Audit Supervisor at RSM Poland
As we announced towards the end of 2019, after discussing a couple of topics on fixed assets and provisions, we will now start a series of articles on financial instruments. Adopting a practical point of view, we would like to explain how to identify financial instruments, and then measure them and present them properly. To this end, we will need the provisions of the Accounting Act (hereinafter: AA) or the Regulation on Detailed Rules of Recognition, Valuation Methods, Scope of Disclosure and Presentation of Financial Instruments (Journal of Laws, item 277) (hereinafter: RMFIF), but also, or rather most of all, International Financial Reporting Standards (IFRS), primarily including IFRS 9, but also IFRS 7, IAS 32 and IAS 39.
What should be emphasised is that for the time being there is no comprehensive study on financial instruments in the form of a National Accounting Standard. However, National Accounting Standard no 4 “Impairment of Assets” defines rules and principles of writing down impaired financial instruments. At the same time, we must be aware of the fact that since IFRS 9 Financial Instruments came into force, i.e. since 1 January 2018, Polish regulations on financial instruments no longer coincide with international regulations.
When it comes to IFRS, the recognition, measurement of assets and financial liabilities, impairment and general hedge accounting are regulated under IFRS 9, which is in principle a revision of IAS 39. IFRS 7 focuses on disclosures and risks of managing financial instruments, thus being a transposition of IAS 32. IAS 32 now regulates presentation only.
Understanding financial instruments
Having so many sources of legal regulation, are we fully aware of what financial instruments actually are? Pursuant to Article 3 par. 1 item 23 of the Accounting Act, a financial instrument shall be understood as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity, provided that the contract concluded between two or more parties has clear economic effects, regardless of whether the exercise of contractual rights or obligations is unconditional or conditional. Therefore, the presence of a contract as well as the creation of financial assets, financial liabilities or equity instrument are key premises for the identification of financial instruments.
IAS 32 defines financial instruments along the same lines. However, please note that its guidelines shall be applied by all entities to all financial instruments with the following exceptions:
- interests in subsidiaries, associates and joint ventures,
- employer’s rights and obligations under employee benefit plans (see: IAS 19),
- insurance contracts (see: IFRS 4) or
- financial instruments, contracts and obligations under share-based payment transactions (see: IFRS 2) with certain exceptions.
The AA and IAS 32 also define financial assets, financial liabilities and equity instruments we are now going to take a closer look at.
What are financial assets?
Pursuant to the AA, financial assets shall be cash assets, equity instruments issued by other entities, as well as a contractual right to receive cash assets or the right to exchange financial instruments with another entity on favourable terms. In other words, financial assets include, among others:
- cash in national currency and foreign currencies on the bank account,
- term deposits, bank deposits,
- Treasury bonds and corporate bonds,
- loan receivables,
- finance lease receivables,
- notes receivables,
- trade receivables,
- shares in another entity,
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At the same time, the Act provides that financial assets do not include in particular the following:
- deferred income tax provisions and assets,
- financial guarantee contracts, where performance of the guarantee is about reimbursing the beneficiary for a loss it incurs because the debtor fails to make payment when due,
- agreements of the transfer of rights from securities in the period between the date of transaction conclusion and settlement, if execution of these agreements requires securities to be released at a proper date, also when the transfer of these rights takes the form of an entry on a securities account maintained by an entity authorised under separate regulations,
- assets and liabilities on any plans resulting in interests of employees and other people related with the entity in the entity’s equity,
- merger agreements that give rise to obligations stipulated in Article 44b par. 9 of the AA.
What does this mean in practice? Entities subject to a mandatory audit that do not meet the criteria of a small entity are obliged to apply detailed rules on financial instruments – RMFIF. This applies both for financial assets and financial liabilities.
To illustrate the above, let us take, for example, receivables and loans granted classified as financial assets: they can be measured at an adjusted purchase price, and if the entity intends to sell them within 3 months – according to the market value or at fair value determined in a different way. Sometimes entities do not care about this and measure the above items at their purchase price; optionally they apply the prudence principle as required under the Act.
For the sake of comparison, according to IAS, a financial asset is any asset that is:
- an equity instrument of another entity,
- a contractual right:
- to receive cash or another financial asset, or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity, or
- a contract that may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to receive a variable number of entity’s own equity instruments,
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
A few words about financial liabilities
The situation is similar for financial liabilities. Pursuant to the AA, it is an entity’s liability to deliver financial assets or exchange a financial instrument with another entity. Financial liabilities may be measured at an adjusted purchase price, and if the entity intends to sell them within 3 months – according to their market value or the fair value determined in a different way. Financial liabilities include:
- loans and credits,
- finance lease liabilities.
In accordance with IAS 32, financial liabilities are somewhat like reverse financial assets, i.e. a financial liability is any liability that is:
- a contractual obligation:
- to deliver cash or another financial asset to another company or,
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity or,
- a contract that will or may be settled in the entity’s own equity instruments and is:
- instrumentem niezaliczanym do instrumentów pochodnych, za który jednostka jest lub może być zobowiązana do uiszczenia zmiennej liczby własnych instrumentów kapitałowych jednostki lub
- instrumentem pochodnym, który może zostać rozliczony w sposób inny niż poprzez zamianę stałej ilości środków pieniężnych lub innych aktywów finansowych na stałą liczbę własnych instrumentów kapitałowych jednostki
At this point, it would be a good idea to recall the definition of a small entity according to Article 3 par. 1c of the AA, where small entities are commercial companies (partnerships, limited liability companies and joint stock companies, including companies in organisation) and civil partnerships, as well as other legal persons and branches of foreign companies within the meaning of the Act of 6 March 2018 on the Rules of Participation of Foreign Entrepreneurs and Other Foreigners in Trade on the Territory of the Republic of Poland, which did not exceed two of the following three threshold values in the fiscal year for which they prepare their financial statements and in the year preceding that fiscal year, and in the case of entities starting their operations or opening their books of account in the manner provided for in the Act: in the fiscal year in which they started their operations or opened their books of account in the manner provided for in the Act:
- PLN 25.5 million in total assets at the end of the fiscal year,
- PLN 51 million in net revenues from sales of goods and finished products in the fiscal year,
- average annual headcount (FTE) of 50 persons,
– with respect to which the approving authority issued a decision on simplified financial statements, which in practice means that a relevant resolution must be adopted, in theory not later than on the final date of the financial statements, i.e. by 31 March of the year following the year for which financial statements are prepared for most entities.
Last but not least: equity instruments
Finally, we should define equity instruments – these are any contracts that evidence a residual interest in the assets of an entity after deducting all of its liabilities, as well as an entity’s obligation to issue or deliver its own equity instruments, in particular shares, share options or warrants.
The AA provides definitions of the aforementioned terms, yet the detailed classification as well as rules and principles of their measurement can be found in the RMFIF, excluding among others:
- equity instruments issued by an entity, including shares, own share options, pre-emptive rights or warrants, rights to shares and other financial instruments classified as the entity’s equity under the Act,
- shares in subsidiaries.
As regards financial instruments, they are classified under the Polish balance sheet law into the following categories:
- financial assets and financial liabilities for trading,
- loans granted and own receivables,
- financial assets held to maturity,
- financial assets available for sale.
The above comparison and preliminary conclusions result from the analysis made on the basis of the AA and RMFIF along with IAS 32. When it comes to detailed aspects of financial instruments presented in international standards, it is a different story. In the upcoming articles we are going to try to explain how to identify financial instruments based on IFRS, how to measure them, how to make disclosures in financial statements and how to approach their impairment, cash flow test, expected loss model and hedging. We encourage you to read them.
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