LESSON : FINANCIAL INSTRUMENTS (IAS 32, IFRS 7 and IFRS 9)
Focus Area
• Financial Instruments
• Financial Assets
• Financial liability
• Examples
Financial Instruments (IAS 32, IFRS 7 and IFRS 9)
Financial instruments are essentially contracts that give rise to financial assets of one entity
and financial liabilities or equity instruments of another entity. They are recognized and
measured in accordance with the standards set by the International Financial Reporting
Standards (IFRS), which include IFRS 7, IFRS 9, and IAS 32.
A Financial Instrument is any contract that gives rise to both a financial asset in one entity and
a liability or equity instrument in another entity.
IAS 32 actually focused on the "Issuer" of a financial instrument. Financial instrument of a
company will either create an asset in its book or liability or equity instrument.
Financial instruments can be broadly categorized into:
• Financial Assets
• Financial Liabilities
• Equity Instruments Financial Assets:
FINANCIAL ASSETS
A financial asset is cash, a contractual right to receive cash or another financial asset, a
contractual right to exchange financial assets or liabilities with another entity on potentially
favourable terms, or an equity instrument, for example shares, of another entity. IAS 32 Para
11.
Any contract that gives a company the contractual right to receive cash or any other form of
settlement in a way that favours it is basically a financial asset.
For example: Emperor purchased N25 Million corporate bond of Dangote PLC. The bond has
a 15% interest rate and a maturity period of 5 years.
From the above, you will agree with me that the investment in the bond of Dangote is an asset
to the buyer (EMPEROR) and a liability to the issuer (Dangote).
EMPEROR has contractual rights to receive cash in the form of interest payment and principal
repayment at maturity of the bond.
That is why it is said that a financial instrument will create a financial asset in one entity and
at the same time a financial liability or equity instrument in another entity. The above example
created a financial asset in the book of EMPEROR and a financial liability in the book of
Dangote.
The entity expecting to receive payment as a result of investing in another entity will recognise
that investment as a financial asset while the other party expected to be paying this money will
recognise a financial liability in her books.
So, going by this explanation, we can also say that, if I have sold goods and I am yet to be paid,
me that is expecting the money which is otherwise called receivable already had a financial
asset while the person owing me automatically has a financial liability.
In summary, if you are expecting a payment you have a financial asset but if you have an
obligation to make then you have a financial liability.
That is all about Financial Asset.
FINANCIAL LIABILITY
It may interest you to know that we already discussed financial liability because anything that
creates an asset in your account has already create a liability in the other party's account.
This is basically an obligation to deliver cash or any other financial instrument under
potentially unfavourable terms. Just the opposite of financial assets.
Example: Trade Payables, Loans and Debentures, Redeemable preference shares etc. How is
it under potentially unfavourable terms???
It is not favorable because it's going to lead to an outflow of cash. No matter how buoyant a
company is, a company will rather prefer to increase her cash than reduce the cash in their
account. A very good example is a company that has collected VAT on behalf of govt would
not like to pay it not until the law catches up on the person .
EQUITY INSTRUMENTS
Any contract that evidences a residual interest in the assets of an entity after deducting all of
its liabilities.
Residual in this context means what is left for owners after other class of stakeholders have
been settled.
Since it combines two features at the same time, the question now is, where should we
classify/present it in our balance sheet? Should we present it under the Liability section or
Equity Section? Since they are not separated, it poses a problem.
IAS 32 stipulates that a compound financial instruments should be split / divided into their
components parts and thereafter present each under respective section.
Please note that the classification and presentation of financial instruments in the books is based
on the substance of the transaction rather than the legal form. A company is expected to look
critically at the reality of the contract/transaction rather than just the legal form.
Substance over form is used to ensure that financial statements give a complete, relevant, and
Accurate picture of transactions and events. Substance over form is critical for reliable financial
Reporting.
For example: A redeemable preference share is not an equity instrument even though it is a
form of shares. It is a liability.
Why is it a liability?
It is a liability because the company is under obligation to redeem/buyback the shares at a
future date and deliver cash (preference dividend) to the preference shareholders. You will
realize that the redeemable preference shares is looking like a debt e.g Loan.
Unlike Irredeemable preference shares which does not necessarily create an obligation to either
pay dividend or redeem the shares. This will be presented as an equity instrument.
Now let's look at the impact of wrong classification
Remember that in presenting a financial instrument, substance over form is what must be
considered. Presenting a financial instrument as an equity when it was actually meant to be
presented as a liability will create a problem.
Example: An entity has a financial instrument which qualifies to be called a financial liability.
However, this was wrongly presented as an equity instrument in the balance sheet.
What is the effect of this wrong presentation?
1. [Link] means the liability section has been understated while the equity portion is now
overstated.
2. Since liability has been understated, the gearing level or debt to equity ratio will also be
impacted.
3. Since liability has been wrong classified as equity, it means the finance cost or
related/associated liability expenses charged to the income statement will be understated.
4. Profit for the year in the statement of profit or loss will be affected too cos of the fact that
finance cost on liability would have been understated.
5. As a result of wrongly classifying the liability as part of equity, KPIs that make use of
equity will also be impacted.
Let's note the above. It's very very examinable. The impact of wrong classification on our
financial statement.
CASE 1
PSHAN having obtained licence to operate as an NGO issued a N10 miilion 6℅ convertible
bond at par redeemable after 4 years or can be converted at any time up to that date into 20
ordinary shares for every N100 bond. The market rate of interest for similar bond with no
conversion option is 8℅.
Required: Show how the above will be presented in the SOFP of PSHAN (show your
workings).
IFRS 9 (IAS 39): RECOGNITION AND MEASUREMENT
To refresh our memory, we discussed financial instruments is broadly categorized into:
• Financial Assets
• Financial Liabilities
• Equity Instruments
So, how do we classify, recognize and measure these instruments?
RECOGNITION PRINCIPLE
Financial instruments should be recognised in the statement of financial position when the
entity becomes a party to the contractual provisions of the instrument. This means that you can
only recognize a financial instrument if you have a contractual right to receive/deliver cash or
other financial assets.
Financial assets and financial Liabilities are initially measured at fair value. However,
subsequently, an entity can now decide to measure at either fair value or amortized cost
depending on some factors.
IFRS 9 classifies financial assets into two of:
1. Financial assets measured at amortised cost
2. Financial assets measured at fair value through profit or loss
3. Financial assets measured at fair value through other comprehensive income
This is a simplified classification compared to IAS 39 which classified financial assets into
four types below:
1. Financial Assets at Fair Value Through Profit or Loss
2. Held to Maturity Financial Assets
3. Loans and Receivables Financial Assets
4. Available for Sale Financial Assets.
To make it easier to remember, the acronym is H.A.L.F
IFRS 9 classification is made on basis of both:
• The entity’s business model for managing the financial assets, and
• The contractual cashflow characteristics of the financial assets
INITIAL MEASUREMENT
Initially recognise at fair value plus transaction costs. Where an entity holds investments in
equity instruments that are not quoted in an active market and it is not possible to determine
their values reliably, they should be measured at cost.
SUBSEQUENT MEASUREMENT
Equity instruments
Fair value through profit or loss (default)
Re-measure to fair value at the reporting date, with gains or losses through profit or loss.
Fair value through other comprehensive income
If there is a strategic intent to hold the asset for the long term, then the option to hold at fair
value through other comprehensive income is available. Re-measure to fair value at reporting
date, with gains or losses through other comprehensive income.
DEBT INSTRUMENTS
Amortised cost
A financial asset is measured at amortised cost if it fulfils both of the following tests:
‣ Business model test – intent to hold the asset until its maturity date; and,
‣ Contractual cash flow test – contractual cash receipts on holding the asset.
If the contractual cash flow test is satisfied but there is no intention to hold the asset until
maturity then the financial asset is held as fair value through other comprehensive income.
Note: The financial asset may still be measured using fair value through profit or loss, even if
both tests are satisfied, if it eliminates an inconsistency in measurements (fair value option).
DERECOGNITION
Financial assets are derecognised when sold, with gains or losses on disposal through profit
or loss or OCI.
However, note that, if equity investments are held at fair value, with gains or losses going
through OCI, then gains and losses are NOT recycled to profit or loss on disposal of the
investment.
FINANCIAL LIABILITY
This is any liability that is a contractual obligation to deliver cash or other financial asset to
another entity.
Initial measurement
Initially recognise at fair value net of transaction costs (‘net proceeds’)
Subsequent measurement
• Amortised cost
• Fair value though profit or loss
Derecognition
Financial liabilities are derecognised when they have been paid in full or transferred to another
party.
Compound Financial Instruments
These are financial instruments that have both equity and liability components. IAS 32 requires
that compound financial instruments should be classified into two components and reported
separately.
IMPAIRMENT OF FINANCIAL ASSETS
At each year end, an entity should assess whether there is any objective evidence that a financial
asset or group is impaired. The impairment is the difference between the asset’s carrying
amount and its recoverable amount. The asset’s recoverable amount is the P.V of the estimated
future cash flows, discounted at the instrument’s original effective interest rate. The amount of
impairment is recognised in the SOPL.
Convertible Debentures
If a convertible instrument is issued, the economic substance is a combination of equity and
liability and is accounted for using split equity accounting.
The liability element is calculated by discounting back the maximum possible amount of cash
that will be repaid assuming that the conversion doesn’t take place. The discount rate to be
used is that of the interest rate on similar debt without a conversion option.
The equity element is the difference between the proceeds on issue and the initial liability
element.
The liability element is subsequently measured at amortised cost, using the interest rate on
similar debt without the conversion option as the effective rate. The equity element is not
subsequently changed.
Issue costs associated with the issue are recognised by adjusting the effective rate of interest
on the debenture.
TEST YOUR UNDERSTANDING
CASE 2
On 1 January 2022 Afeez Adebimpe & Co purchased a bond with a N200,000 nominal value
at a discount of 5% and incurred N15,000 in relation to the purchase of the bond. The nominal
interest rate is 12% and is receivable annually in arrears while the effective interest rate is 15%.
The bond will be redeemed at a premium of N8,000
Required to determine the value of the bond or financial assets upon initial recognition on 1 st
January 2022.
CASE 3
On 1 January 2023 Bolu Plc bought a bond of N500,000 at a premium 2% and alsos incurred
N20,000 in relation to the purchase of the bond. The nominal interest rate is 16% and is
receivable annually in arrears while the effective interest rate is 10%.
Required to determine the value of the bond or financial assets upon initial recognition.
CASE 4
On 1st of Jan 2020, Abia Plc's had a financial asset with a fair value of N5000 designated for
trading. On 31st December, it was remeasured and had a fair value of N7000. How will the
above be accounted for in the books?
CASE 5
Queen purchased a financial asset on 1st January, 2021 and classified it as measured at
Amortised cost.
Terms:
Nominal value N50m
Coupon rate 10%
Term to maturity 3years
Purchase Price N48m
Effective I. rate 11.67%
CASE 6
A company purchased a financial asset for ₦30,000 plus 1% transaction costs on 1 April 2016.
It classified this asset as available for sale.
At the end of the financial year (31 December 2016) the investment was ₦40,000. On 11
January 2017 the asset was sold for ₦50,000.
CASE 7
Chioma Ltd on 1st of January 2018 purchase a financial asset that is worth N200,000. This
financial asset has been designated at fair value through profit or loss. On 31st December, a
remeasurement was carried out and it was discovered that the financial asset now has a fair
value gain of N20,000. Transaction cost of N5,000 was incurred when the financial asset was
bought in January.
Required:
(a) Show how the above will be treated in the books of Chioma Ltd.
(b) what would your answer have been if the asset was measured at fair value through OCI.
CASE 8
On 25th July 2022, Olatunji Plc acquires 1,000 shares of First Bank Plc for $10 per share. It
also incurred a transaction costs (incremental costs that are directly attributable to the
acquisition) of $400 on the same date. The stock market price of the shares develops as follows:
31st December 2022 $10,000
31st December 2023 $9,500
31st December 2024 $9,000
31st December 2025 $9,600
31st December 2026 $11,800
31st December 2027 $11,500
31st December 2028 $13,000
Required to show the accounting entries and the financial statement extract over the relevant
period.
Assume that the shares do not meet the definition of “held for trading” (i.e Olatunji Plc always
measures shares at fair value through OCI)
