Chapter - 11 IFRS-9 Financial instruments

IFRS-9 Financial instruments

1. Introduction
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.

Financial asset

A financial asset is any asset that is:

(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity.

Financial liability

A financial liability is any liability that is:

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

Equity instrument

An equity instrument is any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities.

2. Recognition of financial instruments

A financial asset or a financial liability should be recognised in the statement of financial

position when the reporting entity becomes a party to the contractual provisions of the
instrument.

The recognition criteria of a financial asset or a liability is different from the recognition
criteria for a non-financial asset or liability. Usually an asset or liability is recognised when
there is a probable inflow or outflow of economic benefits.

3. Classification and reclassification of financial instrument

3.1 Classification of financial assets

Classification determines how financial assets are accounted for and in particular, how they
are measured on an ongoing basis.

A company must classify financial assets as subsequently measured at:

• amortised cost;
• fair value through other comprehensive income; or

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• fair value through profit or loss

This classification is made on the basis of both:

• the business model for managing the financial assets and

• the contractual cash flow characteristics of the financial asset.

3.1.1 Financial assets at amortised cost

A financial asset must be measured at amortised cost if both of the following conditions are
met:

• the asset is held within a business model whose objective is to hold assets in order to
collect contractual cash flows; and
• the contractual terms of the financial asset give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal amount outstanding.

3.1.2 Financial assets at fair value through other comprehensive income

A financial asset must be measured at fair value through other comprehensive income if
both of the following conditions are met:

• the financial asset is held within a business model whose objective is achieved by both
collecting contractual cash flows and selling financial assets and
• the contractual terms of the financial asset give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal amount outstanding.

3.1.3 Financial assets at fair value through profit or loss

A financial asset must be measured at fair value through profit or loss unless it is measured
at amortised cost or at fair value through other comprehensive income.

Example: Classification of financial assets

A company makes a large bond issue to the market. Three companies (A Limited, B Limited
and C Limited) each buy identical Rs. 10,000,000 bonds.

Company Business model Classification of bond

A Limited A Limited holds bonds for the A Limited must measure the
purpose of collecting contractual bond at amortised cost
cash flows to maturity
B Limited B Limited holds bonds for the B Limited must measure the
purpose of collecting contractual bond at fair value through OCI
cash flows but sells them on the
market when prices are favourable
C Limited C Limited buys bonds to trade in C Limited must measure the
them bond at fair value through P&L

Other measurement rules

Option to designate a financial asset at fair value through profit or loss Despite the above, a
company may, at initial recognition, irrevocably designate a financial asset as measured at
fair value through profit or loss if doing so eliminates or significantly reduces a measurement
or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would

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otherwise arise from measuring assets or liabilities or recognising the gains and losses on
them on different bases.

Amortised cost criteria - commentary

The rules try to limit the use of amortised cost to those situations where it best reflects the
substance of the transactions. Therefore it can only be used by a company whose business
model is to make loans and collect future repayments.

A company might sell a loan before its maturity. This does not preclude classification of
loans at amortised cost as long as the company’s overall business model is to hold assets in
order to receive contractual cash flows.

On the other hand a company might hold a portfolio of loans in order to profit from the sale of
these assets when market conditions are favourable. In this case the company’s business
model is not to hold assets in order to receive contractual cash flows. The loans in this
portfolio must be measured at fair value.

Overview of classification of financial assets

Method Which instruments?

Amortised cost Loans and receivables that satisfy the amortised cost criteria
Fair value to OCI • Loans and receivables that satisfy the fair value through
OCI criteria
• Equity that has been subject to a declaration
Fair value through • Equity
profit or loss • Derivatives
(FVTPL) • Loans and receivables that fail the amortised cost criteria
• Loans and receivables that satisfy the amortised cost
criteria but are designated into this category on initial
recognition

3.2 Classification of financial liabilities

At initial recognition, financial liabilities are classified as subsequently measured at

amortised cost with specific exceptions including:

• derivatives that are liabilities at the reporting date; and

• financial liabilities that might arise when a financial asset is transferred but this transfer
does not satisfy the derecognition criteria.

Reclassification of a financial liability after initial recognition is not allowed.

Irrevocable designation

A company is allowed to designate a financial liability as measured at fair value through

profit or loss. This designation can only be made if:

• it eliminates or significantly reduces a measurement or recognition inconsistency; or

• this would allow the company to reflect a documented risk management strategy.

Any such designation is irrevocable.

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If a financial liability is measured at fair value any change due to the company’s own credit
risk is recognised in OCI (not P&L)

Summary of accounting of items measured at fair value

Category Examples
Financial asset at fair Whole fair value movement to profit or loss
value through profit or loss
Financial asset at fair Whole fair value movement to OCI
value through OCI
Subsequent sale of the asset
• Gain or loss on disposal calculated based on the
carrying amount of the asset at the date of disposal.
• No reclassification of the amounts previously
recognised in OCI in respect of equity for which an
irrevocable election has been made.
• Reclassification is still required for debt instruments
measured at fair value through OCI.
Financial liability at fair Change in fair value attributed to change in credit risk to
value through profit or loss OCI.
Remaining change in fair value to profit or loss

Transaction costs

Transaction costs are incremental costs that are directly attributable to the acquisition, issue
or disposal of a financial instrument. Examples of transaction costs are:

• fees and commissions paid to agents, advisers, brokers and dealers;

• levies by regulatory agencies and securities exchanges;
• transfer taxes and duties;
• credit assessment fees;
• registration charges and similar costs.

An incremental cost is one that would not have been incurred if the entity had not acquired,
issued or disposed of financial instrument.

Examples of cost that do not qualify as transaction costs are debt premiums or discounts,
financing costs, internal administration costs and holding costs.

For all financial instruments that are not measured at FVTPL the treatment of transaction
costs is made on an instrument-by-instrument basis as follows:

• Fair value of financial asset plus transaction cost

• Fair value of financial liability minus transaction cost

However, trade receivable is an exception to this treatment. Trade receivable are measured
in accordance with IFRS 15

Example: Equity investment

An equity investment is purchased for Rs. 30,000 plus 1% transaction costs on 1 January
2016. It is classified as at fair value through OCI.
At the end of the financial year (31 December) the investment is revalued to its fair value of
Rs. 40,000.

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On 11 December 2017 it is sold for Rs. 50,000.

Required

Explain the accounting treatment for this investment.

Answer

1 January 2016 The investment is recorded at Rs. 30,300. This is the cost plus the
capitalized transaction costs.

31 December 2016 The investment is revalued to its fair value of Rs. 40,000. The gain of Rs.
9,700 is included in other comprehensive income for the year.

11 December 2017 The journal entry to record the disposal is as follows:

Dr Cr
Cash 50,000
Investment 40,000
Statement of profit or loss 10,000

Summary
Investment in:

Debt Equity
instruments instruments

Objective to Objective to All others Not Held for Otherwise

collect collect trading &
At FVTPL
contractual contractual irrevocable
cash flows cash flows + designation
Selling
And
And FVTOCI FVTPL
(Specific
date (Specific
cashflows: date
principal cashflows:
and interest principal
only) and interest
At only)
amortized At FVTOCI
cost

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Comprehensive illustration
CI-1 In February 2018 a company purchased 2,000 (Par Rs 10) listed equity shares at a
price of Rs 40 per share. Transaction costs were Rs 2,000. At the year end of 31 December
2018, these shares were trading at Rs 55.

A dividend of Re 2 per share was received on 30 September 2018.

Required:

Show the financial statement extracts at 31 December 2018 relating to this investment on
the basis that:

(a) The shares were bought for trading (conditions for FVTOCI have not been met)
(b) Conditions for FVTOCI have been met

CI-2 On 1 January 2011, Tokyo bought a Rs 100,000 5% bond for Rs 95,000, incurring
issue costs of Rs 2,000. Interest is received in arrears. The bond will be redeemed at a
premium of Rs 5,960 over nominal value on 31 December 2013. The effective rate of
interest is 8%.

The fair value of the bond was as follows:

31/12/11 Rs 110,000
31/12/12 Rs 104,000

Required:

Explain, with calculations, how the bond will have been accounted for over all relevant years
if:
(a) Tokyo planned to hold the bond until the redemption date.
(b) Tokyo may sell the bond if the possibility of an investment with a higher return arises.
(c) Tokyo planned to trade the bond in the shortterm, selling it for its fair value on 1 January
2012.

The requirement to recognise a loss allowance on debt instruments held at amortised cost or
fair value through other comprehensive income should be ignored.

CI-3 (i) A company issues 5% loan notes at their nominal value of Rs 20,000 with an
effective rate of 5%. The loan notes are repayable at par after 4 years.

What amount will be recorded as a financial liability when the loan notes are issued?

What amounts will be shown in the statement of profit or loss and statement of financial
position for years 1–4?

(ii) A company issues 0% loan notes at their nominal value of Rs 40,000. The loan notes are
repayable at a premium of Rs 11,800 after 3 years. The effective rate of interest is 9%.

What amount will be recorded as a financial liability when the loan notes are issued?

What amounts will be shown in the statement of profit or loss and statement of financial
position for years 1–3?

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(iii) A company issues 4% loan notes with a nominal value of Rs 20,000.

The loan notes are issued at a discount of 2.5% and Rs 534 of issue costs are incurred.
The loan notes will be repayable at a premium of 10% after 5 years.
The effective rate of interest is 7%.

What amount will be recorded as a financial liability when the loan notes are issued?

What amounts will be shown in the statement of profit or loss and statement of financial
position for year 1?

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Practice Questions
PQ-1

(i) A company invests Rs 5,000 in 10% loan notes. The loan notes are repayable at a
premium after 3 years. The effective rate of interest is 12%. The company intends to collect
the contractual cash flows which consist solely of repayments of interest and capital and
have therefore chosen to record the financial asset at amortised cost.

What amounts will be shown in the statement of profit or loss and statement of financial
position for the financial asset for years 1–3?

(ii) A company invested in 10,000 shares of a listed company in November 2017 at a cost of
Rs 4.20 per share. At 31 December 2017 the shares have a market value of Rs 4.90.

Prepare extracts from the statement of profit or loss for the year ended 31 December 2017
and a statement of financial position as at that date.

(iii) A company invested in 20,000 shares of a listed company in October 2017 at a cost of
Rs 3.80 per share. At 31 December 2017 the shares have a market value of Rs 3.40. The
company is not planning on selling these shares in the short term and elects to hold
them as fair value through other comprehensive income.

Prepare extracts from the statement of profit or loss and other comprehensive income for the
year ended 31 December 2017 and a statement of financial position as at that date.

PQ-2

Debt is issued for Rs 1,000. The debt is redeemable at Rs 1,250. The term of the debt is five
years and interest is paid at 5.9% pa. The effective rate of interest is 10%. Show how the
value of the debt changes over its life.

PQ-3

On 1 April 2017, a company issued 40,000 Rs 1 redeemable preference shares with a

coupon rate of 8% at par. They are redeemable at a large premium which gives them an
effective finance cost of 12% per annum.

How would these redeemable preference shares appear in the financial statements for the
years ending 31 March 2018 and 2019?

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Solution of Practice Questions

SOLUTION NO. PQ-1

(i)
This financial instrument appears to be a debt instrument which passes both the business
model test and the contractual cash flow characteristics test. It can be measured at
amortised cost.

Statement of profit or loss

1 2 3
Investment Income 600 612 625

Statement of financial position

1 2 3
Noncurrent assets:
Investments 5,100 0
Current assets:
Investments 5,212

Working:

Year Opening Income Cash Closing

Investment 12% Received 10%
1 5,000 600 (500) 5,100
2 5,100 612 (500) 5,212
3 5,212 625 (500)
(5337) 0

(ii) The investment should be measured at fair value through profit or loss.

Statement of profit or loss

Investment Income (10,000 × (4.90 – 4.20)) 7,000

Statement of financial position

Current assets
Investments (10,000 × 4.90) 49,000

(iii) The investment in these shares is considered to be a financial asset at fair value through
other comprehensive income.

Statement of profit or loss and other comprehensive income

Other comprehensive income
Loss on investment (8,000)

Statement of Financial Position

Noncurrent assets
Investments (20,000 × 3.40) 68,000
FVOCI reserve (8,000)

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SOLUTION NO. PQ-2

This financial liability should be valued at amortised cost.

The debt would initially be recognised at Rs 1,000. The total finance cost of the debt is the
difference between the payments required by the debt which total Rs 1,545 ((5 × Rs 59) +
Rs 1,250) and the proceeds of Rs 1,000, that is Rs 545.

• The movements on the carrying amount of the debt over its term would be as follows:

Year Balance at Finance cost Cost paid Balance paid

beginning of for year (10%) during year end of year
Year
Rs Rs Rs Rs
1 1,000 100 (59) 1,041
2 1,041 104 (59) 1,086
3 1,086 109 (59) 1,136
4 1,136 113 (59) 1,190
5 1,190 119 (1,250 + 59) -
545

• The amounts carried forward at each year end represent the amortised cost valuation to
be shown in the statement of financial position.
• The carrying amount of the debt (amortised cost) is the net proceeds, plus finance
charges recognised in the accounts, less payments made.

SOLUTION NO. PQ-3

Annual payment = 40,000 × Rs 1 × 8% = Rs 3,200

Period Opening Finance Cash paid Closing balance

ended balance cost @ 12% @ 8% 31 March
Rs Rs Rs Rs
2018 40,000 4,800 (3,200) 41,600
2019 41,600 4,992 (3,200) 43,392

Year ended 31 March 2018:

SFP liability value for preference shares Rs 41,600

Interest charged in statement of profit or loss Rs 4,800

Year ended 31 March 2019:

SFP liability value for preference shares Rs 43,392

Interest charged in statement of profit or loss Rs 4,992

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Past Papers

PP-1

On 1 July 2018, Gypsum Limited purchased 5,000 debentures issued by Iron Limited at par
value of Rs. 100 each. The transaction cost associated with the acquisition of the
debentures was Rs. 24,000. The coupon interest rate is 11% per annum payable annually
on 30 June. On 1 July 2018, the effective interest rate was worked out at 9.5% per annum
whereas the market interest rate on similar debentures was 11% per annum.

As on 30 June 2019, the debentures were quoted on Pakistan Stock Exchange at Rs. 96
each.
Required:

Prepare journal entries for the year ended 30 June 2019 if the investment in debentures is
subsequently measured at:

(a) amortized cost (03)

(b) fair value through profit or loss (03) (Aut 19, Q-3, Marks 6)

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