Financial Instruments ( Part 1)

Financial Instruments ( Part 1)

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DEFINITION:

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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 (IAS 32, para 11)

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There are two kinds of financial instruments:

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1.????Financial Assets.

·??????Cash

·??????An equity instrument to receive cash or another financial asset from another entity.

·??????A contractual right to exchange financial instruments with another entity under conditions that are potentially favorable to the entity.

·??????A non-derivative contract for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments ( IAS 32, para 11)

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2.????Financial Liability

·??????A contractual obligation to deliver cash or another financial asset to another entity.

·??????A contractual obligation to exchange financial instruments with another entity under conditions that are potentially unfavorable to the entity.

·??????A non-derivative contract for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments.

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What is Equity Instrument:

An equity instrument in “ any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities” IAS 32, para 11.

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There are three reporting standard that deals with Financial Instrument.

1.?????IAS 32 Financial Instrument: for its presentation and classification into debt and equity.

2.?????IFRS 7 Financial instruments: Disclosures in financial statements.

3.?????IFRS 9 Financial Instruments : for its initial and subsequent measurement in financial statements.

Important note: It is crucial to?correctly recognize the Financial liability or Equity at its inception according to its substance and definition provided as per IAS 32.

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Interest and dividends

·??????Interest received and paid will be charged to P&Loss .

· Dividends, if paid on behalf of preference shares, are charged to P&L otherwise if paid?on behalf of equity be classified into statements of changes and equity.

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Offsetting:

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According to IAS 32 financial assets and financial liabilities may only be offset if :

·??????Has a legally enforceable right to set off the amounts.

·??????Intends either to settle on a net basis or to realize the asset and settle the liability simultaneously. (IAS 32, para 42)

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Recognition and measurement of Financial Liabilities

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All the financial liabilities will be initially measured at fair value.

Transaction cost:

1.?????Fair value through P&L (expensed out immediately)

2.?????Amortized cost (deducted from its carrying amount)

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Subsequent Measurement:

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There are two ways you can measure your financial liabilities.

1.?????Fair value through Profit & Loss (Transaction cost will be expensed out to P&L)

This will only be done if the entity wants to hold them for trading purposes or it would eliminate the accounting mismatch. If that is the case its movement in fair value will be bifurcated in two parts.

·??????Fair value changes due to the entity’s own credit risk. (change for this part will be reported to other comprehensive income)

·??????The remaining fair value change, which is presented in profit and loss.

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2.?????At amortized cost: If the entity wants to hold it till maturity then it will use this method.

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Most liabilities?such as borrowings are subsequently measured at amortized cost using the effective interest rate method.

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*Effective rate: Market rate at which others same kind of bonds are paying interest.

*Coupon rate: At the rate at which entity is paying interest.

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For example an entity issues loan notes at rate 6%?and redeem at premium. The same kind of bond is available at market paying interest of 8%.

*Effective rate is 8%

*Coupon rate is 6%.

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Compound Instruments

A compound instrument is a financial instrument that has characteristics of both equity and liabilities. An example would be debt that can be redeemed either in cash or in a fixed number of equity shares.

According to IAS 32 it has to be split in two components .

A financial liability (Present values of the repayment of interest and capital discounted at market rate of interest instead of coupon rate.)

An equity instrument (option to convert into shares, the residual part after deducing the liability portion.

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Important note: If there is a issue cost then it will be deducted from both equity and financial liability on prorate basis.

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Subsequent Measurement

1.?????Financial Liability: It will be then measured at amortized cost.

2.?????Equity portion: it will be unchanged until conversion.

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This method of working is also called SPLIT ACCOUNTING.

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Financial Assets.

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Initial Recognition of Financial Assets.

According to IFRS 9 entity should recognize a financial asset “when, and only when, the entity becomes a party to the contractual provisions of the instrument” IFRS 9 para 3.1.1

Accounting for Investment in Equity Instruments.

There are two ways you can recognize investment in equity instruments.

1.?????Fair value through profit and loss (FVPL)

2.?????Fair value through other comprehensive income (FVOCI)

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Fair value through profit and loss (FVPL)

By default equity Instruments will be recognized at FVPL. Initially, it will be measured at fair value and incurred cost will be charged to P&L . And will be remeasured on reporting date and gain/loss will be charged to P&L directly.

Fair value through other comprehensive income (FVOCI)

It is possible to use this method, if met the criteria below.

1.?????The equity instrument must not be held for Trading.

2.?????There must be an irrevocable choice for this designation upon initial recognition.

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Initially, equity instrument will be recorded at fair value plus transaction cost. Then at the reporting date it will be re measured and Gain/loss will be taken to other comprehensive income.

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Summary:

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Investment in in equity:

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Fair value through other comprehensive income can be used if:

·??????Not held for sale, trade and

·??????Irrevocably designated.

????Or by Default

·??????Fair Value through Profit and Loss

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Accounting for Investment in Debts

There are three methods available for measuring.

1.?????Fair Value through Profit & Loss (FVPL)

2.?????Fair value through other comprehensive income (FVOCI)

3.?????Amortized cost. (Accrual based Method)

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For FVPL and FVOCI there are two tests that must be passed for this recognition.

1.?????Business Model test: The entity will collect the asset’s contractual cash flow instead of selling it.

2.?????Contractual Terms: Contractual cash flow will be solely from capital and interest.

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Measurement

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For FVOCI and amortized cost model, it will initially be measured at fair value plus transaction cost. Interest income is calculated using effective rate of interest.

FVOCI- it will be remeasured at reporting date and gain and loss will be charged to other comprehensive income. This will be reclassified at asset’s disposal.

FVPL- It will be initially measured at fair value with transaction cost will be charged to P&L. At reporting date it will be remeasured and gain/loss will be charged to P&L . Same will be done at the time of disposal.

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Summary

Investment in debts

Amortized cost if:

·???????Contractual cash flow test passed.

·???????Business model is to hold till maturity.

FVOCI if:

·???????Contractual cash flow test passed.

·???????Business model is to hold till maturity and selling.

FVPL if not measured at:

·??????Amortized cost

·??????FVOCI

Impairment of Financial Assets:

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Definition:

The difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flow that the entity expects to receive?(i.e all cash shortfalls), discounted the original effective interest rate

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There are two kinds of credit loss.

1.????12 Month credit loss (less risk)

2. Lifetime credit loss (Significant risk)

?IFRS 9 Financial instruments require a loss allowance to be recognized on investments in debt that are measured at amortized cost or fair value through other comprehensive income.

If credit risk has not increased significantly since the initial recognition, the loss allowance should be equal to a 12-month expected credit loss. If credit risk has increased significantly, the loss allowance must be equal to lifetime loss.

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When the financial asset is measured at fair value through other comprehensive income, then the loss allowance is not adjusted against the asset’s carrying amount (otherwise the asset will be held below fair value) unless financially impaired.

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Please note that if an investment is impaired already then, the interest income is calculated on the impaired value of the investment, not on all the amounts.

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Simplifications:

IFRS 9 permits some simplifications:

·??????The loss allowance should always be measured at an amount equal to lifetime credit losses for trade receivables and contract assets?( recognized in accordance with IFRS 15 Revenue from Contracts with customers) if they do not have a significant financing component.

·??????For lease receivables, as well as trade receivables and contract assets with a significant financing component, the entity chooses as its accounting policy to measure the loss allowance at an amount equal to lifetime credit losses.

?Impairment reversals

At each reporting date, the loss allowance is recalculated.

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Gains or losses on remeasurement of the loss allowance are recorded in Profit and loss.

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