The Issuer Of Financial Instrument Should Classify Instrument Accounting Essay

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Revised IAS 32 establishes principles for liability and equity, according to the substance of financial instrument. The instrument should classified as a liability when the issuer can be required to deliver either cash or another financial asset to the holder. This is the critical feature that distinguishes a liability from equity.

An instrument is classified as equity when it represents a residual interest in the net assets of the issuer. That is the critical feature whether a financial instrument is a financial liability or a financial equity. We can classify the financial instrument according to the features. For example 1: if the issuer will be forced to redeem the instrument, it should classify as liability because the issuer will be required to deliver the cash or the assets 2: if the instrument is option instrument which give the right to the issuer that can use a fixed amount of cash to exchange a fixed shares, this should classify as a equity instruement.3: Some of the instruments should be split into liability and equity, as the convertible bond which converts into fixed number of shares.

The issuer of financial instrument should classify instrument. On the initial, the instrument must be classified as a financial asset, a financial liability or a financial equity instrument according to the definitions of the financial liability and financial asset and financial equity instrument. According to the Framework Document, One of the principal qualitative characteristics is reliability, when the issuer classifying a instrument the reliability must be compliant. Reliable information would display the true economic substance. When the instrument classified as a financial liability, this liability should be display in the Statement of the Comprehensive Income, the users and investors can know that the entity got obliged to meet. On the initial, if the issuer classify a instrument as a financial liability which should be classify as a financial equity, that will totally mislead the users. So the reliability is the crucial methodology which must be compliant in the Framework document.

Task 2:

According to the exposure draft Fair Value Option for Financial Liabilities, the own credit amount for financial liabilities an entity chooses to measure at fair value should be presented in the other comprehensive income, this process should occur through a two-step approach, this is the different from the former one which occur through a one-step approach. Under the two-step approach, the first step would be to measure the financial liability at its fair value, with the entire change in fair value being presented in profit or loss. And then, the second step would be to determine the amount of the change in fair value that is attributable to changes in the reporting entity`s credit risk. IFRS9 requires the own credit amount to be presented directly in OCI.

In the IFRS 9, when then financial liability is irrevocable at first step, this is an exception to the requirements for own credit amounts, where recognizing the own credit amount directly in OCI would create an accounting mismatch, in this circumstance, the entire fair value change to be recognised in profit and loss.

Compare One-step and Two-steps:

If a company has a financial liability which it values under the fair value option is100, the changes from own credit in fair value is 10.

One-step Tow-step

Income statement (P&L)

Liabilities under fair value option posed two-step approach

Income statement (P&L)

Liabilities under fair value option

Total change in fair value 100

Profit for the year 100

Step 1 - Total change in fair value 100

Step 2 - Change in fair value

from own credit (10)

Profit for the year 90

Statement of comprehensive income

Liabilities under fair value option

Step 2 - Change in fair value

from own credit 10

In the One-step methodology the 100 will be recognized in the Profit and Loss, in the Two-steps methodology 90 will be recognized in the Profit and loss, and then, 10 changes will be recognized in the OIC.

According to the new methodology, the volatility in the Profit and loss will now result from the changes in the own credit, the own credit will shown in the OIC. This requirement will affect large financial liabilities which should required measured at fair value.

In contrast to the latest requirements, Profit and loss resulted from own credit did not provide useful information to the users, and now, when an entity`s creditworthiness deteriorates, for the financial liabilities which measured under the fair value option, the loss to be recognized in the Profit or Loss, the changes of own credits would be show in the OIC. This is much useful to help the investors to understand the fair value of the financial instrument, and help them to understand to reasons of changes.

The Framework document sets out the scope for useful financial statements, the information presented is now useful to investors in measuring the fair value of the financial liabilities. As the previous standard IAS39 have been provide less meaningful and useful information to users, after several times to clarify requirements in IAS 39, it still can not previously undertaken a fundamental reconsideration of reporting for financial instrument, the IASB have to be replace them. Changes in IAS reflect the reliability and timeliness with its principle. The fair value of financial liability is now represented in Profit and Loss, and OCI. These will provide more reliable information to investors.

Task3:

Sometimes financial statements can not assist users in assessing the risks related to financial instruments. The financial crisis of the American International Group(AIG) is a good example to explain that financial reporting failed to assist users in assessing the extent of risks related to financial instruments.

AIG is an American insurance corporation. "According to the 2008 Forbes Global 2000 list, AIG was once the 18th-largest public company in the world." In the September 2008, AIG suffered a liquidity crisis result from its credit ratings were downgraded below "AA" levels. "The United States Federal Reserve Bank created an $85 billion credit facility to enable the company to meet increased collateral obligations consequent to the credit rating downgrade, in exchange for the issuance of a stock warrant to the Federal Reserve Bank for 79.9% of the equity of AIG." The Federal Reserve Bank and the United States Treasury by May 2009 had increased the potential financial support to AIG, with the support of an investment of as much as $70 billion, a $60 billion credit line and $52.5 billion to buy mortgage-based assets owned or guaranteed by AIG, increasing the total amount available to as much as $182.5 billion.  AIG subsequently sold a number of its subsidiaries and other assets to pay down loans received, and continues to seek buyers of its assets.

The reasons of the AIG financial crisis is that AIG sold large amount of credit default swaps(CDS) without properly offsetting their positions. The CDS is a kind of financial instrument. CDS is used for providing insurance on bonds against the default, it is a bear-market warrant for speculating on the deteriorating conditions in an entity.

Under the IAS 39, the CDS is measured at fair value, the revenue of the CDS would be shown in the Comprehensive Income. From the 2004-2008, the stock market is under the bull market, seldom default events was happened, so this was make the value of CDS has been overestimated, AIG also had a good performance in the financial reporting. These mislead more and more investors buy the CDS bonds. But the financial reporting did not affect that the CDS offer limited profits but practically unlimited risks. Until the financial crisis came, stock market changed to bear market, more and more default events happened, investors have lost lots of money and AIG is also under the financial crisis.

The IAS has published the new requirements of measure the financial instruments at the fair value, which requires measure the financial liabilities with two-steps approach, under the two-steps approach, the changes of value would be presented in the Profit and Loss, the change of the own credit would be presented in the OCI. These are much helpful to the investors, make them understand the risk of the financial instruments and affect more meaningful information.

The writer believes that the current IAS 39 standard which in the right direction but needs improvement to how to measure financial instruments more reliable, The proposals came at the time where many problems for the financial instruments culminated and would have been only a matter of times before the problems arose on their own.

Task 4:

The Incurred Loss Approach is used under IAS 39 for amortised cost accounting and Impairment, the process of Incurred Loss Approach is:

(a) After initial recognition, IAS 39 requires financial assets held in the loans and receivables categories to be held at amortised cost and impairment of such assets to be recognised as and when it occurs. (b) The amortised cost is calculated by discounting all estimated cash flows resulting from the contractual terms of the financial asset using the effective interest rate. (c) Recongnize the impaired financial assets in profit or loss or reduce the carrying amount of the asset according to IAS 39 category. (d): The amortised cost is calculated by discounting all estimated cash flows resulting from the financial asset using the effective interest rate.

Under the incurred loss impairment model, any credit loss estimate in determining the effective interest rate is not prohibited. This means if the impairment can be measured reliable, only if there is objective evidence of impairment as a result of a loss event occurred. Hence, the incurred loss impairment got theses disadvantages. Which include: 1. The approach is internally inconsistent for not taking account of expected loss in determining the effective interest rate used for subsequent measurement. 2. Deficient information is provided because late recognition of incurred losses is inconsistent with expected losses. 3. It is not always clear when the loss event take place if the loss incurred. 4. Misleading information of asset impairment might be given when the original expectations have not changed even though the losses have been recognised. 5. Not sure when to reverse a previously recognised impairment loss.

To address the weaknesses, the Board proposed an expected loss approach to measure the impairment and amortised cost for the financial instrument. The expected loss approach uses forward looking cash flows that incorporate expected future credit losses throughout the term of a financial asset. This approach required that when a financial asset first recongnised must be determined the expected credit losses, and then, recognize the interest revenue, less the initial expected credit losses as carrying amount before the estimate change and the present value of the expected cash flows. The entity should build up a provision of the financial assets for the expected credit losses and reassess the credit loss credit loss at the end of each period. "The principles relate to the calculation of

amortised cost as a present value calculation and the two major inputs used. These are the expected cash flows at each measurement date and the allocation mechanism"

By replacing the incurred loss approach to expected loss approach, it would result in earlier recognition of credit loss, this will avoid the systematic bias. The expected loss approach would also reflect lending decisions more faithfully than existing requirements because the proposed amortised cost measurement separates out the portion of the lender's return that compensates for the credit losses expected when the asset was originated. Therefore, the initial estimate of expected credit losses would be included in determining the effective interest rate. The internal inconsistency can be avoided with the initial measurement of the subsequent measurement in the current approach.

The approach is more consistent with the objective of amortised cost measurement because it provide information about the effective return of a financial instrument by allocating interest revenue or interest expense over the expected life of the instrument. As the approach considers the inputs of the amortised cost calculation which reflect estimates of expected outcome, it avoids the inconsistent.

By changing the approach from incurred loss approach to expected loss approach, the standards can provide greater comparability and reliability of financial statements. The impairment and amortised cost can be affect more faithful in the financial statement, also can give much meaningful information to the investors.

http://findarticles.com/p/articles/mi_qa5332/is_11_55/ai_n31162716/pg_4/?tag=content;col1

http://en.wikipedia.org/wiki/American_International_Group#History

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