Topic 6

Financial Instruments

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Financial
Instruments

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IAS 32 Definitions

Definition of a financial instrument

A contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another

Primary instruments Derivatives

E.g. E.g. option to buy steel, forward

• receivables/payables, contract to sell currency
• debt investments/loan liability,
equity investments/equity

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Financial Asset Definition

Cash

Equity investment

Financial Contractual right to receive cash or another financial

asset asset

Contractual right to exchange financial instruments

under potentially favourable conditions

Contract that will or may be settled by receipt of the

entity's own equity instruments

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Financial Liability and Equity Definitions

Financial liability Equity

Contractual obligation to deliver Contract that evidences a

cash or another financial asset residual interest in the assets of
an entity after deducting its
Contractual obligation to liabilities
exchange financial instruments
under potentially unfavourable
conditions
In FR:
Some contracts that will/may be Preference
• Redeemable is liability
settled by delivery of entity’s shares?
• Irredeemable is equity
own equity instruments
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 Settlement in Own Equity Instruments
E.g. a company issues convertible debt (the lender may require repayment in cash
in the future or may choose to receive equity shares of the borrower instead)

Are the amount of debt AND the amount of No

Financial liability
shares that it may be convertible into both fixed
(ex-syllabus)
amounts?
Yes

Compound instrument

Account for separately:

̶ Debt element measured at PV future cash flows ignoring conversion
̶ Equity element is balance
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Activity: Compound Instrument

Calculated the initial measurement at 1 January 20X1 of:

- the liability component
- the equity component

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 Answer to Activity: Compound Instrument

Liability, therefore
equity is $10m –
$9.229m =
$771,000

Dr Bank 10,000,000 Subsequently measured using effective

Cr Liability 9,229,000 interest method
Cr Equity 771,000
Subsequently not remeasured
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Effective Interest Method

Liability in
SOFP

Finance cost in
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SOPL
Maturity of Compound Instrument

At 31 December X3:
• Liability balance $10m
• Equity balance $771,000

Redeem for cash Convert to shares

DR Liability $10m
CR Bank $10m DR Liability $10m
DR Equity $771,000
Equity balance remains CR Share capital/
but can be transferred share premium
to a different account $10,771,000
e.g. retained earnings

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Further IAS 32 Issues

Financial assets and liabilities are only

offset if: • If instrument is liability:
recognise interest, dividends
1. There is a legal right of set off that and gains or losses on
can be exercised immediately by remeasurement in P/L
either party, and
2. The entity intends to settle on a net • If instrument is equity:
basis or realise the asset/settle the recognise dividends in equity
liability simultaneously

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IFRS 9 Recognition Criteria

An entity recognises a financial asset or liability when and only when

the entity becomes party to the contractual provisions of the instrument

Initial Subsequent
Classify Derecognition
measurement accounting

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Classification of Financial Assets

Contractual terms give rise on specific dates to

cash flows that are solely payments of principal
and interest (SPPI) on the principal outstanding
Otherwise
Held within business Held within business
model to collect cash model to collect cash
flows flows and sell assets

Fair value through OCI Fair value through P/L

Amortised cost
(FVTOCI) (FVTPL)

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Activity: Classification of Financial Assets

Considering the classification criteria, how should the following be classified?

1. An investment in equity shares

2. An investment in loan notes intended to be held to maturity
3. An investment in loan notes held for trading and expected to be sold in the
short term
4. An investment in equity shares intended to be held for the long term rather
than to be traded

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Answer to Activity: Classification
1. An investment in equity shares FVTPL
2. An investment in loan notes intended to be held to maturity Amortised
cost
3. An investment in loan notes held for trading and expected to be sold in
the short term FVTPL
4. An investment in equity shares intended to be held for the long term
rather than to be traded FVTPL but can elect to hold at FVTOCI
(at initial recognition only if shares not held for trading)

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Initial Measurement

Classification

Amortised cost FVTOCI FVTPL

Initially measured
Initially measured at fair value + transaction at fair value
costs (transaction costs
in P/L)

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Activity: Measurement at Amortised cost

On 1 January 20X1 Ocean Co acquires $10m loan stock in another

company, receiving interest at 5% at the end of each year. The loan
stock will be redeemed at a premium at 31 December 20X3 and the
effective interest rate is 8.08%.

Calculate amounts to be recognised in Ocean Co’s financial statements

in each of the years ended 31 December 20X1, 20X2 and 20X2
assuming that the loan is measured at amortised cost.

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Answer to Activity: Amortised Cost

($000) B/f Finance Interest C/f

income received 5%
8.08%
20X1 10,000 808 (500) 10,308
20X2 10,200 833 (500) 10,641
20X3 10,416 859 (500) 11,000
(11,000) = 0
20X1 SOFP: Financial asset $10,308,000
SOPL: Finance income $808,000
20X2 SOFP: Financial asset $10,641,000
SOPL: Finance income $833,000
20X3 SOFP: Financial asset $0
SOPL: Finance income $808,000
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 Example: FVTOCI

• FV at 31 December 20X1: $10,300,000

• FV at 31 December 20X2: $10,690,000

($000) B/f Finance Interest C/f OCI to OCI FV

income rec’ble date
8.08% 6%
20X1 10,000 808 (500) 10,308 (8) 10,300
20X2 10,200 833 (500) 10,641 (8) 57 10,690
20X3 10,416 859 (500) 11,000

To SOPL To OCI SOFP

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Impairment of Financial Assets (Credit Losses)

• Amortised cost (inc receivables)

• Debt at FVTOCI

Stage 1 – Stage 2 – Stage 3 –

credit risk not credit risk objective
Initial recognition
increased has increased evidence of
significantly significantly impairment

Recognise 12-month credit losses Recognise lifetime credit losses

(expected lifetime losses from (expected lifetime losses from
default within 12 months) default at any time in life)

Recognise in SOPL © ACCA 20

Simplified Approach to Credit Losses

Dr SOPL 16,263
Cr Receivables 16,263
Record change in subsequent years
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Derecognition of Financial Assets
Derecognise when:

Contractual rights to cash flows Substantially all risks and rewards

expire (settlement/lapse/ or
transferred to another party
cancellation)

1. Remeasure asset at date of derecognition

2. Dr Bank X
Cr Financial asset X
Dr/Cr P/L X
3. If asset was debt at FVTOCI reclassify OCI to P/L

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Example: Transfer of Risks and Rewards

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Real world example

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Financial Liabilities – Classification and Initial
Measurement

FVTPL Amortised cost

Financial liabilities held for trading or All other financial liabilities

designated to avoid accounting
mismatch Initially measure at FV less
Initially measure at FV transaction costs
Subsequently:
• Finance cost to P/L Subsequently apply effective
• FV gains/losses to P/L interest method

Derecognise when discharged, cancelled or expires

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Summary
▪ A financial instrument results in a financial asset for one entity and a financial
liability for another
▪ A financial liability is distinguished from equity by a contractual obligation to
deliver cash
▪ A compound instrument has two elements: debt and equity
▪ A financial asset is classified depending on whether it meets cash flow and
business model tests as at:
̶ amortised cost
̶ fair value through OCI
̶ fair value through P/L
▪ Expected future credit losses are recognised as an impairment loss for
financial assets at amortised cost and FVTOCI
▪ Financial liabilities are measured at amortised cost or FVTPL.
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Thank you

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