4.1 Recognition and measurement of financial instruments

Financial instruments are crucial in modern finance, creating assets for one entity and liabilities for another. This section dives into their classification, recognition, and measurement, covering everything from cash and stocks to complex derivatives and hybrid instruments.

Understanding how financial instruments are categorized and valued is key to grasping their impact on financial statements. We'll explore initial recognition, subsequent measurement, impairment, and derecognition, as well as the effects on balance sheets and income statements.

Financial instrument classification

Types and characteristics of financial instruments

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• Financial instruments create financial assets for one entity and financial liabilities or equity instruments for another entity
• Main categories include
  • Cash
  • Equity instruments (stocks)
  • Debt instruments (bonds)
  • Derivatives (options, futures)
• Classification based on
  • Contractual cash flow characteristics
  • Entity's business model for managing the assets
• Financial assets fall into three measurement categories
  • Amortized cost
  • Fair value through other comprehensive income (FVOCI)
  • Fair value through profit or loss (FVTPL)
• Financial liabilities generally measured at amortized cost, with some exceptions measured at FVTPL
• Equity instruments represent residual interest in entity's assets after deducting liabilities

Special considerations for hybrid instruments

• Hybrid instruments contain both a host contract and an embedded derivative
• Require analysis to determine if embedded derivative should be separated from host contract
• Separation criteria include
  • Economic characteristics and risks not closely related to host
  • Standalone instrument would meet definition of a derivative
  • Entire hybrid contract not measured at FVTPL
• If separated, host contract and embedded derivative accounted for separately
• If not separated, entire hybrid instrument classified based on overall characteristics

Recognition and measurement of financial assets and liabilities

Initial recognition and measurement

• Recognize financial assets/liabilities when entity becomes party to contractual provisions
• Initial measurement generally at fair value
• For instruments not at FVTPL, add or subtract transaction costs
• Transaction costs examples
  • Fees and commissions paid to agents and advisers
  • Levies by regulatory agencies
  • Transfer taxes and duties
• Fair value typically transaction price (amount paid/received)
• Exceptions when transaction not at arm's length or includes non-financial components

Subsequent measurement and impairment

• Financial assets subsequent measurement depends on classification
  • Amortized cost: Effective interest method
  • FVOCI: Fair value changes in other comprehensive income
  • FVTPL: Fair value changes in profit or loss
• Financial liabilities typically at amortized cost using effective interest method
• Effective interest method allocates interest income/expense over relevant period
• Calculates amortized cost as $Amortized Cost = [Present Value](https://www.fiveableKeyTerm:Present_Value) of Future Cash Flows * Effective Interest Rate$
• Impairment recognized using expected credit loss model
• Expected credit losses updated each reporting date based on
  • Changes in credit risk since initial recognition
  • Reasonable and supportable forward-looking information

Derecognition principles

• Derecognize financial assets when
  • Contractual rights to cash flows expire
  • Rights to cash flows transferred and substantially all risks/rewards transferred
• Derecognize financial liabilities when
  • Obligation discharged through payment
  • Debtor legally released from primary responsibility
  • Obligation cancelled or expires
• Partial derecognition possible if only portion of asset transferred
• Gain or loss on derecognition equals difference between
  • Carrying amount (or portion) derecognized
  • Consideration received (including new assets obtained less new liabilities assumed)

Financial instrument categories and accounting

Amortized cost and FVOCI categories

• Amortized cost category for financial assets
  • Business model: Hold to collect contractual cash flows
  • Cash flows solely payments of principal and interest (SPPI)
  • Examples: Most loans, bonds held to maturity
• FVOCI category for financial assets
  • Business model: Hold to collect cash flows and sell
  • Cash flows are SPPI
  • Examples: Bonds held for liquidity management
• Accounting treatment
  • Amortized cost: Interest income, impairment, and gains/losses in profit or loss
  • FVOCI: Fair value changes in OCI, interest and impairment in profit or loss
  • Upon derecognition of FVOCI assets, cumulative gains/losses recycled to profit or loss

FVTPL and equity instrument categories

• FVTPL category includes
  • Assets not meeting criteria for amortized cost or FVOCI
  • Assets designated to eliminate accounting mismatch
  • Examples: Trading securities, derivatives not in hedge accounting
• Equity instruments generally measured at FVTPL
  • Irrevocable option to measure certain instruments at FVOCI
  • FVOCI option typically for strategic investments
  • No recycling of gains/losses to profit or loss for FVOCI equities
• Accounting treatment
  • FVTPL: All fair value changes, dividends, and interest in profit or loss
  • FVOCI equities: Fair value changes in OCI, dividends in profit or loss

Derivatives and hedge accounting considerations

• Derivatives always measured at FVTPL unless in qualifying hedge relationship
• Types of hedge accounting
  • Fair value hedges: Hedge exposure to changes in fair value
  • Cash flow hedges: Hedge exposure to variability in cash flows
  • Net investment hedges: Hedge foreign currency exposure of net investment in foreign operation
• Hedge accounting aligns timing of gain/loss recognition on hedged item and hedging instrument
• Effectiveness requirements must be met to apply hedge accounting
• Ineffective portion of hedge always recognized immediately in profit or loss

Impact of measurement on financial statements

Balance sheet effects

• Initial recognition increases assets or liabilities
• Transaction costs for non-FVTPL instruments affect initial carrying amount
• Subsequent measurement impacts carrying amounts
  • Amortized cost: Reflects outstanding principal plus accrued interest minus repayments/impairment
  • Fair value: Reflects current market value regardless of cost
• FVOCI instruments show cumulative fair value changes in equity (other comprehensive income)
• Impairment allowances reduce carrying amount of financial assets

Income statement and comprehensive income effects

• Interest income/expense recognized using effective interest method for amortized cost and FVOCI instruments
• Impairment losses impact profit or loss for amortized cost and FVOCI assets
• FVTPL instruments: All fair value changes directly affect profit or loss
  • Can increase earnings volatility (trading portfolios)
• FVOCI debt instruments: Fair value changes in OCI, interest and impairment in profit or loss
• FVOCI equity instruments: Only dividends in profit or loss, fair value changes in OCI
• Reclassifications between categories can cause one-time gains/losses
  • Example: Moving from amortized cost to FVTPL requires recognizing unrealized gains/losses

Financial statement analysis implications

• Choice of measurement category affects reported performance and position
• Key financial metrics impacted
  • Profitability ratios (ROA, ROE) affected by recognition of fair value changes and impairment
  • Leverage ratios influenced by carrying amounts of financial assets and liabilities
  • Liquidity ratios consider classification and fair values of financial instruments
• Disclosure requirements help users understand
  • Basis for classification decisions
  • Exposure to risks (credit, market, liquidity)
  • Sensitivity to market variables (interest rates, foreign exchange rates)
• Analysts must consider effects of accounting choices when comparing entities
  • Similar instruments may be accounted for differently based on business model and management intent