Financial Instruments
Recognition & Measurement – IFRS 9
Presentation – IAS 32
Disclosure – IFRS 7
In conceptual framework, we have classified
Assets
1. financial asset
2. non-financial asset
Liabilities
1. financial liabilities
2. non-financial liabilities, and
Equity as residual interest which is after deducting liabilities from assets.
The financial instrument is either a debt instrument or an equity instruments.
Debt (utang or pautang) instruments. Examples – promissory notes, bonds
(government,corporate), commercial papers, government securities (BSP T-Bills),
Certificates of Deposit, Fixed Deposits.
Equity (ownership shares) – ordinary shares, non-redeemable preference shares, share
warrants, share options.
Now the classification whether it is financial asset or financial liability or equity will depend
whether the entity is an ISSUER or a HOLDER.
Financial Asset of Holder = Financial Liability or Equity of Issuer
For example, the ENTITY bought SMC ordinary shares
HOLDER ISSUER
Investment in SMC shares – FINANCIAL ASSET Ordinary Shares - EQUITY
Or the ENTITY bough PREMYO Bonds issued by the Philippine Government
HOLDER ISSUER
Investment in Bonds – FINANCIAL ASSET Bonds Payable – FINANCIAL LIABILITY
WHAT IS A FINANCIAL ASSET?
IAS 32 defines a financial asset that is
(a) cash;
(b) an equity instrument of another entity
(c) a contractual right:
• to receive cash or another financial asset from another entity; or
• to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments and is
1. a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments;,or
2. 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.
Examples:
Financial Asset because
Cash on hand and in banks, Cash
Investment in Ordinary Shares or Preference Equity instrument of another entity
Shares of another entity
Accounts Receivable, Notes Receivable, Contractual right to receive cash
Investment in debt instruments,
Derivative Financial Assets (e.g. Options) a contract that will or may be settled in the
entity’s own equity instruments
NON-FINANCIAL ASSETS
Non-financial Asset because
Physical Assets (inventories, biological Control of such physical asset creates an
assets, property,plant & equipment, and opportunity to generate an inflow of cash
investment properties or another financial asset but it does not
give rise to a present right to receive cash
or another financial asset.
Intangible assets(copyrights, patents and Control of such intangible asset creates an
trademarks) opportunity to generate an inflow of cash
or another financial asset but it does not
give rise to a present right to receive cash
or another financial asset.
Prepaid Expenses The future benefit is the receipt of goods or
services rather than the right to receive
cash or another financial asset.
Current and deferred tax assets Not contractual
WHAT IS A FINANCIAL LIABILITY?
IAS 32 defines a financial liability as any liability that is:
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(a) a non-derivative for which the entity is or may be obliged to deliver a variable number
of the entity’s own equity instruments;,or
(b) 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.
Examples: Accounts Payable, Notes Payable, Loans Payable, Bonds Payable, Other debt
instruments (commercial paper), derivative financial instruments, obligation to deliver
own shares worth a fixed amount of cash.
NON-FINANCIAL LIABILITIES
Non-financial liability because
Deferred Revenue To be settled by delivery of services, not
cash or another financial asset.
Warranty liability To be settled by delivery of services, not
cash or another financial asset.
Current and deferred tax liabilities Not contractual
Constructive obligation Not contractual
WHAT IS AN EQUITY INSTRUMENT?
IAS 32 defines equity instrument as any contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities.
Examples: Ordinary Shares, Non-redeemable preference shares, Preference shares with
no mandatory redemption, warrants, written call options.
NOTES:
✓ Financial instruments arise from rights and obligations under contracts.
✓ The terms ‘contract’ and ‘contractual’ refer to an agreement between two or more parties
that has clear economic consequences that the parties have little, if any, discretion to
avoid, usually because the agreement is enforceable by law.
✓ Contracts, and thus financial instruments, may take a variety of forms and need not be in
writing.
✓ For a contract to be valid, both parties must give their approval. Approval may be given
indirectly (eg by an entity acting in such a way that the other parties involved believe
the entity’s intention is to make a contract).
✓ For example, if an entity purchases or sells goods, buys property, engages a builder to
carry out work, borrows money, or orders goods or machinery from a manufacturer,
these are all types of contracts.
More Examples – financial instruments
Ex 1 A bank advances an entity a five-year loan. The bank also provided the entity with
an overdraft facility for a number of years.
FL- The entity has two financial liabilities—the obligation to repay the five-year loan and the
obligation to repay the bank overdraft to the extent that it has borrowed using the
overdraft facility. Both the loan and the overdraft result in contractual obligations for the
entity to pay cash to the bank for the interest incurred and for the return of the
principal.
FA - The amounts due from the entity under the loan and overdraft facility are financial assets
of the bank.
Ex 2 Entity A owns preference shares in entity B. The preference shares entitle entity A
to dividends, but not to any voting rights.
FA - Entity A’s perspective: The financial asset (investment in entity B) will usually be within the
scope of Section 11 (see paragraph 11.8). The preference shares may be equity
instruments or financial liabilities of entity B, depending on their terms and conditions.
Either way, from the holder’s perspective (i.e. entity A’s perspective) the preference
shares in entity B are a financial asset because the investment will either satisfy part (b)
or (c)(i) of the definition of a financial asset.
FL or E- Entity B’s perspective—preference shares may be equity instruments or financial
liabilities of entity B (the issuer), depending on the terms and conditions of the shares.
Ex 3 An entity (the purchaser) buys goods from a supplier on 60 days’ credit.
FL - The purchaser has a financial liability (trade payable)—a contractual obligation to deliver
cash to its supplier in settlement of the purchase price.
FA - The supplier has a corresponding financial asset (a trade receivable)—a contractual right
to receive cash (the amount due from the purchaser).
Ex 4 Entity A purchases a subsidiary from entity B. Under the agreement, entity A
pays the purchase price in two instalments—CU5 million(1) upfront and
a further
payment (which is not a contingent payment) of CU5 million two years later.
FL - The CU5 million payable two years later is a financial liability of entity A—it is an
obligation to deliver cash in two years’ time.
FA - It is a financial asset of entity B—a contractual right to receive cash.
Examples – not financial instruments
Ex 5 An entity has a present obligation in respect of income tax due for the prior year.
An income tax liability is created as a result of statutory(legal) requirements
imposed by governments. It is not created by contractual provisions and
hence is not a financial liability.
Ex 6 Every year for the past twenty years a catering entity has paid CU50,000 towards
the costs of the carnival in the village in which the entity operates. The entity is
well known as the main sponsor of the annual event and its advertisements
include reference to its status as main sponsor of the village carnival. The
villagers now expect the entity to pay CU50,000 to cover the costs of the carnival
this year.
The obligation to pay CU50,000 does not arise from a contract and hence is not a
financial liability. The obligation may meet the conditions to be recognised as a
constructive obligation in the scope of Provisions and Contingencies (ie if through its
advertisements and by its established pattern of paying the sponsorship each year
the entity has created a valid expectation by the villagers that it will make the
payment).
Note: If, however, the catering entity entered into a contract to pay CU50,000
towards the village carnival, then the entity has a financial liability.
Ex 7 In a lawsuit brought against an entity, a group of people are collectively
seeking compensation for damages to their health as a result of
contamination to the nearby land believed to be caused by waste from that
entity’s production process.
It is doubtful whether the entity is the source of the contamination since many
entities operate in the same area producing similar waste and it is unclear who is
the source of the contamination.
The fact that a lawsuit may result in the payment of cash does not create a
financial liability for the entity because there is no contract between the entity
and the affected people. If it becomes probable that the entity will be judged
guilty then the entity will need to provide for the payment under Provisions and
Contingencies.
Ex 8 An entity is fined for contravening three separate legislative requirements: (i) for
the late payment of income tax; (ii) for failing to submit its company accounts on
time; and (iii) for false claims made in advertisements for its products.
Fines are not contractual (ie they do not result from contracts). They arise as a
result of statutory requirements imposed by governments. Therefore fines are
not financial liabilities of the entity. Since the entity must pay the fines, the entity
will recognise a liability. If the payment is of uncertain timing or amount it is
accounted for as a provision in accordance with Section 21 Provisions and
Contingencies.
Ex 9 An entity has inventories, property plant and equipment, investment
property, acquired patents and licenses in its statement of financial
position.
Physical assets (such as inventories, investment property, and property, plant
and equipment) and intangible assets (such as acquired patents and licenses)
are not financial assets. Control of such physical assets and intangible assets
may create an opportunity to generate an inflow of cash or another financial
asset, but they do not give rise to a present right to receive cash or another
financial asset under a contract.
They are not financial assets.
Ex 10 At the end of the reporting period an entity has an asset for the prepayment
of three months of rent on its office building.
Assets (such as prepaid expenses) for which the future economic benefit is the
receipt of goods or services, rather than the right to receive cash or another
financial asset, are not financial assets.
Similarly, accruals for which the future outflow of benefits is the delivery of goods
or services, rather than the payment of cash or financial assets, are not financial
liabilities.
Ex 11 An entity sells goods to customers and provides a one-year guarantee to repair
or replace any defective products.
The warranty obligation is not a financial liability because the outflow of
economic benefits associated with it is the provision of repair services or the
supply of a replacement product rather than payment of cash or another financial
asset.
Ex 12 An entity buys gold bullion as an investment.
Although bullion is highly liquid, there is no contractual right to receive cash or
another financial asset inherent in bullion. Gold bullion is a commodity, not a
financial asset.