Seminar Slides 8 PDF

AC2101 – Accounting Recognition
and Measurement
Seminar 8
Financial Assets I
Semester 1, AY2017/2018
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Seminar 8 Agenda
• Classification and measurement of

financial instruments (FRS 109)
Financial assets
a. Recognition
b. Classification
c. Measurement
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What is a financial asset?
Any asset that is
a. Cash
b. An equity instrument of another entity
c. A contractual right to
▪ Receive cash or another financial asset from another entity
▪ Potentially favorably exchange financial assets/liabilities with another
entity
d. A contract to be settled in the entity’s own equity instruments
(FRS 32:11)

Financial Instruments:
Recognition
An entity shall recognize a financial asset or

a financial liability in its statement of financial
position when, and only when, the entity
becomes a party to the contractual
provisions of the instrument.
(FRS 109: 3.1.1)

Financial Assets
Recognition
▪ Upon initial recognition, all financial assets are

to be measured at fair value (FRS 109: 5.1.1).
▪ For financial assets measured at Fair Value

through Profit or Loss:
▪ transaction costs should be expensed off;
▪ For financial assets not measured at Fair Value
through Profit or Loss:
▪ transaction costs should be capitalized.
Financial Assets
Classification and Measurement
Classification of financial assets based on an

entity’s
- business model of how the financial assets
are managed and
- the cash flow characteristics of the financial
asset.
(FRS 109: 4.1.1)

Financial Assets
Classification and Measurement:
Reclassification
• Reclassification of financial assets occur only

when the entity changes its business model for
managing those assets. The reclassification will
be accounted for prospectively from the
reclassification date (FRS 109 paras 5.6.1 to
5.6.7).
• Reclassification is expected to be infrequent

Financial Assets
For DEBT instruments:
• Subsequent measurement at amortized cost if

➢ Business model’s objective is to hold FA for
contractual cash flow collection
➢ Contractual cash flows represent solely payments of
principal and interest (SPPI)
(FRS 109: 4.1.2)
➢ Applicability of this classification: look at past sales

information and expectations of future sales activity

Financial Assets
• Subsequent measurement: Amortized cost (AC)

➢ An example of a debt instrument in this category
would be an investment in five-year bonds with a
maturity date matched to the entity’s funding needs in
five years’ time.
➢ Accounting for impairment is required and recognized

through profit or loss.
➢ Illustration 1

Financial Assets
• Subsequent measurement: Amortized cost (AC)

➢ Another example of a debt instrument in this category
are loans originated by the entity
➢ For loans originated by the entity, issues related to

the valuation and accounting for the loans may arise
if the interest rate charged is not at fair market
interest rate
➢ Illustration 2

Illustration 2
(AC -Loans)
1. Case A: Fair interest rate loan to employee (“Fair Interest”

loans)
1. Case B: Interest free loan to employee (“Special Interest”

loans)

Illustration 2 – Case A
(“Fair Interest” Loan)
1/1/x1
$100K
Company CEO
Interest=6% p.a. (mkt rate)

Loan period=3 yrs
Repayable in full on 31/12/x3
Loan receivable
Interest income

Illustration 2- Case B
(“Special Interest” Loan)
1/1/x1
$100K
Company CEO
Interest=0% (mkt rate=6% p.a.)

Loan period=3 yrs
Repayable in full on 31/12/x3
Loan receivable
Deferred staff cost
Interest income

Good Boss Ltd grants an interest-free loan of $25,000 to one of
its employees with $10,000 being repayable at the end of the
second year and the balance of $15,000 at the end of the third
year. The employee must serve the company for next three
years. Assume a market interest rate of 5% per annum. At the
end of the first year, Good Boss Ltd will record an amount of
$1,101 more aptly as
a. Deferred interest expense

b. Interest expense
c. Deferred staff cost
d. Staff cost
e. Loan due from employee
0% 0% 0% 0% 0%
a. b. c. d. e.
Financial Assets
• Subsequent measurement at Fair value through OCI if

➢ Business model’s objective is to hold and to sell
➢ Contractual cash flows solely represent principal and
interest payments (SPPI)
(FRS 109 para 4.1.2A)
➢ This Fair value through OCI category results in

amortised cost information being provided in profit or
loss and fair value information in the balance sheet

Financial Assets
• Subsequent measurement: Fair value through OCI

(FVOCI)
➢ An example of a debt instrument in this category
would be an investment in bonds to fund
expenditure in five years’ time.
➢ Accounting for impairment of the financial asset is

required and recognized through profit or loss, with
recycling to profit or loss when the financial asset is
derecognized.
➢ Illustration 3
Financial Assets
• Subsequent measurement at Fair value through P/L

(FVPL)
– Residual category: when the business model is
neither of the above two categories
– An example of a debt instrument in this category
would be an investment in bonds to take advantage
of changes in bond prices in the short run (collection
of interest is incidental).
– Note that in the profit or loss statement, FRS 109
provides that the interest income and fair value
gain/loss need not be recognized separately (FRS
109 para B5.6.2).
– Illustration 4
Solely Payment of
Principal and Interest (SPPI)
Examples of debt instruments where the
contractual cash flows are SPPI include loan
receivable, investment in bonds (with fixed or
variable rates), investments in some types of
perpetual bonds (e.g., when interest is accrued
for deferred amounts).
Interest must be consideration for time value of

money, credit risk, liquidity risk, profit
margin, and service/administrative costs.
(FRS 109 para B4.1.7A)
SPPI
Contractual terms that introduce exposure to risks or

volatility in the contractual cash flows that is unrelated
to a basic lending arrangement, such as exposure to
changes in equity prices or commodity prices, do not
give rise to contractual cash flows that are SPPI
(FRS 109: B4.1.7A)
For example, an investment in bonds whose interest

is pegged to equity or commodity prices is not a
debt instrument whose contractual cash flows are
SPPI.
Financial Assets
For EQUITY instruments:
– Subsequent measurement at Fair value through

Profit or Loss (FVPL)
– Illustration 5

Financial Assets
For EQUITY instruments:
– Unless an irrevocable choice made by the entity at

initial recognition for the financial instrument to be
classified as
➢ Fair value through OCI (FVOCI)
– This is only for equity instruments that are not held

for trading (FRS 109: 5.7.5)

Financial Assets
– For equity instruments classified as Fair Value

through OCI, there is no need for impairment and
subsequent recycling upon de-recognition.
– Since this is an irrevocable choice, no

reclassification out of this category is permitted.
– Illustration 6

Financial Assets
However, an entity may, at initial recognition, irrevocably

designate a financial asset as measured at Fair value
through profit or loss if doing so eliminates or significantly
reduces an “accounting mismatch”
(FRS 109: 4.1.5)
Accounting Mismatch
A measurement or recognition inconsistency that arises
from measuring assets or liabilities or recognising the
gains/losses on them on different bases.

What is a derivative?
A financial instrument or contract with all of the

following 3 characteristics
a. Its value changes in response to a market variable (e.g.,
interest rate, share price, commodity price, foreign
exchange rate, and price/credit index)
b. It requires no initial net investment or smaller than would be
required for other contracts with similar response to market
variable changes
c. It is settled at a future date
(FRS 109 Appendix A)

Financial Asset: Derivative
As a financial asset, derivatives (not used as

hedging* instruments) are accounted for at Fair
Value through Profit or Loss.
Initial measurement: Fair value
Subsequent measurement: Fair value
Illustration 7
*Hedge accounting will be covered in AC3102

Embedded Derivatives
Note that under FRS 109, embedded derivatives

need not be split from the host instrument if the host
instrument is a financial asset within the scope of
FRS 109 (para 4.3.2).
This simplifies the accounting for hybrid instruments

as compared to FRS 39 where splitting is required if
certain conditions are met.

Embedded Derivatives
• However, if the host instrument is not a financial asset*
within FRS 109, the embedded derivative has to be
separately recognized if
i. the economic characteristics and risks of the
embedded derivative are not closely related to those of
the host contract;
ii. a separate instrument with the same terms as the
embedded derivative would meet the definition of a
derivative; and
iii. the host contract is not “fair value through P/L”, unless
the entire hybrid instrument is designated as fair value
through P/L.
*E.g., a financial liability or equity

Application of FRS 109
• Discuss Seminar Question 1
• Definition of Effective Interest Rate:

– The rate that exactly discounts estimated
future cash payments or receipts through the
expected life of the financial asset or financial
liability to the gross carrying amount of a
financial asset or to the amortised cost of a
financial liability (FRS 109 Appendix A)

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AC2101 – Accounting Recognition

Copyright © Nanyang Business School

• Classification and measurement of

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An entity shall recognize a financial asset or

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▪ Upon initial recognition, all financial assets are

▪ For financial assets measured at Fair Value

Classification of financial assets based on an

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• Reclassification of financial assets occur only

• Reclassification is expected to be infrequent

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• Subsequent measurement at amortized cost if

➢ Applicability of this classification: look at past sales

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• Subsequent measurement: Amortized cost (AC)

➢ Accounting for impairment is required and recognized

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• Subsequent measurement: Amortized cost (AC)

➢ For loans originated by the entity, issues related to

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1. Case A: Fair interest rate loan to employee (“Fair Interest”

1. Case B: Interest free loan to employee (“Special Interest”

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Interest=6% p.a. (mkt rate)

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Interest=0% (mkt rate=6% p.a.)

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a. Deferred interest expense

• Subsequent measurement at Fair value through OCI if

➢ This Fair value through OCI category results in

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• Subsequent measurement: Fair value through OCI

➢ Accounting for impairment of the financial asset is

• Subsequent measurement at Fair value through P/L

Interest must be consideration for time value of

Contractual terms that introduce exposure to risks or

For example, an investment in bonds whose interest

For EQUITY instruments:

– Subsequent measurement at Fair value through

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For EQUITY instruments:

– Unless an irrevocable choice made by the entity at

➢ Fair value through OCI (FVOCI)

– This is only for equity instruments that are not held

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– For equity instruments classified as Fair Value

– Since this is an irrevocable choice, no

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However, an entity may, at initial recognition, irrevocably

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A financial instrument or contract with all of the

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As a financial asset, derivatives (not used as

*Hedge accounting will be covered in AC3102

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Note that under FRS 109, embedded derivatives

This simplifies the accounting for hybrid instruments

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*E.g., a financial liability or equity

• Discuss Seminar Question 1