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Chapter 21 Financial Instruments
Chapter 21 Financial Instruments
Chapter 21
Financial Instruments
Contents: Page
1. Introduction 648
2. Definitions 648
Example 1: financial assets 648
Example 2: financial liabilities 649
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1. Introduction
Most students find the financial instruments section very difficult, but by simply learning and
understanding the various definitions and rules, it will be made a lot easier. The IAS and
IFRS standards covering the recognition, measurement and disclosure of financial instruments
are very long, and therefore this chapter contains only the most important aspects.
2. Definitions
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3. Financial risks
3.1 Overview
Market risk is the risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises of:
• interest rate risk;
• currency risk; and
• other price risk.
Interest rate risk is the risk that the value of the instrument will fluctuate with changes in the
market interest rate. A typical example is a bond: a bond of C100 earning a fixed interest of
10% (i.e. C10) would decrease in value if the market interest rate changed to 20%,
(theoretically, the value would halve to C50: C10/ 20%). If the bond earned a variable
interest rate instead, the value of the bond would not be affected by interest rate fluctuations.
Currency risk is the risk that the value of the instrument will fluctuate because of changes in
the foreign exchange rates. A typical example would be where we have purchased an asset
from a foreign supplier for $1 000 and at the date of order, the exchange rate is $1: C10, but
where the local currency weakens to $1: C15. The amount owing to the foreign creditor has
now grown in local currency to C15 000 (from C10 000).
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Price risk is the risk that the value of the financial instrument will fluctuate as a result of
changes in the market prices. For example: imagine that we committed ourselves to
purchasing 1 000 shares on a certain date in the future, when the share price was C10 on date
of commitment. By making such a commitment, we would be opening ourselves to the risk
that the share price increases (e.g. if the share price increased to C15, we would have to pay
C15 000 instead of only C10 000).
This is the risk that the one party to a financial instrument will fail to discharge an obligation
and cause the other party to incur a financial loss. A typical example is a debtor, being a
financial asset to the entity, who may become insolvent and not pay the debt due (i.e. where a
debtor becomes a bad debt).
This is the risk that the entity will encounter difficulty in raising funds to meet commitments
associated with the financial instrument. An example would be where we (the entity) found
ourselves with insufficient cash to pay our suppliers (i.e. where we become a bad debt to one
of our creditors).
4. Derivatives
4.1 Options
An option gives the holder the opportunity to buy or sell a financial instrument on a future
date at a specified price. The most common option that we see involves options to buy shares
on a future date at a specific price (strike price). These are often granted to directors or
employees of companies. Another example is an option to purchase currency on a future date
at a specific exchange rate. Options may be used to limit risks (as the exercise price of an
option is always specified) or they may be used for speculative purposes (i.e. to trade with).
4.2 Swaps
A swap is when two entities agree to exchange their future cash flows relating to their
financial instruments with one another. A common such agreement is an ‘interest rate swap’.
For example, one entity (A) has a fixed-rate loan and another entity (B) has a variable-rate
loan. The two entities may agree to exchange their interest rates if A would prefer a variable
rate and B would prefer a fixed rate.
Example 3: swaps
Company A has a loan of C100 000 with a fixed interest rate of 10% per annum.
Company B has a loan of C100 000 with a variable interest rate, which is currently 10% per
annum.
Company A and Company B agree to swap their interest rates.
The variable rate changed to 12% in year 2.
The variable rate changed to 8% in year 3.
Required:
Journalise the receipts/ payments of cash in Company A’s books for year 2 and year 3.
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Debit Credit
Year 2
Interest expense (finance charges) 10 000
Bank 10 000
Interest on fixed rate loan paid to lender: 100 000 x 10%
Year 3
Interest expense (finance charges) 10 000
Bank 10 000
Interest on fixed rate loan paid to lender: 100 000 x 10%
Bank 2 000
Interest income 2 000
Difference between variable and fixed rate loan received from
Company B: 100 000 x (12% - 10%)
4.3 Futures
A future is an agreement by the entity to buy a specified type and quantity of a financial
instrument on a specified future date at a specified price. For example, if A does not have the
cash to purchase shares immediately but believes that they are a worthwhile investment, it
may enter into a futures contract with another entity (B) whereby A commits to buying them
on a future date. The difference between a future and an option is that a future commits the
entity whereas an option does not.
Some financial instruments have both equity and liability portions. These are referred to as
compound instruments. These instruments must be split into the two separate elements based
on their substance rather than on their legal form.
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Barmy Limited issued 100 000 cumulative, 10% preference shares on 1 January 20X5 at an
issue price of C5 each (par value). These preference shares are convertible on the 31
December 20X7 into ordinary shares at the option of the holder. If they are not converted
they will be redeemed on this date at par. The market interest rate is 15%.
Required:
Split the compound financial instrument into its equity and liability portions.
Comment:
The preference shares that we issued are convertible into ordinary shares. The conversion is at the
option of the shareholder: in order to be prudent, we assume the worst from a cash flow point of view
and therefore assume that all the shareholders will choose to the redemption instead of the conversion.
The potential liability that we have is therefore (1) the interest that we know we will have to pay each
year for three years plus (2) the possible redemption (repayment) of capital after three years. The
liability is measured at the present value of these two cash outflows.
The difference between the amount we receive and the amount we recognise as a liability (measured at
its present value) is recognised as equity.
1.1 Annuity
Interest payment each year for 3 years (100 000 x C5 x 10%) 50 000
Discount factor for 3 years (based on 15%) (15% for a 3-year annuity) * 2.2832
Liability portion 114 160
1.2 Redemption
Lumpsum payment after 3 years (100 000 x C5 x 100%: par value) 500 000
Discount factor after 3 years (based on 15%) (15% after 3-years) * 0.6575
Liability portion 328 750
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Crazee Limited issued 500 000 C15 par value 20% preference shares on 2 January 20X4. The
preference shares were issued at par and are compulsorily convertible into ordinary shares (1
ordinary share for every 5 preference shares) on 31 December 20X6. The appropriate
adjusted market dividend rate for ‘pure’ redeemable preference shares is 25%.
Required:
Prepare journal entries to record the financial instrument over its three-year life in the
accounting records of Crazee Limited. You may ignore the journal entry for its conversion on
31 December 20X6.
Comment:
The preference shares that we issued are convertible into ordinary shares. The conversion is
compulsory. This means that there is definitely no chance that we will have to repay any of the cash
received).
The potential liability that we have is therefore only the interest that we know we will have to pay each
year for three years. The liability is measured at the present value of these cash outflows.
The difference between the amount we receive and the amount we recognise as a liability (measured at
its present value) is recognised as equity.
Interest payment each year for 3 years (500 000 x C15 x 20%) 1 500 000
Discount factor for 3 years (based on 25%) (25% for a 3-year annuity) * 1.952
Liability portion 2 928 000
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Journals
Debit Credit
2 January 20X4
Bank 7 500 000
Financial liability (preference shares) 2 928 000
Preference share equity 4 572 000
Issue of convertible preference shares
31 December 20X4
Finance costs 732 000
Financial liability (balancing) 768 000
Bank 1 500 000
Payment of preference dividend
31 December 20X5
Finance costs 540 000
Financial liability (balancing) 960 000
Bank 1 500 000
Payment of preference dividend
31 December 20X6
Finance costs 300 000
Financial liability (balancing) 1 200 000
Bank 1 500 000
Payment of preference dividend
On 2 January 20X4, Redvers Limited issued 10 000 C500 par value debentures, at a discount
of C100 on par value, details of which are as follows:
• These debentures are compulsorily redeemable at a premium of 10% over par value, 4
years later.
• The debentures bear interest at 15% per annum payable in arrears.
• The internal rate of return on the debentures is 25.23262%.
Required:
Prepare journal entries to record the financial instrument over its three-year life in the
accounting records of Redvers Limited.
Comment: The debentures that we issued are redeemable. There is no possibility of conversion and
therefore there is definitely no equity component.
The liability that we have is therefore (1) the interest that we know we will have to pay each year for
four years plus (2) the definite redemption (repayment) of capital after four years. The liability is
measured at the present value of these two cash outflows.
The difference between the amount we receive and the amount we recognise as a liability (measured at
its present value) is recognised as equity. This will work out to zero since the issue price will have
been worked out based on our rate of return combined with the 15% interest cost and the 10%
premium.
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1.1 Annuity
Interest payment each year for 4 years (10 000 x C500 x 15%) 750 000
Discount factor for 4 years (for 25.23262%) (25.23262% for a 4-year annuity)* 2.3518567
Liability portion 1 763 890
1.2 Redemption
Lumpsum payment after 4 years (10 000 x C500 x 110%) 5 500 000
Discount factor after 3 years (for 25.23262%) (15% after 3-years) * 0.4065654
Liability portion 2 236 110
Step 2: Calculate the equity portion (not required: there can be no equity since these are
compulsorily redeemable: calculation provided for interest)
Journals
Debit Credit
2 January 20X4
Bank 4 000 000
Financial liability debentures 4 000 000
Issue of convertible preference shares
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There are two main categories of financial liabilities, classified based on how they are
measured. Financial liabilities may be measured at:
• Fair value through profit or loss; or
• Not at fair value through profit or loss (‘other financial liabilities’).
Measurement of financial liabilities that are classified as fair value through profit or loss does
not include transaction costs.
Financial liabilities that are not classified as fair value through profit and loss are initially
recognised at the fair value of the consideration received, net of transaction costs. For
example if debentures were issued for C100 000, with C1 000 transaction costs, the entity
would have received a net amount of C99 000 and therefore the debentures would be
recognised at C99 000 in the statement of financial position.
6.2 Financial liabilities that are measured at fair value through profit or loss (IAS
39.9)
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The designation of fair value through profit and loss is not allowed if
• the contract including the financial liability includes embedded derivatives that do not
significantly change the cash flows otherwise required by the contract, or where the
separation of the embedded derivative is not allowed; and
• it involves an equity instrument that does not have an active market in which it has a
quoted market price and whose fair value cannot be measured reliably.
Fair value through profit or loss financial liabilities are carried at fair value and any changes
in fair value from one year to the next are recognised in profit or loss.
Mousse Limited issued 100 000 debentures on the 1 January 20X5, proceeds totaled
C200 000. On the 31 December 20X5 the debentures had a fair value of C300 000. Mousse
Limited designated these debentures to be held at ‘fair value through profit or loss’.
Required:
Provide the necessary journal entries to show how Mousse Limited should account for the
change in the fair value of the debentures.
6.3 Financial liabilities that are not measured at fair value through profit or loss
A liability that is not held for trading, (and not otherwise designated as fair value through
profit or loss on acquisition) is measured at amortised cost using the effective interest rate
method. This ensures that all the finance costs incurred are recognised over the life of the
financial liability.
Tempo Limited issued 200 000 debentures on the 1 January 20X5 at par of C7. The
debentures are redeemable on the 31 December 20X7 for C10.
Required:
Calculate the finance costs and the carrying amount of the debentures for each affected year.
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7.2 Fair value through profit or loss (IAS 39.9; .11A and .50)
These financial assets are essentially assets that are:
• held for trading, being:
• acquired with the intention to sell in the short term;
• acquired as part of a selling portfolio; or
• derivatives; or
• designated by the entity as fair value through profit and loss. This designation is only
allowed where it provides more relevant information:
• through eliminating measurement or recognition inconsistency, or
• because the financial asset is evaluated by the entity’s key management personnel
(e.g. board of directors) on a fair value basis in accordance with its documented risk
management or investment strategy.
The designation of fair value through profit and loss is not allowed if:
• the contract including the financial asset includes embedded derivatives that do not
significantly change the cash flows otherwise required by the contract, or where the
separation of the embedded derivative is not allowed; and
• it involves an equity instrument that does not have an active market in which it has a
quoted market price and whose fair value cannot be measured reliably.
Any financial asset may be deemed by the entity, when acquired, to be held for trading, but
may not be later reclassified.
Fair value through profit or loss financial assets are carried at fair value and any changes in
fair value from one year to the next are recognised as income or expenses.
Required:
Show the necessary journal entries to record the change in fair value.
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If, however, one of these assets has been sold by the entity in the past 2 years that type of
asset is now tainted and may not be classified as held to maturity.
Held to maturity financial assets are held at amortised cost using the effective interest rate.
Eternity Ltd purchased 10% debentures for C 200 000 on 1 January 20X5, (redeemable on the
31 December 20X6). They intended to hold them to maturity, (and had the ability to do so).
They had never held such debentures before. The fair value on 31 December 20X5 was
C400 000.
Required:
Prepare the necessary journal entries to show how Eternity Ltd should account for the
debentures for the year ended 31 December 20X5.
Debit Credit
1 January 20X5
Debentures (asset) Given 200 000
Bank 200 000
Purchase of debentures
31 December 20X5
Debentures (asset) 200 000 x 10% 20 000
Interest income 20 000
Interest earned on debentures
Notice that no entry is made for the increase in fair value.
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Loans and receivables are carried at amortised cost using the effective interest rate method.
Required:
Show the necessary journals to account for the loan for the year ended 31 December 20X5.
Debit Credit
30 June 20X5
Loan to Grateful Limited (asset) Given 50 000
Bank 50 000
Loan granted to Grateful Ltd
31 December 20X5
Loan to Grateful Limited (asset) 50 000 x 20% x 6 / 12 months 5 000
Interest income 5 000
Interest charged for the year ended 31 December 20X5
Available for sale financial assets are all those non derivative financial assets that are
designated as Available for Sale or are classified into any of the three other categories.
Available for sale financial assets are recorded at fair value, with the resultant changes in fair
value recognised in other comprehensive income (i.e. equity).
Dilly Limited purchased 500 000 shares in Sane Limited on the 31 March 20X5.
They were purchased for C1 000 000.
On the 31 December the fair value of these shares was C2 000 000.
These shares were classified as available for sale.
Required:
Prepare the necessary journal entries to show how Dilly Limited should account for these
shares.
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8.1 Overview
There are a variety of situations where financial instruments may need to be re-classified.
The most important issues are stated below.
An entity is not allowed to reclassify a financial instrument into or out of the ‘fair value
through profit or loss’ category whilst it is held or issued.
If, as a result of a change in intention or ability (or the fair value is no longer able to be
reliably measured), it becomes appropriate to measure at cost or amortised cost rather that at
fair value, then the previous fair value carrying amount becomes the de facto cost or
amortised cost from that date onwards. Any gain or loss recognised in other comprehensive
income whilst it was measured as available for sale must be recognised in profit or loss:
• over the remaining life of the financial asset if it has a fixed maturity;
• when the financial asset is sold or otherwise disposed of.
If a reliable measure becomes available for a financial instrument which was previously not
available, and the financial instrument would have been measured at fair value had fair value
been available, such financial instrument shall be re-measured at fair value. The difference
between its fair value and its carrying amount must be taken directly to equity. [IAS 39.53]
The entity must assess whether its financial assets are impaired at the end of the reporting
period. A financial asset (or group of financial assets) is only impaired at the end of a
reporting period if there is objective evidence that suggests:
• that one or more events occurred after the initial recognition;
• where the event causes loss; and where
• this ‘loss event’ has an impact on estimated future cash flows of the financial asset or
group of financial assets; and
• the amount of the loss can be reliably estimated.
Financial assets and liabilities may not be offset against one another unless:
• the entity has a legal right to set off the two amounts; and
• the entity intends to settle the two instruments simultaneously or on a net basis.
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11. Disclosure
Name of Company
Statement of changes in equity
For the year ended 31 December 20X5 (extracts)
Ordinary Share Available for Retained Total
share premium sale financial earnings
capital assets
C C C C C
Balance: 1 January 20X5 xxx xxx xxx xxx xxx
Ordinary shares issued xxx xxx xxx
Total comprehensive income xxx xxx xxx
Balance: 31 December 20X5 xxx xxx xxx xxx xxx
Name of Company
Statement of financial position (extracts)
As at 31 December 20X5
Note 20X5 20X4
C C
EQUITY AND LIABILITIES or ASSETS
Loan xxx xxx
Financial instruments 39 xxx xxx
Preference shares xxx xxx
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Name of Company
Statement of comprehensive income (extracts)
For the year ended 31 December 20X5
Note 20X5 20X4
C C
Profit before finance costs xxx xxx
Finance costs:
• Fair value adjustment of financial instruments xxx xxx
Profit before tax xxx xxx
Taxation expense xxx xxx
Profit for the year xxx xxx
Other comprehensive income
• Gain/ (loss) on available for sale financial asset xxx xxx
o Gains arising during the year xxx xxx
o Less reclassification adjustment:gains now recognised in profit/ (xxx) (xxx)
loss
Total comprehensive income xxx xxx
Name of Company
Notes to the financial statements of
For the year ended 31 December 20X5 (extracts)
1. Statement of compliance
2. Accounting policies
2.1 Financial Instruments
The following recognition criteria are used for financial instruments…
The fair value of the financial instruments are determined with reference to …
39. Financial instruments
The company uses … to manage Financial Risks.
Such risks and methods are:
• We are exposed to Currency risk in … and Foreign Currency risk is managed by …
• We are exposed to Interest rate risk in … and Interest rate risk is managed by …
• We are exposed to Market risk in … and Market risk is managed by …
• We are exposed to Credit risk in … and Credit risk is managed by …
• We are exposed to Liquidity Risk in … and Liquidity Risk is managed by …
On 1 January 20X5 Nic Limited issued 10 000 C20 par value 10% compulsory redeemable
debentures at par.
The debentures will be redeemed on 31 December 20X9. Interest is paid annually in arrears
on 31 December.
Tiff Limited purchased all 10 000 debentures on the 1 January 20X5. The debentures were
classified as available for sale.
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The following information was extracted from Tiff Limited accounting records (year ended
31 December):
20X5 20X7 20X9
Revenue 1 000 000 2 000 000 4 000 000
Cost of sales (500 000) (1 000 000) (1 500 000)
Required:
Disclose the above information in the financial statements of Tiff Limited in accordance with
IFRSs for the years ended 31 December 20X5, 20X7 and 20X9.
Tiff Limited
Statement of comprehensive income
For the year ended 31 December
20X9 20X7 20X5
C C C
Revenue 4 000 000 2 000 000 1 000 000
Cost of sales (1 500 000) (1 000 000) (500 000)
Gain on redemption 100 000
Profit for the year 2 600 000 1 000 000 500 000
Other comprehensive income
• Available for sale financial asset (70 000) 10 000 20 000
• gains arising during the year 30 000 10 000 20 000
• less reclassification adjustment: gain (100 000)
now included in profit or loss
Tiff Limited
Statement of changes in equity (extract)
For the year ended 31 December
Retained Available for sale Total
earnings financial asset
C C C
Balance: 1/1/20X5 xxx xxx xxx
Total comprehensive income 500 000 W1 20 000 520 000
Balance: 1/1/20X6 xxx 20 000 xxx
Total comprehensive income xxx W1 20 000 xxx
Balance: 1/1/20X7 xxx 40 000 xxx
Total comprehensive income 1 000 000 W1 10 000 1 010 000
Balance: 1/1/20X8 xxx 50 000 xxx
Total comprehensive income xxx W1 20 000 xxx
Balance: 1/1/20X9 xxx 70 000 xxx
Total comprehensive income 2 600 000 W1 (70 000) 2 530 000
Balance: 31/12/20X9 xxx 0 xxx
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Tiff Limited
Statement of financial position (extract)
As at 31 December
20X9 20X7 20X5
ASSETS C C C
Non-current assets
Financial assets 0 250 000 220 000
Total fair value adjustments 20 000 + 20 000 + 10 000 + 20 000 100 000
+ 30 000
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12.Summary
Financial risks
Accounting for
Financial Liabilities
Accounting for
Financial Assets
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