Financial Instruments

• Financial instrument


  Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity
• Financial Asset


  Any asset that is: Cash; or A contractual right to receive cash or another financial asset from another entity; or A contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable; or An equity instrument of another entity; or Contract that will or may be settled in the entity's own equity instruments (e.g. derivatives)
• Financial Assets


  • Trade receivables, options and shares (as an investment)
• Not financial assets


  Physical assets, inventories, prepaid expenses and income taxes (legal obligation)
• Financial Liability


  Any liability that is a contractual obligation: To deliver cash or another financial asset to another entity; or to exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable; or that will or may be settled in the entity's own equity instruments
• Financial Liabilities


  • Trade payables, debenture loans and redeemable preference shares, forward contract (loss position)
• Equity instrument


  Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities
• Equity instruments


  • An entity's own ordinary shares, warrants and irredeemable preference shares
• Classification of financial instrument

  • Should be based on substance of the contract (based on definition of financial liability vs equity)
  • Financial liability has the feature of a contractual obligation by the issuer to deliver cash or another financial asset; if it doesn't, it will be classified as an equity instrument
• Irredeemable preference shares


  If they contain no obligation to make any payment, either of capital or dividend, they are classified as equity
• Redeemable preference shares


  They are classified as a financial liability
• Compound financial instrument


  'Hybrid' financial instrument is one that contains both a financial liability component and an equity component
• Compound financial instruments


  • Convertible loan notes and convertible bonds
• Accounting for compound financial instruments

  1. Split the equity and financial liability portion

  2. Liability is measured at its fair value (present value of future cash flows discounted using market rate of interest for non-convertible debt)

  3. Equity element is equal to the loan proceeds less the calculated liability element

  4. Transaction costs are allocated to the liability and equity components in proportion to the allocation of the proceeds

  5. Subsequently, liability measured at amortised cost (initial liability value + market interest rate - interest paid)

  6. Equity portion - remain at the same value in SFP as a reserve until debt is redeemed
• Offsetting financial assets and liabilities

  Can offset if: the entity has a legal right of offset; and the entity intends to settle on a net basis
• Offsetting


  • A company has several accounts with a single bank, some of which are in credit and some overdrawn
• Credit and overdrawn bank balances would not set them off against each other (even if it had the legal right to do so) because in the normal course of business it is keeping these accounts separate, so it cannot claim that it 'intends' to settle on a net basis
• Treasury shares


  • If an entity reacquires its own equity instruments, the amount paid is presented as a deduction from equity rather than as an asset
  • No gain or loss is recognised in profit or loss on the purchase, sale, issue or cancellation of an entity's own equity instruments
  • Any premium or discount is recognised in reserves
• IFRS 9 - Recognition of financial assets and liabilities

  1. An entity will recognise a financial asset (FA) or financial liability (FL) on its statement of financial position when it becomes a party to the contractual provisions of the instrument rather than when the contract is settled

  2. FA or FL is initially measured at Fair Value plus / minus transaction costs

  3. If FVTPL, transaction costs are recognised in the Income Statement

  4. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability

  5. The fair value at initial recognition is normally the transaction price, i.e. the amount of consideration given or received. If the transaction is not based on market terms, the entity shall recognise the difference between the fair value at initial recognition and transaction price in profit or loss
• IFRS 9 - Classification of financial assets

  • On recognition, IFRS 9 requires that financial assets are classified as measured at either: Amortised Cost (AC), Fair Value through Other Comprehensive Income (FVOCI), or Fair Value through Profit or Loss (FVTPL)
  • Business Model for Managing the FA (Business Model Test)
  • Contractual cash flow characteristics of the FA (SPPI Test)
• Amortised cost


  Business Model - Hold the debt in order to collect contractual cash flows and not to sell; and SPPI Model (pass) - cash flows that are solely payments of principal and interest on the principal outstanding
• Fair value through other comprehensive income

  Business Model - Hold the debt in order to collect contractual cash flows and selling the debt; and SPPI Model (pass) - cash flows that are solely payments of principal and interest on the principal outstanding
• Fair value through profit or loss


  Business Model - is not that of 'hold to collect' or 'hold to collect and sell' / Held for trading; or SPPI Model (fail) - cash flows that are not solely payments of principal and interest on the principal outstanding
• Equity instruments


  Investments in equity instruments are measured at either: FVTPL - by default, or FVOCI - equity instrument must not be held for trading and must have been an irrevocable choice for this designation upon initial recognition of the asset
• Amortised cost


  If a debt instrument is held at amortised cost, the interest income (calculated using the effective interest) will be taken to the statement of profit or loss, and the year-end asset value is similarly calculated using an amortised cost table
• Financial Liabilities


  Measured at either: FVTPL - Held for trading or designated at fair value through profit or loss to eliminate accounting mismatch, or Amortised Cost using effective interest method
• IFRS 7 - Financial Instruments Disclosures

  The major elements of disclosures required are: The carrying amount of each class of financial instrument should be recorded either on the face of the statement of financial position or within the notes, Items of income, expense, gains and losses for each class of financial instrument either in the statement of profit or loss and other comprehensive income or within the notes, Disclosures regarding the nature and extent of risks faced by the entity - this must cover the entity's exposure to risk, management's objectives and policies for managing those risks and any changes in the year
• UK GAAP (FRS 102) has two sections on financial instruments - Basic Financial Instruments and Other Financial Instruments Issues, while IFRS 9 makes no such distinction
• UK GAAP (FRS 102) only allows for amortised cost and FVTPL measurement, while IFRS 9 also allows for FVOCI