13/09/2018

Topic 3
Financial Instruments
(IAS 32, IAS 39, IFRS7, IFRS 9)

Contents
 Conceptual knowledge of financial instruments - definitions
and classifications (IAS 32)
 Accounting treatments: financial liabilities and equity.
 Accounting treatments: financial assets (IAS 39)
 Classification of financial assets
Accounting principles - different groups of financial assets
 Impairment of financial assets – incurred loss model
 Introduction derivatives to hedge accounting – micro based
approach
 Accounting treatments: financial assets (IFRS 9)
New model for classifying financial assets.
 Introduction on expected loss model and macro based approach
in hedge accounting
 Further discussion on accounting for debt factoring
 Disclosure of financial instruments (IFRS 7)

KEY DEFINITIONS

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What are Financial Instruments

(Key definitions)
A financial instrument: a contract that gives rise to a
financial asset of one entity and a financial liability or
equity instrument of another entity
 Examples
 Cash, demand and time deposits
 Commercial paper
 Debt and equity securities, including investments in joint
ventures, associates, and subsidiaries
 Derivatives: options, rights, warrants, future contracts,
forward contracts, and swaps
 Leases
 Employer’s rights and obligations under pension contracts

What are Financial Instruments

(key definitions)
A financial asset: any asset that is
 cash;
 an equity instrument of another entity
 a contractual right:
To receive cash or another financial asset from another
entity; or
To exchange financial assets or liabilities with another
entity under conditions that are potentially favourable to
the entity

What are Financial Instruments

(key definitions)
A financial liability: any liability that is
 A contractual obligation:
To deliver cash or another financial asset to another
entity; or
To exchange financial assets or liabilities with another
entity under conditions that are potentially unfavourable
to the entity
Equity instrument:
A contract that will or may be settled in the entity’s own
equity instruments

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Example: Determination of financial instruments:

Which of the following items are financial

instruments?
(a) Inventory
(b) An investment in ordinary shares
(c) Prepayments for goods or services
(d) A liability for income taxes
(e) An enterprise's obligation to issue its own
shares e.g. a share option

FINANCIAL LIABILITIES AND

EQUITY INSTRUMENTS

Financial liabilities vs equity

 A financial instrument should be classified as either

a financial liability or an equity instrument
according to the substance of the contract not its
legal form
 An equity instrument
The instrument includes no contractual obligation to
deliver cash or other financial asset to another entity; and
If the instrument will or may be settled in the issuer’s
own equity instruments

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Example: Classification of financial instruments in

the financial statements
(1) AB has one million £1 ordinary shares in issue. The amount
of dividend paid each year depends on profits and is proposed
by the directors.
(2) AB has 100,000 8% £1 preference shares in issue. The shares
are not redeemable.
(3) AB has £200,000 of bonds in issue. No interest is payable,
but the bonds are redeemable for £220,000 in five years’ time.
(4) AB has 2% £150,000 convertible bonds in issue. The holders
have the option to convert their bonds into equity shares in
five years' time at a rate of 1 equity share for every £5 of debt.
The market price of AB's equity shares is £5.50 per share.
Required: How should each of these instruments be classified?

Notes: Dividends, interest and gain or

loss
• The accounting treatment of interest,
dividends, losses and gains relating to a
financial instrument follows the treatment of
the instrument itself.
– Dividends paid in respect of preference shares
classified as a liability will be charged as a finance
expense through the income statement.
– Dividends paid on shares classified as equity will
be reported in the statement of changes in equity.

Compound financial instruments

Compound financial instruments:
 Both a liability and an equity component
 To be accounted and presented separately according
to their substance
 The initial carrying amount required to be allocated
to equity and liability components
Example – a convertible bond
A financial liability: the issuer’s contractual obligation
to pay cash
An equity instrument: the holder’s option to convert
into common (ordinary) shares

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Accounting for equity instruments

• Issuance
• Share option
• Share splits
• Treasury share
• Distribution to owners

Original issuance of shares and

other equity instruments

• Recognise when equity is issued and subscriber is obligated

to invest
• If equity is issued before the entity gets cash, the receivable
is an offset to equity (not an asset)
• If entity gets (nonrefundable) cash before equity is issued,
equity is increased
• No increase in equity is recognised for subscribed shares
that have not been issued and entity has not received cash
• Transaction costs in issuing equity instruments
• Accounted for as a reduction of equity (not an expense)

Sale of options, rights, warrants

• Same principles as for original issuance of

shares (previous slide)

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Bonus issues (stock dividends) and

share splits

• These do not change equity

• Accounted for as reclassification of
amounts within equity (out of retained
earnings and into permanent capital)
• Amounts reclassified should be based
on local laws

Treasury shares

• Equity instruments entity has issued and later

reacquired
• Measure at cash paid or FV of other
consideration given to acquire \
• Present as deduction from equity (not asset)
• No gain or loss recognised on purchase, sale,
or cancellation

Distributions to owners

• If cash – measurement = cash paid

• If non-cash – measurement = FV of assets
distributed
• Amount reduces equity
• If entity gets tax deduction for dividend, tax benefit
is adjustment of equity
• Not reduction of income tax expense

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Accounting for financial liabilities

• At fair value: trading liabilities (notes: own
credit risk)
• At amortized cost using effective interest
methods
• Compound instruments: split accounting

What is ‘amortised cost’?

• Amount measured at initial recognition

• Minus repayments of principal
• Plus or minus cumulative amortisation of
any difference between initial measurement
and maturity amount (using effective interest
method)
• Minus (for assets) reduction for impairment
or uncollectibility

What is ‘effective interest

method’?
• Effective interest is rate that exactly discounts
future cash payments (receipts) to the carrying
amount
• Also called ‘Internal Rate of Return’
• Amortised cost = PV of future cash receipts
(payments) discounted at effective interest rate
• Interest expense (income) = carrying amount
at beginning of period x effective interest rate

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Amortized cost - examples

Amortized cost - examples

ACCOUNTING FOR BOND

ISSUED

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Accounting for Bond Issues

Bonds may be issued at

 face value,
 below face value (discount), or
 above face value (premium).
Bond prices are quoted as a percentage of face value.

LO 5

ISSUING BONDS AT FACE VALUE

Illustration: On January 1, 2017, Candlestick AG issues
€100,000, five-year, 10% bonds at 100 (100% of face value). The
entry to record the sale is:
Jan. 1 Cash 100,000
Bonds Payable 100,000

Prepare the entry Candlestick would make to accrue interest on

December 31 (€100,000 x 10%).
Dec. 31 Interest Expense 10,000
Interest Payable 10,000
Prepare the entry Candlestick would make to pay the interest on
Jan. 1, 2018.

Jan. 1 Interest Payable 10,000

Cash 10,000

DISCOUNT OR PREMIUM ON BONDS

Issue at Par, Discount, or Premium?

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Accounting for Bond Issues

Question
Karson Ltd. issues 10-year bonds with a maturity value of
£200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest

rate.

b. the market interest rate exceeds the contractual interest

rate.

c. the contractual interest rate and the market interest rate are
the same.

d. no relationship exists between the two rates.

LO 5

ISSUING BONDS AT A DISCOUNT

The issuance of bonds below face value—at a discount—causes the
total cost of borrowing to differ from the bond interest paid.
The issuing company must pay not only the contractual interest rate over
the term of the bonds but also the face value (rather than the issuance
price) at maturity.
Illustration: Assume that on January 1, 2017, Candlestick AG sells
€100,000, five-year, 10% bonds for €98,000 (98% of face value). Interest is
payable annually on January 1.
Jan. 1 Cash 98,000
Bonds Payable 98,000

Borrowing cost – how much and how to

account for

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ISSUING BONDS AT A DISCOUNT

Amortization of bond discount:

 Allocated to expense in each period – straight line method
or effective interest method?
 Increases the amount of interest expense reported each
period.
 Amount of interest expense reported each period will
exceed the contractual amount paid.

 As the discount is amortized, its balance declines.

 The carrying value of the bonds will increase, until at
maturity the carrying value of the bonds equals their face
amount. LO 5

ISSUING BONDS AT A PREMIUM

Sale of bonds above face value causes the total cost of borrowing to be
less than the bond interest paid.
The borrower is not required to pay the bond premium at the maturity date of
the bonds. Thus, the bond premium is considered to be a reduction in the
cost of borrowing.

Illustration: Assume that the Candlestick AG bonds previously described sell

for €102,000 (102% of face value) rather than for €98,000.
Jan. 1 Cash 102,000
Bonds Payable 102,000

Borrowing cost – how much and how to

account for?

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ISSUING BONDS AT A PREMIUM

Amortization of bond premium:

 Allocated to expense in each period – straight line
methods or effective interest method?
 Decreases the amount of interest expense reported
each period.
 Amount of interest expense reported each period will be
less than the contractual amount paid.

 As the premium is amortized, its balance declines.

 The carrying value of the bonds will decrease, until at
maturity the carrying value of the bonds equals their
face amount. LO 5

REDEEMING BONDS AT MATURITY

Candlestick AG records the redemption of its

bonds at maturity as follows:

Bonds Payable 100,000

Cash 100,000

LO 6

REDEEMING BONDS BEFORE MATURITY

When a company retires bonds before maturity, it is

necessary to:
1. eliminate the carrying value of the bonds at the
redemption date;

2. record the cash paid; and

3. recognize the gain or loss on redemption.

The carrying value of the bonds is the face value of the

bonds less unamortized bond discount or plus unamortized
bond premium at the redemption date.

LO 6

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REDEEMING BONDS BEFORE MATURITY

Illustration: Assume at the end of the fourth period, Candlestick

AG having sold its bonds at a premium, retires the bonds at 103
after paying the annual interest. Assume that the carrying value of
the bonds at the redemption date is €100,476. Candlestick records
the redemption at the end of the fourth interest period (January 1,
2021) as follows:

Jan. 1 Bonds Payable 100,476

Loss on Bond Redemption 2,524
Cash 103,000

LO 6

Issuance of convertible debt

• Must account separately for debt component and

equity component (conversion right)
• Debt proceeds = FV of similar risk debt without
conversion feature (PV calculation)
• Equity proceeds are the residual
• Recorded at issuance; not subsequently revised
• Subsequently, debt discount = additional interest
expense (effective interest method)

Compound instruments – example 1

• An entity issues 2,000 convertible bonds at the start of
Year 1. The bonds have a three year term, and are issued
at par with a face value of £1,000 per bond, giving total
proceeds of £2,000,000. Interest is payable annually in
arrears at a nominal annual interest rate of 6%. Each
bond is convertible at any time up to maturity into 250
common shares.
• When the bonds are issued, the prevailing market interest
rate for similar debt without conversion options is 9%.
• Discounting factors at 9%:
1 year: 0.917; 2 years: 0.842; 3 years: 0.772

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Examples - continued
£

Present value of the principal $2,000,000 payable at the end of 3 years 1,544,000

Present value of the interest $120,000 payable annually in arrears for 3 years 303,720

Total liability component 1,847,720

Equity component (by deduction) 152,280

Proceeds of the bond issue 2,000,000

ACCOUNTING FOR
FINANCIAL ASSETS - IAS39

Classification of financial assets

Financial assets at fair value through profit or loss
This means that the company acquired the instrument
principally for the purpose of selling it in the near
term (held-for-trading instrument)
Held-to-maturity investments
Are financial assets with fixed or determinable
payments and fixed maturity that an entity has the
positive intent and ability to hold to maturity.

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Classification of financial assets

Loans and receivables
Are financial assets with fixed or determinable
payments that are not quoted in an active market,
other than those that the entity intends to sell
immediately or in the near future, which must be
classified as held for trading.
Available-for-sale financial assets
Are any remaining financial assets that do not fall
into any of the three categories above

Example: The classification of financial assets:

At 31 /12/ 20X1, Tewkesbury holds the following financial assets:
(a) A loan of £100,000 to Avon. Under the terms of the loan, Avon
pays interest of 5% per annum and will repay £25,000 on 31
December each year, commencing on 31 December 20X2.
(b) 200,000 £1 shares in Barton. purchased on 1 December 20X1
and being expected to be sold within the next two months.
(c) £ 150,000 5% bonds. The bonds mature on 31 December 20X3
and the company intends to hold them until that date.
(d) A forward exchange contract for SR300,000 at a rate of SR7 to
£1 on 31/01/ 2012. The current exchange rate is SR6.5 to £1.
Required: For each of these investments, state how it is classified
and explain where it will be shown in the balance sheet at 31
December 20X1.

Accounting for financial

instruments – initial recognitions
• At fair value – usually the transaction price
• Transaction cost: capitalized except for
AFVTPL

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Accounting for Financial assets -

subsequent measurement

Amortised Transaction
Fair value
cost costs

FV through profit or - adj. to

Expensed
loss P&L

Held-to-maturity -  Capitalised

Loans and
-  Capitalised
receivables
- adj. to
Available-for-sale Capitalised
equity

Examples 1

Example 2

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Example 2 (cont)

Impairment

Impairment
•A financial asset is impaired when:
– Carrying amount is greater than estimated
recoverable amount
– Must assess for evidence of impairment at each
balance sheet date
•If any evidence of impairment, must estimate the
recoverable amount and recognise any impairment loss
•Incurred loss model rather than an expected loss
model

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Objective evidence?
•At each balance sheet date, an entity must assess if
there is objective evidence of impairment.
•Evidence includes:
– Financial difficulty of issuer
– Default or delinquency, or concessions by lender
– High probability of bankruptcy or financial
reorganisation
– Disappearance of active market in investment due
to financial problems
– Historical pattern of collections of a group of financial assets that
implies that holder will not collect all amounts due.

Objective evidence?
• In addition, for equity investments:
– Significant changes in technological, market,
economic or legal environment
– Significant or prolonged decline in fair value

Impairment - Assets carried at

amortised cost
• Assessment
– The existence of objective evidence of impairment
is assessed:
• Individually for individually significant financial assets
• Individually or collectively for financial assets that are
not individually significant
– If there is no objective evidence of impairment at
an individual level, the asset is grouped with assets
of similar credit risk characteristics for collective
assessment.

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Collective assessment
•Collective assessment is designed to allow recognition of losses
believed to exist in a portfolio but not yet evident; often referred
to as latent losses.
•Historical loss experience should provide the basis for
estimating future cash flows in a group of financial assets
assessed for impairment.
•Collective impairment provision can be made only to the extent
that there are adverse changes in the payment status of borrowers,
or economic conditions that can be shown to correlate with
defaults on the assets, such as increase in macro-unemployment
rates.

Impairment - Assets carried at

amortised cost
• Measurement
– Impairment loss is the difference between the carrying
amount and PV of expected future cash flows discounted at
original effective rate.
• Recognition
– The carrying amount of the asset must be reduced to its
estimated recoverable amount, and the loss is included in
profit or loss for the period.
– Reverse impairment through income statement only if change
causing the reversal can be related objectively to an event
occurring after the write-down.

Impairment - Assets carried at fair

value
• Financial assets carried at fair value
– This section applies only to available-for-sale
financial assets.
– Financial assets held for trading
• Fair value adjustments are to net income
• The impairment loss is recognised automatically

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Impairment - Assets carried at

fair value
•A decline in value may have been recognised in equity
as part of the normal measurement process
•When there is objective evidence of impairment, the
cumulative net loss that had been recognised directly in
equity is removed from equity and recognised in profit or
loss for the period

Impairment - Assets carried at fair

value
• The amount is measured as the difference between
acquisition cost and:
– Current fair value (for equity instruments), or
– Recoverable amount (for debt instruments)
• Recoverable amount is the present value of expected
future cash flows discounted at the current market rate
of interest for a similar financial asset

Impairment - Assets carried at fair

value
•Reversal:
– For AFS equity instruments, impairment cannot be
reversed
– For AFS debt instruments, impairment is reversed
when the recoverable amount increases and the
increase can be objectively related to an event
occurring after the loss was recognised
•Subsequent reversals in AFS debt securities are more
objectively determinable than those of equity securities

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Impairment – Key points

• Discounted cash flow methodology is required to
determine impairment
• Can use formula-based approaches or statistical
methods to determine losses in a group of financial
assets

Impairment – Key points

•Distinction between impairment and non-performing
loan
– A non-performing loan is one that does not
perform according to its original contractual terms.
– The loan shows objective evidence of impairment
but does not necessarily result in impairment loss:
• For example, interest on a loan is 90 days overdue
• It is non-performing but it may be adequately secured and hence not
impaired

Impairment – Key points

•Distinction between impairment and temporary decline
in market value
– Decline in market value below cost is not
conclusive evidence of impairment.
– Factors to consider include deterioration in
earnings, cash flows, net assets or credit rating of
the investee since the date of acquisition.
– Duration for which market value is below cost is
also very important.

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Impairment - example

INTRODUCTION TO
DERIVATIVES AND HEDGE
ACCOUNTING

Derivatives
•Definition (must satisfy all of the following)
•Value changes in response to a change in price of, or
index on, a specified underlying financial or non-
financial item or other variable
•Requires no or comparatively smaller initial net
investment (requires professional judgment)
•Is settled at a future date*
*Settled includes contract expiry without cash flows e.g., out of the money option contract

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Scope clarification
• Regular way exemption
– Delivery within the time frame established by regulation or convention
in the market the transaction is executed
• Combine transactions
• Transactions will be deemed derivatives if they:
– Are entered into at the same time in contemplation of each other
– Are entered into with the same counterparty
– Relate to the same risk
– Have no apparent economic need or substantive business purpose for
being structured separately

Derivative definition - example

Pay fixed

Company A Company B

Receive floating

• Company A enters into a "pay fixed, receive floating" interest rate swap
with Company B. It pre-pays the fixed leg of the swap by paying Company
B the present value of the fixed payment streams.
Is the swap a derivative in accordance with IAS 39?
• YES. The settlement of the contract will be at a future date, the value
changes in response to changes in the variable rate, and there is little net
investment relative to contracts that have similar changes in market
conditions such as a variable rate bond!

Derivative definition - example

Pay floating

Company A Company B

Receive fixed

• Company A enters into a "pay floating, receive fixed" interest rate swap
with Company B. It pre-pays the floating leg of the swap by paying
Company B the present value of the estimated floating payment streams.
Is the swap a derivative in accordance with IAS 39?
• NO! The changes in settlement of the contract will be at a future date and
its values in response to an underlying index. However, the investment is
the same as investing in a fixed rate annuity!

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Embedded derivatives
• Definition
– An embedded derivative is a component of a
hybrid (combined) instrument that also includes a
non-derivative host contract, with the effect that
some of the cash flows of the combined instrument
vary in a similar way to a stand-alone derivative.
– Excludes:
– A derivative that is contractually transferable from the host
– A derivative with a different counterparty from the host
– A derivative embedded in another derivative

Accounting for derivatives

• At fair value through profit or loss
• Hedge accounting

Hedge accounting

• What is hedge accounting?

– Matching the change in FV of the hedging
instrument and the hedged item in the same
income statement
– Hedge accounting is only an issue when normal
accounting would put the two FV changes in
different periods – sometimes referred to as an
‘accounting mismatch’

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Hedge accounting

• The hedger’s accounting dilemma:

– I have a risk in an asset or liability measured at
amortised cost
• Any change in FV or cash flows from that asset or
liability is recognised only when realised in cash
(asset is sold, liability is settled, cash flows occur)
– To hedge, I buy a derivative, which is measured at
FVTPL at each reporting date
• I need special hedge accounting to fix this
‘mismatch’

ACCOUNTING FOR
FINANCIAL ASSETS – IFRS9

IFRS 9 Improvements
• Logical model for
– Classification
– Measurement
– Single forward-looking ‘expected loss’ impairment
model
– Substantially-reformed approach to hedge
accounting including
• enhanced disclosures risk management activity

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Classification
• The business model test: The objective of the entity’s
business model is:
– Hold the financial asset to collect the contractual cash flows
– OR: to sell the instrument prior to its contractual
maturity to realise its fair value changes.
– OR: Both
• The contractual cash flow characteristics test:
– The contractual terms of the financial asset give rise on
specified dates to cash flows that are solely payments of the
instrument and interest on the outstanding amount.

Classification – Equity instruments

• Fair value through profit or loss (FVPL), :
– The default position for equity investments.
– Any transaction costs associated with the purchase of these investments are e
xpensed, not capitalized
– Revalued to fair value at each year end, with the gain/loss being shown in the
statement of profit or loss.
• Fair value through other comprehensive income
– An entity may choose to class the investment as 'fair value
through other comprehensive income' (FVOCI).
– This can only be chosen if the investment is not held for trading
(bought with a view to sell on relatively quickly at a gain),
– Once this category is chosen it cannot be changed to FVPL( irrevocable)
– Transaction costs are capitalized
– The investments are revalued to fair value each year end, with the gain/loss
being taken to an investment reserve in equity and shown in OCI.

Classification – debt instruments

• At fair value through profit or loss
• At fair value through OCI
• At amortized cost

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Amortized cost group

• Pass 2 tets:
– the business model test,
The objective of the entity's business model is to hold the financial
asset to collect the contractual cash flows (rather than to sell the instru
ment prior to its contractual maturity to realise its fair value changes).
– the contractual cash flow characteristics test.
• The interest income will be taken to the statement of profit or
loss, and the year end asset value is shown in the statement of
financial position

FVLOCI
• Criteria
– The business model test:
The financial asset is held within a business model
whose objective is achieved by both collecting contractual cash
flows and selling financial assets
=> sales will be more frequent than for instruments held at amortised cost.
– The contractual cash flow characteristics test.
• Accounting (similar to debt in group AFS in IAS39)
– Initially recognised at fair value plus transaction costs
– Interest income is calculated using the effective interest rate
– At the reporting date: be revalued to fair value with the gain or
loss recognised in other comprehensive income.
– This will be reclassified to profit or loss on disposal of the asset

Fair value option

• Even if a financial instrument passes both tests, it is still
possible to designate a debt instrument as FVTPL if doing so
eliminates or significantly reduces a measurement or
recognition inconsistency (i.e. accounting mismatch) that
would otherwise arise from measuring assets or liabilities or
from recognizing the gains or losses on them on different
bases.

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E
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Example 2

FURTHER DISCUSSION ON
FACTORING OF RECEIVABLES

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Factoring of receivables
• Factoring of receivables is where a company transfers its
receivables balances to another organization (a factor) for
management and collection and receives an advance on the
value of those receivables in return.
– With recourse : the factor can return any unpaid debts to
the business -> the business maintains the risk of
irrecoverable debts.
– Without recourse: the factor bears the risk of irrecoverable
debts.

Factoring of receivable – How to account for?

• Without recourse:
– the receivables should be removed from its statement of financial position
and no liability shown in respect of the proceeds received from the factor.
– A profit or loss should be recognised, calculated as the difference between
the carrying amount of the debts and the proceeds received.
• With recourse:
– A gross asset (equivalent in amount to the gross amount of the receivables)
should be shown in the statement of financial position of the seller within
assets.
– And a corresponding liability in respect of the proceeds received from the
factor should be shown within liabilities.
– The interest element of the factor's charges should be recognised as it
accrues and included in profit or loss with other interest charges.
– Other factoring costs should be similarly accrued.

Factoring of receivable - example

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