Accounting Alert August 2021

Public Benefit Entities: Financial liabilities under PBE IPSAS 41

In the February 2021 edition of Accounting Alert we noted that public benefit entities face substantial changes to accounting for financial instruments, due to PBE IPSAS 41 Financial Instruments (“PBE IPSAS 41”) replacing PBE IPSAS 29 Financial Instruments: Recognition and Measurement (“PBE IPSAS 29”) for financial reporting periods beginning on or after 1 January 2022.

In the March 2021 edition of Accounting Alert and the April 2021 edition of Accounting Alert we discussed various aspects of the classification of financial assets under PBE IPSAS 41. In the May 2021 edition of Accounting Alert we examined the measurement of financial assets under PBE IPSAS 41 and in the July 2021 edition of Accounting Alert we examined the impairment of financial assets under PBE IPSAS 41.

As explored in those articles, the manner in which financial assets are accounted for under PBE IPSAS 41 will differ substantially from the accounting treatment applied under PBE IPSAS 29, with new classification categories for financial assets, and a different impairment approach that may lead to the recognition of earlier and greater amounts of impairment losses.

In this edition of Accounting Alert, we turn our attention to accounting for financial liabilities under PBE IPSAS 41.

Classification of financial liabilities

Although PBE IPSAS 41will herald major changes in the accounting for financial assets, the accounting for financial liabilities will remain largely consistent with that applied under PBE IPSAS 29. Under PBE IPSAS 41, there will be the same two financial liability classification categories as existed under PBE IPSAS 29:

Financial liabilities at fair value through surplus or deficit
Financial liabilities at amortised cost.

A financial liability is classified as a financial liability at fair value through surplus or deficit if it meets one of the following conditions:

It is held for trading
It is designated by the entity as at fair value through surplus or deficit (note that such a designation is only permitted if specified conditions are met).

A financial liability is held for trading if it meets one of the following conditions:

It is incurred principally for the purpose of repurchasing it in the near term
On initial recognition it is 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
It is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).

Examples of financial instruments that fall under this category include interest rate swaps, commodity swaps and foreign currency forwards and options.

An entity may designate a financial liability at fair value through surplus or deficit when doing so results in more relevant information, because either:

It eliminates, or significantly reduces, a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch) that would otherwise arise from measuring assets or liabilities, or recognising the gains and losses on them, on different bases; or
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 information about the group is provided internally on that basis to the entity’s key management personnel.

Measurement of financial liabilities

Financial liabilities at fair value through surplus or deficit are initially recognised at fair value and are thereafter carried at fair value.

Financial liabilities at amortised cost are initially recognised at fair value less transaction costs and are thereafter carried at amortised cost using the effective interest method.

The one major change for financial liabilities designated at fair value through surplus or deficit under PBE IPSAS 41 relates to the manner in which changes in own credit risk are accounted for.

Under PBE IPSAS 29, all changes in the fair value of financial liabilities at fair value through surplus or deficit are recognised in surplus or deficit. However, under PBE IPSAS 41, where a financial liability has been designated at fair value through surplus or deficit, fair value changes related to changes in the entity’s own credit risk are recognised in other comprehensive revenue and expense, while all other fair value changes are recognised in surplus or deficit.

Example

As a brief example, if an entity has a financial liability carried at fair value through surplus or deficit, and that liability has a total fair value decrease of $10,000, with $2,000 of that decrease due to a change in the entity’s own credit risk, under PBE IPSAS 29 the journal entry would be:

Dr Financial liability $10,000
Cr Surplus or deficit $10,000

However, under PBE IPSAS 41 the journal entry would be:

Dr Financial liability $10,000
Cr Other comprehensive revenue and expense $2,000
Cr Surplus or deficit $8,000.

It’s important to note that the requirement to recognise changes in fair value related to the entity’s own credit risk in other comprehensive revenue and expense does not apply to all financial liabilities measured at fair value through surplus or deficit, but rather only to financial liabilities designated at fair value through surplus or deficit. Therefore changes in fair value due to own credit risk for interest rate swaps and other derivatives are recognised in surplus or deficit.

Concluding thoughts

In preparing for their adoption of PBE IPSAS 41, finance teams will need to ensure that they have mechanisms in place to identify any financial liabilities designated at fair value through surplus or deficit and ensure that changes in own credit risk are accounted for correctly in other comprehensive revenue and expense.