Accounting for Financial Instruments

AC2091 Financial Reporting

Session 14
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 Learning Outcomes

• Explain the character of financial instruments

and the accounting issues involved
• Explain the approaches taken by IAS 39 and
IFRS 9 in the measurement and recognition of
financial instruments in some key areas
• Understand how IAS 32 seeks to deal with
issues of presentation and IFRS 7 seeks to deal
with issues of disclosure

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 Financial Instruments:
Presentation (IAS 32)
• Financial instrument
– any contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument of
another entity

Financial
Instrument

Company Company
A B
Goods
& Services

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 Financial Instruments:
Presentation (IAS 32)
• Financial asset includes:
– Cash
– Equity instrument of another company (e.g. shares)
– Contractual right to:
o receive cash or another financial asset from another
entity; or
o exchange financial assets or financial liabilities with
another entity under conditions that are potentially
favourable to the entity
– Examples: bank deposits, trade debtors, loans,
shares and bonds

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 Financial Instruments:
Recognition and Measurement (IAS 39)

Financial
assets

Loans & Held to Fair value Available

receivables maturity through P/L for sale

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 Financial Assets (IAS 39)
• Loans & receivables
– non-derivative financial assets with fixed or
determinable payments that are not quoted in an
active market

• Accounting treatment
– Initial measurement: at fair value plus transaction
costs directly attributable to its acquisition or issue
– Subsequent measurement: at amortised cos t
using the effective interest method less accumulated
impairment losses
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 Financial Assets (IAS 39)
• Held-to-maturity [HTM] investments
– non-derivative financial assets with fixed or
determinable payments and fixed maturity that an
entity has the positive intention and
ability to hold to maturity

• Accounting treatment
– Initial measurement: at fair value plus transaction
costs directly attributable to its acquisition or issue
– Subsequent measurement: at amortised cost
using the effective interest method
less accumulated impairment losses
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 Financial Assets (IAS 39)

• Amortised cost
– amount at initial recognition minus principal
repayments, plus or minus the cumulative
amortisation of any difference between that initial
amount and the maturity amount, and minus any
write-down for impairment or uncollectability
• Effective interest rate
– rate that exactly discounts estimated future cash
payments or receipts through the expected life of the
financial instrument or, when appropriate, a shorter
period to the net carrying amount of the financial
asset or financial liability
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 Financial Assets (IAS 39)

• Fair value through profit & loss [FVTPL]

– Financial assets that are either:
o Held for trading assets; or
o Designated to this category under the fair value
option
– Designated by entity on initial recognition to
be valued at fair value

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 Financial Assets (IAS 39)

• Fair value through profit & loss [FVTPL]

– Held for trading
o acquired or incurred principally for the purpose of
selling or repurchasing it in the near term ;
o 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; or
o a derivative (except for a derivative that is a financial
guarantee contract or a designated and effective
hedging instrument)

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 Financial Assets (IAS 39)

• Fair value through profit & loss [FVTPL]

– Initial measurement: at fair value excluding
transaction costs
– Subsequent measurement: at fair value
with any gain or loss arsing from change in fair
value to be recognised in profit or loss .
– Condition: reliable measure of fair value through
quoted market price in an active market)

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 Financial Assets (IAS 39)

• Available-for-sale [AFS]
– non-derivative financial assets that are designated as
available for sale or are not classified as
o loans and receivables
o held-to-maturity investments or
o financial assets at fair value through profit or loss

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 Financial Assets (IAS 39)

• Available-for-sale [AFS]
– Initial measurement: at fair value plus transaction
costs directly attributable to its acquisition or issue
– Subsequent measurement: at fair value with
any gain or loss arising from change in fair value
recognised in other comprehensive income
o Impairment losses and foreign exchange differences
are recognised in profit or loss
o Cumulative gain or loss previously recognised in equity
shall be recognised in profit or loss when financial
asset is derecognised

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 Financial Assets (IAS 39)

• Impairment
– A financial asset or a group of financial assets is
impaired and impairment losses are incurred if, and
only if, there is objective evidence of impairment as a
result of one or more events that occurred after the
initial recognition of the asset (a ‘loss event’ )
– An entity is required to assess at each balance sheet
date whether there is any objective evidence of
impairment
o If so, entity shall do a detailed impairment calculation
to determine whether an impairment loss should
be recognised

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 Financial Assets (IAS 39)
• Impairment
– Assets measured at amortised cost
o Loss events include:
– significant financial difficulty of the issuer or obligor
– a breach of contract, such as a default or delinquency in
interest or principal payments
– probability that the borrower will enter bankruptcy or
other financial reorganisation
– disappearance of an active market for that financial
asset because of financial difficulties
– observable data indicating that there is a measurable
decrease in the estimated future cash flows from a
group of financial assets since initial recognition

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 Financial Assets (IAS 39)
• Impairment
– Assets measured at amortised cost
o If there is objective evidence of impairment:
– Impairment loss is recognised in profit or loss

PV of
Carrying estimated Impairment
amount future cash loss
flows

– Future cash flows (excluding future credit losses that

have not been incurred) are discounted using asset’s
original effective interest rate
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 Financial Assets (IAS 39)
• Impairment
– Assets measured at amortised cost
o If there is objective evidence of impairment:
– Carrying amount of the asset is reduced either directly
or through the use of an allowance account
– Impairment loss is recognised in profit or loss
– Previously recognised impairment loss can be reversed
either directly or by adjusting an allowance account
– Amount of reversal are to be recognised in profit or loss
– Reversals cannot result in a carrying amount that
exceeds what the amortised cost would have been had
no impairment been recognised

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 Financial Assets (IAS 39)

• Reclassification of financial assets

– HTM securities
o May be reclassified to AFS (for current and next two
years) and re-measured to fair value if no longer
appropriate to classify investment as HTM
o Difference between carrying amount and fair value
recognised in equity
– AFS securities
o May reclassify assets that would have met the definition
of loans and receivables to loans and receivables if
entity has the intention and ability to hold assets for
the foreseeable future or until maturity

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 Financial Assets (IAS 39)

• Reclassification of financial assets

– FVTPL (or held-for-trading) securities
o May not be reclassified out of this category with some
exceptions such as:
– May be reclassified as loans and receivables if financial
asset meet the definition of loans and receivables and
entity has the intention and ability to hold asset for the
foreseeable future or until maturity
– May reclassify instruments to held to maturity or
available for sale in rare circumstances

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 Financial Instruments:
Presentation (IAS 32)
• Financial liabilities include:
– a contractual obligation to:
o deliver cash or another financial asset to another
entity; or
o exchange financial assets or financial liabilities with
another entity under conditions that are potentially
unfavourable to the entity

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 Financial Instruments:
Presentation (IAS 32)
• Financial liabilities include:
– a contract that will or may be settled in the entity’s
own equity instruments and is:
o a non-derivative for which the entity is or may be
obliged to deliver a variable number of the entity’s
own equity instruments; or
o 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

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 Financial Instruments:
Presentation (IAS 32)
• Equity instrument
– Any contract that evidences a residual interest
in the assets of an entity after deducting all
of its liabilities
– Transaction costs of an equity transaction shall be
accounted for as a deduction from equity, net of any
related income tax benefit.
– Net proceeds from the issue of equity shares to be
credited to shareholders’ funds [IAS 39/FRS 4]
o net proceeds: fair value of the consideration received
after deducting the costs incurred directly in
connection with the issue of the shares
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 Share Capital & Reserves
• Share premium
– account records the difference between the nominal
or par value of shares issued and the fair value of
the consideration received
– can only be used for specific purposes:
o to pay up fully paid bonus shares
o to write off preliminary expenses
o to write off expenses of any issue of shares or
debentures
o to write off commission paid or discount allowed on any
issue of shares or debentures
o to provide for the premium payable on any redemption
of debentures
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 Compound Instruments

• Liability vs. equity

– Classification based on substance and not merely
legal form, depending on:
o Contractual agreement on initial recognition
o Definitions of a financial liability and equity instrument
– Critical feature of contractual obligation for liabilities
o ASB (FPPFS)
– If information is to represent faithfully transactions
and other events that it purports to represent, it is
necessary that they are accounted for and presented
in accordance with their substance and economic
reality and not merely their legal form

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 Compound Instruments

• Compound instrument
– Financial instrument that has characteristics of both
equity and liability (e.g. convertible bonds)
– Such components shall be classified separately
as financial liabilities or equity
instruments [IAS 32]
o E.g. convertible bonds = financial liability (to deliver
cash or financial asset) + equity instrument (call
option)
o Value of liability component is calculated first and
deducted from instrument’s value as a whole to
derive residual value for equity component
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 Financial Liability (IAS 39)

• Initial recognition and measurement

– Recognised when entity becomes a party to the
contractual provisions of the instrument
– Measured at its fair value plus transaction costs that
are directly attributable to the issue of the financial
liability
o Exception: For liabilities designated as at fair value
through profit or loss, transaction costs are excluded
from the fair value at initial recognition

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 Financial Liability (IAS 39)

• Subsequent measurement
– Fair value through profit or loss
o Includes financial liabilities held for trading and
financial liabilities designated as at fair value through
profit or loss on initial recognition
o Measured at fair value with gains and losses
recognised in profit or loss
– Amortised cost
o All financial liabilities that are not classified at fair value
through profit or loss
o Measured at amortised cost using effective interest
method

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 Accounting for Debt
• Amount of the liability should be shown as the
amount of the net proceeds of issue
– net proceeds: the fair value of the consideration
received after deducting issue costs incurred
directly in connection with the issue of debt
• Finance costs
– difference between the net proceeds of debt and the
total amount of the payments the issuer has to
make in respect of debt

Total Net Finance

payments proceeds Costs

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 Accounting for Debt
• Finance costs
– allocated to periods over the term of the debt at a
constant rate on the carrying amount
– charged in the income statement using actuarial
method
– carrying amount of debt increased by the finance
costs and reduced by payments made for the period
– effective rate of interest used to allocate finance
costs
o rate of interest that makes the PV of all future
payments in respect of the debt equal to the net
proceeds of issue

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 Accounting for Debt

• Types of borrowings
– Debentures, unsecured loan capital that are bought
and sold like shares and are available to investors
– Hybrid securities
o Financial/capital instruments which combine features of
both debt and equity (e.g. convertible bonds)
– Loans, both long-term and short-term, from banks
and other financial institutions
– Bank overdrafts

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 IFRS 7
Financial Instruments: Disclosures
• Significance of financial instruments
– Statement of Financial Position (examples)
o Total carrying value of each category of financial assets
and liabilities
o Reclassifications of financial instruments from one
category to another
o Financial assets pledged as collateral and about
financial or non-financial assets held as collateral
o Compound financial instruments with embedded
derivatives
o Reconciliation of allowance account for credit losses
o Details of defaults and breaches of loans payable

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 IFRS 7
Financial Instruments: Disclosures
• Significance of financial instruments
– Statement of Comprehensive Income (examples)
o Gain or loss for each category of financial assets and
liabilities
o Total interest income and interest expense (effective
interest method)
o Amount of impairment loss for each financial asset
– Other disclosures include
o Fair value for each class of financial asset and liability
o All relevant accounting policies including measurement
basis

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 IFRS 7
Financial Instruments: Disclosures
• Nature and extent of exposure to risks arising
from financial instruments
– Qualitative disclosures
o Exposure to risk and how it arises
o Objectives, policies and processes for managing risk
and method used to measure risk
– Quantitative disclosure
o Summary of quantitative data about exposure to risk
based on information given to key management
o Disclosures about credit risk, liquidity risk, and market
risk and how these risks are managed
o Concentrations of risks
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 Introduction to IFRS 9

• Replaces IAS 39 with effect from 1 Jan 2018

• Financial assets classified as subsequently
measured at:
– Amortised cost, or
– Fair value through other comprehensive income, or
– Fair value through profit or loss
• Classification to be based on:
– entity’s business model for managing financial assets
– contractual cash flow characteristics of financial
assets

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 Amortised Cost
• Classified as such if both conditions met:
– Business model
o Objective is to hold financial assets to collect
contractual cash flows
– Contractual cash flow characteristics
o Cash flows are solely payments of principal and
interest (SPPI) on the principal
amount outstanding
• Option to use amortised cost is available for debt
instruments rather than equity instruments
• Subsequent measurement
– At amortised cost using the effective interest method
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 Fair Value through
Other Comprehensive Income [FVOCI]
• Debt instruments:
Classification
– designated at initial recognition of instruments if both
of the following conditions are met:
o held within a business model whose objective is
achieved by both collecting contractual cash flows
selling financial assets ; and
o contractual terms of the financial asset give rise on
specified dates to cash flows that are solely
payments of principal and interest (SPPI) on the
principal amount outstanding

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 Fair Value through
Other Comprehensive Income [FVOCI]
• Debt instruments
Subsequent measurement
– Changes in fair value will be included within OCI
– Interest revenue, expected credit losses and foreign
exchange gains and losses are included within P/L
– Cumulative gain or loss recognised within OCI is
reclassified from equity to profit or loss upon
derecognition

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 Fair Value through
Other Comprehensive Income [FVOCI]
• Equity instruments
Classification
– Irrevocably designated at initial recognition of
instruments if not held for trading
Subsequent measurement
– All gains and losses being presented in OCI except
dividend income which is recognised in profit or loss
– Cumulative gain or loss recognised within OCI shall
not be reclassified from equity to profit or loss
upon derecognition

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 Fair Value through
Profit or Loss [FVTPL]
Classification
– Instruments that are:
o not measured at amortised cost
o not measured at fair value through other
comprehensive income
o irrevocably designated at initial recognition as such to
eliminate or significantly reduce a measurement or
recognition inconsistency (sometimes referred to as an
‘accounting mismatch’)
Subsequent measurement
– At fair value with all gains and losses recognised in
profit or loss

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 Impairment of Financial Assets

• Recognise a loss allowance for expected credit

losses on a financial assets such as:
– Financial assets measured at amortised cost (incl.
trade receivables)
– Financial assets measured at fair value through OCI
– Loan commitments and financial guarantees
contracts
– Lease receivables

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 Impairment of Financial Assets

• At the end of each reporting date, entity shall

measure
– loss allowance for a financial instrument at an amount
equal to the lifetime expected credit losses
if the credit risk on that financial instrument has
increased significantly since initial recognition
– loss allowance for that financial instrument at an
amount equal to 12-month expected credit losses
if credit risk on a financial instrument
has not increased significantly since initial recognition

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Thank You

Q&A

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