Deegan8e - Chapter - 14 - PPTs (L 8)

Chapter 14
Accounting for financial

instruments
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Deegan, Financial Accounting, 8e 14-1
Objectives of both lecture
• Understand what a financial instrument is
• Understand the factors that determine whether a financial
instrument shall be presented as debt or equity
• Understand the measurement rules for financial instruments
• Know how to account for gains and losses on financial
instruments
• Understand how to account for derivatives and the assets and
liabilities that are part of a hedging arrangement

Relevant accounting standards
There are three standards that are of direct
importance to this lecture, these being:
1. AASB 7 Financial Instruments: Disclosure
2. AASB 132 Financial Instruments: Presentation
3. AASB 9 Financial Instruments

Financial instruments defined
• A financial instrument (AASB 132) is:
– any contract that gives rise to both a financial asset of
one entity and a financial liability or equity instrument
of another entity
• A financial asset (AASB 132) would include:
– cash, or
– a contractual right to receive cash or another financial
asset from another entity, or (trade receivables)
– a contractual right to exchange financial instruments
with another entity under conditions that are potentially
favourable, or
– an equity instrument of another entity( investment)

Financial instruments defined (cont.)
• A financial liability (AASB 132) would include:
– any liability that is a contractual obligation
 to deliver cash or another financial asset to another entity; or
 to exchange financial assets or liabilities with another entity
under conditions that are potentially unfavourable; or
– a contract that will or may be settled in the entity’s own equity
instruments and
 is a derivative that will or may be settled other than by the
exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments
• An equity instrument (AASB 132) is:
– any contract that evidences a residual interest in the assets of
another entity after deduction of all its liabilities

• Central to the definition of a liability is whether or not a

‘contractual obligation’ exists
– If there is no contractual obligation to deliver cash or
another financial asset, or to exchange another financial
instrument under conditions that are potentially
unfavourable, it is considered to be an equity instrument

Debt versus equity components of financial
instruments
• The issuer of a financial instrument must determine whether to
disclose it as a liability or equity (AASB 132)
– required to consider economic substance rather than just the
legal form
• Critical feature in differentiating financial liability from equity is the
existence of a contractual obligation on the part of one entity
either to deliver cash or another financial asset, or to exchange
another financial instrument
• If classified as debt, then periodic payments are classified as
interest expenses, which will affect profits. If classified as equity,
then the payments are dividends and will not impact reported
profits
– Where an instrument is classified as debt (a liability) the related
interest can sometimes be treated as part of the cost of an asset
under construction

• Examples of financial instruments
– cash at bank
– bank overdrafts
– term deposits
– trade receivables and payables
– investments
– options
– forward foreign exchange agreements (hedging
instruments)
– foreign currency swaps

• Primary financial instruments:
– include receivables, payables and equity securities
such as ordinary shares—accounting treatment fairly
straightforward
• Derivative financial instruments:
– create rights and obligations with the effect of
transferring one or more of the financial risks inherent
in an underlying primary financial instrument
– include financial options, futures, forward contracts
and interest rate and currency swaps

Measurement of financial instruments
• According to AASB 9 (effective date 1st Jan 2018):

– Financial instruments are initially to be measured at fair value
– How they are subsequently measured, and how any gain or loss
is treated, is then dependent upon how the financial asset is
classified
• Categories of financial instruments
Depending upon the entity’s business model for managing its
financial assets and the contractual cash flows of the financial
asset, financial assets shall subsequently be measured at either:
– Amortised cost
– Fair value through other comprehensive income
– Fair value through profit or loss

Measurement of financial assets at
amortised cost
• According to AASB 9, a financial asset shall be subsequently

measured at ‘amortised cost’ if both of the following conditions or
‘tests’ are met:
– The asset is held within a business model whose
objective is to hold assets in order to collect contractual
cash flows (referred to as the business model test); and
– 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 (the cash flow characteristics test).
• Given the reference to cash flows associated with interest and
principal, we can see that the option to use amortised cost is
available for debt instruments rather than equity instruments.

Worked Example 14.5—Determining the amortised cost
of a financial asset
On 1 July 2018, Jack Ltd acquired some corporate bonds issued by

McCoy Ltd.
These bonds cost $1 066 242. They had a ‘face value’ of $1 million
and offered a coupon rate of 10 per cent paid annually ($100 000 per
year, paid on 30 June). The bonds would repay the principal of
$1 million on 30 June 2022.
At the time the market only required a rate of return on 8 per cent on
such bonds.
Jack Ltd operates within a business model where government bonds
are held in order to collect contractual cash flows and there is no
intention to trade them.
Assume that there were no direct costs associated with acquiring the
bonds.

of a financial asset (cont.)
REQUIRED
(a) Explain why the company was prepared to pay $1 066 242 for
the bonds given that, apart from the interest, they expect to
receive only $1 million back in four years.
(b) Determine whether Jack Ltd can measure the government
bonds at amortised cost.
(c) Calculate the amortised cost of the bonds as at 30 June 2019,
2020, 2021 and 2022.
(d) Provide the accounting journal entries for the years ending
30 June 2019 and 2020.

(a) In this instance the market was requiring an 8 per cent return on
securities such as these. However, McCoy Ltd was offering a 10 per
cent return. In this case, and using present values, the issue price will
be $1 066 242, determined as follows:
Present value of interest stream of four payments of $100 000

per year at the end of the next 4 years:
$100 000 × 3.312 126 4 = $331 213
Present value of the principal to be received in 4 years:
$1 000 000 × 0.735 029 7 = $735 029 Fair
value at 1 July 2018 $1 066 242

(b) Jack Ltd can use amortised cost as the basis for measuring
government bonds as:
•The government bonds are held within a business model whose
objective is to hold them in order to collect contractual cash flows,
and
•The contractual terms of the government bonds give rise on
specified dates to cash flows that are solely payments of principal
and interest on the principal amount outstanding.

(c) Date Opening Interest Principal Closing
present revenue repayment present
value value
1 July 2018 1 066 242
30 June 2019 1 066 242 85 299 14 701 1 051 541
30 June 2020 1 051 541 84 123 15 877 1 035 664
30 June 2021 1 035 664 82 853 17 147 1 018 517
30 June 2022 1 018 517 81 483 1 018 517 0

(d) 1 July 2018

Dr Investment in corporate bonds 1 066 242
Cr Cash 1 066 242
30 June 2019
Dr Cash 100 000
Cr Investment in corporate bonds 14 701
Cr Interest income 85 299
30 June 2020
Dr Cash 100 000
Cr Investment in corporate bonds 15 877
Cr Interest income 84 123

Financial asset measured at fair value
through profit or loss
• All financial assets can be measured at fair value
through profit or loss if the entity has made an
election to do so (on the basis that it will eliminate
or significantly reduce a measurement or
recognition inconsistency)
• All equity investments shall subsequently be
measured at fair value. The change in fair value
shall:
– go to profit or loss if the equity investment is held
primarily for trading
– go to OCI if the entity has elected to present changes in
fair value through OCI

Worked Example 14.6—Accounting for a financial
asset at fair value through profit or loss
On 1 July 2018, Bear Ltd acquired 100 000 shares in Island Ltd at
a price of $10 each. There were brokerage fees of $1500. The
closing market price of Island Ltd shares on 30 June 2019—which
is the entity’s financial year end—was $12. Bear Ltd has not made
the election to account for its equity investments at fair value
through OCI.
REQUIRED
Provide the required accounting journal entries for Bear Ltd to
account for the investment in Island Ltd using fair value through
profit or loss.

Worked Example 14.6—Solution
1 July 2018
The financial asset would initially be recorded at fair value. If
the financial asset is measured at fair value through profit or
loss then transaction costs associated with the acquisition of
the asset shall be treated as an expense within profit or loss.
Dr Investment in Island Ltd 1 000 000
Dr Brokerage fee expense 1 500
Cr Cash 1 001 500
30 June 2019
Dr Investment in Island Ltd 200 000
Cr Gain in fair value of equity investments (profit or loss) 200 000

Measurement of financial assets at fair
value through other comprehensive income
For debt instruments:
•A reporting entity can make an election to measure debt instruments
at fair value through other comprehensive income (meaning the
gains or losses on the financial asset do not go directly to profit or
loss) if both of the following conditions are met:
– the financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling
financial assets, and
– 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.
For equity instruments:
•If they are not held for trading, then the reporting entity can make an
election to measure the equity instruments at fair value through OCI

Measurement of financial assets at fair value through
other comprehensive income (cont.)
For debt instruments measured at fair value through OCI:

– changes in fair value will be included within OCI
– interest revenue, expected credit losses and foreign exchange
gains and losses are included within profit or loss
– when the asset is derecognised (sold) the cumulative gain or loss
recognised within OCI is reclassified from equity to profit or loss
For equity instruments measured at fair value through OCI:

– changes in fair value will be included within OCI
– dividends received from the equity instruments will be included
within profit or loss, and
– changes in fair value of equity instruments that are included within
OCI shall not be reclassified to profit or loss on the occurrence of
an event such as the sale of the investments

Worked Example 14.7—Accounting for a financial asset
at fair value through other comprehensive income
The facts are the same as those in Worked Example 14.6 except
this time Bear Ltd has made the decision to measure the equity
investment at fair value through other comprehensive income.
REQUIRED
Provide the required accounting journal entries for Bear Ltd to
account for the investment in Island Ltd using fair value through
other comprehensive income.

Worked Example 14.7—Solution
1 July 2018
The financial asset would initially be recorded at fair value. If the
financial asset is measured at fair value through other
comprehensive income then transaction costs associated with the
acquisition of the asset shall be included as part of the cost of the
asset.
Dr Investment in Island Ltd 1 001 500
Cr Cash 1 001 500
30 June 2019
Dr Investment in Island Ltd 200 000
Cr Gain in fair value included within OCI 200 000
There would be a reserve that is part of equity, which would
accumulate the gains that are included within OCI. For equity
instruments, this reserve cannot subsequently be transferred to
profit or loss. ( cannot recognise the gain in profit and loss)
Recognition and measurement of financial
liabilities
• Initially to be measured at fair value
• Most financial liabilities will then—in the
period after initial recognition—be
measured at amortised cost
• However, some financial liabilities shall
be measured at fair value through profit
or loss, for example, some derivatives

Worked Example 14.11—Financial liabilities other
than those measured at fair value
On 1 July 2018, Slater Ltd issued four-year bonds with a total face
value of $100 000 and a coupon interest rate of 10 per cent per
annum, payable annually in arrears. The market interest rate for
Slater’s bonds was 12 per cent and so the company had to
discount the issue price to its fair value of $93 923.
Amortised
Increase in cost of bond
Beginning Interest at bond payable payable
bond Interest 12% (column (column 4 – (column 2 +
payable payment 2 × 12%) column 3) column 5)
Year ended ($) ($) ($) ($) ($)
06/19 93 923 10 000 11 272 1 272 95 195
06/20 95 195 10 000 11 423 1 423 96 618
06/21 96 618 10 000 11 594 1 594 98 212
06/22 98 212 10 000 11 788 1 788 100 000

Worked Example 14.11—Financial liabilities other than
those measured at fair value (cont.)
1 July 2018
Dr Cash 93 293
Cr Bond payable 93 293
(issue of bonds for $93 293—financial instruments shall initially be
measured at fair value)
30 June 2019
Dr Interest expense 11 272
Cr Bond payable 1 272
Cr Bank 10 000
(interest payment and amortisation of bond payable using effective
interest rate of 12 per cent)

Derivative financial
instruments
• Can include:
– futures contracts
– options contracts
– interest rate swaps
– foreign currency swaps
– forward-rate contracts
• To be recognised initially at fair value (AASB 9)
• The value of a derivative is directly related to
another item; for example, a share option derives
its value from the market value of the underlying
shares

Derivatives used within a hedging
arrangement
• Derivatives often used to hedge gains or losses in future in relation to
other assets or liabilities
• Hedge contract
– Arrangement with another party in which that party accepts the
risks associated with changing commodity prices or exchange
rates
• Three principal types of hedges (AASB 9)
1. Fair value hedges
2. Cash flow hedges
3. Hedges of net investments in foreign operations (we will not
be considering these)
• Need to differentiate between hedged item and hedging instrument
• Refer to Worked Example 14.12—Hedging arrangement

arrangement (cont.)
• Fair value hedge
– Used to hedge the value of particular assets or
liabilities
• Cash flow hedge
– Used to hedge a future expected cash flow
• Unless certain requirements are satisfied in terms
of the hedging arrangement (AASB 9):
– any gain or loss on hedging instrument to be taken to
profit or loss as it arises

arrangement (cont.)
• Fair value hedge
– Both the hedged item and the hedging instrument are to be
measured at fair value
– Any gains or losses to be included as part of profit or loss
• Cash flow hedge
– Gain or loss on measuring hedged item at fair value is to be
part of period’s profit or loss
– Gain or loss on hedging instrument initially transferred to equity
(and included as part of ‘other comprehensive income’)
– When the underlying asset is acquired, or the liability settled,
the gain or loss on the hedging instrument is adjusted against
the cost of the asset, or liability
– Thereafter, any gains or losses on the hedging instrument are
transferred to profit or loss to offset gains or losses on hedged
item

Worked Example 14.15—Cash flow hedge of a
highly probable forecast transaction
• Oz Ltd manufactures electric cars.
• On 15 June 2018, Oz Ltd enters into a non-cancellable
purchase commitment with Vegas Ltd for the supply of
batteries, with those batteries to be shipped on 30 June
2018.
• The total contract price was US$2 000 000 and the full
amount was due for payment on 30 August 2018.
• Because of concerns about movements in foreign exchange
rates, on 15 June 2018 Oz Ltd entered into a forward rate
contract on US dollars with a foreign exchange broker so as
to receive US$2 000 000 on 30 August 2018 at a forward
rate of $A1.00 = US$0.80 (meaning A$2 500 000 will be
payable to the foreign currency broker).
• Oz Ltd elects to treat the hedge as a cash flow hedge.

Worked Example 14.15—Cash flow hedge of a highly
probable forecast transaction (cont.)
The respective spot rates, with the spot rates being the exchange
rates for immediate delivery of currencies to be exchanged, are
provided below. The forward rates offered on particular dates, for
delivery of US dollars on 30 August 2018, are also provided.
On 30 August 2018, the last day of the forward rate contract, the
spot rate and the forward rate will be the same.
Forward rates for 30 August
Date Spot rate delivery of US$
15 June 2018 $A1.00 = US$0.83 $A1.00 = US$0.80
30 June 2018 $A1.00 = US$0.81 $A1.00 = US$0.78
30 Aug. 2018 $A1.00 = US$0.76 $A1.00 = US$0.76

Given this has been designated as a cash flow hedge, and it has
also been assumed that the hedge is ‘effective’, then any gains or
losses on the hedging instrument shall initially be recognised in
equity (and therefore in ‘other comprehensive income’) and then
ultimately transferred to the cost of inventory.
Gains/Losses on the hedged item (the accounts payable) are
calculated as follows:
Amount payable Foreign exchange
Date Spot rate in $A gain/(loss)
15 June 2018 $A1.00 = US$0.83 –
30 June 2018 $A1.00 = US$0.81 $2 469 136
30 Aug. 2018 $A1.00 = US$0.76 $2 631 579 (162 443)

Gains/Losses on the hedging instrument (the forward rate

contract) are calculated as follows:
Date Fwd rate for Receivable on Amount payable Fair value

Gain/(loss) on
delivery of US$ fwd contract in A$ on forward. of forward
forward
on 30 Aug 2018 contract contract
contract
15/6/2018 $A1.00 = US$0.80 $2 500 000 $2 500 000 0
30/6/2018 $A1.00 = US$0.78 $2 564 103 $2 500 000 $64 103
$64 103
30/8/2018 $A1.00 = US$0.76 $2 631 579 $2 500 000 $131 579
$67 476
$131 579

30 June 2018
Dr Forward rate contract (financial asset) 64 103
Cr Gain recorded in equity (other comprehensive income) 64 103
Dr Inventory 2 469 136

Cr Foreign currency payable 2 469 136
Dr Cash flow hedge reserve (other comprehensive income) 64 103

Cr Inventory 64 103
Following the date of acquisition of the inventory all gains and losses on
the forward rate contract and the foreign currency payable with the
supplier are transferred directly to profit or loss just as they would be for a
fair value hedge.

30 August 2018
Dr Forward rate contract (financial asset) 64 476
Cr Foreign exchange gain 64 476
Dr Foreign exchange loss 162 443

Cr Foreign currency payable 162 443
Dr Cash at bank 131 579

Cr Forward rate contract 131 579
Dr Foreign currency payable 2 631 579

Cr Cash at bank 2 631 579
(This represents the amount paid to the overseas battery supplier. As we
can see from the above two entries, the net amount paid for the batteries
was $2 500 000 (which is $2 631 579 – $131 579), which equates to the
amount negotiated in the forward rate contract)

Futures contracts
• A contract to buy or sell an agreed quantity of a
particular item, at an agreed price, on a specific date
• Buy or sell price determined on date contract entered
into
• Financial futures currently traded
– 90-day bank bill futures
– 3-year bond futures
– 10-year bond futures
– share price index futures (SPI futures)
– futures for shares in specific companies
• Huge losses (or gains) can be made on the futures
market

Futures contracts (cont.)
• Share price index (SPI) futures
– Based on, for example, market prices of top 200
companies and on performance of top 50 companies
– Directly related to the All Ordinaries SPI
– May be used for hedging purposes or speculation
• Refer to Worked Example 14.18

Journal entries for SPI futures
(assuming share market is ‘falling’)
• To make a percentage deposit with a futures broker
Debit Deposit on SPI futures x
Credit Cash at bank x
• To ‘mark to market’ the value of the organisation’s share
portfolio
Debit Loss on share portfolio x
Credit Share portfolio x
• To credit gains to the initial deposit held by the futures broker
Debit Deposit held by broker x
Credit Gain on futures contract x

Journal entries for SPI futures (cont.)
If shares are sold and futures contract is closed out

Debit Cash x
Debit Loss on share portfolio x
Credit Share portfolio x
Debit Deposit held by broker x

Credit Gain on futures contract x
Debit Cash at bank x

Credit Deposit held by broker x

Options
• Put options
– Give their holder the right to sell an asset, at a
specified exercise price, on or before a specified date
– Value of option depends on market price of underlying
security
• Call options
– Give their holder the right to buy an asset, at a
specified exercise price, on or before a specified date

Options (cont.)
• Exercise price
– The price the option holder will pay to buy a
company’s shares
• Once the exercise price is determined, it remains
fixed, regardless of variations in the market price
of shares
• When an option is acquired on the ASX, an
amount is paid for it
• The holder of the option has the right to exercise
the option, but typically does not have to do so
• Options are to be measured at fair value, with
changes included as part of profit or loss

Journal entries for options
• Refer to Worked Example 14.20—Valuation of options at
net market price
• To record investment in share options
Debit Investment in share options x
Credit Cash at bank x
• To value share options at fair value

Debit Investment in share options x
Credit Profit on share options x

Compound instruments
• Contain both a financial liability and an equity
component
• Include convertible bonds
• AASB 132 requires:
– equity component to be fair value of the whole
instrument less fair value of the liability component.
That is, the equity component is the residual measure

Worked Example 14.23—Accounting for compound
instruments
Grommett Ltd issues $10 million of convertible bonds on 1 July 2018. The
bonds have a life of four years and a face value of $10.00 each, and they
offer interest, payable at the end of each financial year, at a rate of 6 per
cent per annum. The bonds are issued at their face value and each bond
can be converted into one ordinary share in Grommett Ltd at any time in
the next four years. Organisations of a similar risk profile have recently
issued debt with similar terms, without the option for conversion, at a rate
of 8 per cent per annum.
REQUIRED
(a) Identify the present value of the bonds and, allocating the difference
between the present value and the issue price to the equity component,
provide the appropriate accounting entries.
(b) Calculate the stream of interest expenses across the four years of the
life of the bonds.
(c) Provide the accounting entries if the holders of the options elect to
convert the options to ordinary shares at the end of the third year of the
bonds.

instruments (cont.)
We can identify the present value of the bonds and then allocate to
the equity component the difference between the present value of
these bonds and the issue price of $10 million. In determining the
present value, we will use the rate of 8 per cent, which is the rate of
interest paid on debt of a similar nature and risk that does not provide
an option to convert the liability to ordinary shares.
Present value of bonds at the market rate of debt
Present value of principal to be received in four years discounted at 8 per
cent
$10 000 000 × 0.735 03 = $7 350 300
Present value of interest stream discounted at 8 per cent
$600 000 × 3.312 113 = $1 987 268
Total present value $9 337 568
Equity component $662 432
Total face value of convertible bonds $10 000 000

instruments (cont.)
The accounting entries could therefore be:
1 July 2018
Dr Cash at bank 10 000 000
Cr Convertible bonds (liability) 9 337 568
Cr Convertible bonds (equity component) 662 432
(to record the issue of the convertible bonds and the recognition of the
liability and equity components—the equity component in this case
would be $662 432)
30 June 2019
Cr Cash 600 000
Cr Convertible bonds (liability) 147 005
(to recognise the interest expense, where the expense equals the
present value of the opening liability multiplied by the market rate of
interest; see table that follows)

instruments (cont.)
Date Payment Interest Increase in Bond
expense bond liability
liability
1 July 2018 9 337 568
30 June 2019 600 000 747 005 147 005 9 484 573
30 June 2020 600 000 758 766 158 766 9 643 339
30 June 2021 600 000 771 467 171 467 9 814 806
30 June 2022 600 000 785 194 185 194 10 000 000

instruments (cont.)
If the holders elect to convert the options to ordinary shares at the

end of the third year of the debentures (after receiving their
interest payments), the entries in the third year would be:
30 June 2021
Cr Cash 600 000
Cr Convertible bonds (liability) 171 467
(to recognise interest expense for the period)
Dr Convertible bonds liability 9 814 806
Dr Convertible bonds (equity component) 662 432
Cr Share capital 10 477 238
(to recognise the conversion of the bonds into shares of Grommett
Ltd)


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Chapter 14

Accounting for financial

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• Central to the definition of a liability is whether or not a

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• According to AASB 9 (effective date 1st Jan 2018):

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• According to AASB 9, a financial asset shall be subsequently

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On 1 July 2018, Jack Ltd acquired some corporate bonds issued by

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Present value of interest stream of four payments of $100 000

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(d) 1 July 2018

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For debt instruments measured at fair value through OCI:

For equity instruments measured at fair value through OCI:

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Gains/Losses on the hedging instrument (the forward rate

Date Fwd rate for Receivable on Amount payable Fair value

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Dr Inventory 2 469 136

Dr Cash flow hedge reserve (other comprehensive income) 64 103

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Dr Foreign exchange loss 162 443

Dr Cash at bank 131 579

Dr Foreign currency payable 2 631 579

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If shares are sold and futures contract is closed out

Debit Deposit held by broker x

Debit Cash at bank x

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• To value share options at fair value