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    Financial Instruments

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    Geeta Lalwani
    This document defines key terms related to financial instruments and provides guidance on their classification and measurement. It discusses how financial instruments should be classified as financial liabilities or equity based on their substance rather than legal form. Preference shares that must be redeemed are generally classified as financial liabilities. Compound instruments containing both liability and equity elements must have their components separately classified. Interest on financial liabilities and dividends on equity instruments affect profit or loss, while transaction costs on equity are deducted from equity.

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    Financial Instruments

    Uploaded by

    Geeta Lalwani
    114 views3 pages
    This document defines key terms related to financial instruments and provides guidance on their classification and measurement. It discusses how financial instruments should be classified as financial liabilities or equity based on their substance rather than legal form. Preference shares that must be redeemed are generally classified as financial liabilities. Compound instruments containing both liability and equity elements must have their components separately classified. Interest on financial liabilities and dividends on equity instruments affect profit or loss, while transaction costs on equity are deducted from equity.

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    IFRS 9 Financial instruments

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    This document defines key terms related to financial instruments and provides guidance on their classification and measurement. It discusses how financial instruments should be classified as financial liabilities or equity based on their substance rather than legal form. Preference shares that must be redeemed are generally classified as financial liabilities. Compound instruments containing both liability and equity elements must have their components separately classified. Interest on financial liabilities and dividends on equity instruments affect profit or loss, while transaction costs on equity are deducted from equity.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    114 views3 pages

    Financial Instruments

    Uploaded by

    Geeta Lalwani
    This document defines key terms related to financial instruments and provides guidance on their classification and measurement. It discusses how financial instruments should be classified as financial liabilities or equity based on their substance rather than legal form. Preference shares that must be redeemed are generally classified as financial liabilities. Compound instruments containing both liability and equity elements must have their components separately classified. Interest on financial liabilities and dividends on equity instruments affect profit or loss, while transaction costs on equity are deducted from equity.

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    © All Rights Reserved
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    Definitions

    Financial instrument. Any contract that gives rise to both a financial asset of one entity and a
    financial liability or equity instrument of another entity.
     Financial asset. Any asset that is:
    (a) Cash
    (b) An equity instrument of another entity
    (c) 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. Any liability that is:
    (a) A contractual obligation:
    (i) To deliver cash or another financial asset to another entity, or (ii) To exchange financial
    instruments with another entity under conditions that are potentially unfavourable.
     Equity instrument. Any contract that evidences a residual interest in the assets of an entity after
    deducting all of its liabilities.
     Fair value. Price that would be received to sell an asset or paid to transfer a liability in an orderly
    transaction between market participants at the measurement date.

    Liabilities and equity


    The main principle of IAS 32 is that financial instruments should be presented according to their
    substance, not merely their legal form. In particular, entities which issue financial instruments
    should classify them (or their component parts) as either financial liabilities, or equity.
    The classification of a financial instrument as a liability or as equity depends on the following.
     The substance of the contractual arrangement on initial recognition
     The definitions of a financial liability and an equity instrument
    How should a financial liability be distinguished from an equity instrument? The critical feature of a
    liability is an obligation to transfer economic benefit. Therefore a financial instrument is a financial
    liability if there is a contractual obligation on the issuer either to deliver cash or another financial
    asset to the holder or to exchange another financial instrument with the holder under potentially
    unfavourable conditions to the issuer.
    Where the above critical feature is not met, then the financial instrument is an equity instrument.
    IAS 32 explains that although the holder of an equity instrument may be entitled to a pro rata share
    of any distributions out of equity, the issuer does not have a contractual obligation to make such a
    distribution.
    For instance, a company is not obliged to pay a dividend to its ordinary shareholders. Although
    substance and legal form are often consistent with each other, this is not always the case. In
    particular, a financial instrument may have the legal form of equity, but in substance it is in fact a
    liability. Other instruments may combine features of both equity instruments and financial liabilities.
    For example, many entities issue preference shares which must be redeemed by the issuer for a
    fixed (or determinable) amount at a fixed (or determinable) future date. Alternatively, the holder
    may have the right to require the issuer to redeem the shares at or after a certain date for a fixed
    amount. In such cases, the issuer has an obligation. Therefore the instrument is a financial liability
    and should be classified as such.
    The distinction between redeemable and non-redeemable preference shares is important. Most
    preference shares are redeemable and are therefore classified as a financial liability. Expect to see
    this in your exam.
    Compound financial instruments
    Some financial instruments contain both a liability and an equity element. In such cases, IAS 32
    requires the component parts of the instrument to be classified separately, according to the
    substance of the contractual arrangement and the definitions of a financial liability and an equity
    instrument.
    Example: valuation of compound instruments
    Rathbone Co issues 2,000 convertible bonds at the start of 20X2. The bonds have a three year term,
    and are issued at par with a face value of $1,000 per bond, giving total proceeds of $2,000,000.
    Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each bond is
    convertible at any time up to maturity into 250 ordinary shares.
    When the bonds are issued, the prevailing market interest rate for similar debt without conversion
    options is 9%.
    Required
    What is the value of the equity component in the bond?

    Interest, dividends, losses and gains


    As well as looking at presentation in the statement of financial position, IAS 32 considers how
    financial instruments affect the statement of profit or loss and other comprehensive income (and
    changes in equity). The treatment varies according to whether interest, dividends, losses or gains
    relate to a financial liability or an equity instrument.
    (a) Interest, dividends, losses and gains relating to a financial instrument (or component part)
    classified as a financial liability should be recognised as income or expense in profit or loss.
    (b) Distributions to holders of a financial instrument classified as an equity instrument (dividends to
    ordinary shareholders) should be debited directly to equity by the issuer. These will appear in the
    statement of changes in equity.
    (c) Transaction costs of an equity transaction should be accounted for as a deduction from equity,
    usually debited to the share premium account.

    Initial measurement of financial instruments

    All financial instruments are initially measured at fair value plus or minus, in the case of a financial
    asset or financial liability not at fair value through profit or loss, transaction costs.

    Subsequent measurement of financial assets

    IFRS 9 divides all financial assets that are currently in the scope of IAS 39 into two classifications -
    those measured at amortised cost and those measured at fair value.

    Where assets are measured at fair value, gains and losses are either recognised entirely in profit or
    loss (fair value through profit or loss, FVTPL), or recognised in other comprehensive income (fair
    value through other comprehensive income, FVTOCI).

    For debt instruments the FVTOCI classification is mandatory for certain assets unless the fair value
    option is elected. Whilst for equity investments, the FVTOCI classification is an election.
    Furthermore, the requirements for reclassifying gains or losses recognised in other comprehensive
    income are different for debt instruments and equity investments.

    The classification of a financial asset is made at the time it is initially recognised, namely when the
    entity becomes a party to the contractual provisions of the instrument. [IFRS 9, paragraph 4.1.1] If
    certain conditions are met, the classification of an asset may subsequently need to be reclassified.

    Debt instruments
    A debt instrument that meets the following two conditions must be measured at amortised cost (net
    of any write down for impairment) unless the asset is designated at FVTPL under the fair value
    option (see below):
     Business model test: The objective of the entity's business model is to hold the financial
    asset to collect the contractual cash flows (rather than to sell the instrument prior to its
    contractual maturity to realise its fair value changes).
     Cash flow characteristics test: The contractual terms of the financial asset give rise on
    specified dates to cash flows that are solely payments of principal and interest on the
    principal amount outstanding.
    A debt instrument that meets the following two conditions must be measured at FVTOCI unless the
    asset is designated at FVTPL under the fair value option (see below):
    [IFRS 9, paragraph 4.1.2A]
     Business model test: The financial asset is held within a business model whose objective is
    achieved by both collecting contractual cash flows and selling financial assets.
     Cash flow characteristics test: The contractual terms of the financial asset give rise on
    specified dates to cash flows that are solely payments of principal and interest on the
    principal amount outstanding.
    All other debt instruments must be measured at fair value through profit or loss (FVTPL). [IFRS 9,
    paragraph 4.1.4]
    Fair value option
    Even if an instrument meets the two requirements to be measured at amortised cost or FVTOCI, IFRS
    9 contains an option to designate, at initial recognition, a financial asset as measured at FVTPL if
    doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes
    referred to as an 'accounting mismatch') that would otherwise arise from measuring assets or
    liabilities or recognising the gains and losses on them on different bases. [IFRS 9, paragraph 4.1.5]
    Equity instruments
    All equity investments in scope of IFRS 9 are to be measured at fair value in the statement of
    financial position, with value changes recognised in profit or loss, except for those equity
    investments for which the entity has elected to present value changes in 'other comprehensive
    income'. There is no 'cost exception' for unquoted equities.
    'Other comprehensive income' option
    If an equity investment is not held for trading, an entity can make an irrevocable election at initial
    recognition to measure it at FVTOCI with only dividend income recognised in profit or loss. [IFRS 9,
    paragraph 5.7.5]
    Subsequent measurement of financial liabilities
    After initial recognition all financial liabilities should be measured at amortised cost, with the
    exception of financial liabilities at fair value through profit or loss. These should be measured at fair
    value, but where the fair value is not capable of reliable measurement, they should be measured at
    cost.

    Question Bond
    Galaxy Co issues a bond for $503,778 on 1 January 20X2. No interest is payable on the bond, but it
    will be held to maturity and redeemed on 31 December 20X4 for $600,000. The bond has not been
    designated as at fair value through profit or loss. The effective interest rate is 6%.
    Required
    Calculate the charge to profit or loss in the financial statements of Galaxy Co for the year ended
    31 December 20X2 and the balance outstanding at 31 December 20X2.

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