Financial Instruments

(IAS32, IFRS9, IFRS7)

Chapter 6
 Overview
• Definitions
• Examples of financial instruments
• Classification of financial instruments
• Compound financial instruments
• Recognition and initial measurement
• Subsequent measurement:
– financial assets
– the effective interest method
– financial liabilities
• Disclosure requirements
 Definitions (IAS32)
• 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"
• A financial asset is "any asset that is … cash… or … an
equity instrument of another entity… or … a contractual
right to receive cash …"
• A financial liability is "any liability that is … a
contractual obligation … to deliver cash …"
• An equity instrument is "any contract that evidences a
residual interest in the assets of an entity after
deducting all of its liabilities"
 Examples of financial instruments
• Financial instruments include contracts relating to:
– the issue of shares
– the making of loans
– trade receivables and payables
• Financial instruments also include more complex
arrangements such as:
– convertible debt
– perpetual instruments
– derivatives
– hedging instruments
– interest swaps etc…
IAS32 Financial Instruments: Presentation

The objective of IAS32 is "to establish

principles for presenting financial instruments
as liabilities or equity"

IAS32 takes a substance over form approach to distinguishing

between liabilities and equity.
 Classification of financial instruments
• "The issuer of a financial instrument shall classify the
instrument … in accordance with the substance of the
contractual arrangement …"
• A financial instrument is an equity instrument if and
only if "the instrument includes no contractual
obligation … to deliver cash or another financial asset
…"

Redeemable preference shares are classified as liabilities and dividends paid

to the holders of such shares are classified as expenses.
 Compound financial instruments
• Compound financial instruments are those which
contain both a liability component and an equity
component.
• IAS32 requires that compound financial instruments
should be separated into their two components and
that each of these components should then be
recognised separately, one as a financial liability and
the other as equity.

Loan stock that is convertible to ordinary shares at

the option of the lender is an example of a
compound financial instrument.
 Treatment of interest and
dividends payable
• Interest and dividends which relate to a financial
liability should normally be recognised as an
expense when calculating profit or loss.
• Distributions to holders of an equity instrument
should be debited directly to equity.
• If dividends are classified as an expense, they
should be presented in the statement of
comprehensive income either with interest payable
or as a separate item.
 IFRS9 Financial Instruments
• IFRS9 establishes principles for recognising and
measuring financial assets and financial liabilities.
• Recognition is concerned with determining when a
financial asset or liability should be shown in the
statement of financial position.
• Measurement is concerned with the amount at
which financial assets and liabilities should be
shown (initially and subsequently).
 Recognition of financial assets
and liabilities
Financial assets and financial liabilities arising in
consequence of a financial instrument should be
recognised only when the entity "becomes party
to the contractual provisions of the instrument".
Recognition occurs when the contractual
arrangements become binding.
 Measurement of
financial assets and liabilities
Initial measurement:
• Financial assets and liabilities are recognised initially
at their fair value.
• This is equal to the value of the consideration which
was given when the asset was acquired (or received
when the liability was incurred).
Subsequent measurement:
• The amount at which a financial asset or liability is
measured subsequently depends upon the type of
that asset or liability.
 Types of financial asset
IFRS9 classifies financial assets into:
• financial assets at amortised cost
• financial assets at fair value though OCI
• financial assets at fair value through profit or loss.

After initial recognition, a financial asset is normally measured at amortised

cost (using the effective interest method) if the contractual terms of the asset
give rise on specified dates to cash flows that are solely payments of
principal and interest.
 The effective interest method
• The "amortised cost" of a financial asset is equal to the
amount at which the asset was initially recognised, plus the
amount of interest earned to date, minus any repayments
received to date.
• The "effective interest method" calculates the amount of
interest earned to date using an interest rate that exactly
discounts estimated future cash receipts to the initial
carrying amount of the asset.
• The calculation takes into account not only interest
receivable, but also items such as premiums and discounts.

Trade receivables may be measured at the original invoice amount if

the effect of discounting is not material.
 Subsequent measurement of
financial liabilities
• Most financial liabilities are measured at amortised
cost using the effective interest method.
• But financial liabilities at fair value through profit or
loss (i.e. financial liabilities held for trading) are
measured at fair value. Gains or losses are usually
recognised in the calculation of profit or loss for the
period in which they arise.

Trade payables may be measured at the original invoice amount if the effect
of discounting is not material.
 IFRS7 Financial Instruments: Disclosures
• IFRS7 requires many detailed disclosures relating to
financial instruments.
• The main purpose of these disclosures is to enable
users to evaluate the significance of financial
instruments for the entity's financial position and
performance.
• Disclosures are also required which will enable users
to evaluate the nature and extent of any risk related to
financial instruments.