Financial instruments.

IFRS 9 Financial Instruments and IAS 32 Financial Instruments: Presentation are complex standards,
especially for users and preparers of financial statements. It is, therefore, no surprise that ACCA
candidates find them challenging.

Both of these standards are relevant when accounting for financial instruments and they are both
examinable in the Financial Reporting (FR) exam. This article provides a high-level overview of the
following financial instrument topics which these standards relate to:

1. Financial assets

2. Financial liabilities

3. Convertible instruments

1. Financial assets

There are two types of financial asset which we will consider in this article – investments in equity and
investments in debt instruments.

(a) Equity instruments

Equity instruments are likely to be shares that have been purchased in a company but not enough to give
the investee significant influence (associate), control (subsidiary) or joint control (joint venture).

There are two options here, depending on the business model of the entity and the characteristics of the
financial asset. The default category is fair value through profit or loss (FVTPL).

Equity instruments: fair value through profit or loss (FVTPL)

FVTPL is the default treatment for equity investments where transaction costs such as broker fees are
expensed and not capitalised within the initial cost of the asset. Subsequently, the investment is
revalued to fair value at each year end, with the gain or loss being taken to the statement of profit or
loss.

Alternatively, equity instruments can be classified as fair value through other comprehensive income
(FVTOCI) if an election is made. It is important to note that this election must be made on acquisition
and is irrevocable so the equity investments cannot retrospectively be treated as FVTPL. This is only an
option if the equity investment is intended to be a long-term investment (ie it is not held for trading).

Equity instruments: fair value through other comprehensive income (FVTOCI)

Using FVTOCI, the alternative elected treatment, transaction costs must be capitalised as part of the
initial cost of the investment. Similar to FVTPL, the instrument would then be revalued to fair value at
the year end. The big difference is where the gain or loss is recorded – the gain or loss is recognised
within other comprehensive income and included as part of other components of equity in the
statement of financial position. This might be referred to as an investment revaluation reserve or similar.
In many ways it is like accounting for property, plant and equipment (PPE) using the revaluation model.
However, unlike the treatment for a revaluation surplus related to PPE, there can be a negative (debit)
balance on the investment revaluation reserve.
When the FVTOCI instrument is sold, the surplus/deficit on remeasurement to fair value can be left in
the investment revaluation surplus/deficit or transferred into retained earnings.

(b) Debt instruments

These are usually bonds or loan notes or other instruments which are likely to carry interest and a capital
element of repayment. There are three possible classifications for categorising debt instruments –
amortised cost, FVTOCI or FVTPL.

The classification of an investment in debt instruments should be based on both:

(a) the entity’s business model for managing financial assets; and

(b) the contractual cash flow characteristics of the financial asset.

Debt instruments: amortised cost

To apply this treatment, the instrument must pass two tests; first the business model test and secondly
the contractual cash flow characteristics test.

 Business model test – the entity must intend to hold the financial assets in order to collect the
interest payments and receive repayment on maturity (ie the contractual cash flows).

 Contractual cash flow characteristics test – the contractual terms give rise to cash flows which
are solely repayments of the interest and principal amount.

In the FR exam, it will only be the first test which may (or may not) be met, so management must decide
on their intention for holding the debt instrument. This treatment requires candidates to demonstrate
the principles of amortised cost accounting.

The principles of amortised cost accounting mean that interest must be recorded on the amount
outstanding. This is relatively straight forward for many instruments. For example, on a $10m 5% loan,
with $10m repayable at the end of a three-year term, interest would simply be recorded as $500,000 a
year.

The issues arise when the balance may be repaid at a premium or initial transaction costs were incurred.
For example, the terms of the $10m loan, issued on 1 January 20X1, may be that the holder receives
interest of 5% a year but then receives $11m back at the end of the three-year term, on 31 December
20X3. This means that the holder is now earning investment income in two different ways. Firstly, they
are earning the 5% payment each year. Secondly, they are earning another $1m over three years in the
form of receiving more money back than they invested.

IFRS 9 requires that an effective rate of interest is applied to this balance to better reflect the reality of
the situation. This rate considers both the annual payment and the premium payable on redemption. In
the FR exam, this rate will be provided in the question and is known as the effective interest rate. Let’s
say that in this example, the effective interest rate is 8.08%. This rate is applied to the outstanding
balance each year in order to calculate the interest earned (investment income) on the investment.

The easiest way to do this is often to use a table showing the movement of the asset.
 Effective Balance 31
Balance 1 Jan interest 8.08% Receipt Dec
$’000 $’000 $’000 $’000

20X1 10,000 808 -500 10,308

20X2 10,308 833 -500 10,641

20X3 10,641 859* -500 11,000

* Note that the effective interest for 20X3 has been rounded slightly to arrive at the correct closing
balance – remember that the initial principal of $10m plus an additional $1m at the end of the three-
year loan period is being repaid.

The figures in the effective interest column would be the amounts recorded as investment income in the
statement of profit or loss each year. This is increasing to reflect the fact that the amount owed is
increasing as it gets closer to redemption.

The balance in the final column reflects the amount owed to the entity at each year end and shows how
the balance outstanding increases from $10m to $11m over the three-year period.

The double entries for the asset in year one would be as follows:

1 January 20X1 – The $10m loan is given to the third party. This reduces the entity’s cash balance but
creates a long-term receivable of $10m, meaning the entry is Dr Loan receivable $10m, Cr Cash $10m.

The interest then accrues over the year at the effective interest rate of 8.08%. This increases the amount
of the loan receivable and is recorded in investment income, so the entry is Dr Loan receivable $808,000,
Cr Investment income $808,000.

31 December 20X1 – The entity receives a payment of $500,000, being 5% of the original $10m loaned.
This figure will be the same each year. This reduces the value owed to the entity and so the entry is Dr
Cash $500,000, Cr Loan receivable $500,000.

The result of these entries is that the entity has a closing loan receivable of $10.308m. This will all be
held as a non-current asset, as the amount is not receivable until 31 December 20X3.

This would carry on for the next two years, until the full amount is repaid at 31 December 20X3 with the
entry Dr Cash $11m, Cr Loan receivable $11m.
The total investment income to be recorded in the statement of profit or loss over the three years is
$2.5m, being the $808,000 + $833,000 + $859,000. This $2.5m represents all the annual interest earned
by the entity over the three years. This consists of the $1.5m annual payments ($500,000 a year), and
the additional $1m received (the difference between loaning the $10m and receiving the $11m).

Debt instruments: fair value through other comprehensive income (FVTOCI)

Another possible treatment for a debt instrument is to hold it at fair value through other comprehensive
income (FVTOCI). Similar to holding the instrument at amortised cost, two tests must be passed in order
to hold a debt instrument in this manner.

 Business model test – the objective of the entity’s business model is both to hold the financial
assets in order to collect the contractual cash flows and also to sell the assets. This might include
sales to manage liquidity needs or in order to maintain particular interest yields.

 Contractual cash flow characteristics test – the contractual terms give rise to cash flows which
are solely repayments of the interest and principal amount.

Again, it is only the first of these that candidates will need to consider in the FR exam, highlighting that
the choice of category will depend on the intention of management.

If the entity holds the debt instrument under the FVTOCI category, they will still produce the amortised
cost table as above, taking the same figure to investment income. At the year end, the asset would then
be revalued to fair value, with the gain or loss being recorded in other comprehensive income and
presented as an item that may be reclassified subsequently to profit or loss.

Debt instruments: fair value through profit or loss (FVTPL)

Financial assets should be measured at FVTPL unless they are measured at amortised cost or FVTOCI. For
example, an investment in debt instruments which is held for trading and therefore fails the business
model test for amortised cost and FVTOCI.

Financial assets measured at FVTPL should be revalued at each year end with any revaluation gains or
losses being recognised in the statement of profit or loss.

2. Financial liabilities

In the FR exam, financial liabilities will be held at amortised cost. This will be similar to the measurement
treatment shown earlier for assets held under amortised cost. Instead of having investment income and
an asset, there will be a interest expenses and a liability. The major difference in the accounting
treatment relates to the initial treatment upon issue of the financial liability. Initially these are
recognised at net proceeds, being the cash received less any issue costs.

Therefore, if an entity looks to raise $10m of funding, but pays a broker $200,000 for raising the finance,
the initial double entry is to Dr Cash $9.8m and Cr Liability with the $9.8m. Taking the $200,000
immediately to the statement of profit or loss is incorrect because this fee must be spread over the life
of the instrument. This is effectively done by applying the effective interest rate to the outstanding
liability. As noted earlier, the effective interest rate will be given to candidates in the exam.
Here, the effective interest rate on the liability now incorporates up to three elements. It would
incorporate the annual interest payable, any premium repayable on redemption/ repayment, and any
issue costs. This is shown in the example below.

EXAMPLE
Oviedo Co issued $10m 5% loan notes on 1 January 20X1, incurring $200,000 issue costs. These loan
notes are repayable at a premium of $1m on 31 December 20X3, giving them an effective interest rate of
8.85%.

In the above example, the 5% relates to the coupon rate, which is the amount required as an annual
payment each year. This is always based on the face value (ie ‘nominal’ or ‘par’ value) of the instrument
and so means that $500,000 will be payable annually (being 5% of $10m). Using the wrong figure here is
a common mistake in the FR exam – the amount paid each year will remain the same throughout the life
of the instrument and should not be calculated based on the carrying amount of the liability each year.

As seen in the earlier example relating to financial assets held at amortised cost, the effective interest
rate will be applied to the outstanding balance in each period. Again, a table is the easiest way to
calculate this, as shown below.

Balance 1 Effective Balance 31

January interest 8.85% Payment December
$’000 $’000 $’000 $’000

20X1 9,800 867 -500 10,167

20X2 10,167 900 -500 10,567

20X3 10,567 933* -500 11,000

* Note that the effective interest for 20X3 has been rounded slightly to arrive at the correct closing
balance.

The entries in 20X1 will be as follows:

1 January 20X1 – The loan note is issued, meaning that Oviedo Co receives $9.8m, being the $10m less
the issue costs. Therefore, the entries are Dr Cash $9.8m, Cr Loan payable $9.8m.

Over the year, interest on the liability is accrued at the effective interest rate of 8.85%, giving the entry
Dr Interest expenses on borrowings $867,000, Cr Loan payable $867,000.
31 December 20X1 – The payment of $500,000 is made, giving the entry Dr Loan payable $500,000, Cr
Cash $500,000.

This leaves a closing liability of $10.167m. This will all be presented as a non-current liability as none of it
will be repayable until 31 December 20X3. It would be incorrect to split between a current and non-
current component as you would do with a lease. In this example, at 31 December 20X2, £10.567m
would be presented as a current liability as it will be repaid in the next 12 months.

If we look at the effective interest column, we will see that the total is $2.7m ($867,000 + $900,000 +
$933,000). This is the total which will be expensed to the statement of profit or loss over the three-year
period. This amount consists of three elements:

 $1.5m in annual payments ($500,000 a year)

 $1m premium repaid (issued $10m loan, but repaid $11m)

 $200,000 issue costs

As we can see, the issue costs have been expensed over three years, rather than being expensed
immediately in 20X1. In other words, they have been amortised (spread) over the life of the liability.

3. Convertible instruments

Convertible instruments are financial instruments which give the holder the right to either demand
repayment of the principal amount or alternatively convert the balance into shares. In the FR exam, you
will only have to deal with convertible instruments from the perspective of the issuer, being the person
who has received the cash on issue of a convertible instrument. They will usually take the form of
convertible loan notes (compound instruments).

Convertible instruments present a special challenge, as these could ultimately result in the issue of
shares or the repayment of the loan note but the choice will be in the hand of the loan note holder. As
we do not know whether the holder will choose to receive the cash or convert the instrument into
shares, we must reflect an element of both within the financial statements. Therefore, these are
accounted for by initially separating the instrument into equity and liability components and presenting
each component on the statement of financial position accordingly.

The liability component is the first thing to calculate. We work this out by calculating the present value of
the payments at the market rate of interest (using the interest on an equivalent debt instrument without
the conversion option). The discount rates required to do this will be given to you in the exam.

In reality, the market rate of interest will be higher than the coupon rate, being the annual amount
payable to the holder of the debt instrument. This is because the holder of the debt instrument is willing
to accept a lower rate of annual interest compared to the market, in exchange for the option to convert
the debt instrument into shares.

Once the liability component has been calculated, the equity component is then worked out. This is
simply a balancing figure and represents the difference between the total cash received on issue and the
calculated liability component.
EXAMPLE
Oviedo Co issued $10m 5% convertible loan notes on 1 January 20X1. These will either be repaid at par
($10m) on 31 December 20X3 or converted into 10 million ordinary $0.25 shares on that date.
Equivalent loan notes without the conversion rights carry an interest rate of 8%. Relevant discount rates
are shown below.

Amount payable in: Discount factor at 5% Discount factor at 8%

1 year 0.952 0.926

2 years 0.907 0.857

3 years 0.864 0.794

2.723 2.577

It is important to note that the 5% discount rates are a red herring. It is the discount rates for the market
rate of interest that are important – ie 8%. The only thing we need the 5% for is to work out the annual
interest payment. As these are $10m 5% loan notes, this simply means that Oviedo Co will need to make
an annual payment of $500,000 in relation to these.

Therefore, we can work out the value that the market would place on these loan notes by looking at the
present value of all the payments, discounted at the market rate of interest. If this was a normal loan,
ignoring the conversion, Oviedo Co would pay $500,000 in years 20X1 to 20X3, and then make a final
repayment of $10m on 31 December 20X3.

As the market rate of interest is 8%, the present value of these payments can be calculated. These are
calculated in the table below.

Year Payment Present value

Discount factor 8%
$’000 $’000
 20X1 500 0.926 463

20X2 500 0.857 428.5

20X3 10,500 0.794 8,337

Total 9,229

The present value of all of the payments can be seen as $9.229m. This means that Oviedo Co received
$10m, but the present value of the payments have an initial present value of only $9.229m. As a result,
the holders of the loan notes are effectively losing $771,000 compared to if they had simply given
Oviedo Co a normal loan at the market rate of interest.

Note: an alternative working would be: $’000

3 years interest ($10m × 5% × 2.577) 1,289

Repayment $10m × 0.794 7,940

Liability component 9,229

This $771,000 is the amount of interest the holders are willing to lose in order to have the option to
convert the loan into shares. This is taken as the initial value of the equity element.

On 1 January 20X1, the double entry to record the transaction in the records of Oviedo Co is as follows:

Dr Cash $10m – reflecting the full cash received from the issue of the convertible instrument

Cr Convertible debt $9.229m – reflecting the present value of the liability component on 1 January
20X1

Cr Reserve for convertible debt $771,000 – reflecting the value of the equity component
The equity balance would be held as a reserve for convertible debt within other components of equity. It
would be incorrect to include it within share capital – this is a common error in the FR exam.
Subsequently, this equity amount remains fixed until conversion, but the liability component must be
held at amortised cost. This must be $10m by the end of the three-year loan note period, to reflect the
amount which the holder would require if they demand repayment rather than conversion of the loan
notes.

Balance 1 Effective Balance 31

January interest 8% Payment December
$’000 $’000 $’000 $’000

20X1 9,229 738 -500 9,467

20X2 9,467 757 -500 9,724

20X3 9,724 776* -500 10,000

* Note that the effective interest for 20X3 has been rounded slightly to arrive at the correct closing
balance.

As with the non-convertible financial liability noted earlier, the effective interest rate column is taken to
the statement of profit or loss each year as interest expenses on borrowings.

At the end of the three years, Oviedo Co will either repay the $10m liability, or this will be converted into
10 million $0.25 shares in accordance with the terms of the instrument, with the $10m balance and the
reserve for convertible debt balance of $771,000 transferred to share capital and share premium/other
components of equity as required.

Summary

This article has considered the key issues relating to financial instruments that are potentially
examinable in the FR exam. To perform well at FR, it is essential that candidates are able to identify the
potential treatments for financial assets and liabilities, produce amortised cost calculations and
understand the accounting entries required for a convertible instrument. This is one of the most
technical areas of the syllabus, but also one of the central areas which will be further developed
in Strategic Business Reporting.
Written by a member of the FR examining team