FINANCIAL INSTRUMENTS

Study Notes Summary — Week 1: Identification & Classification

Based on IFRS 9 (Financial Instruments) & IAS 32 (Presentation)

1. Big Picture — How the Topic Flows

Think of this topic as a funnel: you start broad (what even counts as a financial instrument?) and narrow
down step by step until you know exactly how to classify and treat it.

💡 The 4-Step Flow

1. IDENTIFY → Is this even a financial instrument?
2. SCOPE → Does IFRS 9 / IAS 32 actually apply to it (or is it excluded)?
3. CLASSIFY → Is it an asset, liability, or equity? (and for assets — which measurement category?)
4. SPECIAL CASES → Is it a compound instrument (part debt, part equity) or does it contain a
derivative?

The key focus areas examiners test are: Classification, Measurement, Impairment, and Derivatives. This
summary focuses on Week 1: Identification and Classification.

2. What IS a Financial Instrument? (IAS 32 §11)

Definition (simplified):
• A financial instrument is ANY contract that creates:
◦ a financial ASSET for one party, AND
◦ a financial LIABILITY or EQUITY instrument for the other party.

💡 Simple Example
You lend your friend R1,000 and they sign an IOU promising to pay it back with interest.
→ For YOU: it's a financial asset (a contractual right to receive cash).
→ For your FRIEND: it's a financial liability (a contractual obligation to pay cash).
→ Together, this IOU contract is a financial instrument.
Two things must always be true:
• It must arise from a CONTRACT (not just a legal obligation like tax payable, which is imposed by law,
not agreed by contract).
• It must create rights/obligations for TWO DIFFERENT parties.

2.1 What's Excluded from IFRS 9's Scope? (IFRS 9 §2.1)

Even though something might look like a financial instrument, some items are dealt with under other
standards, so IFRS 9 doesn't apply to them:
• Interests in subsidiaries, associates & joint ventures (rather IAS 27 / IAS 28)
• Employee benefit obligations (rather IAS 19)
• Contingent consideration in a business combination (rather IFRS 3)
• Insurance contracts (rather IFRS 17)
• Share-based payments, e.g. share options given to staff (rather IFRS 2)
• Rights/obligations under revenue contracts (rather IFRS 15)
• Lease contracts (rather IFRS 16)

💡 Why this matters

If a question gives you a lease agreement and asks 'is this a financial instrument under IFRS 9?' — the
answer is NO, because leases are scoped out and covered by IFRS 16 instead.

2.2 The 3-Step Identification Process

Step Question to Ask

Step 1 Does the contract meet the definition of a
financial instrument, and specifically a
financial asset or liability?
Step 2 Is the contract specifically included in, or
excluded from, the scope of IAS 32 & IFRS 9?
Step 3 Is the contract partially or fully brought back
into scope because of embedded derivatives
or hedging provisions?
3. Financial Asset vs Financial Liability vs Equity

This is the heart of IAS 32. Every contract needs to be tested to see which 'bucket' it falls into.

3.1 Financial Asset — Simple Definition

A financial asset is any of the following:
• Cash itself
• An equity instrument of ANOTHER entity (e.g. shares you hold in another company)
• A contractual RIGHT to receive cash or another financial asset from someone else
• A contractual right to exchange financial instruments under favourable conditions

💡 Example
A company holds a bond issued by the government. The bond gives the company the right to receive
interest and the capital back.
→ This is a financial ASSET in the company's books (a right to receive cash).

3.2 Financial Liability — The 'Obligation Test'

A financial liability is a contractual OBLIGATION to:
• Deliver cash or another financial asset to someone else, OR
• Exchange financial instruments under conditions that are unfavourable to you

💡 Example
A company borrows R500,000 from a bank and must repay it with interest.
→ This is a financial LIABILITY (an obligation to pay cash in future).

3.3 Equity Instrument — The 'Residual' Definition

An equity instrument is a contract that shows a residual interest in the net assets of an entity, after
deducting all its liabilities. In plain terms:

💡 Think of it like this

Assets − Liabilities = Equity
Equity is basically 'what's left over' once all debts are paid — that's why ordinary shares (which have
no fixed repayment obligation) are equity.
3.4 The 'Own Shares' Test (for contracts settled in a company's own shares)

Sometimes a contract will be settled using the company's OWN shares rather than cash. To decide if
that's a liability or equity,
ask:
- is the NUMBER of shares fixed, and
- is the amount being exchanged for them fixed?

Scenario Classification

Fixed amount of cash exchanged for a FIXED number of own EQUITY

shares

A VARIABLE number of shares will be delivered (e.g. shares LIABILITY

worth a fixed Rand value)

A derivative settled other than by 'fixed-for-fixed' exchange LIABILITY

💡 Example
Company A agrees to deliver shares worth exactly R100,000
(however many shares that takes) in one year's time.
→ Because the NUMBER of shares can vary depending on the
share price, this fails the 'fixed-for-fixed' test.
→ Classified as a financial LIABILITY, not equity.

4. Classification of Financial Assets (IFRS 9)

Once you know something IS a financial asset, IFRS 9 tells you how to measure it going forward. There
are 3 categories:

Category Meaning
Amortised Cost Held to collect contractual cash flows only
(like a normal loan you intend to keep to
maturity)
Fair Value through OCI (FVTOCI) Held to both collect cash flows AND sell if
needed
Fair Value through Profit or Loss (FVTPL) Everything else — e.g. held for trading, or
equity investments by default

To decide which category applies, you run TWO tests:

4.1 Test 1 — The SPPI Test (Cash Flow Characteristics)

SPPI = Solely Payments of Principal and Interest.
Ask: do the cash flows from this asset represent ONLY repayment of the amount lent (principal) plus a
return for time value of money and credit risk (interest)?
• If YES → cash flows are 'basic lending' cash flows → eligible for Amortised Cost or FVTOCI
• If NO → there's some other risk/return built in (e.g. linked to equity growth or commodity prices) →
automatically FVTPL

💡 Example
A government bond pays a fixed 11% interest (compensating for time value of money and credit risk)
and repays the capital at maturity.
→ Passes the SPPI test (it's basic principal + interest).

4.2 Test 2 — The Business Model Test

Ask: WHY does the company hold this asset? What's management's intention?

Business Model Result (if SPPI also passes)

Hold to collect cash flows only Amortised Cost
Hold to collect cash flows AND sell FVTOCI
Other (e.g. trading, held to profit from price FVTPL
changes)
Clues to determine the business model include: how often the company sells these assets, why it sells
them, and how management's performance is measured/rewarded (e.g. bonuses based on fair value
gains suggest a trading business model).

4.3 Putting It Together — Decision Logic

 💡 Ask in this order
1. Are cash flows SOLELY principal + interest (SPPI)? → If NO: straight to FVTPL.
2. If YES → What's the business model?
• Hold only to collect → Amortised Cost
• Hold to collect AND sell → FVTOCI
• Neither (e.g. trading) → FVTPL
3. SPECIAL RULE: a company MAY still elect FVTPL at initial recognition if it removes an accounting
mismatch.
4. SPECIAL RULE for EQUITY investments not held for trading: the company MAY elect FVTOCI
instead of the default FVTPL.

4.4 Worked Example — IntelX (from class notes)

Investment Key Facts Classification & Why

PPS Unit Trust (R238,565) Returns are purely equity FVTPL — fails SPPI test
growth of the unit trust because returns are equity-
style growth, not principal +
interest
SA Government Bonds Market-related 11% interest Amortised Cost — passes SPPI
(R400,500) (incl. credit risk); held to collect (interest only compensates for
cash flows over the bond's life time value & credit risk) AND
business model is 'hold to
collect'
Investment in Curro Ltd Equity investment, NOT held Can ELECT FVTOCI (instead of
(R25,334) for trading, held for long-term the default FVTPL) since it's an
growth equity investment not held for
trading

4.5 Financial Liability Classification (much simpler)

Unlike assets, liabilities are almost always measured at Amortised Cost.
The exception is Fair Value through Profit or Loss (FVTPL), which applies only if:
• The liability is a derivative, OR
• It's designated as FVTPL because it removes an accounting mismatch, OR
• The whole group of liabilities is managed and evaluated on a fair value basis
Important: liabilities can NEVER be reclassified once designated, whereas certain financial assets CAN be
reclassified — but only if the entity changes its business model (this is rare and tested through discussion
questions, not calculations).
5. Debt vs Equity — IAS 32 in Depth

This section matters whenever a company raises capital by issuing shares, bonds, debentures, or
preference shares. The big question every time cash comes in is:

💡 The Core Question

Dr Bank R1,000,000
Cr ????? (Debt / Equity / Compound?)
IAS 32 gives you the rules to decide what goes on the credit side.

5.1 The 3-Step Process

Step What to Do
Step 1 Separate the contract into its components
(e.g. interest payments vs. the
capital/maturity payment vs. any option to
convert to shares)
Step 2 For each component, work out if it
represents a cash flow obligation, or a right
to equity
Step 3 Apply the financial liability test to each part.
If a part does NOT meet the liability
definition, it's equity by default

Golden Rule: an instrument (or component) is only EQUITY if it meets NEITHER the 'contractual
obligation' test NOR the 'own equity' test used to define a liability.

5.2 Test A — The Contractual Obligation Test

Ask: does the issuer have a contractual OBLIGATION to:
• Deliver cash or another financial asset? OR
• Exchange instruments on terms unfavourable to the issuer?

💡 Key Phrase to Look For

'Directors may authorise payment' = NO obligation (discretionary) → points to equity
'Must be repaid on X date' = YES, obligation exists → points to liability
5.3 Test B — The 'Own Equity' / Fixed-for-Fixed Test
If settlement happens in the company's OWN shares rather than cash, check whether it's 'fixed-for-
fixed':
• Non-derivative: settled by delivering a VARIABLE number of own shares → LIABILITY
• Non-derivative: settled by delivering a FIXED number of own shares → EQUITY
• Derivative: only equity if a FIXED amount of cash is exchanged for a FIXED number of shares (both
sides must be fixed)

5.4 Common Liability-Triggering Examples (IAS 32 §19 & §21)

• A contract to deliver shares equal to a FIXED MONETARY VALUE (e.g. 'shares worth R50,000') →
LIABILITY (number of shares varies)
• A contract to deliver shares equal to the value of a commodity or another financial instrument →
LIABILITY
• A contract obliging the company to buy back its OWN shares for cash → LIABILITY
• A FIXED number of own shares exchanged for a VARIABLE amount of cash → LIABILITY

5.5 Contingent Settlement Provisions (IAS 32 §25)

Sometimes settlement depends on an uncertain future event outside the company's control (e.g.
'preference shares are redeemed for cash IF the exchange rate exceeds R14/$'). Such an instrument can
ONLY be equity if:
• The cash-settlement scenario is NOT genuine (i.e. extremely unlikely to occur), OR
• Cash settlement would only happen if the company is liquidated

💡 Why this rule exists

Without it, companies could dress up debt as equity simply by attaching a far-fetched condition to the
repayment clause. IAS 32 closes that loophole.

6. Worked Examples — Debt, Equity & Compound Instruments

These examples all use the SAME method: work out the PRESENT VALUE of any cash flows the company
has an unavoidable obligation to pay (that's the liability component); whatever's left over of the
proceeds received is the equity component.

Example 1 — Simple Redeemable Preference Shares

Facts: ABC Ltd issues redeemable preference shares for R150,000. Dividends (9%) are paid only if
directors approve. Capital must be repaid after 5 years. Market rate = 10%.
• Principal: MUST be repaid → no discretion → this is a LIABILITY obligation
• Dividends: fully discretionary (directors decide) → NOT an obligation → EQUITY component
• Result: Compound instrument. Liability = PV of the R150,000 capital repayment discounted at 10%
for 5 years = R93,138. Equity = R150,000 − R93,138 = R56,862.
Example 2 — Preference Shares with a Guaranteed Minimum Dividend
Facts: ZET Ltd issues preference shares for R180,000. Dividends = guaranteed minimum 8% PLUS a
discretionary bonus of 3%. Capital repayable after 5 years at 10% market rate.
• Principal: must be repaid → LIABILITY
• Guaranteed 8% dividend: NOT discretionary (must be paid) → LIABILITY
• Bonus 3%: discretionary → EQUITY
• Result: Compound instrument. Liability = PV of R180,000 capital + R14,400/year (8% guaranteed) at
10% for 5 years = R166,353. Equity (the discretionary bonus right) = R180,000 − R166,353 = R13,647.

Example 3 — Mandatorily Convertible Bonds

Facts: XYZ Ltd issues 2,000 bonds at R1,000 each (R2,000,000 total), 6% annual interest, 3-year term.
Each bond MUST convert into 250 ordinary shares at maturity (no cash repayment option). Market rate
= 9%.
• Principal: NOT repaid in cash — it's mandatorily settled in a FIXED number of shares → passes the
'fixed-for-fixed' test → EQUITY
• Interest (6% cash coupon): this IS a cash obligation the company cannot avoid → LIABILITY
• Result: Compound instrument. Liability = PV of the interest payments only (R120,000/year for 3
years, discounted at 9%, no capital cash flow since it converts to shares) = R303,755. Equity =
R2,000,000 − R303,755 = R1,696,245.

💡 Pattern to remember across all 3 examples

Whatever the company can be FORCED to pay in cash = Liability (measured at present value using the
market rate).
Whatever is discretionary, OR settled by a fixed number of own shares = Equity (the plug/balancing
figure).
7. Quick-Reference Revision Questions

• 1. What is a financial instrument? — Any contract creating a financial asset for one party and a
liability/equity for another.
• 2. How do you classify a financial instrument? — Test against the asset/liability/equity definitions,
then (for assets) apply the SPPI + Business Model tests.
• 3. How do you identify a derivative? — (Covered in Week 2 — measurement of derivatives)
• 4. How do you identify an embedded derivative? — (Covered in Week 2)

8. Recommended Study Roadmap

Step Activity Approx. Time

1 Work through the slides for a —
basic understanding of IFRS 9
& IAS 32
2 Work through the class 180 min
examples
3 Read the prescribed 30 min
paragraphs of IFRS 9 & IAS 32
in the standard's own
language
4 Build your own one-page 'Big 30 min
Picture' summary
5 Attempt question bank 120 min
questions under exam
conditions