FINANCIAL INSTRUMENTS: RECOGNITION AND DERECOGNITION

Recognition

Under IFRS 9 Financial Instruments, an entity should recognise a financial asset or liability in its statement of financial position when the entity becomes a party to the contractual provisions of the instrument, rather than when the contract is settled.

 

This means that a financial asset and liability should be recognised by both parties to a contract when the contract is entered into.

For example, Entity A sells goods to Entity B on a thirty days credit term. When Entity A delivers the goods to Entity B, both parties are said to have entered into the contractual provisions of the sale. Therefore, Entity A should have recognised a financial asset (i.e. a trade receivable) while Entity B should have recognised a financial liability (i.e. a trade payable). When the outstanding amount is eventually settled, the financial asset and liability in both entity's financial statements would be extinguished. Assuming the sales value to be $1,000, the entries in the books of Entity A would be as follows:

On sale:

	Dr	Trade receivables	$1,000
	Cr	Sales	$1,000

On receipt:

	Dr	Cash	$1,000
	Cr	Trade receivables	$1,000

As we can see above, the trade receivables figure will ultimately be extinguished when the payment is received from Entity B. For the sake of convenience, why don't we wait for the payment from Entity B and only make one entry into the books as follows?

	Dr	Cash	$1,000
	Cr	Sales	$1,000

The entry above would have given the same net effect on the financial statements. However, we would have contradicted the provisions of IFRS 9. By making the above entry, we would have recognised the sale when the contract is settled, rather than when the contract is first entered into.

Likewise, Entity B should have made the following entries:

On purchase:

	Dr	Purchases	$1,000
	Cr	Trade payables	$1,000

On payment:

	Dr	Trade payables	$1,000
	Cr	Cash	$1,000

Derecognition of financial asset
An entity should derecognise a financial asset when either of the following has occurred: 

• the asset has been sold so that the risks and rewards of ownership have been substantially transferred; or
• the contractual right to the cash flow of the financial asset has expired.

Let's look at these derecognition criteria in more detail.

Financial asset is sold
This criteria is not as straightforward as it seems. A financial asset cannot be derecognised simply because it has been sold. An entity needs to evaluate whether the risks and rewards attached to the financial asset has been substantially transferred to another party. IFRS 9 does not define 'substantially transferred' but in practice, this is often taken to mean 'more than 90%'.

Consider the following illustrations:

Illustration 1 

Entity A sold a financial asset to Entity B for $100,000 with an agreement to buy it back one year later at $120,000. 

In this situation, Entity A is obliged to buy back the financial asset a year later. This means that the risks and rewards attached to the financial asset is still with Entity A. As such, Entity A cannot derecognise the financial asset. The substance of this transaction is actually a loan to Entity A secured on the financial asset. It makes sense that the loan amount is $100,000 while the interest on the loan is $20,000.

Illustration 2

Entity A sold a financial asset to Entity B for $100,000 with an option to buy it back one year later at fair value.

In this situation, Entity A is not obliged to buy back the financial asset a year later as the agreement gives Entity A the option, not obligation to repurchase the financial asset at fair value. This means that Entity A can choose to repurchase the financial asset if its fair value had fall or simply let the option lapse unexercised if the fair value of the financial asset had increased. Therefore, the risks and rewards attached to the financial asset have been transferred to Entity B. As such, Entity A should derecognise the financial asset on that sale.

If, as a result of a transfer, a financial asset is derecognised but the transfer results in the entity obtaining a new financial asset or assuming a new financial liability, the entity shall recognise the new financial asset or financial liability at fair value.

Illustration 3

Entity A factors $100,000 receivables to a bank for $95,000. The entity estimates that 1% of the receivables are doubtful and provides a guarantee to the bank to reimburse any outstanding amounts.

In this situation, Entity A should derecognise the trade receivables as the risks and rewards have been substantially transferred to the bank. Entity A is only exposed to 1% risk in respect of the default in payment by the receivables. In addition, Entity A recognises a new financial liability as a result of providing the guarantee to the bank. The financial liability should be measured at fair value.

Contractual right to cash flows expired
A financial asset should be derecognised when the right to its cash flows has expired. This can simply be  illustrated as follows:

Illustration 4

On 1 January 20X9, Entity A enters into a call option to purchase 100 shares on 30 June 20X9 at $2 per share. The cost of each option is $1.

In this case, if Entity A does not exercise the call options on 30 June 20X9, they will be expired and should be derecognised as Entity A could not exercise the call options later or get a refund for the cash paid.

Derecognition of financial liability
An entity should derecognise a financial liability when the liability has been extinguished, i.e. when the obligation specified in the contract is discharged, cancelled or has expired.

There is not much complexity here. A financial liability should be derecognised simply when it is extinguished. For instance, a trade payable should be derecognised when the outstanding balance is settled or waived by the supplier.