The term “initial recognition” refers to the time at which an entity should record an asset or liability initially on its balance sheet. An entity should recognize a financial asset or financial liability when the entity becomes a party to the contractual provisions of the instrument.
In other words, financial assets or liabilities should be recognized when the entity becomes a party to the contract rather than when the transaction is settled.
See also the notes to the consolidated financial statements related to:
However, if loan assets or liabilities are issued at below the market interest rate, then the fair value on recognition is not the amount paid but the amount discounted for the effect of the below-market-value interest on the loans.
Debit | Bank | 98 |
|
Credit | Financial debts |
| 98 |
Liabilities with deferred payment
The fair value is the value of the cash flows owed, discounted using an interest rate on the date of the transaction for the repayment period (the interest rate that enables the discounting of the nominal amount to the present cash purchase price). The fair value based on the discounting principle only applies for liabilities with deferred payment (in general for a period that exceeds 12 months or the normal operating cycle).
In the latter case, the difference stemming from the discounting must be recognized as interest income over the period in which the liability is paid.
In practice, the discounting mechanism will only be employed for at least a 50 kEUR bill.
Loans that are not remunerated or have buydown rates, as well as non-current operating receivables and liabilities (> 1 year), must be analysed and possibly restated.
The standard (IAS 39, Application Guidance AG79) states that:
(...) Short-term receivables and payables with no stated interest rate may be measured at the original invoice amount if the effect of discounting is immaterial.
Initially, the money paid in return for financial assets and liabilities that are not remunerated or have buydown rates must be recognized in 2 separate components:
Subsequent to initial recognition, financial assets and financial liabilities are measured at fair value, amortized cost or cost depending on their classification and whether their fair value can be determined reliably.
The subsequent measurement of financial instruments (IAS 39, par 46) and the accounting treatment of the gain or loss are summarized in the following table:
Fair value determination sequence for financial assets or liabilities at fair value through P&L and quoted available-for-sale financial assets:
Example of the application of the amortized cost method:
The effective interest method is most easily applied to instruments that have fixed payments and a fixed term. The following example illustrates this.
At the end of year Y, a company purchases a debt instrument with 5 years remaining to maturity for its fair value of EUR 1000 (including transaction costs). The instrument has a principal amount of EUR 1250 and carries a fixed interest of 4.72% payable annually (EUR 1250 x 4.72% = EUR 59 per year).
In order to allocate interest receipts and the initial discount over the term of the instrument at a constant rate on the carrying amount, it can be shown that interest needs to be accrued at the rate of 10% annually.
The table below provides information about the amortized cost, interest income, and cash flows of the debt instrument in each reporting period.
Year | (a) Amortized cost at beginning of year | (b) Effective interest rate | (c = a*b) Interest income | (d) Cash flows | (e = a+c-d) Amortized cost at year-end | |
|---|---|---|---|---|---|---|
| Interest | Principal | |||||
Y |
|
|
|
|
| 1000 |
Y+1 | 1000 | 10% | 100 | 59 |
| 1041 |
Y+2 | 1041 | 10% | 104 | 59 |
| 1086 |
Y+3 | 1086 | 10% | 109 | 59 |
| 1136 |
Y+4 | 1136 | 10% | 114 | 59 |
| 1190 |
Y+5 | 1190 | 10% | 119 | 59 | 1250 | 0 |
See also: Methodology applied in respect of the effective rate method
(IAS 39, Application Guidance AG8)
If an entity revises its estimates of payments or receipts, the entity shall adjust the carrying amount of the financial asset or financial liability (or group of financial instruments) to reflect actual and revised estimated cash flows.
The entity recalculates the carrying amount by computing the present value of estimated future cash flows at the financial instrument’s original effective interest rate. The adjustment is recognised as income or expense in profit or loss.
Foreign currency denominated financial liabilities are translated at the historical rate at the date of the transaction.
The application of the effective interest rate method is done on the basis of the foreign currency denominated cash flows.
At each closing, the amortized cost of the foreign currency debt is translated at the closing rate. The resulting translation gains or losses are directly recognized in income (except where the foreign currency debt is classified as a net investment in a foreign operation).
See also the note to the consolidation financial statements related to 8. Foreign currencies