Chapter 11

Financial
instruments
Major accounting issues
• Definition of Financial instruments (IAS 32)
• Recognition and measurement of financial
instruments (IFRS 9)
• Presentation of financial instruments (IAS
32, IFRS 9)
• Disclosure of financial instruments (IFRS 7)
 Need for a standard
Issue
• In recent years there have been many changes to number and
variety of financial instruments which are available to
companies.
• The main issues have surrounded how they are measured and
classified/presented in the financial statements.
• Whether a financial instrument should be classified as debt or
equity is an important consideration mainly because of the
effect this decision could have on a company's gearing ratio.
• There is a definite need for consistency.
 Financial instruments - Definitions
Definitions
• A financial instrument is:
– A contract that gives rise to both a financial asset of one
entity and a financial liability or equity instrument of
another
– Example: a loan agreement from a bank signed by a
company, credit offered to customers, shares of stock of
investee.
 Financial asset, financial liability and equity
Financial assets
▪ Cash
▪ Equity instrument of another entity
▪ Contractual right to receive a financial
instrument
▪ Contractual right to exchange financial
instruments under potentially favourable
conditions
Financial liabilities
▪ Contractual obligation to deliver another
financial asset
▪ Contractual obligation to exchange
financial instruments under potentially
unfavourable conditions
Equity
▪ Contract that evidences a residual interest
in the net assets (i.e. assets – liabilities) of
an entity.
 Example 1: Financial asset, financial liability
and equity
Financial assets Financial liabilities Equity
Cash \ Bank balances Payables in the bank -
Trade receivables Trade payables -
An investment in shares - Share Capital
A loan made to another party Loans payable -
Investment in redeemable Redeemable
-
preference shares (by cash) preference shares
Investment in convertible Convertible preference Convertible
preference shares shares (liability preference shares
component) (equity component)
 Financial asset and financial liability
IAS 32: the following items are NOT financial assets or liabilities:
1. Physical assets, e.g. inventories, property, plant and equipment, leased
assets and intangible assets (e.g. patents, trade marks etc.)
2. Prepaid expenses, deferred revenue and most warranty obligations
3. Liabilities or assets that are not contractual in nature e.g. income taxes that
are the result of statutory requirements imposed by governments; accrued
salary.
4. Contractual rights/obligations that do not involve transfer of a financial asset,
e.g.
Customer deposit that require transfer of inventory or deliver of services
 Recognition
• Financial asset or financial liability should initially be
recognised in the SFP when the reporting entity becomes a
party to the contractual provisions of the instrument.
• A financial asset should be derecognised when:
– The contractual right to the cash flows from the financial
asset expire; or
– The entity transfers substantially all the risks and rewards of
ownership of the financial asset to another party.
• A financial liability should be derecognised when it is
extinguished, namely when the obligation specified in the
contract is discharged, cancelled or expires.
 Classification
Financial assets – Classification
2 Criteria to determine how financial assets are classified
and measured:
(a) The entity’s business model for managing the financial
assets: and
(b) The characteristics of the financial assets’ contractual
cash flows are solely payment of principal and interest
(SPPI).
 Solely payment of principal and interest
(SPPI)
▪ Principal: the fair value of the financial asset at initial recognition (this
amount may change over life of asset – e.g. repayment of principal)

▪ Interest: consideration for the time value of money, for the credit risk
associated with principal amount outstanding during a particular period of
time and for other basic lending risks and costs, as well as a profit margin.
▪ Typically time value of money and credit risk are most significant element of
interest.
▪ If contract includes exposure to risks or volatility unrelated to a basic lending
arrangement (e.g. changes to equity prices or commodity prices or stock
index) – not solely payment for principal and interest on principal amount
outstanding.
 Business Models
▪ Refers to how an entity manages its financial assets to generate cash flows.
IFRS 09 divided business models in 3 groups:
▪ Business model whose objective is to hold assets in order to collect
contractual cash flows (hold to collect – sales are incidental);
▪ Business model whose objective is achieved by both collecting contractual
cash flows and selling financial assets (hold to collect and sell – sales are
integral)
▪ Other business models: Some examples are:
▪ Business models for which the primary objective is realizing cash
flows through sale (i.e. collecting contractual cash flows is
incidental)
▪ Business models which are managed and performance evaluated
on a fair value basis
▪ Held for trading business models
 Financial assets – Classification – Debt
Instruments
On recognition, financial assets are classified in one of three ways
(a) Amortized cost : business model is to collect contractual CF; and contractual
CF are solely payment of principal and interest (SPPI). Example : Account
receivables
(b) Fair value through Other Comprehensive Income (FVOCI) : business
model is both to collect contractual CF and selling the financial assets,
and contractual CF are SPPI. Example : Investment in bonds for long term
purpose.
(c) Fair value through profit or loss (FVTPL) : irrevocable election to designate
them as FVTPL Example : Investment in bonds for short term trading purpose

Financial assets that meet the amortised cost or FVOCI must be classified as such,
unless an irrevocable election is made at initial recognition to designate them as
FVTPL.
 Classification of financial assets – Debt Instruments

Financial Assets
(Debts instrument)

Fair value
Amortised Fair value
through OCI
cost through P/L
(G/L recycle to PL)

Collect Collect Designated

contractual CF contractual CF (irrevocable
election)
SPPI + Selling

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 Financial assets - Classification– Equity Instruments
(a) FVTPL: no contractual CF, must measure in FVTPL:
(b) unless make an irrevocable election at initial recognition to measure
at FVTOCI

Financial Assets
(Equity instrument)

Fair value through OCI Fair value through P/L

(G/L not recycle to P/L) (default)

Irrevocable election

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 Financial assets - Classification

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 Measurement – Financial assets
Financial asset

FVTPL FVTOCI (available for

Amortised Cost
(Held for trading) sale)

- Initial measurement: - Initial measurement: fair value of

Fair value of the the consideration given or received + - Initial measurement: fair
consideration given transaction cost value of the consideration
given or received +
- Transaction cost goes
transaction cost
directly to PL

Subsequence measurement:
-Subsequence - Amortized cost adjustment using
measurement: All effective interest rate. Subsequence measurement:
changes in FV will go to - Changes in FV will go to
- Gains and losses are recognized in PL
PL OCI.
as a result of the amortization process
and when the asset is derecognized. - Dividend income for equity
instrument will go to PL.
 Measurement of Financial Assets at
Amortised Cost
Effective interest rate:
▪ The rate that exactly discounts estimated future cash receipts through the expected life
of the financial asset to the gross carrying amount of a financial asset.
▪ The calculation includes all fees and points paid or received between parties to the
contract that are an integral part of the effective interest rate, transaction costs, and all
other premiums or discounts.
 Example
Example 1: Financial asset at amortised cost
A company purchases a deep discount bond with a par value of
$500,000 on 1 January 20X1 for proceeds of $440,000.
Annual coupon payments of 5% are payable on 31 December
each year.
The entity incurred transaction costs of $5,867. The bond will
be redeemed on 31 December 20X3 at par.
The effective interest rate on the bond has been calculated at
9.3%.
Required
Show the profit or loss impact and carrying value of the bond
for each of the years of the bond's life. (20X1–20X3)
 Example

Amortised
Amortised cost at Interest coupon cost at year
beginning of year income received end

year 1 445,867 41,466 25 462,333

2 462,333 42,997 25 480,330

3 480,330 44,671 25 500,000

 Example
Example 2:
• In February 20X8 a company purchased 20,000 $1 listed equity
shares at a price of $4 per share. Transaction costs were $2,000. At
the year end of 31 December 20X8, these shares were trading at
$5.50. A dividend of 20c per share was received on 30 September
20X8.
• Show the financial statement extracts at 31 December 20X8 relating
to this investment on the basis that:
• (a) The shares were bought for trading (conditions for FVTOCI have
not been met)
• (b) Conditions for FVTOCI have been met
 Example
On 1 October 20X3, Bertrand paid $9.027 million to purchase $10
million loan notes which carry a coupon rate of 5% per annum.
Transaction cost $0,2 million. The loan notes are redeemable on 30
September 20X6 at par for cash. The effective interest rate of this
investment is 8%
Required:
a) What is the interest income to be shown in the SOPL for the year
ended 31 Sep 20X5?
b) What is the closing balance of investment in loan notes to be
shown in SOFP for the year ended 31 Sep X5
c) Assume that the borrowing interest at 31 Sep 20X5 is 10%. Calculate
the FV of the loan notes at that date and How should we account for this
information?
 Financial liabilities – Classification

Financial
Liabilities

Held for trading which means it is:

Amortised cost FVTPL ▪ acquired or incurred principally for
the purpose of selling or
repurchasing it in the near term; or
▪ there is actual pattern of short-term
Held for Trading or profit-taking; or
Default Designated
▪ a derivative.
 Measurement – Financial liabilities

Financial liabilities

FVTPL Amortised cost

- Initial recognition: Proceed received

- Initial recognition: Proceed received
- Transaction cost goes directly to PL less trading cost

- Subsequent measurement: All - Subsequent measurement: Amortised

changes in FV will go directly to PL cost adjustment using effective interest
rate
 Recognition and Measurement of Financial
Liabilities
▪ Example 1: Company G borrows a loan of CU 100million from a bank. The bank
charges CU 2million transaction cost. The loan will be repaid in one year plus
interest amounting to CU 110million.
How would Company G account for the loan?
 Example 2: Measurement of Financial liabilities at
Amortised Cost
▪ Company A borrows a fixed interest loan $80m at 8% p.a. on 1 Jan 20x1 when
the market interest rate is also 8%. Assume no transaction cost.

▪ The loan is repayable on 31 Dec 20x5 (5 yrs)

Account for the loan at amortised cost.
 Factoring of receivables

• Receivables can be factored with recourse or without

recourse.
• Receivables factored with recourse are not derecognised.
They continue to be an asset of the seller (assigned
receivables) and a liability is recognised for amounts advanced
by the factor
• Receivables factored without recourse are derecognised and
a profit or loss recognised on the sale.
• Deciding whether or not to treat the factoring transaction as a
sale, and to therefore derecognise the receivables, depends
on the transfer of risks and rewards.
 Factoring of receivables
• To derecognise or not?
Indications that the debts are not Indications that the debts are an asset
an asset of the seller of the seller
Transfer is for a single Finance cost varies with speed of
non-returnable fixed sum. collection of debts

There is no recourse to the seller for
losses.
Factor is paid all amounts received
from the factored debts (and no
more). Seller has no rights to further
sums from the factor.
There is full recourse to the seller for
losses.
Seller is required to repay amounts
received from the factor on or before a
set date, regardless of timing or amounts
of collections from debtors.
 Presentation of financial instruments
• IAS 32 deals with the classification of financial instruments
between liabilities and equity and the presentation of certain
compound instruments such as convertible debt.
• It states that financial instruments should be classified as debt
(financial asset or liability) or equity depending on their
substance rather than their legal form.
 Presentation of financial instruments
Debt instruments
• Debt instruments are those which meet the definition of a
financial asset or a financial liability.
Debt or equity?
• A company issues $100,000 6% redeemable preference shares.

Points to consider:
• How we name it: Redeemable preference shares .
• Reality:
• The preference shares are redeemable creating an obligation to
repay them at some point in the future.
• Fit Conceptual Framework’ s definition of a liability.
• 6% dividend payable seems to indicate that the preference
shareholders will be paid a lender's return.
 Presentation of financial instruments
Conclusion
• The redeemable preference shares will be reported under
non-current liabilities in the statement of financial position
(assuming they are redeemable after more than one year).
• The 6% annual dividend ($6,000) would be reported in the
statement of profit or loss and other comprehensive income as
part of the finance costs charge for the year.
 Presentation of financial instruments
Equity instruments
• An equity instrument is defined as 'any contract which
evidences a residual interest in the assets of an entity after
deducting all of its liabilities'.
Debt or equity?
• Consider the following scenario: a company issues 100,000 $1
shares when the market price is $2.60 per share. Issue costs of
$3,000 are incurred.
 Presentation of financial instruments
Points to consider
• Here there is no indication that the shares have limited rights or that
the company has any obligations in relation to the shareholders.
• As such the shares should be recorded in equity.
• IAS 32 states that the shares should be recorded at their net
proceeds and so any issue costs would reduce the value recorded
for the shares and be deducted from premium at which the shares
are issued.
• The company should record the following in equity:
$
Share capital (100,000 × $1) 100,000

Share premium [(100,000 × $1.60) – ($3,000)] 157,000

 Presentation of financial instruments
Compound financial instruments
• This term describes financial instruments which contain both a liability
and an equity element.
• IAS 32 states that each component part of the instrument should be
classified and valued separately according to the substance of the
arrangement.
• The most common type of compound instrument is convertible debt.
• The compound instrument should be separated as follows.
– Firstly determine the carrying amount of the debt component by
reference to a similar liability that does not have conversion rights
– Then value the equity component as the balancing figure
 Presentation of financial instruments
Example 1: Convertible bond
• A company issued 3,000 convertible bonds at par on 1 January 20X1. The bonds
are redeemable 31 December 20X4 at their par value of $100 per bond. The
bonds pay interest annually in arrears at an interest rate (based on nominal value)
of 5%. Each bond can be converted at the maturity date into 5 $1 shares. The
prevailing market interest rate for four year bonds that have no right of conversion
is 8%.
• The present value at 8% of $1 receivable at end of:
Year 1 0.926
Year 2 0.857
Year 3 0.794
Year 4 0.735
• Required : Show the accounting treatment of the:
(a) Bond at inception
(b) Financial liability component at 31 December 20X1 using amortised cost
 Disclosure of financial instruments
• IFRS 7 requires specific monetary disclosures of financial
instruments and also encourages the preparers of financial
statements to include a narrative commentary on the entity's
financial instruments.
• This commentary would help users understand management's
attitude to risk.
• IFRS 7 does not however prescribe the format or location of these
disclosures thus allowing management to exercise judgement.
• Common sense should also be applied and where there are a large
number of similar financial instrument transactions they may be
grouped together. Similarly where a single significant transaction
requires full disclosure this should also be made.