IAS 32 Financial Instruments: Presentation
IFRS 7 Financial Instruments: Disclosures
IFRS 9 Financial Instruments
FINANCIAL INSTRUMENT
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' (IAS 32, para 11).
A financial asset is any asset that is:
• 'cash
• an equity instrument of another entity
• a contractual right to receive cash or another financial asset from
another entity
• a contractual right to exchange financial instruments with another
entity under conditions that are potentially favorable to the entity
• a non-derivative contract for which the entity is or may be obliged
to receive a variable number of the entity's own equity
instruments' (IAS 32).
A financial liability is any liability that is a:
• contractual obligation to deliver cash or another financial asset to
another entity
• contractual obligation to exchange financial instruments with
another entity under conditions that are potentially unfavorable.
• a non-derivative contract for which the entity is or may be obliged
to deliver a variable number of the entity’s own equity
instruments.' (IAS 32).
An equity instrument is 'any contract that evidences a residual
interest in the assets of an entity after deducting all of its liabilities'
(IAS 32).
Financial liability
At initial recognition, financial liabilities are measured at fair value.
• If the financial liability will be held at fair value through profit
or loss, transaction costs should be expensed to the statement
of profit or loss
• If the financial liability will not be held at fair value through
profit or loss, transaction costs should be deducted from its
carrying amount.
The subsequent treatment of a financial liability is that they can be
measured at either:
• amortised cost
• fair value through profit or loss
At Amortised is calculated thus:
1. amount initially recognized as a liability (initial cost) plus
2. interest expense recognized (using the effective rate) less
3. interest actually paid (cash paid)
Illustration
On 1 January 20X1 James issued a loan note with a N50,000 nominal
value. It was issued at a discount of 16% of nominal value. The costs
of issue were N2,000. Interest of 5% of the nominal value is payable
annually in arrears. The bond must be redeemed on 1 January 20X6
(after 5 years) at a premium of N4,611. The effective rate of interest is
12% per year.
Required: How will this be reported in the financial statements of
James over the period to redemption?
SOLUTION
The liability will be initially recognised at the net proceeds received:
$
Face valuE 50,000
Less: 16% discount (8,000)
Less: Issue costs (2,000)
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Initial recognition of liability 40,000
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The liability is then measured at amortised cost:
Year Opening balance Finance cost (Liability × 12%) Cash payments ($50,000 × 5%) Closing balance
N N N N
1 40,000 4,800 (2,500) 42,300
2 42,300 5,076 (2,500) 44,876
3 44,876 5,385 (2,500) 47,761
4 47,761 5,731 (2,500) 50,992
5 50,992 6,119 (2,500) 54,611
27,111 (12,500)
To: Profit or loss To: Statement of cash flows To: SOFP
According to the above working, the total cost of the loan over the five
year period is $27,111.
This is made up as follows:
Repayments: N N
Capital 50,000
Premium 4,611
54,611
Interest ($50,000 × 5% × 5 years) 12,500
67,111
Cash received (40,000)
Total finance cost 27,111
The finance charge taken to profit or loss in each year is greater than
the actual interest paid. This means that the value of the liability
increases over the life of the instrument until it equals the redemption
value at the end of its term.
FAIR VALUE THROUGH PROFIT OR LOSS
On 1 January 20X1, McGrath issued a financial liability for its nominal
value of $10 million. Interest is payable at a rate of 5% in arrears. The
liability is repayable on 31 December 20X3. McGrath trades financial
liabilities in the short-term. At 31 December 20X1, market rates of
interest have risen to 10%.
Required: Discuss the accounting treatment of the liability at 31
December 20X1
SOLUTION
The financial liability is traded in the short-term and so is measured at
fair value through profit or loss. The liability must be remeasured to fair
value at the reporting date. Assuming that the fair value of the liability
cannot be observed from an active market, it can be calculated by
discounting the future cash flows at a market rate of interest. The fair
value of the liability at the year-end is $9.13 million. The following
adjustment is required:
Date Cash flow ($m) Discount rate Present value ($m)
31/12/X2 0.5* 1/1.1 0.45
31/12/X3 10.5 1/1.12 8.68
9.13
The interest payments are $10m × 5% = $0.5m
Dr Liability ($10m – $9.13m) $0.87m
Cr Profit or loss $0.87m
COMPOUND INSTRUMENT
A compound instrument is a financial instrument that has
characteristics of both equity and liabilities. An example would be debt
that can be redeemed either in cash or in a fixed number of equity
shares. Presentation of compound instruments IAS 32 requires
compound financial instruments be split into two components:
• a financial liability (the liability to repay the debt holder in cash)
• an equity instrument (the option to convert into shares).
These two elements must be shown separately in the financial
statements. The initial recognition of compound instruments On initial
recognition, a compound instrument must be split into a liability
component and an equity component:
• The liability component is calculated as the present value of the
repayments, discounted at a market rate of interest for a similar
instrument without conversion rights.
• The equity component is calculated as the difference between the
cash proceeds from the issue of the instrument and the value of
the liability component.
ILLUSTRATION
ABC PLC issued 2,000 convertible Bond at the start of 2012. The Bond
have a 3year term and are issued at par with a face value of N1,000 per
bond giving a total proceed of N2,000,000.
Interest is payable annually in arrears at a nominal interest rate of 6%.
Each bond is convertible at any time up to maturity into 250 ordinary
shares. When the bonds are issued, the prevailing market interest rate
for similar debt without conversion option is 9%.
The risk free annual interest rate for a 3 year term is 5%.
Required:
What is the value of equity component in the BOND.
SOLUTION
The cash payments on the bond should be discounted to their present
value using the interest rate for a bond without the conversion rights,
i.e. 9%
year Cash flow Discount factor (9%) Present value
1 Interest 120,000 1/1.09 110,091.74
2 interest 120,000 1/1.092 101,001.59
3 interest 120,000 1/1.093 92,662.02
3 principal 2,000,000 1/1.093 1,544,366.96
Liability component 1,848,122.31
Equity component (Bal fig) 151,877.68
Amount received 2,000,000.00
interest = 2,000,000 X 6% = 120,000
Financial Asset
Financial Assets that are Equity Instruments
Investments in equity instruments (such as an investment in the
ordinary shares of another entity) are measured at either:
• fair value either through profit or loss, or
• fair value through other comprehensive income.
Fair value through profit or loss
The normal expectation is that equity instruments will have the
designation of fair value through profit or loss.
Fair value through other comprehensive income
It is possible to designate an equity instrument as fair value through
other comprehensive income, provided that the following conditions
are complied with:
• the equity instrument must not be held for trading, and
• there must have been an irrevocable choice for this designation
upon initial recognition of the asset.
Measurement:
Fair value through profit or loss
Investments in equity instruments that are classified as fair value through profit
or loss are initially recognised at fair value. Transaction costs are expensed to
profit or loss. At the reporting date, the asset is revalued to fair value with the
gain or loss recorded in the statement of profit or loss. Fair value through other
comprehensive income
Investments in equity instruments that are classified as fair value through other
comprehensive income are initially recognised at fair value plus transaction costs.
At the reporting date, the asset is revalued to fair value with the gain or loss
recorded in other comprehensive income. This gain or loss will not be reclassified
to profit or loss in future periods.
Financial Assets that are Debt Instruments
Accounting for investments in debt instruments
Classification
Financial assets that are debt instruments can be measured in one of three ways:
• Amortised cost
• Fair value through other comprehensive income
• Fair value through profit or loss.
Measurement Amortised cost
For investments in debt that are measured at amortised cost:
• The asset is initially recognised at fair value plus transaction costs.
• Interest income is calculated using the effective rate of interest.
It is calculated thus:
1. Amount initially recognized (initial cost of investment) plus
2. Interest income (using effective rate) less
3. Interest actually received (cash received).
Illustration
On Jan. 2010, ABC purchased a debt instrument for its fair value of N1,000. The
debt instrument is due to mature on 31st Dec. 2015. The instrument has a
principal amount of N1,250 and the instrument carries fixed interest at 4.72% that
is paid Annually. The effective interest rate is 10%.
How should ABC account for the debt instrument over its 5 year term.
Solution
Effective interest fixed interest
Yr bal @begining int. income(10%) cash received (4.72%) Bal @end
1 1,000 100 (59) 1.041
2 1,041 104 (59) 1,086
3 1,086 109 (59) 1,136
4 1,136 114 (59) 1,191
5 1,191 118 (59 + 1250) 0
Annual interest received = 4.72% x 1,250 = 59
Interest income yr 1 = 10% of the bal. = 10% x 1,000 = 100
“ “ yr 2 = 10% of 1,041 = 104
Consideration given = 1,000
Principal Amount = 1,250