ADVANCED FINANCIAL
REPORTING
Financial Instruments
FINANCIAL INSTRUMENTS
Financial instruments cover the following standards:
• IAS 32 – classification & presentation
• IFRS 9 – how they are measured & when to record
in the financial statements
• IFRS 7 – disclosures
DEFINITIONS
1) Financial instruments are
• contracts (pieces of paper) that give rise to
• financial assets of one entity &
• financial liabilities or equity instruments of the other entity
2) Examples include
• Invoices for sale of goods (R/A & P/A)
• Subscription of shares (Investment in shares & Share
capital)
• Issuance of debentures (Investment & financial liability)
• DERIVATIVES (see next slide)
Definition: Types of derivatives:
A security whose value is derived • Forwards (Customized contracts)
from the value of another asset
(underlying asset). • Futures (similar to forwards but
Underlying assets include shares, are standardized & regulated.
bonds, commodities, currencies, Mostly used for speculation)
interest rates, market indexes etc.
• Options (right to buy or sell a
Purpose: financial asset)
• Risk hedging
• Speculation • Swaps (exchange of one security
for another)
positive FV of derivatives
negative FV of derivatives
DISTINCTION BETWEEN DEBT & EQUITY
1) Why this distinction is required?
• Impact on P&L account
• Effect the financial risk of the company i.e. gearing
ratio etc.
2) Financial liability – Obligation to repay
3) Equity – No obligation to repay (residual interest)
4) Compound financial instruments = Mixture of debt &
equity i.e. convertible bonds
Financial Liabilities
RECOGNITION & MEASUREMENT
Financial liabilities – Recognition
INITIAL measurement Bond
$1000 interest rate 10%
$1000= face value/ par value/ nominal value
10%= coupon rate
• Initial measurement = Fair Value (net proceeds)
1. $1000 bond issued at par value= $1000
2. $1000 bond issued at 10% discount= $900
3. $1000 bond issued at (10% discount + issuance cost
$100)= $800
Financial liabilities – Recognition
SUBSEQUENT measurement Bond
$1000 interest rate 10%
$1000= face value/ par value/ nominal value
10%= coupon rate
• Subsequent measurement = Amortized cost
Amortized cost= Initial cost + Effective interest rate (discount
factor) – Interest paid (normally coupon rate) – check next slide
Attributes of the effective interest rate (cost of capital or DF):
• Compounded rate
• Similar to IRR (real rate)
• Reconciliation of Initial and closing liability
The concept of Amortized cost
A loan note of $1,000 is issued and redeemable at $1,250 after 5 years. The coupon
and effective
Initialinterest (discount
accounting entry: factor) rates are 5.9% and 10%, respectively.
Cash 1,000
Solution: Liability 1,000 (PV)
1) The total payments against this loan are:
Subsequent valuation:
5 years’ interestcost:
Amortized –> coupon rate (59 x 5 = 295) + principal 1,250) = $1,545
1st year
opening balance 1,000
2) The PV+ Effective
of theserate
payments
of interestis : 100-Finance charges
– interest paid (coupon rate) (59)
= ClosingDF@10%
year payments balance PV 1,041
1 59 0.91 53.64
2 Accounting
59 entries at the
0.83 48.76 end of 1 st
year:
1) Finance charges 100 2) Liability 59
3 59 0.75 Liability
44.33 100 Cash 59
4 59 0.68 40.30
5 1,309 0.62
The valuation of 812.79cost is provided on the next slide
amortized
Note: This slide is just for
1,545 information and you can directly start this question from the
1,000
Amortized cost.
Test Yourself
Test Yourself continued…….
Accounting entries at the end of 1st year:
1) Finance charges 100 2) Liability 59
Liability 100 Cash 59
Test Yourself
Solution
Financial liabilities
Preference shares
EQUITY OR FINANCIAL LIABILITY????
1. Financial liability (obligation to pay)
1. Cumulative
2. Redeemable preference shares
2. Otherwise Equity (no obligation to pay)
Test Yourself
Compound Financial Instruments (Mixture of equity & liability)
1. The substance of financial instruments may differ from its legal
form
2. When an instrument combines the features of debt + equity i.e.
convertible bonds then they are known as
Compound
instruments
Recorded
DEBT simultaneously EQUITY
as
Features of compound instruments
The compound instruments i.e. convertible bonds have
the following features:
a. Repayable at the lender’s option in shares rather
than cash
b. Fixed shares at inception
c. Lower interest rate as compared to non-convertible
instruments
Recognition of compound instruments
INITIAL measurement:
1. Liability
Fair value = Present value of future cash OUTFLOWS
(capital + interest) by using MARKET interest rate
2. Equity
The difference between Loan taken & its present value
Example:
5 years’ convertible bonds of $500,000 were issued on Jan 1st, 2021. The
present value of cash outflows is $450,000. How these instruments will be
recorded in the financial statements?
Long term liability (bonds)= $450,000
Equity (equity option) = $500,000 - $450,000 = $50,000
Recognition of compound instruments
SUBSEQUENT measurement:
1. Liability
Amortized cost= Initial cost + Effective interest rate – Interest paid
(normally coupon rate)
2. Equity
No Change (Equity will not be re-measured and remain same till the
redemption of debt)
SUMMARY:
Initial Subsequent
Liability FV (PV of outflows) Amortized cost
Equity Difference between No change
loan taken & its PV
Test Yourself
Solution
Test Yourself
Solution
Financial Assets
RECOGNITION & MEASUREMENT
Financial Assets – Recognition
INITIAL recognition
INITIAL measurement
• Financial instruments = FAIR VALUE
• FAIR VALUE = Purchased consideration. Transaction
cost will NOT be capitalized if the asset is valued at
Fair value through Profit & loss (FVPL).
Financial Assets – Recognition
Measurement for Equity instruments (2 options) - No Interest
1) FVPL 2) FVOCI
Fair value through profit & loss Fair value through other
(default category) comprehensive income
CAN NOT be
LONG TERM Designated at
changed after
Investments ACQUISITION
designation
Transaction costs are charged to Transaction costs are
P&L CAPITALIZED
Revaluation = Each year end
Revaluation = Each year end
Gain/loss= OCI & Investment
Gain/loss= P&L
reserves in EQUITY
Financial Assets – Recognition
Measurement for Debt instruments (3 options) –
Interest-bearing
1. Fair value through profit & loss (FVPL – default
category)
2. Amortized cost
3. Fair value through other comprehensive income
(FVOCI)
Categories 2 & 3 are dependent on passing the following
2 tests:
a. Business model test (check next slide)
b. Contractual cash flow characteristics test (check next slide)
Financial Assets – Recognition
a. Business model test:
This test is used to assess the holding period of
instrument
b. Contractual cash flow characteristics test:
• It determines that contractual terms must ensure
that cash flows will be generated purely from
principal + interest
• Compound instruments fail this test due to the
conversion option and must be measured at FVPL
Financial Assets – Recognition
Measurement for Debt instruments
Amortized cost:
1. Business model test:
a. Retention of investment = Till maturity
2. Contractual cash flow characteristics test
a. As per the contract = Cash flows must be from principal +
interest
b. Interest income will be calculated by using the effective interest
rate
c. The accounting treatment will be same as previously used for
financial liabilities (initial measurement + transaction cost)
Financial Assets – Recognition
Measurement for Debt instruments
Fair value through other comprehensive income (FVOCI):
1. Business model test:
a. Retention of investment = i) Till maturity but 1st difference
ii) may sell if other asset yield higher returns between FVOCI
& AC
2. Contractual cash flow characteristics test
a. As per the contract = Cash flows must be from principal +
interest
b. Interest income will be calculated by using the effective interest
rate (similar to amortized cost)
c. Initial measurement = Fair value + Transaction cost
d. Each year end = Assets will be revalued and gains/losses will be
recorded in OCI
2nd difference between FVOCI & Amortized cost
Financial Assets – Recognition
Measurement for Debt instruments
Similarities & Differences between FVOCI & Amortized
Amortized Cost- VALUATION Cost FVOCI
1) Initial measurement (principal + issuance cost) SAME
2) Interest income SAME
3) Retention of Assets DIFFERENT
May sell
Hold till before
maturity maturity
Revaluation of
4) Assets DIFFERENT
Recorde
Ignored d in OCI
Financial Assets – Recognition
Measurement for Debt instruments (Comparative
valuations of all 3 methods)
AMORTIZED
FVPL FVOCI COST
Short-term (one
exception -
1) Duration convertible securities) long term long term
2) Purchase price cost of asset cost of asset cost of asset
3) Issuance cost recorded in p&l cost of asset cost of asset
based on based on
4) Interest income based on coupon rate effective rate effective rate
5) Changes in FV recorded in p&l recorded in OCI ignored
Test Yourself
Solution
Test Yourself
Test Yourself
Test Yourself
Solution(a)
$102,741
Solution(b)
Solution(c)