FINANCIAL

INSTRUMENTS
To cover: IFRS 9, IFRS 7 & IFRS 32
1. Financial instruments
2. Presentation of financial instruments
3. Disclosure of financial instruments
4. Recognition of financial instruments
5. Measurement of financial instruments
Measurement of Financial
Instruments
 Initial measurement
 Subsequent measurement
1. Initial Measurement

Under IFRS 9,
all financial assets should be initially measured at cost = fair value plus transaction
costs.
Financial liabilities should be measured at transaction price ie fair value of the
consideration received.
The exception to this rule is where a financial instrument is designated as at fair
value through profit or loss (this term is explained below). In this case, transaction
costs are not added to fair value at initial recognition.
The fair value of the consideration is normally the transaction price or market
prices. If market prices are not reliable, the fair value may be estimated using a
valuation technique (for example, by discounting cash flows).
• A financial asset or liability at fair value through profit or loss
meets either of the following conditions:
a) It is classified as held for trading. A financial instrument is classified as
held for trading if it is:
i. Acquired or incurred principally for the purpose of selling or repurchasing it in
the near term
ii. Part of a portfolio of identified financial instruments that are managed together
and for which there is evidence of a recent actual pattern of short-term profit-
taking
b) Upon initial recognition it is designated by the entity as at fair value
through profit or loss.
2. Subsequent measurement of financial
assets – debt instruments
• After initial recognition, IFRS 9 requires an entity to measure financial
assets at
• either amortised cost,
• fair value through other comprehensive income or
• fair value through profit or loss based,
• On:
• The entity's business model for managing the financial assets
• The contractual cash flow characteristics of the financial asset
 A financial asset is measured at amortised cost if both of the following
conditions are met:
a) The asset is held within a business model whose objective is to hold assets in
order to collect contractual cash flows.
b) 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.
 After initial recognition, all financial assets other than those held at fair
value through profit or loss should be remeasured to either fair value
or amortised cost.
 IFRS 9 allows the option to initially measure a financial asset at fair
value through profit or loss where a mismatch would otherwise arise
between the asset and a related liability. In this case, the asset will also
be subsequently measured at fair value through profit or loss.
Financial assets at amortised cost
• Assets held at amortised cost are measured using the effective interest method.
• Amortised cost of a financial asset or financial liability is the amount at which
the financial asset or liability is measured at initial recognition minus principal
repayments, plus or minus the cumulative amortisation of any difference
between that initial amount and the maturity amount, and minus any writedown
for impairment or uncollectability.
• The effective interest method is a method of calculating the amortised cost of a
financial instrument and of allocating the interest income or interest expense
over the relevant period.
• The effective interest rate is the rate that exactly discounts estimated future
cash payments or receipts through the expected life of the financial instrument to
the net carrying amount.
Example
• On 1 January 2021 Abacus Co purchases a debt instrument for its fair
value of $1,000. The debt instrument is due to mature on 31 December
2025. The instrument has a principal amount of $1,250 and the
instrument carries fixed interest at 4.72% that is paid annually. The
effective rate of interest is 10%. How should Abacus Co account for
the debt instrument over its five year term?
• Abacus Co will receive interest of $59 (1,250 x 4.72%) each year and
$1,250 when the instrument matures.
• Abacus must allocate the discount of $250 and the interest receivable
over the five year term at a constant rate on the carrying amount of the
debt. To do this, it must apply the effective interest rate of 10%. The
following table shows the allocation over the years.
• Each year the carrying amount of the financial asset is increased by the
interest income for the year and reduced by the interest actually received
during the year.
• This is a financial asset that has passed the cash flow test for measurement at
amortised cost.
• If Abacus was also holding this instrument for trading, the IFRS 9 business
model would allow it to be carried at fair value through other comprehensive
income.
• In this case, fair value changes will go through other comprehensive income;
• interest charges will be measured at amortised cost and go through profit or
loss.
• For instance, if at 1 January 2022 the fair value of the debt instrument was
$1,080, the difference of $39 (1,080 – 1,041) would go to OCI and the asset
would be shown in the statement of financial position at $1,080.
Equity instruments
• After initial recognition equity instruments are measured at either fair value
through profit or loss (FVTPL) or fair value through other comprehensive
income (FVTOCI).
• If equity instruments are held at FVTPL no transaction costs are included in the
carrying amount.
• Equity instruments can be held at FVTOCI if:
a) They are not held for trading (ie the intention is to hold them for the long term to collect
dividend income)
b) An irrevocable election is made at initial recognition to measure the investment at
FVTOCI
• If the investment is held at FVTOCI, all changes in fair value go through other
comprehensive income.
• Only dividend income will appear in profit or loss.
• In February 2018 a company purchased 20,000 $1 listed
equity shares at a price of $4 per share. Transaction costs
were $2,000. At the year end of 31 December 2018, these
shares were trading at $5.50. A dividend of 20c per share was
received on 30 September 2018. 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
INTRODUCTION
IAS 32: Financial instruments: presentation, IFRS 9:
Financial instruments, and IFRS 7: Financial instruments:
disclosure are the relevant standards.
IAS 32 and IAS 39 were introduced to regulate the
accounting treatment of financial instruments, especially
derivatives which had previously been 'off balance sheet’.
IFRS 9 was brought in to simplify the treatment of financial
instruments and now replaces IAS 39.
Explain the need for an accounting
standard on financial instruments
Define financial instruments in terms of
financial assets and financial liabilities
Explain and account for the factoring of
receivables
• Indicate for the following categories of financial instruments how they
should be measured and how any gains and losses from subsequent
measurement should be treated in the financial statements:
• Amortised cost
• Fair value through other comprehensive income (including where an
irrevocable election has been made for equity instruments that are
not held for trading)
• Fair value through profit or loss
Distinguish between debt and equity capital
• Apply the requirements of relevant accounting standards to the issue
and finance costs of:
• Equity
• Redeemable preference shares and debt instruments with no
conversion rights (principle of amortised cost)
• Convertible debt
• Financial instruments
• A financial instrument gives rise to a financial asset of one entity and a
financial liability or equity instrument of another.
• Introduction
• If you read the financial press you will probably be aware of rapid international
expansion in the use of financial instruments. These vary from straightforward,
traditional instruments, eg bonds, through to various forms of so-called
'derivative instruments'. We can perhaps summarise the reasons why a project
on accounting for financial instruments was considered necessary as follows.
(a) The significant growth of financial instruments over recent years has
outstripped the development of guidance for their accounting.
• (b) The topic is of international concern, other national standard-
setters are involved as well as the IASB. (c) There have been recent
high-profile disasters involving derivatives which, while not caused by
accounting failures, have raised questions about accounting and
disclosure practices. Three accounting standards deal with financial
instruments: (a) IAS 32 Financial instruments: presentation, which
deals with: (i) The classification of financial instruments between
liabilities and equity (ii) Presentation of certain compound
instruments (instruments combining debt and equity) (b) IFRS 7
Financial instruments: disclosure (c) IFRS 9 Financial instruments. IFRS
9 deals with: (i) Recognition and derecognition (ii) Measurement of
financial instruments (iii) Impairment (iv) Hedging
• Definitions
• Financial instrument. Any contract that gives rise to both a financial asset of
one entity and a financial liability or equity instrument of another entity. 
Financial asset. Any 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 instruments with another entity under
conditions that are potentially favourable to the entity  Financial liability. Any
liability that is: (a) A contractual obligation: (i) To deliver cash or another
financial asset to another entity, or (ii) To exchange financial instruments with
another entity under conditions that are potentially unfavourable.  Equity
instrument. Any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities.  Fair value. Price that would be
received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.
• We should clarify some points arising from these definitions. Firstly, one or two terms
above should be themselves defined: (a) A 'contract' need not be in writing, but it must
comprise an agreement that has 'clear economic consequences' and which the parties
to it cannot avoid, usually because the agreement is enforceable in law. (b) An 'entity'
here could be an individual, partnership, incorporated body or government agency.
• The definitions of financial assets and financial liabilities may seem rather circular,
referring as they do to the terms financial asset and financial instrument. The point is
that there may be a chain of contractual rights and obligations, but it will lead
ultimately to the receipt or payment of cash or the acquisition or issue of an equity
instrument. Examples of financial assets include: (a) Trade receivables (b) Options (c)
Shares (when held as an investment) Examples of financial liabilities include: (a) Trade
payables (b) Debenture loans payable (c) Redeemable preference (non-equity) shares
IAS 32 makes it clear that the following items are not financial instruments. (a) Physical
assets, eg inventories, property, plant and equipment, leased assets and intangible
assets (patents, trademarks etc) (b) Prepaid expenses, deferred revenue and most
warranty obligations (c) Liabilities or assets that are not contractual in nature
Question: Can you give the reasons why physical assets and prepaid
expenses do not qualify as financial instruments?
Refer to the definitions of financial assets and liabilities given above.
(a) Physical assets: control of these creates an opportunity to generate
an inflow of cash or other assets, but it does not give rise to a present
right to receive cash or other financial assets. (b) Prepaid expenses,
etc: the future economic benefit is the receipt of goods/services rather
than the right to receive cash or other financial assets.
Contingent rights and obligations meet the definition of financial
assets and financial liabilities respectively, even though many do not
qualify for recognition in financial statements. This is because the
contractual rights or obligations exist because of a past transaction or
event (eg assumption of a guarantee).