Financial Instruments

IAS 32 -Financial Instruments: Presentation

IFRS 7 -Financial Instruments: Disclosures
IFRS 9 -Financial Instruments: Measurement and Recognition (replaced IAS 39)
Definitions
Financial Instruments: A Financial Instrument is any contract that gives rise to both a
financial asset to one entity and a financial liability or equity instrument to another entity.
Financial Asset: This is any asset that is cash or equity instrument of another entity (e.g
shares of another entity). It can equally be described as 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: This is any liability that is a contractual obligation to deliver cash or
another financial asset to another entity. It can also be referred to as a contractual obligation to
exchange financial instruments with another entity under conditions that are potentially
unfavorable or a contract that will or may be settled in the entity's own equity.
Equity instrument: This is any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities.
Compound financial instruments: These are financial instruments that contain both a
liability and an equity element. E.g Convertible loan notes.
Derivative: This is any financial instrument that derives its value from the changes in the price
or rate of an underlying item. Common examples of derivatives are forward contracts, futures
contracts, options and swaps (ie currency or interest rate swaps). What are the differences
between Futures and Forwards, Forwards and Options, Call and Put Options, Buying and
Writing a Call/Put Option.
Using Derivatives as Hedging Instruments
Derivatives can be used to obtain protection against exposure to the risk of an unfavourable
movement in the market price of an item, such as the price of a commodity, an interest rate or a
foreign exchange rate
Scope Exclusions
The following may meet the definition of either Financial Assets or Liabilities but they do not fall
within the scope of IFRS 9 because they have been addressed by and fall within the scope of
other relevant standards.
1. An investment in a subsidiary meets the definition of a financial asset but such
investments are subject to detailed accounting rules set out in IFRS 3; Business
Combinations and IFRS 10: Consolidated Financial Statements. The same can be said for
investments in associates and joint ventures
2. Lease receivables meet the definition of a financial asset but are recognised and
measured in accordance with IFRS 16: Leases. However, the IFRS 9 derecognition and
 impairment rules both apply to lease receivables as do the rules concerning embedded
derivatives.
3. An entity’s own equity is outside the scope of IFRS 9. Therefore, an entity does not fair
value its own equity
4. An entity might guarantee another entity’s borrowing. In such a case, if the borrower
fails to repay the loan the entity giving the guarantee (the guarantor) would be called on
to repay it. Financial guarantees are accounted for (as a financial liability) under IFRS 9
unless the entity has “previously asserted explicitly” that it regards such contracts as
insurance contracts. In this case the entity can elect to apply IFRS 17: Insurance
Contracts or IFRS 9 on a contract by contract basis.
Business Models and Classification of Financial Instruments
Why do organizations hold Financial Assets?
Financial Assets Held to Collect/Financial Assets Held to Maturity (HTM)
Financial Assets Held to Collect and/or Sell depending on market conditions
Financial Assets Held for Sale (HFS)
Classification of Financial Assets
Financial Assets measured at Amortized Cost
Financial Assets measured at Fair Value through Other comprehensive Income (FVTOCI)
Financial Assets measured at Fair Value through Profit or Loss FVTPL
The CCC or SPPI Test
Contractual Cashflows Characteristics Or Solely Payment of Principal and Interest
This is to test whether the contractual cash flows (or agreed cash flows) to be collected on the
financial asset consist solely of principal and interests (ie principal and interest on outstanding
principal) A financial asset is said to have passed the CCC test or SPPI test if the contractual cash
flows to be collected from such financial assets consist of only principal and interest.
How to Classify and measure Financial Assets

Business Model Met CCC/SPPI Test? Classification and Measurement

HTM YES Amortized Cost
NO FVTPL
HTM and/or Sale YES FVTOCI
NO FVTPL
HFT YES/NO FVTPL

Assuming there were no guidelines as to the appropriate classifications and measurement,

which bucket would a random organization chose? Why would it be reasonable to do so? What
are the risks involved?
Initial and Subsequent Recognition:
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. This is different from the normal recognition criteria for an asset or a liability. The
IASB’s Framework states that an item should be recognised when there is a probable inflow or
outflow of economic benefits
Initial measurement: A financial instrument should initially be measured at fair value. This
is usually the transaction price, in other words, the price paid for an asset or the price received
for a liability. If the transaction price differs from the fair value a gain or loss would be
recognised on initial recognition.
Transaction Costs: These are incremental costs that are directly attributable to the
acquisition or disposal of financial assets (or directly attributable to the issue or transfer of
financial liability and equity instruments). Attributable or incremental costs are those costs that
would not have been incured if the financial asset was not acquired or dis posed (or if the
financial liability and equity instruments were not issued or transferred).
Transaction costs are to be capitalized (i.e added to the purchase cost) on Initial recognition if
the Financial instrument is measured at Amortized cost or FVTOCI. However, it should be
expensed if the Instrument is measured at FVTPL.
Subsequent to Initial Recognition: Financial Instruments should be measured based on
their classifications (Amortized Cost, FVTPL or FVOCI).
Can you hold Equity Instruments to maturity? Do they pass the CCC or SPPI test?. How should
they be measured?
Equity Instruments should be measured Initially at purchase price, transaction costs should
be recognized as expense in the PorL, Dividend received should be recognized as
Investment/Finance Income in the PorL. In the SFP, the Equity Instruments should be
measured at fair Value any changes in the Fairvalue should be recognized in the PorL. Recall
IFRS13.
Amortized Cost and Effective Interest rate (EIR)
According to IRS 9, financial instruments at amortized cost are measured using the effective
interest rate method. The amortized cost method is also known effective interest rate method.
Effective interest rate: This is the interest rate that determines the amount of interest
income or interest expense in the statement of profit or loss. It is the same as the yields on
bonds. It is approximately the internal rate of return (IRR), that is the interest rate that equate
fair value (or present value) of cash outflows with present value of its cash inflows.

Recall that IRR is the discount rate that equates NPV to zero.
Amortized cost Computation
Details Carrying Amount
Amount at initial recognition XX
Plus: Interest recognised at the effective rate
(income for an asset or expense for a liability): XX
Less: cash flows (receipts for an asset or payments for a liability) (XX)
Amortised cost XX
Note: The computation of Amortised cost for Financial Assets and Liabilities generally follow
similar principle, the only difference is the terminologies used. What is an asset to one person is
exactly a liability to another.
When measuring financial Asset, Expected credit loss (read Impairment) is accounted for and
used to adjust the FV. The other leg is posted to PorL or OCI depending on classification.
Procedures for financial assets measured at mortised cost
The following steps should be maintained:
1. The loan amortization schedule table should be prepared in order to derive the amounts
that will be shown in the financial statements.
2. The opening balance at the start of year one, should be purchase price plus transaction
costs if any
3. The investment income or interest income to be shown in the profit or loss should be
determined by applying the effective interest rate on the respective opening balances.
4. The periodic interest received should be derived by applying the nominal interest rate (or
coupon rate) on the principal or nominal value of the financial asset
5. The financial asset value to shown in the statement of financial position should be the
closing balance (Le the amortised value at the end) from the amortisation schedule.

Example 1: Financial Asset measured at Amortized Cost

X purchased a loan on 1 January 20X5 and classified it as measured at amortised cost.
Terms:
Nominal value ₦50 million Coupon rate 10%
Term to maturity 3 years
Purchase price ₦48 million
Effective rate 11.67%
Required
Show the double entry for each year to maturity of the bond. (Ignore loss allowances).

Example 2: Financial asset at fair value through OCI

X purchased a loan on 1 January 20X5 and classified it as measured at Fair value through OCI.
Terms:
Nominal value ₦50 million Coupon rate 10%
Term to maturity 3 years
Purchase price ₦48 million
Effective rate 11.67%
Fair values at each year end to maturity are as follows
31 December 20X5 ₦49.2 million
31 December 20X6 ₦49.5 million
31 December 20X7 ₦50.0 million
Required
Show the double entry for each year to maturity of the bond. (Ignore loss allowances).

Classification of Financial Liabilities

Financial Liabilities measured at Amortized Cost
Financial Liabilities measured at Fair Value through Profit or Loss FVTPL
A company is allowed to designate a financial liability as measured at fair value through profit or
loss. This designation is irrevocable and can only be made if:
a. It eliminates or significantly reduces a measurement or recognition inconsistency; or
b. This would allow the company to reflect a documented risk management strategy.
The computation of the Amortization schedule for Financial Liabilities follow exactly the same
procedure as in Financial Assets.
Expected Credit Losses (ECL) and Impairment of Financial Assests
The expected loss model applies to all debt instruments (loans, receivables etc.) recorded at
amortised cost or at fair value through OCI. It also applies to lease receivables (IFRS 16),
contract assets (IFRS 15).
The aim of the expected loss model is that financial statements should reflect the deterioration
or improvement in the credit quality of financial instruments held by an entity. This is achieved
by recognising amounts for the expected credit loss associated with financial assets
Credit Loss: The difference between all contractual cash flows that are due to an entity in
accordance with the contract and all the cash flows that the entity expects to receive (i.e. all cash
shortfalls), discounted at the original effective interest rate.
Accounting treatment
The movement on the loss allowance is recognised in profit or loss. The loss allowance balance is
netted against the financial asset to which it relates on the face of the statement of financial
position. NB: this is just for presentation only; the loss allowance does not reduce the carrying
amount of the financial asset in the double entry system.
The loss allowance does not affect the recognition of interest revenue. Interest revenue is
calculated on the gross carrying amount (i.e. without adjustment for credit losses).
Credit Impairment
A financial asset is credit-impaired when one or more events that have a detrimental impact on
the estimated future cash flows of that financial asset have occurred. Evidence that a financial
asset is credit-impaired include (but is not limited to) observable data about the following
events:
a. Significant financial difficulty of the issuer or the borrower;
b. Breach of contract, such as a default or past due event;
c. The lender has granted to the borrower a concession for economic or contractual reasons
relating to the borrower’s financial difficulty that the lender would not otherwise have
considered:
d. It is becoming probable that the borrower will enter bankruptcy or other financial
reorganisation;
e. The disappearance of an active market for that financial asset because of financial
difficulties; or
f. The purchase or origination of a financial asset at a deep discount that reflects the
incurred credit losses.
The impairment loss is the difference between the carrying amount of the financial asset and its
recoverable amount. The Asset should be adjusted and Impairment is recognized through PorL
Example: Credit impairment
Company X invests in a bond.
The bond has an issue value of ₦1 million and pays a coupon rate of 5% interest for two years,
then 7% interest for two years.
Interest is paid annually on the anniversary of the bond issue. The bond will be redeemed at par
after four years.
The effective rate for this bond is 5.942%
At the end of the second year it becomes apparent that the issuer has financial difficulties and it
is estimated that Company X will only receive 60c in the dollar of the future cash flows.
Derecognition
Derecognition is the removal of a previously recognised financial asset or financial liability from
an entity’s statement of financial position. A financial liability (or a part of a financial liability) is
derecognised when, and only when, it is extinguished. This is when the obligation specified in
the contract is discharged or cancelled or expires.
Derecognition of Financial Asset
IFRS 9 gave a detailed guidline on derecognition of Financial asset which has been summarized
below. A financial asset is derecognised if one of three combinations of circumstances occur:
a. The contractual rights to the cash flows from the financial asset expire; or
 b. The financial asset is transferred and substantially all of the risks and rewards of
ownership pass to the transferee; or
c. The financial asset is transferred, substantially all of the risks and rewards of ownership
are neither transferred nor retained but control of the asset has been lost.
Other circumstances include;
Most transactions being considered involve receipt of cash.
Transactions where assets is derecognised may lead to the recognition of a profit or loss on
disposal.
Transactions where asset is NOT derecognised lead to the recognition of
liability for the cash received.
Example: Derecognition
Modified Grace Plc purchased a five year 8% bond for $200,000 on 1 January 20×1. The bond is
redeemable at a premium of $24,420 and is payable on 31 December 20x5. The effective interest
rate is 10% per annum while market interest rate on 1 January 20x4 is 12% per annum. On 1
January 20x4, Modified Grace Plc sells the bond to Mercy Plc at its fair value.
Required
Today is January 1 20x4
a. Calculate the carrying amount of the bond as at today
b. Calculate the redemption value of the bond investment as at
c. Calculate the present value of the bond investment on 1 January today
d. Calculate the fair value of the bond investment as at today
e. Calculate the profit or loss of the bond investment as at today and Prepare the necessary
entries in the financial statements on 1 January 20x4.
Hedge Accounting
Hedging is the process of entering into a transaction in order to reduce risk. Companies may use
derivatives to establish ‘positions’, so that gains or losses from holding the position in
derivatives will offset losses or gains on the related item that is being hedged.

Hedge accounting is only allowed for hedges involving derivatives external to the entity. A
member of a group might take a derivative position with another member of the group in order
to hedge a risk and (subject to meeting the hedge accounting criteria) it may use hedge
accounting in its own financial statements. However, this hedge accounting is removed on
consolidation because the derivative is not external to the group.
A hedging instrument may not be designated for a part of its change in fair value that results
from only a portion of the time period during which the hedging instrument remains
outstanding.
Fair Value and Cashflow Hedge
A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or
liability or an unrecognised firm commitment, or a component of any such item, that is
attributable to a particular risk and could affect profit or loss.
Accounting for a fair value hedge is as follows:
The gain or loss on the hedging instrument (the derivative) is taken to profit or loss, as normal.
(Note the exception to this that is explained below). Debit
The carrying amount of the hedged item is adjusted by the loss or gain on the hedged item
attributable to the hedged risk with the other side of the entry recognised in profit or loss.

A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a
particular risk associated with a recognised asset or liability or a highly probable forecast
transaction, and could affect profit or loss
Hedges relating to future cash flows from interest payments or foreign exchange receipts are
common cash flow hedges. E.g Swaps
Accounting for a cash flow hedge is as follows:
The change in the fair value of the hedging instrument is analysed into ‘effective’ and
‘ineffective’ elements.
The ‘effective’ portion is recognised in other comprehensive income (and accumulated as a
reserve in equity).
The ‘ineffective’ portion is recognised in profit or loss.
The amount recognised in other comprehensive income is subsequently released to the profit or
loss as a reclassification adjustment in the same period as the hedged forecast cash flows affect
profit or loss.

Practice Questions
CR M20Q6, CR M19Q3, CR M17Q6b, CR M23Q1b
FR M23Q5, FR M20Q5a, FRM17Q5

IAS 32 Financial Instrument; Presentation

Financial instruments issued by a company must be classified as either liabilities or equity. This
classification should be based on the substance of the contract, rather than the legal form.
A financial liability is any liability where the issuer has a contractual obligation:
a. To deliver cash or another financial asset to another entity, or
 b. To exchange financial instruments with another entity on potentially unfavourable
terms.
The owner of an equity instrument is entitled to receive a dividend, but the company does not
have a contractual obligation to make the payment. So equity does not meet the above definition
of a financial liability.
An equity instrument is defined as any contract that offers the residual interest in the assets of
the company after deducting all of the liabilities.
Preference Share, Liability or Equity?
Depending on their characteristics, preference shares issued by a company might be classified as
equity, a financial liability of the company; or a compound financial instrument containing
elements of both financial liability and equity.
Recognition of Preference shares as Equity or Liability
IAS 32 states (in a guidance note) that the key factor for classifying preference shares is the
extent to which the entity is obliged to make future payments to the preference shareholders.
a. Redemption is mandatory: Since the issuing entity will be required to redeem the
shares, there is an obligation. The shares are a financial liability.
b. Redemption at the choice of the holder: Since the issuing entity does not have an
unconditional right to avoid delivering cash or another financial asset there is an
obligation. The shares are a financial liability.
c. Redemption at the choice of the issuer: The issuing entity has an unconditional
right to avoid delivering cash or another financial asset there is no obligation. The shares
are equity.
d. Irredeemable non-cumulative preference shares should be treated as equity, because the
entity has no obligation to the shareholders that the shareholders have any right to
enforce.
Compound Instrument
A compound instrument is a financial instrument, issued by a company that cannot be classified
as simply a liability or as equity, because it contains elements of both debt and equity. An
example of a compound instrument is a convertible bond. The company issues a bond that can
be converted into equity in the future or redeemed for cash. Initially, it is a liability, but it has a
call option on the company’s equity embedded within it.
Accounting for Compound financial Instruments
On initial recognition of compound instrument, the credit entry for the financial instrument
must be split into the two component parts, equity and liability.
When convertible bonds are issued they are shown in the statement of financial position partly
as debt finance and partly as equity finance

IFRS 7 -Disclosure
Statement of financial position disclosures
The carrying amounts of financial instruments must be shown, either in the statement of
financial position or in a note to the financial statements, for each class of financial instrument:
a. financial assets at fair value through profit or loss;
b. financial assets at amortised cost;
c. financial assets at fair value through other comprehensive income;
d. financial liabilities at fair value through profit or loss; and
e. financial liabilities measured at amortised cost.
Other disclosures relating to the statement of financial position are also required. These include
the following:
a. Collateral. A note should disclose the amount of financial assets that the entity has
pledged as collateral for liabilities or contingent liabilities.
b. Allowance account for credit losses. When financial assets (such as trade receivables) are
impaired by credit losses and the impairment is recorded in a separate account (such as
an allowance account for irrecoverable trade receivables), the entity should provide a
reconciliation of changes in the account during the period, for each class of financial
assets.
c. Defaults and breaches. For loans payable, the entity should disclose details of any
defaults during the period in the loan payments, or any other breaches in the loan
conditions.
Statement of profit or loss disclosures
An entity must disclose the following items either in the statement of profit or loss or in notes to
the financial statements:
a. Net gains or losses on financial assets or financial liabilities at fair value through profit or
loss.
b. Net gains or losses on financial liabilities measured at amortised cost.
c. Net gains or losses on financial assets at fair value through other comprehensive income.
d. Net gains or losses on investments in equity instruments designated at fair value through
other comprehensive income.
e. Total interest income and total interest expense, calculated using the effective interest
method, for financial assets or liabilities that are not at fair value through profit or loss.
f. Fee income and expenses arising from financial assets or liabilities that are not at fair
value through profit or loss.
Other Disclosures Include
Risk Disclosure; Credit risk, Liquidity risk, market risk e.t.c