Question 24 (a) (i)

The directors of Lizzer have decided not to disclose any

information concerning the two matters below. (i) Lizzer
is a debt issuer whose business is the securitisation of a
portfolio of underlying investments and financing their
purchase through the issuing of listed, limited recourse
debt. The repayment of the debt is dependent upon the
performance of the underlying investments. Debt-holders
bear the ultimate risks and rewards of ownership of the
underlying investments. Given the debt specific nature of
the underlying investments, the risk profile of individual
debt may differ.
Lizzer does not consider its debt-holders as being
amongst the primary users of the financial statements
and, accordingly, does not wish to provide disclosure of
the debtholders' exposure to risks in the financial
statements, as distinct from the risks faced by the
company's shareholders, in accordance with IFRS 7
Financial Instruments: Disclosures.
Required
Discuss the reasons why the debt-holders of Lizzer may
be interested in its financial statements and advise the
directors whether their decision not to provide disclosure

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of the debt-holders exposure to risks is consistent with
the principles of IFRS 7
Disclosure of debt risk
Users of financial statements
It is not for Lizzer alone to determine who the primary users
of financial statements are and what disclosures are
necessary. The entity needs to consider the requirements
of IFRS 7 Financial Instruments: Disclosures, and apply
them more broadly to include debt-holders as well as just
shareholders. More generally, IAS 1 Presentation of
Financial Statements states that the objective of financial
statements is to provide information about an entity's
financial performance, financial position and cash flows that
is useful to a wide range of users in making economic
decisions. These users
are defined by the Conceptual Framework (and the revised
Conceptual Framework) as 'existing and potential investors,
lenders and other creditors' (Conceptual Framework: para.
OB1).

The debt-holders of Lizzer are creditors of the entity. They

have provided funds to the entity from which they expect to
receive a return, based on the performance of the underlying
investments. The debt holders ultimately bear the risks and
rewards associated with the investments Lizzer has made.
They will be interested in the financial statements of Lizzer
in order to understand the risks associated with the

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underlying investments and assess the impact on their own
risk and return.

IFRS 7 requirements
The objective of IFRS 7 is to require entities to provide
disclosures in their financial statements that enable users to
evaluate:

(1) The significance of financial instruments for the entity's

financial position and performance
(2) The nature and extent of risks arising from financial
instruments to which the entity is exposed during the period
and at the reporting date, and how the entity manages those
risks

The key requirement of IFRS 7 is to show the extent to

which an entity is exposed to different types of risk,
relating to both recognised and unrecognized financial
instruments. The risk disclosures required by IFRS 7 are
given from the perspective of management which should
allow the users of financial statements to better understand
how management perceives, measures and manages the risks
associated with financial instruments.

Credit risk is one such risk, defined by the Standard as: 'The
risk that one party to a financial instrument will cause a
financial loss for the other party by failing to discharge an
obligation' (IFRS 7: Appendix A).

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Clearly disclosures about credit risk are important to debt-
holders. Such disclosures are qualitative (exposure to risk
and objectives, policies and processes for managing risk) and
quantitative, based on the information provided internally to
management personnel, enhanced if this is insufficient.

More important in this context is market risk. The debt-

holders are exposed to the risk of the underlying investments
whose value could go up or down depending on market
value.

Market risk is defined as: 'The risk that the fair value or
future cash flows of a financial instrument will fluctuate
because of changes in market prices. Market risk comprises
three types of risk: currency risk, interest rate risk and other
price risk' (IFRS 7: Appendix A).

Disclosures required in connection with market risk are:

(1) Sensitivity analysis, showing the effects on profit or loss

of changes in each market risk
(2) If the sensitivity analysis reflects interdependencies
between risk variables, such as interest rates and exchange
rates the method, assumptions and limitations must be
disclosed

(ii) At the date of the financial statements, 31 January

20X3, Lizzer's liquidity position was quite poor, such that

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the directors described it as 'unsatisfactory' in the
management report. During the first quarter of 20X3, the
situation worsened with the result that Lizzer was in
breach of certain loan covenants at 31 March 20X3. The
financial statements were authorised for issue at the end
of April 20X3. The directors' and auditor's reports both
emphasised the considerable risk of not being able to
continue as a going concern.
The notes to the financial statements indicated that there
was 'ample' compliance with all loan covenants as at the
date of the financial statements. No additional
information about the loan covenants was included in the
financial statements. Lizzer had been close to breaching
the loan covenants in respect of free cash flows and
equity ratio requirements at 31 January 20X3. The
directors of Lizzer felt that, given the existing
information in the financial statements, any further
disclosure would be excessive and confusing to users.
Required
Critique from the perspective of the investors and
potential investors of Lizzer, the decision of the directors
not to include further disclosure about the breach of loan
covenants.
Potential breach of loan covenants
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The applicable standards here are IFRS 7 Financial
Instruments: Disclosures, and IAS 10 Events after the
Reporting Period.

The directors of Lizzer are not correct in their decision not to

disclosure additional information about the breach of loan
covenants after the year end date. According to IFRS 7,
Lizzer should have included additional information about
the loan covenants sufficient to enable the users of its
financial statements to evaluate the nature and extent of
risks arising from financial instruments to which the
entity is exposed at the end of the reporting period. Such
disclosure is particularly important in Lizzer's case because
there was considerable risk at the year end (31 January
20X3) that the loan covenants would be breached in the near
future, as indicated by the directors' and auditors' doubts
about the company
continuing as a going concern. Although the breach of loan
covenants does not directly impact the investors as they have
not provided borrowings to Lizzer, there are implications in
terms of the ability of Lizzer to continue as a going concern
as this will have negative consequences for the returns they
receive on their investments. Potential investors are unlikely
to invest in a company that is a going concern risk due to the
uncertainty around its future.

Information should have been given about the conditions

attached to the loans and how close the entity was at the
year end to breaching the covenants. IFRS 7 requires

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disclosure of additional information about the covenants
relating to each loan or group of loans, including headroom
(the difference between the amount of the loan facility and
the amount required). The actual breach of the loan
covenants at 31 March 20X3 was a material event after the
reporting period as defined in IAS 10. The breach, after the
date of the financial statements but before those statements
were authorized, represents a material non-adjusting event,
which should have given rise to further disclosures in
accordance with IAS 10.

Although the breach is a non-adjusting event, there appears

to be some inconsistency between the information in the
directors' and auditor's reports (which express going concern
doubts) and the information in the financial statements,
which are prepared on a going-concern basis. If any of the
figures in the statement of financial position are affected,
these will need to be adjusted.

(b) The directors of Lizzer have read various reports

about excessive disclosure in annual reports. Some
reports suggested that excessive disclosure is burdensome
and can overwhelm users. However, other reports argued
that there is no such thing as too much 'useful'
information for users.
Required

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(i) Discuss why it is important to ensure the optimal level
of disclosure in annual reports, describing the reasons
why users of annual reports may have found disclosure to
be excessive in recent years and the actions taken by the
IASB to address this issue.
Optimal level of disclosure

It is important to ensure the optimal level of disclosure in

annual reports because excessive disclosure can obscure
relevant information and make it harder for users to find
the key points about the performance of the business and its
prospects for long-term success. It is important that financial
statements are relevant, reliable and can be understood.
However, it is equally important that useful information is
presented in a coherent way so that users can find what
they are looking for and gain an understanding of the
company's business and the opportunities, risks and
constraints that it faces.

There has been a gradual increase in the length of annual

reports over time. This, often, has not resulted in better
information for the users of financial statements, but
more confusion as to the reason for the disclosure.

Causes of excessive disclosure

Requirements of different regulators and standard-setters

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A significant cause of excessive disclosure in annual reports
is the vast array of requirements imposed by laws,
regulations and financial reporting standards.

Regulators and standard setters have a key role to play in

reducing excessive disclosure, both by cutting the
requirements that they themselves already impose and by
guarding against the imposition of unnecessary new
disclosures. A listed company may have to comply with
listing rules, company law, international financial reporting
standards and the corporate governance codes. Thus a major
source of
excessive disclosure is the fact that different parties
require differing disclosures for the same matter.

Furthermore, many disclosure requirements have been

introduced in new or revised international financial reporting
standards in previous years without any review of their
overall impact on the length or usefulness of the resulting
financial statements.

Consideration of other stakeholders

Preparers now have to consider many other stakeholders
including employees, unions, environmentalists, suppliers,
customers, etc. The disclosures required to meet the needs
of this wider audience have contributed to the increased
volume of disclosure. The growth of previous initiatives on
going concern, sustainability, risk, the business model and

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others that have been identified by regulators as 'key' has also
expanded the annual report size.

Inappropriate use of 'checklists'

A problem that seems to exist is that disclosures are being
made because a disclosure checklist suggests it may need
to be made, without assessing whether the disclosure is
necessary in a company's particular circumstances. This
requires the application of materiality to disclosures and
therefore requires judgment.

Response of IASB

The IASB launched the Disclosure Initiative in 2013 in

response to feedback that there is a need to improve the
effectiveness of disclosures in financial statements. It
includes:

 Materiality implementation projects. The IASB believe

that uncertainty on behalf of the preparers of financial
statements as to how the concept of materiality should
be applied has compounded the disclosure issue. An
Exposure Draft (ED/2015/8) on the application of
materiality to financial statements has therefore been
issued. In a separate project (ED/2017/6) the IASB is
proposing
to amend the definition of materiality to make it clearer
that information is material if omitting, misstating or
obscuring it could reasonably be expected to influence
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 the decisions of users of the financial statements,
addressing the issue that too much information can be
just as problematic as the omission of information.

 Research projects. A Discussion Paper Disclosure

Initiative – Principles of Disclosure has been issued
with the aim of encouraging entities to apply better
judgment and communicate more effectively in making
disclosures. Disclosure principles will also help the
IASB improve disclosure requirements. A further
project, the Standards-level Review of Disclosures, will
consider how to improve disclosure requirements in
Standards.

(ii) Describe the barriers, which may exist, to reducing

excessive disclosure in annual reports.

Barriers to reducing disclosure

Entities are sometimes reluctant to reduce the level of
disclosure. These barriers are behavioural and include the
following:
(1) The perception that disclosing everything will satisfy
all interested parties. Many of the disclosures will not be
applicable to the needs of any one user.

(2) The threat of criticism or litigation. Preparers of

financial statements err on the side of caution rather than risk
falling foul of the law by omitting a required disclosure.

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Removing disclosures is seen as creating a risk of adverse
comment and regulatory challenge.

(3) Cut and paste mentality. If items were disclosed in last

year's annual report and the issue is still ongoing, there is a
tendency to copy the disclosures into this year's report. It is
thought that, if such disclosures are removed, stakeholders
may wonder whether the financial statements still give a true
and fair view. Disclosure is therefore the safest option and
the default position.

(4) Checklist approach. While materiality should determine

what is disclosed, because what is material is what may
influence the user, the assessment of what is material can be
a matter of judgment. The purpose of checklists is to include
all possible disclosures that could be material. Users may not
know which of the checklist disclosures is actually material
in the context of their specific needs.

Question 36 (a)

Evolve is a real estate company, which is listed on the

stock exchange and has a year end of 31 August. On 21
August 20X6, Evolve undertook a scrip (bonus) issue
where the shareholders of Evolve received certain rights.
The shareholders are able to choose between:

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(i) Receiving newly issued shares of Evolve, which could
be traded on 30 September 20X6; or
(ii) Transferring their rights back to Evolve by 10
September 20X6 for a fixed cash price which would be
paid on 20 September 20X6.

In the financial statements at 31 August 20X6, Evolve

believed that the criteria for the recognition of a financial
liability as regards the second option were not met at 31
August 20X6 because it was impossible to reliably
determine the full amount to be paid, until 10 September
20X6. Evolve felt that the transferring of the rights back
to Evolve was a put option on its own equity, which
would lead to recording changes in fair value in profit or
loss in the next financial year. Evolve disclosed the
transaction as a non-adjusting event after the reporting
period.

A financial liability for the present value of the maximum

amount payable to shareholders should be recognised in the
financial statements as of 31 August 20X6. At 31 August
20X6, the rights are equivalent to a written put option
because they represent for Evolve a purchase obligation
which gives shareholders the right to sell the entity's own
equity instruments for a fixed price. The fundamental
principle of IAS 32 Financial Instruments: Presentation is
that 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, and the

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definitions of financial liability and equity instrument. IAS
32 states that a contract which contains an entity's obligation
to purchase its own equity instruments gives rise to a
financial liability, which should be recognised at the present
value of its redemption amount. IAS 32 also states that a
contractual obligation for an entity to purchase its own
equity instruments gives rise to a financial liability for the
present value of the redemption amount even if the
obligation is conditional on the counterparty exercising a
right to redeem, as is the case with the scrip issue of Evolve.

Evolve had set up the conditions for the share capital

increase in August 20X6 and, therefore, the contract gave
rise to financial liabilities from that date and Evolve should
have recognised a financial liability for the present value of
the maximum amount payable to shareholders in its financial
statements for the year ended 31 August 20X6. A non-
adjusting event under IAS 10 Events After the Reporting
Period is an event after the reporting period which is
indicative of a condition which arose after the end of the
reporting period. However, it could be argued that the
transferring of the free allocation rights back to Evolve is in
fact an adjusting event as it is an event after the reporting
period which provides further evidence of conditions which
existed at the end of the reporting period.

Question 37(b)
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Gasnature has entered into a ten-year contract with Agas
for the purchase of natural gas. Gasnature has made an
advance payment to Agas for an amount equal to the
total quantity of gas contracted for ten years which has
been calculated using the forecasted price of gas. The
advance carries interest of 6% per annum, which is
settled by way of the supply of extra gas. Fixed quantities
of gas have to be supplied each month and there is a price
adjustment mechanism in the contract whereby the
difference between the forecasted price of gas and the
prevailing market price is settled in cash monthly. If
Agas does not deliver gas as agreed, Gasnature has the
right to claim compensation at the current market price
of gas. Gasnature wishes to know whether the contract
with Agas should be accounted for under IFRS 9
Financial Instruments.
IFRS 9 Financial Instruments applies to those contracts to
buy or sell a non-financial item which can be settled net in
cash with the exception of contracts which are held for the
purpose of the receipt or delivery of a non-financial item in
accordance with the entity's expected purchase, sale or usage
requirements (own use contract). In other words, it will result
in physical delivery of the commodity, in this case the extra
gas. Contracts which are for an entity's 'own use' are exempt
from the requirements of IFRS 9. Such a contract can be
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irrevocably designated as measured at fair value through
profit or loss even if it was entered into for the above
purpose. This designation is available only at inception of the
contract and only if it eliminates or significantly reduces a
recognition inconsistency (sometimes referred to as an
'accounting mismatch') which would otherwise arise from
not recognising that contract because it is excluded from the
scope of IFRS 9. There are various ways in which a contract
to buy or sell a non-financial item can be settled net in cash
or another financial instrument or by exchanging financial
instruments. These include the following:
(i) When the terms of the contract permit either party to settle
it net in cash.
(ii) When the ability to settle net in cash is not explicit in the
terms of the contract, but the entity has a practice of settling
similar contracts net in cash.
(iii) When, for similar contracts, the entity has a practice of
taking delivery of the underlying and selling it within a short
period after delivery, for the purpose of generating a profit.
(iv) When the non-financial item which is the subject of the
contract is readily convertible to cash.
A written option to buy or sell a non-financial item which
can be settled net in cash is within the scope of IFRS 9. Such

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a contract cannot be entered into for the purpose of the
receipt or delivery of the non-financial item in accordance
with the entities expected purchase, sale or usage
requirements. Contracts to buy or sell a non-financial item,
such as a commodity, which can be settled net in cash or
another financial instrument, or by exchanging financial
instruments, are within the scope of IFRS 9. They are
accounted for as derivatives. A level of judgment will be
required in this area as net settlements caused by unique
events beyond management's control may not necessarily
prevent the entity from applying the 'own use' exemption to
all similar contracts.
The contract entered into by Gasnature with Agas seems to
be an own use contract which falls outside IFRS 9 and
therefore would be treated as an executory contract.
However, it could be argued that the contract is net settled
because the penalty mechanism requires Agas to compensate
Gasnature at the current prevailing market price. Further, if
natural gas is readily convertible into cash in the location
where the delivery takes place, the contract could be
considered net settled. Additionally, if there is volume
flexibility, then the contract could be regarded as a written
option, which falls within the scope of IFRS 9.
However, the contract will probably still qualify as 'own use'
as long as it has been entered into and continues to be held
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for the expected counterparties' sales/usage requirements.
Additionally, the entity has not irrevocably designated the
contract as measured at fair value through profit or loss, thus
adding weight to the 'own use' designation.

Question 40(b)
At the start of the financial year to 30 November 20X3,
Coatmin gave a financial guarantee contract on behalf of
one of its subsidiaries, a charitable organisation,
committing it to repay the principal amount of $60
million if the subsidiary defaulted on any payments due
under a loan. The loan related to the financing of the
construction of new office premises and has a term of
three years. It is being repaid by equal annual
instalments of principal with the first payment having
been paid. Coatmin has not secured any compensation in
return for giving the guarantee, but assessed that it had a
fair value of $1.2 million. The guarantee is measured at
fair value through profit or loss. The guarantee was given
on the basis that it was probable that it would not be
called upon. At 30 November 20X4, Coatmin became
aware of the fact that the subsidiary was having financial
difficulties with the result that it has not paid the second
instalment of principal. It is assessed that it is probable

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that the guarantee will now be called. However, just
before the signing of the financial statements for the year
ended 30 November 20X4, the subsidiary secured a
donation which enabled it to make the second repayment
before the guarantee was called upon. It is now
anticipated that the subsidiary will be able to meet the
final payment. Discounting is immaterial and the fair
value of the guarantee is higher than amount of the loss
allowance determined in accordance with the IFRS 9
rules on expected credit losses. Coatmin wishes to know
the principles behind accounting for the above guarantee
under IFRS and how the transaction would be accounted
for in the financial records.
IFRS 9 Financial Instruments requires entities to classify all
financial liabilities as subsequently measured at amortised
cost using the effective interest method, with the following
exceptions.
(i) Financial liabilities at fair value through profit or loss.
Such liabilities, including derivatives that are liabilities, must
be subsequently measured at fair value.

(ii) Financial liabilities that arise when a transfer of a

financial asset does not qualify for derecognition or when
the continuing involvement approach applies

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(iii) Financial guarantee contracts. After initial
recognition, an issuer of such a contract must subsequently
measure it at the higher of:

(1) The amount of the loss allowance determined in

accordance with the IFRS 9 rules on expected credit losses;
and

(2) The amount initially recognised less, when appropriate,

the cumulative amount of income recognised in accordance
with the principles of IFRS 15 Revenue from

Contracts with Customers.

If an entity chooses to measure a financial guarantee contract

(or loan commitment) at fair value through profit or loss,
as here, all fair value movements go through profit or loss
with no transfer to other comprehensive income. Changes in
the credit risk of liabilities relating to financial guarantee
contracts are not required to be presented in other
comprehensive income under IFRS 9. Assuming that
discounting is not material, the accounting entries will be as
follows.

At 1 December 20X2
DEBIT Profit or loss $1.2m
CREDIT Financial liabilities $1.2m
To record the loss incurred in giving the guarantee

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At 30 November 20X3
DEBIT Financial liabilities $0.4m
CREDIT Profit or loss $0.4m
To amortize the initial fair value over the life of the
guarantee

This reflects the reduction in exposure arising from the fact

that the subsidiary has made the first repayment.

At 30 November 20X4
DEBIT Profit or loss ($40m – ($1.2m – $0.4m))
$39.2m
CREDIT Financial liabilities $39.2m
To provide for the calling of the guarantee

DEBIT Financial liabilities ($40m – $0.4m) $39.6m

CREDIT Profit or loss $39.6m
To record movement from expected credit loss allowance to
measurement at amortized initial value

The above change was made in the light of the subsidiary's

receipt of the donation enabling it to make the second
repayment, which means a change in probability that the
guarantee will be called. This is an event after the reporting
period which provides further evidence of conditions
existing at the end of the reporting period, and so is an
adjusting event.

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Question 40 (c)

Coatmin's creditworthiness has been worsening but it has

entered into an interest rate swap agreement which acts
as a hedge against a $2 million 2% bond issue which
matures on 31 May 20X6. Coatmin wishes to know the
circumstances in which it can use hedge accounting. In
particular, it needs advice on hedge effectiveness and
whether this can be calculated.

Hedging

IFRS 9 Financial Instruments allows hedge accounting but

only if all of the following conditions are met.

(i) The hedging relationship consists only of eligible

hedging instruments and eligible hedged items.

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(ii) There must be formal documentation (including
identification of the hedged item, the hedging instrument, the
nature of the risk that is to be hedged and how the entity will
assess the hedging instrument's effectiveness in offsetting the
exposure to changes in the hedged item's fair value or cash
flows attributable to the hedged risk).

(iii) The hedging relationship meets all of the IFRS 9 hedge

effectiveness criteria. IFRS 9 defines hedge effectiveness as
the degree to which changes in the fair value or cash flows of
the hedged item attributable to a hedged risk are offset by
changes in the fair value or cash flows of the hedging
instrument. The directors of Coatmin have asked whether
hedge effectiveness can be calculated. IFRS 9 uses an
objective-based assessment for hedge effectiveness, under
which the following criteria must be met.

(i) There is an economic relationship between the hedged

item and the hedging instrument, ie the hedging instrument
and the hedged item have values that generally move in the
opposite direction because of the same risk, which is the
hedged risk;

(ii) The effect of credit risk does not dominate the value
changes that result from that economic relationship, ie the
gain or loss from credit risk does not frustrate the effect of
changes in the underlying item on the value of the hedging
instrument or the hedged item, even if those changes were
significant; and

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(iii) The hedge ratio of the hedging relationship (quantity
of hedging instrument vs quantity of hedged item) is the
same as that resulting from the quantity of the hedged item
that the entity actually hedges and the quantity of the
hedging instrument that the entity actually uses to hedge that
quantity of hedged item.

Question 40 (d)
Coatmin provides loans to customers and funds the loans
by selling bonds in the market. The liability is designated
as at fair value through profit or loss. The bonds have a
fair value decrease of $50 million in the year to 30
November 20X4 of which $5 million relates to the
reduction in Coatmin's creditworthiness. The directors of
Coatmin would like advice on how to account for this
movement.

Liability
IFRS 9 Financial Instruments requires that financial
liabilities which are designated as measured at fair value
through profit or loss are treated differently. In this case
the gain or loss in a period must be classified into:
Gain or loss resulting from credit risk; and
Other gain or loss.

This provision of IFRS 9 was in response to an anomaly

regarding changes in the credit risk of
a financial liability.

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Changes in a financial liability's credit risk affect the fair
value of that financial liability. This means that when an
entity's creditworthiness deteriorates, the fair value of its
issued debt will decrease (and vice versa). IFRS 9 requires
the gain or loss as a result of credit risk to be recognised in
other comprehensive income, unless it creates or enlarges an
accounting mismatch, in which case it is recognised in
profit or loss. The other gain or loss (not the result of credit
risk) is recognised in profit or loss.

On derecognition any gains or losses recognised in other

comprehensive income are not transferred to profit or loss,
although the cumulative gain or loss may be transferred
within equity.

This is a decrease in the fair value of the liability, which is a

fair value gain in the books of Coatmin. Coatmin should split
the fair value decrease as follows:

STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME (EXTRACT)
FOR THE YEAR ENDED 30 NOVEMBER 20X4

Profit or loss for the year

Liabilities at fair value

$'000
Fair value gain not attributable to change in credit risk
45

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Profit (loss) for the year
45
Other comprehensive income (not reclassified to profit or
loss)
Fair value gain on financial liability attributable to change in
credit risk 5
Total comprehensive income
50

Question 41 (a)
The difference between debt and equity in an entity's
statement of financial position is not easily
distinguishable for preparers of financial statements.
Some financial instruments may have both features,
which can lead to inconsistency of reporting. The
International Accounting Standards Board (IASB) has
agreed that greater clarity may be required in its
definitions of assets and liabilities for debt instruments. It
is thought that defining the nature of liabilities would
help the IASB's thinking on the difference between
financial instruments classified as equity and liabilities.
Required
(i) Discuss the key classification differences between debt
and equity under International Financial Reporting

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Standards. Note. Examples should be given to illustrate
your answer.
Classification differences between debt and equity
It is not always easy to distinguish between debt and
equity in an entity's statement of financial position, partly
because many financial instruments have elements of both.

IAS 32 Financial Instruments: Presentation brings clarity

and consistency to this matter, so that the classification is
based on principles rather than driven by perceptions of
users.

IAS 32 defines an equity instrument as: 'any contract that

evidences a residual interest in the assets of an entity after
deducting all of its liabilities (IAS 32: para. 11). It must first
be established that an instrument is not a financial
liability, before it can be classified as equity.

A key feature of the IAS 32 definition of a financial

liability is that it is a contractual obligation to deliver cash
or another financial asset to another entity. The
contractual obligation may arise from a requirement to make
payments of principal, interest or dividends. The contractual
obligation may be explicit, but it may be implied indirectly
in the terms of the contract. An example of a debt instrument
is a bond which requires the issuer to make interest payments
and redeem the bond for cash.

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A financial instrument is an equity instrument only if there
is no obligation to deliver cash or other financial assets to
another entity and if the instrument will or may be settled in
the issuer's own equity instruments. An example of an equity
instrument is ordinary shares, on which dividends are
payable at the discretion of the issuer. A less obvious
example is preference shares required to be converted into a
fixed number of ordinary shares on a fixed date or on the
occurrence of an event which
is certain to occur.

An instrument may be classified as an equity instrument if it

contains a contingent settlement provision requiring
settlement in cash or a variable number of the entity's own
shares only on the occurrence of an event which is very
unlikely to occur – such a provision is not considered to be
genuine. If the contingent payment condition is beyond
the control of both the entity and the holder of the
instrument, then the instrument is classified as a financial
liability.

A contract resulting in the receipt or delivery of an

entity's own shares is not automatically an equity
instrument. The classification depends on the socalled
'fixed test' in IAS 32. A contract which will be settled by the
entity receiving or delivering a fixed number of its own
equity instruments in exchange for a fixed amount of
cash is an equity instrument. The reasoning behind this is
that

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by fixing upfront the number of shares to be received or
delivered on settlement of the instrument in concern, the
holder is exposed to the upside and downside risk of
movements in the entity's share price.

In contrast, if the amount of cash or own equity shares to

be delivered or received is variable, then the contract is a
financial liability or asset. The reasoning behind this is that
using a variable number of own equity instruments to settle a
contract can be similar to using own shares as 'currency' to
settle what in substance is a financial liability. Such a
contract does not evidence a residual interest in the entity's
net assets. Equity classification is therefore inappropriate.

IAS 32 gives two examples of contracts where the number

of own equity instruments to be received or delivered varies
so that their fair value equals the amount of the contractual
right or obligation.
(1) A contract to deliver a variable number of own equity
instruments equal in value to a fixed monetary amount on the
settlement date is classified as a financial liability.

(2) A contract to deliver as many of the entity's own equity

instruments as are equal in value to the value of 100 ounces
of a commodity results in liability classification of the
instrument.

There are other factors which might result in an instrument

being classified as debt.

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(1) Dividends are non-discretionary.
(2) Redemption is at the option of the instrument holder.
(3) The instrument has a limited life.
(4) Redemption is triggered by a future uncertain event
which is beyond the control
of both the issuer and the holder of the instrument.

Other factors which might result in an instrument being

classified as equity include the following.
(1) Dividends are discretionary.
(2) The shares are non-redeemable.
(3) There is no liquidation date.

(ii) Explain why it is important for entities to understand

the impact of the classification of a financial instrument
as debt or equity in the financial statements.

Significance of debt/equity classification for the financial

statements

The distinction between debt and equity is very important,

since the classification of a financial instrument as either
debt or equity can have a significant impact on the entity's
reported earnings and gearing ratio, which in turn can

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affect debt covenants. Companies may wish to classify a
financial instrument as equity, in order to give a favorable
impression of gearing, but this may in turn have a negative
effect on the perceptions of existing shareholders if it is seen
as diluting existing equity interests.

The distinction is also relevant in the context of a business

combination where an entity issues financial instruments
as part consideration, or to raise funds to settle a business
combination in cash. Management is often called upon to
evaluate different financing options, and in order to do so
must understand the classification rules and their
potential effects. For example, classification as a liability
generally means that payments are treated as interest and
charged to profit or loss, and this may, in turn, affect the
entity's ability to pay dividends on equity shares.

Question 40 (b)
The directors of Avco, a public limited company, are
reviewing the financial statements of two entities which are
acquisition targets, Cavor and Lidan. They have asked for
clarification on the treatment of the following financial
instruments within the financial statements of the entities.
Cavor has two classes of shares: A and B shares. A shares
are Cavor's ordinary shares and are correctly classed as
equity. B shares are not mandatorily redeemable shares but
contain a call option allowing Cavor to repurchase them.
Dividends are payable on the B shares if, and only if,
dividends have been paid on the A ordinary shares. The

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terms of the B shares are such that dividends are payable at a
rate equal to that of the A ordinary shares. Additionally,
Cavor has also issued share options which give the
counterparty rights to buy a fixed number of its B shares for
a fixed amount of $10 million. The contract can be settled
only by the issuance of shares for cash by Cavor. Lidan has
in issue two classes of shares: A shares and B shares. A
shares are correctly classified as equity. Two million B
shares of nominal value of $1 each are in issue. The B shares
are redeemable in two years' time. Lidan has a choice as to
the method of redemption of the B shares. It may either
redeem the B shares for cash at their nominal value or it may
issue one million A shares in settlement. A shares are
currently valued at $10 per share. The lowest price for
Lidan's A shares since its formation has been $5 per share.

Required
Discuss whether the above arrangements regarding the B
shares of each of Cavor and Lidan should be treated as
liabilities or equity in the financial statements of the
respective issuing companies.

Cavor

B shares
The classification of Cavor's B shares will be made by
applying the principles-based definitions of equity and
liability in IAS 32, and considering the substance, rather
than the legal form of the instrument. 'Substance' here relates

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only to consideration of the contractual terms of the
instrument. Factors outside the contractual terms are not
relevant to the classification. The following factors
demonstrate that Cavor's B shares are equity instruments.

(1) Dividends are discretionary in that they need only be

paid if paid on the A shares, on which there is no obligation
to pay dividends. Dividends on the B shares will be paid at
the same rate as on the A shares, which will be variable.

(2) Cavor has no obligation to redeem the B shares.

Share options
The 'fixed test' must be applied. If the amount of cash or own
equity shares to be delivered is variable, then the contract is a
debt instrument. Here, however, the contract is to be settled
by Cavor issuing a fixed number of its own equity
instruments for a fixed amount of cash. Accordingly there is
no variability, and the share options are classified as an
equity instrument.

(ii) Lidan

A financial liability under IAS 32 is a contractual

obligation to deliver cash or another financial asset to
another entity. The contractual obligation may arise from a
requirement to make payments of principal, interest or
dividends. The contractual obligation may be explicit, but it

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may be implied indirectly in the terms of the contract. In the
case of Lidan, the contractual obligation is not explicit. At
first glance it looks as if Lidan has a choice as to how much
it pays to redeem the B shares. However, the conditions of
the financial instrument are such that the value of the
settlement in own shares is considerably greater than the
cash settlement obligation.

The effect of this is that Lidan is implicitly obliged to

redeem the B shares at for a cash amount of $1 per share.
The own-share settlement alternative is uneconomic in
comparison to the cash settlement alternative, and cannot
therefore serve as a means of avoiding classification as a
liability.

IAS 32 states further that where a derivative contract has

settlement options, all of the settlement alternatives must
result in it being classified as an equity instrument;
otherwise it is a financial asset or liability. In conclusion,
Lidan's B shares must be classified as a liability.

Question 42
The definition of a financial instrument captures a wide
variety of assets and liabilities including cash, evidence of
an ownership interest in an entity, or a contractual right
to receive or deliver cash or another financial instrument.
Preparers, auditors and users of financial statements
have found the requirements for reporting financial
assets and liabilities to be very complex, problematic and

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sometimes subjective. It is important that a standard in
this area should allow users to understand the economic
substance of the transaction and preparers to properly
apply generally accepted accounting principles.
Required

(a) (i) Discuss, from the perspective of preparers and

users of financial statements, how the measurement of
financial instruments under International Financial
Reporting Standards can create confusion and
complexity.

Many users and preparers of accounts have found financial

instruments to be complex. The main reason for complexity
in accounting for financial instruments is the many different
ways in which they can be measured. The measurement
method depends on:

(1) The applicable financial reporting standard. A variety

of IFRS and IAS apply to the measurement of financial
instruments. For example, financial assets may be measured
using consolidation for subsidiaries (IFRS 10), the equity
method for associates and joint ventures (IAS 28 and IFRS
11) or IFRS 9 for most
other financial assets.

(2) The categorisation of the financial instrument. While

IFRS 9 classifies financial assets as measured at amortised
cost, fair value through profit or loss or fair value

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through other comprehensive income A financial asset
may only be classified as measured at amortized cost if the
object of the business model in which it is held is to collect
contracted cash flows and its contractual terms give rise on
specified dates to cash flows that are solely payments of
principal and interest.

(3) Whether hedge accounting has been applied. Hedge

accounting is complex, for example when cash flow hedge
accounting is used, gains and losses may be split between
profit or loss for the year and other comprehensive income
(items that may subsequently be reclassified to profit or
loss). In addition, there may be mismatches when hedge
accounting applies reflecting the underlying mismatches
under the non-hedging rules.

Some measurement methods use an estimate of current

value, and others use historical cost. Some include
impairment losses, others do not. The different measurement
methods for financial instruments create a number of
problems for preparers and users of accounts:

(1) The treatment of a particular instrument may not be the

best, but may be determined by other factors.

(2) Gains or losses resulting from different measurement

methods may be combined in the same line item in the
statement of profit or loss and other comprehensive income.
Comparability is therefore compromised.

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(3) Comparability is also affected when it is not clear what
measurement method has been used.

(4) It is difficult to apply the criteria for deciding which

instrument is to be measured in which way. As new types of
instruments are created, the criteria may be applied in ways
that are not consistent.

(ii) Set out the reasons why using fair value to measure
all financial instruments may result in less complexity in
accounting for financial instruments, but may lead to
uncertainty in financial statements.

(ii) A single fair value model would be much simpler to

apply than the current mixed model. A single measurement
method would, it is argued:

(1) Significantly reduce complexity in classification. There

would be no need to classify financial instruments into the
four categories of fair value through profit or loss, available
for sale financial assets, loans and receivables and held to
maturity. This simplification has already been partially
achieved by IFRS 9.

(2) Reduce complexity in accounting. There would be no

need to account for transfers between the above categories,
or to report how impairment losses have been quantified.

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(3) Eliminated measurement mismatches between
financial instruments and reduce the need for fair value
hedge accounting.

(4) Eliminate the need to identify and separate embedded

derivatives.

(5) Better reflect the cash flows that would be paid if

liabilities were transferred at the re-measurement date.

(6) Make reported information easier to understand.

(7) Improve the comparability of reported information

between entities and between periods.

However, while fair value has some obvious advantages, it

has problems too. Uncertainty may be an issue for the
following reasons

(1) Markets are not all liquid and transparent.

(2) Many assets and liabilities do not have an active market,

and methods for estimating their value are more subjective.

(3) Management must exercise judgement in the valuation

process, and may not be entirely objective in doing so.

(4) Because fair value, in the absence of an active market,

represents an estimate, additional disclosures are needed to

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explain and justify the estimates. These disclosures may
themselves be subjective.

(5) Independent verification of fair value estimates is

difficult for all the above reasons.

(b)
A company borrowed $47 million on 1 December 20X4
when the market and effective interest rate was 5%. On
30 November 20X5, the company borrowed an additional
$45 million when the current market and effective
interest rate was 7.4%. Both financial liabilities are
repayable on 30 November 20X9 and are single payment
notes, whereby interest and capital are repaid on that
date.

Required
Discuss the accounting for the above financial liabilities
under IFRS 9 using amortised cost, and additionally
using fair value as at 30 November 20X5.

Different valuation methods bring comparability problems,

as indicated in Part (a), and this can be seen with the
examples in this part of the question.

Amortized cost

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Using amortized cost, both the initial loan and the new loan
result in single payments that are almost identical on 30
November 20X9:

Initial loan: $47m × 1.05 for 5 years = $59.98m

New loan: $45m × 1.074 for 4 years = $59.89m

However, the carrying amounts at 30 November 20X5 will

be different:
Initial loan: $47m + ($47m × 5%) = $49.35m
New loan: $45m

Fair value
If the two loans were carried at fair value, both the initial
loan and the new loan would have the same value, and be
carried at $45m. There would be a net profit of $2m, made
up of the interest expense of $47m × 5% = $2.35m and the
unrealised gain of $49.35m – $45m = $4.35m.

Arguably, since the obligation on 30 November 20X9 will be

the same for both loans, fair
value is a more appropriate measure than amortised cost.

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