IFRS 9 /IAS 32

Financial
Instruments
Day 4

1
Financial instruments
Any contract that gives rise to both:

 a financial asset of one entity, and

 a financial liability or equity instrument of another entity

Examples
 primary instruments (e.g. receivables, payables and equity
securities)
 derivative instruments (e.g. financial options, futures and
forwards, interest rate swaps and currency swaps).

2
Classification (IAS 32)
Any contract that gives rise to
both a financial asset of one
Financial entity and a financial liability
or equity instrument of
instruments another entity

Financial Financial Equity

assets liabilities instruments
(a) Cash Contractual obligation to: Any contract that
(b) Equity instrument of • Deliver cash/another FA evidences a residual
another entity • Exchange FA/FL under interest in the net
conditions potentially assets of an entity
(c) Contractual right to:
• Receive cash/another unfavourable
FA
• Exchange FA/FL under
conditions potentially
favourable

3
Classification (IAS 32)

Financial instruments

Financial Equity
Financial assets
liabilities instruments

Any contract that gives

rise to both a financial
Compound
asset of one entity and a
instruments
financial liability or
equity instrument of
another entity
4
Derivative
A derivative – a financial instrument:

5
Amortised cost
 Amount measured at initial recognition
minus
 Principal repayments
plus or minus
 Cumulative amortisation of any difference between initial
amount and maturity amount
minus
 Any write-down for impairment or uncollectability.

6
Effective interest method
 A method of calculating amortisation using the effective
interest rate

 This rate exactly discounts the expected stream of future

cash outflows to the current net carrying amount of the
financial asset (or liability)

 The computation should include all cash flows between the

parties to the contract.

7
Case Study – Amortised cost

8
Answer

9
Presentation (IAS 32)
 Financial instruments should be classified as:
 liabilities, or
 equity
in accordance with their substance on initial recognition.

10
Compound instruments – Presentation
 Financial instruments containing both a liability and an
equity element are classified into their component parts
 Convertible bonds:
 grant an option to the holder to convert them into equity
instruments
 consist of:
 the obligation to repay the bonds (a liability), and
 the option to convert (equity).

11
Compound instruments – Carrying amounts
 Equity component is the residual amount after deducting
the measurable debt component based on the PV of the
future payments relating to the instrument

12
Case Study – Convertible bond
An entity issues 2,000 convertible, $1,000 bonds at par on 1st January
2015.

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 31st December 2017.

Required:

Calculate the values at which the bond will be included in the financial
statements of the entity at initial recognition.

13
Convertible bond – Solution

$
Present value of principle
$2,000,000 × 0.772 1,544,000
Present value of interest stream
$120,000 × 2.531 303,720
Total liability component 1,847,720

Equity component (Balancing figure) 152,280

Proceeds of issue 2,000,000

14
Convertible bond 31 Dec 2015 – Solution

$
Present value of liability 1,847,720
Interest charge at 9% 166,295
Interest paid (120,000)

Liability balance 1,894,015

If this calculation was rolled forward for a further 2 years

the value of the liability would be $2,000,000

15
Treasury shares
 An entities own shares acquired are classed as treasury
shares

 Presented as a debit within equity

 Any gain/loss presented directly within equity, probably

retained earnings

16
Initial Measurement Financial Asset
 On initial recognition, financial assets (except trade
receivables) are measured at fair value. If the financial asset
is not classified as fair value through profit or loss, any
directly attributable transaction costs are adjusted against the
fair value.

 Trade receivables, which do not have a major financing

element, are measured at their transaction price in accordance
with IFRS 15.

17
Subsequent Measurement Financial Asset

Once recognised, a financial asset is subsequently measured

at either:

 Amortised cost;

 Fair value through other comprehensive income; or

 Fair value through profit or loss.

18
Amortised Cost

A financial asset is subsequently measured at amortised cost

if it meets two conditions:

1. It is held within a business model whose objective is

achieved through holding financial assets to collect
contractual cash flows; and
2. Its contractual terms give rise to cash flows on
specified dates which are solely payments of principal and
interest (on the outstanding principal).

19
Illustration 5 Amortised Cost

An entity purchased a debt instrument for $1,000. The

instrument pays interest of $60 annually and had 10 years to
maturity when purchased. The business model test was met
and the instrument was classified as a financial asset at
amortised cost.
Nine years have passed and the entity is suffering a liquidity
crisis and needs to sell the asset to raise funds.
The sale was not expected on initial classification and does
not affect the classification (i.e. there is no retrospective
reclassification).

20
Fair Value Through OCI
It meets two conditions:
1. It is held within a business model whose objective is achieved
through collect contractual cash flows and sell financial assets; and
2. Its contractual terms give rise to cash flows on specified dates,
which are solely payments of principal and interest.

Interest/dividends income based on the amortised cost of the asset is

recognised in the SOPL

Any difference in fair value is recognised in other comprehensive

income.

21
Example
An entity anticipates the purchase of a large property in eight years’ time.
The entity invests cash surpluses in short and long-term financial assets.
Many of the financial assets purchased have a maturity in excess of eight
years.

The entity holds the financial assets for their contractual cash flows but
will sell them and re-invest the cash for a higher return as and when an
opportunity arises.

The objective of the business model is achieved by collecting contractual

cash flows and selling the financial assets. The entity’s decisions to hold
or sell aim to maximise returns from the portfolio of financial assets.

This will be classified as FV through OCI

22
Fair Value Through Profit or Loss
 All other financial assets are measured at fair value through
profit or loss.

 On initial recognition an entity may irrevocably elect to

designate an equity instrument at fair value through other
comprehensive income.

  An entity can opt to designate any financial asset at fair

value through profit or loss in order to eliminate an
accounting mismatch .

23
Classification and Measurement Summary

Contractual cash flows are solely No

principal and interest?

Yes
Held to collect contractual No Held to collect contractual
cash flows only? cash flows and for sale?

Yes No Yes
Fair value options? Fair value options?

No Yes Yes No

Amortised Fair value through Fair value through other

cost profit or loss comprehensive income

24
Question: Financial transactions

Palermo has requested your advice on accounting for the

following financial instrument transactions:
(a) Palermo purchased $50,000 par value of loan notes at
a 10% discount on their issue on 1 January 20X6 intending to
hold them until their maturity on 31 December 20X9. An
interest coupon of 3% of par value is paid annually on 31
December. Transaction costs of $450 were incurred on the
purchase. The annual internal rate of return on the loan notes
is 5.6%.

25
Question: Financial transactions (cont'd)

(b) Palermo purchased some shares in an unquoted

company as an investment for $12,000 during
March 20X6. At the year end the directors stated
that the shares might be worth about $13,000, but
a formal valuation was unable to be performed
due to lack of data.

26
 27

Question: Financial transactions (cont'd)

c) Palermo took out a speculative forward contract to buy

coffee beans for delivery on 30 April 20X7 at an agreed
price of $6,000 intending to settle net in cash. Due to a
surge in expected supply, a forward contract for
delivery on 30 April 20X7 would have cost $5,000 on
31 December 20X6.

27
Question: Financial transactions (cont'd)

(d) In July 20X6 Palermo sold 12,000 shares for $16,800

(their market price at that date). It had purchased the
shares through a broker in 20X5 for $1.25 per share. The
quoted price at the 20X5 year end was $1.32 per share.
The broker charges transaction costs of 1% purchase/sale
price.

Palermo makes the irrevocable election for the changes in fair

value of investments in equity instruments not held for
trading to be presented in other comprehensive income
wherever possible.

28
Question: Financial transactions (cont'd)

Required

Explain how the above transactions should be accounted for

in the financial statements for the year ended 31 December
20X6.

29
Answer: Financial transactions
(a) Loan notes
The loan notes should be held at amortised cost under IFRS 9 as the
company's business model was to hold them until maturity when
purchased and the contractual terms give rise to cash flows that are
solely payments of principal and interest on the principal amount
outstanding. They are therefore held at amortised cost as follows.
$
Cash paid on 1 January 20X6 ((50,000 × 90%) + 450) 45,450
Effective interest income (45,450 × 5.6%) 2,545
Coupon received (50,000 × 3%) (1,500)
Amortised cost at 31 December 20X6 46,495
Consequently, $2,545 of finance income will be recognised in profit or
loss for the year and there will be a $46,495 loan note asset.

30
Answer: Financial transactions (cont'd)

(b) Unquoted shares

Investments in equity instruments must always be measured at
fair value.

The shares will therefore remain at $12,000 as an investment

asset.

31
Answer: Financial transactions (cont'd)
(c) Forward contract
A forward contract is accounted for at fair value through profit or loss.
The value of a forward contract at inception is zero.
The value of the contract at the year end is:
$
Market price of forward contract at year end for delivery on 30 April
5,000
Palermo's forward price  (6,000)
 (1,000)

A financial liability of $1,000 is therefore recognised with a corresponding charge

of $1,000 to profit or loss.

32
 Answer: Financial transactions (cont'd)
(d) Quoted shares sold

The shares are held at fair value through other comprehensive income due to
Palermo's accounting policy of holding investments in equity instruments not
held for trading at fair value through OCI wherever possible. They were
originally recorded at their cost of $15,150 in 20X5 and revalued to market
value at the year end with a gain of $690 reported in other comprehensive
income:
$
20X5 Purchase ((12,000 × $1.25) + (1%  $15,000)) 15,150
Fair value gain at 31.12.20X5 690
Fair value at 31.12.20X5 (12,000 × $1.32 bid price) 15,840

33
Answer: Financial transactions (cont'd)
At the date of the derecognition in July 20X6, the shares must first
be remeasured to their fair value (i.e. the sales price as they were
sold at market price) and the gain is reported in other
comprehensive income ('items that will not be reclassified to profit
or loss’):

DEBIT Financial asset (16,800 – 15,840) $960

CREDIT Other comprehensive income $960

34
Answer: Financial transactions (cont'd)
On derecognition, the transaction costs are charged to profit or loss:
DEBIT Cash (16,800 – (1% × 16,800)) $16,632
DEBIT Profit or loss (1% × 16,800) $168
CREDIT Financial asset $16,800

Tutorial note. Under IFRS 9, where the irrevocable election is made to

hold an investment in equity instruments not held for trading at fair value
through other comprehensive income, all changes in fair value up to the
point of derecognition are recognised in other comprehensive income and
they are not subsequently reclassified to profit or loss.

35
Categories of financial liability
 Fair
value through profit or loss
 Amortised cost

36
Financial Liabilities – Initial recognition
 On initial recognition all Financial Liabilities are measured
at FV.

 Ifmeasured at amortised cost then any transaction costs

will be deducted

37
 38

Financial Liabilities – Subsequent recognition

After initial recognition, all financial liabilities should be

measured at amortised cost, with the exception of financial
liabilities at fair value through profit or loss (including most
derivatives). These should be measured at fair value, but
where the fair value is not capable of reliable
measurement, they should be measured at cost.

38