INSTITUTE OF PUBLIC ADMINISTRATION AND MANAGEMENT

(IPAM).
UNIVERSITY OF SIERRA LEONE.
IPAM-USL

FACULTY: FACULTY OF MANAGEMENT SCIENCES.

DEPARTMENT: DEPARTMENT OF ACCOUNTANCY.
MODULE TITLE: FINANCIAL STATEMENT
LECTURER: MR. ERNEST MOHAMED SMITH
SEMESTER: FIRST SEMESTER.
TASK: ASSIGNMENT.
COURSE: APPLIED ACCOUNTING.
YEAR: YEAR THREE (3)
NAME: MOHAMED SAMBA BAH.

ID: 28197
SHIFT: SHIFT (A) MORNING.

FINANCIAL INSTRUMENTS
INTRODUCTION:
The investment industry exists to serve its customers. There are two main groups of customers
– investors and security issuers. Investors may be private individuals, charities, companies,
banks, collective investment schemes such as pension funds and insurance funds, central and
local governments or “supranational institutions” such as the World Bank.
Investors in turn have investment objectives, which may be to increase wealth (capital growth)
or to provide income. Some investors will have only one of these objectives, some will have
both. For example, a high earning private individual probably has all the income that he or she
needs from employment, and wishes to invest surplus cash to provide capital growth. A charity,
however, may need the maximum possible income that it can get from its investments in order
to fund its activities.
There are four main classes of financial instrument that investors make use of to achieve either
income or capital growth. These are:
 Equities, also known as stocks or shares
 Debt instruments, also known as bonds or bills
 Cash
 Derivatives.
Equities and debt instruments are collectively known as securities. In order for there to be any
securities for the investor to invest in, then some organization, such as a company, a bank, a
government or a supranational institution, has to issue securities. Securities issuers are the
other main customer group.

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. In recent years there has been a huge
growth worldwide in the variety and complexity of financial instruments in international
financial markets. There were numerous concerns about the accounting practices used for
financial instruments which led to demands for an accounting standard. The concerns included
the following:
• There had been significant growth in the number and complexity of financial instruments
• Accounting standards had not developed in line with the growth in instruments
•There had been a particular problem with derivatives (i.e., forwards, futures, swaps, etc.)
• Unrealized gains/losses on many financial instruments were not recognized
• Companies could choose when to recognize profits on instruments in order to smooth profits.
LITERATURE REVIEW:
a) Financial assets and financial liabilities. PUBLISHING Need for accounting standards. The
reporting standards that deal with financial instruments are:
 IAS 32 deals with the classification of financial instruments and their presentation in
financial statements.
 IFRS 9 deals with how financial instruments are measured and when they should be
recognized in financial statements.
 IFRS 7 deals with the disclosure of financial instruments in financial statements.
 IAS 39 Financial Instruments: Recognition and Measurement.
IFRS 9 Financial Instruments; Sets out requirements for recognition and measurement of
financial instruments, including impairment, derecognition and general hedge accounting.
Initial measurement All financial instruments are initially measured at fair value plus or minus,
in the case of a financial asset or financial liability not at fair value through profit or loss,
transaction costs. Equity investments Equity investments held are measured at fair value.
Changes in the fair value are recognized in profit or loss (FVTPL). However, if an equity
investment is not held for trading, an entity can make an irrevocable election at initial
recognition to recognize the fair value changes in OCI (FVTOCI) with only dividend income
recognized in profit or loss. There is no reclassification to profit or loss on disposal. The
impairment requirements do not apply to equity instruments. Classification of financial assets
financial assets with contractual terms that give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount outstanding (the contractual
cash flows test) are classified according to the objective of the business model of the entity. If
the objective is to hold the financial assets to collect the contractual cash flows, they are
measured at amortized cost, unless the entity applies the fair value option. Interest revenue is
calculated by applying the effective interest rate to the amortized cost (which is the gross
carrying amount minus any loss allowance) for credit-impaired financial assets while for all
other instruments, it is calculated based on the gross carrying amount. If the objective is to
both collect contractual cash flows and sell financial assets, they are measured at FVTOCI (with
reclassification to profit or loss on disposal), unless the entity applies the fair value option. All
other financial assets must be measured at fair value through profit or loss (FVTPL). IFRS in your
pocket Fair value option an entity may, at initial recognition, irrevocably designate a financial
asset as measured at FVTPL if doing so eliminates or significantly reduces a measurement or
recognition inconsistency (accounting mismatch) that would otherwise arise from measuring
assets or liabilities or recognizing the gains and losses on them on different bases. Financial
liabilities held for trading are measured at FVTPL. All other financial liabilities are measured at
amortized cost unless the fair value option is applied. The fair value option can be elected at
initial recognition if doing so eliminates or significantly reduces an accounting mismatch. In
addition, financial liabilities can be designated as at FVTPL if a group of financial instruments is
managed on a fair value basis or if the designation is made in relation to embedded derivatives
that would otherwise be bifurcated from the liability host. Changes in fair value attributable to
changes in credit risk of the liability designated as at FVTPL are presented in OCI (and there is
no reclassification to profit or loss). Derivatives All derivatives in the scope of IFRS 9, including
those linked to unquoted equity investments, are measured at fair value. Value changes are
recognized in profit or loss unless the entity has elected to apply hedge accounting by
designating the derivative as a hedging instrument in an eligible hedging relationship.
Embedded derivatives. The contractual cash flows of a financial asset are assessed in their
entirety, including those of an embedded derivative that is not closely related to its host. The
financial asset as a whole is measured at FVTPL if the contractual cash flow characteristics test
is not passed. For financial liabilities, an embedded derivative not closely related to its host is
accounted for separately at fair value in the case of financial liabilities not designated at FVTPL.
For other non-financial asset host contracts, an embedded derivative not closely related to its
host is accounted for separately at fair value. Hedge accounting. The hedge accounting
requirements in IFRS 9 are optional. If the eligibility and qualification criteria are met, hedge
accounting allows an entity to reflect risk management activities in the financial statements by
matching gains or losses on hedging instruments with losses or gains on the risk exposures they
hedge. There are three types of hedging relationships: Fair value hedge; Cash flow hedge and
Hedge of a net investment in a foreign operation.
A hedging relationship qualifies for hedge accounting only if the hedging relationship consists
only of eligible hedging instruments and eligible hedged items, the hedging relationship is
formally designated and documented (including the entity’s risk management objective and
strategy for undertaking the hedge) at inception and the hedging relationship is effective. To be
effective there must be an economic relationship between the hedged item and the hedging
instrument, the effect of credit risk must not dominate the value changes that result from that
economic relationship and the hedge ratio of the hedging relationship must be the same as that
actually used in the economic hedge. The impairment model in IFRS 9 is based on expected
credit losses. It applies to financial assets measured at amortized cost or FVTOCI, lease
receivables, contract assets within the scope of IFRS 15 and specified written loan commitments
(unless measured at FVTPL) and financial guarantee contracts (unless they are accounted for in
accordance with. Expected credit losses (with the exception of purchased or original credit-
impaired financial assets) are required to be measured through a loss allowance at an amount
equal to the 12-month expected credit losses. If the credit risk has increased significantly since
initial recognition of the financial instrument, full lifetime expected credit losses are recognized.
This is equally true for credit impaired financial assets for which interest income is based on
amortized cost rather than gross carrying amount. IFRS 9 requires expected credit losses to
reflect an unbiased and probability-weighted amount, the time value of money and reasonable
and supportable information about past events, current conditions and forecasts of future
economic conditions.

IFRS 7 Financial Instruments: Disclosures

Overview: Prescribes disclosures to help the primary users of the financial statements evaluate
the significance of financial instruments to the entity, the nature and extent of their risks and
how the entity manages those risks. Significance of financial instruments Requires disclosure of
information about the significance of financial instruments to an entity’s financial position and
performance, including its accounting policies and application of hedge accounting. Financial
position Entities must disclose information about financial assets and financial liabilities by
category; special disclosures when the fair value option or fair value through OCI option is used;
reclassifications; offsetting of financial assets and liabilities; collateral; allowance accounts;
compound financial instruments with embedded derivatives; defaults and breaches and
transfers of financial assets. Financial performance Information must be disclosed about
financial instruments-related recognized income, expenses, gains and losses; interest income
and expense; fee income; and impairment losses. Other disclosures. The significant accounting
policies on financial instruments must be disclosed. When hedge accounting is applied,
extensive information about the risk management strategy, the amount, timing and uncertainty
of future cash flows and the effects of hedge accounting on financial position and performance
must be disclosed. This information is required regardless of whether an entity has applied
hedge accounting in accordance with IAS 39 or IFRS 9. Fair values must be disclosed for each
class of financial instrument and IFRS 13 also requires information to be disclosed about the fair
values. Risk Entities must disclose the nature and extent of risks arising from financial
instruments. This includes qualitative information about exposures to each class of risk and how
those risks are managed and quantitative information about exposures to each class of risk.
Extensive disclosures are required for credit risk to assess expected credit losses. This includes
reconciliations of the loss allowance and gross carrying amounts and information about credit
quality. Additional disclosure requirements relate to liquidity risk and market risk (including
sensitivity analyses for market risk). The amendments enable entities to reflect the effects of
transitioning from benchmark interest rates, such as interbank offered rates (IBORs) to
alternative benchmark interest rates without giving rise to accounting impacts that would not
provide useful information to users of financial statements. The amendments are effective for
annual periods beginning on or after 1 January 2021, with earlier application permitted.

IAS 32 Financial Instruments: Presentation

Overview: Prescribes the accounting for classifying and presenting financial instruments as
liabilities or equity and for offsetting financial assets and liabilities.
Classification: Classification of an instrument is based on its substance rather than its form and
the assessment is made at the time of issue and is not altered subsequently. An equity
instrument is an instrument that evidences a residual interest in the assets of the entity after
deducting all of its liabilities. A financial liability is an instrument that obligates an entity to
deliver cash or another financial asset, or the holder has a right to demand cash or another
financial asset. Examples are bank loans and trade payables, but also mandatorily redeemable
preference shares. Puttable instruments and instruments that impose on the entity an
obligation to deliver a pro-rata share of net assets only on liquidation that are subordinate to all
other classes of instruments and meet additional criteria, are classified as equity instruments
even though they would otherwise meet the definition of a liability. An issuer classifies
separately the debt and equity components of a single compound instrument such as
convertible debt, at the time of issue. The cost of treasury shares is deducted from equity.
Resales of treasury shares are accounted for as equity issuances. Cost Costs of issuing or
reacquiring equity instruments are accounted for as a deduction from equity. Offsetting
Financial assets and liabilities can only 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 simultaneously. Statement of financial performance Interest, dividends, gains and losses
relating to an instrument classified as a liability are reported as income or expense. Members’
Shares in Co-operative Entities and Similar Instruments clarifies that these are liabilities unless
the co-op has the legal right not to redeem on demand. Changes effective this year None
Pending changes The Board is exploring whether it can improve the requirements in IAS 32 for
classifying financial instruments into equity and liabilities and issued a DP in 2018. After
reviewing the responses to the DP, the Board decided to develop amendments to IAS 32 to
address practice issues, clarify the underlying principles in IAS 32 and develop additional
application guidance.

IAS 39 Financial Instruments: Recognition and Measurement

Sets out the requirements for hedge accounting. An entity can elect to apply these
requirements or those in IFRS 9. Hedge accounting Hedge accounting (recognizing the offsetting
effects of both the hedging instrument and the hedged item in the same period’s profit or loss)
is permitted if the hedging relationship is clearly designated and documented, measurable and
effective. Because IFRS 9 includes only general hedge accounting requirements, the
requirements on portfolio hedges in IAS 39 remain applicable. Fair value hedge When there is a
hedge of a change in fair value of a recognized asset or liability or firm commitment, the change
in fair values of both the hedging instrument and the hedged item for the designated risk are
recognized in profit or loss when they occur and the carrying amount of the hedged item is
adjusted to reflect changes in the hedged risk. Cash flow hedge When an entity hedges changes
in the future cash flows relating to a recognized asset or liability or a highly probable forecast
transaction that involves a party external to the entity, or a firm commitment in some cases,
then the change in fair value of the hedging instrument is recognized in other comprehensive
income to the extent that the hedge is effective until such time as the hedged future cash flows
occur. Hedge of a net investment in a foreign entity. This relates to a net investment in a
foreign operation including a hedge of a monetary item that is accounted for as part of the net
investment. The accounting for such a hedge is similar to a cash flow hedge. Intragroup hedges
the foreign currency risk of a highly probable forecast intragroup transaction can qualify as the
hedged item in a cash flow hedge in the consolidated financial statements, provided that the
transaction is denominated in a currency other than the functional currency of the entity
entering into that transaction and the foreign currency risk will affect the consolidated profit or
loss. If the hedge of a forecast intragroup transaction qualifies for hedge accounting, any gain or
loss that is recognized in other comprehensive income in accordance with the hedging rules in
IAS 39 is reclassified from equity to profit or loss in the same period or periods in which the
foreign currency risk of the hedged transaction affects profit or loss. Portfolio Hedge A portfolio
hedge of interest rate risk (hedging an amount rather than a specific asset or liability) can
qualify as a fair value hedge or a cash flow hedge if specified conditions are met. Interpretations
None Changes effective this year The Board issued amendments to the amendments enable
entities to reflect the effects of transitioning from benchmark interest rates, such as interbank
offered rates (IBORs) to alternative benchmark interest rates without giving rise to accounting
impacts that would not provide useful information to users of financial statements. The
amendments are effective for annual periods beginning on or after 1 January 2021, with earlier
application permitted. Pending changes IFRS 9 does not replace the requirements for portfolio
fair value hedge accounting for interest rate risk (often referred to as the ‘macro hedge
accounting’ requirements). The Board is currently undertaking outreach on the Both developed
core model.

b) FINANCIAL INSTRUMENTS DERIVATIVES

Financial assets: There are two types of financial asset which we will consider in this article
investments in equity and investments in debt instruments.

Equity instruments: Equity instruments are likely to be shares that have been purchased in
a company, but not enough to give the investee significant influence (associate), control
(subsidiary) or joint control (joint venture).
There are two options here, depending on the business model of the entity and the
characteristics of the financial asset. The default category is fair value through profit or loss
(FVPL).

Equity instruments: fair value through profit or loss (FVPL)

FVPL is the default treatment for equity investments where transaction costs such as broker
fees are expensed and not capitalized within the initial cost of the asset. Subsequently, the
investment is revalued to fair value at each year end, with the gain or loss being taken to the
statement of profit or loss.
Alternatively, equity instruments can be classified as fair value through other comprehensive
income (FVOCI) if an election is made. It is important to note that this election must be made
on acquisition and is irrevocable so the equity investments cannot retrospectively be treated as
FVPL. This is only an option if the equity investment is intended to be a long-term investment
(i.e., it is not held for trading).

Equity instruments: fair value through other comprehensive income (FVOCI)

Using FVOCI, the alternative elected treatment, transaction costs must be capitalized as part of
the initial cost of the investment. Similar to FVPL, the instrument would then be revalued to fair
value at the year end. The big difference is where the gain or loss is recorded – the gain or loss
is recognized within other comprehensive income and included as part of other components of
equity in the statement of financial position. This might be referred to as an investment
revaluation reserve or similar. In many ways it is like accounting for property, plant and
equipment (PPE) using the revaluation model. However, unlike the treatment for a revaluation
surplus related to PPE, there can be a negative (debit) balance on the investment revaluation
reserve.
When the FVOCI instrument is sold, the reserve can be left in the investment revaluation
reserve or transferred into retained earnings.
Debt instruments: These are usually bonds or loan notes, or other instruments which are
likely to carry interest and a capital element of repayment. There are three possible
classifications for categorizing debt instruments amortized cost, FVOCI or FVPL.
The classification of an investment in debt instruments should be based on both:
The entity’s business model for managing financial assets; and
The contractual cash flow characteristics of the financial asset.

Debt instruments: amortized cost to apply this treatment, the instrument must pass two
tests; first the business model test and secondly the contractual cash flow characteristics test.
Business model test the entity must intend to hold the financial assets in order to collect the
interest payments and receive repayment on maturity (i.e., the contractual cash flows).
Contractual cash flow characteristics test the contractual terms give rise to cash flows which are
solely repayments of the interest and principal amount.
In the FR exam, it will only be the first test which may (or may not) be met, so management
must decide on their intention for holding the debt instrument. This treatment requires
candidates to demonstrate the principles of amortized cost accounting.
The principles of amortized cost accounting mean that interest must be recorded on the
amount outstanding. This is relatively straight forward for many instruments.
Financial instruments are assets that can be traded, or they can also be seen as packages of
capital that may be traded. Most types of financial instruments provide efficient flow and
transfer of capital all throughout the world’s investors. These assets can be in the form of cash,
a contractual right to deliver or receive cash or another type of financial instrument, or
evidence of one’s ownership in some entity.
Examples of financial instruments include stocks, exchange-traded funds (ETFs), bonds,
certificates of deposit (CDs), mutual funds, loans, and derivatives contracts, among others.
Financial instruments may be divided into two types: cash instruments and derivative
instruments.
Financial instruments may also be divided according to an asset class, which depends on
whether they are debt-based or equity-based.
Foreign exchange instruments comprise a third, unique type of financial instrument.
Understanding Financial Instruments
Financial instruments can be real or virtual documents representing a legal agreement involving
any kind of monetary value. Equity-based financial instruments represent ownership of an
asset. Debt-based financial instruments represent a loan made by an investor to the owner of
the asset.
Foreign exchange instruments comprise a third, unique type of financial instrument. Different
subcategories of each instrument type exist, such as preferred share equity and common share
equity.
International Accounting Standards (IAS) define financial instruments as “any contract that
gives rise to a financial asset of one entity and a financial liability or equity instrument of
another entity.”
The values of cash instruments are directly influenced and determined by the markets. These
can be securities that are easily transferable. Stocks and bonds are common examples of such
instruments.
Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.
Checks are an example of a cash instrument because they transmit payment from one bank
account to another.
The value and characteristics of derivative instruments are based on the vehicle’s underlying
components, such as assets, interest rates, or indices.
An equity options contract such as a call option on a particular stock, for example is a derivative
because it derives its value from the underlying shares. The call option gives the right, but not
the obligation, to buy shares of the stock at a specified price and by a certain date. As the price
of the underlying stock rises and falls, so does the value of the option, although not necessarily
by the same percentage.
There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a
market or process whereby securities which are not listed on formal exchanges are priced and
traded.

Instruments Types of Asset Classes of Financial:

Financial instruments may also be divided according to an asset class, which depends on
whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Short-term debt-based financial instruments last for one year or less. Securities of this kind
come in the form of Treasury bills and commercial paper. Bank deposits and certificates of
deposit (CDs) are also technically debt-based instruments that credit depositors with interest
payments.
Exchange-traded derivatives exist for short-term, debt-based financial instruments, such as
short-dated interest rate futures. OTC derivatives also exist, such as forward rate agreements
(FRAs).
Long-term debt-based financial instruments last for more than a year. Long-term debt
securities are typically issued as bonds or mortgage-backed securities (MBS). Exchange-traded
derivatives on these instruments are traded in the form of fixed-income futures and options.
OTC derivatives on long-term debts include interest rate swaps, interest rate caps and floors,
and long-dated interest rate options.

Equity-Based Financial Instruments

Securities that trade under the banner of equity-based financial instruments are most often
stocks, which can be either common stock or preferred shares. ETFs and mutual funds may also
be equity-based instruments.
Exchange-traded derivatives in this category include stock options and equity futures.

Foreign Exchange Instruments

Foreign exchange instruments include derivatives such as forwards, futures, and options on
currency pairs, as well as contracts for difference (CFDs). Currency swaps are another common
form of forex instrument. In addition, forex traders may engage in spot transactions for the
immediate conversion of one currency into another.
Forms of Financial Instruments
Financial instruments come in many forms and types. What makes them financial instruments is
that they confer a financial obligation or right to the holder. Common examples of financial
instruments include stocks, exchange-traded funds (ETFs), mutual funds, real estate investment
trusts (REITs), bonds, derivatives contracts (such as options, futures, and swaps), checks,
certificates of deposit (CDs), bank deposits, and loans.
Are commodities financial instruments?
While commodities themselves, such as precious metals, energy products, raw materials, or
agricultural products, are traded on global markets, they do not typically meet the definition of
a financial instrument. That’s because they do not confer a claim or obligation over something
else. However, commodities derivatives, such as futures, forwards, and options contracts that
use a commodity as the underlying asset, would be a financial instrument.
Are insurance policies financial instruments?
An insurance policy is a legally binding contract established with the insurance company and
policy owner that provides monetary benefits if certain conditions are met (e.g., death in the
case of life insurance). If the insurer is a mutual company, the policy may also confer ownership
and a claim to dividends. Insurance policies also have a specified value in terms of both the
death benefit and living benefits (e.g., cash value) for permanent policies.
While insurance policies are not considered securities, one could possibly view them an
alternative type of financial instrument because they confer a claim and certain rights to the
policyholder and obligations to the insure
IFRS 9 requires that a constant rate of interest is applied to this balance to better reflect the
reality of the situation. This rate takes into account both the annual payment and the premium
payable on redemption. In the FR exam, this rate will be provided in the question and is known
as the effective interest rate. Let’s say that in this example, the effective interest rate is 8.08%.
This rate is applied to the outstanding balance each year in order to calculate the interest
earned (finance income) on the investment, which is the amount to be recorded in finance
income in the statement of profit or loss.
The easiest way to do this is often to use a table showing the movement of the asset.
The figures in the effective interest column would be the amounts recorded as finance income
in the statement of profit or loss each year. This is increasing to reflect the fact that the amount
owed is increasing as it gets closer to redemption.
Debt instruments: fair value through other comprehensive income (FVOCI)
Another possible treatment for a debt instrument is to hold it at fair value through other
comprehensive income (FVOCI). Similar to holding the instrument at amortized cost, two tests
must be passed in order to hold a debt instrument in this manner.
Business model test the objective of the entity’s business model is both to hold the financial
assets in order to collect the contractual cash flows and also to sell the assets. This might
include sales to manage liquidity needs or in order to maintain particular interest yields.
Contractual cash flow characteristics test the contractual terms give rise to cash flows which are
solely repayments of the interest and principal amount.
Again, it is only the first of these that candidates will need to consider in the FR exam,
highlighting that the choice of category will depend on the intention of management.
If the entity holds the debt instrument under the FVOCI category, they will still produce the
amortized cost table as above, taking the same figure to finance income. At the year end, the
asset would then be revalued to fair value, with the gain or loss being recorded in other
comprehensive income and presented as an item that may be reclassified subsequently to
profit or loss.

Debt instruments: fair value through profit or loss (FVPL)

Financial assets should be measured at FVPL unless they are measured at amortized cost or
FVOCI. For example, an investment in debt instruments which is held for trading and therefore
fails the business model test for amortized cost and FVOCI.
Financial assets measured at FVPL should be revalued at each year end with any revaluation
gains or losses being recognized in the statement of profit or loss.

Financial liabilities: In the FR exam, financial liabilities will be held at amortized cost. This will
be similar to the measurement treatment shown earlier for assets held under amortized cost.
Instead of having finance income and an asset, there will be a finance cost and a liability. The
major difference in the accounting treatment relates to the initial treatment upon issue of the
financial liability. Initially these are recognized at NET PROCEEDS, being the cash received less
Convertible instruments
Convertible instruments are financial instruments which give the holder the right to either
demand repayment of the principal amount or alternatively convert the balance into shares. In
the FR exam, you will only have to deal with convertible instruments from the perspective of
the issuer, being the person who has received the cash on issue of a convertible instrument.
They will usually take the form of convertible loan notes or convertible debentures (debt
instruments).
Convertible instruments present a special challenge, as these could ultimately result in the issue
of shares or the repayment of the loan note/debenture, but the choice will be in the hand of
the loan note/debenture holder. As we do not know whether the holder will choose to receive
the cash or convert the instrument into shares, we must reflect an element of both within the
financial statements. Therefore, these are accounted for by initially separating the instrument
into equity and liability components and presenting each component on the statement of
financial position accordingly.
The liability component is the first thing to calculate. We work this out by calculating the
present value of the payments at the market rate of interest (using the interest on an
equivalent debt instrument without the conversion option). The discount rates required to do
this will be given to you in the exam.
In reality, the market rate of interest will be higher than the coupon rate, being the annual
amount payable to the holder of the debt instrument. This is because the holder of the debt
instrument is willing to accept a lower rate of annual interest compared to the market, in
exchange for the option to convert the debt instrument into shares.
Once the liability component has been calculated, the equity component is then worked out.
This is simply a balancing figure and represents the difference between the total cash received
on issue and the calculated liability component.
Prescribes the accounting for classifying and presenting financial instruments as liabilities or
equity and for offsetting financial assets and liabilities. Classification of an instrument is based
on its substance rather than its form and the assessment is made at the time of issue and is not
altered subsequently. An equity instrument is an instrument that evidences a residual interest
in the assets of the entity after deducting all of its liabilities. A financial liability is an instrument
that obligates an entity to deliver cash or another financial asset, or the holder has a right to
demand cash or another financial asset. Examples are bank loans and trade payables, but also
mandatorily redeemable preference shares. Puttable instruments and instruments that impose
on the entity an obligation to deliver a pro-rata share of net assets only on liquidation that are
subordinate to all other classes of instruments and meet additional criteria, are classified as
equity instruments even though they would otherwise meet the definition of a liability. An
issuer classifies separately the debt and equity components of a single compound instrument
such as convertible debt, at the time of issue. The cost of treasury shares is deducted from
equity. Resales of treasury shares are accounted for as equity issuances. Costs of issuing or
reacquiring equity instruments are accounted for as a deduction from equity. Offsetting
Financial assets and liabilities can only 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 simultaneously. Statement of financial performance Interest, dividends, gains and losses
relating to an instrument classified as a liability are reported as income or expense.
Interpretations IFRIC 2 Members’ Shares in Co-operative Entities and Similar Instruments
clarifies that these are liabilities unless the co-op has the legal right not to redeem on demand.
Changes effective this year None Pending changes The IASB is exploring whether it can improve
the requirements in IAS 32 for classifying financial instruments into equity and liabilities and
issued a DP in 2018. History Issued in the set of improved Standards effective for annual periods
beginning on or after 1 January 2005. In December 2005 all of the disclosure requirements were
moved to IFRS 7. The IASB also amended IAS 32 for puttable financial instruments in October
2009.
 Financial derivatives are financial instruments that are linked to a specific financial
instrument or indicator or commodity, and through which specific financial risks can be
traded in financial markets in their own right. Transactions in financial derivatives should
be treated as separate transactions rather than as integral parts of the value of
underlying transactions to which they may be linked. The value of a financial derivative
derives from the price of an underlying item, such as an asset or index. Unlike debt
instruments, no principal amount is advanced to be repaid and no investment income
accrues. Financial derivatives are used for a number of purposes including risk
management, hedging, arbitrage between markets, and speculation.
 Financial derivatives enable parties to trade specific financial risks (such as interest rate
risk, currency, equity and commodity price risk, and credit risk, etc.) to other entities
who are more willing, or better suited, to take or manage these risks typically, but not
always, without trading in a primary asset or commodity. The risk embodied in a
derivatives contract can be traded either by trading the contract itself, such as with
options, or by creating a new contract which embodies risk characteristics that match, in
a countervailing manner, those of the existing contract owned. This latter is termed
offset ability, and occurs in forward markets. Offset ability means that it will often be
possible to eliminate the risk associated with the derivative by creating a new, but
“reverse”, contract that has characteristics that countervail the risk of the first
derivative. Buying the new derivative is the functional equivalent of selling the first
derivative, as the result is the elimination of risk. The ability to replace the risk on the
market is therefore considered the equivalent of tradability in demonstrating value. The
outlay that would be required to replace the existing derivative contract represents its
value actual offsetting is not required to demonstrate value.
 Financial derivatives contracts are usually settled by net payments of cash. This often
occurs before maturity for exchange traded contracts such as commodity futures. Cash
settlement is a logical consequence of the use of financial derivatives to trade risk
independently of ownership of an underlying item. However, some financial derivative
contracts, particularly involving foreign currency, are associated with transactions in the
underlying item.
Financial Derivatives: A Supplement to the Fifth Edition of the Balance of Payments Manual on
financial derivatives was released in 2000. This document included a provisional decision
regarding the classification of financial derivatives involving affiliated enterprises.
The final decision on the classification of these financial derivatives was promulgated in 2002.
See Classification of Financial Derivatives Involving Affiliated Enterprises in the Balance of
Payments Statistics and the International Investment Position Statement.

CONCLUSION.
The International Accounting Standards Board believes that users of financial statements need
information about the entity's exposure to risks and how those risks are managed. Some of
these scandals have exposed accounting weaknesses. The accountants at Barings, for instance,
were unaware of the huge losses Barings was making with financial instruments. The internet
bubble also challenged accountants, since they were forced to recognize revenue prematurely
from internet companies. Northern Rock was probably the incident that regulators will
remember quite well. When the bank got into trouble, the regulators had difficulty in deciding
who was in charge. Mervyn King, the Bank of England Governor, attempted to avoid rescuing
banks that were badly managed but he was then forced to do a quick U-turn. A financial
instrument is a real or virtual document representing a legal agreement involving any kind of
monetary value, and the use of financial instruments can reduce exposures to certain business
risks, for example changes in exchange rates, interest rates and commodity prices or a
combination of those risks. Banks can borrow money through off-balance sheet vehicles and
only bring them on to the balance sheet when they are forced to subsidize the losses of these
vehicles. Unfortunately, investors rely on these standards and also rely on the regulators to
ensure that profits and risks are reported correctly. Regrettably, there is an abundance of
evidence to suggest that their reliance is misplaced in both cases.