FINANCIAL INSTRUMENTS

1. Financial instruments

Introduction

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.
Need for accounting standard
In recent years there has been a huge growth worldwide in the variety and complexity of financial instruments
in international financial markets.

There were numerous concerns about the accounting practices used for financial instruments which led to
demands for an accounting standard. The concern included the following:
• There had been significant growth in the number and complexity of financial instruments.
• Accounting standards had not developed in line with the growth in instruments.
• There had been a particular problem with derivatives (e.g. forwards, future, swaps, etc.)
• Unrealized gains/losses on many financial instruments were not recognized.
• Entities could choose when to recognize profits on instruments in order to smooth profits.

Accounting standards
There are three reporting standards that deal with financial instruments:
• IFRS 9 Financial Instruments: Recognition and Measurement
• IAS 32 Financial Instruments: Classification and Presentation
• IFRS 7 Financial Instruments: Disclosures

IFRS 9 deals with how financial instruments are measured and when they should be recognized in financial statements.
IAS 32 deals with the classification of financial instruments and their presentation in financial statements.
IFRS 7 deals with the disclosure of financial instruments in financial statements.

Financial assets
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 (IAS 32, para 11)

Examples of financial assets include:

• Trade receivables
• Options
• Investments in equity shares.

Financial liabilities
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 (IAS 32, para 11)

Examples of financial liabilities include:

• Trade payables
• Debentures loans
• Redeemable preference shares

Financial assets Nonfinancial assets Financial liabilities Nonfinancial liabilities

1. Cash and cash equivalents 1. Merchandise inventory 1. Accounts payable 1. Advances from customers
2. Accounts receivable 2. Biological assets 2. Utilities payable 2. Unearned rent
3. Allowance for bad debts 3. Non-current asset held for sale 3. Accrued interest expense 3. Warranty obligation
4. Notes receivable 4. Investment property 4. Cash dividends payable 4. Unearned interest on
5. Interest receivable 5. Property, plant and equipment 5. Finance lease liability receivables or Unearned
6. Loans receivable 6. Accumulated depreciation 6. Bonds payable interest income
7. Prepaid interest (not a 7. Intangible assets 7. Add premium or Less discount 5. Income taxes payable
valuation account to financial 8. Prepaid rent on bonds payable 6. SSS contributions payable
liability) 9. Claims for tax refund 8. Security deposit 7. Philhealth payable
8. Investment in equity and 10. Deferred tax assets 9. Issued redeemable preference 8. Property dividends
debt instrument 11. Gold bullion deposited in shares (with mandatory payable
9. Investment in associate banks redemption) 9. Deferred tax liabilities
10. Investment in subsidiary 10. Stock appreciation rights 10. Provision for warranties
11. Cash surrender value payable
12. Sinking fund
13. Derivatives

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 instruments 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

Who should care about IFRS 7 Financial Instruments: Disclosures?

The standard IFRS 7 prescribes the disclosure requirements for all entities that have some financial instruments in their books.

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 IFRS 7 applies to everybody. So even if you work for a trading company and you have some loans and lots of trade receivables, then yes,
you should be familiar with IFRS 7 to know what to include in your notes to the financial statements.

There are some types of instruments that are exempt from IFRS 7 and you should provide disclosures in line with other standards,
such as:
• Subsidiaries, joint ventures, associates
• Insurance contracts
• Employee benefit plans
• Share-based payments
• Equity instruments in line with IAS 32 (here, OWN equity instruments are excluded, not the equity instruments in other entities
as these are your financial assets)

What disclosures are required by IFRS 7?

IFRS 7 requires certain disclosures in 2 main areas:

1. Significance of financial instruments, and
2. Nature and extent of risks from financial instruments and how they are managed

Significance of financial instruments

These disclosures are necessary to understand whether the financial instruments are significant for entity’s financial position and
performance.

They are divided into few subgroups and let me list a few of them here for your information:
1. Disclosures for the statement of financial position:
o Carrying amounts of your financial instruments by their categories
o Financial assets or financial liabilities measured at fair value through profit or loss (FVTPL)
o Investments in equity instruments designated at fair value through other comprehensive income (FVOCI)
o Reclassifications
o Offsetting financial assets and financial liabilities
o Collaterals
o Allowance account for credit losses
o Compound financial instruments with multiple embedded derivatives
o Default and breaches
2. Disclosures for the statement of comprehensive income:
You should disclose the items of income, expense, gains or losses (by categories), mainly:
o Net gains or net losses on each category of the financial instruments
o Total interest revenue and total interest expense
o Fee income and expense
o Analysis of the gain or loss in the statement of comprehensive income from the derecognition of financial assets at
amortized cost
3. Other disclosures:
o Accounting policies
o Hedge accounting disclosures (risk management strategies, effect of hedge accounting…)
o Fair value (how it was determined, fair values of FA and FL, explanations when the fair value cannot be determined)
You should disclose most of the information listed above in breakdowns at least by the categories of financial instruments.

Nature and extent of risks from financial instruments

This part of the disclosures is really demanding, because it requires additional analysis and work, especially for market risk disclosures.

IFRS 7 requires qualitative and quantitative disclosures for three main risks:
1. Credit risk
2. Liquidity risk
3. Market risk

For each type of risk, you should disclose:

• Qualitative disclosures:
Here, you would normally describe how the company is exposed to the risks, how the risks arise and how it manages these
risks.
• Quantitative disclosures:

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 You need to provide a summary of quantitative data (numbers) about the exposures to the risk.
It’s a lot of details and IFRS 7 requires specific quantitative disclosures for each type of risk (see below).
You should also provide the disclosures about the concentration of risks.

Credit risk

Credit risk relates to your financial assets and simply speaking, it is a risk that you will suffer a financial loss due to counterparty failing
to pay its obligations.

If you have trade receivables or you provide loans, then you are exposed to credit risk and you should focus on this part of the standard.

You should disclose:

• Credit risk management practices
• Information about amounts arising from expected credit losses
• Credit risk exposure
• Collateral and other credit enhancements obtained

This is one example of how your quantitative credit risk disclosure can look like for trade receivables:

Liquidity risk

Liquidity risk relates to your financial liabilities and it is a kind of “opposite” to the credit risk.

It is the risk that YOU will not meet your obligations from financial liabilities to be settled with cash or another financial asset.

You should disclose:

• Maturity analysis of financial liabilities with remaining contractual maturities (separately for non-derivative and derivative)
• How you manage the liquidity risk

Here, there’s an illustration of quantitative risk disclosure for liquidity risk:

Market risk

Market risk is the risk that either the fair value or future cash flows from your financial assets or financial liabilities will fluctuate due to
changes in market prices.

Market risk has a few components, based on what causes the change in future cash flows or fair value:
• Currency risk: the risk that foreign exchange rate changes cause the fluctuations in cash flows or fair values;
• Interest rate risk: : fluctuations are caused by the changes in interest rates;
• Other price risk: Fluctuations are caused by the changes in other market prices, such as commodity prices, equity prices, etc.

The disclosures for market risk are quite demanding and require some work, because you need to produce sensitivity analysis.

There are two types of sensitivity analysis and you can choose the one that’s the best in your situation:
1. ”Basic” sensitivity analysis: Here, you need to simulate the changes in certain variable (interest rate, foreign exchange
rate, etc.) and show how profit or loss and equity would have been affected.
2. Value-at-risk analysis: Here, you need to analyze interdependencies between variables, for example between interest rates
and exchange rates.

Other disclosures

Except for these 2 big groups of IFRS 7 disclosures (significance and nature of risk), there is few more information required about:
• Transfers of financial assets, and
• Information required on initial application of IFRS 9

How to present the disclosures?

As you can see from the above summary, IFRS 7 requires loads and loads of information to be presented. So, if you want your
disclosures to be useful for the readers, please bear a few rules in mind:
• Lots of disclosures are required by the classes of financial instruments (for example, credit risk disclosures or liquidity risk
disclosures).
Classes are not the same as categories of financial instruments and here, you should group your financial instruments into
classes according to your judgment, what’s the best for your readers to understand. Also, you don’t need to use the same
classes for different risks.
• You can provide the disclosures in an integrated package.
Thus, one disclosure can satisfy more requirements.
• Find the right balance between the level of detail and materiality.
• Make sure you include all material information, but don’t include excessive details about items not significant that
much, because otherwise the users will be confused and the disclosures would be useless.

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 FINANCIAL 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)

Use the following information for the next five (5) questions:

On December 31, data for Diaz Co. include the following:

FA NFA FL NFL SHE
1. Accounts receivable P200,000
2. Allowance for bad debts 20,000
3. Cash and cash equivalents 140,000
4. Interest receivable 42,000
5. Prepaid interest (not a valuation account to 40,000
financial liability)
6. Investment in associate 90,000
7. Stock appreciation rights payable (SARs 240,000
payable)
8. Investment in equity instruments 250,000
9. Investment in subsidiary 140,000
10. Investment in bonds 340,000
11. Cash surrender value 120,000
12. Sinking fund 80,000
13. Share premium 70,000
14. Unearned interest on receivables/Unearned 10,000
interest income
15. Income taxes payable 18,000
16. SSS contributions payable 10,000
17. Intangible assets 60,000
18. Prepaid rent 40,000
19. Treasury shares 46,000
20. Claims for tax refund 90,000
21. Deferred tax assets 120,000
22. Accounts payable 300,000
23. Utilities payable 500,000
24. Accrued interest expense 36,000
25. Cash dividends payable 54,000
26. Finance lease liability 90,000
27. Bonds payable 240,000
28. Discount on bonds payable 30,000
29. Security deposit 60,000
30. Advances from customers 32,000
31. Unearned rent 16,000
32. Merchandise inventories 266,000
33. Biological assets 240,000
34. Accumulated depreciation 100,000
35. Warranty obligations 26,000
36. Philhealth contributions payable 12,000
37. Deferred tax liabilities 38,000
38. Accumulated profits-appropriated for plant 1,000,000
expansion
39. Accumulated profits-unappropriated 6,400,000
40. Issued redeemable preference shares (with 200,000
mandatory redemption)
41. Issued preference shares capital 700,000
Total
Compute the balance of:
1. Financial Assets__________________
A. P1,422,000 B. P1,522,000 C. P1,622,000 D. P1,722,000

2. Non-financial Assets______________
A. P716,000 B. P816,000 C. P916,000 D. P1,016,000

3. Financial Liabilities _______________

A. P1,690,000 B. P1,790,000 C. P1,890,000 D. P1,990,000

4. Non-financial Liabilities____________
A. P162,000 B. P172,000 C. P182,000 D. P192,000

5. Shareholders’ equity______________
A. P8,124,000 B. P8,125,000 C. P8,136,000 D. P8,137,000

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