Financial instruments

A financial asset is any asset that is:

 'cash'
 'a contractual right to receive cash or another financial asset from
another entity'
 'a contractual right to exchange financial assets or liabilities with
another entity under conditions that are potentially favourable'
 'an equity instrument of another entity'

A financial liability is 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', or
 'that will or may be settled in the entity’s own equity instruments.'

Identify which of the following are financial instruments:

(a) inventories
(b) investment in ordinary shares
(c) prepayments for goods or services
(d) liability for income taxes
(e) a share option (an entity’s obligation to issue its own shares).

Initial recognition criteria

Initial measurement
A financial liability is initially recognised at its fair value.
Subsequent measurement of financial liabilities
Financial liabilities will be carried at amortised cost

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

1 A company issues 5% loan notes at their nominal value of $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?

2 A company issues 0% loan notes at their nominal value of $40,000. The loan notes are
repayable at a premium of $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?

3 A company issues 4% loan notes with a nominal value of $20,000.

The loan notes are issued at a discount of 2.5% and $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?
Preference shares
If irredeemable preference shares contain no obligation to make any payment,
either of capital or dividend, they are classified as equity.
If preference shares are redeemable, or have a fixed cumulative dividend they
are classified as a financial liability.

On 1 April 20X7, a company issued 40,000 $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 20X8 and 20X9?

Compound instruments
A compound instrument is a financial instrument that has characteristics of both equity and
liabilities, such as a convertible loan.
A convertible loan has the following characteristics:
 It is repayable, at the lender's option, in shares of the issuing company instead of cash
 The number of shares to be issued is fixed at the inception of the loan
 The lender will accept a rate of interest below the market rate for nonconvertible
Instruments

Initial recognition

Subsequent measurement
The liability is measured at amortised cost:
Convert Co issues a convertible loan that pays interest of 2% per annum in arrears. The
market rate is 8%, being the interest rate for an equivalent debt without the conversion
option. The loan of $5 million is repayable in full after three years or convertible to equity.
Discount factors are as follows:
Year Discount factor
at 8%
1 0.926
2 0.857
3 0.794
Required:
Split the loan between debt and equity at inception and calculate the finance charge for each
year until conversion/redemption.

1 An entity issues 2% convertible bonds at their nominal value of

$36,000. Interest is payable annually in arrears.
The bonds are convertible at any time up to maturity into 40
ordinary shares for each $100 of bond. Alternatively the bonds will
be redeemed at par after 3 years.
Similar non-convertible bonds would carry an interest rate of 9.1%. The present value of $1
payable at the end of year, based on rates of 2% and 9.1% are as follows:
End of year 2% 9.1%
1 0.98 0.92
2 0.96 0.84
3 0.94 0.77
What amounts will be shown as a financial liability and as equity when the convertible
bonds are issued?
What amounts will be shown in the statement of profit or loss and statement of financial
position for years 1–3?
Work to the nearest $000.
2 A company issues 4% convertible bonds at their nominal value of $5 million. Interest is
payable annually in arrears. Each $1,000 bond is convertible at any time up to maturity into
400 ordinary shares. Alternatively the bonds will be redeemed at
par after 3 years.
The market rate applicable to non-convertible bonds is 6%.
The present value of $1 payable at the end of year, based on rates of 4% and 6% are as
follows:
End of year 4% 6%
1 0.96 0.94
2 0.92 0.89
3 0.89 0.84
What amounts will be shown as a financial liability and as equity when the convertible
bonds are issued?
What amounts will be shown in the statement of profit or loss and statement of financial
position for years 1–3?
Financial assets
Initial recognition of financial assets
IFRS 9 deals with recognition and measurement of financial assets. 'An entity
shall recognise a financial asset on its statement of financial position
when, and only when, the entity becomes party to the contractual
provisions of the instrument

Initial measurement of financial assets

At initial recognition, all financial assets are measured at fair value. This is likely
to be the purchase consideration paid to acquire the financial asset. Transaction
costs are included unless the asset is fair value through profit or loss

Equity instruments
Equity instruments (purchases of shares in other entities) are measured at
either:
 fair value through profit or loss, or
 fair value through other comprehensive income
Debt instruments
Debt instruments (such as bonds or redeemable preference shares) are
categorised in one of three ways:
 Fair value through profit or loss
 Amortised cost
 Fair value through other comprehensive income
The default category is again fair value through profit or loss (FVPL). The
other two categories depend on the instrument passing two tests:
 Business model test. This considers the entity's purpose in holding the
investment.
 Contractual cash flow characteristics test. This looks at the cash that
will be received as a result of holding the investment, and considers what
it comprises. Amortised cost
For an instrument to be carried at amortised cost, the two tests to be passed
are:
 Business model test. The entity must intend to hold the investment to
maturity.
 Contractual cash flow characteristics test. The contractual terms of the
financial asset must give rise to cash flows that are solely of principal and
interest.
Fair value though other comprehensive income (FVOCI)
For an instrument to be carried at FVOCI, the two tests to be passed are:
 Business model test. The entity must intend to hold the investment to
maturity but may sell the asset if the possibility of buying another asset
with a higher return arises.
 Contractual cash flow characteristics test. The contractual terms of the
financial asset must give rise to cash flows that are solely of principal and
interest, as for amortised cost.
If a debt instrument is held at FVOCI
 The asset is initially recognised at fair value plus transaction costs
 Interest income is calculated using the effective rate of interest, in the
same way as the amounts that would have been recognised in profit or
loss if using amortised cost.
 At the reporting date, the asset will 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.
1 A company invests $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?
2 A company invested in 10,000 shares of a listed company in November 20X7 at a cost of
$4.20 per share. At 31 December 20X7 the shares have a market value of $4.90.
Prepare extracts from the statement of profit or loss for the year ended 31 December
20X7 and a statement of financial position as at that date.
3 A company invested in 20,000 shares of a listed company in October 20X7 at a cost of
$3.80 per share. At 31 December 20X7 the shares have a market value of $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 20X7 and a statement of financial position as at that
date.
On 1 January 20X5 Bland bought a $10,000 6% bond for $9,000, incurring acquisition costs
of $144. Interest is received annually in arrears, and the bond will be redeemed at a premium
of $500 over its nominal value on 31 December 20X7. The effective rate of interest is
11%. The fair value of the bond was as follows:
31 December 20X5 $11,000
31 December 20X6 $10,400
Required:
Show how the bond will be accounted for over the three-year period if:
(a) Bland planned to hold the bond until the redemption date.
(b) Bland may sell the bond if the possibility of an investment with a higher return
arises.

Offsetting financial assets/financial liabilities

Derecognition
Derecognition of financial instruments
Financial instruments should be derecognised as follows:
 financial asset – 'when, and only when, the contractual rights to the
cash flows from the financial asset expire' (IFRS 9, para 3.2.3),
e.g. when an option held by the entity has expired and become worthless
or when the financial asset has been sold and the transfer qualifies for
derecognition because substantially all the risks and rewards of ownership
have been transferred from the seller to the buyer.
 financial liability – 'when, and only when, the obligation specified in the
contract is discharged or cancelled or expires

Factoring of receivables
A sale of receivables with recourse means that the factor can return any
unpaid debts to the business, meaning the business retains the risk of
irrecoverable debts. In this situation the transaction is treated as a secure loan
against the receivables, rather than a sale.
A sale of receivables without recourse means the factor bears the risk of
irrecoverable debts. In this case, this is usually treated as a sale and the
receivables are removed from the entity’s financial statements.

An entity has an outstanding receivables balance with a major

customer amounting to $12 million, and this was factored to Finance
Co on 1 September 20X7. The terms of the factoring were:
Finance Co will pay 80% of the gross receivable outstanding account to
the entity immediately.
 The balance will be paid (less the charges below) when the debt
is collected in full. Any amount of the debt outstanding after four
months will be transferred back to the entity at its full book value.
 Finance Co will charge 1% per month of the net amount owing
from the entity at the beginning of each month. Finance Co had
not collected any of the factored receivable amount by the yearend.
 the entity debited the cash from Finance Co to its bank account
and removed the receivable from its accounts. It has prudently
charged the difference as an administration cost.
How should this arrangement be accounted for in the financial
statements for the year ended 30 September 20X7?
Disclosure of financial instruments
IFRS 7 provides the disclosure requirements for financial instruments. The
major elements of disclosures required are:
 The carrying amount of each class of financial instrument should be
recorded either on the face of the statement of financial position or within
the notes.
 An entity must also disclose items of income, expense, gains and losses
for each class of financial instrument either in the statement of profit or
loss and other comprehensive income or within the notes.
 An entity must also make disclosures regarding the nature and extent of
risks faced by the entity. This must cover the entity's exposure to risk,
management's objectives and policies for managing those risks and any
changes in the year.