Financial Instruments

• 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.
- Note that a financial instrument has two parties. It should be recognised as an asset by one party
and either a liability or equity by the other.

• Financial assets are cash, a contractual right to receive cash or another financial asset (such as shares)
with fixed monetary amount or a contract to exchange financial assets or liabilities on favourable
terms, or holdings of equity instruments (such as shares). Common financial assets include:
- Cash and timed deposits
- Trade and loan receivables
- Investments in shares issued by other entities
- A derivative that is ‘in the money’

Assets that have physical substance, such as plant and machinery, are not financial assets and
neither are intangible assets, such as patents and brands. These assets generate future economic
benefits for an entity although there is no contractual right to receive cash or another financial
asset.

• A financial liability is a contractual obligation to deliver cash or another financial asset, or a contractual
obligation to exchange financial assets or liabilities on potentially unfavourable terms.
- Examples of financial liabilities include trade payables, loans and redeemable preference shares. A
bank overdraft is a financial liability as it is repayable in cash and a derivative that is ‘out of the
money’ is also a financial liability.
- A product warranty provision would not be a financial liability because the obligation is to deliver
additional goods or services, not cash.

• An equity instrument is any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
- Holders of ordinary shares in a company (i.e. shareholders) own equity instruments.
- An entity that invests in the ordinary shares of another entity holds a financial asset.

In 20X2 an entity entered into a contract that required it to issue shares to the value of £10,000 on 1
January 20X5.
- This is a financial liability since the entity is required to settle the contract by issuing a variable number of
shares based on a fixed monetary amount.
- If the number of shares were fixed, it would not meet the definition of a financial liability and should be
presented as an equity instrument.

• The classification of financial instrument should be made at the time the instrument is issued and not
changed subsequently.
- The classification is important as it changes the perceived risk of the entity. The classification of an
instrument as a financial liability will potentially have an adverse effect on the gearing ratio of a
company and may reduce its ability to obtain further debt funding.

• Initial recognition: In general a financial asset or financial liability initially measured at fair value of
consideration received or paid.
- The general rule is that transaction costs, such as brokers’ and professional fees, should be
included in the initial carrying amount.
- The exception is that transaction costs for financial instruments classified as at ‘fair value through
profit or loss’ should be recognised as an expense in profit or loss.

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Financial Instruments
• Classification of financial assets:
Category (HALF)
Held-to-maturity investment
- These are financial assets with fixed or
determinable payments that an entity
intends (and is able) to hold to maturity
- This classification commonly includes
quoted debt securities and quoted
redeemable preference shares held as
investments.
Available-for-sale financial assets
- The term ‘available-for-sale’ is quite
strange as the majority of financial assets
under this category are going to be long-
term assets.
- This category includes all investment in
equity securities (i.e. long-term investment
in equity shares) other than those at ‘fair
value through profit or loss’.
Loans and receivables
- These are financial assets with fixed or
determinable payments, originated or
acquired, that are not quoted in an active
market, and not held for trading.
- These include accounts receivable and
loans (i.e. simple receivables) extended to
credit customers where there is no
intention to trade these receivables.
Financial assets at fair value through profit or loss
- These are financial assets and derivatives
(except those designated as hedging
instruments) acquired or held for the
purpose of selling in the short-term to
make short-term profit through a dealer’s
margin.
• Classifications of financial liabilities:
Category
Financial liability measured at amortised cost
- This is the default category
- Examples: trade creditors, loans, debenture
liabilities
Financial liabilities at fair value through profit or loss
- These are speculative derivatives
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Accounting treatment
- These are measured at amortised cost.
- Measured at fair value in the Statement of
Financial Position.
- The changes in value are recognised in
Reserves (through Other Comprehensive
Income).
- The cumulative gain or loss that was
recognised in equity is recognised in
income when an ‘available-for-sale financial
asset’ is derecognised; i.e. reserve from
gain or loss is recycled to income
statement. (Example 2)
- Loans and receivables are measured at
amortised cost.
- Provisions are no longer made for bad and
doubtful debts; instead receivables are
subject to an impairment review and
written down to their recoverable amount
(Example 3)
- These are measured at fair value in the
Statement of Financial Position.
- The changes in value are recognised in
income statement.
Accounting treatment
- Measured at amortised cost (Example 1)
- Measured at fair value in the Statement of
Financial Position
- Changes in value recognised in Income
Statement.
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Financial Instruments

Example 1: Accounting for a liability using amortised cost

Giles issues a debt instrument at discount of $500 and is redeemed at a premium of $1,075 (i.e. total of $11,075).
Nominal value of the instrument is $10,000 and redeemable in two years. Coupon rate is 2% and effective rate is
10%.

Opening balance Charge in I/S @ 10% Cash flow Y/end balance (SFP)
Year 1 9,500 (10,000-500) 950 (9,500X10%) (200) (10,000X2%) 10,250
Year 2 10,250 1,025 (200) 11,075

- If there was a issue cost of $500, instead of initial $500 discount, the result would have been same.

Example 2: Available-for-sale
Tobago purchased an investment in shares for $10,000. Transaction costs incurred were an additional $500. At the
year end, the fair value of the investment had risen to $15,000. Shortly after the year end, the asset was sold for
$16,000.

At initial recognition:
DR Financial asset $10,500
CR Cash $10,500

At year-end, ‘available-for-sale financial asset’ measured at fair value:

DR Financial asset $4,500
CR Equity reserves $4,500

On disposal cumulative gain or loss recycled to I/S from reserve:

DR Cash $16,000
CR Financial asset $15,000
DR Equity reserve $4,500
CR Income $5,500

Example 3: Impairment and amortised cost

Lagos made a three year loan of $10,000 on 1 January 2005 to a customer, requiring that the customer pay a simple
interest rate of 10% on an annual basis, and that the principal sum of $10,000 be repaid at the end of three year. The
effective rate of interest is also 10%. At the current end of 31 December 2006, all due payments have been received
as expected, but the borrower is in financial difficulty. It is now estimated that the only future cash flow will be
$5,000 in one-year’s time, i.e. three years after the date of the original advance.

1 January 2005:
DR Financial asset 10,000 (asset is classified as ‘loans and receivables’)
CR Cash 10,000

Opening balance Interest in I/S @ 10% Cash flow Y/end balance (SFP)
31.12.05 10,000 1,000 (1,000) 10,000
31.12.06 10,000 1,000 (1,000) 10,000

But, Impairment review:

PV of future cash flows = $5,000 X 0.909 = $4,545
Carrying amount = $10,000
So, Impairment loss = $10,000 - $4,545 = $5,455 (DR I/S: Impairment loss; CR Financial asset)

31.12.07 4,545 455 (0) 5,000

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Financial Instruments

• Compound financial instruments:

A compound or ‘hybrid’ financial instrument is one that contains both a liability component and an equity
component. As an example, an issuer of a convertible bond has:
- The obligation to pay annual interest and eventually repay the capital – the liability component
- The possibility of issuing equity, should bondholders choose the conversion option – the equity
component.

In substance the issue of such a bond is the same as issuing separately a non-convertible bond and an
option to purchase shares. At the date of issue the components of such instruments should be classified
separately according to their substance. This is often called ‘split’ accounting.

The amount received on the issue (net of any issue expense) should be allocated between the separate
components as follows:
- The fair value of the liability component should be measured at the present value of the periodic
interest payments and the eventual capital repayment assuming the bond is redeemed.

The present value should be discounted at the market rate for an instrument of comparable
credit status and the same cash flows but without the conversion option.

- The fair value of the equity component should be measured as the remainder of the net
proceeds.

On 1 January 20X7 an entity issued 10,000 6% convertible bonds at a par value of £100. Each bond is redeemable
at par or convertible into four shares on 31 December 20X8. Interest is payable annually in arrears. The market
rate of interest for similar debt without the conversion option is 8%.

Year Cash flow Discount factor Present value

£ £
20X7 60,000 1/1.08 55,556
20X8 1,060,000 1/1.082 908,779
Total liability component 964,335
Total proceeds (10,000 × £100) 1,000,000
Equity element 35,665

The subsequent accounting for the liability component should be as follows:

Year Opening balance Interest expense (8%) Interest paid Closing balance
£ £ £ £
20X7 964,335 77,147 (60,000) 981,482
20X8 981,482 78,518 (60,000) 1,000,000

Note how the £77,147 interest expense is greater than the £60,000 (6% × 10,000 × £100) interest paid because it
includes the amortisation of the discount attributable to the liability element. Only the interest actually paid
should be presented in the statement of cash flows.

If on 31 December 20X8 all the bond holders elect to convert into equity, then the £1 million liability should be
reclassified to equity, making £1,035,665 in total. The double entry should be:
DR Financial liability £1 million
CR Equity £1 million

If none of the bonds are converted to equity, the liability of £1 million will be extinguished by the cash
repayment. However, the amount already included in equity of £35,665 should remain there. The double entry
should be:
DR Financial liability £1 million
CR Cash £1 million

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Financial Instruments

Note that the rate of interest on the convertible will be lower than the rate of interest on the
comparable instrument without the convertibility option, because of the value of the option to
acquire equity.

The allocation should not be revised for subsequent changes in market interest rates, share prices
or other events that have changed the likelihood that the conversion option will be exercised. This
is the case even if the terms become so disadvantageous that it is extremely unlikely that the
option will be exercised.

• The scope of IAS 32 is that it applies to all entities and to all types of financial instruments except
where another standard is more specific.

Greatdane plc acquired 40,000 ordinary shares in Subtime Ltd which represents 80% of its issued ordinary share
capital. Whilst these ordinary shares are a financial asset of Greatdane, IAS 32 (and IAS 39) does not apply; the
provisions of IAS 27 Consolidated and Separate Financial Statements should be applied.

In the separate (company only) financial statements of Greatdane plc, IAS 27 allows a choice of accounting
treatment. The investment may be accounted for either at cost or in accordance with IAS 39 (as a financial asset).

In practice most companies account for investments in subsidiaries, associates and jointly controlled entities at
cost in their separate financial statements.

• When equity shares are issued, the transaction costs should be deducted from equity, net of any
related income tax benefit.
- The transaction costs to be deducted are only those incremental costs attributable to the equity
transaction that otherwise would have been avoided.
An entity issued 100,000 new £1 ordinary shares which have a fair value of £2.50 per share for cash. Professional
fees in respect of the share issue were £50,000 and are deductible for tax purposes. The tax rate is 40%. The
management of the entity estimates that costs incurred internally for time incurred working on the share issue
are £25,000.

How should these transactions be recorded in the financial statements?

Solution:
The internal costs should be recognised as an expense in profit or loss as they were not incremental costs; they
would have been incurred in any event. The professional fees were directly attributable to the transaction and
£30,000 should be deducted from equity (£50,000 net of 40% tax).

The double entry to record this transaction should be:

DR Cash (£250,000 less £50,000) £200,000
DR Tax liability (£50,000 × 40%) £20,000
CR Share capital £100,000
CR Share premium ((100,000 × (£2.50 less £1.00)) less £50,000 × 60%) £120,000

• Treasury shares: Equity instruments reacquired by the entity which issued them are known as treasury
shares. The treatment of these treasury shares is that:
- They should be deducted from equity (from retained earnings, not from share capital or share
premium!)
- No gain or loss should be recognised in profit or loss on their purchase, sale, issue or cancellation.
Consideration paid or received should be recognised directly in equity
- The amount of treasury shares held should be disclosed either in the statement of financial
position or in the notes to the financial statements in accordance with IAS 1 Presentation of
Financial Statements.

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Financial Instruments

Treasury share:
An entity entered into a share buyback scheme. It reacquired 10,000 £1 ordinary shares for £2 cash per
share. The shares had originally been issued for £1.20 per share.

The entity should record the reacquired shares as a debit entry of £20,000 in equity. The original share capital
and share premium amounts of £10,000 and £2,000 remain unchanged.

• Preference shares:
Preference shares provide the holder with the right to receive an annual dividend (usually of a
predetermined and unchanging amount) out of the profits of a company, together with a fixed amount on
the ultimate liquidation of the company or at an earlier date if the shares are redeemable. The legal form of
the instrument is equity.

In substance the fixed level of dividend is interest and the redemption amount is a repayment of a loan.
Because financial reporting focuses on the substance of the transactions, redeemable preference shares
should be presented as liabilities. In practical terms, only irredeemable preference shares are included in
equity.

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Financial Instruments

• A derivative is a financial instrument or other contract within the scope of IAS 39 with all three of the
following characteristics:
i. Its value changes in response to an underlying item; e.g. the change in a specified interest rate,
financial instrument price, commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index, or other variable, provided in the case of a non-financial variable
that the variable is not specific to the party to the contract (sometimes called the 'underlying').
ii. It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors; and
iii. It is settled at a future date.

Example: Derivative
A contract sold for £20; this requires the fixed payment of £1,000 if a commodity price increases by 5%. This is
a derivative because:
i. Its value changes as the commodity price changes
ii. It requires a small initial investment in comparison to contracts that would be expected to have a
similar response
iii. It is settled at a future date

Example: Derivative
Swapper (ER) Ltd enters into an interest rate swap with Swappee (EE) Ltd that requires ER to pay a fixed rate of
6% and receive a variable rate of three-month LIBOR, reset on a quarterly basis. The fixed and variable
amounts are determined based on a £10 million notional amount. The notional amount is not exchanged, but
ER pays or receives a net cash amount each quarter based on the difference between 6% and three-month
LIBOR, reset quarterly.

The contract meets the definition of a derivative because:

(i) there is no initial net investment (there is only a small initial cost)
(ii) settlements occur at future quarterly dates, and
(iii) the underlying variable is LIBOR, which changes over time.

Identify which of the following are financial instruments, financial assets, financial liabilities, equity
instruments or derivatives and for which party.
i. Offertake Ltd sells £5,000 of inventory to Guideprice Ltd on 30 day payment terms.
ii. Ashdell Ltd pays £20,000 in advance for a twelve month insurance policy.
iii. Tollbar Ltd enters into a contract to sell $400,000 in six months' time for £280,000.
iv. Wellbeck Ltd issues 100,000 ordinary shares which are acquired by Keeload Ltd.
v. Cashlow plc borrows £200,000 under a mortgage from Norbert plc.

Answers:
i. The inventory is not a financial instrument as it is a physical asset. Guideprice Ltd should
recognise a trade payable in its financial statements; this is a financial liability because there is a
contractual obligation to pay the amount in cash. Conversely, Offertake Ltd records a trade
receivable for £5,000, which is a financial asset as it has the contractual right to receive cash.
ii. Ashdell Ltd has paid for services in advance. The £20,000 should be recorded as a prepayment.
The future economic benefit is the right to receive insurance services rather than cash, ordinary
shares or another financial asset. Therefore, prepayments are not financial instruments.
iii. Tollbar Ltd has entered into a forward currency contract. The contract is a derivative financial
instrument as it is linked to an underlying variable (the $/£ exchange rate), which requires no
initial investment and is due for settlement in six months time. At inception it will have no value
so is neither an asset nor liability.
iv. The ordinary shares are an equity instrument of Wellbeck Ltd as they give the holder a residual
interest in the assets of Wellbeck Ltd after deducting the liabilities. The ordinary shares are a
financial asset of Keeload Ltd.
v. Cashlow plc has entered into a mortgage. The contractual obligation to repay £200,000 to
Norbert plc is a financial liability. Norbert plc has a financial asset as it has the contractual right to
receive £200,000 cash.

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Financial Instruments

• When a derivative financial instrument gives one party a choice over how it is settled, it is a financial
asset or a financial liability unless all of the settlement alternatives would result in it being an equity
instrument.
A company has issued a share option that allows it to offer cash in settlement or to issue a variable number of
equity shares instead.

This is a financial liability as the derivative has alternative settlement options which are not equity. The share
option would be classified as a financial liability even if the choice of settlement as cash or equity shares was at
the option of the holder.

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