The loan is recorded at its fair value of $880 (in this example, assumed to be the net present value of $50
interest payable annually for five years and $1,000 principal repaid after five years, all discounted at 8%).
This equals the net amount of cash exchanged ($1,000 loan less $120 origination fee) and hence no gain or
loss is recognised on initial recognition of the loan.
Applying the requirements of IFRS 9 to the simple fact pattern provided by the IASB is
a relatively straightforward exercise. In practice, however, it may be more difficult to
identify those fees that are required by IFRS 9 to be treated as part of the financial
Financial instruments: Recognition and initial measurement 3673
instrument and those that should be dealt with in another way, for example under
IFRS 15. In particular it may be difficult to determine the extent to which fees associated
with a financial instrument that is not quoted in an active market represent
compensation for off-market terms or for the genuine provision of services.
3.3.2
Measurement of financial instruments following modification of
contractual terms that leads to initial recognition of a new instrument
An entity may agree (with the holder or the issuer) to modify the terms of an instrument
that it already recognises in its financial statements as a financial asset, a financial
liability or an equity instrument. In such a scenario, an entity needs to consider whether
the modification of the terms triggers derecognition of the existing instrument and
recognition of a new instrument (see Chapter 48 at 3.4.1). If so, the new instrument
would be initially measured at fair value in accordance with the general requirements
discussed at 3.1 above.
For example, when the contractual terms of an issued equity instrument are modified
such that it is subsequently reclassified as a financial liability, it should be measured at
its fair value on the date it is initially recognised as a financial liability, with any
difference between this amount and the amount recorded in equity being taken to
equity. This follows IAS 32 which prohibits the recognition of gains or losses on the
purchase, issue, or cancellation of an entity’s own equity instrument.3
Example 45.7: Changes in the contractual terms of an existing equity instrument
On 1 January 2018, Company L issues a fixed rate cumulative perpetual instrument with a face value of
£10 million at par. Dividends on the instrument are cumulative but discretionary and therefore it is initially
classified as equity. On 1 January 2019, L adds a new clause to the instrument so that if L is subject to a
change of control, L will be required to redeem the instrument at an amount equal to the face value plus any
accumulated unpaid dividends. This results in a reclassification of the instrument from equity to liability. The
fair value of the instrument on 1 January 2019 is £12 million.
Upon reclassification, L should recognise the financial liability at its then fair value of £12 million and the
difference of £2 million is recognised in equity (e.g. retained earnings).
The accounting for a modification of a financial asset (or financial liability) that results
in the recognition of a new financial asset (or financial liability) is dealt with in more
detail in Chapter 48 at 3.4 and 6.2.
3.3.3
Financial guarantee contracts and off-market loan commitments
The requirement to measure financial instruments at fair value on initial recognition
also applies to issued financial guarantee contracts that are within the scope of IFRS 9
as well as to commitments to provide a loan at a below-market interest rate (see
Chapter 41 at 3.4 and 3.5).
When issued to an unrelated party in a stand-alone arm’s length transaction, the fair
value of a financial guarantee contract at inception is likely to equal the premium
received, unless there is evidence to the contrary. [IFRS 9.B2.5(a)]. There is likely to be
such evidence where, say, a parent provided to a bank a financial guarantee in respect
of its subsidiary’s borrowings and charged no fee.
When an off-market loan is provided to an entity’s subsidiary (see 3.3.1 above), a ‘spare
debit’ arises in the separate financial statements of the parent as a result of the recognition
3674 Chapter 45
of the loan at fair value. The same situation can arise when a parent provides a subsidiary
with an off-market loan commitment. Again, it is normally appropriate to treat this
difference as an additional cost of investment in the subsidiary in the separate accounts of
the parent (and as an equity contribution from the parent in the accounts of the subsidiary).
3.3.4
Loans and receivables acquired in a business combination
Consistent with IFRS 9 and IFRS 13, IFRS 3 – Business Combinations – requires
financial assets acquired in a business combination to be measured by the acquirer on
initial recognition at their fair value. [IFRS 3.18].
IFRS 3 contains application guidance explaining that an acquirer should not recognise a
separate valuation allowance (i.e. bad debt provision) in respect of loans and receivables
for contractual cash flows that are deemed to be uncollectible at the acquisition date.
This is because the effects of uncertainty about future cash flows are included in the fair
value measure (see Chapter 9 at 5.5.5 and Chapter 47 at 7.3.1). [IFRS 3.B41].
3.3.5
Acquisition of a group of assets that does not constitute a business
Where a group of assets that does not constitute a business is acquired, IFRS 3 requires
the acquiring entity to:
• identify and recognise the individual identifiable assets acquired and liabilities
assumed; and
• allocate the cost of the group to the individual identifiable assets and liabilities
based on their relative fair values at the date of the acquisition. [IFRS 3.2(b)].
The Interpretations Committee has considered how to allocate the transaction price to
the identifiable assets acquired and liabilities assumed when:
• the sum of the individual fair values of the identifiable assets and liabilities is
different from the transaction price; and
• the group of assets includes identifiable assets and liabilities initially measured both
at cost and at an amount other than cost, e.g. financial instruments which are
measured on initial recognition at their fair value.
The Committee observed that if an entity initially considers that there might be a
difference between the transaction price for the group and the sum of the individual fair
values of the identifiable assets and liabilities, it first reviews the procedures used to
determine those individual fair values to assess whether such a difference truly exists
before allocating the transaction price.
The Committee concluded that a reasonable reading of the requirements of IFRS 3
results in two possible ways of accounting for the acquisition of the group:
(a) Under the first approach, the entity accounts for the acquisition of the group as follows:
• it identifies the individual identifiable assets acquired and liabilities assumed
that it recognises at the date of the acquisition;
• it determines the individual transaction price for each identifiable asset and
liability
by allocating the cost of the group based on the relative fair values of
those assets and liabilities at the date of the acquisition; and then
Financial instruments: Recognition and initial measurement 3675
• it applies the initial measurement requirements in applicable IFRS to each
identifiable asset acquired and liability assumed. The entity accounts for
any difference between the amount at which the asset or liability is
initially measured and its individual transaction price applying the
relevant requirements.
In the case of any financial instruments within the group, the entity should
treat the difference between the fair value and allocated transaction price as
a ‘day 1’ profit, the requirements for which are discussed at 3.3 above;
(b) Under the second approach, any identifiable asset or liability that is initially
measured at an amount other than cost is initially measured at the amount
specified in the applicable IFRS, i.e. fair value in the case of a financial
instrument. The entity first deducts from the transaction price of the group the
amounts allocated to the assets and liabilities initially measured at an amount
other than cost, and then determines the cost of the remaining identifiable assets
and liabilities by allocating the residual transaction price based on their relative
fair values at the date of the acquisition.
The Committee observed that an entity applies its reading of the requirements
consistently to all such acquisitions.4
3.4 Transaction
costs
3.4.1 Accounting
treatment
As noted at 3.1 above, the initial carrying amount of an instrument should be adjusted
for transaction costs, except for financial instruments subsequently carried at fair value
through profit or loss and trade receivables that do not have a significant financing
component in accordance with IFRS 15. The consequences of this requirement are:
• For financial instruments subsequently measured at amortised cost and debt
instruments subsequently measured at fair value through other comprehensive
income, transaction costs are included in the calculation of the amortised cost
using the effective interest method, in effect reducing (increasing) the amount of
interest income (expense) recognised over the life of the instrument.
• For investments in equity instruments that are subsequently measured at fair value
through other comprehensive income, transaction costs are recognised in other
comprehensive income as part of the change in fair value at the next
remeasurement and they are never reclassified into profit or loss.
[IFRS 9.B5.7.1, IG E.1.1]
• Transaction costs relating to the acquisition or incurrence of financial instruments at
fair value through profit or loss are recognised in profit or loss as they are incurred.
Transaction costs that relate to the issue of a compound financial instrument are
allocated to the liability and equity components of the instrument in proportion to the
allocation of proceeds. [IAS 32.38]. This is discussed in more detail in Chapter 43 at 6.2.
IFRS 9 does not address how to allocate transaction costs that relate to a hybrid
financial instrument where the embedded derivative is separated from the host.
3676 Chapter 45
Therefore entities should choose an accounting policy and apply it consistently, the
approaches more commonly observed being to allocate the transaction costs:
• exclusively to the non-derivative host, in which case the transaction costs are
included in full in its initial measurement; and
• to the non-derivative host and the embedded derivative in proportion to their fair
values, i.e. in a similar fashion to compound financial instruments. Under this
approach, the proportion attributable to the non-derivative host will be included
in its initial measurement, while the proportion attributable to the embedded
derivative will be expensed as incurred. However, this approach will usually only
lead to a different accounting when the embedded derivative has an option feature
and hence a non-zero fair value.
Transaction costs that would be incurred on transfer or disposal of a financial
instrument are not included in the initial or subsequent measurement of the financial
instrument. [IFRS 9.IG E.1.1].
The following example illustrates the accounting treatment of transaction costs for a
financial asset classified as measured at fair value through other comprehensive income.
Example 45.8: Transaction costs – initial measurement
Company A acquires an equity security that will be classified as measured at fair value through other
comprehensive income. The security has a fair value of £100 and this is the amount A is required to pay. In
addition, A also pays a purchase commission of £2. If the asset was to be sold, a sales commission of £3
would be payable.
The initial measurement of the asset is £102, i.e. the sum of its initial fair value and the purchase commission.
The commission payable on sale is not considered for this purpose. If A had a reporting date immediately
after the purchase of this security it would measure the security at £100 and recognise a loss of £2 in other
comprehensive income. [IFRS 9.B5.2.2].
3.4.2 Identifying
transaction
costs
Transaction costs are defined as incremental costs that are directly attributable to the
acquisition, issue or disposal of a financial asset or liability. An incremental cost is one
that would not have been incurred had the financial instrument not been acquired,
issued or disposed of. [IFRS 9 Appendix A].
Transaction costs include fees and commissions paid to agents (including employees
acting as selling agents), advisers, brokers, and dealers. They also include levies by
regulatory agencies and securities exchanges, transfer taxes and duties. Debt premiums
or discounts, financing costs and allocations of internal administrative or holding costs
are not transaction costs. [IFRS 9.B5.4.8].
Treating internal costs as transaction costs could open up a number of possibilities for
abuse by allowing entities to defer expenses inappropriately. However, internal costs
should be treated as transaction costs only if they are incremental and directly
attributable to the acquisition, issue or disposal of a financial asset or financial liability.5
Therefore, it will be rare for internal costs (other than, for instance, commissions paid
to sales staff in respect of a product sold that results in the origination or issuance of a
financial instrument) to be treated as transaction costs.
Financial instruments: Recognition and initial measurement 3677
3.5
Embedded derivatives and financial instrument hosts
In Chapter 42 at 6, it was explained that the terms of an embedded derivative that is
required to be separated from a financial liability and those of the associated host should
be determined. The derivative is initially recorded at its fair value and the host as the
residual (at least for an optional derivative – a non-option embedded derivative will have
a fair value and initial carrying amount of zero). [IFRS 9.B4.3.3]. Unlike under IAS 39, under
IFRS 9 separation does not apply to embedded derivat
ives with financial asset hosts.
3.6
Regular way transactions
When settlement date accounting is used for ‘regular way’ transactions (see 2.2.4 above)
and those transactions result in the recognition of assets that are subsequently measured
at amortised cost or (very rarely) at cost, there is an exception to the general
requirement to measure the asset on initial recognition at its fair value (see 3.1 above).
In such circumstances, rather than being initially measured by reference to their fair value
on the date they are first recognised, i.e. settlement date, these financial instruments are
initially measured by reference to their fair value on the trade date. [IFRS 9.5.1.2].
In practice, the difference will rarely be significant because of the short time scale
involved between trade date and settlement date. It is because of this short duration that
regular way transactions are not recognised as derivative financial instruments, but
accounted for as set out at 2.2 above. [IFRS 9.BA.4].
3.7
Assets and liabilities arising from loan commitments
Loan commitments are a form of derivative financial instrument, although for pragmatic
reasons the IASB decided that certain loan commitments could be excluded from the
recognition requirements of IFRS 9 (see Chapter 41 at 3.5).
This exclusion of loan commitments from the recognition requirements creates a degree
of confusion over how assets and liabilities arising from such arrangements should be
measured on initial recognition, as illustrated in the example below.
Although IFRS 9 requires an issuer of loan commitments not within the scope of its
recognition requirements to apply its impairment rules (see Chapter 47 at 11) to such
loan commitments, for simplicity this is not illustrated in the example. [IFRS 9.2.1(g)].
Example 45.9: Drawdown under a committed borrowing facility
Company H obtains from Bank Q a committed facility allowing it to borrow up to €10,000 at any time over
the following five years, provided certain covenants specified in the facility agreement are not breached.
Interest on any drawdowns is payable at LIBOR plus a fixed margin, representing Q’s initial assessment of
H’s credit risk. Any such borrowings can be repaid at any time at the option of H, but must be repaid by the
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 727
