Financial Reporting

Lecture 7
Financial Instruments (HKAS 32, HKFRS 9)

Contents
 Definitions
 Initial measurement and recognition of financial assets and
liabilities
 Classification and subsequent measurement of financial assets
and liabilities
 Impairment
 Derivative and Embedded Derivatives
 Equity Vs Financial liabilities
 Compound Financial Instrument

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 Definitions

What is a 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 Asset Financial Liability

Definitions
Financial Asset

A contract that may be

An equity settled in the entity’s
instrument of a contractual own equity instrument
cash another entity. right to and is

(1) receive cash or another (1) a non-derivative for

financial asset from another
entity
(2) exchange financial assets/
liabilities with another entity
under conditions that are
potentially favorable to the entity.
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which the entity is or may
be obliged to receive a
variable number of the
entity’s own instruments.
(2) 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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 Definitions
Financial Liability

A contractual obligation to a contract that may be settled in the

entity’s own equity instrument and
is

1. deliver cash or another financial asset to
another entity.
2. exchange financial assets/liabilities with
another entity under conditions that are
potentially unfavorable to the entity.
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(1) a non-derivative for which the
entity is or may be obliged to
deliver a variable number of the
entity’s own equity instrument;
(2) 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

Definitions

Equity Instrument

Any contract

that evidences a residual interest in the

assets of an entity after deducting all of
its liabilities.

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 Examples of financial assets, liabilities
and equity instruments
 Financial asset
 Cash, investment in shares or other equity instrument issued by
other entities, receivable, loans to other entities, investments in
bonds and other debt instruments, derivative financial assets.
 Financial liability
 Payable, loans from other entities, issued bonds and other debt
instruments, derivative financial liabilities.
 Equity instruments
 Ordinary shares, preference shares (not redeemed) , warrants
or written call option.

Examples –these assets and liabilities

are not financial instruments
 Physical assets inventories, property, plant and equipment.
 Leased assets, intangible assets, prepaid expense, deferred
revenue, warranty obligation

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 Initial recognition
 An entity shall recognize a financial assets and financial
liabilities in its statement of financial position when the entity
becomes party to the contractual provisions of the
instrument.

Illustration 1
 Forward contracts are recognized as assets on the
commitment date, not on the date when the item under
contract is transferred from seller to buyer. (a forward
contract is a commitment to buy or sell a financial
instrument or a commodity). I.e. It shall be recognized on
the date of the forward contract rather than on the date the
actual exchange takes place.

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 Initial measurement of financial assets
 All financial assets are initially measured at fair value(except
trade receivables).
 This is likely to be the consideration given.
 When a financial asset is acquired, there will usually be
transaction costs incurred in addition to any purchase cost.
For example, transaction costs may include a broker’s fees
depends on how the instrument is subsequently measured.
• FVTPL
– Written off as an expense in P&L
• FVTOCI and AC
– The transaction cost is capitalized and included in the initial cost of the
financial assets.

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Initial measurement of financial liabilities

 A financial liability is measured at
 FV through profit or loss (if held for trading or designated as
such) or
 amortized cost
 For all financial liabilities other than those classified as fair
value through profit or loss (FVTPL), transaction costs are
deducted from the fair value of the instrument at initial
measurement.

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 Illustration 2
 a) A debt security that is held for trading (i.e. FVTPL) is
purchased for $50,000. Transaction costs of $200 are
incurred.
 b) A bond of classified as not for trading (FVTOCI) is
purchased at premium to par. The par value is $100,000
and the premium is $1,000 (such that the total amount
paid is $101,000). In addition, transaction cost of $1,500
are incurred.

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Illustration 2
 A) The initial carrying amount is $50,000. The transaction
costs of $200 are expensed. This treatment applies because
the debt security is classified as held for trading and,
therefore, measured at fair value with changes in fair value
recognized in profit and loss.
 B) The initial carrying amount is $102,500 (i.e. the sum of
the amount paid for the securities and transaction costs).
This treatment applies because the bond is not measured at
fair value with changes in fair value recognized in profit and
loss.

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 Illustration 3
 During 2021, Entity A acquires and incurs a financial liabilities:
 issue bond for $30,000 to be measured at amortized cost. Issuance
costs are $600.
 The initial carrying amount is $29,400 (i.e. the amount received
from issuing the bond less the transaction costs paid). For
liabilities, transaction costs are deducted, not added, from the
initial carrying amount. This treatment applies because the bond is
not measured at fair value with changes in fair value recognized in
profit and loss.

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Classification of financial
instruments
 Once recognised, a financial asset is subsequently classified:
 amortised cost (AC) ;
 fair value through other comprehensive income (FVTOCI); or
 fair value through profit or loss (FVTPL).
 A financial liability is classified as:
 at fair value through profit or loss (FVTPL);
 at amortised cost (AC).

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 Classification of financial assets
 Investments in debt instruments are classified in one of three
ways:
 amortised cost
 fair value through other comprehensive income
 fair value through profit or loss
 Investments in equity instruments (such as an investment in
the ordinary shares of another entity) are classified at either:
 fair value through other comprehensive income
 fair value through profit or loss

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Classification –Debt at AC
 Investment in a debt instrument is measured at AC if:
 The entity's business model is to collect the asset's contractual
cash flows; and
 The contractual terms of the financial asset give rise to cash
flows that are solely payments of principal, and interest (“SPPI”)
on the principal amount outstanding.
 These conditions capture simple debt instruments that are
intended to be held for the long term, may be until maturity.

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 Subsequent measurement –Debt
at AC
 Debt at AC will subsequently be measured at amortized cost using the effective
interest method.
 The effective interest rate is sometimes termed the ”level yield-to-maturity” (or
to the next re-pricing date), and is the internal rate of return of the financial
asset for that period.
 This method also determines how much interest income should be reported in
profit and loss.
 When the financial asset is derecognised, the gain or loss is recognised in profit
or loss.
 Financial
 asset
 Amount at initial recognition X
 Plus: interest recognized the effective rate as income X
 Less: cash flow (X)
 (i.e. interest received )
 Amortized cost c/f X

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Illustration 4
Example:
Financial asset
measured at amortised cost

 Example 1 - A debt security has a stated principal amount

of $5,000 which will be repaid in five years at an interest
rate of 6% per year, payable annually at the end of each
year. The company purchases the security on 1 January
20X1, at a discount, for $4,670. The company classifies the
debt security as financial asset measured at amortised cost.

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 Illustration 4

 Formula for Effective Interest Rate

 4,670 = (5,000x6%) + (5,000x6%) + (5,000x6%)
(1 + r ) (1 + r)2 (1 + r)3
 + (5,000x6%) + 5,000+(5,000x6%)
(1 + r)4 (1 + r)5

r = 7.65% = 0.0765

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Illustration 4
Year (A) (B) Interest (C) (D) (E) End-of-
Beginning-of- cash inflows Interest Amortisation period
period amortised at 6% income of debt C-B amortised
cost A x 7.65% cost A+D
(Amount shown
Statement of
Financial Position)

20X1 4,670 300 357 57 4,727

20X2 4,727 300 362 62 4,789
20X3 4,789 300 366 66 4,855
20X4 4,855 300 371 71 4,926
20X5 4,926 300 374 74 5,000 (cash
(rounded received)
down)
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 Illustration 4
 The effective interest rate of the investment in the debt
security is approximately 7.65%.This is the discount rate that
will give a present value of the future cash flows that equal the
purchase price. Based on the effective interest rate of 7.65%,
the followings are the journal entries.

 At the end of 20X1, the company enters the following entries:

Dr Cash $300
Dr Debt security $ 57
Cr Interest income $357

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Classification - Debt at FVTOCI

 Investment in a debt instrument is measured at FVTOCI if:
 The entity's business model involves both collecting contractual
cash flows and selling financial assets; and
 The contractual terms of the financial asset give rise to cash
flows that are solely payments of principal, and interest (“SPPI”)
on the principal amount outstanding.
 There is no commitment to keep the asset until maturity.
Cash may be realised by selling the asset at any time. This
category also captures debt instruments, but without
intention to hold until maturity.

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 Subsequent measurement-Debt at
FVTOCI
 Gains and losses on fair value change are recognised in OCI,
except for the interest income , which are recognised in
profit or loss in the same manner as for financial assets
measured at amortised cost.
 When the financial asset is derecognised, the cumulative gain
or loss previously recognised in OCI is reclassified from
equity to profit or loss.

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Business Model Test – Examples

 Example 1: An entity holds quoted bonds to collect their
principal and interest but would sell the investments to fund
capital expenditures if the need arises.
 The business model is to hold bonds to collect contractual CFs as sale is
expected to be infrequent.

 Example 2: An entity holds bonds to meet its daily liquidity needs.

The entity actively manages the returns on the bonds.
 The business model is to both hold bonds to collect contractual cash flows
and for sale.

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 Contractual Cash Flows Test –
Examples
 Example 1: A bond’s contractual terms specify payments of
principal and interest on principal linked to an equity index.
 The bond does not meet the contractual cash flow characteristics test.

 Example 2: A bond's contractual terms specify payments of

principal and interest on principal that is reset for a three month
term based on the current 3-month LIBOR rate.
 A floating rate bond meets the contractual cash flow characteristics test.

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Illustration 5
 Investment in quoted loan stock is measured at amortised cost if it
meets the two HKFRS 9 criteria. If there were a sale of 10% of
the stock before the maturity date because the holding entity
needs cash to fund capital investment, the objective of collecting
contractual cash flows is not violated if those sales are infrequent.
 Although an entity may consider, among other information, the
financial assets’ fair values from a liquidity perspective (i.e. the
cash amount that would be realised if the entity needs to sell
assets), the entity’s objective is to hold the financial assets and
collect the contractual cash flows. Some sales would not contradict
that objective.

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 Classification - Debt at FVTPL
 An investment in a debt instrument that is not measured at
amortised cost or fair value through other comprehensive
income will be measured at fair value through profit or loss
(i.e. Other business models)

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Subsequent measurement - Debt

at FVTPL
 Gains and losses on fair value change, both on subsequent
measurement and derecognition, are recognised in profit or
loss.
 The interest income , which are recognised in profit or loss
in the same manner as for financial assets measured at
amortised cost

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 Classification – Equity at FVTOCI
 Designate an equity instrument as FVTOCI, provided that
the following conditions are complied with:
 the equity instrument must not be held for trading*, and
 there must have been an irrevocable choice for this designation
upon initial recognition of the asset.

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Subsequent measurement –Equity

at FVOCI
 Gains and losses on fair value change are recognised in OCI.
 Dividends (as defined in IFRS 9) are recognised in profit or
loss unless they clearly represent a repayment of part of the
cost of the investment.
 When the financial asset is derecognized, the cumulative
amounts recognised in OCI in respect of equity instruments
are not reclassified to profit or loss.
 The entity may only transfer the cumulative gain or loss
within equity.

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 Classification - Equity at FVTPL
 All equity instruments (including derivatives) , and any
equity instruments if this would eliminate or significantly
reduce on accounting mismatch*, will be measured at fair
value through profit or loss.
 * An accounting mismatch is a measurement or recognition inconsistency that would otherwise
arise from measuring assets and liabilities or recognising gains or losses on them on different bases.
Any financial asset can be designated at FVTPL if this would eliminate the mismatch. An entity can
opt to designate any financial asset at fair value through profit or loss in order to eliminate an
accounting mismatch (i.e. where a linked financial liability is measured at fair value through profit
or loss). This so-called fair value option is also irrevocable.

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Subsequent measurement –Equity

at FVTPL
 Gains and losses on fair value change, both on subsequent
measurement and derecognition, are recognised in profit or
loss.

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 Illustration 6
Example: Financial Asset at Fair Value through
Profit or Loss
Financial asset classified as Fair Initial recognition
value through profit or loss Dr. Assets- FVTPL $10,000
Cr. Cash $10,000
An entity acquires for cash 1000
shares at $10 per share and can 31 December 2021
designate them at fair value Dr. Assets -FVTPL $6,000
through profit or loss. At the year Cr. Statement of P/L $6,000
end 31 December 2021, the
quoted price increases to $16. 31 January 2022
The entity sells the shares for Dr. Cash $16,400
$16,400 on 31 January 2022. Cr. Assets -FVTPL $16,000
Cr. Statement of P/L $400

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Illustration 7
Example: Financial Asset at Fair Value
through Other Comprehensive Income
Financial asset classified as Initial recognition
FVTOCI Dr. Assets -FVTOCI $10,000
Cr. Cash $10,000
If the entity had classified the
shares as FVTOCI, the different 31 December 2021
entries would be as shown in the Dr. FVTOCI $6,000
left hand side. Cr. FVTOCI Reserves (via OCI) $6,000

31 January 2022
Dr. Cash $16,400
Dr. FVTOCI Reserve $6,000
Cr. Assets-FVTOCI $16,000
Cr. Retained earnings $6,000
Cr. Statement of P/L $400
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 Classification of Financial
Liabilities
 A financial liability is classified as measured at fair value
through profit or loss if:
 1. it is held for trading
 2. at initial recognition it is designated as fair value through
profit or loss to eliminate/significantly reduce an accounting
mismatch
 3. Derivatives that are liabilities
 All other financial liabilities are measured at amortized cost.

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Subsequent measurement -
amortized cost
 The amortised cost of a financial liability is measured using
the same principles as we have already seen in relation to
financial assets at amortised cost
 Financial liabilities will subsequently be measured at
amortized cost using the effective interest method.
 Financial
 liabilities
 Amount at initial recognition X
 Plus: interest recongized the effective rate as expense X
 Less: cash flows (X)
 (i.e. interest payment )
 Amortized cost c/f X

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 Illustration 9
 A company issues a $100,000 zero coupon bond redeemable in 5 years at $150,000.
 The internal rate of return (the yield) on these flows is 8.45%. This should be used to allocate the
expense.
 Period Opening balance Interest @ Closing Balance
 (8.45%)
 1 100,000 8,450 108,450
 2 108,450 9,164 117,614
 3 117,614 9,938 127,552
 4 127,552 10,778 138,330
 5 138,330 11,689 150,019
 This should be
150,000.The
difference of 19 is
due to rounding

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Subsequent measurement --fair

value through profit or loss
 Gains and losses on fair value change, both on subsequent
measurement and derecognition, are recognised in profit or
loss.

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 Illustration 10
 On 1 January 2021, M Ltd issued a financial liability for its
nominal value of $10 million. Interest is payable at a rate of
5% in arrears (ie effective interest rate = coupon rate)
 The liability is repayable on 31 December 2023. M Ltd
trades financial liabilities in the short-term.
 At 31 December 2021, market rates of interest have risen to
10%.
 Required:
 Discuss the accounting treatment of the liability at 31
December 2021.

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Illustration 10
 The financial liability is traded in the short-term and so is measured at fair value through profit or loss.
 The liability must be remeasured to fair value at the reporting date.
 Assuming that the fair value of the liability cannot be observed from an active market, it can be calculated
by discounting the future cash flows at a market rate of interest.
 Date Cash flow ($m) Discount rate Present
value
 ($m)
 31/12/22 0.5* 1/1.1 0.45
 31/12/23 10.5 1/1.12 8.68
 ––––
 9.13
 ––––
 * The interest payments are $10m × 5% = $0.5m
 The fair value of the liability at the year-end is $9.13 million.
 The following adjustment is required at 31 Dec 2020:
 Dr Liability ($10m – $9.13m) $0.87m
 Cr Profit or loss $0.87m

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 Derivatives
Example: Create rights/obligations that have
the effect of transferring between the parties
to the instrument one or more of the financial
risks inherent in an underlying primary
financial instrument (as the terms are fixed on
inception, as prices in financial market Derivatives
change, those terms may become either
favorable or unfavorable)
Either or

Value changes Settled at a No initial An initial net

in response to the future date. investment. investment that
change in a specified is smaller than
underlying variable. would be
Type of contract Underlying variable
required for other
Interest rate swap interest rate types of contracts.
Currency swap Currency rates
Equity swap Equity prices
Bond option Interest rates
Interest rate future Interest rates
Currency forward Currency rates
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Derivatives
• A derivative may be a financial asset or a financial
liability depending on whether it is ‘in the money’ or
‘out of the money’.
• An ‘in the money’ derivative will currently result in a
positive outcome for the holder and is a financial asset.
• An ‘out of the money’ derivative will currently result in
a negative outcome for the holder and is a financial
liability.

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 Derivatives
 Unless the derivative is qualified for hedge accounting, all
derivatives, including those linked to unquoted equity
investments, are measured at fair value through profit or loss,
as they do not give rise to contractual cash flows on specified
dates that are solely payments of principal and interest
thereon.

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Derivatives

Derivatives (Classification)
Deemed as

Held for short-term gain Hedging instruments

Fair Value thru P/L Fair Value hedge Cash flow hedge
( P/L) (Equity) –
Only effective portion

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 Illustration 11
 Entity A has a reporting date of 31 December. It enters into
an option on 1 June 2020, to purchase 10,000 shares in
another entity on 1 November 2021 for $10 per share. The
purchase price of each option is $1. This is recorded as
follows:
 Debit Option (PVTPL) (10,000 × $1) $10,000
 Credit Cash $10,000
 By 31 Dec the fair value of each option has increased to
$1.30. This increase is recorded as follows:
 Debit Option (PVTPL) (10,000 × ($1.30 – 1)) $3,000
 Credit Profit or loss $3,000

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Illustration 11
 On 1 November 2021 , the fair value per option increases to
$1.50. The share price on the same date is $11.50. Entity A
exercises the option on 1 November 2021 and the shares are
classified at fair value through profit or loss. Financial assets
are recognised at their fair value so the shares are initially
measured at $115,000 (10,000 × $11.50):
 Debit Investment in shares ( FVTPL) $115,000
 Credit Cash (10,000 × $10) $100,000
 Credit Option (FVTPL) ($10,000 + $3,000) $13,000
 Credit Profit or loss (gain on option) $2,000

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 Embedded derivatives
• An embedded derivative is a component of a hybrid
contract that also includes a non-derivative host, with the
effect that some of the cash flows of the combined
instrument vary in a way similar to a stand-alone
derivative. A derivative that is attached to a financial
instrument but is contractually transferable independently
of that instrument, or has a different counterparty, is not an
embedded derivative, but a separate financial instrument.

Embedded Derivative

Host: Debt, equity, sale,

A component of a hybrid instrument that combines insurance, lease, purchase
the derivatives and a non-derivative host contract
so that the effect of some of the cash flows of the
combined instrument vary similar to a stand alone Embedded derivatives:
derivative. Inflation, conversion
49 option, equity index

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Embedded derivatives
 The contractual cash flows of the financial asset are assessed in their
entirety, and the asset as a whole is measured at FVPL if any of its
cash flows do not represent payments of principal and interest.

2. Does the 3. Is the

No embedded Yes embedded No
1. Is the host
derivative meet derivative Separate
contract fair
the definition closely related accounting
valued?
on a stand- to the host
alone basis? contract?

Yes No Yes
No separate accounting under HKFRS 9

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 Illustration 12
 An entity has an investment in a convertible bond, which can
be converted into a fixed number of equity shares at a
specified future date.
 The bond is a non-derivative host contract and the option to
convert to shares is therefore a derivative element.
 The host contract, the bond, is a financial asset and so is
within the scope of IFRS 9. This means that the rules of IFRS
9 must be applied to the entire contract.
 The bond would fail the contractual cash flow characteristics
test and therefore the entire contract should be measured at
fair value through profit or loss.

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Impairment Loss (Credit Loss)

 The impairment requirements of HKFRS 9 are applied to:
 Debt instruments measured at amortised cost or FVTOCI
 Lease receivables (HKFRS 16)
 Contract assets (HKFRS 15)
 Loan commitments within the scope of HKFRS 9 and not measured at FVTPL
 Financial guarantee commitments not measured at FVTPL
 Debt and equity instruments measured at FVTPL are not within the
scope of HKFRS 9 credit loss guidance as they are measured at fair value
with gains and losses recognised in profit or loss in the same way as an
impairment loss.
 Equity instruments measured at FVTOCI are also scoped out of the
guidance as changes in fair value (including impairment loss) are
recognised in other comprehensive income.

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 Definitions
 Credit loss: The difference between all contractual cash flows
that are due to an entity in accordance with the contract and all
the cash flow that the entity expects to receive (i.e. all cash
shortfalls), discounted at the original effective interest rate
 Expected credit losses: The weighted average of credit losses
with the respective risks of a default occurring as the weights.
 Lifetime expected credit losses: The expected credit losses
that result from all possible default events over the expected life of
a financial instrument.
 12month expected credit losses: The portion of lifetime
expected credit losses that represent the expected credit losses
that result from default events on a financial instrument that are
possible within the 12 months after the reporting date

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Expected Credit Losses

 Expected credit losses are a probability-weighted estimate of credit
losses (i.e. the present value of all cash shortfalls) over the expected
life of the financial instrument. A cash shortfall is the difference
between the cash flows that are due to an entity in accordance with
the contract and the cash flows that the entity expects to receive.
Because expected credit losses consider the amount and timing of
payments, a credit loss arises even if the entity expects to be paid in
full but later than when contractually due.
 Expected credit losses should be discounted for the time value of
money, using the interest rate effective at the date of initial
recognition.

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 Impairments
 Two approaches
 General approaches
 Simplified Approach

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1. A general approach
 At initial recognition of a financial asset:
 Recognise 12-month expected credit losses. This will
acknowledge the probability of there being an event in the next
12 months which will cause a loan receivable to become
impaired.
 This “event” could be the liquidation or death of the customer. It
is expected that this probability will be relatively low for most
businesses.

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 1. A general approach
 The determination of expected losses at reporting date is performed on a
three-stage basis dependent on the credit status of the financial instrument.
 Stage 1 – if credit risk has not increased significantly since initial recognition, then 12
months of expected credit losses are recognised. Effective interest is computed on
the gross amortised cost base.
 Stage 2 – if the risk of default has significantly increased since initial recognition, an
entity is required to recognise the ‘lifetime expected credit loss’ on a financial
instrument. Effective interest is computed on the gross amortised cost base.
 Stage 3 – if the financial instrument is ‘credit impaired’ (objective evidence of
impairment), an entity is required to recognise the ‘lifetime expected credit loss’ on
a financial instrument. Effective interest is computed net of impairment losses.
 The expected credit losses (or reversals) are recognised as an impairment gain or
loss.

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Example – general approach

 On 1 January 20x1 ABC Limited acquired an investment in
$1,000,000 6% loan stock which is matured on 31 December
20x5. The investment is measured at amortised cost.
 At 31 December 20x1, there is a 5% probability that the borrower
will default on the loan during 20x1 resulting in a 100% loss.
 At 31 December 20x2, the probability of the default payment is
increased to 40%.
 At 31 December 20x3, it is notified by the issuer that it will only
be able to pay $450,000 at maturity. It is unlikely that ABC
Limited will receive any more after this date.

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 Example – general approach
 The impairment loss and interest revenue are recognised in
each of the years ended 31 December 20x1, 20x2 and 20x3.
Impairment allowance Interest revenue

31 December 20x1 5% x $1,000,000 = $50,000 $1,000,000 x 6% = $60,000

(stage 1)

31 December 20x2 (stage 40% x $1,000,000 = $400,000 $1,000,000 x 6% = $60,000

2)
31 December 20x3 (stage $1,000,000 - $450,000 = $450,000 x 6% =
3) $550,000 $27,000

Journal entries:
20x1: Dr P&L $50,000, Cr Allowance accounts $50,000
20x2: Dr P&L $350,000, Cr Allowance accounts $350,000
59
20x3: Dr P&L $150,000, Cr Allowance accounts $150,000

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Illustration 13
• On 1 January 2020, N Ltd purchased a bond for $1m which is
measured at amortised cost. Interest of 10% is payable in arrears.
Repayment is due on 31 December 2023. The effective rate of
interest is 10%.
• On 31 December 2020, N Ltd received interest of $100,000. It
was estimated that the probability of default on the bond within
the next 12 months would be 0.5%. If default occurs within the
first 12 months then N Ltd estimated that no further interest will
be received and that only 50% of the capital will be repaid on 31
December 2023.
• The asset’s credit risk at 31 December 2020 is low.
• Required:
– Discuss the accounting treatment of the financial asset at 31
December 2020.

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 Illustration 13
 The credit risk on the financial asset has not significantly
increased. Therefore, a loss allowance should be made equal
to 12 month expected credit losses. The loss allowance
should factor in a range of possible outcomes, as well as the
time value of money.
 The credit loss on the asset is $549,211(W1). This represents
the present value of the difference between the contractual
cash flows and the expected receipts if a default occurs.

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Illustration 13
• The expected credit loss is $2,746 ($549,211 credit loss ×
0.5% probability of occurrence). A loss allowance of $2,746
will be created and an impairment loss of$2,746 will be
charged to profit or loss in the year ended 31 December
2020.
• The net carrying amount of the financial asset on the
statement of financial position is $997,254 ($1,000,000 –
$2,746).
• Note: Interest in future periods will continue to be charged
on the asset’s gross carrying amount of $1,000,000.

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 Illustration 13
Date of Expected cash Discount Present
receipt shortfall rate value
31/12/21 100,000 1/1.1 $90,909
31/12/22 100,000 1/1.21 82,645
31/12/23 500,000 1/1.331 375,657
Total $549,211

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2. Simplified Approach
 Applies to trade receivables with maturities less than 12
months.
 For accounts receivable and lease receivables greater than 12
months a choice is available either by adopting the simplified
approach or by applying the full three-stage approach.
 Under simplified approach the expected loss is calculated
based on the ‘lifetime expected credit losses’.
 HKFRS 9 permits the use of a provision matrix to calculate
lifetime credit losses for trade receivables/contract assets
resulting from transactions under HKFRS 15 Revenue from
Contracts with Customers
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 2. Simplified Approach
 This involves grouping trade receivables (or contract assets)
based on customer bases or groupings with different
historical loss patterns (eg region, type of customer, product
type). Historical provision rates are then applied, although
these may be adjusted to reflect relevant current
information.
 For example, 1% if not past due, 2% if less than 30 days past
due, 5% if more than 30 but less than 90, etc.)

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Example – Simplified approach

 A provision matrix may be used to calculate lifetime credit losses for trade
receivables. This involves grouping trade receivables based on customer
bases or groupings with different historical loss patterns (e.g. region, type
of customer, product type). Historical provision rates are then applied,
although these may be adjusted to reflect relevant current information.
 Example:
Expected default Gross carrying amount Credit loss allowance
rate

Current 0.6% $850,000 $5,100

1-30 days past due 1.0% $560,000 $5,600

31-60 days past due 2.5% $320,000 $8,000

61-90 days past due 3.2% $120,000 $3,840

Over 90 days past due 8.0% $80,000 $6,400

66 Total $1,930,000 $28,940

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 Illustration 14
 Villa Ltd has trade receivables amounting to $250,000 at 31 December 2021. These are
made up of a large number of small customers, and Villa Ltd uses a provision matrix to
determine expected credit losses.
 This matrix is based on historic observed default rates, which are adjusted for current
conditions and forward looking estimates.
 The credit loss allowance at 31 December 2020 was $5,430; the calculation of the credit
loss allowance at 31 December 2021 is as follows:
 Expected Gross Credit
 default rate carrying Loss
 amount ($) allowance ($) Current
0.2% 114,000 228
 1–30 days past due 1.5% 43,000 645
 31–60 days past due 2.9% 38,000 1,102
 61–90 days past due 7.1% 35,000 2,485
 More than 90 days past due 12.3% 20,000 2,460
 250,000 6,920

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Illustration 14
 The credit loss allowance is increased from $5,430 to
$6,920; this is recognised by:
 DEBIT Expected credit losses (PL) $1,490
 CREDIT Credit loss allowance (BS) $1,490
 Trade receivables in the statement of financial position are
reported at their net amount of $243,080 ($250,000 −
$6,920)

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 HKAS 32 Financial Instruments: Presentation

Entities are often motivated, when Instruments classified as liabilities

raising fund, to issue instruments
that as classified as equity for rather than equity affect:
accounting purposes.

A company’s gearing/solvency ratios.

Distinguishing
Debt covenants with financial institutions.
financial liabilities
from Whether periodic payments on these
equity instruments instruments are treated as interest or
dividends.
(debt versus equity)
Regulatory requirements for capital
adequacy (reference to assets and equity).
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HKAS 32 Financial Instruments: Presentation

The instrument includes no contractual
obligation (Condition a):

1) to deliver cash or another financial asset to another

entity; or

(2) to exchange financial assets or financial liabilities with

An instrument shall another entity under conditions that are potentially
unfavorable to the issuer.
be classified as
an equity instrument If the instrument that will or may be
settled in the issuer’s own equity
if, and only if, both instruments and is:
conditions (a) and (Condition b)
(b) are met (1) a non-derivative that includes no contractual obligation
for the issuer to deliver a variable number of its own equity
instrument; or

(2 ) a derivative that will be settled only by the issuer

exchanging a fixed amount of cash or another financial asset
70
for a fixed number of its own equity instruments.

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 HKAS 32 Financial Instruments: Presentation

Example - How to classify

(Preference Shares)

If company A issues preference shares for $1 each that pay a fixed rate
of cumulative dividend (5% annually) and that have a mandatory
redemption feature at a future date. The substance is that company A
now has a contractual obligation to deliver cash (both in respect of
dividends and to return the cash) and, therefore, it should be
recognized as a financial liability.

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Illustration 15
• Redeemable preference shares are not classified as equity under
IAS 32 as there is a contractual obligation to transfer financial
assets (e.g. cash) to the holder of the shares. They are therefore a
financial liability.
• If such shares are redeemable at the option of the issuer, they
would not meet the definition of a financial liability as there is no
present obligation to transfer a financial asset to the holder of the
shares. When the issuer becomes obliged to redeem the shares,
they become a financial liability and will then be transferred out of
equity.
• For non-redeemable preference shares, the substance of the
contract would need to be studied. For example, if distributions to
the holders of the instrument are at the discretion of the issuer,
the shares are equity instruments.

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 Settlement in own equity
instruments
• A financial liability will arise when:
– there is a non-derivative contract to deliver, or be required to
deliver, a variable number of own equity instruments;
– there is a derivative that will or may be settled other than by
issuing a fixed number of own equity instruments for the fixed
amount of cash (functional currency).
– In such transactions, the counterparty bears no share price
risk, and is therefore not in the same position as a “true”
equity shareholders.

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Settlement in own equity

instruments
 An equity instrument will arise when:
 a non- derivative that comprises an obligation for the issuer to
deliver a fixed number of its own equity instruments (fixed
rule) ; or
 a derivative that will be settled only by the issuer exchanging a
fixed number amount of cash (functional currency) for a fixed
number of its own equity instruments (fixed for fixed rule).

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 HKAS 32 Financial Instruments: Presentation
Example – How to classify
(Issuance of fixed monetary
amount of equity instruments)
A contractual obligation to deliver a variable number of the equity’s own shares whose value equals
a fixed amount or an amount based on changes in an underlying variables (e.g. commodity price),
this is a financial liability.

For example, company A has an obligation to deliver to party B as many of company’s A own
ordinary shares as will equal $100,000. The number of shares that Company A will have to issue
will vary depending on the market price of it own shares. If the share price is $1, it will have to
deliver 100,000 shares, but if the share price is $0.5 and it will have to deliver 200,000 shares.

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Illustration 16
 (a) A company enters into a contract to deliver 1,000 of its own
common shares to a third party in settlement of an obligation. As
the number of shares are fixed within the contract to meet the
obligation, it is an equity instrument. There is no obligation to
transfer cash, another financial asset or an equivalent value.
 (b) The same company enters into another contract that requires it
to settle a contractual obligation using its own shares in an amount
that equals the contractual obligation. In this case the number of
shares to be issued will vary depending on, for example, the market
price of the shares at the date of the contract or settlement. If the
contract was agreed at a different date, a different number of
shares may be issued. Whilst cash has not been paid, the equivalent
value in shares will be transferred. The contract is a financial
liability.

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 HKAS 32 Financial Instruments: Presentation
Compound Financial Instruments

Determine if a non-derivative financial instrument contains

both a liability and an equity component

Substance of the contractual arrangements

Such components must be classified and presented separately

Liability component Equity component

Classification as debt or equity is made on initial recognition, and is not

allowed for change later as a result of a change in the likelihood that the
conversion option may be exercised or lapsed.
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Split accounting for Compound

Financial Instruments
• On initial recognition of compound financial instrument, the credit
entry for the financial instrument must be split into two component
parts, equity and liability.
• Steps:
– Step 1, derive the fair value of the liability
• The liability is measured by discounting the stream of future payments at the
prevailing market rate for a similar liability without the associated equity
component.
– Step 2, Fair value of compound instrument - fair value of liability
component (i.e. step 1) = Initial carrying value of equity component
– Step 3, transaction costs relating to the issue of a compound financial
instrument are allocated to the liability and equity components in
proportion to the split in value above.

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 HKAS 32 Financial Instruments: Presentation

 Since the host contract contains an obligation to transfer cash

(repayment of principal and interest), and the issuer does not have
unconditional right to avoid delivery cash or another financial asset in
settlement of that obligation, there is a liability element.
 At the same time, the instrument also carries an option feature where
the entity can be required to exchange a fixed amount of cash for a fixed
number of its own equity instruments, there is an equity element (i.e.
fixed-for-fixed test criterion is fulfilled).
 The entity should therefore:
 Calculate the fair value for the liability component based on similar
instruments without the conversions rights; and
 Deduct this from the instrument as a whole to leave a residual value
for the equity component.
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HKAS 32 Financial Instruments: Compound

Instrument

Compound Instrument
Example - How to separate the equity and liability
components in financial statement

1 January 2021 Issued 2,000 convertible debenture at par value $1,000 per
debenture - total value is $2 million)

Terms 3 years

Interest rate 6% per annum in arrear

Conversion terms (a) At holder’s discretion, (b) 1 bond convertible to 250 ordinary
shares

Prevailing market 9% for similar debt without conversion option

interest rate

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 HKAS 32 Financial Instruments: Compound
Instrument

Present value of the principal at 9%: 2,000,000/(1.09)^3 1,544,369

Sum of Present value of $120,000 (6% of the principal 303, 755

$2,000,000) annual interest

Interest at Year 1: 120,000/1.09 110,092

Interest at Year 2: 120,000/(1.09)^2 101,002

Interest at Year 3: 120,000/(1.09)^3 92,661

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HKAS 32 Financial Instruments: Compound

Instrument

Present value of the principal at 9%:$ 2,000,000/(1.09)^3 1,544,369

Total present value of $120,000 (6% of the principal 303, 755

$2,000,000) interest each year for 3 years, at the end of Year 3

Total bond component 1,848,124

Residual equity component ($2,000,000 - $1,848,124) 151,876

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 HKAS 32 Financial Instruments: Compound
Instrument
 Journal entry at time of issuance

Dr. Cash 2,000,000

Cr. Convertible note payable1,848,124

Cr. Equity – conversion options 151,876

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HKAS 32 Financial Instruments: Compound

Instrument
 Breakdown of payments

Interest Interest
Date Op bal Cl bal
expense payment
$ $ $ $
1/1/2021 1,848,124 1,848,124
31/12/2021 1,848,124 166,331 (120,000) 1,894,455
31/12/2022 1,894,455 170,501 (120,000) 1,944,956
31/12/2023 1,944,956 175,044 (120,000) 2,000,000

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 HKAS 32 Financial Instruments: Compound
Instrument
 End of Year 1
31 December
Interest expense 166,331
Cash 120,000
Note liabilities 46,331

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HKAS 32 Financial Instruments: Compound

Instrument
 End of Year 2
31 December
Dr. Interest expense 170,501
Cr. Cash 120,000
Cr. Note liabilities 50,501

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 HKAS 32 Financial Instruments: Compound
Instrument
 End of Year 3
31 December
Dr. Interest expense 175,044
Cr. Cash 120,000
Cr. Note liabilities 55,044

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HKAS 32 Financial Instruments: Compound

Instrument
 At redemption/Conversion
Dr. Note liabilities 2,000,000
Cr. Cash/Share Capital 2,000,000

 Conversion options restated

Dr. Conversion options (equity) 151,876
Cr. Retained profits/Share Capital 151,876

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 Illustration 17
 An entity issues 2,000 convertible, $1,000 bonds at par
on 1 January 2021.
 Interest is payable annually in arrears at a nominal
interest rate of 6%.
 The prevailing market rates of interest at the date of
issue of the bond was 9%.
 The bond is redeemable 31 December 2023.
 Required:
 Calculate the values at which the bond will be included in
the financial statements of the entity at initial recognition.

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Illustration 17
 Present value of the principle repayable in 3 years time
 $2,000,000 × 0.772 (3 year, 9% discount factor) 1,544,000
 Present value of the interest stream
 $120,000 × 2.531 (3 year, cumulative,9% discount factor) 303,720
 Total liability component 1,847,720
 Equity component (taken as a balancing figure) 152,280
 Proceeds of the issue 2,000,000

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 END

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