Financial Instruments

LECTURE 1 IAS 32 Financial Instruments – Presentation

LECTURE 2 IFRS 7 Financial Instruments - Disclosures

LECTURE 3 IAS 32 Financial Instruments

Financial Instruments
The issue of IFRS 9, Financial Instruments is part of the project to replace IAS 39, Financial
Instruments - Recognition and Measurement. IFRS 9 represents the outcome of work to date
undertaken by the International Accounting Standards Board (IASB) in conjunction with the
Financial Accounting Standards Board (FASB) in the US to improve and converge financial
reporting standards. It was issued in November 2009 and initially dealt with classification
and measurement of financial assets. IFRS 9 was subsequently updated in October 2010 to
include accounting for financial liabilities.
Financial Instruments
 IFRS 9 is effective for accounting periods commencing on or after 1 January 2013, with
earlier application possible. Note that further developments are in progress dealing with
impairment, derivatives and hedging. To the extent that IFRS 9 does not yet deal with a
particular issue, the requirements of IAS 39 continue to apply.

 Arguably, IFRS 9 has simplified and improved accounting for financial assets in
comparison with its predecessor, IAS 39. The number of classifications has been reduced
from four to three, as the available-for-sale classification has not been retained within
IFRS 9.
Financial Instruments
There are three accounting standards that deal with financial instruments:

1. IAS 32 Financial instruments: Presentation

Deals with how financial instruments are presented in the financial statements and in
particular whether financial instruments are disclosed as liabilities or equity.

2. IFRS 7 Financial instruments: Disclosures

Deals with the disclosure of financial instruments to ensure that users have a full
understanding of the financial instruments used by an entity.

3. IFRS 9 Financial Instruments

Deals with the recognition, measurement and de-recognition of financial assets and
liabilities, the impairment of financial assets and general hedge accounting.
Financial Instruments
Definition

 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.

 With references to assets, liabilities and equity instruments, the statement of financial
position immediately comes to mind.

 Further, the definition describes financial instruments as contracts, and therefore in

essence financial assets, financial liabilities and equity instruments are going to be pieces
of paper.
Financial Instruments
Examples of financial instruments

Example 1
when an invoice is issued on the sale of goods on credit, the entity that has sold the goods
has a financial asset - the receivable - while the buyer has to account for a financial liability
- the payable.

Example 2
When an entity raises finance by issuing equity shares. The entity that subscribes to the
shares has a financial asset - an investment - while the issuer of the shares who raised
finance has to account for an equity instrument - equity share capital.

Example 3
When an entity raises finance by issuing bonds (debentures). The entity that subscribes to
the bonds - ie lends the money - has a financial asset - an investment - while the issuer of
the bonds - ie the borrower who has raised the finance - has to account for the bonds as a
financial liability.
Financial Instruments
 When we talk about accounting for financial instruments, in simple terms what we are
really talking about is how we account for investments in shares, investments in bonds
and receivables (financial assets), how we account for trade payables and long-term
loans (financial liabilities) and how we account for equity share capital (equity
instruments). (Note: financial instruments do also include derivatives)

 In considering the rules as to how to account for financial instruments there are various
issues around classification, initial measurement and subsequent measurement
Financial Instruments
Definition

A financial asset is any asset that is:

 cash;

 an equity instrument of another entity;

 a contractual right to receive cash or another asset from another entity;

 a contractual right to exchange financial assets or liabilities with another entity under
conditions that are potentially favourable;

 a contract that will be settled in the entity's own equity instruments.

Financial Instruments
Definition
A financial liability is any liability that is contractual obligation:
 to deliver cash or another financial asset to another entity;
 to exchange financial assets or liabilities with another entity under conditions
 that are potentially unfavourable;
 a contract that will or may be settled in the entity's own equity instruments.
Definition

 An equity instrument is any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities.
Financial Instruments
 Financial assets therefore include shares or loan stock of another entity and receivable
balances;

 Financial liabilities include issued loan stock and redeemable preference shares as well
as payables and

 Equity includes issued ordinary shares and irredeemable preference shares.

 The distinction between liabilities and equity is explored in detail in IAS 32.
Financial Instruments
IAS 32 Financial Instruments: Presentation

The objective of IAS 32 Financial Instruments: Presentation is to establish principles for

presenting financial instruments as financial assets, financial liabilities or equity and for
offsetting financial assets and financial liabilities.
Financial Instruments
Financial liabilities and equity

 IAS 32 states that the issuer of a financial instrument should classify it on initial
recognition as a financial liability, a financial asset or an equity instrument in
accordance with the substance of the contractual arrangement and the definitions given in
the previous section.

 In the case of a financial asset this is generally relatively straightforward. Whether a

financial instrument is a liability or equity is, however, not always as clear.
Financial Instruments
Distinguishing debt & equity

When arranging its financing needs, a company normally uses a combination of equity and
debt funding. Debt is usually the cheapest source of finance, as interest is tax deductible and
debt holders have a preferential claim on a company's assets, which reduces their risk. Equity
is a more expensive source of finance, as dividends are not tax deductible. Shareholders
only have an entitlement to a company's assets when all other prior claims have been met.

For an entity that is raising finance it is important that the instrument is correctly classified
as either a financial liability (debt) or an equity instrument (shares).
Financial Instruments
This distinction is so important as it will directly affect the calculation of the gearing ratio, a
key measure that the users of the financial statements use to assess the financial risk of the
entity.

The distinction will also impact on the measurement of profit as the finance costs associated
with financial liabilities will be charged to the statement of profit or loss, thus reducing the
reported profit of the entity, while the dividends paid on equity shares are an appropriation of
profit rather than an expense.
Financial Instrument
 IAS 32 states that a financial instrument is an equity instrument if both conditions below
are met.

1. The instrument includes no contractual obligation:

 To deliver cash or another financial asset to another entity; or

 to exchange financial assets or financial liabilities with another entity under conditions
that are potentially unfavourable to the issuer.

2. If the instrument will or may be settled in the issuer`s own equity instruments,
Financial Instrument
Example

 The issue of a bond (debenture) creates a financial liability as the monies received will
have to be repaid, while the issue of ordinary shares will create an equity instrument.

 It is possible that a single instrument is issued that contains both debt and equity elements.
An example of this is a convertible bond – i.e where the bond contains an embedded
derivative in the form of an option to convert to shares rather than be repaid in cash.

 Redeemable preference shares are an example of such an instrument. Here the issuing
company for a fixed amount of cash will repurchase the shares in the future. Hence there is a
contractual obligation to deliver cash to the shareholder and so the shares cannot be
classified as equity.
Financial Instrument
Importance of distinguishing between financial liabilities and equity instruments

A key objective of IAS 32 is to ensure that there is a clear distinction between financial
liabilities and equity instruments in an entity's financial statements.
The statement of financial position of Thorpe Limited shows that the company has financial liabilities (e.g. trade
payables, loans) of €6M, none of which are secured by a charge against the company's assets. Thorpe Limited also
has total equity (e.g. share capital and retained earnings) of €7M.

Bank of the World is considering whether to provide additional unsecured loan finance of €3M to Thorpe Limited.
Advise Bank of the World as to whether it should advance an additional loan of €3M to Thorpe Limited.
€M
Total assets of Thorpe if loan of €3M is advanced (6M + 7M + 3M) 16
Total unsecured creditors (€6M + €3M) (9)
Excess assets to which creditors have a prior claim over equity shareholders 7

The assets of Thorpe Limited would have to fall by more than €7M, before they would be
insufficient to fully cover the amounts due to creditors, which include the loan of €3M from Bank
of the World. On this basis, Bank of the World has a substantial level of asset backing for its
proposed loan, and it can have reasonable assurance that the loan will be repaid.
Assuming the same facts as in the example above, outline the implications for Bank of the World if
€5.5M of Thorpe Limited`s existing loan has been incorrectly classified as equity capital in its statement
of financial position.

 Total assets of Thorpe if loan of €3M is advanced 16

 Total unsecured creditors (€6M + €5.5M + €3M) (14.5)

 Excess assets to which creditors have a prior claim over equity 1.5

shareholders

The reclassification of €5.5M of equity capital as loans leaves Bank of the World with a much reduced
level of asset backing for its proposed loan. Should the assets of Thorpe limited fall by more than
€1.5M, they will be insufficient to cover all of the amounts owed to creditors. Should Bank of the World
advance the loan, there is therefore a significant risk that Thorpe limited will default.
Financial Instrument
IFRS 9 Financial Instruments

IFRS 9 provides guidance on:

 Accounting for equity instrument

 recognition criteria applied to financial instruments

 classification and measurement of financial assets

 classification and measurement of financial liabilities

 the impairment of financial assets

 de-recognition criteria relevant to financial instruments

 hedge accounting
Financial Instrument
Financial assets: Classification and measurement

There have been some recent changes following the issue of IFRS 9, Financial Instruments
which will supersede IAS 39, Financial Instruments: Recognition and Measurement. The new
standard applies to all types of financial assets, except for investments in subsidiaries,
associates and joint ventures and pension schemes, as these are all accounted for under various
other accounting standards.

IFRS 9, Financial Instruments has simplified the way that financial assets are accounted. As
with financial liabilities the standard retains a mixed measurement system for financial
assets, allowing some to be stated at fair value while others at amortised cost.
Financial assets
On the same basis that when an entity issues a financial instrument it has to classify it as a
financial liability or equity instrument, so when an entity acquires a financial asset it will
be acquiring a debt asset (eg an investment in bonds, trade receivables) or an equity asset (eg
an investment in ordinary shares). Financial assets have to be classified and accounted for in
one of three categories: (i) amortised cost, (ii) FVTPL or (iii) Fair Value Through Other
Comprehensive Income (FVTOCI). They are initially measured at fair value plus, in the
case of a financial asset not at FVTPL, transaction costs.
Financial assets
Arguably, IFRS 9 has simplified and improved accounting for financial assets in comparison
with its predecessor, IAS 39. The number of classifications has been reduced from four to
three, as the available-for-sale classification has not been retained within IFRS 9.

There is increased emphasis on fair value accounting and reporting, which is regarded as
both relevant and reliable information to those interested in financial reports. IFRS 9 has also
reduced the degree of discretion for classification and accounting treatment of financial
assets, which should support consistent reporting of financial information relating to financial
assets and enhance understanding and comparability of that information.
Financial assets
The measurement of financial assets depends on their classification as measured at

 Amortised cost, or

 Fair value through other comprehensive income (FVTOCI), or

 Fair value through profit or loss (FVTPL).

The classification of a financial asset as measured at amortised cost, FVTOCI or FVTPL,

depends on the business model for managing the financial asset and the contractual cash flow
characteristics of the financial asset. IFRS 9 provides conditions that, when met, result in a
financial asset being measured at amortised cost or FVTOCI:
Measured at Business Model Contractual cash flow characteristics
Amortised cost Objective is to hold assets The contractual terms of the financial assets
in order to collect give rise on specified dates to cash flows that
contractual cash flows. are solely payments of principal and interest
on the principal outstanding
FVTOCI Objective is achieved by both
Collecting contractual cash
Flows and selling financial assets
1. All other financial assets must be measured at fair value through profit or loss.
2. Financial assets that do meet the criteria above to be classified as measured at amortised
cost or FVTOCI may be designated as measured at FVTPL at initial recognition if this would
result in the avoidance of an 'accounting mismatch'.
Financial assets
Initial measurement

A financial asset classified as measured at:

 fair value through profit or loss (FVTPL) is initially measured at its fair value which is
usually the price paid to acquire the asset.

 fair value through other comprehensive income (FVTOCI) is initially measured at its fair
value plus transaction costs that are directly attributable to its acquisition.

 amortised cost is initially measured at its fair value plus transaction costs, which are
directly attributable to its acquisition.

A trade receivable that does not have a significant financing component is measured at its
transaction price determined in accordance with IFRS 15.
Financial assets
Subsequent measurement

After initial recognition, financial assets are measured according to their classification at:

 Fair value through profit or loss (FVTPL), subsequently measured at fair value with
gains and losses recognised in P&L.

 Fair value through other comprehensive income (FVTOCI), subsequently measured

at fair value with gains and losses recognised in reserves and other comprehensive
income.

 Amortised cost, is subsequent measurement at amortised cost/Fair value.

 Financial Assets

Debt Instruments Equity Instruments

Contain an obligation Evidence of an ownership

to be repaid interest in the residual
net asse
Standard bought shares on the stock exchange for $390,000 shortly before the year-end. The shares were acquired for the purpose of

speculating. Transaction costs amounted to $10,000. The fair value at the year-end is $330,000 and this rises to $370,000 a few weeks later

when the shares are sold. Required: Explain how this F. Asset is classified, initially recognised and subsequently measured in

accordance with IFRS.

The shares are an equity instrument, therefore they are measured at fair value. The shares are acquired for speculative

purposes ie they are held for trading. Therefore re-measurements must be recognised in profit or loss and there is no

available option to recognise them in other comprehensive income.

Initial recognition
 DR Financial asset investment (390 + 10) 400,000
 CR Cash 400,000
Subsequent measurement
 DR Loss on financial asset investment 70,000
 CR Financial asset investment (400 – 330) 70,000
On disposal
 DR Cash 370,000
 CR Financial asset investment 330,000
 CR Gain on disposal of financial asset investment (P&l) 40,000
On 6th November 2018, Exception Co. acquired an equity investment with the intention of holding it in
the long term. The investment cost $500,000. At Exception Co`s year end 31 December 2018, the fair
value of the investment is $520,000. How is the asset initially and subsequently measured?

Exception Co. has elected to recognise changes in the fair value of the equity investment in other
comprehensive income.
Required: Show how this F. Asset is initially recognised and subsequently measured?
The asset is initially recognised at the fair value of the consideration being $500,000.
 DR Investment $500,000
 CR Cash$500,000
 At the year-end it is re-measured to fair value of $520,000
 DR Investment $20,000
 CR Other comprehensive income $20,000
Bliny bought loan stock on the stock exchange for a short-term investment shortly before the year-end. The cost was $900 and

the year-end fair value was $800. Shortly after the start of the new year, the debentures were sold for $850. Bliny elected to

designate the investment as FVTPL.

Required: What journals are required to recognise the investment and account for it subsequently?

The investment is a debt instrument. Bliny has elected to classify it as a financial asset measured at fair value with gains and

losses recognised in profit and loss.

Purchase journal
 DR Financial asset900
 CR Bank 900
Year-end journal
 DR Loss on financial asset measured at FVTPL 100
 CR Financial asset 100
Closure journals
 DR Financial assets 50
 CR Gain on financial asset at FVTPL 50
 DR Bank 850
 CR Financial asset850
Amortised Cost
Jojo Co intend to buy loan stock with a nominal value of $16,000. The coupon rate is 1%, but
the market demands a return of 8%. The loan has four years to run. The intent is to hold the
investment to maturity and Jojo believes that the investment passes both the 'hold to collect'
business model test and the contractual cash flow test.

Required:

 Calculate the fair value of the asset and, assuming this is what JoJo pays for the loan
stock, show how it is wound up to redemption value over the four years.
Jojo will not be prepared to pay $16,000 for this loan stock as it is only returning 1% when
the market rate is 8%. As the interest rate rises this Instrument will fall in value.
The loan stock's market value can be calculated as the present value of the future cash flows.
Jojo will receive 1% interest each year for 3 years and then on redemption date will receive
$16,000 from the borrower. The fair value of the instrument is calculated as follows:
DCF CF 8% PV
1 160 0.930 148.80
2 160 0.860 137.60
3 160 0.790 126.40
4 16,160 0.735 11,878.00
FV on market 12,290.80
The instrument meets the 'hold to collect' business model and contractual cash flow tests
and so is measured at amortised cost.
Initial recognition
DR Financial asset investment $12,291
CR Cash $12,291
Subsequent measurement – amortised cost
B/f Finance Income Cash Received C/f
8% 1%
1 12,291 983 (160) 13,114

2 13,114 1,049 (160) 14,003

3 14,003 1,120 (160) 14,963
4 14,963 1,197 (160) 16,000
SPL SFP