regulation of the Minister of Finance on Financial Instruments, hereinafter: RMFIF), the classification of a given transaction as a financial instrument may differ from the approach of international standards. The next stumbling block is the measurement. But let us look at it one by one.

Bonds, meaning what?

Bonds are securities, under which the issuer owes the bond holder a debt and has a certain performance obligation towards the bond holder. As a reminder, according to the AA, issued bonds are financial liabilities measured at the adjusted purchase price (only financial liabilities held for trading shall be measured at fair value, according to the Polish balance sheet law). As regards purchased bonds, depending on their purpose, they may be recognised and measured according to the following categories:

• assets held for trading purposes;
• assets held to maturity (HTM);
• assets available for sale.

There is also another group of financial assets being loans and receivables (LAR), but, as the name suggests, this closed group does not include bonds.

As a rule, financial assets are measured at fair value, but LAR (not available for sale) and HTM (hence often also bonds) are measured at adjusted purchase price. Clearly, you need to consider and determine:

• if you can determine the fair value in a reliable way;
• if maturity is known;
• what if we are dealing with hedging instruments or instruments in foreign currencies.

RMFIF regulations are useful here; however, they are not being discussed here. Therefore, summing up, bonds with a known maturity should be measured with an effective interest rate.

One might think that IFRSs have an equally interesting approach to the classification and measurement of financial instruments. And they really do. In particular after the changes that have been introduced over the last years. Until recently, IAS 39 prescribed a classification of financial assets similar to the above and on the basis of the Polish balance sheet law (hence, broken down into loans and receivables, held to maturity, available for sale, and fair value through profit or loss). But that is already history[1].

Today, the following seems fundamental for the appropriate classification and measurement of financial assets according to IFRS 9:

• division of financial assets according to what they are, i.e. what type of instrument they represent (step I);
• cash flow characteristics test (hereinafter: SPPI[2]) for debt instruments (step II); business model test to answer some ancillary questions (step III).

In step I, you classify financial assets as either:

• debt instruments;
• derivatives;
• equity instruments.

The proper classification of a bond that we took as an example, is a prerequisite for further steps. If this bond is properly classified as a debt instrument, it will undergo the SPPI test which we will discuss in the upcoming articles on our blog. The SPPI test can be positive or negative: a bond that tests negative shall be measured at fair value through profit or loss, whereas if it tests positive, it shall move on to the next step, where a business model test shall be made, namely you must determine if:

• the bond  is held with the objective of collecting contractual cash flows;
• the bond is held with the objective of collecting contractual cash flows and selling it;
• none of the above.

If the first option is correct, the bond shall be measured at amortised cost. If the second option is correct, the bond shall be measured at fair value through other comprehensive income recognised in profit or loss. If the last option is the correct one, the bond shall be treated as a derivative and measured at fair value through profit or loss. The diagram below is a summary:

We will most probably refer to this diagram more than once when discussing the classification and measurement of financial assets in our articles to come. Finally, I am obliged to give you the principles of measurement of bonds being your financial liabilities. In this case, as set forth by the Polish balance sheet law, the amortised cost method shall be applied, which is in line with IFRS 9, paragraphs 4.2.1 and 4.2.2., to be precise, stating clearly that all financial liabilities, including bonds we discuss, must be measured with this method, unless the entity decides to measure financial liabilities at fair value through profit or loss, provided that e.g. this will give more accurate and more appropriate data than in the amortised cost scenario.

We encourage you to follow our articles on the blog: the upcoming one will discuss the SPPI test.