Advanced Financial Accounting

FINANCIAL INSTRUMENTS

Katarzyna Bareja
 ACCOUNTING FOR FINANCIAL INSTRUMENTS
Reasons:
- growth in the number of financial instruments
- increasing complexity of financial instruments
- lack of rules:
- unrealised gains/losses recognised vs. unrecognised
- tool for smoothing profit

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 DEFINITION OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that
gives rise to
a financial asset of one entity
and
a financial liability or equity instrument in another entity

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 DEFINITION OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that
gives rise to

financial asset in entity A financial asset in entity A

and or and

financial liability in entity B equity in entity B

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IAS/IFRS STANDARDS FOR FINANCIAL INSTRUMENTS
IAS 32 Financial Instruments: Presentation
Deals with the classification of financial instruments and their presentation
in financial statements
IFRS 7 Financial Instruments: Disclosures
Deals with the disclosure of financial instruments in financial statements

IFRS 9 Financial Instruments

Deals with how financial instruments are measured and when and how
they should be recognised in financial statements

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 DEFINITION OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that
gives rise to
a financial asset of one entity
and
a financial liability or equity instrument in another entity

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 FINANCIAL ASSETS
A financial asset is any asset that is
• cash
• a contractual right to receive cash or another financial asset from
another entity (e.g. trade receivables)
• a contractual right to exchange financial assets or liabilities with
another entity under conditions that are potentially favourable
(e.g. options)
• an equity instrument of another entity (e.g. investment in equity
shares)
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 DEFINITION OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that
gives rise to
a financial asset of one entity
and
a financial liability or equity instrument in another entity

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 FINANCIAL LIABILITY
A financial liability is any liability that is a contractual obligation:
• to deliver cash or another financial asset to another entity (e.g.
trade payables, debenture loans, redeemable preference shares)
• to exchange financial assets or liabilities with another entity under
conditions that are potentially unfavourable (e.g. options)
• that will or may be settled in the entity’s own equity instruments
(e.g. convertible loan, redeemable preference shares)

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 FINANCIAL LIABILITY
A financial liability:
• payables
• debentures (convertible, nonconvertible)
• bonds (zero-coupon bonds, regular bonds; convertible,
nonconvertible)
• notes (convertible, nonconvertible)
• redeemable preference shares (convertible, nonconvertible)
• loans

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 DEFINITION OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that
gives rise to
a financial asset of one entity
and
a financial liability or equity instrument in another entity

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 EQUITY INSTRUMENTS
An equity instrument evidences a residual interest in the assets of an
entity after all liabilities have been settled in the event of a
liquidation

Accounting for equity instruments

• initial measurement is at fair value less any associated issue costs
• share capital is stated in nominal value (par value, face value)
• fair value > nominal value => share premium
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 EQUITY INSTRUMENTS
Illustration
An entity issues 500 000 $1 equity shares for $3.5 each and pays issue
costs of $20 000

• share capital (500 000 x $1) $500 000 (Cr)

• share premium (500 000 x $2.5 - $20 000) $1 230 000 (Cr)
• cash inflow (500 000 x $3.5 - $20 000) $1 730 000 (Dr)
• having recorded the issue of shares at face value and the associated
share premium (net of issue costs) the equity instrument is not
remeasured
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 DEFINITION OF FINANCIAL INSTRUMENTS

contract
entity A entity B
(financial asset) (financial liability or equity)

• receivable • payable
• investment in shares • shares issued
• investment in debt • debt issued

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 DEFINITION OF FINANCIAL INSTRUMENTS

debt instrument equity instrument

financial asset in entity A financial asset in entity A

and and

financial liability in entity B equity in entity B

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 DEFINITION OF FINANCIAL INSTRUMENTS

compound instrument

financial asset in entity A

and

financial liability & equity in entity B

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 Initial recognition of financial instrument
When the entity becomes a party to the contractual provisions of the
instrument it can recognise (as well as derecognise later on) using
two methods of accounting for recognition and derecognition.
• Regular way purchase or sale of financial assets shall be recognised
and derecognised using:
– trade date accounting
– settlement date accounting

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 Classification of financial assets
An entity shall classify financial assets as subsequently measured at:
• amortised cost
• fair value through other comprehensive income
• fair value through profit or loss
on the basis of both:
(a) the entity’s business model for managing the financial assets and
(b) the contractual cash flow characteristics of the financial asset.

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 Classification of financial assets
A financial asset shall be measured at amortised cost if both of the
following conditions are met:
(a – business model) the financial asset is held within a business
model whose objective is to hold financial assets in order to collect
contractual cash flows
and
(b – contractual cash flow characteristic, SPPI test) the contractual
terms of the financial asset give rise on specified dates to cash flows
that are solely payments of principal and interest (SPPI) on the
principal amount outstanding.
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 Classification of financial assets
A financial asset shall be measured at fair value through other
comprehensive income if both of the following conditions are met:
(a – business model) the financial asset is held within a business
model whose objective is achieved by both collecting contractual
cash flows and selling financial assets
(b – contractual cash flow characteristic, SPPI test) the contractual
terms of the financial asset give rise on specified dates to cash flows
that are solely payments of principal and interest on the principal
amount outstanding.
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 Classification of financial assets
A financial asset shall be measured at fair value through profit or loss
unless it is measured at amortised cost or at fair value through other
comprehensive income (in accordance with above conditions)

However an entity may make an irrevocable election at initial

recognition for particular investments in equity instruments that
would otherwise be measured at fair value through profit or loss to
present subsequent changes in fair value in other comprehensive
income
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 Two types of financial assets
the contractual terms of the financial asset

equity instruments debt instrument

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 Classification of financial assets
Equity instruments:
- measured at fair value through profit or loss (default)
- measured at fair value through other comprehensive income
(irrevocable election)

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Classification and initial measurement of financial assets

Equity instruments:
- measured at fair value through profit or loss (default)
- measured at fair value through other comprehensive income

Initial measurement:
- fair value excluding transaction costs
- fair value including transaction costs

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Classification and subsequent measurement of financial assets

Equity instruments:
- measured at fair value through profit or loss
- measured at fair value through other comprehensive income

Subsequent measurement:
- remeasured to fair value at the reporting date => gains or
losses through profit or loss (FVTPL)
- remeasured to fair value at the reporting date => gains or
losses through other comprehensive income (FVTOCI)
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Classification and subsequent measurement of financial assets

Equity instruments:
- measured at fair value through profit or loss
- measured at fair value through other comprehensive income

Other issues:
- dividends received => P/L
- disposal: (proceeds-carrying amount:) gain/loss on sale: P/L
- disposal => accumulated gains or losses on remeasurement =>
transfer to retained earnings
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 Financial assets – equity instruments
Alfa bought 10 000 shares in a listed company on 1 November 2018.
Each share cost $10 to purchase and a fee of $0.2 per share was paid
as a commission to a broker. The fair value of the share at 31
December 2018 was $12.
Two scenarios:
1. Alfa is going to sell shares when their price reaches $15
2. Alfa has strategic intent to hold shares in a long term
How these assets should be accounted for in the financial statements?

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 Financial assets – equity instruments
1 2
Classified as FVTPL FVTOCI
Initial measurement 10 000 x 10 = 100 000 10 000 x 10.2 = 102 000
Transaction costs -2 000 P/L 2 000 included in initial value
Reporting date measurement 10 000 x 12 = 120 000 10 000 x 12 = 120 000
Gain on revaluation +20 000 P/L +18 000
Treatment of that gain P/L +18 000 OCI +18 000
B/S: Equity:
Accumulated gain on revaluation

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 Financial assets – equity instruments
Alfa bought 10 000 shares in a listed company on 1 November 2018.
Each share cost $10 to purchase and a fee of $0.2 per share was paid
as a commission to a broker. The fair value of the share at 31
December 2018 was $12.
Two scenarios:
1. Alfa is going to sell shares when their price reaches $15.
It happened on 1 March 2019 and on that day Alfa sold all shares.
2. Alfa has strategic intent to hold shares in a long term. On 31 December
2019 Alfa still has these shares. Their price is falling. It is $9. Alfa decides to
sell shares on 1 February when the price is $8.
How these assets should be accounted for in the financial statements?
AFA Katarzyna Bareja
 Financial assets – equity instruments
1 2
Classified as FVTPL FVTOCI
Initial measurement 10 000 x 10 = 100 000 10 000 x 10.2 = 102 000
Transaction costs -2 000 P/L 2 000 included in initial value
Reporting date measurement 10 000 x 12 = 120 000 10 000 x 12 = 120 000
Gain on revaluation +20 000 P/L +18 000
Treatment of that gain P/L +18 000 OCI +18 000
B/S: Equity:
Accumulated gain on revaluation

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 Financial assets – equity instruments
1 2
Classified as FVTPL FVTOCI
Value @ last revaluation 120 000 120 000
1 March 2019 selling price 10 000 x 15 = 150 000
1 March 2019 Income 30 000 (P/L)
31 December 2019 – reporting 10 000 x 9 = 90 000
date remeasurement
Loss on revaluation - 30 000 (OCI)
Accumulated AOCI in B/S 18 000 – 30 000 = - 12 000
1 Fabruary 2020 selling price 10 000 x 8 = 80 000
Expense – loss on disposal -10 000 (P/L)
Transfer within equity (B/S) +12 000 (AOCI to be nil)
AFA Katarzyna Bareja -12 000 (RE)
 Classification of financial assets
Debt instruments:
- measured at amortised cost
- measured at fair value through profit or loss (fair value option)
- measured at fair value through other comprehensive income

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 Classification of financial assets
Debt instruments:
- measured at amortised cost – if two tests satisfied:
- the business model test (T1) – the asset is held with the intention of
realising asset’s cash flows rather than being held for early sale
- the cash flow characteristic test, SPPI test (T2) – the asset terms are
such that cash flow will arise on specific dates in the future
representing interest payments and repayments of principal

T1 v, T2 v => fair value option

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 Classification of financial assets
Debt instruments:
- measured at fair value through other comprehensive income
- the business model test (T1) – the asset is held with the intention of
both realising asset’s cash flows or selling the assets
- the cash flow characteristic test, SPPI test (T2) – the asset terms are
such that cash flow will arise on specific dates in the future
representing interest payments and repayments of principal

T1 v, T2 v => fair value option

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 Classification of financial assets
Debt instruments:
- measured at amortised cost
- measured at fair value through profit or loss (fair value option)
- measured at fair value through other comprehensive income

Initial measurement:
- fair value excluding tranasaction costs
- fair value including transaction costs
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 Classification and subsequent measurement of financial assets

Debt instruments:
- measured at amortised cost
- measured at fair value through profit or loss
- measured at fair value through other comprehensive income
Subsequent measurement:
- carried at amortised cost calculated as:
initial value + effective interest – interest received
- remeasured to fair value at the reporting date => gains or losses through P/L
- calculated as follows:
initial value + effective interest – interest received
remeasured to fair value at theAFAreporting
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date => gains or losses through OCI
Classification and subsequent measurement of financial assets

Debt instruments:
- measured at amortised cost
Subsequent measurement:
- carried at amortised cost calculated as:
initial value + effective interest – interest received – principal paid back
interest income – calculated using the effective interest
– taken to P/L
effective interest ≠ interest received if:
initial value ≠ par value
par value ≠ redemption value
initial value ≠ redemption value
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Classification and subsequent measurement of financial assets

Debt instruments:
- measured at fair value through profit or loss
Subsequent measurement:
- fair value
gains or losses in profit or loss
interest income in profit or loss

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Classification and subsequent measurement of financial assets

Debt instruments:
- measured at fair value through other comprehensive income
Subsequent measurement:
- calculated as follows:
initial value + effective interest – interest received – principal paid back
interest income – calculated using the effective interest
– taken to P/L
effective interest ≠ interest received (if… – see above)
remeasured to fair value with gains or losses recognised in other
comprehensive income. This will be reclassified to profit or loss on disposal
of the asset
e
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Classification and subsequent measurement of financial assets

Debt instruments:
- measured at amortised cost
- measured at fair value through profit or loss
- measured at fair value through other comprehensive income

EXAMPLE

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 Financial assets – debt instrument
Debt instruments (excel file)
On 2 January 20X1 Alfa bought a $200,000 5% bond for $180,000, incurring transaction
costs of $5,000. Interest is received in arrears. The bond will be redeemed at the
premium of $6,500 over par value in three years. The effective rate of interest is
8.9523%.
The fair value of the bond is as follows:
31/12/20X1 $200,000
31/12/20X2 $197,000
Explain, with calculations, how the bond is accounted for over all relevant years if:
(a) Alfa plans to hold the bond until the redemption date.
(b) Alfa assumes it will sell the bond if the investment with higher return arises and
eventually sells it on 2/01/20X3 for its fair value.
(c) Alfa plans to sell the bond in short-term, and eventually sells it on 2/01/20X2 for its
fair value.
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 Financial assets – impairment

IFRS 9 suggests that only debt assets held at amortised cost and FVTOCI are
subject to annual impairment review.
Impairment refers to debt instruments measured at amortised cost and at
FVTOCI.

Expected loss model is introduced – investor holding financial assets should

determine and account for expected losses when the asset is acquired rather than
wait until the investee entity defaults.

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 Classification of financial liabilities
- measured at amortised cost
- measured at fair value through profit or loss (e.g. derivates,
fair value option)

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 Classification of financial liability
Financial liability:
- measured at amortised cost
- measured at fair value through profit or loss

Initial measurement:
- fair value excluding tranasaction costs
- fair value including transaction costs
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 Initial measurement of financial assets
and financial liabilities – general rule
Except for some trade receivables*, at initial recognition, an entity
shall measure a financial asset or financial liability at its fair value plus
or minus, in the case of a financial asset or financial liability not held
at fair value through profit or loss, transaction costs that are directly
attributable to the acquisition or issue of the financial asset or
financial liability.

*not containing a significant financing component (as defined in

IFRS15)
* entity applies a practical expedient in accordance with IRFS 15.63
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 Classification and subsequent measurement of financial liability

Financial liability:
- measured at amortised cost
- measured at fair value through profit or loss

Subsequent measurement:
- carried at amortised cost calculated as follows:
initial value + effective interest – interest paid – principal paid back
- remeasured to fair value at the reporting date => gains or losses through P/L

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Classification and subsequent measurement of financial liability

Financial liability:
- measured at amortised cost
Subsequent measurement:
- carried at amortised cost calculated as follows:
initial value + effective interest – interest paid – principal paid back
interest income – calculated using the effective interest
– taken to P/L
effective interest ≠ interest paid if:
initial value ≠ par value
par value ≠ redemption value
initial value ≠ redemption value
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Classification and subsequent measurement of financial liability

Financial liability – deep discount bond:

- issued at a significant discount to its par value

- typically it has a coupon rate of interest much lower than the
market rate
- Redeemed at a significant premium added to its par value
- the full cost of borrowing is likely to include:
- issue cost
- discount on issue
- annual interest payments
- premium on redemption
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Classification and subsequent measurement of financial liability

Financial liability – other types of bonds:

- issued at a discount to its par value with zero coupon rate

- issued at par value with zero coupon rate and redeemed at a
premium
- issued at par value with coupon rate

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Classification and subsequent measurement of financial liability

Financial liability – other types of bonds:

- convertible bonds – compound/mixed instruments

- contains a mixture of both debt and equity
- debt component is recognised as a liability in B/S
- equity component is recognised in equity in B/S
- bond holder has the right to receive shares in company
(as opposed exclusive right to settlement in cash)
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Classification and subsequent measurement of financial liability

Financial liability – other types of bonds:

- Preference shares
- recognised as equity in B/S
- recognised as a liability in B/S
- recognised as both equity and liability in B/S => compound
instrument
- depends on:
- payment of dividends: discretionary or nondiscretionary
- redemption of shares: redeemable or non-redeemable
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Classification and subsequent measurement of financial liability

Financial liability – interest and dividends:

- The accounting treatment of interest and dividends depends

upon the accounting treatment of the underlying instrument
itself:
- equity dividends declared are reported directly in equity
- dividends on instruments classified as a liability are treated as a
finance cost in the P/L

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Financial liability - examples

in excel file

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