6 Financial Instruments - IFRS 9 and IAS 32

7/12/23, 5:50 AM CGMA LMS Tailor Preview
TOPIC
Financial Instruments — IFRS 9 and IAS 32
Course learning objective

After completing this course, you should be able to apply financial reporting standards to
transactions related to financial instruments.
Introduction
Within International Financial Reporting Standards (IFRS), financial instruments are a broad area
requiring substantial accounting and reporting guidance, much of which is notably complex
relative to other areas in IFRS. IFRS 9, Financial Instruments, outlines the initial and subsequent
measurement of financial instruments. It replaced IAS 39, Financial Instruments: Recognition and
Measurement, and became effective for annual periods beginning on or after January 1, 2018.
IAS 32, Financial Instruments: Presentation, provides guidance on the classification of financial
instruments and their presentation in the financial statements.
A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity. This means that items that will be settled
through the receipt or delivery of goods or services are not financial instruments.
IFRS 9 covers four main areas of financial instruments:
● Classification and measurement of financial assets

● Classification and measurement of financial liabilities
● Impairment
● Hedge accounting
Contrary to popular belief, financial instruments are not things that only financial institutions
have. Any organisation that sells its goods or services on credit has financial instruments (in this
case, the trade receivables). Any organisation that has an investment in the equity securities of
another entity has a financial instrument. So, most organisations need a solid understanding of
IFRS 9 and IAS 32. Note that impairment of financial assets and hedge accounting are beyond
the scope of this topic.
Key terms
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Financial instruments are a relatively complex area within IFRS. So, it is important to first cover
key definitions included in both IFRS 9 and IAS 32. IAS 32 provides the following key definitions
for financial instruments:
Click each folder to learn more.
Financial instrument
A financial instrument is a contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity. Within IAS 32, a contract and
contractual refer to an agreement between two or more parties that has clear economic
consequences that the parties have little, if any, discretion to avoid, usually because the
agreement is enforceable by law.
Financial instruments can be illustrated using a simple graphic that shows one entity holding
a financial asset while another entity holds either a financial liability or equity instrument.
Financial asset
A financial asset is any asset that is
● cash,
● an equity instrument of another entity,
● a contractual right to receive cash or another financial asset from another entity,
or
● a contractual right to exchange financial assets or financial liabilities with
another entity under conditions that are potentially favourable to the entity.
In addition to cash, common examples of financial assets include investments in bonds and
ordinary shares of other entities, trade receivables, and derivative financial assets. Although
investments in subsidiaries, associates, and joint ventures are financial assets, they are
accounted for in accordance with other standards (that is, not IFRS 9 or IAS 32).
Financial liability
A financial liability is any liability that is
● a contractual obligation to deliver cash or another financial asset to another

entity or
● a contractual obligation to exchange financial assets or financial liabilities with
another entity under conditions that are potentially unfavourable to the entity.
Examples of financial liabilities are accounts payable, loans and bonds issued by an entity, and
derivative financial liabilities.
Equity instrument
An equity instrument is any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities.
An example of an equity instrument is an entity’s investment in the ordinary shares of another

entity that does not result in consolidation or the equity method of accounting.
This topic covers equity instruments primarily in the context of investments in the equity
instruments of another entity; that is, the ‘acquiring’ entity rather than the “issuing’ entity.
Classification
IAS 32 Financial Instruments: Presentation provides guidance on whether a financial instrument
should be classified as a liability or equity in the issuing entity. The definitions of financial liability
and equity instrument have been provided previously in this topic.
This classification should always be based on the substance of the instrument over its legal
form. This is not always obvious – a redeemable preference share may appear to be an equity
instrument, but if it receives a fixed annual return and is redeemed at some point in the future,
then it is more like a loan and should be classified as a financial liability.
Generally, a financial instrument that is ‘purchased’ or ‘acquired’ is a financial asset, and a

financial instrument that is ‘issued’ is a financial liability or equity instrument. If it contains an
obligation, it is normally a financial liability whereas, if there is no obligation, it is normally an
equity instrument.
All financial instruments are initially recognised at fair value as set out in IFRS 9.
Subsequent measurement depends on whether they are classified as financial liabilities or

financial assets, and later sections will cover these separately.
Interest and dividends, losses and gains
The treatment of the interest and dividends

should follow the classification of the financial
instrument.
Interest on liabilities is a finance cost in the

statement of profit or loss, as are dividends paid
on preference shares classified as a liability.
Dividends paid on equity instruments should be

reported in the statement of changes in equity.
Compound financial instruments
From the point of view of the issuer who is raising finance, compound financial instruments
contain both a liability and an equity component. IAS 32 requires that the liability and equity
components be presented separately in the financial statements according to their substance
and based on the definitions of liability and equity.
The split is done at the date the instrument is issued (that is, at initial recognition) and not
amended for any subsequent changes in the instrument.
One of the most common examples of compound instruments is a debt instrument that has the
option for the holder to convert the outstanding balance into ordinary shares.
● The liability component is the contractual obligation to repay the instrument.
● The equity element is the holders’ option to convert into ordinary shares.
Offsetting
IAS 32 also provides guidance for the offsetting of financial assets and financial liabilities. It
states that a financial asset and financial liability may be offset, and the net amount reported
when an entity
● has a legally enforceable right to set off the amounts and

● intends either to settle on a net basis or to realise the asset and settle the liability
simultaneously.
Recognition and measurement: Financial liabilities
Initial recognition
An entity creates a financial liability when it raises finance (such as loan stock or the issue of
bonds). As required by IFRS 9, financial liabilities are initially recognised at fair value, with any
transaction costs dealt with based on their classification.
Subsequent measurement
Financial liabilities are subsequently measured at amortised cost with some limited exceptions,
including financial liabilities that are held for trading and financial liabilities for which the ‘fair
value option’ is elected at initial recognition. Generally, ‘held for trading’ means that
management’s intention is to repurchase them (that is, buy them back) in the near term, rather
than to hold them beyond the near term.
Amortised cost is measured at each year end as the amount brought forward (or the amount
initially recorded in the first year) plus interest less repayments. The interest rate charged is the
‘effective’ interest rate, or the internal rate of return of the instrument.
Financial liabilities that are held for trading are measured at fair value through profit or loss
(FVPL), with transaction costs charged to profit or loss. Derivatives are also treated in this way.
Another exception to subsequent measurement at amortised cost exists for those financial
liabilities for which an election is made to apply fair value through profit or loss. Certain eligibility
criteria must be met to apply this ‘fair value option’, most commonly that it would eliminate or
reduce inconsistencies in recognition or measurement, often referred to as an ‘accounting
mismatch’.
Scenario
You are a finance manager working for London Company, a large manufacturing organisation
that invests in a portfolio of financial instruments and finances its business using various
methods.
Throughout this topic, London Company is used in the examples to illustrate the application of
IFRS 9 and IAS 32.
London Company issued a debt instrument on 1 January 20X7 for a nominal value of $1m.
Interest is paid annually in arrears at a rate of 6%. This financial liability is repayable in two years’
time, but London Company tends to trade these short-term liabilities. Because London Company
trades these liabilities, they are initially recognised at fair value and subsequently measured at
fair value through profit or loss.
Consider the following three independent situations:
● At 31 December 20X7, market interest rates have increased to 10%, which has
resulted in the fair value of the financial liability falling to $800,000.
● No fair value from an active market is available.
● The financial liability had fallen in value by $180,000 due to the change in interest
rates and by $100,000 due to the credit risk.
The fair value is the consideration received from the issue.
Initial recognition, 1 January 20X7
Dr Cash $1m
Cr Financial liability $1m
Now, consider the three different situations.
1. Subsequent measurement, 31 December 20X7

Because the fall in value is based on an interest rate change rather than the credit risk of London
Company, the fall in fair value of $200,000 ($1m – $800,000) is recognised in profit or loss.
Dr Financial liability $200,000
Cr Profit or loss $200,000

If the fair value had not been available, then the present value of the future cash flows would be
calculated using the market interest rate of 10%. Note that there may be rounding differences in
the calculations.
Date Cash flow Discount rate Present value

$
31 December 20X8 Interest 60,000 1 ÷ 1.1 54,540

(6% × $1m)
31 December 20X9 Interest 60,000 1 ÷ 1.1² 49,560

(6% × $1m)
Capital $1m 1 ÷ 1.1² 826,000
930,100
The initial recognition would be the same, but the change in fair value would be as follows:
Dr Financial liability ($1m – $930,100) $69,900
The fall in fair value of the financial liability is due to the change in interest rates and the change
in credit risk. It should therefore be recognised between other comprehensive income and profit
or loss.
Dr Financial liability ($180,000 + $100,000) $280,000
Cr Other comprehensive income — Credit risk component $100,000
Cr Profit or loss — Balance $180,000
Knowledge check
Select the choice(s) that best answers the question below.
Question
Brighton issued a $2m bond on 1 January 20X8. Interest is paid annually in arrears at a
rate of 5%. Brighton trades these types of liabilities. The fair value of the bonds has fallen
by $300,000, of which half is related to the change in credit risk of Brighton.
Solution
A. The bond should be subsequently measured at amortised cost.
B. The fall in value relating to the change in credit risk is recognised in profit
or loss.
C. The bond should initially be recognised at fair value minus transaction

costs.
D. The fall in value should be recognised in profit or loss and other

comprehensive income.
E. The bond should be subsequently measured at fair value through profit or

loss.
Submit
Feedback
A Incorrect.
. As the bond is traded, it should be subsequently measured at fair value through profit
or loss.
B Incorrect.
. The change in fair value relating to the change in credit risk is recognised in other
C Incorrect.
.
Transaction costs are charged to profit or loss when the instrument is subsequently
measured at fair value through profit or loss.
D Correct.
. Changes in fair value that relate to credit risk are recognised in other comprehensive
income and the remaining change in profit or loss.
E Correct.
.
As the bond is held for trading, it should be subsequently measured at fair value
through profit or loss.
Subsequent measurement (continued)
Amortised cost
Recall that normally financial liabilities are subsequently measured at amortised cost using an
effective interest method, calculated as follows:
Opening Plus Less Closing

liability finance cost paid liability
X X (X) X
The financial liability is initially recognised as follows:
Dr Cash
Cr Financial liability
Where transaction costs are incurred, these are offset against the consideration from the issue of
the instrument.
Dr Financial liability
Cr Cash
As a result, the amortised cost table starts with net proceeds.
Net proceeds = Consideration from the issue (net of discount) less transaction costs
The finance cost is calculated by applying the effective interest rate to the opening liability. The
finance cost is then added to the opening liability.
Dr Finance cost
Cr Financial liability
This amount is recognised in the statement of profit or loss.
A payment is made, usually annually, based on the coupon or actual rate of interest, which is
multiplied by the nominal value (also called face or par value) of the instrument before discounts
or transaction costs.
Dr Financial liability
Cr Cash
Year Opening Finance cost Amount Paid Closing liability

liability
1 Net proceeds Net proceeds × Nominal value Opening liability + Finance

effective interest × cost
rate Coupon rate – Amount Paid
2 X X (X) X
onwards
Scenario (continued)
London Company issued a loan note/bond with a $500,000 nominal value on 1 January 20X6. To
attract investors, it was issued at a discount of 3%, with transaction costs of $5,000 being
incurred on the issue. The coupon rate is 6% paid annually in arrears. The bond is due for
repayment five years from the date of issue at a premium of $29,279. The effective rate of
interest on the bond is 8%.
We start by calculating net proceeds:
Nominal value 500,000
Less: Discount (15,000)

3% × 500,000
Less: Transaction costs (5,000)
480,000
London Company records the following entries:
Consideration ($500,000 less discount $15,000)
Dr Cash $485,000
Cr Financial liability $485,000
Transaction costs
Cr Cash $5,000
Year Opening liability Finance cost Paid Closing liability

$ $ $ $
1 480,000
The finance cost for Year 1 is then calculated by multiplying the net proceeds of $480,000 by the
effective interest rate of 8%:
8% × $480,000 = $38,400
London Company records the following entry:
Dr Finance cost $38,400
Cr Financial liability $38,400

$ $ $ $
1 480,000 38,400
The payment made at the end of the year is calculated by multiplying the coupon rate (6%) by the
nominal value of the bond before discount and transaction costs.
6% × $500,000 = $30,000
Cr Cash $30,000

$ $ $ $
1 480,000 38,400 (30,000)
The closing liability for the year is then calculated and carried forward to the next year.
Opening liability + Finance cost – Payment = Closing liability

$ $ $ $
1 480,000 38,400 (30,000) 488,400
2 488,400
The process is then repeated each year until the end of the fifth year:

8% (6% × 500,000)
$ $ $ $
1 480,000 38,400 (30,000) 488,400
2 488,400 39,072 (30,000) 497,472
3 497,472 39,798 (30,000) 507,270
4 507,270 40,581 (30,000) 517,851
5 517,851 41,428 (30,000) 529,279
The balance outstanding at the end of the last year is the nominal value of $500,000 plus the
premium on repayment of $29,279 (provided earlier in the scenario).
Use the table to explain the concept of effective interest in the amortised cost table.
Calculate the total cost of issuing the debt, which is the total cost of borrowing:
Discount given 15,000
Transaction costs 5,000
Coupon rate paid 150,000

(5 × $30,000)
Premium on repayment 29,279
199,279
Compare that to the total of the finance cost column in the amortised cost table:
Finance cost
8%
38,400
39,072
39,798
40,581
41,428
199,279
The purpose of the effective interest rate is to allocate the total cost of borrowing over the life of
the financial instrument used.
Knowledge check
Select one choice that best answers the question below.
Question
Glasgow issued bond financing with a US$40,000 nominal value on 1 January 20X8. It
was issued at a discount of 10% with transaction costs of $2,000 being incurred on the
issue. The coupon rate is 6% paid annually in arrears. The bond is due for repayment four
years from the date of issue at a premium of $2,030. The effective rate of interest on the
bond is 12%.
Which row represents the financing costs and closing liability, respectively, to be recorded
in the financial statements of Glasgow at 31 December 20X8?
Finance cost Closing liability

$ $
A 2,400 35,680
B 2,400 36,040
C 4,080 35,680
D 4,080 36,040
Solution
A. Row A.
B. Row B.
C. Row C.
D. Row D.
Submit
Feedback
A. Incorrect.
Finance cost is based on effective interest of 12%.
B Incorrect.
. Finance cost is based on effective interest of 12%, and the paid amount should be the
coupon rate multiplied by nominal value of the loan note/bond.
C Correct.
. The net proceeds are used to calculate the finance cost using effective interest. This is
added to the liability, which is then reduced by the payment made based on nominal
value and coupon rate.
D Incorrect.
. The paid amount should be the coupon rate multiplied by nominal value of the loan
note/bond.
Knowledge check feedback
Nominal value 40,000
Less: Discount (4,000)

10% × 40,000
Less: Transaction costs (2,000)
34,000
1 January 20X8 12% (6% × 40,000) 31 December 20X8
$ $ $ $
1 34,000 4,080 (2,400) 35,680
Recognition and measurement: Financial assets
Initial recognition
As a reminder, when an entity PROVIDES finance to another entity, the entity providing finance
becomes the holder of a financial asset. As with financial liabilities, financial assets are initially
recognised at fair value, with any transaction costs dealt with based on their classification.
In accordance with IFRS 9, financial assets are recognised when the entity becomes party to the
contractual provision of the instrument. IFRS 9 provides for three principal measurement
categories for subsequent measurement of financial assets:
● Amortised cost
● Fair value through profit or loss (FVPL)
● Fair value through other comprehensive income (FVOCI)
A financial asset is classified into a measurement category at inception and is reclassified only in
rare circumstances. For ease of understanding, this topic splits the discussion of the treatment
of financial assets into the different types — equity and debt instruments.
Investment in equity instruments – subsequent measurement
Investments in equity instruments are measured at fair value through profit or loss unless they
are designated as fair value through other comprehensive income. The FVOCI designation cannot
be used if the equity instruments are held for trading, and it is an irrevocable choice made at
initial recognition.
Fair value through profit or loss

Subsequent measurement values the financial asset at fair value at the reporting date, with any
resulting gain or loss recognised in the statement of profit or loss.
Fair value through other comprehensive income

If the eligibility requirements are met and management elects FVOCI (as previously described),
subsequent measurement values the financial asset at fair value at the reporting date, with any
resulting gain or loss recognised in other comprehensive income (OCI). This gain or loss cannot
be reclassified to profit or loss. Other comprehensive income consists of items not reported on
the entity’s statement of profit or loss but, nevertheless, have an effect on the balance sheet.
London Company purchased the following equity investments on 1 January 20X8 (none of which
meet the requirements for consolidation accounting or equity method accounting):
● Investment 1 is 300,000 ordinary shares in a relatively new business that has

shown great potential since incorporation. The intention is to sell the shares as
soon as the targeted return on investment of 3% is met. The investment cost is
$450,000, with transaction costs of US$4,500, and it has a fair value at 31
December 20X8 of $448,000.
● Investment 2 is 152,000 ordinary shares of Falmouth, a supplier of a key
component of London Company’s manufacturing process. The investment cost is
$3.8m, with transaction costs of $50,000, and it has fair value of $4m at 31
December 20X8.
Investment 1
Following the classification rules of IFRS 9, the first investment appears to be held for trading and
therefore cannot be designated as fair value through other comprehensive income and should be
measured at fair value through profit or loss, as follows:
Initially, the investment is recognised at fair value with transaction costs charged to profit or loss.
Dr Financial asset $450,000
Cr Cash $450,000
Dr Profit or loss $4,500
Cr Cash $4,500
Subsequently, the asset is measured at fair value at the reporting date ($448,000), and the
resulting loss of $2,000 ($450,000 cost – $448,000 fair value) is recognised in profit or loss.
Cr Financial asset $2,000
Investment 2
The classification rules of IFRS 9 show that the second investment has a choice of accounting
treatment because the investment is not held for trading.
The initial recognition should be at fair value, but the treatment of the transaction costs is
dependent on the chosen classification.
If London Company elects to account for the investment as fair value through profit or loss, the
transaction costs are charged to profit or loss:
Dr Financial asset $3.8m
Cr Cash $3.8m
Cr Cash $50,000
The subsequent measurement has the asset measured at fair value at the reporting date
(US$4m), and the resulting gain of $200,000 (US$4m fair value – $3.8m cost) is recognised in
profit or loss.
If London Company elects to account for the investment as fair value through other
comprehensive income, the transaction costs are added to the cost of the investment at initial
recognition.
Dr Financial asset $3.8m
Cr Cash $3.8m
Cr Cash $50,000
The subsequent measurement has the asset measured at fair value at the reporting date ($4m),
and the resulting gain of $150,000 ($4m fair value – $3.85m cost) is recognised in other
Knowledge check
Select one choice that best answers the question below.
Question
On 1 July 20X8, Belfast acquired 200,000 $1 equity shares for $400,000, with a view to
obtaining a return on its investment in the short term, which would be re-invested to
continue increasing the return. There were transaction costs incurred of $1,000, and the
fair value of the equity shares was $405,000 at 31 December 20X8.
Choose the answer that completes the following statement for the investment for the year
ended 31 December 20X8.
Because the investment is in an equity instrument and is (a)____, it should be measured at

(b)____ with transaction costs of $1,000 (c)____.
Solution
A. (a) not held for trading, (b) fair value through profit or loss, (c) added to
the cost of the investment.
B. (a) held for trading, (b) fair value through profit or loss, (c) charged to
profit or loss.
C. (a) not held for trading, (b) fair value through other comprehensive
income, (c) charged to profit or loss.
D. (a) held for trading, (b) fair value through other comprehensive income,
(c) added to the cost of the investment.
Submit
Because the investment is in an equity instrument and is (a) held for trading, it should be
measured at (b) fair value through profit or loss with transaction costs of $1,000 (c) charged to
profit or loss.
Recognition and measurement: Financial assets (continued)
Investment in debt instruments - subsequent measurement
Now having covered the subsequent measurement of investments in equity instruments, let’s
look at the subsequent measurement of investments in debt instruments. Recall that there are
three measurement categories established by IFRS 9 for financial assets:
● Amortised cost
● Fair value through other comprehensive income (FVOCI)
● Fair value through profit or loss (FVPL)
Unless management designates the fair value option (discussed shortly), investments in a debt
instrument meeting the following two conditions must be measured at amortised cost (net of
any write down for impairment):
Business model test Cash flow characteristics test
The objective of the entity is to hold the financial The contractual terms of the financial asset give
asset to collect contractual cash flows (rather rise to cash flows (on specified dates) that are
than to sell the instrument). solely payments of principal and interest on the
principal amount outstanding.
A debt instrument that also meets the cash flow characteristics test (previously described) but is
held within a business model that is achieved by collecting contractual cash flows and selling the
debt instruments, must be measured at FVOCI, unless management designates FVPL under the
fair value option.
All other investments in debt instruments must be measured at fair value through profit or loss
(FVPL).
Even if an instrument meets the requirements to be measured at either amortised cost or FVOCI
(both previously described), IFRS 9 permits management to designate, at initial recognition, the
debt instrument to be subsequently measured at FVPL if doing so eliminates or significantly

reduces a measurement or recognition inconsistency (sometimes referred to as an 'accounting
mismatch') that would otherwise arise from measuring assets or liabilities or recognising the
gains and losses on them on different bases. Therefore, management must have a compelling
reason to use FVPL rather than amortised cost or FVOCI.
The accounting treatment for investments in debt instruments, initial recognition and subsequent
measurement, can be summarised as follows:
On 1 January 20X8, London Company purchased a $200,000 loan note/bond for $190,000
(receiving a discount of $10,000) incurring transaction costs of $4,000. The loan note/bond has a
coupon rate of 5% that is payable in arrears. The loan note/bond is repayable in three years’ time
at a premium of $11,920. The effective interest rate on the loan note/bond is 8%.
Using different assumptions, the loan note/bond could be measured using any of the three
measurement categories for financial assets, as follows:
1. Amortised cost
Let’s assume that the intention of London Company is to hold the loan note/bond until it’s
redemption in three years. London company will collect the interest payable in arrears at 5%, as
well as the principal amount ($200,000) and the premium ($11,920) at redemption.
Using these assumptions, the loan note/bond passes both the business model test and the
contractual cash flow characteristics test and must be measured at amortised cost using the
effective interest rate method. The management of Lindon Company does not designate the debt
instrument to be measured at FVPL.
To correctly account for the purchase, the transaction costs of $4,000 are added to the purchase
cost, less the discount received, of $190,000 ($200,000 – $10,000):
Nominal value less discount 190,000
Plus: Transaction costs 4,000
194,000
Cr Cash $194,000
The opening asset is then multiplied by the effective interest rate of 8% and the finance income is
added to the financial asset balance, illustrated as follows:
Year Opening asset Interest income 8% Interest received Closing asset
(5% × 200,000)
$ $ $ $
1 194,000 15,520 (10,000) 199,520
The finance income is recorded:
Cr Interest income $15,520
The cash received is recorded:
Dr Cash $10,000
This is again repeated each year until the investment is repaid:
(5% × 200,000)
$ $ $ $
1 194,000 15,520 (10,000) 199,520
2 199,520 15,962 (10,000) 205,482
3 205,482 16,438 (10,000) 211,920
The amortised cost table concludes with $211,920, which is the nominal value of $200,000 plus
the premium on redemption of $11,920.
2. Fair value through other comprehensive income

Now assume that the loan note/bond again meets the same contractual cash flow
characteristics test. However, now let’s also assume that the intention of London Company is to
hold the loan note/bond until its redemption in three years’ time unless other investments could
yield a higher return, in which case the loan note/bond will be sold. Therefore, the business model
has changed, and now the loan note/bond meets the requirements to account for the loan
note/bond at FVOCI. The management of London Company does not designate the debt
instrument to be measured at FVPL. The fair value of the loan note/bond is $220,000 at 31
December 20X8 and $208,000 at 31 December 20X9.
As a result of the combined intention of holding or selling the investment, the financial asset
must be measured at fair value through other comprehensive income.
To correctly account for the purchase, the transaction costs of $4,000 are added to the purchase
cost, less the discount received, of $190,000 ($200,000 – $10,000):
Nominal value less discount 190,000
Plus: Transaction costs 4,000
194,000
Cr Cash $194,000
The interest income is calculated using the effect interest rate and the cash received is based on
the coupon rate of 5% multiplied by the nominal value of the loan note/bond ($200,000). The
closing balance of the financial asset is calculated as usual using the amortised cost approach.
(5% × 200,000)
$ $ $ $
1 194,000 15,520 (10,000) 199,520
The interest income and receipt are recorded as follows:
Dr Cash $10,000
Because the asst is now being carried at FVOCI, the instrument (loan note/bond) is then revalued
to its fair value of $220,000 and the resulting gain of $20,480 ($220,000 fair value – $199,520) is
recognised in other comprehensive income:
Year Opening asset Interest income 8% Interest received Closing

asset
(5% × 200,000)
$ $ $ $
1 194,000 15,520 (10,000) 199,520 20,480 220,000
Cr Other comprehensive income $20,480
This process is then repeated in the following year. Note that interest income is calculated using
the same effective interest rate method used for the amortised cost measurement category,
which ignores the effect of marking the debt instrument to fair value. Therefore, the interest
income recognised using FVOCI is the same as that recognised using amortised cost.
Year Opening Interest Received Total Gain/(loss) Fair

asset income 8% (5% × 200,000) value
$ $ $ $ $ $
1 194,000 15,520 (10,000) 199,520 20,480 220,000
2 220,000 15,962 (10,000) 225,962 (17,962) 208,000
In Year 2, the interest income and receipt are recorded as follows:
Dr Cash $10,000
And the change in fair value as of 31 December 20X9:
Dr Other comprehensive income $17,962
In the final year, the redemption amount of $211,920 should be the closing balance at the end of
the year, reflecting the actual amount to be received. The interest income is based on the
amortised cost table and the receipt is the same ($10,000).

$ $ $ $ $ $
1 194,000 15,520 (10,000) 199,520 20,480 220,000
2 220,000 15,962 (10,000) 225,962 (17,962) 208,000

$ $ $ $ $ $
3 208,000 16,438 (10,000) 214,438 (2,518) 211,920
In the final year, the balance outstanding has been calculated to be $214,438, but London
Company will only receive $211,920 ($200,000 + $11,920 redemption premium). Therefore, a final
loss of $2,518 ($214,438 – $211,920) is be recognised in other comprehensive income.
3. Fair value through profit or loss

Finally, let’s assume the that the loan note/bond meets the same requirements as previously
described when accounting for it at FVOCI, but the management of London company designates
the debt instrument to be measured at FVPL, as management believes that an accounting
mismatch would otherwise arise. The fair value of the loan note/bond at 31 December 20X8 was
$220,000, and the loan note/bond was sold on 1 January 20X9 for fair value (which is assumed
to be the same as the day before).
The loan note/bond should initially be recognised at fair value, with transaction costs being
charged to profit or loss, as follows:
Cr Cash $190,000
Cr Cash $4,000
At 31 December 20X8, the subsequent measurement of the loan note/bond is to revalue to fair
value of $220,000, and the resulting gain of $30,000 ($220,000 fair value – $190,000 cost) is
recognised in profit or loss:
The interest income received of $10,000 (5% × $200,000) should be recognised in profit or loss:
Dr Cash $10,000
On 1 January 20X9, when the loan note/bond is sold, the proceeds of $220,000 are recognised
and the loan note/bond derecognised. Because the loan note/bond was sold for fair value, and it
had already been marked to fair value for the previous year end (just one day before), there is no
gain or loss on the sale.
Dr Cash $220,000
Knowledge check
Group items by dragging them into their corresponding boxes.
Question
Classify each of the following investments (financial assets) to the correct measurement
category based on the information provided.
Solution
A bond purchased and to be held for trading
Ordinary shares acquired as a short-term investment
A loan note/bond investment that will be held until maturity unless better use of the funds is
found
A debt instrument acquired with the intention to hold until maturity
Fair value through other Fair value through profit or

Amortised cost
comprehensive income loss
Submit
Financial assets are measured using amortised cost when the business model test and the cash
flow characteristics test are met.
A debt instrument acquired with the intention to hold until maturity meets the business model
test; and, assuming the cash flow characteristics test is also met, the debt instrument is
measured using amortised cost.
Investments in financial assets are measured using the FVOCI category if the financial assets do
not meet the business model test because they are managed to collect contractual cash flows
and sold when advantageous to do so.
A loan note/bond being held (with the possibility of selling if a better use of the funds is found)
results in the application of FVOCI.
Investments in equity instruments held for trading are accounted for using the FVPL category. As
such, ordinary shares being held on a temporary basis results in the application of FVPL.
Investments in debt instruments that do not qualify for measuring using the amortised cost
category of or the FVOCI category must be measured using the FVPL category.
A bond purchased to be held for trading does not qualify for either the amortised cost category or
the FVOCI category and therefore must be measured using the FVPL category.
Derivatives
A derivative is a financial instrument whose value is derived from the value of one or more
underlying assets, which can be commodities, precious metals, currency, bonds, stocks, stocks
indices, etc. Derivatives are typically used by investors for one or more of the following reasons:
● To hedge a position in an asset, meaning to protect or insure against the adverse

price movement of the asset
● To speculate on an asset’s movement, meaning to bet on the future price of the
asset in an attempt to realise significant gains, while having to put very little money
at risk for loss
● To increase leverage, meaning to acquire a sizeable contract value at a cheap price
relative to the cost of the equivalent amount of the underlying asset.
Derivatives have the following characteristics:
● Their value changes in response to the change in an underlying item (for example, a
specified interest rate, foreign exchange rate, commodity price, or similar variables).
● They require little or no initial investment.
● They will be settled at a future date.
When a derivative is valued and shows a gain (sometimes described as a favourable derivative),
the gain is shown as a financial asset and included in the statement of profit or loss as finance
income. If the value demonstrates a loss (sometimes described as an unfavourable derivative),
the loss is shown as a financial liability and included in the statement of profit or loss under
finance costs.
Examples of derivatives are forward contracts, futures contracts, swaps, and options. All of these
types of derivatives are covered in detail in the context of managing risk in the strategic level of
this programme. While the accounting for derivatives can be complex, this topic covers the basic
recognition and measurement principles of derivatives.
Where a contract exists to buy or sell a nonfinancial asset such as inventory, it is only a derivative
if
● it can be settled net in cash (or other financial asset) and

● the contract was not established to take receipt or make delivery of the asset.
Net in cash is when the terms of the contract allow either party to settle the contract net, the
entity has a past practice of settling contracts net, the nonfinancial item is readily convertible to
cash, and the entity has a past practice of taking receipt of the item and selling it on quickly to
realise a profit.
Measurement
Initial recognition — Derivatives are initially recognised at fair value with transaction costs
charged to profit or loss.
Subsequent measurement — Derivatives are remeasured at fair value at the reporting date, with
any gains and losses recognised in profit or loss.
On 1 January 20X8, London Company enters into a forward contract to buy oil for $65m on 31
March 20X9. The contract has nil cost. London Company will not take delivery of the oil but will
settle net in cash with a view to generate a good return.
At 1 January 20X8, the derivative has no value. There is no cost to the agreement and the
underlying item — the price of oil — has not yet changed.
At 31 December 20X8, the price of oil has increased. So, to purchase the equivalent volume of oil
would now cost $78m.
At 31 December 20X8, the value of the underlying item has increased to $78m, but London
Company is still under agreement to pay just $65m. This is a gain to London Company $13m
($78m fair value at 31 December 20X8 less $65m fair value at 1 January 20X8) that will create a
financial asset and a gain to be recognised in profit or loss.
Dr Financial asset — Derivative $13m
Cr Profit or loss $13m
On 31 March 20X9, the value of the oil has fallen to $70m.

On 31 March 20X9, the settlement date, the value of the underlying item has fallen to $70m; but,
again, London Company is under agreement to pay $65m. The fall in value of the underlying item
$8m (US$78m fair value at 31 December 20X8 less $70m fair value at 31 March 20X9) must be
recognised through profit or loss.
Dr Profit or loss $8m
Cr Financial asset — Derivative $8m
This leaves a debit balance of $5m ($13m gain less $8m loss) as a financial asset. However, 31
March 20X9 is the settlement date for the forward contract, so the derivative financial asset
should be derecognised when the settlement net in cash is made and London Company receives
the $5m due ($70m fair value – $65m forward contract price).
Dr Cash $5m
Cr Financial asset—derivative $5m
Knowledge check
Select the choice(s) that best answers the question below.
Question
On 1 June 20X7, Bolton entered into a forward foreign exchange contract to buy 1m
dinars for $500,000 on 31 March 20X9.
Relevant exchange rates for the two currencies were as follows:
1 June 20X7 $1 = 2.0 dinars
31 December 20X7 $1 = 1.7 dinars
31 December 20X8 $1 = 1.5 dinars
Which two statements are correct relating to the treatment of this contract?
Solution
A. The forward foreign exchange contract has no value at 1 June 20X7.
B. The loss recognised at 31 December 20X8 was $78,432.
C. A financial asset of $500,000 is recognised at 1 June 20X8.
D. All gains and losses arising are recognised in other comprehensive

income.
E. The gain recognised at 31 December 20X7 was $88,235.
Submit
Feedback
A
. Correct. There is no mention of a cost or fee for the contract and the underlying item,
the exchange rate of dinars, has not yet changed.
B Incorrect. The cost of 1m dinars has risen, so the increase is a gain or financial asset to
. the entity ((1m dinars ÷ 1.5) – 500,000 agreed amount – 88,235 20X7 gain).
C Incorrect. Because there is no initial cost and the underlying item has not yet changed,
. there is no asset to recognise.
D. Incorrect. Derivatives are held at fair value through profit or loss.
E Correct. 1m dinars ÷ 1.7 (rate at 31 December 20X8) less $500,000 agreed amount
. gives a gain of $88,235.
Conclusion
Together, IFRS 9 and IAS 32 establish the recognition, derecognition, measurement,
classification, and presentation requirements for financial instruments. The initial measurement
requirement is based on fair value, with all financial assets and liabilities measured at fair value at
initial recognition. An exception exists for trade receivables that do not contain a significant
financing component.
After initial recognition, the basis for measurement of financial assets depends on their
classification and includes amortised cost, FVPL, and FVOCI. Financial assets are comprised of
equity instruments and debt instruments. All equity investments within the scope of IFRS 9 are
measured at fair value, with value changes recognised in profit or loss, except for those equity
investments that are not held for trading and for which the entity has made an irrevocable
election to present value changes in other comprehensive income.
For financial assets that are debt instruments, subsequent measurement is based on the
business model test and the cash flow characteristics test, unless management has a
compelling reason to elect the fair value option that requires subsequent measurement using fair
value with value changes recognised in profit or loss (FVPL). Generally this election is only
available if management believes it would eliminate or significantly reduce a measurement or
recognition inconsistency (sometimes referred to as an 'accounting mismatch').
Most financial liabilities are subsequently measured at amortised cost, unless one of the
following exceptions apply (in which case subsequent measurement is based on FVPL):
● The financial liabilities are held for trading, or

● Management applies the fair value option to eliminate or significantly reduce an
'accounting mismatch'.

6 Financial Instruments - IFRS 9 and IAS 32

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6 Financial Instruments - IFRS 9 and IAS 32

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Course learning objective

IFRS 9 covers four main areas of financial instruments:

● Classification and measurement of financial assets

Click each folder to learn more.

A financial asset is any asset that is

A financial liability is any liability that is

● a contractual obligation to deliver cash or another financial asset to another

An example of an equity instrument is an entity’s investment in the ordinary shares of another

Generally, a financial instrument that is ‘purchased’ or ‘acquired’ is a financial asset, and a

Subsequent measurement depends on whether they are classified as financial liabilities or

Interest and dividends, losses and gains

The treatment of the interest and dividends

Interest on liabilities is a finance cost in the

Dividends paid on equity instruments should be

Compound financial instruments

● The liability component is the contractual obligation to repay the instrument.

● has a legally enforceable right to set off the amounts and

Recognition and measurement: Financial liabilities

Consider the following three independent situations:

The fair value is the consideration received from the issue.

Initial recognition, 1 January 20X7

Cr Financial liability $1m

Now, consider the three different situations.

1. Subsequent measurement, 31 December 20X7

Dr Financial liability $200,000

Cr Profit or loss $200,000

2. Subsequent measurement, 31 December 20X7

Date Cash flow Discount rate Present value

31 December 20X8 Interest 60,000 1 ÷ 1.1 54,540

31 December 20X9 Interest 60,000 1 ÷ 1.1² 49,560

Capital $1m 1 ÷ 1.1² 826,000

Dr Financial liability ($1m – $930,100) $69,900

Cr Profit or loss $69,900

3. Subsequent measurement, 31 December 20X7

Dr Financial liability ($180,000 + $100,000) $280,000

Cr Other comprehensive income — Credit risk component $100,000

Cr Profit or loss — Balance $180,000

Select the choice(s) that best answers the question below.

A. The bond should be subsequently measured at amortised cost.

C. The bond should initially be recognised at fair value minus transaction

D. The fall in value should be recognised in profit or loss and other

E. The bond should be subsequently measured at fair value through profit or

Subsequent measurement (continued)

Opening Plus Less Closing

The financial liability is initially recognised as follows:

As a result, the amortised cost table starts with net proceeds.

This amount is recognised in the statement of profit or loss.

Year Opening Finance cost Amount Paid Closing liability

1 Net proceeds Net proceeds × Nominal value Opening liability + Finance

We start by calculating net proceeds:

Nominal value 500,000

Less: Discount (15,000)

Less: Transaction costs (5,000)

London Company records the following entries:

Consideration ($500,000 less discount $15,000)

Cr Financial liability $485,000

Dr Financial liability $5,000

Year Opening liability Finance cost Paid Closing liability

London Company records the following entry:

Dr Finance cost $38,400

Cr Financial liability $38,400

Year Opening liability Finance cost Paid Closing liability