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IAS 39 defines financial liability is any liability that is a contractual obligation to deliver a financial asset to another entity; or to exchange financial instruments with another enterprise under conditions that are potentially unfavourable to the entity.
An equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities and there is no contractual obligation to deliver cash or another financial asset to another entity.
It is very important for entity's to differentiate between equity and liabilities on their balance sheet. The point is commonly known as debt versus equity which is a great concern for businesses because instruments classified as liabilities rather than equity affects a company's gearing and solvency ratios.
For further classification; an instrument is classified as equity when it represents a residual interest in the issuer's assets after deducting all its liabilities. Ordinary shares or common stock, where all the payments are at the discretion of the issuer, are examples of equity of the issuer.
For liability instrument has to have terms such that there is an obligation on the enterprise to transfer financial assets to redeem the obligation regardless of its legal nature. For example preferences shares are the main instrument where substance they could be liabilities but legally are equity. They are treated as liabilities because annual dividends are compulsory and not at the director's decision and also it gives the holder the choice to redeem upon the occurrence of a future event that is highly likely to occur.
The fundamental principle of IAS 32 is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form, and their definitions. The decision is made at the time when instrument is recognised and is not changed due to changes in circumstances.
IAS 32 currently requires a financial instrument to be classified as a liability if the holder of that instrument can require the issuer to redeem it for cash for example Redeemable Preference shares which have to be repaid by the company after the term of which for which the preference shares have been issued. Therefore they are liability because these can be cashed (redeemed) by the company at set dates there is an outflow of economic benefit.
However Irredeemable Preference shares means preference shares need not repaid by the company except on winding up of the company. Company pays fixed dividends every six months.
The methodology is complaint to the Framework Document to the extent which matches the definition of recognising Liabilities and equity. The Framework Document suggests that you recognise an item in the balance sheet once it's probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.
Many users of financial statements and other interested parties think requirements in IAS 39 are difficult to understand, relate and interpret. They have urged the Board to develop a new standard of financial reporting for financial instruments that is principle-based and less complex.
Exposure draft is proposed version of a document which is issued for open discussion earlier before its release as a final document by IASB and welcomes other authorities to comment. One of the recent exposure drafts of Financial Liabilities is Classification and Measurement which proposes changes in the accounting for financial liabilities that an entity chooses to measure at fair value.
Fair Value Option proposed the two-step approach which would address the P&L volatiliy arising from own credit. The first step is where the liability is changed because of fair value under the fair value option would be recognised in profit and loss. In second step approach the portion of the fair value changed because of own credit would be reversed out of P&L and recognised in other comprehensive income.
According to the current requirement you have to address the total change in fair value under the Income Statement Before profit for the year.
Changes in a financial liability's credit risk affect the fair value of that financial liability. This means that when an entity's creditworthiness fails, the fair value of the issued debt will decrease. For financial liabilities measured using the FVO this causes a gain (or loss) to be recognised in the P&L.
Recently IAS 39 has been a source of debate within financial markets especially among commercial banks.
IAs39 requires entities to value derivatives, shares, and bonds at fair value not at historical costs. But does not recognise macro-hedging and internal-risk transfers. However, banks are heavy users of macro-hedging and inter-group transfers of risks. Not recognising macro-hedging would mean that marked-to-market changes in the value of derivative position would be booked to earnings and would raise volatility. If recongnised, derivatives position would be booked to equity and not earnings. Banks have opposed IAS 39 because they believe that it could damage their risk management practice
(source IMF 2005A:250)
On 5 November 2009, (IASB) issued ED/2009/12, Financial Instruments: Amortised Cost and Impairment relates to two areas of financial reporting; interest margin and how to include credit loss expectations in the amortised cost measurement of financial assets.
The ED applies to all financial assets held at amortised cost. It requires an entity to determine the expected credit losses on a financial asset when first obtained and reassess them at the end of each period. If any changes occur over the life of instrument should be recognised immediately in credit loss expectations.
'to provide information about the effective return on a financial asset or financial liability by allocating interest revenue or interest expense over the expected life of the financial instrument
Exposure draft proposes to strengthen the objective of amortised cost measurement with measurement principles. Amortised cost is the present value of the expected cash flows over the remaining life of the financial instrument discounted using the effective interest rate.
The exposure draft proposes stating the objective of presentation and disclosure in relation to financial instruments measured at amortised cost. The proposed description of the objective is providing 'information that enables users of the financial statements to evaluate the financial effect of interest revenue and expense, and the quality of financial assets including credit risk.' The exposure draft further emphasises the importance of explaining to users of the financial statements the overall effect on the entity's performance and financial position and the interaction between different aspects of the information provided (including a discussion of the causes of both that overall effect and any interaction between different aspects).
The measurement approach requires an entity to take into account the amount of expected credit losses when calculating amortised cost and allocate that amount over the expected life of asset.
ED propose that the presentation of SOCI should separately present results of gains and losses from changes in estimates in relation to financial assets and liabilities that are measured at amortised cost as well as interest expense.