Intermediate Accounting 1

Module 7, Part 1
PFRS 9 - FINANCIAL INSTRUMENTS

Objectives
After this module, readers are expected to gain familiarization and demonstrate mastery of the following:
1. Definition of financial instrument
2. Definition of financial asset, financial liability, and equity instrument
3. Guideline when an instrument is a financial liability or an equity instrument
4. Recognition of a compound financial instrument
5. Identification of financial assets that can be measured at fair value through profit or loss
6. Measurement of equity investments at fair value through other comprehensive income
7. Measurement of debt investments at fair value through other comprehensive income
8. Measurement of debt investments at amortized cost

Theoretical framework

• Philippine Financial Reporting Standards (PFRS) 9 Financial Instruments replaced Philippine Accounting
Standard (PAS) 39 Financial Instruments: Recognition and Measurement.
• PFRS 9 establishes accounting principles for recognizing, measuring and disclosing information about
financial assets and financial liabilities
• When addressing hedging there are, in addition to PFRS 9, primarily three standards have an impact on the
way a hedge is structured:
• PAS 21 The Effects of Changes in Foreign Exchange Rates,
• PAS 32 Financial Instruments: Disclosure and Presentation
• PFRS 13 Fair Value Measurement

Objective of PFRS 9
Establish principles for the financial reporting of financial assets and financial liabilities that will present relevant and
useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an
entity’s future cash flows.

Scope of PFRS 9

PFRS 9 shall be applied by all entities to all types of financial instruments except:
Ø Interests in subsidiaries, associates and joint ventures
Ø Rights and obligations under leases
Ø Employers’ rights and obligations under employee benefit plans
Ø Financial instruments issued by the entity that meet the definition of an equity instrument in PAS 32
Ø Insurance contract
Ø Forward contract under business combinations
Ø Loan commitments
Ø Financial instruments, contracts and obligations under share-based payment
Ø Reimbursements classified as provisions
Ø Rights and obligations rising from revenue from contracts with customers

PFRS 9 does not cover the accounting treatment of some financial instruments –for example,
Ø Own equity instruments,
Ø Insurance contracts,
Ø Leasing contracts,
Ø Some financial guarantee contracts,
Ø Weather derivatives
Ø Loans not settled in cash (or in any financial instruments),
Ø Interest in subsidiaries, associates, joint ventures
Ø Employee benefit plans
Ø Share-based payment transactions
Ø Contracts to buy/sell an acquiree in a business combination
Ø Contracts for contingent consideration in business combination

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Definitions

12-month expected The portion of lifetime expected credit losses that represent the expected credit
credit losses losses that result from default events on a financial instrument that are possible within
the 12 months after the reporting date.

Amortized cost of a The amount at which the financial asset or financial liability is measured at initial
financial asset or recognition minus the principal repayments, plus or minus the cumulative amortization
financial liability using the effective interest method of any difference between that initial amount and
the maturity amount and, for financial assets, adjusted for any loss allowance.

Derecognition The removal of a previously recognized financial asset or financial liability from an
entity’s statement of financial position.

Derivative A financial instrument or other contract within the scope of PFRS 9 with all three of the
following characteristics.

a. its value changes in response to the change in a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or
rates, credit rating or credit index, or other variable, provided in the case of a
non-financial variable that the variable is not specific to a party to the contract
(sometimes called the ‘underlying’).

b. it requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a
similar response to changes in market factors.

c. it is settled at a future date.

Dividends Distributions of profits to holders of equity instruments in proportion to their holdings of a

particular class of capital.

Effective interest The method that is used in the calculation of the amortized cost of a financial asset or
method a financial liability and in the allocation and recognition of the interest revenue or
interest expense in profit or loss over the relevant period.

Effective interest rate The rate that exactly discounts estimated future cash payments or receipts through the
expected life of the financial asset or financial liability to the gross carrying amount of a
financial asset or to the amortized cost of a financial liability.

Reclassification date The first day of the first reporting period following the change in business model that
results in an entity reclassifying financial assets.

Solely payments of Returns consistent with a basic lending arrangement, interest may include return not only
principal and interest for the time value of money and credit risk but also for other components such as a
(SPPI) return for liquidity risk, amounts to cover expenses and a profit margin.

Transaction costs Incremental costs that is directly attributable to the acquisition, issue or disposal of a
financial asset or financial liability. An incremental cost is one that would not have been
incurred if the entity had not acquired, issued or disposed of the financial instrument.

INITIAL RECOGNITION OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

Ø When the entity becomes party to the contractual provisions of the instrument.

INITIAL MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

At fair value, plus for those financial assets and liabilities not classified at fair value through profit or loss, directly
attributable transaction costs.

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Ø Fair value - is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date
Ø Directly attributable transaction costs - incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset or financial liability.

In other words transaction cost would immediately be recognized as an expense if the financial asset or liability is
classified at fair value through profit or loss.

Accounting categories for financial assets

PFRS 9 considers three categories of financial assets

Ø At amortized cost (by requirement)
Ø At fair value through other comprehensive income (by requirement and/or designation)
Ø At fair value through profit or loss (designation, and/or residual/default)

SUBSEQUENT CLASSIFICATION AND MEASUREMENT OF FINANCIAL ASSETS

Ø Debt instruments shall be classified at Amortized Cost (AC), Fair Value through Other Comprehensive
Income (FVOCI) or Fair Value through Profit or Loss (FVPL).
Ø Equity instruments shall be classified at Fair Value through Other Comprehensive Income (FVOCI) or Fair
Value through Profit or Loss (FVPL).

DEBT INSTRUMENTS (DI)

(DI) Financial Assets at Amortized Cost

Requisites for Ø The asset is held to collect its contractual cash flows and
Classification Ø The asset’s contractual cash flows represent ‘solely payments of principal and interest’

Profit or Loss Ø Effective interest income

Implications Ø Impairments losses and reversal gains
Ø Gain or loss on derecognition

Statement of Ø Measured at amortized cost

financial position • The carrying amount of an instrument accounted for at amortized cost is
computed as:
a. the amount to be repaid at maturity (usually the principal amount); plus
b. any unamortized original premium, net of transaction costs; or less
c. any unamortized original discount including transaction costs; less
d. principal repayments; less
e. any reduction for impairment or uncollectability.

The EIR is the rate that exactly discounts the stream of principal and interest cash flows to
the initial net outlay (in the case of assets) or proceeds (in the case of a liability). In this way,
the contractual interest expense in each period is adjusted to amortize any premium, discount
or transaction costs over the life of the instrument.

Transaction costs include fees, commissions and taxes paid to other parties. Transaction
costs do not include internal administrative costs.

Ø Classified as a non-current asset unless maturity is within 12 months after the end of the
reporting period

Ø This is a mandatory classification, meaning the business model test and contractual cash flow test must
be complied with (see “Requisites for Classification” shown above), unless the fair value option is applied.
Ø Financial assets in the amortized cost category include non-callable debt (i.e. loans, bonds and most trade
receivables), callable debt (provided that if it is called the holder would recover substantially all of debt’s
carrying amount) and senior tranches of pass-through asset-backed securities.
Ø Even if an asset is eligible for classification at amortized cost or at FVOCI, management also has the option
– the FVO – to designate a financial asset at FVTPL if doing so reduces or eliminates a measurement or
recognition inconsistency (commonly referred to as “accounting mismatch”).

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Ø If an entity is unsure of the business model for the debt investments, the default category would be at
FVTPL.
Ø Note: This category consists ONLY of debt investments that meet both the business model test and
the contractual cash flow test, AND for which the fair value option (FVO) is not applied.

(DI) Financial Assets at Fair Value Through Other Comprehensive Income

Requisites for Ø The objective of the business model is achieved both by collecting contractual cash
Classification flows and selling financial assets; and
Ø The asset’s contractual cash flows represent SPPI.

Profit or Loss Ø Effective interest (income)

Implications Ø Impairments losses and reversal gains
Ø Gain or loss on derecognition including reclassification adjustments (PAS 1)

OCI Ø Changes in fair value due to subsequent measurement

Statement of Ø Measured at fair value after amortization for the effective interest
Financial Position Ø Cumulative gain or loss on fair value in Equity
Ø Since PFRS 5 excludes the scope for financial assets, FVOCI are non current asset
unless maturity is within 12 months after the end of the reporting period

Note that both amortization is applied under the effective interest method before applying the FV
measurement requirement for the FVOCI classification

Ø This category consists of debt investments that meet the contractual cash flows test, for which their business
model is held to collect and for sale.
Ø This is a mandatory classification, meaning the business model test and contractual cash flow test must
be complied with, unless the FVO is applied.
Ø This category is intended to acknowledge the practical reality that an entity may invest in debt instruments to
capture yield but may also sell if, for example, the price is considered advantageous or it is necessary to
periodically adjust or rebalance the entity’s net risk, duration or liquidity position.

(DI) Financial Assets at Fair Value Through Profit Or Loss

Requisites for Ø This is a “residual category” if none of the two previously mentioned (AC and FVOCI)
Classification business models apply or if any of the two business model apply but the contractual cash
flows are NOT SPPI for example if interest will include a profit participation.
Ø If the two requisites for the AC and FVOCI category are met but the entity elects to
measure debt instruments at FVPL to eliminate an “accounting mismatch” because
financial liabilities are measured at FVPL.

Profit or Loss Ø Nominal interest (income)

Implications Ø Direct transaction cost incurred on acquisition
Ø Gain or loss on changes in fair value on subsequent measurement
Ø Gain or loss on derecognition

Statement of Ø Measured at fair value

Financial Position Ø Under the assumption the Financial asset is held for trading, FVPL shall be classified as
a current asset (PAS 1)

Ø This category consists of financial assets that are NEITHER measured at AMORTIZED COST nor at
FVOCI.

The FVTPL category is in effect the “residual category” for instruments that do not qualify for the amortized cost or
FVOCI categories. The following financial assets would be included in the FVTPL category:
A. financial assets held for trading;
B. financial assets managed on a fair value basis to maximize cash flows through the sale of financial assets
such that collecting cash flows is only incidental;
C. financial assets managed, and whose performance is evaluated, on a fair value basis;

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D. financial assets where the collection of cash flows is not integral to achieving the business model objective
(but only incidental to it); and
E. financial assets that fail the SPPI test.
F. Undesignated derivatives
G. Derivatives being hedging instruments in a fair value hedge

Derivatives are recognized at FVTPL unless they are a hedging instrument in cash flow hedge or net investment in
foreign operation. Therefore, derivatives undesignated or being hedging instruments in fair value hedging
relationships are classified at FVTPL.

1.1 PFRS 9 financial assets classification categories – summary flowchart

EQUITY INSTRUMENTS (EI)

(EI) Financial Assets at Fair Value Through Profit Or Loss

Requisites for Ø Both held for Trading or Non Trading

Classification

Profit or Loss Ø Dividends

Implications Ø Direct transaction cost incurred on acquisition
Ø Gain or loss on changes in fair value on subsequent measurement
Ø Gain or loss on derecognition

Statement of Ø Measured at fair value

Financial Position Ø Under the assumption the Financial asset is held for trading, FVPL shall be classified as
a current asset (PAS 1)

1.2 PFRS 9 financial assets classification categories – summary flowchart

(EI) Financial Assets at Fair Value Through Other Comprehensive Income

Requisites for Ø An irrevocable election to present in OCI an investment in equity instruments that is not
Classification held for trading

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Profit or Loss Ø Dividends

Implications

OCI Ø Changes in fair value due to subsequent measurement

Ø Gain or loss on derecognition and may be transferred within Equity (Retained Earnings)

Statement of Ø Measured at fair value

Financial Position Ø Cumulative gain or loss on fair value in Equity
Ø Non trading investments are classified under the non-current assets section of the
statement of financial position

This category consists of equity investments which are not held for trading.
An entity can choose to classify non-trading equity investments in this category on an instrument-by- instrument
basis. This is an irrevocable election.

Note: PFRS 9 has eliminated the impairment loss category for equity instruments

BUSINESS MODEL TEST

• If the entity’s objective is to hold the asset to collect the contractual cash flows, then it will meet the first
criterion to qualify for amortized cost.
• Examples of factors to consider when assessing the business model for a portfolio are:
• the way the assets are managed;
• how performance of the business is reported to the entity’s key management personnel;
• how management is compensated (whether the compensation is based on the fair value
of the assets managed); and
• the historical frequency, timing and volume of sales in prior periods, the reasons for these
sales (such as credit deterioration), and expectations about future sales activity.

The entity’s business model does not depend on management’s intentions for the individual asset, but rather on the
basis of how an entity manages the portfolio of debt instruments.

• The following are still consistent with the amortized cost business model even if sales occurred:
• Sales due to DETERIORATION OF THE CREDIT QUALITY of the financial assets so that they no
longer meet the entity’s documented investment policy would be consistent with the amortized cost
business model;
• Sales are infrequent (even if significant) OR insignificant (even if frequent); or
• Sales take place CLOSE TO THE MATURITY of the financial asset and the proceeds from the
sale approximate the collection of the remaining contractual cash flows.

For example, an entity could sell one financial asset that results in a large gain and this would not necessarily fail the
business model test due to its significant effect on profit or loss unless it was the entity’s business model to sell
financial assets to maximize returns. If an entity is unsure of the business model for the debt investments, the default
category would be at FVTPL.

• Example 1.1: Liquidity portfolio (Amortized Cost)

• A bank holds financial assets in a portfolio to meet liquidity needs in a “stress case”
scenario that is deemed to occur only infrequently. Sales are not expected except in a
liquidity stress situation. The bank also monitors the fair value of the assets in the portfolio
to ensure that the cash amount that would be realized if a sale is required would be
sufficient to meet liquidity needs. In this case (i.e., where the “stress case” is deemed to
be rare), the bank’s business model is to HOLD THE FINANCIAL ASSETS TO COLLECT
CONTRACTUAL CASH FLOWS.

• Example 1.2: Liquidity portfolio (Not Amortized Cost)

• If the bank holds financial assets in a portfolio to meet everyday liquidity needs and that
involves recurring and significant sales activity, the objective is NOT to hold to collect the
contractual cash flows.

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• Another, If the bank is required by the regulator to routinely sell significant volumes of
financial assets(FA) in a portfolio to demonstrate the assets are liquid, the bank’s business
model is NOT to hold to collect contractual cash flows (the fact that this requirement is
imposed by a third party is not relevant to the analysis).

In contrast, if the objective of the regulator is for the bank to demonstrate liquidity (other than routinely selling FA), the
bank could consider other ways to demonstrate liquidity that would allow the portfolio to still qualify for amortized cost
(e.g., entering into a repurchase agreement for the debt investments).

• Example 2: Financial assets backing insurance contracts (Not Amortized Cost)

• An insurer holds financial assets in a portfolio TO FUND INSURANCE CONTRACT
LIABILITIES. The insurer uses the proceeds from the contractual cash flows to settle the
insurance liabilities as they come due. There is also REBALANCING of the portfolio on
a regular basis as estimates of the cash flows to fund the insurance liabilities are not
always predictable.
• ANALYSIS: The objective of the insurer’s business model is BOTH to hold the
financial assets to COLLECT CONTRACTUAL CASH FLOWS to fund
liabilities as they come due AND TO SELL TO MAINTAIN THE DESIRED
PROFILE in the asset portfolio. In this case, the insurer holds financial assets
with a dual objective to fund insurance liabilities and maintain the desired profile
of the asset portfolio. This portfolio would FAIL the business model test of
holding to collect contractual cash flows BUT WOULD LIKELY QUALIFY
FOR FVOCI subject to the contractual cash flow test.

CONTRACTUAL CASH FLOWS TEST

• If the financial asset’s contractual terms give rise on specified dates to cash flows that are “solely payments
of principal and interest on the principal amount outstanding” (SPPI), then it will meet the second
criterion to qualify for amortized cost.
• IFRS 9 also refers to the case of “modified economic relationships”. For example, a financial
asset may contain leverage or an interest rate that is resettable, but the frequency of the reset
does not match the tenor of the interest rate (an “interest rate mismatch”). In such cases, the entity
is required to assess the modification to determine whether the contractual cash flows represent
solely payments of principal and interest on the principal amount outstanding

Interest is defined as “consideration for the time value of money and for the credit risk associated with the principal
amount outstanding during a particular period of time”. The assessment as to whether cash flows meet this test is
made in the currency of denomination of the financial asset.

ASSESSMENT OF MODIFICATION: To do this, an entity considers cash flows on a comparable or benchmark

financial asset that does not contain the modification. The benchmark asset is a contract of the same credit quality
and with the same contractual terms (including, when relevant, the same reset periods), except for the contractual
term under evaluation (i.e., the underlying rate).

Leverage increases the variability of the contractual cash flows, with the result that they do not have the
economic characteristics of interest.

• Example 1: Constant Maturity Swap (Not Amortized Cost)

• A constant maturity bond with a 5-year term pays a variable rate that is reset semiannually
linked to the 5-year swap rate. The benchmark cash flows are those of an otherwise
identical bond but linked to the 6-month rate. At the time of initial recognition, the
difference between the 6-month rate and the 5-year swap rate is insignificant. This bond
does not meet the SPPI requirement because the interest payable in each period is
disconnected from the term of the instrument (except at origination). In other words,
the relationship between the 6-month rate and the 5-year swap rate could change over the
life of the instrument so that the asset and the benchmark cash flows could be more than
insignificantly different.

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ACCOUNTING TREATMENT OF EACH CATEGORY OF FINANCIAL ASSETS (SUMMARY)

Accounting Treatment Amortized Cost FVOCI FVTPL
Initial Recognition Fair Value Fair Value Fair Value
Transaction cost Charged to premium or Capitalized* Expensed
discount
Subsequent Amortized cost less Fair Value* Fair Value
Measurement impairment
Fair Value Changes Not relevant Recognized in OCI Recognized in profit or loss
Recycling of gains or Not relevant Debt only: Recycled to P/L Not relevant
loss when sold/derecognized
Impairment Recognized in profit or loss Debt only (DI): Credit No impairment is recorded
impairment recognized in
profit or loss
Reversal Reversed in profit or loss Reversed in profit or loss Not relevant
Interest income Recognized in profit or loss Recognized in profit or loss Recognized in profit or loss
(effective interest) (effective interest) (nominal interest)
Dividend Not relevant Equity only (EI): Profit or Equity only (EI): Profit or
loss loss
* Debt investment classified at FVOCI keeps amortized cost calculation to recognize interest income in profit or loss

RECLASSIFICATIONS OF DEBT INVESTMENTS (DI)

• IFRS 9 requires an entity to reclassify financial assets IF AND ONLY IF the objective of the entity’s
business model for managing those assets changes.
• These modifications have to be significant to the entity’s operations and demonstrable to external parties.
• Reclassification is applied PROSPECTIVELY from the start of the first reporting period following the
change in business model.

Note: Such changes are expected to be infrequent, and need to be determined by the entity’s senior management as
a result of internal or external modifications.
Original category New category Accounting impact
Fair value is measured at
reclassification date. Difference
Amortized cost FVPL
from carrying amount should be
recognized in profit or loss.

Fair value at the reclassification

FVPL Amortized Cost date becomes its new gross
carrying amount

Fair value is measured at

reclassification date. Difference
from amortized cost should be
Amortized cost FVOCI
recognized in OCI. Effective
interest rate is not adjusted as a
result of the reclassification.

Fair value at the reclassification

date becomes its new amortized
cost carrying amount. Cumulative
FVOCI Amortized cost gain or loss in OCI is adjusted
against the fair value of the
financial asset at reclassification
date.

Fair value at reclassification date

FVPL FVOCI
becomes its new carrying amount.

FVOCI FVPL Fair value at reclassification date

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Original category New category Accounting impact

becomes carrying amount.
Cumulative gain or loss on OCI is
reclassified to profit or loss at
reclassification date

The classification of an instrument is determined on initial recognition.

Reclassifications are made only upon a change in an entity’s business model, and are expected to be very infrequent.
No other reclassifications are permitted.

2.1 Reclassification of (DI) financial assets

Ø Both the amortized cost and FVOCI categories require the effective interest rate to be determined at
initial recognition.
Ø Therefore, when reclassifying a financial asset between the amortized cost and the FVOCI categories, the
recognition of interest income would not change and the entity would continue to use the effective interest
rate determined at initial recognition. A financial asset reclassified out of the FVOCI category to the
amortized cost category would be measured at amortized cost as if it had always been so classified. This
will be effected by transferring the cumulative gain or loss previously recognized in OCI out of equity, with an
offsetting entry against the fair value carrying amount at the reclassification date.
Ø However, for financial assets at FVTPL, and entity is not required to separately recognize interest income.
When reclassifying a financial asset out of the FVTPL category, the effective interest rate would be
determined based on the fair value carrying amount at the reclassification date.

IMPAIRMENT OF FINANCIAL ASSETS

Scope
A single set of an impairment model will be applied to:

a. Financial assets measured at amortized cost including trade receivables

b. Financial assets measured at fair value through OCI
c. Loan commitments and financial guarantees contracts where losses are currently accounted for under IAS
37 Provisions, Contingent Liabilities and Contingent Assets
d. Lease receivables

The impairment model follows a three-stage approach based on changes in expected credit losses of a financial
instrument that determine

a. The recognition of impairment, and

b. The recognition of interest revenue

THREE STAGE APPROACH TO IMPAIRMENT

Stage 1 – Applied at initial recognition and subsequent measurement when there is no significant increase in credit
risk
a. As soon as a financial instrument is originated or purchased, 12-month expected credit losses are
recognized in profit or loss and a loss allowance is established.
b. Entities continue to recognize 12 month expected losses that are updated at each reporting date

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c. Effective interest is based on the gross carrying amount rather than the carrying amount net of allowance for
impairment.

Stage 2 – Applied at subsequent measurement when there is a significant increase in credit risk.

a. If the credit risk increases significantly and the resulting credit quality is not considered to be low credit risk,
full lifetime expected credit losses are recognized.
b. Lifetime expected credit losses are only recognized if the credit risk increases significantly from when the
entity originates or purchases the financial instrument.
c. Effective interest is based on the gross carrying amount rather than the carrying amount net of allowance for
impairment.
Stage 3 – Applied at subsequent measurement when there is credit impairment

a. If the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest
revenue is calculated based on the net amortized cost
b. Financial assets in this stage will generally be individually assessed.
c. Lifetime expected credit losses are still recognized on the financial assets.

MEASUREMENT OF CREDIT LOSSES

Credit losses are the present value of all cash shortfalls. Expected credit losses are an estimate of credit losses over
the life of the financial instrument.

Factors in measuring credit losses:

a. The probability-weighted outcome: expected credit losses should represent neither a best or worst-case
scenario. Rather, the estimate should reflect the possibility that a credit loss occurs and the possibility that
no credit loss occurs.
b. The time value of money: expected credit losses should be discounted to the reporting date.
c. Reasonable and supportable information that is available without undue cost or effort.

FINANCIAL LIABILITIES

Classification Subsequent Measurement

Ø Amortized Cost Amortized cost using the effective interest method of

amortization

Ø FVPL for financial liabilities that are:

a. Held for trading At fair value with all gains and losses recognized in profit or
b. Derivative financial liabilities loss
c. Designated at initial recognition at FV

Financial guarantee contracts and Higher amount between the amount determined in
Commitments to provide a loan at a accordance with IAS 37 and the amount initially recognized
below market interest rate minus cumulative amortization recognized.

Financial liabilities resulting from the Amortized cost of the rights and obligations retained of the
transfer of a financial asset fair value of the rights and obligations retained by the entity
when measured on a stand-alone basis.

Under IFRS 9 there are only two categories of financial liabilities

Ø At amortized cost (by default) ; and
Ø At FVTPL (by designation)

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3.1 Accounting categories for financial liabilities

The category of financial liabilities at FVTPL has two sub-categories: liabilities held for trading and those designated
to this category at their inception using the FVO. Financial liabilities classified as held for trading include:
A. financial liabilities acquired or incurred principally for the purpose of generating a short- term profit (i.e., held
for trading);
B. a derivative not designated in a cash flow or net investment hedging relationship, or the ineffective part if
designated;
C. obligations to deliver securities or other financial assets borrowed by a short seller;
D. financial liabilities that are part of a portfolio of identified financial instruments that are managed together and
for which there is evidence of a recent actual pattern of short-term profit taking.

To determine whether the treatment would create or enlarge an accounting mismatch, the entity must assess whether
it expects the effect of the change in the liability’s credit risk to be offset in profit or loss by a change in fair value of
another financial instrument. In reality, such instances are expected to be rare, unless an entity, for example, holds
an asset whose fair value is linked to the fair value of the liability.

The changes in credit risk recognized in OCI are not recycled to profit or loss on settlement of the liability.

THE FAIR VALUE OPTION

• The fair value option is an option to designate financial assets or financial liabilities at FVTPL.
• The election is available only on initial recognition and is irrevocable. In the case of financial assets,
the FVO is available for instruments that would otherwise be mandatorily recognized at amortized cost or at
FVOCI, being permitted only if:
• it eliminates or significantly reduces a measurement or recognition inconsistency (an
accounting mismatch).

• In the case of financial liabilities, the FVO is available for instruments that would other- wise be mandatorily
recognized at amortized cost, being permitted only if:
(1) it eliminates or significantly reduces an accounting mismatch; or
(2) a group of financial liabilities (or financial assets and financial liabilities) is managed and its
performance is evaluated on a fair value basis, - in accordance with a documented risk
management or investment strategy, and the information about the group is provided internally on
that basis to the entity’s key management personnel; or
(3) a contract contains one or more embedded derivatives and the host is not a financial asset, in
which case an entity may designate the entire hybrid contract at FVTPL, unless the embedded
derivative is insignificant or it is obvious that separation of the embedded derivative would be
prohibited.

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DERECOGNITION

FINANCIAL LIABILITIES
a. A financial liability is derecognized only when extinguished
b. An exchange between an existing borrower and lender of debt instruments with substantially different terms
or substantial modification of the terms of an existing financial liability of part thereof is accounted for as an
extinguishment
c. The difference between the carrying amount of a financial liability extinguished or transferred to a 3rd party
and the consideration paid is recognized in profit or loss.

FINANCIAL ASSETS
The following criteria should be met in order for an entity to derecognize a financial asset:

a. The rights to the cash flows from the asset has expired.
b. The entity has transferred its rights to receive the cash flows from the asset and transferred substantially all
the risk and rewards.
c. If the entity does not retain control of the asset

The recognition for the gains and losses from derecognition will depend if the financial asset is a debt instrument or
equity instrument and its classification as AC, FVOCI or FVPL.

4.1 PFRS 9 HYBRID CONTRACTS ACCOUNTING TREATMENT

When the host contract is a financial asset within the scope of PFRS 9, the hybrid financial instrument is not
bifurcated; instead it is assessed in its entirety for classification under the standard.

Existence of a derivative feature in a hybrid instrument might not preclude amortized cost. This may be the case
when the economic risks and characteristics of the instrument are closely related to the host contract.

Host Contract is a Financial Liability or a Non-financial Host

When the host contract is either (i) a financial liability within the scope of PFRS 9 or (ii) an instrument not within the
scope of PFRS 9, an assessment is performed to determine whether the embedded derivative must be separated
from the host (i.e., whether the embedded derivative should be accounted for separately).

4.2 Bifurcation of embedded derivative in financial liabilities – decision tree

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CONCEPT OF COMPOUND INSTRUMENTS

• A hybrid instrument is comprised of a liability component (the host contract) and an embedded derivative
while a compound instrument is comprised of a liability component (the host contract) and an equity
component.

• The concept of compound instruments is similar to that of hybrid instruments.

o An example of a compound instrument is a bond issued by the entity that is convertible into a fixed
number of shares of the entity, which can be split between: a liability component – an obligation
to pay the scheduled coupons and, when the bond is not converted, the principal; and an equity
component – the conversion right by the bondholders (a sold call option on own shares).

• Compound instruments are defined in IAS 32. The liability and equity components of a com- pound
instrument are required to be accounted for separately, upon initial recognition, and the separation is not
subsequently revised.

• The split between the two components is implemented in two steps:

o The fair value of the liability component is calculated, and this fair value establishes the initial
carrying amount of the liability component,
o The fair value of the liability component is deducted from the fair value of the instrument in its
entirety, with the residual amount being an equity component.

DERIVATIVES
Definition
Under PFRS 9, a derivative is a financial instrument (or other contract within the scope of PFRS 9) with all of the
following characteristics:
1. Its value changes in response to changes in a specified “underlying”;
2. It requires no initial investment, or an initial net investment that is smaller than would be required for other
types of contracts that would be expected to have a similar response to changes in market factors.
3. It is settled at a future date.

HEDGE ACCOUNTING
5.1 Relevant accounting standards for hedging

Objective of Hedge Accounting

Ø The objective of hedge accounting is to represent, in the financial statements, the effect of an entity’s risk
management activities that use financial instruments to manage market risk exposures that could affect
profit or loss (or OCI in the case of equity investments at FVOCI).

Hedged Item and Hedging Instrument

Ø The hedged item is the item that exposes the entity to a market risk(s). It is the element that is designated
as being hedged.
Ø The hedging instrument is the element that hedges the risk(s) to which the hedged item is exposed.
Frequently, the hedging instrument is a derivative.

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Hedge accounting is:

Ø A technique that modifies the normal basis for recognizing gains and losses (or revenues and expenses)
associated with a hedged item or a hedging instrument to enable gains and losses on the hedging
instrument to be recognized in profit or loss (or in OCI in the case of hedges of equity instruments at
FVOCI) in the same period as offsetting losses and gains on the hedged item.
Ø To be able to apply hedge accounting, the hedge must meet remarkably strict criteria at inception and
throughout the life of the hedging relationship.

Accounting for Derivatives

Ø Fluctuations in the derivative’s fair value can be recognized in different ways, depending on the type of
hedging relationship:
• undesignated or speculative;
• fair value hedge;
• cash flow hedge;
• net investment hedge.
Ø Fair value hedge – recognizing gains or losses (or revenues or expenses) in respect of both the hedging
instrument and hedged item in earnings in the same accounting period.
Ø Cash flow hedge or net investment hedge – deferring recognized gains and losses in respect of the
hedging instrument on the balance sheet until the hedged item affects earnings.
Ø Undesignated or Speculative - some derivatives are termed “undesignated” or “speculative”. They include
derivatives that do not qualify for hedge accounting. They also include derivatives that the entity may
decide to treat as undesignated even though they could qualify for hedge accounting. These derivatives are
recognized as assets or liabilities for trading. The gain or loss arising from their fair value fluctuation
is recognized directly in profit or loss.
Ø A net investment hedge, or hedge of a net investment in a foreign operation, is a hedge of the foreign
currency exposure arising from the reporting entity’s interest in the net assets of a foreign
operation.
o The effective portion of the gain or loss on the hedging instrument is recognized in the
“foreign currency translation reserve” of OCI. As the exchange difference arising on the net
investment is also recognized in OCI, the objective is to match both exchange rate differences.
o The ineffective portion of the gain or loss on the hedging instrument is recognized immediately in
profit or loss.
o
Sources:
1. Philippine Financial Reporting Standard 9 – Financial Instruments
2. Valix, Peralta and Valix, 2019, Conceptual Framework and Accounting Standards
3. Ramirez, 2015, Accounting for Derivatives, Advance Hedging under PFRS 9 2nd Edition

QUESTION
1. Define a financial instrument.
2. Define a financial asset.
3. Give examples of financial asset.
4. Define a financial liability.
5. Give examples of a financial liability.
6. Define an equity instrument.
7. What is the guideline in determining whether a financial instrument is a financial liability or an equity
instrument?
8. Explain a redeemable preference share.
9. Explain the accounting for a compound financial instrument.
10. Explain the accounting for bonds payable issued with share warrants and convertible bonds.
11. Explain the initial measurement of financial asset.
12. Explain the subsequent measurement of financial asset.
13. What are the financial assets measured at fair value through other comprehensive income.
14. Explain financial asset held for trading.
15. Explain measurement of equity investment at fair value through other comprehensive income.
16. Explain measurement of debt investment at amortized cost.
17. Explain measurement of debt investment at fair value through other comprehensive income.
18. Explain the treatment of unrealized gain and loss on financial asset at fair value.
19. Explain the derecognition of financial asset at fair value through profit or loss.
20. Explain derecognition of equity investment at fair value through other comprehensive income.

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21. A financial instrument is any contract that gives rise to

A. A financial asset
B. A financial liability
C. A financial asset of one entity and a financial liability of another entity
D. A financial asset of one entity and a financial liability or equity instrument of another entity

22. Which is not classified as a financial instrument?

A. Convertible bond C. Warranty provision
B. Foreign currency contract D. Loan receivabl

23. Which cannot be considered a financial asset?

A. Cash
B. A contractual right to receive cash or another financial asset from another entity
C. A contractual right to exchange financial instruments which another entity under conditions that are
potentially unfavorable
D. An equity instrument of another entity

24. Which should be classified as financial asset?

A. Patent C. Inventory
B. Trade accounts receivable D. Land

25. A financial liability

A. Must be classified as noncurrent liability
B. Is a contractual obligation to deliver cash or another financial asset to another entity
C. Is a contractual obligation to exchange financial instrument with another entity under conditions that
are potentially favorable to the entity
D. Is a contractual obligation to deliver cash or any asset to another entity.

26. Financial liabilities include all of the following, except

A. Trade accounts payable
B. Notes payable
C. Bonds payable
D. Income tax payable

27. It is any contract that evidences residual interest in the assets of an entity after deducting all of the liabilities
A. Equity instrument
B. Debt instrument
C. Loan receivable
D. Financial asset with indeterminable fair value

28. How should preference shares that are redeemable mandatorily be presented in the statement of financial
position?
A. Noncurrent liability
B. Current liability
C. Equity
D. Either current or noncurrent liability depending on redemption date

29. What is the presentation of preference dividend on mandatorily redeemable preference shares?
A. Deducted from retained earnings
B. Deducted from share premium
C. Interest expense
D. Deducted from share capital

30. Which is not an equity instrument?

A. Ordinary share capital C. Preference share capital
B. Bond payable D. Share option or warran

31. Depending on the business model for managing financial assets, an entity shall classify financial assets
subsequent to initial recognition at
A. Fair value through profit or loss

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B. Amortized cost
C. Fair value through other comprehensive income
D. All of these are used in measuring financial assets

32. Which of the following is a characteristic of a financial asset held for trading?
A. It is acquired principally for the purpose of selling or repurchasing it in the near term.
B. It is part of a portfolio of financial assets that are managed together and for which there is actual
pattern of short-term profit taking.
C. It is a derivative that is not designated as an effective hedging instrument.
D. All of these are correct

33. Under PFRS, the presumption is that equity investments are

A. Held for trading
B. Held to profit from price changes
C. Held for trading and held to profit from price changes
D. Held as financial assets at fair value through other comprehensive

34. All of the following shall be measured at FVPL, except

A. Financial asset held for trading
B. Debt investment irrevocably designated at FVPL
C. Investment in quoted equity instrument
D. Debt investment at amortized cost

35. Equity investments irrevocably accounted for at fair value through other comprehensive income are
A. Nontrading investments of less than 20%
B. Trading investments of less than 20%
C. Investments of between 20% and 50%
D. Investments of more than 50%

36. Entities are required to measure financial asset based on all of the following, except
A. The business model for managing financial asset
B. Whether the financial asset is a debt or an equity investment
C. The contractual cash flow characteristics of the financial asset
D. All of the choices are required

37. Debt investment that meet the business model and contractual cash flow tests are reported at
A. Net realizable value
B. Fair value
C. Amortized cost
D. The lower of amortized cost and fair value

38. Debt investment not held for collection are reported at

A. Amortized cost
B. Fair value
C. The lower of amortized cost and fair value
D. Net realizable value

39. Debt investments reported at amortized cost are

A. Managed and evaluated based on a documented risk management strategy
B. Trading debt investments
C. Held for collection debt investments
D. All of these are correct

40. A debt investment shall be measured at fair value through other comprehensive income
A. When the debt investment is held for trading
B. When the debt investment is not held for trading
C. By irrevocable designation
D. When the business model is to collect contractual cash flows that are solely payments of principal
and interest and also to sell the financial asset

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