Financial instrument

Financial instruments
• There are three accounting standards on financial instruments:
• IAS 32 Financial Instruments: Presentation, which deals with:
• The classification of financial instruments between liabilities and equity.
• Presentation of certain compound instruments.
• IFRS 7 Financial Instruments: Disclosures
• IFRS 9 Financial Instruments replaces IAS 39 Financial Instruments:
Recognition and Measurement. The standard covers:
• Recognition and de-recognition.
• The measurement of financial instruments.
• Impairment
• General hedge accounting
Definitions
• Financial instrument: Any contract that gives rise to both a financial
asset of one entity and a financial liability or equity instrument of
another entity.
• Financial assets include, Cash, right to receive cash A/R, investments under
20% more than this is investment in associate or subsidiary.
• Financial liabilities include, Trade payables, loans, Forward contracts standing
at a loss
• Equity instrument.
Presentation of financial instruments
• Liabilities and equity, based on contractual obligation:
• Financial liability if there is a contractual obligation on the issuer either to deliver
cash or another financial asset to the holder.
• Equity instrument Where the above critical feature is not met, although the
holder of an equity instrument may be entitled to a pro rata share of any
distributions out of equity, the issuer does not have a contractual obligation to
make such a distribution.
• Example: of preference shares (a share which entitles the holder to a fixed
dividend, whose payment takes priority over that of ordinary share dividends)
which must be redeemed by the issuer for a fixed {or determinable) amount at a
fixed (or determinable) future date. In such cases, the issuer has an obligation.
Therefore the instrument is a financial liability and should be classified as such.
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• Liabilities and equity, based on Contingent settlement provisions:
• The way in which it is settled depends on:
• The occurrence or non-occurrence of uncertain future events.
• The outcome of uncertain circumstances
• That are beyond the control of both the holder and the issuer of the
instrument. For example, an entity might have to deliver cash instead
of issuing equity shares. In this situation it is not immediately clear
whether the entity has an equity instrument or a financial liability.
• Such financial instruments should be classified as financial liabilities
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• Compound financial instruments: (Very Imp)

• Some financial instruments contain both a liability and an equity

element.
• Parts of the instrument to be classified separately.
• Compound instrument is convertible debt. This creates a primary
financial liability of the issuer and grants an option to the holder of
the instrument to convert it into an equity instrument (usually
ordinary shares)
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• Compound financial instruments – Continue
• Example:
• Rathbone Co issues 2,000 convertible bonds at the start of 2012. The bonds have a
three-year term, and are issued at par with a face value of $1,000 per bond, Interest
is payable annually in arrears at an annual interest rate of 6%.
• When the bonds are issued, the market interest rate for similar debt without
conversion options is 9%, using a discount rate of 9%, the present value of $1
payable at the end of three years is $0.772, the cumulative present value of $1 paid
annually in arrears for three years is $2.531.
• Required
• What is the value of the equity component in the bond?
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Embedded derivatives
• An embedded derivative is a derivative instrument that is combined
with a non-derivative host contract to form a single hybrid
instrument.
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• Offsetting a financial asset and a financial liability.
• In all cases, financial assets and financial liabilities are presented
separately except the following:
• Has a legally enforceable right of set offset.
• Intends to settle on a net basis

• This will reflect the expected future cash flows of the entity.
Recognition of financial instruments
• Initial recognition
• Financial instruments should be recognized in the statement of
financial position when the entity becomes a party to the contractual
provisions of the instrument, this is different from the recognition
criteria in the Conceptual Framework and in most other standards.
Items are normally recognized when there is a probable inflow or
outflow of resources and the item has a cost or value that can be
measured reliably.
Recognition of financial instruments –
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• An entity has entered into two separate contracts:
• A firm commitment (an order) to buy a specific quantity of iron.
• A forward contract to buy a specific quantity of iron at a specified price on a specified date,
provided delivery of the iron is not taken.
• Contract (a) is a normal trading contract. The entity does not recognize a liability
for the iron until the goods have actually been delivered. (this contract is not a
financial instrument because it involves a physical asset, rather than a financial
asset.)
• Contract (b) is a financial instrument Under IFRS 9, the entity recognizes a
financial liability (an obligation to deliver cash) on the commitment date, rather
than waiting for the closing date on which the exchange takes place.
• Note that planned future transactions, no matter how likely, are not assets and
liabilities of an entity - the entity has not yet become a party to the contract.
De-recognition of financial assets
• Derecognize a financial asset when:
• The contractual rights to the cash flows from the financial asset expire.
• The entity transfers the financial asset or substantially all the risks and
rewards of ownership of the financial asset to another party.
• Derecognize a financial liability when:
• Settled or expired
• Legally released.
• Loan restructure.
• Possible for only part of a financial asset or liability to be derecognized, For
example, if an entity holds a bond it has the right to two separate sets of cash
inflows: those relating to the principal and those relating to the interest. It could
sell the right to receive the interest to another party while retaining the right to
receive the principal.
Classification of Financial Assets
• Initial measurement
Classification of Financial Assets – Dec-16 exam
Classification of Financial Assets
• Basis of classification, IFRS 9 requires that financial assets are
classified as measured at either (Very Imp):
• Amortized cost.
• Fair value through other comprehensive Income.
• Fair value through profit or loss.
• Classification is made based on both:
• The entity's business model for managing the financial assets (Business model
test)
• The contractual cash flow characteristics (Cash flow test)
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• Reclassification between amortized cost and fair value is allowed in case of

changing the business model, The reclassification should be applied
prospectively from the reclassification date.
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• Equity instruments, must be measured at fair value because
contractual cash flows on specified dates are not a characteristic of
equity instruments.
• If an equity instrument is not held for trading (to sell within 12 month), direct
cost will be capitalized measure it at fair value through other comprehensive
income, which will be recycled to profit & loss when the asset is sold, with
only dividend Income recognized in profit or loss
• If held for trading measure it at fair value through profit and loss, direct cost
will be expensed.
Classification of financial liabilities
• All financial liabilities should be classified as measured at amortized
cost.
• A financial liability is classified at fair value through profit or loss if:
• It is held for trading.
• Is a derivative.
• Upon initial recognition, it is irrevocably designated at fair value through
profit or loss.
Initial measurement: Financial assets
• Financial assets measured at amortized cost:
Example:
On 1 January 2001 Abacus Co purchases a debt instrument for its fair
value of $1000. The debt instrument is due to mature on 31 December
The instrument has a principal amount of $1,250 and the instrument
carries fixed interest at 4.72% that is paid annually. (The effective
interest rate is 10%.) How should Abacus Co account for the debt
instrument over its five-year term?
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• Abacus Co will receive interest of $59 (1,250 x 4.72%) each year and
$1,250 when the instrument matures.
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• Financial assets measured at fair value
Example:
On 8 February Orange Co acquires a quoted investment in the shares of Lemon Co
with the intention of holding it in the long term. The investment cost $850,000. At
Orange Co's year end of 31 March 20X8 the market price of an identical investment
is $900,000. How is the asset initially and subsequently measured?
Orange Co has elected to recognize changes in the fair value of the equity
investment in other comprehensive income.
Solution:
• The asset is initially recognized at the fair value of the consideration, being
$850,000
• At the period end it is re-measured to $900,000
• This results in the recognition of $50,000 in other comprehensive income
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• Example:
In January 20X6 Wolf purchased 10 million $1 listed equity shares in Hall at a price
of $5 per share. Transaction costs were $3m. Wolf's year end is 30 November.
At 30 November 20X6, the shares in Hall were trading at $6.50. On 31 October Wolf
received a dividend from Hall of 20c per share.
Show the financial statement extracts of Wolf at 30 November 20X6 relating to the
investment in Hall on the basis that:
• The shares were bought for trading.
• The shares were bought as a source of dividend income and were the subject
of an irrevocable election at initial recognition to recognize them at fair value
through other comprehensive income.
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Initial measurement: Financial liabilities
• IFRS 9 requires that financial liabilities are initially measured at
transaction price, ie the fair value of consideration received,
Transaction costs are deducted from this amount for financial
liabilities classified as measured at amortized cost.

• All financial liabilities should be measured at amortized cost, with the

exception of financial liabilities at fair value through profit or loss.
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Example:
Galaxy Co issues a bond for $503,778 on January 20X2. No interest is
payable on the bond, but it will be redeemed on 31 December for
$600,000. The effective interest rate of the bond is 6%.
Required
Calculate the charge to profit or loss of Galaxy Co for the year ended 31
December and the balance outstanding at 31 December 20X2.
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It is measured at amortized cost, difference between the initial cost of
the bond and the price at which it will be redeemed is a finance cost,
must be allocated over the term of the bond.
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• Example:
1 January 20X3 Dazzle issued $600,000 loan notes. Issue costs were
$200. The loan notes do not carry interest, but are redeemable at a
premium of $152,389 on 31 December The effective finance cost of the
debentures is 12%.
What is the finance cost in respect of the loan notes for the year ended
31 December 20X4.
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Hedge accounting
• Entities hedge to reduce their exposure to risk and uncertainty, such
as changes in prices, interest rates or foreign exchange rates.
• Adopting the hedge accounting provisions of IFRS 9 is mandatory
where the hedging relations meets all of the following criteria: V.Imp
• The hedging relationship consists only of eligible hedging instruments and
eligible hedged items.
• Providing the needed supporting documents.
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• Example:
A company owns inventories of 20,000 gallons of oil, which cost $400,000 on 1
December 20x3
In order to hedge the fluctuation in the market value of the oil the company signs a
futures contract to deliver 20,000 gallons of oil on 31 March at the futures price of
$22 per gallon.
The market price of oil on 31 December is $23 per gallon and the futures price for
delivery on 31 March is $24 per gallon.
Required
Explain the Impact of the transactions on the financial statements of the company:
• Without hedge accounting
• With hedge accounting
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• Three types of hedging:
• Fair value hedge: a hedge of the exposure to changes in fair value of a
recognized asset or liability, or an unrecognized firm commitment, or a
component of any such item, that is attributable to a particular risk and could
affect profit or loss.
• Cash flow hedge: a hedge of the exposure to variability in cash flows that
Is attributable to a particular risk associated with all, or a component of, a
recognized asset or liability (such as ail or some future interest payments on
variable rate debt) or a highly probable forecast transaction.
• Net investment hedge (Forex)
Only fair value hedges and cash flow hedges are examinable
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• Example - Fair value hedge:
On 1 July Jules acquired 10,000 ounces of a material which it held in its
inventory. This cost $200 per ounce, so a total of $2m. Jules was concerned
that the price of this inventory would fall, so on 1 July 20X6 he sold 10,000
ounces in the futures market for $210 per ounce for delivery on 30 June
20x7. On 1 July 20X6 the conditions for hedge accounting were all met.
At 31 December 20x6, the end of Jules' reporting period, the fair value of
the inventory was $220 per ounce while the futures price for 30 June
delivery was $227 per ounce. On 30 June 20X7 the trader sold the inventory
and closed out the futures position at the then spot price of $230 per ounce.
The FRS 9 hedge accounting criteria have been met.
Required
Set out the accounting entries in respect of the above transactions.
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• Example - Cash flow hedge:
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Impairment of financial assets
• The entity should estimate the expected credit losses considering the past events,
current conditions and reasonable and supportable forecasts.
• Credit losses is the present value of all cash shortfalls.
• Expected credit losses updated each reporting date, for the assets measured at fair value
through P&L any impairment is recognized automatically in the measurement basis – no
credit losses model applied.
• Events have occurred that have a detrimental impact on the estimated future cash flows
of that financial asset.
• A breach of contract, such as a default in interest or principal payments.
• The lender granting a concession to the borrower that the lender would not otherwise consider,
for reasons relating to the borrower's financial difficulty.
• It becomes probable that the borrower will enter bankruptcy.
• The disappearance of an active market for that financial asset because of financial difficulties
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• Measuring the expected credit losses

Adjustment of losses allowance

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• Expected credit loss model, requires entities to base their measurement of expected
credit losses on reasonable and supportable information that is available without
undue cost or effort. This will include historical, current and forecast information.
• Example
Orange Co advanced a three-year interest bearing loan of $2m to Lemon Co on 1 July at
that date management estimates the risk of default in the next 12 months as 2% and the
risk of default over the remaining term of the loan as 5.5%. The loss that would result
from the default was estimated at $800,000.
What is the amount of the credit loss provision that Orange Co should record on initial
recognition?
• Solution
The credit loss provision on initial recognition is based on the 12-month expected losses.
A provision of $16,000 (2% x $800,000) should be recognized.
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• Example continued
Orange Co has a repotting date of 31 December. By 31 December 20x4
management estimates that the risk of default in the next 12 months is 3.5% and in
the remaining term of the loan is 10.5%. The loss that would result from the default
was estimated at $750,000.
What is the amount of the credit loss provision that should be included in the
statements of financial position as at 31 December 20x4?
• Solution
Since the total risk of default has increased from 7.5% on initial recognition to 14%
by this would seem to be a significant increase in credit risk. The credit loss
provision must therefore be based on lifetime expected losses and would be
$105,OOO ((3.5% + 10.5%) x $750,000).
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• By 31 December management estimates that the risk of default in the next
12 months is 1.5% and in the remaining term of the loan is 1%. The loss
that would result from the default was estimated at $450,000.
What is the amount of the credit loss provision that should be included in
the statements of financial position as at 31 December
• Solution
Since the total risk of default has decreased from 14% on initial recognition
to 2.5% by 31/1 2/X5, this would seem to be a significant improvement in
credit quality. The 12-month expected credit loss basis Is now reinstated, and
a credit loss provision of $6,750 (1.5% x $450,000) should be included.
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Thank you